Pillar 3 Disclosures for the year ended 4 April 2014

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1 Pillar 3 Disclosures for the year ended 4 April 2014

2 Table of Contents 1 Overview Background Basis and frequency of disclosures Location and verification Scope Changes to disclosure requirements 5 2 Risk management Enterprise Risk Management Framework Risk culture Risk governance and control Risk strategy Risk measurement Stress testing and planning Coverage of risks 11 3 Capital resources Total available capital Tier 1 capital Tier 2 capital Individual (Solo) consolidation Leverage ratio 18 4 Capital adequacy Capital management Internal Capital Adequacy Assessment Process Minimum capital requirement: Pillar Minimum capital requirement: credit risk 22 5 Credit risks Credit risk overview Retail credit risk Commercial credit risk Treasury credit risk Impairment provisions Credit risk concentrations Credit risk mitigation Credit derivatives Securitisation Counterparty credit risk Model approvals and validation IRB credit risk model performance 42 6 Other Financial Risks Financial risk overview Liquidity and funding risk Market risk management Pension risk 51 7 Operational risk Operational Risk Overview Operational risk capital calculation approach 56 8 Remuneration 57 9 Glossary of terms 72 2

3 Contacts Stuart Williamson Media Relations Sarah Hill Treasury Investor Relations Certain statements in this Pillar 3 Disclosure document are forward looking. Although Nationwide believes that the expectations reflected in these forward-looking statements are reasonable, Nationwide can give no assurance that these expectations will prove to be an accurate reflection of actual results. Because these statements involve risks and uncertainties, actual results may differ materially from those expressed or implied by these forward-looking statements. Nationwide undertakes no obligation to update any forward-looking statements whether as a result of new information, future events or otherwise. 3

4 1 Overview 1.1 Background The European Union Capital Requirements Directive came into effect on 1 January This introduced consistent capital adequacy standards and an associated supervisory framework in the EU based on the Basel II Accord. This was replaced by Capital Requirements Regulation (CRR) and Capital Requirements Directive (together referred to as CRDIV) which came into force on 1 st January 2014 and is enforced in the UK, together with local implementing rules and guidance, by the Prudential Regulatory Authority (PRA). The rules include disclosure requirements known as Pillar 3 which apply to banks and building societies. These are designed to promote market discipline through the disclosure of key information about risk exposures and risk management processes. In May 2008, the FSA granted Nationwide permission to use Internal Ratings Based (IRB) approaches for credit risk and capital management. This permission was updated to become a CRR IRB permission from 1 January The disclosures in this document are based on IRB approaches for certain portfolios and Standardised for the remainder of credit risks and operational risk, as detailed in the capital management section (4.1). 1.2 Basis and frequency of disclosures This document sets out the 2014 Pillar 3 Disclosures for Nationwide. The sole purpose of these disclosures is to give information on the basis of calculating Basel III capital requirements and on the management of risks faced by the Group. This is in accordance with the rules laid out in the Capital Requirements Regulation (Part Eight). The disclosures may differ from similar information in the Annual Report and Accounts 2014 prepared in accordance with International Financial Reporting Standards ( IFRS ); therefore, the information in these disclosures may not be directly comparable with that information. Unless otherwise stated, all figures are as at 4 April 2014, Nationwide s financial year-end, with comparative figures for 4 April 2013 where relevant. Pillar 3 Disclosures are published annually concurrently with the Annual Report and Accounts in accordance with regulatory guidelines. The introduction of CRD IV means that our 2014 capital position is presented on a different basis to that reported in Where appropriate we have disclosed 4 April 2013 on a proforma basis to aid comparability and have annotated this accordingly in the relevant tables. Nationwide s accounting (IFRS) balance sheet is prepared on the same basis as our regulatory balance sheet there are no entities that are derecognised from the accounting balance sheet for regulatory purposes. 1.3 Location and verification These disclosures have been reviewed by the Executive Risk Committee and the Group s Board Risk Committee, and are published on the Group s corporate website (nationwide.co.uk/investorrelations). All figures disclosed within this document have been subject to internal verification. These disclosures have not been externally audited and do not constitute any part of the Group s financial statements. 1.4 Scope Nationwide is an EEA parent institution that is regulated by the PRA and FCA. The Basel III Framework therefore applies to Nationwide and its subsidiary undertakings (together, the Group ). The Group also includes the business combinations that took place in the financial year 2008/09 from the mergers with Derbyshire and Cheshire building societies, and assets and liabilities acquired from the Dunfermline Building Society (together, the regional brands ). There is a requirement to calculate and maintain regulatory capital ratios on both a Group basis and on a Individual Consolidated (or solo) basis. However, there are no differences between the basis of consolidation of the Group for accounting and prudential purposes. Full details of the principal subsidiary undertakings are included in Note 18 to the Annual Report and Accounts. The principal subsidiaries included on the Individual Consolidation basis are: 4

