Investor Report. RBS Citizens Financial Group, Inc. September 30, 2012

Transcription

1 Investor Report RBS Citizens Financial Group, Inc. September 30, 2012 To the holders of the 4.15% Subordinated Notes due 2022 Issued under, and pursuant to the terms of, an indenture dated as of September 28, 2012 between RBS Citizens Financial Group, Inc. and The Bank of New York Mellon, as Trustee RBS Citizens Financial Group, Inc. is a subsidiary of The Royal Bank of Scotland Group plc. This Quarterly Report is being provided to the holders of the 4.15% Subordinated Notes due 2022 (the Subordinated Notes ) issued by RBS Citizens Financial Group, Inc. under the terms of the Subordinated Note Indenture dated as of September 28, 2012 between RBS Citizens Financial Group, Inc., as issuer, and The Bank of New York Mellon, as trustee, as amended, supplemented or modified from time to time. This Report is not intended for any other purpose.

2 Management s Discussion & Analysis of Financial Condition & Results of Operations and Condensed Consolidated Interim Financial Statements (unaudited) September 30, 2012

3 Table of Contents Page Management s Discussion & Analysis of Financial Condition & Results of Operations Selected Financial Data 1 Forward-Looking Statements... 2 Introduction.. 3 Executive Overview. 3 Net Income... 5 Net Interest Income.. 5 Noninterest Income... 7 Noninterest Expense. 8 Provision for Income Taxes... 9 Securities Available-for-Sale ( AFS ) Loans and Leases. 11 Allowance for Credit Losses & Nonperforming Assets Non-Core Assets Deposits 14 Borrowed Funds Derivatives Capital Resources. 16 Critical Accounting Policies 18 Off-Balance Sheet Arrangements 22 Enterprise Risk Management Independent Accountants Review Report. 26 Consolidated Financial Statements (Unaudited) Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Changes in Stockholder s Equity.. 29 Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements (Unaudited) Note 1: Significant Accounting Policies Note 2: Securities. 36 Note 3: Loans and Leases 39 Note 4: Allowance for Credit Losses, Nonperforming Assets, and Concentrations of Credit Risk Note 5: Goodwill and Intangible Assets.. 47 Note 6: Mortgage Banking Note 7: Deposits Note 8: Borrowed Funds.. 50 Note 9: Income Taxes.. 51 Note 10: Derivatives 52 Note 11: Commitments, Guarantees and Contingencies.. 56 Note 12: Divestitures Note 13: Related Party Transactions 59 Note 14: Fair Value Measurements Note 15: Regulatory Matters Note 16: Supplemental Cash Flow Information Note 17: Subsequent Events. 66

4 Selected Financial Data MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following tables present RBS Citizens selected consolidated historical financial information. You should read this information together with the Consolidated Financial Statements, related notes, and the other information included elsewhere in this document. The data for the three and nine months ended September 30, 2012 and 2011 and at September 30, 2012 and December 31, 2011 have been derived from the RBS Citizens unaudited and audited Consolidated Financial Statements. The Company has prepared the unaudited Consolidated Financial Statements on the same basis as the audited Consolidated Financial Statements. Three Months Ended September 30 Nine Months Ended September 30 (dollars in millions) OPERATING DATA: Net interest income. $810 $838 $2,455 $2,497 Provision for credit losses Noninterest income ,277 1,266 Noninterest expense ,561 2,481 Net income OTHER DATA:. Return on average tangible assets % 0.44 % 0.62 % 0.43 % Return on average tangible common equity Net interest margin September 30, December 31, (dollars in millions) BALANCE SHEET DATA: Total assets. $131,580 $129,654 Securities. 21,341 23,352 Total loans and leases. 86,941 86,795 Allowance for loan and lease losses. 1,347 1,698 Goodwill and other intangible assets. 11,322 11,324 Deposits. 96,481 92,888 Federal funds purchased and securities sold under agreements to repurchase. 3,241 4,152 Borrowed funds. 4,699 6,342 Stockholder's equity. 24,109 23,393 OTHER DATA: Allowance for loan and lease losses as a % of total loans and leases 1.55 % 1.96 % Allowance for loan and lease losses as a % of nonperforming loans and leases Nonperforming loans and leases as a % of total loans and leases Capital ratios Tier Total Leverage ratio

5 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management s Discussion and Analysis of Financial Condition and Results of Operations ( MD&A ) provides information that management believes will assist in understanding the financial performance of RBS Citizens Financial Group, Inc. and its subsidiaries ( RBS Citizens or the Company ). You should read the following discussion and analysis of the Company s consolidated financial position and results of operations together with the Consolidated Financial Statements and the Notes to Consolidated Financial Statements. Forward-Looking Statements The information included in this report contains certain forward-looking statements. These forward-looking statements may relate to the Company s financial condition, results of operations, plans, objectives, future performance and business, including, but not limited to, statements with respect to expected earnings levels, the adequacy of the allowance for credit losses, delinquency trends, market risk and the impact of interest rate changes, capital market conditions, capital adequacy and liquidity, the effect of legal proceedings, and new accounting standards on the Company s financial condition and results of operations. All statements contained herein that are not clearly historical in nature are forward-looking, and the words anticipate, believe, continues, expect, estimate, intend, project and similar expressions and future or conditional verbs such as will, would, should, could, might, can, may, or similar expressions are generally intended to identify forward-looking statements. Forward-looking statements are not guarantees of future performance, are based on management s current expectations and, by their nature, involve certain risks, uncertainties, estimates and assumptions by management that are difficult to predict. Various factors, some of which are beyond the Company s control, could cause actual results to differ materially from those expressed in, or implied by, such forward-looking statements. Factors that might cause such a difference include, but are not limited to: the rate of growth in the economy and employment levels, as well as general business and economic conditions; changes in interest rates and market liquidity, as well as the magnitude of such changes, which may reduce interest margins, impact funding sources and affect the ability to originate and distribute financial products in the primary and secondary markets; changes in federal bank regulatory and supervisory policies, including required levels of capital; the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd Frank Act ) on the Company s businesses, business practices and costs of operations; the relative strength or weakness of the consumer and commercial credit sectors and of the real estate markets in the markets in which the Company s borrowers are located; competition in the financial services industry; additional Federal Deposit Insurance Corporation ( FDIC ) assessments; and legislative, tax, accounting or regulatory changes. Other possible events or factors that could cause results or performance to differ materially from those expressed in such forward-looking statements include the following: negative economic conditions that adversely affect the general economy, housing prices, the job market, consumer confidence and spending habits which may affect, among other things, the level of nonperforming assets, charge-offs and provision expense; adverse movements and volatility in debt and equity capital markets; 2

6 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS changes in market rates and prices, which may adversely impact the value of financial assets and liabilities; liabilities resulting from litigation and regulatory investigations; the Company s ability to grow its core businesses; decisions to downsize, sell or close units or otherwise change the Company s business mix; and management s ability to identify and manage these and other risks. All forward-looking statements included in this document are based upon information available to the Company as of the date of this document, and other than as required by law, including the requirements of applicable securities laws. The Company assumes no obligation to update or revise any such forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements. Introduction RBS Citizens is a Bank Holding Company ( BHC ) and Financial Holding Company ( FHC ) headquartered in Providence, Rhode Island, and through its subsidiaries has more than 1,400 branches, approximately 3,600 branded ATMs, and almost 19,000 employees. Its two bank subsidiaries, RBS Citizens, N.A. and Citizens Bank of Pennsylvania, operate a twelve-state branch network under the Citizens Bank brand in Connecticut, Delaware, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island and Vermont; and under the Charter One brand in Illinois, Michigan and Ohio. RBS Citizens is a wholly-owned subsidiary of The Royal Bank of Scotland Group plc ( RBS Group or RBSG ). On December 1, 2008, the United Kingdom ( UK ) Government became the ultimate controlling party of RBS Group. The UK Government s shareholding is managed by UK Financial Investments Limited, a company wholly-owned by the UK Government. RBS Group reports the results of RBS Citizens core businesses as U.S. Retail and Commercial-Core in its published financial statements in accordance with International Financial Reporting Standards ( IFRS ), as defined by the International Accounting Standards Board. The financial position and results of operations included herein are prepared in accordance with accounting principles generally accepted in the United States of America ( U.S. GAAP ) and represent all of RBS Citizens assets, including its non-core assets. RBS Citizens non-core assets include those loans and other assets that management considers to be outside the Company s core business strategy. See the Non-Core Assets section below for further detail. Executive Overview RBS Citizens reported pre-tax income for the third quarter of 2012 of $332 million, as compared to a pre-tax income of $201 million in the third quarter of The quarter marked the Company s ninth consecutive quarter of pretax income from continuing operations. The quarter s performance was driven by stable revenues on a smaller base of interest earning assets, improved expenses, and greatly improved credit. Total revenues of $1.2 billion were essentially unchanged from a year ago reflecting challenges in the broader economy, most notably the low rate environment which has limited opportunities for spread expansion. Increases in mortgage banking fees and gains on the sale of securities more than offset declines in customer deposit fees and service charges on ATM and debit card transactions. Expenses remain a keen area of management focus. Noninterest expenses of $791 million for the third quarter declined $52 million, or 6%, from $843 million one year ago driven by a reduction in rewards program expense and reduced costs associated with the management of nonperforming assets. The provision for credit losses for the third quarter was $109 million compared with $201 million one year ago, and $132 million in the prior quarter. Credit trends continued to improve across every asset class. Net charge-offs for the 3

