Sant Uk.10te% Regulatory News (SAN)

Santander UK plc

OPERATIONAL RISK (unreviewed)

Definition

Operational risk is the risk of loss to the Group, resulting from inadequate or failed internal processes, people and systems, or from external events. This includes regulatory, legal and compliance risk. Such risks can materialise as frauds, process failures, system downtime or damage to assets due to fire, floods for example. When such risks materialise they have not only immediate financial consequences for the Group but also an effect on its business objectives, customer service and regulatory responsibilities.

Objective

As operational risk is inherent in the processes the Group operates in order to provide services to customers and generate profit for investors, an objective of operational risk management is not to remove operational risk altogether but to manage the risk to an acceptable level, taking into account the cost/benefits of minimisation as opposed to the inherent risk levels.

The Operational Risk Framework

Operational risk exposures arise across the Group's business divisions and operating units, and are managed on a consistent basis. The aim pursued by the Group in operational risk management is to identify, measure/assess, control/mitigate and inform regarding this risk. The Group's priority is to identify and minimise the risk of loss wherever appropriate, irrespective of whether losses have occurred. Measurement of the risk also contributes to the establishment of priorities in operational risk management, and includes the use of such methods as:

The operational risk framework creates the consistent approach to how the Group controls and manages its operational risks and helps everyone understand their responsibilities within this approach. The operational risk framework is a core component of the overall risk framework and crucially involves the setting of risk appetite, risk and issue escalation processes, and underpins management approaches to the control environment. The framework facilitates the ongoing reassessment of risk, appetites and controls, in order to ensure that the Group manages its risks at all times in line with its business objectives.

Further enhancements to the risk framework have been approved by the Board during 2012 with the aim of extending the methods for managing operational risks increasing the transparency of risk management, and producing a tighter internal control framework which enhances the assurance that risks are being managed consistently and appropriately across the business.

For the purpose of calculating capital for operational risk, the Group employs the standardised approach provided for under Basel II rules in line with the Banco Santander, S.A. group. The Group also uses its operational risk data and especially its stress and scenario data to assess its capital adequacy.

Managing operational risk

The framework defines the operational risk requirements to be adhered to. The Group obtains assurance that the appropriate standards of risk management are being maintained through the application of the Group's risk governance framework as follows:

This approach applies throughout the Group and is implemented taking account of the materiality and perceived risk of the different business areas by using the following key operational risk management techniques:

Scenario Analysis

The Group performs simulations of control failures that may cause the most extreme loss events. These simulations are developed around high impact risks likely to exceed the Group's future appetite. The scenario analysis allows management to better understand the potential impacts and remediate issues:

Risk and Control Self Assessments

Business units identify and assess their operational risks to ensure they are being effectively managed and controlled, and actions prioritised and aligned to the Group's risk appetite.

Key Risk Indicators

The Group uses key risk indicators to monitor, and mitigation strategies to manage, operational risks. Indicator metrics are used to provide insight into the changing risk profile of the organisation and are also used to assess the performance of key controls.

Key risk indicator performance is monitored against tolerances and trigger points that prompt an early warning to potential exposures, whilst the creation of mitigation strategies help address potential concerns.

Loss Data Management

Loss data capture and analysis processes exist to capture all operational risk loss events. The data is used to identify and correct control weaknesses using events as opportunities to prevent or reduce the impacts of recurrence, identify emerging themes, inform risk and control assessments, scenario analysis and risk reporting. Escalation of single or aggregated events to senior management and risk fora is determined by threshold breaches.

Reporting

Reporting forms an integral part of operational risk management ensuring that issues are identified, escalated and managed on a timely basis. Exposures for each business area are reported through monthly risk and control reports which include details on risk exposures and mitigating plans. Events that have a material impact on the Group's finances, reputation, or customers are prioritised and reported immediately to key executives.

Measurement

A high proportion of the Group's operational risk events have a low financial cost associated with them and only a very small proportion have a material impact. Operational risk loss events are categorised using the international Basel standards as follows:

2012 operational risk loss profile

The percentage distribution of the value and number of loss events by event type during first half of 2012 is shown in the table below:

http://www.rns-pdf.londonstockexchange.com/rns/1551L_1-2012-8-30.pdf 

In the first half of 2012, 70% of operational risk events fell within execution, delivery and process management category and yet these accounted for only 8.1% of the losses by value. In contrast, over 75% of losses by value were caused by only 13% of operational risk events. These principally represented payouts on the sales of payment protection insurance ('PPI') products under the 'clients, products and business practices' category. See Note 25 to the Condensed Consolidated Interim Financial Statements for more information on PPI. This demonstrates the critical operational risk challenges for the Group in reducing the volume and impact of operational risk events (some of the Company's critical responses are contained in its approach to service quality and conduct risk - see section on customer risk activity below).

Key operational risk activity in the first half of 2012

Santander UK manages its key operational risks in the interest of all its stakeholders, responding to critical developments both within the Group and in the environment in which it operates. Below are some of the key risks and the activities undertaken to manage them during the first half of 2012.

Financial crime risk

Financial crime risk is the risk of reductions in earnings and/or value, through financial or reputational loss, associated with financial crime and failure to comply with related legal and regulatory obligations, these losses may include censure, fines or the cost of litigation.

The Group has continued to invest in staff education and improved fraud detection and prevention systems, processes and controls in order to counter the increasing threat of financial crime and to safeguard the investments of the Group's customers and assets. The introduction of sophisticated chip and pin terminals at counters in the Group's retail branches, for example, has reduced the risk of fraudulent account takeovers by organised criminals by enhancing our customer identification protocols in a customer-friendly manner.

The Group Financial Crime Team and Fraud Oversight function continually monitor emerging fraud trends and losses on a case-by-case basis. Action plans are formulated and tracked to ensure root causes have been identified and effective remediation conducted.

Losses and prevention strategies deployed in response to financial crime are escalated to the Executive Risk Committee as appropriate.

Cyber security risk

Cyber security risk is the risk of reductions in earnings and/or value, through financial or reputational loss, associated with the failure of electronic information security or failure to comply with related legal and regulatory obligations. These losses may include censure, fines or the cost of litigation.