5 The Mortgage Works (UK) plc UCB Home Loans Corporation Limited Derbyshire Home Loans Limited E-Mex Home Funding Limited Nationwide Syndications Limited All of the Group s subsidiaries are included in the data provided in our Pillar 3 disclosures, unless the data specifically relates to the Individual Consolidated (or solo) basis. Nationwide has a branch in the Republic of Ireland (Nationwide UK Ireland) which is a retail deposit taker and is regulated by the Central Bank and Financial Services Authority of Ireland. With that exception, the Group does not foresee any practical or legal impediments to the transfer of capital resources or the repayment of liabilities within the Group. 1.5 Changes to disclosure requirements Nationwide continues to develop the quality and transparency of disclosures to ensure that they are as clear and informative as possible. The Financial Stability Board (FSB) established the Enhanced Disclosures Task Force (EDTF) with a remit to broaden and deepen the risk disclosures of financial institutions in a number of areas, including risk management, liquidity and funding risk, credit risk and market risk. In 2013, we implemented the recommendations of the EDTF s October 2012 report Enhancing the risk disclosures of Banks. For 2014, we have enhanced these disclosures to comply with revised recommendations. Basel III was implemented on 1 January 2014 through the Capital Requirements Regulation and Capital Requirements Directive (together referred to as CRD IV). CRD IV set disclosure requirements for financial institutions, which have also been included in this document or in our Annual Report and Accounts, as appropriate. 5

6 2 Risk management 2.1 Enterprise Risk Management Framework Nationwide seeks to manage appropriately all the risks that arise from its activities. There is a formal structure for monitoring and managing risks across the Group comprising a risk appetite approved by the Board, detailed risk management frameworks (including policies and supporting documentation), and independent governance and oversight of risk. The Enterprise Risk Management Framework (ERMF), which applies to the entire Nationwide Group including all trading divisions and subsidiaries, is structured around five headings: Heading Risk culture Risk governance and control Risk strategy Risk measurement Stress testing and planning Description Sets out the values and behaviours present throughout the organisation that shape risk decisions across the Group. Sets the risk categories, the Three Lines of Defence and how these are deployed, the committee governance structure, and standards for documentation and policy. Sets out the Board s risk appetite and overall strategy for risk management, connecting the Board s corporate plan and risk appetite with practical and detailed strategies, controls and limits to deliver this strategy without compromising risk appetite. Sets out the standards across the Group, encompassing risk data and systems, the use of models, reporting, and risk-based performance measurement. Sets out the approach to Group-wide stress testing, scenario analysis, contingency plans, and the interactions with other corporate processes Framework developments introduced during financial year 2013/14 include: The appointment of a Chief Compliance Officer (CCO) with responsibility for compliance and oversight of the customer and compliance risks for the Group. The Chief Risk Officer (CRO) retains responsibility for the risk framework and risk aggregation across all risks including compliance risks. Both the CCO and CRO report to the Chief Executive Officer. The creation of a first line Operational Risk Committee under the chairmanship of the Chief Operating Officer. This committee replaced the previous Operational Risk Oversight Committee. The Group Risk Oversight Committee has been renamed the Group Risk and Compliance Committee (GRCC) with enhanced focus on compliance matters. The GRCC continues to be chaired by the CRO, with the CCO as deputy chair and the Group Risk Director and Director of Compliance Oversight as committee members. The composition and chairmanship of the existing risk committees has been revisited. Re-grouping of the sub-categories for customer and compliance risk. 2.2 Risk culture Within Nationwide, risk culture is defined as the values, beliefs, knowledge and understanding about risk and the management of risk, advocated by the Board, shared and adopted by employees within the organisation. This tone from the top is supported by appropriate levels of resource with the necessary skills. The risk culture therefore sets out: our approach to maintaining a strong risk culture at Nationwide the risk culture statements to which all directors and staff are committed required ( do ) and prohibited ( don t ) behaviours at Enterprise level. The risk culture statements are grouped under four high-level objectives; shared understanding and attitude, clear communication, effective risk teams, and highest standards. Through the understanding of these statements, the aim is to ensure that all staff are risk aware, communicate effectively about risk, and work together to recognise, manage and mitigate risk. In the final quarter of the year, a survey is undertaken to assess the effectiveness of the risk culture at Nationwide, the results of which feed into the objectives for the risk management division for the next financial year. 6

7 2.3 Risk governance and control Risk categorisation Each type of risk which the Group faces is defined within the Enterprise Risk Management Framework s risk categorisation model. The five principal risk categories in the framework are as follows: Risk Category Definition Sub-components Further coverage Lending The risk that a borrower or counterparty fails to pay the interest or to repay the principal on a loan or other financial instrument (e.g. a bond) on time. Lending risk also encompasses extension risk and concentration risk. Retail (secured) Retail (unsecured) Commercial Treasury s5. Credit Risks Financial The risk of Nationwide having inadequate earnings, cash flow or capital to meet current or future requirements and expectations. It includes loss or damage to the earnings capacity, market value or liquidity of the Group, arising from mismatches between the Group s assets, funding and other commitments, and which may be exposed by changes in market rates, market conditions or Nationwide s credit profile. Solvency Risk Liquidity & Funding Risk Market risk Pension risk s3. Capital Resources s4. Capital Adequacy s5.11 Model approvals and validation s6. Financial Risk Operational The risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Financial Reporting and Tax Fraud (Internal/External) Group Security Information and Financial Management Infrastructure and Resilience People Transformation s7. Operational Risk Customer & Compliance The risk that the organisation fails to design and implement operational arrangements, systems and controls such that it can maintain legal and regulatory compliance, deliver fair customer outcomes and achieve a positive experience for our customers. Customer Experience Firm & Culture Retail Conduct Prudential Standards Wholesale Conduct Financial Crime Annual Report and Accounts: Business and Risk Report Strategic The risk of significant loss or damage arising from business decisions that impact the longterm interests of the membership, or from an inability to adapt to external developments. Business model risk Reputation risk Strategic initiatives risk Annual Report and Accounts: Business and Risk Report In addition to these principal categories of risk, model risk, which is defined below, is managed under a separate framework that applies across all risk categories and business areas where models are used. Nationwide has a dedicated department within Risk Management Division to oversee model risk across the Group. The model risk framework ensures effective governance and oversight of models, and that standards are consistently applied. The department oversees the Group s model risk profile and has specific responsibilities to undertake independent validations of models. 7

