REG - Royal Bk Scot.Grp. - Annual Financial Report <Origin Href="QuoteRef">RBS.L</Origin> - Part 2

NatwestAnnouncement

24/02/2017 07:08

- Part 2: For the preceding part double click  ID:nRSX7683Xa 

large the buffer should be up to a
maximum of 3% of a firm's risk-weighted assets. The systemic risk buffer will
apply to ring-fenced entities only and not all entities within a banking
group. The systemic risk buffer is part of the UK framework for identifying
and setting higher capital buffers for domestic systemically important banks
(D-SIBs), which are groups that, upon distress or failure, could have an
important impact on their domestic financial systems. This follows on the 2012
framework recommendations by the FSB that national authorities should identify
D-SIBs and take measures to reduce the probability and impact of the distress
or failure of D-SIBs. 
 
In addition, national supervisory authorities may add extra capital
requirements (the "Pillar 2A requirements") to cover risks that they believe
are not covered or insufficiently covered by Pillar 1 requirements. The
Group's current Pillar 2A requirement set by the PRA at an equivalent of 3.8%
of risk-weighted assets. The PRA has also introduced the PRA buffer which is a
forward-looking requirement set annually and based on various factors
including firm-specific stress test results and credible recovery and
resolution planning and is to be met with CET1 capital (in addition to any
CET1 Capital used to meet any Pillar 1 or Pillar 2A requirements). 
 
Where appropriate, the PRA may require an increase in an institution's PRA
buffer to reflect additional capital required to be held to mitigate the risk
of additional losses that could be incurred as a result of risk management and
governance weaknesses, including with respect to the effectiveness of the
internal stress testing framework and control environment. UK banks are
required to meet the higher of the combined buffer requirement or PRA buffer
requirement. 
 
In addition to capital requirements and buffers, the regulatory framework
adopted under CRD IV, as transposed in the UK, sets out minimum leverage ratio
requirements for financial institutions, namely: (i) a minimum leverage
requirement of 3% which applies to major UK banks, (ii) an additional leverage
ratio to be met by G-SIBs and ring-fenced institutions to be calibrated at 35%
of the relevant firm's capital G-SIB Buffer or systemic risk buffer and which
is being phased in from 2016 (currently set at 0.175% from 1 January 2017) and
(iii) a countercyclical leverage ratio buffer for all firms subject to the
minimum leverage ratio requirements which is calibrated at 35% of a firm's
countercyclical capital buffer. Further changes may be made to the current
leverage ratio framework as a result of future regulatory reforms, including
FSB proposals and proposed amendments to the CRD IV proposed by the European
Commission in November 2016. 
 
Most of the capital requirements which apply or will apply to the Group will
need to be met in whole or in part with CET1 capital. CET1 capital broadly
comprises retained earnings and equity instruments, including ordinary shares.
As a result, the Group's ability meet applicable CET1 capital requirements is
dependent on organic generation of CET1 through sustained profitability and/or
the Group's ability to issue ordinary shares, and there is no guarantee that
the Group may be able to generate CET1 capital through either of these
alternatives. 
 
The amount of regulatory capital required to meet the Group's regulatory
capital requirements (and any additional management buffer), is determined by
reference to the amount of risk-weighted assets held by the Group. The models
and methodologies used to calculate applicable risk-weightings are a
combination of individual models, subject to regulatory permissions, and more
standardised approaches. The rules are applicable to the calculation of the
Group's risk-weighted assets are subject to regulatory changes which may
impact the levels of regulatory capital required to be met by the Group. 
 
The Basel Committee and other agencies remain focused on changes that will
increase, or recalibrate, measures of risk-weighted assets as the key measure
of the different categories of risk in the denominator of the risk-based
capital ratio. While they are at different stages of maturity, a number of
initiatives across risk types and business lines are in progress that are
expected to impact the calculation of risk-weighted assets. 
 
The Basel Committee is currently consulting on new rules relating to the risk
weighting of real estate exposures and other changes to risk-weighting
calculations, including proposals to introduce floors for the calculation of
risk-weighted assets, which could directly affect the calculation of capital
ratios. However, given recent delays, the timing and outcome of this
consultation is increasingly uncertain. In the UK, the PRA is also considering
ways of reducing the sensitivity of UK mortgage risk weights to economic
conditions. The Basel Committee is also consulting on a revised standardised
measurement approach for operational risk. Certain EU officials have raised
concerns in relation to the new proposed rules and there is therefore
uncertainty as to the way in which the FSB's proposals would be implemented in
the EU. The new approach for operational risk would replace the three existing
standardised approaches for calculating operational risk, as well as the
internal model-based approach. The proposed new methodology combines a
financial statement-based measure of operational risk, with an individual
firm's past operational losses. While the quantum of impact of these reforms
remains uncertain owing to lack of clarity of the proposed changes and the
timing of their introduction, the implementation of such initiatives may
result in higher levels of risk-weighted assets and therefore higher levels of
capital, and in particular CET1 capital, required to be held by the Group,
under Pillar 1 requirements. Such requirements would be separate from any
further capital overlays required to be held as part of the PRA's
determination of the Group's Pillar 2A or PRA buffer requirements with respect
to such exposures. 
 
Although the above provides an overview of the capital and leverage
requirements currently applicable to the Group, such requirements are subject
to ongoing amendments and revisions, including as a result of final rules and
recommendations adopted by the FSB or by European or UK regulators. In
particular, on 23 November 2016, the European Commission published a
comprehensive package of reforms including proposed amendments to CRD IV and
the EU Bank Recovery and Resolution Directive "BRRD". Although such proposals
are currently being considered and discussed among the European Commission,
the European Parliament and the European Council and their final form and the
timetable for their implementation are not known, such amendments may result
in increased or more stringent requirements applying to the Group or its
subsidiaries. This uncertainty is compounded by the UK's decision to leave the
EU following the outcome of the EU Referendum which may result in further
changes to the prudential and regulatory framework applicable to the Group. 
 