All customer, employee and Group data is considered confidential and appropriate security is applied to protect it. The Group continues to invest in the protection of customer, employee and Group information to reduce the risks associated with the loss of confidentiality, integrity and of availability of this information. Measures taken to reduce the risks include staff education, data encryption and the deployment of specialist software such as Rapport which identifies when internet banking customers are at risk of disclosing information to unauthorised parties.

Losses and prevention strategies deployed in response to cyber security are escalated to the Executive Risk Committee as appropriate.

Human resources risk

The risk of reductions in earnings and/or value, through financial or reputational loss, from inappropriate colleague actions and behaviour, industrial action, legal action in relation to people, or health and safety issues. Loss can also be incurred through failure to recruit, retain, train, reward and incentivise appropriately skilled staff to achieve business objectives and through failure to take appropriate action as a result of staff underperformance.

The Group takes a robust approach to managing human resources risk in full alignment with the operational risk framework. The Group has a mandatory training suite and policies which set out minimum standards and aim to mitigate risk in the areas of:

Conformance to policies is monitored through a comprehensive committee structure which reviews and actions enhancements on an ongoing basis. Risks are identified, managed and mitigated through ongoing risk management practices. Significant risks are reported to the Internal Control Committee and the Executive Risk Committee, as appropriate.

The Group has a robust employee relations governance framework in place that enables regular consultation at both national and local levels with its recognised trade unions enabling the Group to maintain a stable employee relations climate minimising any risk of disruption.

Significant progress has been made on harmonising terms and conditions from the Group's acquisitions, and a key focus for 2012 is preparing for the acquisition and integration from RBS of a number of branches, regional offices and associated customers to ensure strong risk controls are maintained.

The Group has worked to develop its employer brand to embed an identity and a set of recognisable cultural values in a sector that is dominated by established brand names. The outcomes of this activity will underpin the Group's recruitment proposition and communications, to support attracting new talent into the organisation.

Customer and conduct risk

The risk of reductions in earnings and/or value, through financial or reputational loss, from inappropriate or poor customer treatment (customer treatment risk) or reductions resulting from poor externally-facing business processes (customer process risk). Customer process risk includes customer transaction and processing errors due to incorrect capturing of customer information and/or system failure.

Customer risks are primarily managed through the Group Service Quality framework. Service Quality is an independent function which guides, supports, reviews and reports on customer satisfaction as measured through surveys (20,000 retail customers each month), agreed service levels and feedback via complaints. There is regular reporting to Executive Committee members and other senior directors across the business. Payments arising from complaints and root cause improvement initiatives are managed within the operational risk and losses framework.

Over recent years, the Group has grown significantly. It has integrated Abbey, the Bradford & Bingley savings business and Alliance & Leicester into its UK operations. Currently, preparations are continuing for the acquisition and integration of a number of branches, regional offices and associated customers from RBS. This period of growth and business change has been challenging in a time of turbulence in financial markets and many actions have been taken to minimise the operational risks arising whilst meeting key customer requirements by enhancing the network including expanding the number of branches and customer facing roles as well as providing more dedicated customer help lines to resolve any customer problems that might arise.

Conduct risk reviews of the Group's product offering began in 2011 in response to this emerging risk. Reviews are focused on the simplification of the Group's product offerings and product communications. A conduct risk management framework has been produced with a governance structure which includes the Internal Control Committee and an executive level Product Approval & Oversight Committee created to provide challenge and oversight for product development proposals and post-implementation reviews, as well as a Product Office to centralise product information and monitoring.

A number of customer service initiatives began in 2012, including the launch of Customer Experience Working Groups whilst significant time has been invested in Treating Customers Fairly training in the branch network.

Regulatory, legal and compliance risk

Regulatory, legal and compliance risk includes the risk of reductions in earnings and/or value, through financial or reputational loss, from failing to comply with the laws, regulations or codes applicable or through incomplete legal documentation.

Regulatory, legal and compliance exposure is driven by the significant volume of current legislation and regulation with which the Group has to comply, along with new legislation and regulation which needs to be reviewed, assessed and embedded into day-to-day operational and business practices across the Group as a whole. Following the financial crisis, the pace and extent of regulatory reform proposals, both in the UK and internationally, have increased significantly, and can be expected to remain at high levels. Future changes in regulation, fiscal or other policies are unpredictable and beyond the control of the Group, but could for instance affect the Group's future business strategy, structure or approach to funding. Further uncertainties arise where regulations are principles-based without the regulator defining supporting minimum standards either for the benefit of the consumer or firms. This gives rise to both the risk of retrospection from any one regulator and also to the risk of differing interpretation by individual regulators.

For legal and regulatory issues there are significant reputational impacts associated with potential censure which drive the Group's stance on the appetites referred to above. There are clear accountabilities and processes in place for reviewing new and changing requirements. Each division and significant business areas have a nominated individual with 'compliance oversight' responsibility under UK Financial Services Authority rules. The role of such individuals is to advise and assist management to ensure that each business has a control structure which creates awareness of the FSA rules and regulations, to which the Group is subject, and to monitor and report on adherence to these rules and regulations.

Basel II

Santander UK's risk management complies with Basel principles. The Group applies the retail internal ratings-based approach for credit risk to its key retail portfolios. Beyond retail, a combination of internal ratings-based approaches is employed for the principal portfolios. For the remaining credit exposures, currently on the Basel II standardised approach, a rolling programme of transition to the appropriate IRB approach continues. The standardised approach for operational risk continues to be applied.

The Group applied Basel II to its capital disclosures made to the market. The Group has applied Banco Santander, S.A.'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 34 to the Condensed Consolidated Interim Financial Statements.

Further information on the Basel II risk measurement of the Group's exposures is included in Banco Santander, S.A.'s 2011 Pillar 3 disclosures report. The Group's Pillar 3 disclosures are set out in the Balance Sheet Business Review section on page 40.

Forthcoming regulatory changes

In forecasting the Group's capital and liquidity positions, the implications of forthcoming regulatory changes (commonly referred to as Basel III), have been taken into account. In cases where proposed rules are still in the formative stage, the Group has applied appropriately conservative assumptions. Similarly, a conservative approach has been adopted in respect of the proposed implementation timescales, to allow for acceleration by the regulatory authorities.