7 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS quarter of $245 million included new regulatory guidance requiring loans discharged under Chapter 7 bankruptcy and not reaffirmed by the borrowers, to be charged-off to their collateral value and considered nonaccrual, regardless of their delinquency status. Approximately 90% of the loans impacted by this regulatory guidance were fully performing at the time they were deemed collateral dependent and charged-off to their collateral value. Excluding the impact of the new regulatory guidance, net charge-offs during the quarter would have been $174 million compared with $277 million in the prior year and $248 million in the prior quarter. RBS Citizens total average balance sheet remained substantially unchanged. This was due to strong growth in commercial lending which was nominally offset by declines in the investment portfolio and consumer assets, particularly home equity loans. Total demand deposits and money market accounts increased by 18% from December balances, but were offset by declines in other interest bearing deposits, particularly checking with interest and term deposits which declined by 21% and 14%, respectively. The decrease in checking with interest was primarily attributable to a shift to demand deposits resulting from the Company s program to exit certain government banking markets. RBS Citizens capital position remains strong both in terms of quantity and quality of capital. The Company s Basel I Tier 1 Common Equity ratio ended the quarter at 13.8%, while the Basel I Tier 1 Capital ratio ended the quarter at 14.1%. On September 28, 2012 RBS Citizens issued $350 million of 4.150% subordinated notes due in 2022 in a private offering. The offering represented RBS Citizens first such offering. 4

8 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Results of Operations Net Income Net income was $542 million for the nine months ended September 30, 2012, compared to $379 million for the nine months ended September 30, Lower levels of provision for loan and lease losses due to improved asset quality, and a gain on sale of RBS Citizens investment in Visa Inc. shares, contributed to higher net income. The Company accrued and paid $138 million in 2012 to settle litigation related to overdraft fee practices. Net Interest Income The following tables show the major components of net interest income and net interest margin: Three Months Ended September 30, 2012 September 30, 2011 Increase (Decrease) Average Income/ Yields/ Average Income/ Yields/ Average Yields/ (dollars in millions) Balances Expense Rates Balances Expense Rates Balances Rates Assets Investments $23,981 $ % $24,786 $ % ($805) (0.57%) Commercial 27, , ,140 (0.07) Commercial real estate 6, , (1,284) 0.01 Leases 3, , (0.25) Total commercial loans 37, , ,000 (0.05) Home equity lines of credit 17, , Residential mortgage 9, , (184) (0.39) Home equity loans 7, , (2,328) (0.02) Automobile 8, , (1.14) Student and other installment loans 3, , (847) 0.11 Credit cards 1, , Total retail loans 49, , (2,036) (0.34) Total loans 87, , (36) (0.25) Loans held for sale (0.54) Total earning assets 111, ,156 1, (624) (0.31) Loan loss reserve (1,469) (1,876) 407 Goodwill and other intangibles 11,323 11,340 (17) Other non earning assets 6,695 7,121 (426) Total non earning assets 16,549 16,585 (36) Total assets $128,081 $128,741 ($660) Liabilities and Stockholder's Equity Checking with interest $13,515 $3 0.08% $16,046 $4 0.09% ($2,531) (0.01%) Money market & savings 41, , , Term deposits 13, , (2,919) (1.19) Total interest bearing deposits 68, , (1,251) (0.28) Customer repos and fed funds purchased 2, , (619) 3.12 Borrowed funds - other 5, , (2,758) (0.47) Total borrowed funds 7, , (3,377) 0.57 Total interest bearing liabilities 76, , (4,628) (0.26) Total demand deposits 24,997 21,637 3,360 Other liabilities 2,614 2,787 (173) Equity 24,104 23, Total liabilities and equity $128,081 $128,741 ($660) Net interest income $810 $838 ($28) Net interest margin 2.88% 2.97% (0.09%) 5

9 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Nine Months Ended September 30, 2012 September 30, 2011 Increase (Decrease) Average Income/ Yields/ Average Income/ Yields/ Average Yields/ (dollars in millions) Balances Expense Rates Balances Expense Rates Balances Rates Assets Investments $24,019 $ % $24,730 $ % ($711) (0.36%) Commercial 27, , ,504 (0.15) Commercial real estate 7, , (1,253) (0.07) Leases 3, , (0.34) Total commercial loans 37, , ,576 (0.13) Home equity lines of credit 17, , Residential mortgage 9, , (120) (0.33) Home equity loans 8, , (2,458) (0.03) Automobile 8, , (1.23) Student and other installment loans 4, , (940) 0.04 Credit cards 1, , Total retail loans 49,680 1, ,833 1, (2,153) (0.34) Total loans 87,097 2, ,674 2, (0.28) Loans held for sale (0.67) Total earning assets 111,630 2, ,740 3, (110) (0.30) Loan loss reserve (1,565) (1,927) 362 Goodwill and other intangibles 11,324 11,348 (24) Other non earning assets 6,787 7,184 (397) Total non earning assets 16,546 16,605 (59) Total assets $128,176 $128,345 ($169) Liabilities and Stockholder's Equity Checking with interest $13,491 $8 0.08% $16,125 $ % ($2,634) (0.02%) Money market & savings 40, , , Term deposits 13, , (3,119) (0.27) Total interest bearing deposits 68, , (2,437) (0.10) Customer repos and fed funds purchased 2, , (1,172) (1.82) Borrowed funds - other 6, , (1,912) (0.42) Total borrowed funds 8, , (3,084) (0.89) Total interest bearing liabilities 76, , (5,521) (0.27) Total demand deposits 24,861 20,750 4,111 Other liabilities 2,716 2, Equity 23,814 23, Total liabilities and equity $128,176 $128,345 ($169) Net interest income $2,455 $2,497 ($42) Net interest margin 2.93% 2.98% (0.05) For the three month period ended September 30, 2012, net interest income was $810 million and net interest margin was 2.88%. This reflects a decline of $28 million and 9 basis points ( bps ), respectively, when compared to the three month period ended September 30, The record low interest rate environment seen during the three month period ended September 30, 2012 adversely impacted net interest income and the net interest margin. Total investments and total loans declined $805 million and $36 million, respectively, and loan interest income decreased $53 million as mortgage refinancing activity picked up. Since these refinanced loans were generally higher yielding loans, the decline in loan volume caused a disproportionate decrease in interest income. Additionally, yields on the investment portfolio dropped 57 bps due to low reinvestment rates, increased premium amortization expense and portfolio sales. Yields on earning assets decreased a total of 31 bps compared to the same period last year. 6