If the Group is unable to raise the requisite amount of regulatory capital
(including loss absorbing capital), or to otherwise meet regulatory capital
and leverage requirements, it may be exposed to increased regulatory
supervision or sanctions, loss of investor confidence, restrictions on
distributions and it may be required to reduce further the amount of its
risk-weighted assets or total assets and engage in the disposal of core and
other non-core businesses, which may not occur on a timely basis or achieve
prices which would otherwise be attractive to the Group. 
 
This may also result in write-down or the conversion into equity of certain
regulatory capital instruments issued by the Group or the issue of additional
equity by the Group, each of which could result in the dilution of the Group's
existing shareholders. A breach of the Group's applicable capital or leverage
requirements may also trigger the application of the Group's recovery plan to
remediate a deficient capital position. 
 
Failure by the Group to comply with its capital requirements or to maintain
sufficient distributable reserves may result in the application of
restrictions on its ability to make discretionary distributions, including the
payment of dividends to its ordinary shareholders and coupons on certain
capital instruments. 
 
In accordance with the provisions of CRD IV, a minimum level of capital
adequacy is required to be met by the Group in order for it to be entitled to
make certain discretionary payments. 
 
Pursuant to Article 141 (Restrictions on distribution) of the CRD IV
Directive, as transposed in the UK, institutions that fail to meet the
"combined buffer requirement" will be subject to restricted "discretionary
payments" (which are defined broadly by CRD IV as payments relating to CET1
instruments (dividends), variable remuneration and coupon payments on
additional tier 1 instruments). The resulting restrictions are scaled
according to the extent of the breach of the "combined buffer requirement" and
calculated as a percentage of the profits of the institution since the last
distribution of profits or "discretionary payment" which gives rise to a
maximum distributable amount (MDA) (if any) that the financial institution can
distribute through discretionary payments. The EBA has clarified that the CET1
capital to be taken into account for the MDA calculation should be limited to
the amount not used to meet the Pillar 1 and Pillar 2 own funds requirements
of the institution. In the event of a breach of the combined buffer
requirement, the Group will be required to calculate its MDA, and as a
consequence it may be necessary for the Group to reduce or cease discretionary
payments to the extent of the breach. 
 
The ability of the Group to meet the combined buffer requirement will be
subject to the Group holding sufficient CET1 capital in excess of its minimum
Pillar 1 and Pillar 2 capital requirements. In addition, the interaction of
such restrictions on distributions with the capital requirements and buffers
applicable to the Group remains uncertain in many respects while the relevant
authorities in the EU and the UK consult on and develop their proposals and
guidance on the application of the rules. In particular, the proposals
published by the European Commission in November 2016 contain certain proposed
amendments to Article 141, including to introduce a "stacking order" in the
calculation of the maximum distributable amount and establish certain
priorities in the payments which could be made in the event the restrictions
apply (with payments relating to additional tier 1 instruments being required
to be made before payments on CET1 instruments (dividends) or other
discretionary payments). The treatment of MDA breaches under the European
Commission proposals differ from the proposed consequences set out in the
final PRA rules and may result in uncertainty in the application of these
rules. 
 
In addition to these rules, in order to make distributions (including dividend
payments) in the first place, RBSG is required to have sufficient
distributable reserves available. Furthermore, coupon payments due on the
additional tier 1 instruments issued by RBSG must be cancelled in the event
that RBSG has insufficient "distributable items" as defined under CRD IV. Both
distributable reserves and distributable items are largely impacted by the
Group's ability to generate and accumulate profits or conversely by material
losses (including losses resulting from conduct related-costs, restructuring
costs or impairments). 
 
RBSG's distributable reserves and distributable items are sensitive to the
accounting impact of factors including the redemption of preference shares,
restructuring costs and impairment charges and the carrying value of its
investments in subsidiaries which are carried at the lower of cost and their
prevailing recoverable amount. Recoverable amounts depend on discounted future
cash flows which can be affected by restructurings, including the
restructuring required to implement the UK ring-fencing regime, or unforeseen
events. The distributable reserves of RBSG also depend on the receipt of
income from subsidiaries, principally as dividends. The ability of
subsidiaries to pay dividends is subject to their performance and applicable
local laws and other restrictions, including their respective regulatory
requirements and distributable reserves. Any of these factors, including
restructuring costs, impairment charges and a reduction in the carrying value
of RBSG subsidiaries or a shortage of dividends from them could limit RBSG's
ability to maintain sufficient distributable reserves to be able to pay
coupons on certain capital instruments and dividends to its ordinary
shareholders. In Q3 2016, the Group reviewed the value of the investments in
subsidiaries held in the parent company, RBSG, and in light of the
deterioration in the economic outlook, impaired the carrying value of the
investments by £6.0 billion to £44.7 billion. 
 
This had the effect of reducing distributable profits of RBSG by £6.0 billion
and the Group may be required to recognise further impairments in the future
if the outlook for its subsidiaries were to worsen. Whilst this level of
distributable profits does not impact upon RBSG's ability to pay coupons on
existing securities, the Group intends to implement a capital reorganisation
in 2017 (subject to shareholder and court approval) in order to increase
RBSG's distributable reserves, providing greater flexibility for potential
future distributions and preference share redemptions (if any). 
 
Failure by the Group to meet the combined buffer requirement or retain
sufficient distributable reserves or distributable items as a result of
reduced profitability or losses, or changes in regulation or taxes adversely
impacting distributable reserves or distributable items, may therefore result
in limitations on the Group's ability to make discretionary distributions
which may negatively impact the Group's shareholders, holders of additional
tier 1 instruments, staff receiving variable compensation (such as bonuses)
and other stakeholders and impact its market valuation and investors' and
analysts' perception of its financial soundness. 
 