Further information on Basel III and additional potential forthcoming regulatory changes, specifically the Independent Commission on Banking ('ICB') are listed below.

(i) Independent Commission on Banking and White Paper on banking reform

The Government appointed an Independent Commission on Banking ('ICB') to review possible measures to reform the banking system and promote stability and competition. The ICB published its final report on the 12 September 2011 putting forward recommendations to require ring-fencing of the retail activities of banks from their investment banking activities and additional capital requirements beyond those required under current drafts of the Capital Requirements Directive IV. The report also makes recommendations in relation to the competitiveness of the UK banking market, including enhancing the competition remit of the new Financial Conduct Authority ('FCA'), implementing a new industry-wide switching solution by September 2013, and improving transparency.

The ICB recommended that ring-fenced banks should hold a common equity capital base of at least 10% and primary loss-absorbing capacity of at least 17% to absorb the impact of potential losses or financial crises. The ICB, which following the final report completed its mandate, had the authority only to make recommendations, which the Government could choose to accept or reject.

The Government published its response to the ICB recommendations on 19 December 2011 and, following an extensive first consultation, it published a White Paper on 14 June 2012, setting out its more detailed proposals for implementing the ICB's recommendations. Its intention remains to complete primary and secondary legislation before the end of the current Parliamentary term in May 2015 and for banks to comply with all the measures proposed in the paper by 2019, as the ICB recommended. The Government also reaffirmed its determination that changes to the account switching process should be completed by September 2013, as already scheduled. A further period of consultation has now been established, which runs until 6 September 2012.

The content of the White Paper was broadly in line with expectations following the Response, with ring-fencing to be implemented as set out in the ICB recommendations and loss-absorbency requirements also largely consistent.

Given that the Group is predominantly a retail and commercial bank, it would expect to be less affected by the implementation of a retail ringfence, but believes it will be important for any transition period to be flexible in order to minimise any impact on economic growth, and for banks to implement the required structural changes.

(ii) Basel III

Basel III is a comprehensive set of reform measures, developed by the Basel Committee on Banking Supervision, to strengthen the regulation, supervision and risk management of the banking sector. These measures aim to: (i) improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source; (ii) improve risk management and governance; and (iii) strengthen banks' transparency and disclosures. The reforms target: (a) bank-level, or micro-prudential, regulation, with the aim of helping raise the resilience of individual banking institutions to periods of stress, and (b) macro-prudential, system-wide risks that can build up across the banking sector as well as the pro-cyclical amplification of these risks over time. These two approaches to supervision are complementary as greater resilience at the individual bank level reduces the risk of system-wide shocks. The European Commission published its proposed legislation for the CRD and the Capital Requirements Regulation, which together form the CRD IV package, in July 2011. As well as reflecting the Basel III capital proposals, the CRD IV package also includes new proposals on sanctions for non-compliance with prudential rules, corporate governance and remuneration. These changes are due to be implemented beginning in January 2013. The Group is currently engaged in the assessment of the impact of the Basel III measures. See "Basel III" in "Capital Management and resources" on page 40 of the Balance Sheet Business Review for further information, including an estimate of the effect of Basel III.

(iii) Crisis Management Directive and European Banking Union

The financial crisis provided clear evidence of the need for more robust crisis management arrangements as well as the need for better cross border banking arrangements. On 6 June 2012, the European Commission adopted a legislative proposal known as the Crisis Management Directive for bank recovery and resolution. The framework set out necessary steps and powers to ensure that bank failures across the EU are managed in a way which avoids financial instability and minimises costs for the taxpayer. The proposals establish a framework for the recovery and resolution of banks and investment firms. Proposals within the Directive include having a resolution 'Bail-In' tool which will see the costs borne by the taxpayer being borne by bank shareholders and creditors. The draft Directive also proposes 'resolution funding' whereby a fund is created to which banks contribute. In addition, the Directive proposed a mechanism whereby national funds can borrow from each other. The proposals are expected to come into force from 1 January 2015, although the Bail-In regime will be delayed until 1 January 2018. In June, the European Commission published ideas for a European Banking Union to help pave the way towards deeper economic integration. The Commission proposed (i) an integrated system for the supervision of cross-border banks, (ii) a single deposit guarantee scheme and (iii) an EU resolution fund. Later that month the President of the European Council published a report on establishing a stable economic and monetary union. The report proposed a vision for a stable and prosperous union based on a number of essential building blocks: (i) an integrated financial framework; (ii) an integrated budgetary framework; and (iii) an integrated economic policy framework. A further report is expected by 11 September 2012 and consultations with Member States and EU institutions will take place in due course.

(iv) Liquidity Risk Management

The Group notes the Basel Committee's Principles of Sound Liquidity Risk Management and Supervision (Sound Principles). The planned introduction of the Liquidity Coverage Ratio (LCR - January 2015) and Net Stable Funding Ratio (NSFR - January 2018) contained within CRD IV are intended to raise the resilience of banks to potential liquidity shocks and provide the basis for a harmonised approach to liquidity risk management. The LCR measure promotes short-term resilience of the liquidity profile by ensuring that banks have sufficient high quality liquid assets to meet potential funding outflows in a stressed environment within a one month period. The NSFR promotes resilience over a longer time horizon by requiring banks to fund their activities with a more stable source of funding on a going concern basis. This has a time horizon of one year and has been developed to ensure a sustainable maturity structure of assets and liabilities.

The guidance issued by the Basel Committee is still subject to final ratification by the EU and the methodology is likely to be refined on the basis of feedback from banks and regulators during the observation period.

(v) Other

There are a number of other regulatory developments going through a consultation and implementation process which may have some effect on the Group's business. These include the FSCS arrangements, consumer credit regulations, financial stability, and conduct of business arrangements such as those resulting from the Retail Distribution Review, and the Mortgage Market Review.

OTHER RISKS (unreviewed)

PENSION OBLIGATION RISK

Definition

Pension obligation risk is the risk of an unplanned increase in funding required by the Group's pension schemes, either because of a loss of net asset value or because of changes in legislation or regulatory action.