8 Risk Category Model Risk Definition The risk that an adverse outcome (incorrect or unintended decision or financial loss) occurs as a direct result of weaknesses or failures in the design or use of a model. The adverse consequences include financial loss, poor business or strategic decision making, or damage to Nationwide s reputation. The frameworks for the above risks (including associated risk appetite, limits, supporting policies and other documents) are reviewed annually or more frequently as appropriate. They are also subject to continuous monitoring by the relevant committees, and by the Chief Risk Officer. Three Lines of Defence Nationwide continues to adopt the Three Lines of Defence model with the objectives of: Making the Group resilient, compliant and efficient Making risk appetite and risk exposure simple, transparent and controlled Maintaining a strong risk culture. First line of defence Second line of defence Third line of defence Every Nationwide employee is responsible for the risks that are a part of their day-to-day jobs. The first line of defence ensures all key risks within their operations are identified, mitigated and monitored by appropriate internal controls within an overall control environment. Independent functions within the risk management and compliance divisions that are responsible for providing oversight and challenge of activities conducted in the first line. Group Internal Audit provides independent assurance over the first and second lines of defence. In organisational terms, the Three Lines of Defence model brings distinct separation between the elements of risk control (first line), independent oversight (second line) and audit assurance (third line). First line risk control is provided by all relevant business units. These are supported by key control functions and, where risks apply across the Group, through an embedded network of risk representatives within the organisational areas under the control of Executive and Group Directors. Second line oversight functions, independent from the first line, report either into the Group Risk Director (reporting to the Chief Risk Officer) or the Compliance Oversight Director (reporting to the Chief Compliance Officer). These functions are aligned to the principal risk categories and model risk to oversee the first line management of risk, including concentrations where appropriate. The oversight teams maintain risk management frameworks, set standards, review policies, establish limits that are consistent with risk appetite, and monitor and report on compliance with those limits. Third line assurance is provided by Group Internal Audit, which ultimately reports to the Audit Committee. Group Internal Audit provides independent assurance regarding the activities of both first line risk control and second line risk oversight. Information about the role and activities of the Audit Committee can be found in the Corporate Governance section of the Annual Report & Accounts. Risk governance The principal committees that form the Group s risk governance structure are set out below: 8

9 Risk governance structure at Group level The Board Risk Committee and Audit Committee continue to provide support and advice to the Board. The Executive Risk Committee continues to ensure a co-ordinated management approach across all risks in operational terms. As part of the 2013 annual ERMF governance review, the composition and chairmanship of the existing risk committees was revisited. A number of changes to the risk committee structure were agreed and implemented at the start of the financial year, including the introduction of a first line Operational Risk Committee and enhanced focus of the Group Risk & Compliance Committee on compliance. The Chief Risk Officer chairs the Group Risk & Compliance Committee and, as an attendee of the Board Risk Committee, has direct access to the Chair of the Board Risk Committee to escalate risk issues as appropriate. The Chief Compliance Officer is deputy chair of the Group Risk & Compliance Committee and has the same direct access to the Chair of the Board Risk Committee as the Chief Risk Officer. Beneath the second line Group Risk & Compliance Committee there is a specialist Model Risk Oversight subcommittee. Customer Committee, Operational Risk Committee, Lending Committee and Assets & Liabilities Committee (ALCo) in the first line are supported by specialist sub-committees, forums and working groups that consider technical detail and reports, making recommendations to their parent committee as appropriate. In addition, all executive divisions hold risk and control meetings so that there is the opportunity to report and escalate risks across the entire organisation. 9

10 Organisation and governance arrangements for the principal risks are set out in the table below: Risk Category Organisation Governance 1 st Line Control 2 nd Line Oversight 1 st LOD 2 nd LOD Financial Risk Capital Management (Finance)/ Balance Sheet Risk (Treasury) Group Financial & Strategic Risk ALCo Group Risk & Compliance Committee Lending Risk Retail, Commercial and Treasury Credit Risk Management Group Lending Risk Lending Committee Group Risk & Compliance Committee Operational Risk All Divisions, supported by specialist Key Control Functions Group Operational Risk Operational Risk Committee Group Risk & Compliance Committee Customer Committee Customer & Compliance Risk All Divisions and 1 st line control functions Customer and Compliance Risk Oversight (ALCO & Lending Committee for relevant prudential compliance areas) Group Risk & Compliance Committee Strategic Risk ExCo Group Financial & Strategic Risk Executive Risk Committee Group Risk & Compliance Committee 2.4 Risk strategy Board risk appetite The Board sets high-level risk appetite to enable Nationwide to: Identify and define the type and levels of risks it is willing to accept in both qualitative and quantitative terms Describe the risks Nationwide is willing to take, and those it will not take, in pursuit of its strategic goals Establish a framework for business decision-making. The Board set high-level risk appetite in 2013/14 as follows: Financial Risk Lending Risk Operational Risk Customer & Compliance Risk Strategic Risk The Group holds sufficient capital and liquidity resources, and sustains this with stable earnings, diverse sources of funding and minimal exposure to market and off-balance sheet risks. The Group builds high quality lending portfolios that seek to earn an adequate return. The Group ensures controls are effective to minimise serious customer or business disruption. The Group maintains legal and regulatory compliance, delivers fair customer outcomes, and achieves a positive experience for customers. The Group ensures that the business model and strategy are focused on securing the long-term needs of its membership. The Board risk appetite statements are further expanded into qualitative statements that are supported by a focused suite of Board risk metrics, limits and triggers, designed to cover all the Group s risks. Board risk appetite is also incorporated into, and informs, relevant group processes, e.g. the corporate planning process. Board risk appetite is reviewed annually. Board risk appetite is supported by risk strategies for the principal risks that are approved by the Board Risk Committee. The risk strategies set out in detail the key risks posed, how the risk is managed, and a more granular view of risk appetite including detailed limits and triggers that are monitored by first line risk committees. Reporting, 10