The Group is subject to stress tests mandated by its regulators in the UK and
in Europe which may result in additional capital requirements or management
actions which, in turn, may impact the Group's financial condition, results of
operations and investor confidence or result in restrictions on
distributions. 
 
The Group is subject to annual stress tests by its regulator in the UK and
also subject to stress tests by the European regulators with respect to RBSG,
RBS NV and Ulster Bank. Stress tests provide an estimate of the amount of
capital banks might deplete in a hypothetical stress scenario. In addition, if
the stress tests reveal that a bank's existing regulatory capital buffers are
not sufficient to absorb the impact of the stress, it is possible that it will
need to take action to strengthen its capital position. There is a strong
expectation that the PRA would require a bank to take action if, at any point
during the stress, a bank were projected to breach any of its minimum CET1
capital or leverage ratio requirements. However, if a bank is projected to
fail to meet its systemic buffers, it will still be expected to strengthen its
capital position over time but the supervisory response is expected to be less
intensive than if it were projected to breach its minimum capital
requirements. The PRA will also use the annual stress test results to inform
its determination of whether individual banks' current capital positions are
adequate or need strengthening. For some banks, their individual stress-test
results might imply that the capital conservation buffer and countercyclical
rates set for all banks is not consistent with the impact of the stress on
them. In that case, the PRA can increase regulatory capital buffers for
individual banks by adjusting their PRA buffers. 
 
Under the 2016 Bank of England stress tests, which were based on the balance
sheet of the Group for the year ended 31 December 2015, the Group did not meet
its CET1 capital or Tier 1 leverage hurdle rates before additional tier 1
conversion. After additional tier 1 conversion, it did not meet its CET1
systemic reference point or Tier 1 leverage ratio hurdle rate. In light of the
stress test results the Group agreed a revised capital plan with the PRA to
improve its stress resilience in light of the various challenges and
uncertainties facing both the Group and the wider economy highlighted by the
concurrent stress testing process. As part of this revised capital plan, the
Group intends to execute an array of capital management actions to supplement
organic capital generation from its core franchises and further improve its
stress resilience, including: further decreasing the cost base of the Group;
further reductions in risk-weighted assets across the Group; further run-down
and sale of other non-core loan portfolios in relation to the personal and
commercial franchises and the management of undrawn facilities in 2017.
Additional management actions may be required by the PRA until the Group's
balance sheet is sufficiently resilient to meet the regulator's stressed
scenarios. 
 
Consistent with the approach set out in the 2015, the 2017 Bank of England
stress test will, for the first time, test the resilience of the system, and
individual banks within it, against two stress scenarios. In addition to the
annual cyclical scenario, there will be an additional 'exploratory' scenario
that will be tested for the first time in 2017. This will allow the Bank of
England to assess the resilience of the system, and the individual banks
within it, to a wider range of potential threats, including weak global supply
growth, persistently low interest rates, and a continuation of declines in
both world trade relative to GDP and cross-border banking activity. If the
Group were to fail under either of these scenarios, it may be required to take
further action to strengthen its capital position. In addition, the
introduction of IFRS 9, effective for annual periods beginning on or after 1
January 2018, is expected to result in capital volatility for the Group, which
in turn could have an impact on the Group's ability to meet its required CET1
ratio in a stress test scenario. 
 
Failure by the Group to meet the thresholds set as part of the stress tests
carried out by its regulators in the UK and elsewhere may result in the
Group's regulators requiring the Group to generate additional capital,
increased supervision and/or regulatory sanctions, restrictions on capital
distributions and loss of investor confidence, which may impact the Group's
financial condition, results of operations and prospects. 
 
As a result of extensive reforms being implemented relating to the resolution
of financial institutions within the UK, the EU and globally, material
additional requirements will arise to ensure that financial institutions
maintain sufficient loss-absorbing capacity. Such changes to the funding and
regulatory capital framework may require the Group to meet higher capital
levels than the Group anticipated within its strategic plans and affect the
Group's funding costs. 
 
In addition to the prudential requirements applicable under CRD IV, the BRRD
introduces, among other things, a requirement for banks to maintain at all
times a sufficient aggregate amount of own funds and "eligible liabilities"
(that is, liabilities that can absorb loss and assist in recapitalising a firm
in accordance with a predetermined resolution strategy), known as the minimum
requirements for own funds and eligible liabilities (MREL), designed to ensure
that the resolution of a financial institution may be carried out, without
public funds being exposed to the risk of loss and in a way which ensures the
continuity of critical economic functions, maintains financial stability and
protects depositors. 
 
In November 2015, the FSB published a final term sheet setting out its total
loss-absorbing capacity (TLAC) standards for G-SIBs. The EBA was mandated to
assess the implementation of MREL in the EU and the consistency of MREL with
the final TLAC standards and published an interim report setting out the
conclusions of its review in July 2016 and its final report in December 2016.
On the basis of the EBA's work and its own assessment of CRD IV and the BRRD,
the European Commission published in November 2016 a comprehensive set of
proposals, seeking to make certain amendments to the existing MREL framework.
In particular, the proposals make a number of amendments to the MREL
requirements under the BRRD, in part in order to transpose the FSB's final
TLAC term sheet. 
 
The UK government is required to transpose the BRRD's provisions relating to
MREL into law through further secondary legislation. In November 2016, the
Bank of England published its final rules setting out its approach to setting
MREL for UK banks. These final rules (which were adopted on the basis of the
current MREL framework in force in the EU) do not take into account the
European Commission's most recent proposals with respect to MREL and differ in
a number of respects. In addition, rules relating to a number of specific
issues under the framework remain to be implemented, following the publication
of further rules by the FSB, in particular rules on internal MREL
requirements, cross holdings and disclosure requirements are outstanding. 
 