Managing pension obligation risk

The Group has statutory funding obligations as the sponsoring employer for a number of defined benefit 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 arise from an increase in the value of the liabilities due to reductions in the discount rate, increases in inflation, adverse changes in the longevity assumptions, and the scheme assets being adversely affected by market movements.

The Group works closely with the pension Trustees to ensure that appropriate asset allocations are maintained, and to minimise the long-term cost of the pension scheme to the Group while managing risk and volatility. The Chief Financial Officer is responsible for managing the Group's exposure to pension obligation risk, in conjunction with the trustees. The Group's Strategic Pensions Committee, under the authority of the Chief Executive Officer, is responsible for the strategic management of pensions strategy and reviews actuarial valuations and assumptions and the impact on the Group's contributions, capital and funding arrangements, in addition to reviewing the pension risk exposure and impact to ensure it is in line with the Group's risk appetite. Further information on pensions can be found in 'Critical Accounting Policies' in Note 1 and in Note 26 to the Condensed Consolidated Interim Financial Statements.

BUSINESS/STRATEGIC RISK

Definition

Business/strategic risk is the current or prospective risk to earnings and capital arising from changes in the business environment and from adverse business decisions, improper implementation of decisions or lack of responsiveness to changes in the business environment. This includes pro-cyclicality and capital planning risk. The internal component is the risk related to implementing the strategy. The external component is the risk of the business environment change on the Group's strategy.

Managing business/strategic risk

Business/strategic risk is managed on a monthly basis by the Executive Risk Committee via the Economic Capital model. This is further discussed in the 'Economic Capital' section. In addition, economically driven risks are assessed through the Group's stress-testing programme.

REPUTATIONAL RISK

Definition

Reputational risk is the risk of financial loss or reputational damage arising from treating customers unfairly, a failure to manage risk, a breakdown in internal controls, or poor communication with stakeholders. This includes the risk of decline in the value of the Group's franchise potentially arising from reduced market share, a change in business development expectations, complexity, tenor and performance of products and distribution mechanisms. Reputational risk also relates to judicial, economic-financial, ethical, social and environmental aspects, amongst others.

Managing reputational risk

Reputational risk is managed within the operational risk framework and other internal control and approval processes, and is undertaken by various governance structures, depending on where the risk originated from. The management of reputational risk which could arise from an inadequate product sales process or an inappropriate provision of service, or non-compliance is undertaken by the following bodies:

a) The Executive Risk Committee

As the senior body responsible for the management of risk, the committee assesses reputational risk whenever it is relevant to its activities and decision-making.

b) The Product Approval and Oversight Committee

This committee is currently chaired by the Chief Financial Officer and has representatives from Risk, Product Development and Marketing, Regulatory Affairs, Compliance, Manufacturing, Customer Experience, Finance, Legal, Human Resources, and Internal Governance and Control as members. It is the decision-making body which approves and monitors products and services. The scope of the Product Approval and Oversight Committee in respect of new products is as follows:

The Product Approval and Oversight Committee pays particular attention to ensuring that any product or service sold adheres to the risk management framework and especially to ensuring that:

RESIDUAL VALUE RISK

Definition

Residual value risk is the risk that the value of an asset at the end of a contract may be worth less than that required to achieve the minimum return from the transaction that had been assumed at its inception. Residual value risk relates to the operating lease assets of the Group, which consist of commercial vehicles and other assets to its corporate customers, of which the Group is the lessor, and the finance lease assets, which consist mainly of office fixtures and equipment of which the Group is the lessee.

Managing residual value risk

Residual value risk is controlled through asset specific policies and delegated authorities agreed by the Executive Risk Committee. The residual value risk is reassessed each time a new lease is written or an existing lease renewed and extended. In addition, portfolio impairment reviews are undertaken and independently evaluated and signed-off by the Risk Division, with impairment loss allowances being raised where appropriate.

Use of outsourcing

Following the outsourcing of key IT and operations processes (including information technology support, maintenance and consultancy services in connection with Partenon, the global banking informational technology platform utilised by Banco Santander, S.A. to which the Group transitioned in 2008) to Banco Santander, S.A. group companies, risk governance of these entities is crucial. The Group uses written service level agreements with these entities that include key service performance metrics to support this governance. The high-level governance processes include relationship management, service delivery management and contract management. Across these, there are a number of more detailed processes including:

The Group works closely, and continues to enhance its interaction, with outsourced service providers via the application of appropriate risk frameworks. These frameworks include processes and procedures designed to ensure that, with appropriate periodicity, arrangements are in place to ensure continuity of critical services up to and including disaster scenarios and that these plans are regularly validated through testing.

FINANCIAL INSTRUMENTS OF SPECIAL INTEREST

This section summarises the types of financial instruments which have been of special interest as a result of the economic environment of the last few years. The table below shows the type of financial instrument and where they are classified on the Group's Consolidated Balance Sheet. It also provides cross references to the Notes to the Condensed Consolidated Interim Financial Statements containing additional analysis of the significant assets.

The Group's financial instruments which are considered to have been most affected by the current credit environment include floating rate notes ('FRNs'), asset-backed securities ('ABS') (including mortgage-backed securities ('MBS') and the Group's exposures to monoline insurers), Collateralised Debt Obligations ('CDOs'), Collateralised Loan Obligations ('CLOs'), loans to banks, certain credit derivatives in the Treasury Asset Portfolio, and off-balance sheet entities. The Group has no holdings in Structured Investment Vehicles.

The Group aims to actively manage these exposures. Additional information on the Group's exposures by country is disclosed in 'Balance Sheet Business Review - Country risk exposure'.

CLASSIFICATION IN THE CONSOLIDATED BALANCE SHEET

The classification of these assets in the Group's Consolidated Balance Sheet, and cross references to the Notes to the Condensed Consolidated Interim Financial Statements containing additional analysis of the significant assets, is as follows:

(1) Credit derivatives - Treasury Asset Portfolio. In November 2010, the Group acquired a portfolio of loans to banks, asset-backed securities and related credit derivatives, as part of an alignment of portfolios across the Banco Santander, S.A. group. Disclosures regarding the geographic location of the counterparties to the credit derivatives recognised as a result of the acquisition of that portfolio are set out in the "Corporate Centre" section within "Credit Risk" on page 100. Further information on all the Group's holdings of derivatives (including these credit derivatives) is set out in Note 8 to the Condensed Consolidated Interim Financial Statements.