10 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS For the nine month period ended September 30, 2012, net interest income was $2.5 billion and net interest margin was 2.93%. This reflects a decline of $42 million and 5 bps when compared to the nine month period ended September 30, Driven by historically low interest rates, yields on both earning assets and interest-bearing liabilities declined sharply compared to the prior year. On the asset side, while net average loan balances for the nine months ended September 30, 2012 increased $423 million compared to the same period in 2011, interest income on loans decreased $167 million. Yields on earning assets declined 30 bps compared to the same period last year. Additionally, yields on the investment portfolio dropped 36 bps from Declines are attributed to run-off and prepayment of higher-yielding, fixed rate assets and new originations of loans with lower yields as well as sales of higher yielding investment securities. In addition, the increase in prepayment speeds increased net premium amortization expense on investment securities. On the funding side, interest-bearing deposit expense was reduced by $60 million and deposit costs declined 10 bps. Many deposit products have hit pricing floors at or near zero, making any further rate reductions difficult and thus compressing margin. However, RBS Citizens cost of other borrowed funds improved $60 million, or 42 bps, due to maturing legacy fixed rate swaps that carried high pay-fixed interest rates. Noninterest Income The following table details the significant components of total noninterest income: Three Months Nine Months Ended September 30 Increase Ended September 30 Increase (dollars in millions) (Decrease) (Decrease) 1 Service charges on deposits $141 $155 (9) % $423 $447 (5) % Net gains on sales of securities NM (24) Mortgage banking 49 - NM NM ATM and debit card (47) (44) Other service fee income (3) Trust and investment services revenue (6) (1) International fees (10) (9) Credit card fees (5) Bank-owned life insurance Capital markets fee income Other income 2 (2) 8 NM Total noninterest income $422 $407 4 % $1,277 $1,266 1 % 1 NM - not meaningful. Those changes over 100 percent were not considered to be meaningful. 2 Includes net impairment losses recognized in earnings, other net gains (losses), and other income Total noninterest income was $422 million for the three months ended September 30, 2012 and $1.3 billion for the nine months ended September 30, 2012, both up slightly from the prior year levels. Regulatory changes drove lower ATM and debit card revenue and lower deposit fees, mainly non-sufficient funds fees, partially offset by higher mortgage fees and net gains from the sale of securities. Mortgage banking fees increased $49 million and $110 million for the three and nine months ended September 30, 2012, respectively, compared to the three and nine months ended September 30, The increases in both periods were primarily driven by gains on sales of mortgage loans and lower impairment of mortgage servicing rights. ATM and debit card fees decreased $37 million, or 47%, and $98 million, or 44%, for the three and nine months ended September 30, 2012, respectively, compared to the three and nine months ended September 30, The decreases are primarily driven by implementation of The Durbin Amendment (see below) which limits the interchange fees that banks can charge to customers, and reduced overdraft fees resulting from Regulation E (see below). Capital markets fee income increased for the three and nine months ended September 30, 2012, $5 million, or 71%, and $6 million, or 19%, respectively, compared to the three and nine months ended September 30, The increase is due to increases in commercial syndication fees and referral fees. 7

11 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The Durbin Amendment The Durbin Amendment amended the Electronic Funds Transfer Act which, among other things, gave the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers. In June 2011, the Federal Reserve issued a final rule that, among other things, established standards for determining whether an interchange fee received or charged by an issuer with respect to an electronic debit transaction is reasonable and proportional to the cost incurred by the issuer with respect to the transaction. These new standards took effect on October 1, 2011 and apply to issuers, such as RBS Citizens, that, together with their affiliates, have assets of $10 billion or more. Under the rule, the maximum permissible interchange fee for an electronic debit transaction is 21 cents per transaction and 4 basis points multiplied by the value of the transaction. The Federal Reserve also issued an interim final rule that allows for an upward adjustment of no more than one cent per transaction to an issuer s debit card interchange fee if the issuer develops and implements policies and procedures reasonably designed to achieve the fraud-prevention standards set out in the interim final rule. The fraud-prevention adjustment was effective on October 1, 2011, concurrent with the debit card interchange fee limits. Regulation E The Federal Reserve also amended its Regulation E in a final rule that was issued in 2009 and became effective in the third quarter of This rule prohibits financial institutions from charging consumers fees for allowing overdrafts on ATM and debit card transactions, unless a consumer affirmatively consents, or opts in, to the overdraft service for those types of transactions. Consumers must be provided a notice that explains the financial institution s overdraft services, including the fees associated with the services, and the consumer s choice. Noninterest Expense The following table displays the significant components of noninterest expense: Three Months Ended September 30 Increase Nine Months Ended September 30 Increase (dollars in millions) (Decrease) (Decrease) Salaries and employee benefits $407 $408 (0) % $1,265 $1,210 5 % Equipment expense Occupancy (5) (4) Outside services (16) (2) Promotional expense (12) (18) Other operating expense (20) Total noninterest expense $791 $843 (6) % $2,561 $2,481 3 % Noninterest expense decreased $52 million, or 6%, in the three months ended September 30, 2012 compared to the three months ended September 30, Noninterest expense increased $80 million, or 3%, in the nine months ended September 30, 2012 compared to the nine months ended September 30, The drivers for the increase were higher salaries and benefits and other operating expenses, offset by lower promotional and amortization of intangibles expense. Outside services expense decreased $14 million, or 16%, in the three months ended September 30, 2012 compared to the three months ended September 30, 2011 due mainly to lower legal and consultant fees. Promotional expense decreased $3 million, or 12%, in the three months ended September 30, 2012 compared to the three months ended September 30, 2011 due primarily to lower advertising costs of approximately $3 million. Additionally, promotional expense decreased $14 million, or 18%, in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, due to a $14 million decrease in advertising costs. 8

12 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Other operating expense decreased $23 million, or 17%, in the three months ended September 30, 2012 compared to the three months ended September 30, The main drivers for the decrease were an approximate $6 million decrease in credit cards rewards program expense, and a decrease in net other real estate owned and nonperforming assets expense of $12 million. Other operating expense increased $74 million, or 18%, in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, reflecting a $138 million accrual to settle overdraft fee litigation and $3 million in one-time costs related to the sale of 57 New York branches. Offsetting the other operating expense increase, card rewards program expense decreased $23 million, and deposit insurance expense decreased $20 million. Nonperforming asset expense also decreased in the nine months ended September 30, 2012 compared to the nine months ended September 30, Excluding the impact of litigation and branch sale, noninterest expense declined by 2.5% Provision for Income Taxes The provision for income taxes was $123 million and $71 million, for the three months ended September 30, 2012 and 2011, respectively. The provision represents projected annualized effective tax rates of 37% and 35% for the three months ended September 30, 2012 and September 30, 2011, respectively. The provision for income taxes was $318 million and $205 million, for the nine months ended September 30, 2012 and 2011, respectively. The provision represents projected annualized effective tax rates of 37% and 35% for the nine months ended September 30, 2012 and September 30, 2011, respectively. The increase in the rate from 2011 to 2012 represents the incremental tax rate impact of a 2012 state tax settlement. The Company settled a state tax issue for the years 2003 through 2008 related to its real estate investment trust and various passive investment companies. Settlement of these uncertainties reduced the unrecognized tax benefit as of September 30, 2012 by $133 million. 9

13 Analysis of Financial Condition Securities Available-for-Sale ( AFS ) MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RBS Citizens securities portfolio is managed to promote the maximization of return while maintaining prudent levels of quality, market risk and liquidity. Substantially all of the Company s AFS securities are held for asset and liability management and liquidity management purposes. The table below presents RBS Citizens AFS portfolio. See further discussion of the Company s AFS portfolio in the Consolidated Financial Statements. (dollars in millions) September 30, 2012 December 31, 2011 Amort. Cost Fair Value Amort. Cost Fair Value Increase (Decrease) U.S. Treasury $15 $15 $15 $15 0 % State and political subdivisions Other bonds, notes and debentures (100) Mortgage-backed securities: Federal agencies and U.S. government sponsored entities 17,975 18,643 19,537 20,129 (7) Other 1,577 1,499 2,095 1,893 (21) Total mortgage-backed securities 19,552 20,142 21,632 22,022 (9) Total debt securities 19,654 20,249 21,734 22,128 (8) Marketable equity securities (30) Other equity securities Total equity securities (14) Total available-for-sale securities $19,671 $20,268 $21,754 $22,150 (8) % The fair value of AFS securities decreased by $1.9 billion in the nine months ended September 30, 2012, or 8%, compared to December 31, U.S. Government-guaranteed and government sponsored entity issued mortgage-backed securities ( MBS ) comprise the majority of AFS holdings and are currently in excess of 90% of the total portfolio. Reinvestments have been directed predominantly into fixed rate products, and as of September 30, 2012, the AFS portfolio had an average life of 3.2 years. Given low long-term interest rates, additional reinvestment has been modest and at times focused on fulfilling Community Reinvestment Act requirements. Meanwhile, the Other non-agency MBS inventory, which ran-off during 2011, continued to do so in the first nine months of 2012 without reinvestment in this asset class. The market value of the portfolio has trended downward during the first nine months of 2012 due to slower reinvestment and slower than anticipated cash flows in the low rate environment. 10