The Bank of England is responsible for setting the MREL requirements for each
UK bank, building society and certain investment firms in consultation with
the PRA and the FCA, and such requirement will be set depending on the
resolution strategy of the financial institution. In its final rules, the Bank
of England has set out a staggered compliance timeline for UK banks, including
with respect to those requirements applicable to G-SIBs (including the Group).
Under the revised timeline, G-SIBs will be expected to (i) meet the minimum
requirements set out in the FSB's TLAC term sheet from 1 January 2019 (i.e.
the higher of 16% of risk-weighted assets or 6% of leverage exposures), and
(ii) meet the full MREL requirements to be phased in from 1 January 2020, with
the full requirements applicable from 2 January 2022 (i.e. for G-SIBs two
times Pillar 1 plus Pillar 2A or the higher of two times the applicable
leverage ratio requirement or 6.75% of leverage exposures). MREL requirements
are expected to be set on consolidated, sub-consolidated and individual bases,
and are in addition to regulatory capital requirements(so that there can be no
double counting of instruments qualifying for capital requirements). 
 
For institutions, including the Group, for which bail-in is the required
resolution strategy and which are structured to permit single point of entry
resolution due to their size and systemic importance, the Bank of England has
indicated that in order to qualify as MREL, eligible liabilities must be
issued by the resolution entity (i.e. the holding company for the Group) and
be structurally subordinated to operating and excluded liabilities (which
include insured deposits, short-term debt, derivatives, structured notes and
tax liabilities). 
 
The final PRA rules set out a number of liabilities which cannot qualify as
MREL and are therefore "excluded liabilities". As a result, senior unsecured
issuances by RBSG will need to be subordinated to the excluded liabilities
described above. The proceeds from such issuances will be transferred
downstream to material operating subsidiaries in the form of capital or
another form of subordinated claim. In this way, MREL resources will be
"structurally subordinated" to senior liabilities of operating companies,
allowing losses from operating companies to be transferred to the holding
company and - if necessary - for resolution to occur at the holding company
level, without placing the operating companies into a resolution process. The
TLAC standard includes an exemption from this requirement if the total amount
of excluded liabilities on RBSG's balance sheet does not exceed 5% of its
external TLAC (i.e. the eligible liabilities RBSG has issued to investors
which meet the TLAC requirements) and the Bank of England has adopted this
criterion in its final rules. If the Group were to fail to comply with this
"clean balance sheet" requirement, it could disqualify otherwise eligible
liabilities from counting towards MREL and result in the Group breaching its
MREL requirements. 
 
Compliance with these and other future changes to capital adequacy and
loss-absorbency requirements in the EU and the UK by the relevant deadline
will require the Group to restructure its balance sheet and issue additional
capital compliant with the rules which may be costly whilst certain existing
Tier 1 and Tier 2 securities and other senior instruments issued by the Group
will cease to count towards the Group's loss-absorbing capital for the
purposes of meeting MREL/TLAC requirements. The Group's resolution authority
can impose an MREL requirement over and above the regulatory minima and
potentially higher than the Group's peers, if it has concerns regarding the
resolvability of the Group. As a result, RBSG may be required to issue
additional loss-absorbing instruments in the form of CET1 capital or
subordinated or senior unsecured debt instruments or may result in an
increased risk of a breach of the Group's combined buffer requirement,
triggering the restrictions relating to the MDA described above. 
 
There remain some areas of uncertainty as to how these rules will be
implemented within the UK, the EU and globally and the final requirements to
which the Group will be subject, and the Group may therefore need to revise
its capital plan accordingly. The European Commission's recent proposals also
include a proposal seeking to harmonise the priority ranking of unsecured debt
instruments under national insolvency proceedings to facilitate the
implementation of MREL across Europe. This rule is currently subject to
consideration and negotiation by the European institutions but, to the extent
it were to apply to the Group, it could impact the ranking of current or
future senior unsecured creditors of the Group. 
 
The Group's borrowing costs, its access to the debt capital markets and its
liquidity depend significantly on its credit ratings and, to a lesser extent,
on the rating of the UK Government. 
 
The credit ratings of RBSG, RBS plc and other Group members directly affect
the cost of funding and capital instruments issued by the Group, as well as
secondary market liquidity in those instruments. A number of UK and other
European financial institutions, including RBSG, RBS plc and other Group
companies, have been downgraded multiple times in recent years in connection
with rating methodology changes and credit rating agencies' revised outlook
relating to regulatory developments, macroeconomic trends and a financial
institution's capital position and financial prospects. 
 
The senior unsecured long-term and short-term credit ratings of RBSG are below
investment grade by Moody's, and investment grade by S&P and Fitch. The senior
unsecured long-term and short-term credit ratings of RBS plc are investment
grade by Moody's, S&P and Fitch. The outlook for RBSG and RBS plc by Moody's
is currently positive and is stable for S&P and Fitch. 
 
Rating agencies regularly review the RBSG and Group entity credit ratings and
their ratings of long-term debt are based on a number of factors, including
the Group's financial strength as well as factors not within the Group's
control, including political developments and conditions affecting the
financial services industry generally. In particular, the rating agencies may
further review the RBSG and Group entity ratings as a result of the
implementation of the UK ring-fencing regime, pension and
litigation/regulatory investigation risk, including potential fines relating
to investigations relating to legacy conduct issues, and other macroeconomic
and political developments, including in light of the outcome of the
negotiations relating to the shape and timing of the UK's exit from the EU. A
challenging macroeconomic environment, reduced profitability and greater
market uncertainty could negatively impact the Group's performance and
potentially lead to credit ratings downgrades which could adversely impact the
Group's ability and cost of funding. The Group's ability to access capital
markets on acceptable terms and hence its ability to raise the amount of
capital and funding required to meet its regulatory requirements and targets,
including those relating to loss-absorbing instruments to be issued by the
Group, could be affected. 
 
Any further reductions in the long-term or short-term credit ratings of RBSG
or of certain of its subsidiaries (particularly RBS plc), including further
downgrades below investment grade, could adversely affect the Group's issuance
capacity in the financial markets, increase its funding and borrowing costs,
require the Group to replace funding lost due to the downgrade, which may
include the loss of customer deposits and may limit the Group's access to
capital and money markets and trigger additional collateral or other
requirements in derivatives contracts and other secured funding arrangements
or the need to amend such arrangements, limit the range of counterparties
willing to enter into transactions with the Group and its subsidiaries and
adversely affect its competitive position, all of which could have a material
adverse impact on the Group's earnings, cash flow and financial condition. 
 
As discussed above, the success of the implementation of the UK ring-fencing
regime and the restructuring of the Group's NatWest Markets franchise, is in
part dependent upon the relevant banking entities obtaining a sustainable
credit rating. A failure to obtain such a rating, or any subsequent downgrades
to current ratings may threaten the ability of the NatWest Markets franchise
or other entities outside of the RFB, in particular with respect to their
ability to meet prudential capital requirements. At 31 December 2016, a
simultaneous one-notch long-term and associated short-term downgrade in the
credit ratings of RBSG and RBS plc by the three main ratings agencies would
have required the Group to post estimated additional collateral of £3.3
billion, without taking account of mitigating action by management. Individual
credit ratings of RBSG, RBS plc, RBS N.V, RBS International and Ulster Bank
are also important to the Group when competing in certain markets such as
corporate deposits and over-the-counter derivatives. 
 
The major credit rating agencies downgraded and changed their outlook to
negative on the UK's sovereign credit rating following the results of the EU
Referendum in June 2016. Any further downgrade in the UK Government's credit
ratings could adversely affect the credit ratings of Group companies and may
result in the effects noted above. Further political developments, including
in relation to the UK's exit from the EU or the outcome of any further
Scottish referendum could negatively impact the credit ratings of the UK
Government and result in a downgrade of the credit ratings of RBSG and Group
entities. 
 
The Group's ability to meet its obligations including its funding commitments
depends on the Group's ability to access sources of liquidity and funding. 
 
Liquidity risk is the risk that a bank will be unable to meet its obligations,
including funding commitments, as they fall due. This risk is inherent in
banking operations and can be heightened by a number of factors, including an
over-reliance on a particular source of wholesale funding (including, for
example, short-term and overnight funding), changes in credit ratings or
market-wide phenomena such as market dislocation and major disasters. Credit
markets worldwide, including interbank markets, have experienced severe
reductions in liquidity and term funding during prolonged periods in recent
years. In 2016, although the Group's overall liquidity position remained
strong, credit markets experienced elevated volatility and certain European
banks, in particular in the peripheral countries of Spain, Portugal, Greece
and Italy, remained reliant on the ECB as one of their principal sources of
liquidity. 
 
The Group relies on retail and wholesale deposits to meet a considerable
portion of its funding. The level of deposits may fluctuate due to factors
outside the Group's control, such as a loss of confidence, increasing
competitive pressures for retail customer deposits or the repatriation of
deposits by foreign wholesale depositors, which could result in a significant
outflow of deposits within a short period of time. 
 
An inability to grow, or any material decrease in, the Group's deposits could,
particularly if accompanied by one of the other factors described above, have
a material adverse impact on the Group's ability to satisfy its liquidity
needs. Increases in the cost of retail deposit funding may impact the Group's
margins and profitability. 
 
The Group is using the Bank of England's term funding scheme which was
introduced in August 2016, in order to reduce the funding costs for the Group.
Such funding has a short maturity profile and hence the Group will diversify
its sources of funding. 
 
The market view of bank credit risk has changed radically as a result of the
financial crisis and banks perceived by the market to be riskier have had to
issue debt at significantly higher costs. Although conditions have improved,
there have been recent periods where corporate and financial institution
counterparties have reduced their credit exposures to banks and other
financial institutions, limiting the availability of these sources of funding.
Rules currently proposed by the FSB and in the EU in relation to the
implementation of TLAC and MREL may also limit the ability of certain large
financial institutions to hold debt instruments issued by other large
financial institutions. The ability of the Bank of England to resolve the
Group in an orderly manner may also increase investors' perception of risk and
hence affect the availability and cost of funding for the Group. Any
uncertainty relating to the credit risk of financial institutions may lead to
reductions in levels of interbank lending or may restrict the Group's access
to traditional sources of funding or increase the costs or collateral
requirements for accessing such funding. 
 
The Group has, at times, been required to rely on shorter-term and overnight
funding with a consequent reduction in overall liquidity, and to increase its
recourse to liquidity schemes provided by central banks. Such schemes require
assets to be pledged as collateral. Changes in asset values or eligibility
criteria can reduce available assets and consequently available liquidity,
particularly during periods of stress when access to the schemes may be needed
most. The implementation of the UK ring-fencing regime may also impact the
Group's funding strategy and the cost of funding may increase for certain
Group entities which will be required to manage their own funding and
liquidity strategy, in particular those entities outside the ring-fence which
will no longer be able to rely on retail deposit funding. 
 
In addition, the Group is subject to certain regulatory requirements with
respect to liquidity coverage, including a liquidity coverage ratio set by the
PRA in the UK. This requirement is currently being phased in and is set at 90%
from 1 January 2017 to increase 100% in January 2018 (as required by the CRR).
The PRA may also impose additional liquidity requirements to reflect risks not
captured in the leverage coverage ratio by way of Pillar 2 add-ons, which may
increase from time to time and require the Group to obtain additional funding
or diversify its sources of funding. Current proposals by the FSB and the
European Commission also seek to introduce certain liquidity requirements for
financial institutions, including the introduction of a net stable funding
ratio (NSFR). Under the European Commission November 2016 proposals, the NSFR
would be calculated as the ratio of an institution's available stable funding
relative to the required stable funding it needs over a one-year horizon. 
 