11 limits and controls are therefore set in a hierarchy that links the Board s tolerance for risk with on-the-ground risktaking actions and behaviour throughout the Group. Lower level metrics from first line risk committees are escalated to the Executive Risk Committee and the Board Risk Committee should they fall out of tolerance or breach risk appetite. 2.5 Risk measurement Nationwide has clear risk management objectives and a strategy to deliver them through core risk management processes put in place under ERMF. At a strategic level, our risk management objectives are to: Identify risks against the Corporate Plan and divisional objectives Assess risk exposure by impact and likelihood Respond to risks by evaluating the position against risk appetite and formulating associated management response Monitor the agreed management action plans and updates. In the course of such risk assessment, controls may be challenged, strengthened and risks mitigated within the context of risk appetite. The approach serves to help executives improve the control and co-ordination of risk taking across the business and to manage the risk profile in the context of corporate objectives. Each of the Society s Top and Emerging Risks has associated risk metrics which provide insight into the impact and likelihood of the risk occurring. These are monitored within the Risk Governance structure. 2.6 Stress testing and planning The Group engages in thorough stress testing, scenario analysis and contingency planning, in order to better understand and prepare for low-frequency, high impact events. A range of group wide, multi-risk category corporate stress tests, and operational risk scenario analyses are undertaken to ensure that the financial position and risk profile of the Group provide sufficient resilience to withstand the impact of stressed economic and market conditions (systemic stress) or one-off events (idiosyncratic stress). Stress testing is an integral part of the annual corporate planning process, the adequacy assessment processes for liquidity and capital, and the annual review of Group risk appetite. The stress testing and scenario analysis programme is overseen by the Board Risk Committee, with corporate stress testing co-ordinated by ALCo, supported by the Capital & Stress Testing Committee, and operational risk scenario analysis activity coordinated by the Operational Risk Committee. The Group s ERMF document includes high-level principles and minimum standards that apply to any stress testing or scenario analysis activity undertaken, which are supported by more detailed standards and methodologies at a local level. This includes a common three stage process (planning and preparation, running the stress test, and review and report), and minimum requirements for each stage aimed at ensuring an appropriate choice of scenarios, supported by robust documentation, with stakeholder engagement, challenge and review throughout the design, completion and subsequent reporting of the stress test. Corporate Stress Testing standards are further defined in the Financial Risk Framework, and the supporting Stress Testing Framework document. This includes a detailed planning stage that consists of an assumption setting process for economic, market and business specific assumptions to ensure that the appropriate scenario is chosen, and the identification of management actions with input from key representatives from across the business. The Group also undertakes reverse stress tests to identify scenarios that could result in the business model ceasing to be viable under a range of adverse circumstances. The exercise represents financial and non-financial consequences for the Society which are designed to impact the financial performance of the firm and the confidence of key stakeholder groups. Outputs from stress testing activity are used to inform capital and liquidity planning, articulate potential management actions within contingency plans, and further improve the management of the Group s risk profile. Further detail about stress testing can be found in the Annual Report & Accounts under Business and Risk Report and section 4.2 of this document. 2.7 Coverage of risks Pillar 3 disclosures in this document cover credit risks (section 5), liquidity and funding risks 1 (section 6), market risks (section 6.3), and operational risks (section 7). Additional information regarding risks can be found in the Annual Report and Accounts. 1 Included for completeness as liquidity and funding risk falls outside the disclosure requirements for Pillar 3. 11

12 3 Capital resources 3.1 Total available capital At 4 April 2014 and throughout the financial year, the Group complied with the capital requirements that were in force as set out by European and National legislation. The Group continues to use an Internal Ratings Based (IRB) approach, using its IRB models to calculate capital requirements. The PRA have confirmed that the original 2008 permission transferred to a CRR IRB permission from 1 January Basel III was implemented on 1 January 2014 through the Capital Requirements Regulation and Capital Requirements Directive (together referred to as CRD IV). This regulatory framework is supplemented by a number of technical standards issued by the European Banking Authority, and the Directive is implemented in the UK through PRA rules. CRD IV increases the quantity and quality of capital that firms are required to hold, through the introduction of additional and increased deductions from Common Equity Tier One (CET1) resources and a phased implementation of new buffers, designed to prevent firms from breaching their minimum regulatory requirement in a stressed environment. Table 1 shows the composition of capital resources under Pillar 3 for the Nationwide Group as at 4 April 2014 on a CRD IV basis (see Appendix 1 for the full CRD IV disclosure template as published by the EBA in Implementing Technical Standard (ITS) 2013/01). Nationwide s Common Equity Tier 1 (CET1) capital and CET1 ratio are disclosed on an end-point basis as transitional provisions apply in full to these items. Additional Tier 1 (AT1) and Tier 2 capital (and therefore total capital) include instruments that are grandfathered so are disclosed on a transitional basis. Capital resources are shown on a Group and Individual (solo) Consolidated basis (where only the core lending subsidiaries are included see section 3.4 for more detail). 12