14 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Loans and Leases The following table shows the composition of total loans and leases. See further discussion of the Company s loan and lease portfolio in the Consolidated Financial Statements. September 30, December 31, Increase (dollars in millions) (Decrease) Commercial $27,831 $25,770 8 % Commercial real estate 6,657 7,602 (12) Leases 3,218 3,164 2 Total commercial 37,706 36,536 3 Home equity lines of credit 16,777 16,666 1 Residential mortgages 9,535 9,719 (2) Home equity loans 5,476 6,766 (19) Home equity products serviced by others 3,134 3,624 (14) Automobile 8,734 7, Student and other installment 3,921 4,276 (8) Credit card 1,658 1,637 1 Total retail 49,235 50,259 (2) Total loans and leases $86,941 $86,795 0 % Loan balances as of September 30, 2012, compared to December 31, 2011, reflected increases in commercial lending offset by declines in commercial real estate and home equity loans. In the first quarter of 2012, the Company purchased a portfolio of automobile loans with outstanding principal balances totaling $922 million. The following table is a summary of loans and leases by remaining maturity or repricing date: September 30, December 31, Increase (dollars in millions) (Decrease) Due in one year or less $45,675 $43,743 4 % Due after one year through five years 16,153 15,129 7 Due after five years 25,113 27,923 (10) Total loans and leases $86,941 $86,795 0 % Allowance for Credit Losses & Nonperforming Assets Overall Commercial Asset Quality RBS Citizens commercial portfolio consists of traditional commercial and commercial real estate businesses. The portfolios are focused on high quality, in-footprint customers where the Company s local delivery model provides for strong client connectivity with its bank subsidiaries. The core portfolio has experienced reasonable growth and sustained improvement in credit quality metrics since The majority of the growth has resulted from expansion of existing relationships and new client acquisition in the Company s mid-corporate portfolio. Losses in the portfolio have been concentrated in commercial real estate and have moderated as underlying property values have stabilized and market supply and demand metrics have moved toward equilibrium. The trend of risk is stable and the trend of net charge-offs is improving. 11

15 Overall Retail Asset Quality MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RBS Citizens retail portfolio focuses on the Company s core footprint, targeting lower-risk products, owning (branch-based) or actively managing the origination channel (indirect auto), and maintaining conservative underwriting policies. The overall retail portfolio had a refreshed FICO score of 754 and real estate combined loan-to-value ( CLTV ) of 76.7% (excluding non-core home equity products, it was 73.0%) as of September 30, New origination portfolios continued to exhibit strong risk characteristics with an average FICO score of 779 and real estate CLTV of 64.5% in the third quarter of Asset quality continues to improve, which is reflected in downward trending delinquency and loss performance. Credit card and automobile net charge-off rates are near or below pre-crisis levels. The Company tightened credit policies in 2009 to address deteriorating economic conditions. The response included curtailing originations outside footprint states, focusing on branch-based originations, tightening FICO and loanto-value ( LTV ) cutoffs, terminating third party mortgage broker channel, and enhancing collection activities. Over the past three years, RBS Citizens has intensely focused on organic / relationship lending and quarantined the few material purchased portfolios by including them in the non-core portfolio. The overall rate of delinquency more than 30 days improved 49 bps to 1.0% as of September 30, 2012 from 1.49% as of December 31, 2011, driven by favorable movement in residential mortgage, home equity, vehicle, and credit card. Further improvement in delinquencies and losses will depend on the pace of economic recovery, specifically related to unemployment and housing. Reserves and total loan coverage continued to trend down during the first nine months of 2012, but remained at levels commensurate with improvements in credit quality. Nonperforming loans increased due to recently issued Office of Comptroller of Currency ( OCC ) guidance regarding accounts that have been through a Chapter 7 Bankruptcy proceeding and not reaffirmed by the borrower; however, the reserve coverage for losses remains adequate as of September 30, 2012 Provision for Credit Losses Due to recovering asset quality requiring lower reserve coverage and improving loss trends, the provision for credit losses for the nine months ended September 30, 2012 was $311 million, which was a 55% decrease from the same period in Net charge-offs were $685 million for the nine months ended September 30, 2012, which was a 18% decline compared to net charge-offs of $832 million for the nine months ended September 30, Included in third quarter net charge-offs are $71 million in write-offs related to the recently issued OCC guidance on Chapter 7 Bankruptcy. In addition, $274 million of performing loans were moved to nonaccrual status upon implementation of the new OCC guidance. Continued improvement in the credit cycle and a $131 million increase in loan assets at September 30, 2012 compared to the same period in 2011, allowed for measured reduction in the allowance for loan and lease losses. 12

16 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Non-Core Assets In the second quarter of 2009, approximately $20.5 billion of assets were designated as non-core. These loans and other assets were designated as non-core assets principally because they are included in portfolios that are not considered to be strategic to the Company s core business strategy (e.g., out of footprint, in asset classes and customer sets that were being de-marketed, or credit impaired.) Through September 30, 2012, the Company decreased non-core assets by more than two-thirds by actively managing down the portfolio. The table below is a composition of RBS Citizens non-core assets as of the dates indicated: September 30, December 31, (Date of Designation) June 30, Decrease Decrease (dollars in millions) from 2011 from 2009 Home equity products serviced by others $3,072 $3,583 $6,180 (14) % (50) % Commercial real estate 980 1,554 3,412 (37) (71) Student and other installment 898 1,173 4,763 (23) (81) Residential mortgages ,467 (23) (51) Commercial ,900 (34) (87) Home equity loans (15) (50) Home equity lines of credit (11) (38) Credit card (31) (90) Automobile (56) (92) Other assets (67) Total Non-Core Assets $6,527 $8,405 $20,479 (22) % (68) % Since designating certain loans and other assets as non-core in 2009, RBS Citizens has reduced the balance in noncore assets: run-off of approximately $9 billion, including $1 billion of run-off in the first nine months of 2012; net charge-offs of approximately $3.5 billion, including $308 million of net charge-offs in the first nine months of 2012; $2 billion of transfers to RBS Citizens core portfolio, including the transfer of $1.6 billion of recreational vehicle ( RV ) and marine loans to the Company s core portfolio in the fourth quarter of 2011; and $1 billion of sales, including a $530 million sale of credit card receivables in the second quarter of 2010 and a $393 million sale of RV and marine loans in the third quarter of Non-core assets are expected to continue to decline through a combination of the factors described above. Retail Non-Core SBO Portfolio The home equity products serviced by others ( SBO ) portfolio consists of purchased pools of home equity loans and lines of credit. This portfolio represents 8.8% of the entire real estate portfolio and 6.2% of the overall retail portfolio as of September 30, The SBO portfolio has experienced an annualized charge-off rate of 9% and a cumulative charge-off rate of 24.6% as of the third quarter of 2012, due to poor geographical concentrations, high second lien concentration (95%), and continued weakness in the housing sector, creating high loan-to-value exposure. SBO has been closed to new purchases since the third quarter of 2007 and is in run-off, with outstandings down to $3.1 billion as of 13

17 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS September 30, 2012 from $3.6 billion as of December 31, 2011 and a peak balance of $9.0 billion in July The performance of SBO continues to improve with delinquencies and losses decreasing year-over-year. The rate of delinquency greater than 90 days as of September 30, 2012 continued to trend lower at 1.9%, which was 4 bps lower than as of September 30, The continued improvement in performance is due to portfolio liquidation (the weakest loans have been charged-off), as well as more effective account servicing and collections, following a servicer conversion in Commercial Non-Core Portfolio The commercial non-core portfolio consists of commercial real estate and commercial loans that do not fit the current strategy of RBS Citizens due to geographic location, industry or product type. These loans have been actively managed down over the last three years. RBS Citizens has reported consistent reduction in commercial non-core balances and significant reductions in the net charge-offs attributed to this portfolio through September 30, The portfolio reduction has been accomplished through active remediation strategies, including individual note and portfolio sales, contractual repayments, successful refinancing by other institutions and net charge-offs. The bulk of the commercial noncore portfolio at September 30, 2012 was comprised of amortizing commercial real estate loans. The Company has a portfolio management process that revalues the underlying collateral coverage and has recognized losses proactively when the collateral values are not protective. The trend of loss has significantly decreased through September 30, The Company continues to work down the balance of this legacy portfolio. Deposits The table below presents RBS Citizens major components of deposits. See further discussion of the Company s deposits in the Consolidated Financial Statements. September 30, December 31, Increase (dollars in millions) (Decrease) Demand $27,114 $23, % Checking with interest 13,683 17,328 (21) Regular savings 7,943 7,906 0 Money market accounts 34,469 29, Term deposits 13,272 15,430 (14) Total deposits $96,481 $92,888 4 % Total deposits at September 30, 2012 were $96.5 billion, compared with $92.9 billion at December 31, Deposits remained stable overall but reflect a shift from higher-cost term deposits and government deposits and into demand and personal money market accounts. Checking with interest declined $3.6 billion, or 21%, and was primarily attributable to a $1.9 billion transfer of checking with interest deposits into demand deposits as part of a program to exit certain government banking markets. Additionally, term deposits decreased $2.2 billion, or 14%, reflecting the continued run-off of expensive term deposits, and money market accounts increased 18% from December 31,