The NSFR would be expressed as a percentage and set at a minimum level of
100%, which indicates that an institution holds sufficient stable funding to
meet its funding needs during a one-year period under both normal and stressed
conditions. If an institution's NSFR were to fall below the 100% level, the
institution would be required to take the measures laid down in the CRD IV
Regulation for a timely restoration to the minimum level. Competent
authorities would assess the reasons for non-compliance with the NSFR
requirement before deciding on any potential supervisory measures. These
proposals are currently being considered and negotiated among the European
Commission, the European Parliament and the Council and, in light of the UK's
decision to leave the EU, there is considerable uncertainty as to the extent
to which such rules will apply to the Group. 
 
If the Group is unable to raise funds through deposits and/or in the capital
markets, its liquidity position could be adversely affected and it might be
unable to meet deposit withdrawals on demand or at their contractual maturity,
to repay borrowings as they mature, to meet its obligations under committed
financing facilities, to comply with regulatory funding requirements or to
fund new loans, investments and businesses. The Group may need to liquidate
unencumbered assets to meet its liabilities, including disposals of assets not
previously identified for disposal to reduce its funding commitments. In a
time of reduced liquidity, the Group may be unable to sell some of its assets,
or may need to sell assets at depressed prices, which in either case could
have a material adverse effect on the Group's financial condition and results
of operations. 
 
The Group's businesses and performance can be negatively affected by actual or
perceived economic conditions in the UK and globally and other global risks
and the Group will be increasingly impacted by developments in the UK as its
operations become increasingly concentrated in the UK. 
 
Actual or perceived difficult global economic conditions create challenging
economic and market conditions and a difficult operating environment for the
Group's businesses and its customers and counterparties. As part of its
revised strategy, the Group has been refocusing its business in the UK, the
ROI and Western Europe and, accordingly is more exposed to the economic
conditions of the British economy as well as the Eurozone. In particular, the
longer term effects of the EU Referendum are difficult to predict, and subject
to wider global macro-economic trends, but may include periods of financial
market volatility and slower economic growth, in the UK in particular, but
also in the ROI, Europe and the global economy, at least in the short to
medium term. 
 
The outlook for the global economy over the medium-term remains uncertain due
to a number of factors including: political instability, continued slowdown of
global growth, an extended period of low inflation and low interest rates and
delays in normalising monetary policy. Such conditions could be worsened by a
number of factors including political uncertainty or macro-economic
deterioration in the Eurozone or the US, increased instability in the global
financial system and concerns relating to further financial shocks or
contagion, a further weakening of the pound sterling, new or extended economic
sanctions, volatility in commodity prices or concerns regarding sovereign
debt. In particular, concerns relating to emerging markets, including lower
economic growth or recession, concerns relating to the Chinese economy and
financial markets, reduced global trade in emerging market economies to which
the Group is exposed (including those economies to which the Group remains
exposed pending the exit of certain of its businesses and which include China,
India and Saudi Arabia) or increased financing needs as existing debt matures,
may give rise to further instability and financial market volatility. Any of
the above developments could impact the Group directly by resulting in credit
losses and indirectly by further impacting global economic growth and
financial markets. 
 
Developments relating to current economic conditions, including those
discussed above, could have a material adverse effect on the Group's business,
financial condition, results of operations and prospects. Any such
developments may also adversely impact the financial position of the Group's
pension schemes, which may result in the Group being required to make
additional contributions. See "The Group is subject to pension risks and may
be required to make additional contributions to cover pension funding deficits
as a result of degraded economic conditions or as a result of the
restructuring of its pension schemes in relation to the implementation of the
UK ring-fencing regime". 
 
In addition, the Group is exposed to risks arising out of geopolitical events
or political developments, such as trade barriers, exchange controls,
sanctions and other measures taken by sovereign governments that can hinder
economic or financial activity levels. Furthermore, unfavourable political,
military or diplomatic events, armed conflict, pandemics and terrorist acts
and threats, and the responses to them by governments, could also adversely
affect economic activity and have an adverse effect upon the Group's business,
financial condition and results of operations. 
 
Changes in interest rates or foreign exchange rates have significantly
affected and will continue to affect the Group's business and results of
operations. 
 
Some of the most significant market risks that the Group faces are interest
rate and foreign exchange risks. Monetary policy has been highly accommodative
in recent years, including as a result of certain policies implemented by the
Bank of England and HM Treasury such as the 'Funding for Lending' scheme,
which have helped to support demand at a time of very pronounced fiscal
tightening and balance sheet repair. In the UK, the Bank of England lowered
interest rates to 0.25% in August 2016 and there remains considerable
uncertainty as to whether or when the Bank of England and other central banks
will increase interest rates. While the ECB has been conducting a quantitative
easing programme since January 2015 designed to improve confidence in the
Eurozone and encourage more private bank lending, there remains considerable
uncertainty as to whether such measures have been or will be sufficient or
successful and the extension of this programme during 2017 may put additional
pressure on margins. Further decreases in interest rates by the Bank of
England or other central banks, continued sustained low or negative interest
rates or any divergences in monetary policy approach between the Bank of
England and other major central banks could put further pressure on the
Group's interest margins and adversely affect the Group's profitability and
prospects. A continued period of low interest rates and yield curves and
spreads may affect the interest rate margin realised between lending and
borrowing costs, the effect of which may be heightened during periods of
liquidity stress. 
 