EXPOSURE TO OFF-BALANCE SHEET ENTITIES SPONSORED BY THE GROUP 

Certain Special Purpose Entities ('SPEs') are formed by the Group to accomplish specific and well-defined objectives, such as securitising financial assets. The Group consolidates these SPEs when the substance of the relationship indicates control, as described in Note 1 of the Consolidated Financial Statements in the Group's 2011 Annual Report. Details of SPEs sponsored by the Group (including SPEs not consolidated by the Group) are set out in Notes 12 and 13 to the Condensed Consolidated Interim Financial Statements.

The only 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.

Our Group's 2011 Annual Report outlines our assessment of the principal risks and uncertainties facing the Group, together with the processes that are in place to monitor and mitigate those risks where possible. Material risk factors are described in the Risk Factors section on page 186 to 199 of this Half Yearly Financial Report. Financial risks are described in the Risk Management Report for each segment of the business by type of risk on pages 61 to 114 of this Half Yearly Financial Report.

Financial risks are:

Material risk factors are:

Looking forward to the second half of the current financial year, we believe that the risks and uncertainties identified above are still applicable.

For a full description of related party activity at 31 December 2011, please refer to Note 44 of the Group's 2011 Annual Report. Significant changes to these arrangements during the first half of the year are described in Note 31 of the Group's 2012 Condensed Consolidated Interim Financial Statements.

Directors' Responsibility Statement

This Half Yearly Financial Report is the responsibility of the Directors. See 'Directors' Responsibility Statement' on page 208.

INDEPENDENT REVIEW REPORT TO SANTANDER UK PLC

We have been engaged by Santander UK plc (the 'Company') to review the condensed set of financial statements in the half-yearly financial report for the six months ended 30 June 2012 comprise the Condensed Consolidated Income Statement, the Condensed Consolidated Statement of Comprehensive Income, the Condensed Consolidated Balance Sheet, the Condensed Consolidated Statement of Changes in Equity, the Condensed Consolidated Cash Flow Statement, the related Notes 1 to 35, the reviewed information in the Risk Management Report in the Business and Financial Review (pages 52 to 123) and the information in the Balance Sheet Business Review marked reviewed (pages 28 to 36 and 46 to 48), together the consolidated financial statements. We have read the other information contained in the half-yearly financial report and considered whether it contains any apparent misstatements or material inconsistencies with the information in the condensed set of financial statements.

This report is made solely to the Company in accordance with International Standard on Review Engagements (UK and Ireland) 2410 "Review of Interim Financial Information Performed by the Independent Auditor of the Entity" issued by the Auditing Practices Board. Our work has been undertaken so that we might state to the Company those matters we are required to state to it in an independent review 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, for our review work, for this report, or for the conclusions we have formed.

Directors' responsibilities

The half-yearly financial report is the responsibility of, and has been approved by, the directors. The directors are responsible for preparing the half-yearly financial report in accordance with the Disclosure and Transparency Rules of the United Kingdom's Financial Services Authority.

As disclosed in Note 1, the annual financial statements of the Company are prepared in accordance with IFRSs as adopted by the European Union. The condensed set of financial statements included in this half-yearly financial report has been prepared in accordance with International Accounting Standard 34, "Interim Financial Reporting," as adopted by the European Union.

Our responsibility

Our responsibility is to express to the Company a conclusion on the condensed set of financial statements in the half-yearly financial report based on our review.

Scope of Review

We conducted our review in accordance with International Standard on Review Engagements (UK and Ireland) 2410 "Review of Interim Financial Information Performed by the Independent Auditor of the Entity" issued by the Auditing Practices Board for use in the United Kingdom. A review of interim financial information consists of making inquiries, primarily of persons responsible for financial and accounting matters, and applying analytical and other review procedures. A review is substantially less in scope than an audit conducted in accordance with International Standards on Auditing (UK and Ireland) and consequently does not enable us to obtain assurance that we would become aware of all significant matters that might be identified in an audit. Accordingly, we do not express an audit opinion.

Conclusion

Based on our review, nothing has come to our attention that causes us to believe that the condensed set of financial statements in the half-yearly financial report for the six months ended 30 June 2012 is not prepared, in all material respects, in accordance with International Accounting Standard 34 as adopted by the European Union and the Disclosure and Transparency Rules of the United Kingdom's Financial Services Authority.

Deloitte LLP

Chartered Accountants and Statutory Auditor

London, United Kingdom

30 August 2012

Condensed Consolidated Income Statement (unaudited)

For the six months ended 30 June 2012 and 2011

All profits during the period were generated from continuing operations.

Condensed Consolidated Statement of Comprehensive Income (unaudited)

For the six months ended 30 June 2012 and 2011

The accompanying Notes on pages 131 to 185 and the reviewed sections of the Risk Management Report on pages 52 to 123 and the information in the Balance Sheet Business Review marked reviewed (pages 28 to 36 and 46 to 48) form an integral part of these Condensed Consolidated Interim Financial Statements.

Condensed Consolidated Balance Sheet (unaudited)

At 30 June 2012 and 31 December 2011

The accompanying Notes on pages 131 to 185 and the reviewed sections of the Risk Management Report on pages 52 to 123 and the information in the Balance Sheet Business Review marked reviewed (pages 28 to 36 and 46 to 48) form an integral part of these Condensed Consolidated Interim Financial Statements.

Condensed Consolidated Statement of Changes in Equity (unaudited)

For the six months ended 30 June 2012 and 2011

The accompanying Notes on pages 131 to 185 and the reviewed sections of the Risk Management Report on pages 52 to 123 and the information in the Balance Sheet Business Review marked reviewed (pages 28 to 36 and 46 to 48) form an integral part of these Condensed Consolidated Interim Financial Statements.