18 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Borrowed Funds The table below presents the Company s borrowed funds. See further discussion of RBS Citizens borrowed funds in the Consolidated Financial Statements. September 30, 2012 December 31, 2011 Increase (dollars in millions) Amount Rate Amount Rate (Decrease) Royal Bank of Scotland Group: Subordinated debt, due 2034, LIBOR % with quarterly resets $ % $ % (43) % Other borrowings: Subordinated debt, due % FHLB fixed rate advances with original maturity under one year % 1, % (55) FHLB variable rate advances with semi-annual resets, due , % 4, % (18) FHLB fixed rate advances, due % % - Fixed rate, subordinated debt, due % (100) Other 33 various 58 various (43) Total borrowed funds $4,699 $6,342 (26) % RBS Citizens structural liquidity is strong, as deposits exceed loans by $9.5 billion at September 30, Shortterm unsecured borrowings are minimal and are offset by $2 billion in average excess reserves held at the Federal Reserve Bank ( FRB ) at September 30, Other borrowings include capital instruments and secured Federal Home Loan Bank ( FHLB ) advances. Additionally, asset liquidity is considered strong. At September 30, 2012, unencumbered high-quality securities totaled $15.1 billion; unused FHLB capacity was approximately $5.9 billion; and unencumbered loans pledged at the FRBs created additional contingent borrowing capacity of approximately $12.6 billion. Asset liquidity is projected to remain at historically high levels, providing access to funds as needed through repurchase agreements, collateralized borrowings, or asset sales. Additionally, there appears to be substantial capacity to grow deposits. While access to short-term wholesale markets is limited, the Company has been able to meet its funding needs for the medium term with deposits and collateralized borrowings. Derivatives Historically, RBS Citizens has used plain vanilla pay-fixed swaps to synthetically lengthen liabilities, offsetting duration in fixed-rate assets. With material prepayment of fixed-rate mortgages and home equity loans since 2008, these swaps were no longer needed. Most have been terminated or allowed to run-off. The assets and liabilities for derivatives designated as hedges reflect the market value of these hedge instruments. The Company also sells interest rate swaps and foreign exchange forwards to commercial customers, and offsets these transactions with RBS Group. The assets and liabilities for derivatives not designated as hedges reflect the market value of these transactions. 15

19 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The table below presents RBS Citizens derivative assets and liabilities. See further discussion of the Company s derivative instruments in the Consolidated Financial Statements. September 30, 2012 December 31, 2011 (dollars in millions) Notional Amount 1 Assets Liabilities Notional Amount 1 Assets Liabilities Increase (Decrease) Derivatives designated as hedging instruments: Interest rate contracts $5,200 $1 $304 $9,200 $1 $476 (36) % Derivatives not designated as hedging instruments: Interest rate contracts 32,272 1,209 1,150 30,114 1,243 1,146 (39) Foreign exchange contracts 6, , Other contracts 1, , Total derivatives not designated as hedging instruments 1,344 1,250 1,356 1,242 (18) Gross derivative fair values $1,345 $1,554 $1,357 $1,718 (42) % Less: Counterparty netting 2 (66) (66) (70) (70) Total derivative fair values $1,279 $1,488 $1,287 $1,648 1 The notional or contractual amount of interest rate derivatives and foreign exchange contracts is the amount upon which interest and other payments under the contract are based. For interest rate derivatives, the notional amount is typically not exchanged. Therefore, notional amounts should not be taken as the measure of credit or market risk as they tend to greatly overstate the true economic risk of these contracts. 2 Amounts represent the impact of legally enforceable master netting agreements that allow the Company to settle positive and negative positions. Capital Resources As a BHC and a FHC, RBS Citizens is subject to regulation and supervision by the Federal Reserve. The two primary subsidiaries of RBS Citizens are its two insured depository institutions, RBS Citizens, N.A., a national banking association whose primary federal regulator is the OCC, and Citizens Bank of Pennsylvania, a Pennsylvania-charted savings bank regulated by the Department of Banking of the Commonwealth of Pennsylvania and supervised by the FDIC as its primary federal regulator. RBS Citizens is currently subject only to requirements to maintain a minimum total risk-based capital (or Total Capital ) ratio, Tier 1 Capital ratio, and Tier 1 Leverage ratio. The minimum standards for the Total Capital ratio (the ratio of the Company s Total Capital, or the sum of its Tier 1 and Tier 2 Capital, to total risk-weighted assets) and Tier 1 Capital ratio (the ratio of the Company s Tier 1 Capital to total risk-weighted assets) are 8.0% and 4.0%, respectively. The minimum Tier 1 Leverage ratio (the ratio of a banking organization s Tier 1 Capital to total adjusted quarterly average assets, as defined for regulatory purposes) is 3.0% for BHCs that either have the highest supervisory rating or have implemented the Federal Reserve s risk-adjusted measure for market risk. The minimum Tier 1 Leverage ratio for all other BHCs is 4.0%, unless a different minimum is specified by the Federal Reserve. RBS Citizens and its subsidiary banks continue to anticipate implementation of the Basel III regime in the U.S., including as proposed, in part, in the three Notice of Proposed Rulemaking ( NPRs ) published by the U.S. banking agencies in the Federal Register on August 30, New regulatory capital requirements are expected to include a fiveyear phase in of new regulatory capital minimums for purposes of capital adequacy and to begin sometime after the first quarter of 2013 as well as certain changes and additions to the regulatory ratios under the FDIC s prompt corrective action framework beginning in In addition, the NPRs outline a plan to adopt a new standardized methodology for calculating general risk-based capital requirements that will apply to all BHCs and insured depository institutions beginning in

20 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS By targeting all regulatory ratios to fully phased-in Basel III minimums, including required capital conservation buffers and an additional cushion for various uncertainties, RBS Citizens maintains strong ratios compared to its current regulatory minimums. In addition, the Company believes that it is well-positioned for the implementation of Basel III. The table below provides a comparison of RBS Citizens regulatory ratios as of September 30, 2012, calculated under both current Basel I and proposed Basel III methodologies, including application of the standardized approach to riskweighting assets used in Basel III calculations, versus current and proposed regulatory minima. Regulatory Ratios as of September 30, 2012 Basel I vs. Basel III Rules Regulatory Ratio Basel I Ratios and Requirements Pro Forma Basel III Ratios and Requirements (including adoption of U.S. Standardized Approach Risk-Weighted Assets) Actual Basel I Ratio Required Minimum Well-Capitalized Minimum for Purposes of Prompt Corrective Action Pro Forma Basel III Ratio Required Minimum + Required Capital Conservation Buffer for Non-Leverage Ratios Well-Capitalized Minimum for Purposes of Prompt Corrective Action Common Equity Tier 1 Capital to Risk Weighted Assets 13.80% Not Applicable Not Applicable 12.30% 7.00% 6.50% Tier 1 Capital to Risk Weighted Assets 14.10% 4.00% 6.00% 12.30% 8.50% 8.00% Total Capital to Risk Weighted Assets Tier 1 Capital to Average Total Assets (Tier 1 Leverage) 15.70% 8.00% 10.00% 14.10% 10.50% 11.90% 3.00% 5.00% 11.70% 4.00% 10.00% 5.00% In addition, the Federal Reserve has issued proposed rules that would be applicable to BHCs, including RBS Citizens, with total consolidated assets of $50 billion or more. When issued in final form, these rules will implement further enhanced prudential standards for Systemically-Important Financial Institutions ( SIFIs ) under The Dodd-Frank Act, including with respect to risk-based capital requirements, leverage limits and liquidity requirements for certain large, interconnected financial institutions such as RBS Citizens. Assessment of capital adequacy for RBS Citizens and its subsidiary banks is an ongoing and integrated process. This assessment process annually feeds development of capital plans that are now submitted to the Federal Reserve under the Federal Reserve s final rule, published in November 2011, requiring U.S. BHCs, including RBS Citizens, with $50 billion or more of total consolidated assets, to submit annual capital plans in which the Company must set forth a range of information. The Company refers to the capital analysis and review process provided for in the rule known as the Capital Plan Rules. Additionally, under the Capital Plan Rules, RBS Citizens may only take certain capital actions, including payment of dividends and repurchases of securities, in accordance with a capital plan that the Federal Reserve has reviewed and to which the Federal Reserve has not objected. RBS Citizens submitted its first annual capital plan under the Capital Plan Rules in January RBS Citizens capital adequacy assessment process begins with the Company s risk appetite and risk management framework, which provides for the identification, measurement and management of material risks. Required capital is determined for actual / forecasted risk portfolios using applicable U.S. Basel I methodologies and any estimated impacts of outstanding regulatory proposals as they apply to future periods. The base case forecasting process is supplemented by key analytical frameworks, including integrated stress testing and an internal capital adequacy requirement, which builds on internally-assessed economic capital requirements. These supplemental frameworks enable the comprehensive assessment of capital adequacy versus unexpected loss. RBS Citizens Capital Adequacy Process is supported by a robust governance framework. This process includes: 1) capital management policies and procedures, which document internal capital 17