Conversely while increases in interest rates may support Group income, sharp
increases in interest rates could lead to generally weaker than expected
growth, or even contracting GDP, reduced business confidence, higher levels of
unemployment or underemployment, adverse changes to levels of inflation,
potentially higher interest rates and falling property prices in the markets
in which the Group operates. In turn, this could cause stress in the loan
portfolio of the Group, particularly in relation to non-investment grade
lending or real estate loans and consequently to an increase in delinquency
rates and default rates among customers, leading to the possibility of the
Group incurring higher impairment charges. Similar risks result from the
exceptionally low level of inflation in developed economies, which in Europe
particularly could deteriorate into sustained deflation if policy measures
prove ineffective. Reduced monetary stimulus and the actions and commercial
soundness of other financial institutions have the potential to impact market
liquidity. 
 
Changes in currency rates, particularly in the sterling-US dollar and
sterling-euro exchange rates, affect the value of assets, liabilities, income
and expenses denominated in foreign currencies and the reported earnings of
the Group's non-UK subsidiaries and may affect the Group's reported
consolidated financial condition or its income from foreign exchange dealing.
Such changes may result from the decisions of the Bank of England, ECB or of
the US Federal Reserve or from political events and lead to sharp and sudden
variations in foreign exchange rates, such as those seen in the GBP/USD
exchange rates during the second half of 2016 following the EU Referendum. 
 
The Group's earnings and financial condition have been, and its future
earnings and financial condition may continue to be, materially affected by
depressed asset valuations resulting from poor market conditions. 
 
The Group's businesses and performance are affected by financial market
conditions. The performance and volatility of financial markets affect bond
and equity prices and have caused, and may in the future cause, changes in the
value of the Group's investment and trading portfolios. Financial markets have
recently experienced and may in the near term experience significant
volatility, including as a result of concerns about the outcome of the EU
Referendum, political and financial developments in the US and in Europe,
including as a result of general elections, geopolitical developments and
developments relating to trade agreements volatility and instability in the
Chinese and global stock markets, expectations relating to or actions taken by
central banks with respect to monetary policy, and weakening fundamentals of
the Chinese economy, resulting in further short-term changes in the valuation
of certain of the Group's assets. Uncertainty about potential fines for past
misconduct and concerns about the longer-term viability of business models
have also weighed heavily on the valuations of some financial institutions in
Europe and in the UK, including the Group. 
 
Any further deterioration in economic and financial market conditions or weak
economic growth could require the Group to recognise further significant
write-downs and realise increased impairment charges or goodwill impairments,
all of which may have a material adverse effect on its financial condition,
results of operations and capital ratios. As part of its transformation
programme, the Group is executing the run-down or disposal of a number of
businesses, assets and portfolios. In addition, the Group's interest in the
remainder of the businesses and portfolios within the exiting business may be
difficult to sell due to unfavourable market conditions for such assets or
businesses. 
 
Moreover, market volatility and illiquidity (and the assumptions, judgements
and estimates in relation to such matters that may change over time and may
ultimately not turn out to be accurate) make it difficult to value certain of
the Group's exposures. Valuations in future periods reflecting, among other
things, the then-prevailing market conditions and changes in the credit
ratings of certain of the Group's assets may result in significant changes in
the fair values of the Group's exposures, such as credit market exposures, and
the value ultimately realised by the Group may be materially different from
the current or estimated fair value. As part of its ongoing derivatives
operations, the Group also faces significant basis, volatility and correlation
risks, the occurrence of which are also impacted by the factors noted above. 
 
In addition, for accounting purposes, the Group carries some of its issued
debt, such as debt securities, at the current market price on its balance
sheet. Factors affecting the current market price for such debt, such as the
credit spreads of the Group, may result in a change to the fair value of such
debt, which is recognised in the income statement as a profit or loss. 
 
The financial performance of the Group has been, and may continue to be,
materially affected by customer and counterparty credit quality and
deterioration in credit quality could arise due to prevailing economic and
market conditions and legal and regulatory developments. 
 
The Group has exposure to many different industries, customers and
counterparties, and risks arising from actual or perceived changes in credit
quality and the recoverability of monies due from borrowers and other
counterparties are inherent in a wide range of the Group's businesses. 
 
In particular, the Group has significant exposure to certain individual
customers and other counterparties in weaker business sectors and geographic
markets and also has concentrated country exposure in the UK, the US and
across the rest of Europe principally Germany, the Netherlands, Ireland and
France. 
 
At 31 December 2016, current exposure in the UK was £338.9 billion, in the US
was £22.4 billion and in Western Europe (excluding the UK) was £79.7 billion);
and within certain business sectors, namely personal, financial institutions,
property, shipping and the oil and gas sector (at 31 December 2016, personal
lending amounted to £166.2 billion, lending to banks and other financial
institutions was £47.7 billion, property lending was £42.4 billion, lending to
the oil and gas sector was £2.9 billion and shipping was £4.6 billion). 
 
Provisions held on loans in default have decreased in recent years due to
asset sales and the portfolio run-down in Ulster Bank ROI and Capital
Resolution. If the risk profile of these loans were to increase, including as
a result of a degradation of economic or market conditions, this could result
in an increase in the cost of risk and the Group may be required to make
additional provisions, which in turn would reduce earnings and impact the
Group's profitability. The Group's lending strategy or processes may also fail
to identify or anticipate weaknesses or risks in a particular sector, market
or borrower category, which may result in an increase in default rates, which
may, in turn, impact the Group's profitability. Any adverse impact on the
credit quality of the Group's customers and other counterparties, coupled with
a decline in collateral values, could lead to a reduction in recoverability
and value of the Group's assets and higher levels of impairment allowances,
which could have an adverse effect on the Group's operations, financial
position or prospects. 
 
The credit quality of the Group's borrowers and its other counterparties is
impacted by prevailing economic and market conditions and by the legal and
regulatory landscape in their respective markets. Credit quality has improved
in certain of the Group's core markets, in particular the UK and Ireland, as
these economies have improved. However, a further deterioration in economic
and market conditions or changes to legal or regulatory landscapes could
worsen borrower and counterparty credit quality and also impact the Group's
ability to enforce contractual security rights. In particular, the UK's
decision to leave the EU may adversely impact credit quality in the UK. 
 