Condensed Consolidated Cash Flow Statement (unaudited)

For the six months ended 30 June 2012 and 2011

The accompanying Notes on pages 131 to 185 and the reviewed sections of the Risk Management Report on pages 52 to 123 and the information in the Balance Sheet Business Review marked reviewed (pages 28 to 36 and 46 to 48) form an integral part of these Condensed Consolidated Interim Financial Statements.

Going Concern

The Directors have assessed the ability of Santander UK plc (the 'Company') and its subsidiaries (together the 'Group') to continue as a going concern, in the light of uncertain current and anticipated economic conditions, including analysing the financial resources available to it and stress testing performance forecasts through various scenarios. The Directors confirm they are satisfied that the Group has adequate resources to continue in business for the foreseeable future. For this reason, they continue to adopt the 'going concern' basis of accounting for preparing financial statements.

These Condensed Consolidated Interim Financial Statements are not a form of statutory accounts. The information for the year ended 31 December 2011 does not constitute statutory accounts as defined in section 434 of the Companies Act 2006. A copy of the statutory accounts for that year has been delivered to the Registrar of Companies. The auditor's report on those accounts was unqualified, did not draw attention to any matters by way of emphasis and did not contain a statement under section 498(2) or (3) of the Companies Act 2006.

The Condensed Consolidated Interim Financial Statements have been prepared in accordance with International Accounting Standards ('IAS') 34 'Interim Financial Reporting', as issued by the International Accounting Standards Board ('IASB'), and as adopted or use in the European Union. Accordingly, certain information and disclosures normally required to be included in the notes to the annual financial statements have been omitted or condensed. The Condensed Consolidated Interim Financial Statements should be read in conjunction with the Consolidated Financial Statements of the Group for the year ended 31 December 2011 which were prepared in accordance with International Financial Reporting Standards ('IFRS') as issued by the IASB in addition to being consistent with IFRS as adopted for use in the European Union.

Disclosures required by IFRS 7 "Financial Instruments: Disclosure" relating to the nature and extent of risks arising from financial instruments can be found in the Risk Management Report on pages 52 to 123 which form an integral part of these Condensed Consolidated Interim Financial Statements.

The same accounting policies, presentation and methods of computation are followed in these Condensed Consolidated Interim Financial Statements as were applied in the presentation of the Group's 2011 Annual Report except as described below:

Recent accounting developments

The Group has adopted the following amendments to standards which became effective for financial years beginning on 1 January 2012.

Future accounting developments

The Group has not yet adopted the following significant new or revised standards and interpretations, and amendments thereto, which have been issued but which are not yet effective for the Group:

The Condensed Consolidated Interim Financial Statements reflect all adjustments that, in the opinion of management of the Group, are necessary for a fair presentation of the results of operations for the interim period. All such adjustments to the financial information are of a normal, recurring nature. Because the results from common banking activities are so closely related and responsive to changes in market conditions, the results for any interim period are not necessarily indicative of the results that can be expected for the year.

CRITICAL ACCOUNTING POLICIES AND AREAS OF SIGNIFICANT MANAGEMENT JUDGEMENT

The preparation of the Group's Condensed Consolidated Interim Financial Statements requires management to make estimates and judgements that affect the reported amount of assets and liabilities at the date of the 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 various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

The following accounting estimates and judgements are considered important to the portrayal of the Group's financial results and financial condition because: (i) they are highly susceptible to change from period to period as assumptions are made to calculate the estimates, and (ii) any significant difference between the Group's estimated amounts and actual amounts could have a material impact on the Group's future financial results and financial condition.

In calculating each estimate, a range of outcomes was calculated based principally on management's conclusions regarding the input assumptions relative to historic experience. The actual estimates were based on what management concluded to be the most probable assumptions within the range of reasonably possible assumptions.

(a) Impairment loss allowances for loans and advances

The Group estimates impairment losses for loans and advances to customers, loans and receivables securities, and loans and advances to banks as described in the accounting policy "Impairment of financial assets" on page 177 of the Group's 2011 Annual Report. The Group's assumptions about estimated losses are based on past performance, past customer behaviour, the credit quality of recent underwritten business and general economic conditions, which are not necessarily an indication of future losses.

(i) Loans and advances to customers

The net impairment loss (i.e. after recoveries) for loans and advances to customers in the Retail Banking segment recognised in the six months ended 30 June 2012 was £234m (six months ended 30 June 2011: £172m), in the Corporate Banking segment was £61m (six months ended 30 June 2011: £59m) and in the Corporate Centre segment was £73m (six months ended 30 June 2011: £28m). In calculating the Retail Banking and Corporate Banking impairment loss allowances, a range of outcomes was calculated, either for each individual loan or by portfolio, based on management's conclusions regarding the estimated number of accounts that will be written off or repossessed (the 'loss propensity'), the estimated proportion of such cases that will result in a loss (the 'loss factor') and the average loss incurred (the 'loss per case') relative to historic experience.

Had management used different assumptions, a larger or smaller impairment loss allowance would have resulted that could have had a material impact on the Group's reported profit before tax. Specifically, if management's conclusions as to the loss propensity, the loss factor and the estimated loss per case were different, but within the range of what management deemed to be reasonably possible, the impairment loss for loans and advances in the Retail Banking segment could have decreased in the first half of 2012 from an actual impairment loss of £234m (six months ended 30 June 2011: £172m) by up to £51m (six months ended 30 June 2011: £72m), with a potential corresponding increase in the Group's profit before tax in the first half of 2012 of up to 7% (six months ended 2011: 13%), or increased by up to £28m (six months ended 30 June 2011: £52m), with a potential corresponding decrease in the Group's profit before tax in the first half of 2012 of up to 4% (six months ended 30 June 2011: 9%). Similarly, the impairment loss for loans and advances in the Corporate Banking and Corporate Centre segments could have decreased in the first half of 2012 from an actual impairment loss of £134m (six months ended 30 June 2011: £87m) by up to £21m (six months ended 30 June 2011: £13m), with a potential corresponding increase in the Group's profit before tax in the first half of 2012 of up to 3% (six months ended 30 June 2011: 2%), or increased by up to £19m (six months ended 30 June 2011: £27m), with a potential corresponding decrease in the Group's profit before tax in the first half of 2012 of up to 3% (six months ended 30 June 2011: 5%).