21 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS adequacy metrics and limits and a comprehensive capital contingency plan, as well as 2) the active engagement of both the legal entity boards and senior management in oversight and decision-making. Prior to June 2012, RBS Citizens had not paid a common dividend since December Given sustained profitability throughout 2011, strong capital levels, and the stabilized economic environment, the Company incorporated quarterly dividends and other capital distributions in the 2012 capital plan that was submitted to the Federal Reserve in January This plan was submitted in accordance with requirements of the Capital Plan Rules, and the Federal Reserve made no objection to these actions. RBS Citizens Board of Directors expects to continue to review quarterly earnings performance and to consider declaring quarterly dividends that are consistent both with regulatory requirements under the Capital Plan Rules and with internal policy standards. To date, RBS Citizens has completed the following capital actions for 2012: Common dividends of $40 million and $55 million were declared and paid in June 2012 and September 2012, respectively; $206 million of floating rate junior subordinated deferrable interest debentures due March 4, 2034 were redeemed June 27, 2012; $8 million of 10.18% junior subordinated deferrable interest debentures due June 8, 2031 were redeemed July 2, 2012; $8 million of % junior subordinated deferrable interest debentures due March 8, 2030 were redeemed on September 8, 2012; and $350 million of 4.15% Tier 2 qualifying subordinated notes due September 28, 2022 were issued under Rule 144A / Reg S on September 28, Critical Accounting Policies RBS Citizens Consolidated Financial Statements are prepared in accordance with U.S. GAAP. The preparation of financial statements in conformity with U.S. GAAP requires RBS Citizens to establish accounting policies and make estimates that affect amounts reported in the Company s Consolidated Financial Statements. Note 1 of the Notes to the Consolidated Financial Statements, which is incorporated by reference into this MD&A, describes the significant accounting policies used in the Consolidated Financial Statements. An accounting estimate requires assumptions and judgments about uncertain matters that could have a material effect of the Consolidated Financial Statements. Estimates are made using facts and circumstances known at a point in time, and changes in those facts and circumstances could produce results substantially different from those estimates. The most significant accounting policies and estimates and their related application are discussed below. Allowance for Credit Losses Management s estimate of probable credit losses in RBS Citizens loan portfolios is recorded in the allowance for loan and lease losses and the reserve for unfunded lending commitments. The Company evaluates the adequacy of the allowance for loan and lease losses by performing reviews of certain individual loans and leases, analyzing changes in the composition, size and delinquency of the portfolio, reviewing previous loss experience, and considering current and anticipated economic factors. The allowance is maintained at a level which management considers to be adequate based on the results of this evaluation, and is established through charges to earnings in the form of a provision for credit losses. Amounts determined to be uncollectible are deducted from the allowance and subsequent recoveries, if any, are added to the allowance. While management uses available information to estimate loan losses, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review RBS Citizens allowance for credit losses. Such agencies may require the Company to 18

22 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS recognize changes to the allowance based on their judgment of information available to them at the time of their examination. The allowance for loan and lease losses includes allocated and unallocated reserves. The allocated reserve is attributable to certain individual impaired loans and to pools of loans. The reserve for pools of loans is calculated using models sensitive to credit factors such as loan payment status and historical loss rates adjusted to reflect current conditions. The unallocated reserve provides a supplemental contingency for the allocated reserve and protects against latent or embedded losses in the overall loan portfolio and model imprecision. It reflects factors that apply to the portfolio as a whole and that are difficult to attribute to individually impaired loans or to groups of loans. These factors include changing underwriting criteria, changes in the types and mix of loans originated, industry concentrations and evaluations, allowance levels relative to selected overall credit criteria and other economic indicators used to estimate probable incurred losses. In addition to the allowance for loan and lease losses, the Company also estimates probable credit losses associated with off-balance sheet financial instruments such as letters of credit, financial guarantees and binding unfunded loan commitments. Off-balance sheet commitments are subject to individual reviews and are analyzed and segregated by risk according to the Company s internal risk rating scale. These risk classifications, in conjunction with historical loss experience, economic conditions and performance trends within specific portfolio segments, result in the estimate of the reserve for unfunded lending commitments. Additional information regarding RBS Citizens allowance for credit losses can be found in the Notes to the Consolidated Financial Statements. Nonperforming Loans and Leases Commercial loans, commercial real estate loans, and leases are generally placed on nonaccrual status when contractually past due 90 days or more, or earlier if management believes that the probability of collection is insufficient to warrant further accrual. Some of these loans and leases may remain on accrual status when contractually past due 90 days or more if management considers the loan collectible. A loan may be returned to accrual status if (1) principal and interest payments have been brought current, and the Company expects repayment of the remaining contractual principal and interest, (2) the loan or lease has otherwise become well-secured and in the process of collection, or (3) the borrower has been making regularly scheduled payments in full for the prior six months and it s reasonably assured that the loan or lease will be brought fully current within a reasonable period. Residential mortgages are generally placed on nonaccrual status when past due 120 days, or sooner if determined to be collateral-dependent. Residential mortgages are returned to accrual status when principal and interest payments become less than 120 days past due and when future payments are reasonably assured. Home equity loans and lines of credit, home equity products serviced by others, automobile loans, and other installment loans are generally placed on nonaccrual status when past due 90 days or more. Loans less than 90 days past due may be placed on nonaccrual status upon the death of the borrower, surrender or repossession of collateral, or bankruptcy. Non-guaranteed student loans are placed on nonaccrual status when they become 90 days past due or in the event of fraud, bankruptcy, or the borrower s death. A loan may be returned to accrual status if the loan becomes less than 15 days past due. Guaranteed student loans are not placed on nonaccrual status. Credit card balances are placed on nonaccrual status when past due 90 days or more. They are restored to accruing status if they subsequently become less than 90 days past due. Cash receipts on nonaccruing loans and leases are generally applied to reduce the unpaid principal balance. Impaired Loans Loans and leases are generally placed on nonaccrual status when certain delinquency thresholds have been reached, or earlier if management believes the probability of collection is sufficient to warrant further accrual. Delinquency thresholds vary by loan type. Generally, a loan that has been partially charged-off may not be returned to accrual status. A loan is considered to be impaired when it is probable that the Company will be unable to collect all of the contractual interest and principal payments as scheduled in the loan agreement. Impaired loans include nonaccruing larger balance (greater than $3 million carrying value) non-homogenous commercial and commercial real estate loans, and restructured loans which are deemed troubled debt restructurings ( TDRs ). A loan is identified as a TDR when the Company grants the borrower a concession the Company would not otherwise make in response to the borrower s financial difficulties. Concessions granted in TDRs for all classes of loans may include lowering the interest rate, forgiving a portion of principal, extending the loan term, lowering scheduled payments for a specified period of time, principal forbearance, or 19