13 Table 1: Capital composition Group Individual (Solo) CRD IV Basel II CRD IV Basel II m m m m Common Equity Tier 1 General reserve 7,363 6,765 7,332 6,536 Core capital deferred shares (CCDS) Revaluation reserve Foreseeable distributions 2 (45) - (45) - Available for sale deductions 3 (51) - (51) - Prudent valuation adjustment 4 (5) - (5) - Own credit valuation adjustments 5 (17) - (17) - Pension fund deficit adjustment Intangible assets 7 (890) (878) (890) (878) Goodwill (12) (16) (12) (16) Excess of expected loss over impairment 8 (1,096) (429) (1,096) (429) Securitisation and other positions 9 - (251) - (251) 5,849 5,454 5,818 5,225 Tier 1 Additional Tier 1 (AT1) capital securities Permanent Interest Bearing Shares (PIBS) , ,304 Tax in respect of expected loss over impairments Material holdings in non-solo consolidated 11 subsidiaries (16) 7,433 6,894 7,402 6,649 Tier 2 Revaluation reserve Subordinated debt 10 2,073 2,281 2,073 2,281 Collective impairment allowance Surplus of impairment over expected loss Excess of expected loss over impairment 8 - (565) - (565) Securitisation and other positions 9 - (251) - (251) Material holdings in non-solo consolidated 11 subsidiaries (16) 2,271 1,602 2,271 1,586 Holdings in non-solo consolidated subsidiaries (13) Total capital 9,704 8,496 9,673 8,222 Risk weighted assets - Pillar 1 12 Retail mortgages 15,105 16,953 15,105 16,953 Retail unsecured lending 6,899 6,485 6,899 6,485 Commercial loans 9,061 13,643 9,061 13,643 Treasury 4,304 2,802 4,226 2,839 Other 1,295 1,107 1,404 1,035 Operational risk 3,762 3,398 3,762 3,398 Market risk Total risk weighted assets 40,455 44,440 40,486 44,405 Capital ratios 13 Common Equity Tier 1 ratio 14.5% 12.3% 14.4% 11.8% Tier 1 ratio 18.4% 15.5% 18.3% 15.0% Total capital ratio 24.0% 19.1% 23.9% 18.5% 1 Under CRD IV the revaluation reserve can be counted as CET 1 capital. 2 Foreseeable distributions in respect of CCDS and AT1 securities are deducted from CET1 capital under CRD IV. 13

14 3 The Available For Sale reserve is included in regulatory capital under CRD IV. 4 A prudent valuation adjustment is applied in respect of fair valued instruments as required under regulatory capital rules. This will be revised when the EBA Regulatory Technical Standard comes into force later this year. 5 Own credit and debit valuation adjustments are applied to remove gains or losses of fair valued liabilities and derivatives that result from changes in Nationwide s own credit standing and risk, in accordance with CRD IV rules. 6 CRD IV does not allow the pension fund deficit to be added back to regulatory capital, as was allowed under Basel II. 7 Intangible assets and goodwill do not qualify as capital for regulatory purposes. 8 Under CRD IV, the net expected loss over accounting provisions is deducted from CET1 capital, gross of tax. Under Basel II the deduction was split 50%, net of tax, from Core Tier 1 and 50%, gross of tax, from Tier 2 with the Tier 2 tax offset being counted within Tier 1 capital. 9 Securitisation assets rated below BB- are now being risk weighted at 1250%. There are no other deductions as at 2014 ( 6 million in 2013). Under Basel II the deduction was split 50% from Core Tier 1 and 50% from Tier Permanent interest bearing shares and subordinated debt include fair value adjustments related to changes in market interest rates, adjustments for unamortised premiums and discounts that are included in the consolidated balance sheet, and any amortisation of the capital value of Tier 2 instruments required by regulatory rules for instruments with less than five years to maturity. The values are subject to the CRD IV grandfathering cap as at January Material and other holdings in non-solo subsidiaries are risk weighted under CRD IV rules. 12 The CRD IV Pillar 1 capital requirements (risk weights) are calculated using the Retail IRB approach for prime, buy-to-let and self-certified mortgages (other than those originated by the Derbyshire, Cheshire and Dunfermline building societies) and unsecured lending; Foundation IRB and slotting for treasury and commercial portfolios (other than sovereign exposures); and the Standardised approach for all other credit risk exposures, including some treasury and commercial exposures that are exempt from using the IRB approach. 13 Capital (solvency) ratios are calculated as relevant total capital divided by risk weighted assets. Total capital has strengthened by 1.2 billion to 9.7 billion (2013: 8.5 billion), driven by organic profitability and the issuance of core capital deferred shares (CCDS) and Additional Tier 1 capital securities (AT1). This is despite the CRD IV adjustments which reduced CET1 and Tier 1 capital resources and increased capital requirements. Risk weighted assets (RWAs) decreased by 4 billion, with deleveraging of the Treasury ABS and Commercial portfolios and the transfer of some retail specialist lending portfolios onto the IRB approach more than offsetting RWA increases due to the implementation of CRD IV (such as deferred tax assets carrying a 250% risk weighting and the introduction of a credit valuation charge for derivatives) and the risk weighting of securitisation positions that were also previously deducted from capital resources (50% from CET1 and 50% from Tier 2), which the Group elected to risk weight from 1 January 2014 (the alternative under CRD IV is to deduct 100% from CET1). The table below shows movements in capital in 2013/14 and highlights the movements that include the impact of the adoption of CRD IV. 14