(ii) Loans and receivables securities

In the six months ended 30 June 201 and 20112, the Group did not incur any impairment losses in respect of loans and receivables securities. Based on the conditions at the balance sheet date, management determined that a reasonably possible change in any of its assumptions would not cause an impairment loss to be recognised.

(iii) Loans and advances to banks

In the six months ended 30 June 2012 and 2011, the Group did not incur any impairment losses in respect of loans and advances to banks. Based on the conditions at the balance sheet date, management determined that a reasonably possible change in any of its assumptions would not cause an impairment loss to be recognised.

(b) Valuation of financial instruments

The Group trades in a wide variety of financial instruments in the major financial markets. When estimating the value of its financial instruments, including derivatives where quoted market prices are not available, management therefore considers a range of interest rates, volatility, exchange rates, counterparty credit ratings, valuation adjustments and other similar inputs, all of which vary across maturity bands. These are chosen to best reflect the particular characteristics of each transaction.

Had management used different assumptions, a larger or smaller change in the valuation of financial instruments including derivatives where quoted market prices are not available would have resulted that could have had a material impact on the Group's reported profit before tax.

Detailed disclosures on financial instruments, including sensitivities, can be found in Note 33. Further information about sensitivities to market risk (including Value-at-Risk ('VaR')) arising from financial instrument trading activities can be found in the Risk Management Report on page 105.

(c) Goodwill impairment

A goodwill impairment loss of £nil was recognised in the first half of 2012 (six months ended 30 June 2011: £nil). The carrying amount of goodwill was £1,834m at 30 June 2012 (31 December 2011: £1,834m). The Group evaluates whether the carrying value of goodwill is impaired and performs impairment testing annually or more frequently if there are impairment indicators present. Details of the Group's approach to identifying and quantifying impairment of goodwill are set out in Note 17.

Assumptions about the measurement of the estimated recoverable amount of goodwill are based on management's estimates of future cash flows and growth rates of the cash-generating units. The Group's assumptions about estimated future cash flows and growth rates are based on management's view of future business prospects at the time of the assessment and are subject to a high degree of uncertainty.

Had management used different assumptions, a larger or smaller goodwill impairment loss would have resulted that could have had a material impact on the Group's reported profit before tax. Detailed disclosures on the assumptions used, including sensitivities, can be found in Note 17.

(d) Provision for customer remediation, principally payment protection insurance ('PPI')

The provision charge for customer remediation, principally PPI, relating to products sold recognised in the first half of 2012 was £1m (year ended 31 December 2011: charge of £753m) before tax. The balance sheet provision amounted to £613m (31 December 2011: £671m). Detailed disclosures on the provision for customer remediation can be found in Note 25.

The provision represents management's best estimate of the anticipated costs of related customer contact and/or redress, including administration expenses. However, there are still a number of uncertainties as to the eventual costs from any such contact and/or redress given the inherent difficulties in assessing the impact of detailed implementation of the FSA Policy Statement of 10 August 2010 for all PPI complaints, uncertainties around the ultimate emergence period for complaints, the availability of supporting evidence and the activities of claims management companies, all of which will significantly affect complaints volumes, uphold rates and redress costs.

The provision requires significant judgement by management in determining appropriate assumptions, which include the level of complaints, of those, the number that will be upheld, as well as redress costs for each of the different populations of customers identified by the Group in its analyses used to determine the best estimate of the anticipated costs of redress.

Had management used different assumptions, a larger or smaller provision release/charge would have resulted that could have had a material impact on the Group's reported profit before tax. Specifically, if the level of complaints had been one percentage point higher/(lower) than estimated for all policies written then the provision at 30 June 2012 would have increased/(decreased) by approximately £33m (31 December 2011: £36m). There are a large number of inter-dependent assumptions under-pinning the provision; this sensitivity assumes that all assumptions, other than the level of complaints, remain constant.

The Group will re-evaluate the assumptions underlying its analysis at each reporting date as more information becomes available. As noted above, there is inherent uncertainty in making estimates; actual results in future periods may differ from the amount provided.

(e) Pensions

The Group operates a number of defined benefit pension schemes as described in Note 26 and estimates their fair values as described in the accounting policy "Pensions and other post retirement benefits" on page 172 of the Group's 2011 Annual Report.

The defined benefit service cost recognised in the six months ended 30 June 2012 of £15m (six months ended 30 June 2011: £14m) was broadly unchanged from the previous period. The defined benefit pension schemes which were in a net asset position had a surplus of £411m (31 December 2011: £241m) and the defined benefit pension schemes which were in a net liability position had a deficit of £36m (31 December 2011: £216m).

Accounting for defined benefit pension schemes requires management to make assumptions, principally about mortality, but also about price inflation, discount rates, pension increases, and earnings growth. Management's assumptions are based on past experience and current economic trends, which are not necessarily an indication of future experience.

Detailed disclosures on the current period service cost and surplus, including sensitivities and the date of the last formal actuarial valuations of the assets and liabilities of the schemes can be found in Note 26

2. SEGMENTS

The principal activity of the Group is financial services. The Group's business is managed and reported on the basis of the following segments:

In the first half of 2012, certain non-core portfolios were transferred to Corporate Centre (formerly known as Group Infrastructure) where this was felt to be more appropriate for the management of these assets and liabilities. The non-core portfolios transferred into Corporate Centre included certain Social Housing assets and Commercial Mortgage loans, previously managed within Corporate Banking. With respect to the former, even though there are no credit concerns the terms of these loans are unfavourable in the current funding environment. The latter are typically medium to long-term arrangements primarily written via agents or intermediaries. The Group's intention is to hold these assets to maturity and as such the balances will gradually decrease over time. The corporate legacy portfolio in run-off (largely relating to assets acquired as part of the acquisition of Alliance & Leicester) was also transferred to Corporate Centre from Corporate Banking. Non-core customer deposits are financial intermediary/institutional deposits which are managed centrally for liquidity purposes, most of which were previously managed within Corporate Banking or Markets. In addition, the management of reorganisation, customer remediation, and other costs, and hedging and other variances has been transferred to Corporate Centre, principally from Retail Banking.