In addition, as the Group implements its new strategy and withdraws from many
geographic markets and continues to materially scale down its international
activities, the Group's relative exposure to the UK and certain sectors and
asset classes in the UK will increase significantly as its business becomes
more concentrated in the UK. The level of UK household indebtedness remains
high and the ability of some households to service their debts could be
challenged by a period of higher unemployment. Highly indebted households are
particularly vulnerable to shocks, such as falls in incomes or increases in
interest rates, which threaten their ability to service their debts. 
 
In particular, in the UK the Group is at risk from volatility in property
prices in both the residential and commercial sectors. With UK home loans
representing the most significant portion of the Group's total loans and
advances to the retail sector, the Group has a large exposure to adverse
developments in the UK residential property sector. In the UK commercial real
estate market, activity slowed during the second half of 2016 following the EU
Referendum. There is a risk of further adjustment given the reliance of the UK
commercial real estate market in recent years on inflows of foreign capital
and, in some segments, stretched property valuations. As a result, a fall in
house prices, particularly in London and the South East of the UK, would be
likely to lead to higher impairment and negative capital impact as loss given
default rate increases. In addition, reduced affordability of residential and
commercial property in the UK, for example, as a result of higher interest
rates or increased unemployment, could also lead to higher impairments on
loans held by the Group being recognised. 
 
The Group also remains exposed to certain counterparties operating in certain
industries which have been under pressure in recent years, including the oil
and gas and shipping industries, and any further deterioration in the outlook
the credit quality of these counterparties may require the Group to make
additional provisions, which in turn would reduce earnings and impact the
Group's profitability. 
 
In addition, the Group's credit risk is exacerbated when the collateral it
holds cannot be realised as a result of market conditions or regulatory
intervention or is liquidated at prices not sufficient to recover the full
amount of the loan or derivative exposure that is due to the Group, which is
most likely to occur during periods of illiquidity and depressed asset
valuations, such as those experienced in recent years. This has particularly
been the case with respect to large parts of the Group's commercial real
estate portfolio. Any such deteriorations in the Group's recoveries on
defaulting loans could have an adverse effect on the Group's results of
operations and financial condition. 
 
Concerns about, or a default by, one financial institution could lead to
significant liquidity problems and losses or defaults by other financial
institutions, as the commercial and financial soundness of many financial
institutions may be closely related as a result of credit, trading, clearing
and other relationships. Even the perceived lack of creditworthiness of, or
questions about, a counterparty may lead to market-wide liquidity problems and
losses for, or defaults by, the Group. This systemic risk may also adversely
affect financial intermediaries, such as clearing agencies, clearing houses,
banks, securities firms and exchanges with which the Group interacts on a
daily basis. 
 
The effectiveness of recent prudential reforms designed to contain systemic
risk in the EU and the UK is yet to be tested. Counterparty risk within the
financial system or failures of the Group's financial counterparties could
have a material adverse effect on the Group's access to liquidity or could
result in losses which could have a material adverse effect on the Group's
financial condition, results of operations and prospects. 
 
The trends and risks affecting borrower and counterparty credit quality have
caused, and in the future may cause, the Group to experience further and
accelerated impairment charges, increased repurchase demands, higher costs,
additional write-downs and losses for the Group and an inability to engage in
routine funding transactions. 
 
The Group's operations are highly dependent on its IT systems. A failure of
the Group's IT systems, including as a result of the lack of or untimely
investments, could adversely affect its operations, competitive position and
investor and customer confidence and expose the Group to regulatory
sanctions. 
 
The Group's operations are dependent on the ability to process a very large
number of transactions efficiently and accurately while complying with
applicable laws and regulations where it does business. The proper functioning
of the Group's payment systems, financial and sanctions controls, risk
management, credit analysis and reporting, accounting, customer service and
other IT systems, as well as the communication networks between its branches
and main data processing centres, are critical to the Group's operations. 
 
The vulnerabilities of the Group's IT systems are due to their complexity,
attributable in part to overlapping multiple dated systems that result from
the Group's historical acquisitions and insufficient investment prior to 2013
to keep the IT applications and infrastructure up-to-date. A complex IT estate
containing end-of-life hardware and software creates challenges in recovering
from system breakdowns. IT failures adversely affect the Group's relationship
with its customers and reputation and have led, and may in the future, lead to
regulatory investigations and redress. 
 
The Group experienced a limited number of IT failures in 2016 affecting
customers, although improvements introduced since 2012 allowed the Group to
contain the impact of such failures. The Group's regulators in the UK are
actively surveying progress made by banks in the UK to modernise, manage and
secure their IT infrastructures, in order to prevent future failures affecting
customers. Any critical system failure, any prolonged loss of service
availability or any material breach of data security could cause serious
damage to the Group's ability to service its customers, could result in
significant compensation costs or fines resulting from regulatory
investigations and could breach regulations under which the Group operates. 
 
In particular, failures or breaches resulting in the loss or publication of
confidential customer data could cause long-term damage to the Group's
reputation, business and brands, which could undermine its ability to attract
and keep customers. 
 
The Group is currently implementing a number of complex initiatives, including
its transformation programme, the UK ring-fencing regime and the restructuring
of the NatWest Markets franchise, all which put additional strains on the
Group's existing IT systems. A failure to safely and timely implement one or
several of these initiatives could lead to disruptions of the Group's IT
infrastructure and in turn cause long-term damage to the Group's reputation,
brands, results of operations and financial position. 
 
The Group has made, and will continue to make, considerable investments in its
IT systems to further simplify and upgrade the systems and capabilities to
make them more cost-effective and improve controls and procedures, strengthen
cyber security defences, enhance the digital services provided to its bank
customers and improve its competitive position and address system failures


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