23 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS capitalizing arrearages. A rate increase can be a concession if the increased rate is lower than a market rate for debt with risk similar to that of the restructured loan. Additionally, TDRs for commercial loans and leases may also involve creating a multiple note structure, accepting non-cash assets, accepting an equity interest, or receiving a performance-based fee. In some cases a TDR may involve multiple concessions. The financial effects of TDRs for all loan classes may include lower income (either due to a lower interest rate or a delay in the timing of cash flows), larger loan loss provisions, and accelerated charge-offs if the modification renders the loan collateral-dependent. In some cases interest income may increase if, for example, the loan is extended or the interest rate is increased as a result of the modification. Impairment evaluations are performed at the individual loan level, and consider expected future cash flows from the loan, including, if appropriate, the realizable value of collateral. Impaired loans which are not TDRs are nonaccruing, and loans involved in TDRs may be accruing or nonaccruing. Consumer loans that are discharged in Chapter 7 Bankruptcy are deemed to be collateral-dependent and are charged-off to the value of the collateral, less cost to sell, and less amounts recoverable under a government guarantee. Collateral dependent consumer loans are moved to nonaccrual status regardless of the payment history. Cash receipts on nonaccruing impaired loans, including nonaccruing loans involved in TDRs, are generally applied to reduce the unpaid principal balance. Loans are generally restored to accrual status when principal and interest payments are brought current and when future payments are reasonably assured, following a sustained period of repayment performance by the borrower in accordance with the loan s contractual terms. Nonaccruing loans for all classes that are modified in a TDR are generally returned to accrual status after the borrower has made payments of cash or cash equivalents under the revised terms for at least six months subsequent to the restructuring date, and if management believes that all contractual payments due under the revised terms are collectible. Fair Value The Company measures fair value using the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is based upon quoted market prices in an active market, where available. If quoted prices are not available, observable market-based inputs or independently sourced parameters are used to develop fair value, whenever possible. Such inputs may include prices of similar assets or liabilities, yield curves, interest rates, prepayments speeds, and foreign exchange rates. Assets and liabilities carried at fair value inherently result in a higher degree of financial statement volatility. RBS Citizens assets and liabilities carried at fair value include available-for-sale securities, private equity investments, and derivative instruments. In addition, the Company elects to account for its residential mortgages held-for-sale at fair value. The Company classifies its assets and liabilities that are carried at fair value in accordance with the three-level valuation hierarchy: Level 1. Quoted prices in active markets for identical assets or liabilities. Level 2. Observable inputs other than Level 1 prices; examples include quoted prices for similar instruments, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by market data for substantially the full term of the asset or liability. Level 3. Unobservable inputs that are supported by little or no market information and that are significant to the fair value measurement. Classification in the hierarchy is based upon the lowest level input that is significant to the fair value measurement of the asset or liability. For instruments classified in Level 1 and 2 where inputs are primarily based upon observable market data, there is less judgment applied in arriving at the fair value. For instruments classified in Level 3, management judgment is more significant due to the lack of observable market data. RBS Citizens reviews and updates the fair value hierarchy classifications on a quarterly basis. Changes from one quarter to the next related to the observability of inputs in fair value measurements may result in a reclassification between the fair value hierarchy levels and are recognized based on period-ending balances. Fair value is also used on a nonrecurring basis to evaluate certain assets for impairment or for disclosure purposes. Examples of nonrecurring uses of fair value include MSRs accounted for by the amortization method, loan impairments for certain loans, and goodwill impairment. Additional information regarding RBS Citizens fair value measurements can be found in the Notes to the Consolidated Financial Statements. 20

24 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Goodwill and Intangible Assets Goodwill is an intangible asset representing the difference between the purchase price of an acquired business and the net fair value of its assets and liabilities. Goodwill is not amortized, but is subject to an annual impairment test. The goodwill impairment analysis is a two-step test. The first step, used to identify potential impairment, involves comparing each reporting unit s fair value to its carrying value including goodwill. If the fair value of a reporting unit exceeds its carrying value, applicable goodwill is deemed to be not impaired. If the carrying value exceeds fair value, there is an indication of impairment and the second step is performed to measure the amount of impairment. The second step involves calculating an implied fair value of goodwill for each reporting unit for which the first step indicated impairment. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination, which is the excess of the fair value of the reporting unit, as determined in the first step, over the aggregate fair values of the individual assets, liabilities and identifiable intangible assets as if the reporting unit was being acquired in a business combination. If the implied fair value of goodwill exceeds the goodwill assigned to the reporting unit, there is no impairment. If the goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss recognized cannot exceed the amount of goodwill assigned to a reporting unit, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment losses is not permitted. Significant judgment is applied when goodwill is assessed for impairment. This judgment includes developing cash flow projections, selecting appropriate discount rates, identifying relevant market comparables, incorporating general economic and market conditions, and selecting an appropriate control premium. The selection and weighting of the various fair value techniques may result in a higher or lower fair value. Judgment is applied in determining the weightings that are most representative of fair value. Due to current economic and other uncertainties, it is possible that RBS Citizens estimates and assumptions may adversely change in the future. The Company may be required to record goodwill impairment losses in future periods, whether in connection with the Company s next annual impairment testing or prior to that time, if any changes constitute a triggering event. Additional information regarding RBS Citizens goodwill impairment tests can be found in the Notes to the Consolidated Financial Statements. 21

25 Off-Balance Sheet Arrangements MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following table presents RBS Citizens outstanding off-balance sheet commitments. See further discussion of the Company s off-balance sheet arrangements in the Consolidated Financial Statements. September 30, December 31, Increase (dollars in millions) (Decrease) Commitment amount: Undrawn commitments to extend credit $53,271 $49,347 8 % Financial standby letters of credit 3,880 4,259 (9) Performance letters of credit Commercial letters of credit (3) Marketing rights (5) Risk participation agreements (3) Residential mortgage loans sold with recourse Fund investment commitments 5 14 (64) Total $57,524 $53,977 7 % Enterprise Risk Management RBS Citizens defines risk appetite as the maximum limit of acceptable risk, beyond which the Company would be unable to achieve its strategic objectives, or would assume an unacceptable amount of risk in order to do so. RBS Citizens risk appetite contains four main objectives (i.e., maintain capital adequacy of 7% post-stress Tier 1 common, deliver stable earnings growth, maintain stable and efficient access to funding and maintain stakeholder confidence) and their associated measures. By including the capital adequacy target of 7% post-stress Tier 1 common within the risk appetite, RBS Citizens has made an explicit linkage between the risk appetite and the capital adequacy process. The Company considers the 7% post-stress Tier 1 common requirement when reviewing both the adequacy of capital targets and the post-stress buffer. As an additional control, and in line with RBS Citizens risk appetite, it has also implemented an earnings volatility target, that requires the Company to remain profitable under severe stress events and appropriately capitalized under extreme stress events. As a banking organization regulated under U.K. law, RBS Group exercises enterprise-wide management over all of its subsidiaries, including RBS Citizens. Therefore, RBS Citizens must also manage its risks consistent with the maximum limit of risk acceptable to RBS Group. Pursuant to a cease and desist order entered into by RBS Group with the Federal Reserve and certain state banking supervisors in 2011 (the Cease and Desist Order ), RBS Group was required to strengthen its U.S. corporate governance structure and develop an enterprise-wide risk management program, among other requirements with respect to its U.S. operations, which include RBS Citizens. RBS Citizens maintains a governance structure that delineates the responsibilities for risk management activities, as well as governance and oversight of those activities, by management and the Board of Directors. Board members have access to executive management and are provided frequent and periodic management updates, including reports from Risk Management, Finance and Treasury, and RBS Group Internal Audit. Managing risk is an essential component of RBS Citizens business. Risk identification and monitoring are key elements in overall risk management. The following principal risks, which have been incorporated into RBS Citizens risk management program, consistent with RBS Group s enterprise-wide risk management program and the governance standards imposed by the Cease and Desist Order, include: 22

26 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Credit Risk Credit risk represents the potential for default or loss resulting from an obligor s failure to meet the terms of any contract with RBS Citizens, or its subsidiaries, or failure otherwise to perform as agreed. Credit risk arises from all activities where success depends on counterparty, issuer, or borrower performance. Credit Policy administers the Credit Approval Framework that controls the underwriting and approval of new business for the Company. Risk Policy Committees govern all changes to the consumer and commercial credit policies. The Credit Approval Framework vests credit authority in select individuals throughout the Company. Transactions must be approved by designated personnel and the level of approval escalates based on the size and complexity of the transaction. RBS Citizens is currently focused on streamlining and simplifying the Credit Policy and supporting procedures without compromising asset quality and sound lending processes. Credit Portfolio Management oversight resides with assigned retail and commercial credit officers who are focused on transactions and portfolio management capabilities. Concentration limits for asset classes and sectors are formally approved by the Risk Policy and Risk Concentration Risk Committees and approved by the Chief Credit Officer. Credit officers are responsible for monitoring the performance of assigned portfolios, credit policy compliance and adherence to concentration limits. Credit officers, partner with the line of business to conduct regular portfolio reviews to identify and remediate risks and to execute on portfolio management strategies, including decisions on sales of assets, participation levels, leveraged lending arrangements and watched asset reviews. A recovery group of credit professionals is engaged in the restructuring, remediation and collection of stressed loan relationships. An independent model validation function delivers objective validation assessments for all models in the decision support framework. RBS Citizens Risk Architecture Center of Excellence centralizes all activities associated with the oversight of risk systems, data, analytics, and reporting. Risk Architecture manages a single, integrated roadmap of projects to enhance its risk and capital management capabilities, inclusive of key risk initiatives around the regulatory reform agenda. These include Basel II, economic capital enhancements, comprehensive capital analysis and review, stress testing and Dodd-Frank Act compliance. Relationship managers are responsible for all aspects of the credit relationship including sales negotiations, profitability, underwriting, regulatory compliance, documentation, portfolio administration, and problem loan identification. Relationship managers seek to ensure that the proper probability of default and loss given default ratings are assigned to the credit at all times and continuously monitored and managed based on all information received. Relationship management also entails oversight and liaison with other areas of RBS Citizens whenever appropriate, particularly in deteriorating scenarios. Relationship management teams may be comprised of team leaders, relationship managers, portfolio management analysts, underwriters and lending analysts. Every member of the team plays a critical role and shares a significant level of responsibility, however, the relationship manager assigned to the credit ultimately is charged with the primary credit stewardship responsibilities and accountability. Interest Rate Risk Interest rate risk is the risk to earnings or capital arising from movement of interest rates. It arises from differences in the maturity and / or re-pricing of assets and liabilities, including the impact of interest-rate-related options embedded in bank products. The primary objectives of interest rate risk management are to identify the nature and estimate the magnitude of interest rate risk in the structural (non-trading) balance sheet, place limits on that risk reflecting risk tolerance, and then manage the risk within those limits. All of RBS Citizens interest rate risk measures are within current limits. RBS Citizens structural interest rate risk position is asset-sensitive. Net interest income would benefit from rising rates, as loan assets would generally re-price upward faster than customer deposits. Adverse exposure to declining rates is limited by the low starting level of rates. The primary drivers of this adverse exposure include prepayment risk for mortgage-related assets, pricing floors on retail deposits, and rollover risk for fixed-rate assets, all of which become magnified at low interest rate levels. Given the prolonged period of low interest rates, the cumulative impact of rollover risk grows. 23

27 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Liquidity Risk Liquidity risk is defined as the risk that RBS Citizens or any of its subsidiaries / affiliates are unable to meet their contractual or potential payment obligations in a timely manner. This risk can be broken down into asset liquidity risk and funding liquidity risk. Asset liquidity risk arises when changes in the market conditions make the liquidation of certain assets difficult and substantially reduces the liquidation value of such assets. Funding liquidity risk refers to the inability of the Company to honor its payment obligations due to difficulties raising funds from counterparties and / or depositors. RBS Citizens considers the effective and prudent management of wholesale funding and liquidity to be fundamental to the health and strength of the Company. Liquidity risk is measured and managed within approved policy guidelines as determined by the Board of Directors, the RBS Citizens Asset and Liability Management Committee and RBS Group Asset Liability Committee. The Wholesale Funding and Liquidity unit monitors various key liquidity metrics for each bank and RBS Citizens on stand-alone and consolidated bases daily. Net overnight position, free securities, internal liquidity, available FHLB capacity, and total asset liquidity are calculated on a spot basis and forecasted monthly over a one-year horizon. This forecast is intended to identify emerging balance sheet trends and inform funding decisions. RBS Citizens stress testing indicates that sufficient liquidity would be maintained even in a long and severe crisis. The Company s inherent liquidity risk is moderate, due to RBS Citizens stable core deposits and significant high-quality assets. Asset liquidity, which remains at historic high levels, is comprised primarily of unencumbered securities and unused FHLB capacity. Other wholesale funding includes stable FHLB advances as well as certain other cost-advantaged funding. Precautionary excess cash balances are generally maintained at the FRB. As traditional sources of wholesale funding remain relatively limited, RBS Citizens continues to manage with no reliance on wholesale markets, with ample liquidity due to stable deposits, and with contingent liquidity provided by high quality assets. Market Risk Market risk is defined as the risk of loss resulting from changes in market prices as a result of changes in rates, credit and liquidity or general economic conditions. Market risk at RBS Citizens is limited to the risk of loss resulting from derivative products entered into to meet the financing needs of the Company s customers. To effectively eliminate the market risk associated with customer derivative products, RBS Citizens simultaneously enters into offsetting derivative agreements with RBS Group. Additionally, RBS Citizens enters into foreign exchange contracts on behalf of customers for the purpose of hedging exposure related to cash orders, loans, and deposits denominated in a foreign currency. The primary risks associated with these transactions arise from exposure to changes in foreign currency exchange rates and the ability of the counterparties to meet the terms of the contract. To effectively eliminate the market risks associated with these risks, the Company simultaneously enters into offsetting foreign exchange contracts with RBS Group. Operational Risk Operational risk represents the possibility that inadequate or failed systems and internal controls or procedures, human error, fraud or external influences such as disasters, can cause losses. RBS Citizens risk management framework is embedded in the business through the Three Lines of Defense Model which defines responsibilities and accountabilities. The business units (including business areas and support functions) are the First Line of Defense and are accountable for owning and managing, within a defined risk appetite, the risks which exist in their business area. These include establishing and maintaining risk assessments to identify and assess the material risks that arise in their area of responsibility, complying with relevant RBS Group Policies, testing and certifying the adequacy and effectiveness of their controls on a regular basis, establishing and documenting operating procedures, establishing and owning a governance structure for identifying and managing risk, and for defining and approving an appropriate risk appetite. The Second Line of Defense includes independent monitoring and control functions accountable for owning and developing the risk and control frameworks and tools which the business uses to discharge its responsibilities. Monitoring and control functions include the management and oversight of risk, financial management and valuation, and legal and regulatory compliance. The Second Line is appropriately independent from the business and is accountable for overseeing and challenging the First Line of Defense on the effective management of its risks. Second Line of Defense accountability includes communication, training and awareness, providing expert support and advice to the business on risk management. This includes interpreting and complying with the risk policy standards and risk management framework, conducting 24

28 MANAGEMENT S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS suitable reviews to focus on ensuring First Line compliance with policies and responsibilities, providing relevant management information and escalating concerns where appropriate. The RBS Citizens Executive Risk Committee actively considers the inherent, material risks of the business / organization. This committee analyzes the risk profile and seeks confirmation that the risks are being appropriately identified, assessed and mitigated to the desired level. RBS Citizens Internal Audit is the Third Line of Defense and provides independent assurance over the key risks to the Company, which includes an assessment of the entire control framework. Compliance Risk & Legal Risk Compliance and legal risk represents the potential for loss resulting from violations of or non-conformance with laws, rules, regulations, prescribed practices, existing contracts or ethical standards. RBS Citizens has established policy standards that seek to ensure RBS Citizens works within all relevant laws and regulations applicable in all jurisdictions where it does business. Strategic Risk Strategic risk is the current and prospective impact on earnings or capital arising from adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes. This risk is a function of the compatibility of an organization s strategic goals, the business strategies developed to achieve those goals, the resources deployed against these goals, and the quality of implementation. The resources needed to carry out business strategies are both tangible and intangible. They include communication channels, operating systems, delivery networks, and managerial capacities and capabilities. The Company s internal characteristics must be evaluated against the impact of economic, technological, competitive, regulatory, and other environmental changes. There is risk in the ability to deliver upon strategic initiatives in light of a slow economic recovery and a flat yield curve. However, actions have been taken to mitigate against this risk by working to optimize loan pricing and maintain conservative underwriting. Moreover, the Company is growing the fee income business and the commercial loan portfolio to drive revenue while maintaining cost discipline. The Company is positioned for a rising rate environment, but at the same time seeks alternative sources of revenue in this low rate environment. The Company will continue to run-off noncore loans and focus on organic growth as well as maintain strong capital ratios. To date, the revenue and expense impact of new regulations have been mitigated; however, as new rules are implemented, the costs of compliance will impact the Company and the entire industry. Reputational Risk Reputational risk is the potential for loss arising from negative public opinion. RBS Citizens manages reputational risk through various policies and processes which are embedded throughout the Company. These processes are both proactive and reactive in nature and include communications and branding strategies, extensive compliance training and strong regulatory relations, liquidity and capital adequacy planning, operational process and systems monitoring, and robust incident management protocols to address issues as they arise. 25

29 INDEPENDENT ACCOUNTANTS REVIEW REPORT To the Board of Directors and Stockholder of RBS Citizens Financial Group, Inc. Providence, Rhode Island We have reviewed the accompanying condensed consolidated balance sheet of RBS Citizens Financial Group, Inc. and subsidiaries ( the Company ) as of September 30, 2012, and the related condensed consolidated statements of operations, for the three- and nine-month periods ended September 30, 2012 and 2011, and changes in stockholder s equity and cash flows for the nine-month periods ended September 30, 2012 and This condensed financial information is the responsibility of the Company s management. We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants for reviews of interim financial information. A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial information taken as a whole. Accordingly, we do not express such an opinion. Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim financial information for it to be in conformity with accounting principles generally accepted in the United States of America. We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet as of December 31, 2011, and the related consolidated statements of operations, changes in stockholder s equity, and cash flows for the year then ended (not presented herein); and in our report dated February 21, 2012, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2011 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived. January 18, 2013