15 Table 2: Flow statement for regulatory capital Group m Common Equity Tier 1 capital at 5 April ,454 Issuance of Core Capital Deferred Shares (CCDS) 531 Profit for the year 549 Change in reserves 48 Foreseeable distributions (45) Prudent valuation adjustment (5) Intangible assets* (8) Election to risk weight securitisation and other deductions 251 Revaluation reserve* 71 Available for sale reserve* (51) Own credit valuation adjustments* (17) Pension deficit adjustment* (263) Excess of expected loss over impairment* (666) Common Equity Tier capital at 4 April ,849 Additional Tier 1 capital at 5 April ,440 Issuance of Additional Tier 1 (AT1) capital securities 992 Buy back of Permanent Interest Bearing Shares (PIBS) (506) Fair value adjustments (197) Transfer of eligible PIBS to Tier 2* 1 (9) Tax on excess of expected loss over impairment* (136) Additional Tier 1 capital at 4 April ,584 Total Tier 1 capital at 4 April ,433 Tier 2 capital at 5 April ,602 Redeemed capital (15) Amortisation of tier 2 debt (54) Fair value adjustments (148) Collective impairment (43) Election to risk weight securitisation and other deductions 251 Revaluation reserves* (67) Transfer of eligible PIBS to Tier 2* 1 9 Surplus of impairment over expected loss* 171 Excess of expected loss over impairment* 565 Tier 2 capital at 4 April ,271 Total regulatory capital at 4 April ,704 *Capital flow for these line items is due in part to the adoption of CRD IV. 1 9million of PIBS are eligible as Tier 2 capital instruments under CRD IV rather than AT1 The table above shows that the Group s strong trading performance and capital issuance more than offset the new requirements to deduct the excess of expected loss over impairment in full from CET1 (gross of tax), the liability management activity undertaken during the year and the fact that CET1 capital can no longer be adjusted to exclude the pension deficit. Table 3 includes the April 2013 figures on a proforma basis had the CRD IV transitional rules been applied at that date and reflects the changes in treatment of certain securitisation exposures. It also shows our capital position on a CRD IV end point basis (i.e. assuming all CRD IV requirements were in force in full with no transitional provisions permitted). On a Group basis, Nationwide s end point CET1 ratio remains at 14.5% (4 April 2013: 9.1%). For Nationwide, the difference between the transitional and the end point position is due to capital instrument grandfathering provisions, which permit PIBS and certain Subordinated Debt instruments to be eligible as capital during a transitional period 15

16 on a phased basis. The transitional period ends on 31 December Note that a minority of Nationwide s PIBS have features that make them eligible as Tier 2 under CRD IV, so these are included accordingly in the capital structure on a transitional and an end point basis. Table 3: CRD IV end point analysis Common Equity Tier 1 Transitional CRD IV End point CRD IV m m m m General reserve 7,363 6,765 7,363 6,765 Revaluation reserve Foreseeable distributions (45) - (45) - Available for sale deductions (51) (252) (51) (252) Prudential valuation adjustment (5) (13) (5) (13) Own credit valuation adjustments (17) (37) (17) (37) Pension fund deficit adjustment CCDS Intangible assets (890) (821) (890) (821) Goodwill (12) (16) (12) (16) Excess of expected loss over impairment (1,096) (1,130) (1,096) (1,130) Other positions - (12) - (12) Tier 1 5,849 4,551 5,849 4,551 AT1 capital securities Permanent Interest Bearing Shares (PIBS) Tier 2 7,433 5,488 6,841 4,551 Subordinated debt 2,073 2,167 1,886 1,972 Collective impairment allowance Surplus of impairment over expected loss ,271 2,258 2,084 2,063 Total capital 9,704 7,746 8,925 6,614 Total risk weighted assets 40,455 50,285 40,455 50,285 Capital ratios Common Equity Tier 1 ratio 14.5% 9.1% 14.5% 9.1% Tier 1 ratio 18.4% 10.9% 16.9% 9.1% Total capital ratio 24.0% 15.4% 22.1% 13.2% 3.2 Tier 1 capital Tier 1 capital comprises: Core capital deferred shares (CCDS) General reserves Revaluation reserves Permanent Interest Bearing Shares (PIBS) Additional tier 1 (AT1) Capital Adjustments as set out by the regulatory requirements governing capital resources. The general reserves represent the Group s accumulated accounting profits as well as adjustments for pensions and property disposals. 16

17 In December 2013 the Group successfully issued 550 million ( 531 million net of issuance costs) of CCDS which qualifies as CET1 capital. In addition the Group issued 1 billion ( 992 million net of issuance costs) of Additional Tier 1 capital in March These successful transactions demonstrate that Nationwide has access to the external market when required to support the Group s capital position and the achievement of its strategic objectives. As part of its capital management strategy, the Group bought back 506 million of its own permanent interest bearing shares (PIBS) in September and October These transactions removed instruments that are not eligible as capital under end-point CRD IV rules and generated additional CET1 by crystallising gains. Future liability management options and decisions with respect to capital calls will be made at the Group s discretion in light of the then prevailing market, economic and regulatory conditions. Appendix 2 shows the key features of the capital instruments issued by Nationwide, and more information can be found in Notes to the Annual Report & Accounts. Adjustments are required by the regulatory requirements, set out in CRD IV, governing capital resources: An adjustment is made in respect of intangible assets. For accounting purposes, items including computer software, other intangibles resulting from business combinations and goodwill are capitalised as intangible fixed assets subject to certain criteria. Intangibles are deducted from capital under the regulatory rules. At 4 April million was deducted from CET1 in respect of intangible assets (including goodwill). Deductions in respect of expected loss for IRB portfolios, where it exceeds accounting provisions, are made from CET1. At 4 April ,096 million was deducted in respect of excess expected loss. A number of valuation adjustments are made to CET1 capital: o o o 3.3 Tier 2 capital Tier 2 capital comprises: Prudent Valuation Adjustment (PVA): a prudent calculation of all assets and liabilities that are fair valued (e.g. on AFS assets and derivatives) Own Credit Adjustment (OCA): an adjustment is made to unrealised gains or losses that have resulted from changes in the fair value of (non-derivative) liabilities that are due to changes to own credit risk. Debit Valuation Adjustment (DVA): an adjustment is made to unrealised gains or losses that have resulted from changes in the fair value of derivative liabilities that are due to changes to own credit risk. Qualifying subordinated notes Collective impairment allowance (for exposures treated on the Standardised basis) Add-back of provisions where they are in excess of expected loss for IRB portfolios Adjustments as required by the regulatory requirements governing capital resources. Subordinated notes are unsecured and rank behind the claims of all depositors, creditors and investing members (other than holders of PIBS, AT1 securities and CCDS) of the Society. More details of the subordinated notes are included in Note 28 to the 2014 Annual Report and Accounts. Qualifying subordinated notes must not exceed 50% of the total of Tier 1 capital, and Tier 2 capital must not exceed Tier 1 capital. Deductions are required accordingly, although Nationwide did not exceed any of these limits at 4 April Individual (Solo) consolidation Nationwide calculates capital requirements on a Group and Solo basis (the Solo consolidation includes entities that meet certain criteria as set out in CRD IV and for Nationwide represents only the core lending entities). Table 1 shows Nationwide s Group and Solo capital position. The differences relate primarily to reserves held by entities that sit outside of the scope of Solo consolidation that are included in the Group consolidation, and a small impact from the risk weighted assets of these entities. As part of the strategic management of the Group structure, Nationwide International Limited (NIL) converted from a subsidiary to a branch in March 2014, which reduced the difference between our Group and Solo CET1 ratios (2014: 0.1%, 2013: 0.5%). 17

18 3.5 Leverage ratio CRD IV requires firms to calculate a non-risk based Leverage Ratio, to supplement risk-based capital requirements. The leverage ratio measures the relationship between the capital resources of the organisation and its total assets. The purpose of monitoring and managing this metric is to enable Regulators to constrain the buildup of excessive leverage, which was considered to be one of the drivers of the banking crisis. It is calculated as: Tier 1 capital / total on and off balance sheet assets adjusted for deductions. The Leverage Ratio is a three-month average of capital as a proportion of total exposures, defined as: Capital: Tier 1 capital defined according to CRD IV on an end point basis (assuming the full impact of CRD IV requirements on Tier 1 capital were in force with no transitional provisions) with 2013 values restated according to CRD IV rules for comparison Exposures: total on and off balance sheet exposures less the deductions applied to Tier 1 capital as per Basel III December 2010 requirements. The Basel Committee has implemented a monitoring period which runs to January 2017, during which time a minimum leverage ratio of 3% should apply. This limit will be reassessed in 2017 before becoming mandatory in In January 2014, the Basel Committee on Banking Supervision (BCBS) published a revised definition for calculating the leverage ratio. The revised definition allows the application of credit conversion factors to commitments, thus reducing the exposure measure. To be adopted in the EU, amendments would be required to CRD IV, so this definition is not currently in force. However, in Table 4 we have also shown Nationwide s Leverage Ratio according to this revised BCBS definition. 18

19 Table 4: Leverage ratios Exposure basis 2014 Basel III 1 ( m) 2013 Basel III 1 ( m) 2014 Latest BCBS 2 ( m) Capital (Tier 1 CRD IV 'end point') 6,841 4,551 6,841 Exposure: Balance sheet exposure 189, , ,926 Mortgage pipeline 5,344 4,735 1,069 Other committed facilities 10,786 12,807 5,733 Repurchase agreements 5,550 2,941 5,550 Netted derivatives adjustment (690) (1,554) (1,087) Tier 1 deductions (2,003) (1,991) (2,003) Leverage ratio exposure 208, , ,188 Leverage ratio 3.3% 2.2% 3.4% As per Annual Report & Accounts Netted derivatives adjustment (2,041) 3 (3,291) 3 (1,087) Leverage ratio exposure 207, , ,188 Leverage ratio 3.3% 2.2% 3.4% 1 Basel III December 2010 basis 2 BCBS approach as published in January The alternative Netted Derivatives Adjustment included in the Leverage Ratio Exposure disclosed in our Annual Report and Accounts recognised increased netting for collateral received against derivative positions. In future reporting, the BCBS basis of exposure measurement will be used and hence the difference noted above will not arise. 19

20 4 Capital adequacy 4.1 Capital management The Group manages its capital structure to ensure it continues to meet minimum regulatory requirements, as well as meeting the expectations of other key stakeholders. Capital is monitored on a monthly basis against the capital plan and supported by a range of limits and triggers that ensure that capital continues to be within the Board s Risk Appetite. In addition to calculating the minimum Capital Resource Requirement as required under CRD IV rules, the Group has an internal capital framework to support the management of its capital requirements. The Capital Resource Requirement covers all Pillar 1 risks (credit risk, operational risk and market risk). Credit risk The Group uses Internal Ratings Based (IRB) approaches for certain credit risk portfolios following FSA approval in May Nationwide has received permission from the PRA to continue to use an IRB approach under the CRD IV framework. The scope of Internal Ratings Based permission for the year ended 4 April 2014 is as follows: Retail IRB Foundation IRB Slotting IRB Society prime mortgages 1, specialist retail mortgages, unsecured lending (personal loans), and qualifying revolving credit risks (FlexAccount, Nationwide s current account, and credit cards). Treasury exposures (excluding certain corporates, central banks and governments, and certain multi-lateral development banks) and exposures to housing associations (Registered Social Landlords) Commercial: Income Producing Real estate (IPRE) and Project Finance Initiatives (PFI) All other credit risks adopt the Standardised Approach. The more significant credit risk portfolios currently using the Standardised approach (prime retail mortgages from the regional brands) are expected to migrate to IRB approaches under a rollout plan. Market risk Market risk for the Group arises from foreign exchange risk under Pillar 1 due to foreign currencies in the banking book. The Foreign Exchange Position Risk Requirement (FX PRR) charge is the amount of regulatory capital required to cover the risk of losses on open foreign currency positions due to movements in foreign exchange rates. This is calculated in accordance with the Standardised Approach rules. Other market risks are not included in regulatory capital under Pillar 1 as the Group does not have a trading book under the CRD IV definition. Operational risk The Standardised Approach is adopted for operational risk. Reporting Capital is reported monthly in the Board Performance Pack. More detailed reports of capital and risk, including information by business stream, are considered monthly by the Capital and Stress Testing Committee (CSTC), a sub-committee of the Assets and Liabilities Committee (ALCo). Specific reports of capital by business stream are also included in the monthly packs of the risk committees as appropriate. Nationwide has set a medium-term target to have a Common Equity Tier 1 ratio in excess of 16%. A range of Key Risk Indicators and Key Performance Indicators are routinely monitored (in both actual and forecast terms) by management to ensure that appropriate actions can be taken should triggers be breached. 4.2 Internal Capital Adequacy Assessment Process The Group undertakes an Internal Capital Adequacy Assessment Process (ICAAP) which is an internal assessment of its capital needs for Pillar 2 purposes. This internal assessment considers risks included in the Pillar 1 Capital Resource Requirement as well as other risks not included in Pillar 1. The ICAAP is performed annually or more frequently should the need arise. The ICAAP includes an assessment of the Group s business strategy, risk 1 Prime mortgages originated by Nationwide and Portman only; prime mortgages from the regional brands are currently treated under the Standardised Approach. 20

21 appetite, risk profile and capital plan throughout a five-year planning horizon. The capital plan forms the starting point for stress testing which ensures the Group remains within its risk appetite through the consideration of management actions. The outcome of the ICAAP is presented in an Internal Capital Assessment (ICA) document covering the Group and its subsidiaries. The ICA covers all material risks to determine the capital requirement, and ensures that Nationwide can meet its future capital needs. Accordingly, Nationwide s capital strategy has established the target capital base that it aims to achieve over the planning horizon through understanding current and future capital quantity and quality needs in the context of its external stakeholders including members, investors, rating agencies and regulators. The ICA is presented to ALCo, Executive Risk Committee and Board Risk Committee, for challenge and approval. The Board formally approves the ICA after due consideration of any matters referred to it by Board Risk Committee. The PRA assesses Nationwide s ICA and sets Individual Capital Guidance (ICG) for the Group on an IRB basis. The Group retains capital in excess of the ICG at all times. Stress Testing Nationwide s stress testing programme is designed to test the Society s business model using the major sources of risks identified in the PRA rulebook of the Internal Capital Adequacy Assessment rules, and emerging risks identified internally by the Board. Stress testing scenarios can comprise a firm-specific stress (idiosyncratic), a market-wide stress (systemic) or a combination of the two to assess capital and liquidity adequacy. The outcome of stress testing informs risk appetite, and provides senior management with insight around early-warning triggers, business vulnerabilities, management actions and recovery plans. The stress testing programme therefore forms an integral part of the corporate planning process and is a key element of the overall risk management framework. Stress testing papers are produced to highlight capital and liquidity adequacy and risks for various committees. These reports are reviewed, challenged and approved by the Capital and Stress Testing Committee (CSTC), Assets and Liabilities Committee (ALCo), Executive Risk Committee (ERC) and Board Risk Committee (BRC) prior to formal Board approval. This governance process ensures that there is Board-level engagement. The Bank of England discussion paper A framework for stress testing the UK banking system published in October 2013 outlined that building the industry s capability to deliver the stress testing framework will take a number of years. Nationwide has made progress to evolve its stress testing framework through the planned delivery of both tactical and strategic solutions for data, systems and processes. A dedicated programme will support this development. Key learnings from the 2014 FPC stress testing exercise will be used to inform the overall programme for 2015 and beyond. During autumn 2013, Nationwide performed a stress test using the PRA s Anchor scenario (systemic stress) and applied a firm-specific (idiosyncratic stress) liquidity stress. This exercise supported the issuance of Core Capital Deferred Shares (CCDS). The analysis demonstrated that the Society can withstand a severe but plausible solvency and liquidity stress without breaching regulatory thresholds. All regulatory capital requirements were comfortably maintained, even at the peak of the stress. 4.3 Minimum capital requirement: Pillar 1 Nationwide s overall minimum Capital Resources Requirement under Pillar 1 is calculated by adding the credit risk charge (section 4.4) to that required for credit valuation adjustments (CVA), market risk and operational risk. The following table shows the Group s capital resources requirement and capital resources surplus under Pillar 1 as at 4 April 2014: 21

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