The prior period's segmental analysis has been adjusted to reflect the fact that reportable segments have changed.

The Group's segments are strategic business units that offer different products and services. They are managed separately because each business requires different technology and marketing strategies. The Group has four segments:

The Company's board of directors (the 'Board') is the chief operating decision maker for the Group. The segment information below is presented on the basis used by the Board to evaluate performance and allocate resources. The Board reviews discrete financial information for each segment of the business which follows the Group's normal accounting policies and principles, including measures of operating results, assets and liabilities.

Transactions between the business segments are on normal commercial terms and conditions. The accounting policies of the segments are the same as those described in the summary of significant accounting policies in the Group's 2011 Annual Report. Internal charges and transfer pricing adjustments have been reflected in the performance of each business. Revenue sharing agreements are used to allocate external customer revenues to a business segment on a reasonable basis. Funds are ordinarily reallocated between segments. Interest charged for these funds is based on the Group's cost of capital.

Interest receivable and interest payable have not been reported separately. The majority of the revenues from the segments presented below are interest income in nature and the Board relies primarily on net interest revenues to both assess the performance of the segment and to make decisions regarding allocation of segmental resources.

(1) Includes customer assets, net of impairment loss allowances.

 (1) Includes customer assets, net of impairment loss allowances.

3. Net Trading and Other Income

4. Impairment Losses and Provisions

5. Taxation Charge

Interim period corporation tax is accrued based on the estimated average annual effective corporation tax rate for the year of 23.5% (2011: 25%). The standard rate of UK corporation tax was 24.5% (2011: 26.5%).

The standard rate of UK corporation tax was reduced from 26% to 24% with effect from 1 April 2012. Taxation for other jurisdictions is calculated at the rates prevailing in the relevant jurisdictions.

The Finance Bill 2012 proposed a reduction in the main rate of UK corporation tax from 26% to 24% effective from 1 April 2012. This reduction in the rate to 24% was enacted on 26 March 2012 under the Provisional Collection of Taxes Act 1968. As this change in rate was substantively enacted prior to 30 June 2012, it has been reflected in the deferred tax balance at 30 June 2012. The UK Government has also indicated that it intends to enact future 1% reductions each year down to 22% by 1 April 2014. These changes in the rate had not been substantively enacted at the balance sheet date and, therefore, are not included in these financial statements. The estimated financial effect of these changes is insignificant.

The tax on the Group's profit before tax differs from the theoretical amount that would arise using the basic corporation tax rate of the Group as follows:

The effective tax rate for the first six months of 2012, based on profit before tax, was 24.1% (30 June 2011: 24.8%). The effective tax rate differed from the UK corporation tax rate of 24.5% (30 June 2011: 26.5%) principally because of the effect of non-equalised items, the reduction in deferred tax asset as a result of the change in the tax rate and the impact of the non deductible UK Bank Levy.

6. Dividends

Dividends of £425m (2011: £375m) were paid on Santander UK plc's ordinary shares in issue during the period. The annual dividend of £21m on the Step-Up Callable Perpetual Reserve Capital Instruments was paid on 14 February 2012, the annual dividend of £17m on the £300m Step-up Callable Perpetual Preferred Securities, was paid on 22 March 2012, and the annual dividend of £19m on the £300m fixed/floating rate non-cumulative callable preference shares was paid on 24 May 2012.

7. Trading Assets

(1) Comprises short-term loans of £205m (31 December 2011: £84m) and cash collateral placed of £2,736m (31 December 2011: £3,004m).

(2) Comprises short-term loans.

Debt securities can be analysed by type of issuer as follows:

(1) The FRNs are 40% AAA and 60% A rated (2011: 100% AAA rated).

Debt securities and equity securities can be analysed by listing status as follows:

Included in the above balances are amounts owed to the Group by the ultimate parent undertaking and by fellow subsidiaries of £249m (31 December 2011: £270m) and £nil (31 December 2011: £14m) respectively.

8. Derivative Financial Instruments

Derivatives are financial instruments whose value is derived from the price of one or more underlying items such as equities, equity indices, interest rates, foreign exchange rates, property indices, commodities and credit spreads. Derivatives enable users to manage exposure to credit or market risks. The Group sells derivatives to its customers and uses derivatives to manage its own exposure to credit and market risks.

Details of the Group's uses of derivatives are set out in Note 15 of the Group's 2011 Annual Report.

(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.

(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.

Included in the above balances are amounts owed to the Group by the ultimate parent undertaking and by fellow subsidiaries of £2,435m (31 December 2011: £2,644m) and £163m (31 December 2011: £66m) respectively and amounts owed by the Group to the ultimate parent undertaking and to fellow subsidiaries of £1,904m (31 December 2011: £2,144m) and £110m (31 December 2011: £35m). The net exposures after collateral to the ultimate parent undertaking and fellow subsidiaries at 30 June 2012 amounted to £195m (31 December 2011: £149m) and £6m (31 December 2011: £nil) respectively.

Net gains or losses arising from fair value hedges included in net trading and other income

The Group hedges its exposures to various risks, including interest rate risk and foreign currency risk, in connection with certain mortgage assets, covered bond issuances, and subordinated and senior debt securities in issue. The gains/(losses) arising on these assets and liabilities are presented in the table above on a combined basis.

9. FINANCIAL ASSETS DESIGNATED AT FAIR VALUE

Included in the above balances are amounts owed to the Group by the ultimate parent undertaking and by fellow subsidiaries of £nil (31 December 2011: £nil) and £44m (31 December 2011: £51m) respectively.

The maximum exposure to credit risk on loans and advances designated as held at fair value through profit or loss at the balance sheet date was £3,618m (31 December 2011: £4,376m). The maximum exposure was mitigated by a charge over the residential properties in respect of lending to housing associations amounting to £3,978m (31 December 2011: £4,609m).

Debt securities can be analysed by type of issuer as follows:

Asset-backed securities can be analysed by the geographical location of the issuer or counterparty as follows:

Asset-backed securities can be analysed by the credit rating of the issuer or counterparty as follows: