1. Key Regulatory Metrics

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2 Contents 1. Key Regulatory Metrics Overview Introduction Overview of Basel III Basis of Preparation Capital Resources Total Regulatory Capital and Reconciliation to Accounting Capital Capital Adequacy Capital Management Capital Requirement Movements in RWA Continued Impact of Basel III Quality of Capital Impact Leverage Capital Buffers Capital Adequacy Through Transition Risk Management Objectives and Policies Overview Risk Appetite Risk Management Structure Risk Governance Stress Testing Principal Risk Measurement, Mitigation and Reporting Credit Risk Overview Liquidity Risk Market Risk Conduct Risk Operational Risk Securitisation Retained Securitisation Positions Purchased Securitisation Positions Appendix A Grandfathering Profile & Capital Allowances Appendix B - Remuneration Glossary of Terms...37

3 1. Key Regulatory Metrics Common Equity Tier 1 Capital Common Equity Tier 1 Capital m 18.2% m 16.9%* m 11.8% Tier 1 Capital Tier 1 Ratio m 20.5% m 18.7%* m 13.7% Total Regulatory Capital Total Capital Ratio m 22.5% m 20.2%* m 16.0% Leverage Ratio Leverage Exposure (Transitional Position) ,484.4m 5.7% ,376.0m 5.4% *Increase due to movement of exposures to IRB from see Section 2.1 Page 1 of 40

4 2. Overview 2.1 Introduction The Capital Requirements Directive IV (CRD IV), commonly known as Basel III came into effect on 1 January 2014, there are transitional rules in place until 1 January This document reflects the transitional Basel III position for 31 December 2014, compared with 2013 results under the Basel II requirements. In addition it states the Group s position based on two further scenarios where appropriate: 2013 positions restated for Basel III rules as at 1 January 2014 to make for better comparisons to positions as at 31 December 2014; As if the final Basel III rules applied (known as the final Basel III position) 2.2 Overview of Basel III The Basel III framework has applied since 1 January 2014 with transitional arrangements in place until full implementation on 1 January The three pillar framework of Basel II is unchanged but there have been changes to the detailed requirements within each pillar. Pillar 1 This is the minimum capital requirement and defines rules for the calculation of credit, market and operational risk capital requirements under the following approaches: o Standardised approach: assesses capital requirements using standard industry-wide risk weightings based on a detailed classification of asset types o Internal Ratings Based approach (IRB): assesses capital requirements using firm specific data and internal models to calculate risk weightings. The IRB approach is further subdivided into three approaches: Advanced IRB (A-IRB): where internal calculations of probability of default (PD), loss given default (LGD) and credit conversion factors are used to model risk exposures Foundation IRB (F-IRB): where internal calculations of PD, but standardised parameters for LGD and credit conversion factors are used o Specialised Lending Exposures: where standardised parameters for risk weight and expected loss are set based on risk grade allocated. Pillar 2 This is the supervisory review process which requires firms to undertake an individual capital adequacy assessment process (ICAAP) for other risks (see Section 4.1) and to agree total capital requirements with the regulator; and Pillar 3 This outlines market discipline such as requirements for disclosure of risk and capital information as specified in the Basel rules to promote transparency and good risk management allowing the market to assess and compare the capital adequacy of firms. The changes to the detailed requirements include more detailed Pillar 3 disclosure requirements and generic templates to be adopted over the course of the transition to allow improved comparability and transparency between institutions covered by the Basel accords. Basel III has strengthened the rules on the quality of capital to ensure loss absorption is adequate and allow financial institutions to deal with shocks and stresses related to financial and economic factors. Basel III requires that the quality of capital to cover Pillar 1 capital requirements is improved in terms of its ability to absorb losses, meaning that more of the Pillar I capital requirement must be met from Common Equity Tier 1 (CET1). 2.3 Basis of Preparation The sole purpose of these disclosures is to give information on the basis of calculating capital requirements and on the management of risks faced by the Group. This is in accordance with the rules laid out in the Prudential Regulation Authority (PRA) Handbook and CRD IV. All calculations that include elements of own funds are prepared in line with current Basel regulation unless explicitly stated. Page 2 of 40

5 2.3.1 Frequency of Disclosure Disclosures will be issued at least annually, on the Principality internet site based on the most recent published Annual Report and Accounts. Unless otherwise stated, all figures are as at 31 December 2014, the Group s financial year end Presentation of Risk Data This document discloses assets in terms of exposures and capital requirements. For the purposes of this document, credit exposure is defined as the estimate of the amount at risk in the event of a default (before any recoveries) or through the decline in value of an asset. This estimate takes account of contractual commitments related to undrawn amounts. In contrast, an asset in the Group s balance sheet is reported as a drawn balance only. This is one of the reasons why exposure values in the Pillar 3 report will differ from asset values as reported in the 2014 Annual Report and Accounts prepared in accordance with International Financial Reporting Standards (IFRS) Scope of Application The Basel III Framework applies to the Society and its subsidiary undertakings (the Group). This is enforced by the PRA and Financial Conduct Authority (FCA) through regulation. The Group is made up of the following main trading entities: Principality Building Society Nemo Personal Finance Limited Full details of the principal subsidiary undertakings are included in note 22 to the 2014 Annual Report and Accounts. There is a requirement to calculate and maintain regulatory capital ratios on both a Group basis and on a solo consolidation basis. However, there are no significant differences between the Group and solo consolidation disclosures. The only entities outside of the solo consolidated basis are dormant or immaterial, therefore this document includes only the Group analysis. There are no differences in the basis of consolidation for accounting and regulatory capital purposes. Full details of the basis of consolidation can be found in note 1 to the 2014 Annual Report and Accounts. Restrictions on transfer of funds or regulatory capital There are no legal or regulatory restrictions that constitute a material limitation on the ability of our subsidiaries to pay dividends or our ability to transfer funds or regulatory capital within the Group Scope of Permission of Internal Ratings Based Approach In August 2013 Principality was granted permission by the PRA to adopt the IRB approach for credit risk. The IRB approach has been applied to first charge Retail and Commercial portfolios from the 1 st October The disclosures in this document cover the IRB approach and the standardised approach, which applies to the second charge retail lending, Residential Social Landlords (RSL), treasury portfolios and operational risk. Roll-out of the IRB approach to the second charge retail lending portfolio is due to be implemented during 2015 subject to PRA approval. Were the Group to have adopted an IRB approach for second charge mortgages at the 2014 year end based on current models, the CET1 ratio would have been a still healthy 13.87% and the Solvency ratio 17.17% Location of Risk Disclosures These disclosures have been reviewed by the Audit Committee and are published on the Groups website alongside the Annual Report and Accounts ( Verification and Sign-off These disclosures are not subject to external audit except where they are equivalent to those prepared under accounting requirements for inclusion in the Group s audited Annual Report and Accounts. They are reviewed internally by the Audit Committee in accordance with the Group s policies on disclosure and its financial reporting and governance process. Page 3 of 40

6 2.3.7 Remuneration The responsibilities and decision-making process for determining remuneration policy, the link between pay and performance and the design and structure of remuneration, including the performance pay plans, have been disclosed in the Report of the Remuneration Committee on pages in the 2014 Annual Report and Accounts. Supplementary tables have been included in Appendix B to meet the requirements of Pillar 3 disclosures on remuneration analysing remuneration between fixed and variable remuneration for Senior Code Staff. Page 4 of 40

7 3. Capital Resources 3.1 Total Regulatory Capital and Reconciliation to Accounting Capital As at 31 December 2014 and throughout the year, the Group complied with the capital requirements that were in force as set out by the PRA. The following table shows the breakdown of the total available capital for the Group as at 31 December 2014 under the Basel III rules: Basel III 2014 Basel II 2013 Notes m m General Reserves AFS Reserves 2.6 (3.0) Total Accounting Capital Adjustments for Regulatory Capital:- AFS Reserve 2 (2.6) 3.0 Intangible Assets 4 (1.7) - Additional Value Adjustment (AVA) 7 (0.5) - Deferred Income 7 (1.0) - Provision Deductions 8 (29.8) - Common Equity Tier 1 Capital Permanent Interest Bearing Shares (PIBS) Additional Tier 1 Capital Intangible Assets 4 - (4.4) Provision deductions 8 - (15.0) Deductions from Tier 1 Capital - (19.4) Total Tier 1 Capital Amortised Subordinated Debt Tier 2 Allowance of Grandfathered AT Tier 2 Capital Provision deductions 8 - (14.9) Deductions from Tier 2 Capital - (14.9) Total Tier 2 Capital Total Regulatory Capital Resource Notes and General Information on Capital Resources 1 The general reserve represents the Group s accumulated profits. Further details of the general reserve are provided in note 36 to the 2014 Annual Report and Accounts. 2. Under Basel II AFS reserves were excluded from Regulatory Capital Resources. Under Basel III transitional rules during 2014 they can only be included if they show a loss. Therefore for both 2013 and 2014 AFS reserves are excluded from regulatory capital. Page 5 of 40

8 3. Permanent interest bearings shares (PIBS) are unsecured deferred shares and rank behind the claims of all subordinated note holders, depositors, creditors and investing Members of the Society. They are being grandfathered out of Tier 1 availability as part of the Basel III transitional rules. Further details of the PIBS are provided in note 35 to the 2014 Annual Report and Accounts. 4. Intangible assets include goodwill and software development costs. Further details of the intangible assets are provided in note 23 to the 2014 Annual Report and Accounts. 5. Subordinated notes are unsecured and rank behind the claims of all depositors, creditors and investing Members (other than holders of PIBS) of the Society. Under CRR article 494, Tier 2 Capital must be under 100% of Tier 1 capital during The subordinated notes, as a Tier 2 instrument, started amortising out of regulatory capital over five years from July 2011 under CRR article Due to the straight line amortisation of our Subordinated notes we are below the Tier 2 grandfathered limit. CRR Article 486 allows for any Tier 1 instruments excluded from Tier 1 due to the grandfathered limit to be included within Tier 2 up to the Tier 2 grandfathering limit (See section 5.1 for more detail). Further details of the subordinated notes are included in note 34 to the 2014 Annual Report and Accounts. 7. Additional Valuation Adjustment (AVA) is the prudential valuation of all fair valued assets which, as per CRR article 34, is deducted from CET1 capital. Deferred income is income dependent on the future performance of second charge loans sold to other institutions. We do not therefore recognise the income as an asset and instead, as per CRR article 3, deduct the income from CET1. 8. Provision deductions arise from the IRB approach. The calculation is the difference between the expected losses from IRB portfolios and the amount of specific and collective provisions held for those same portfolios. CRR Article 36 states this deduction is taken 100% from CET 1 capital. Page 6 of 40

9 4. Capital Adequacy 4.1 Capital Management During August 2013 the PRA granted the Group permission to use the IRB approach. At the end of 2014 the Group was therefore using a mixture of standardised and IRB to calculate Basel III Pillar 1 minimum capital requirement as follows: Retail IRB Society first charge mortgages Specialised Lending Exposures Commercial lending Standardised Second charge mortgages, Registered Social Landlords, Treasury exposures and other assets Second charge mortgages are expected to migrate to the Retail IRB approach during 2015 subject to PRA approval. Details of the methodologies used are included in Section 7. Pillar 1 capital adequacy is monitored monthly with capital forecasts formally reviewed and approved at least annually. Pillar 2 risks are considered every 12 months as part of the ICAAP. Actual capital levels are considered monthly by Board and the Asset and Liability Committee (ALCo). The Group s minimum capital level is that which the Board considers necessary to protect unsecured creditors from loss and reflects the Group s planned activity as a whole, set in the competitive and economic environment in which it operates. The assessment of the minimum capital requirement is a combination of model outputs from its standardised and IRB systems, supplemented by the use of other risk models, together with judgement exercised by the Board. Internal Capital Adequacy Assessment Process The Group conducts an Internal Capital Adequacy Assessment Process (ICAAP) to assess the Group s capital adequacy and determine the levels of capital required to support the current and future risks faced by the Group. The ICAAP covers all material risks to determine the capital requirement over a five-year horizon and includes stress scenarios which are intended to meet internal and regulatory requirements. The capital requirements are presented to the Board for approval with the most recent review being completed and approved by the Board in July 2014, the next ICAAP is due to be submitted to the PRA during May The ICAAP is used by the PRA to determine and set the Group s Individual Capital Guidance (ICG). The ICG was recalibrated by the PRA after IRB approval was granted in September The amounts and composition of the Group s capital requirements are determined by assessing the relevant Basel Pillar 1 minimum capital requirement, the requirement for other risks not included in Pillar 1, and the impact of stress and scenario tests under Pillar 2 (applied via an ICG). The Group manages its capital above the minimum ICG threshold, including a capital planning buffer, at all times. Capital levels for the Group are reported to, and monitored by, the Board on a monthly basis. Page 7 of 40

10 4.2 Capital Requirement The Group s total capital requirement under Pillar 1 is calculated by applying appropriate risk weightings to each class of exposure, then applying a fixed 8% multiplier. Dec-2014 Average Risk Weights % m m Retail financial services 14% Secured personal lending 41% Retail financial services-past due items 211% Secured personal lending-past due items 106% Retail exposures classes Commercial lending-non Housing association 92% Commercial lending-housing association 35% Commercial lending-past due items * 0% - - Commercial exposure classes Financial institutions 5% Other exposure classes Fixed and other assets 99% Other Credit risk minimum capital requirement Operational risk CVA Total minimum capital required Total own funds Excess of own funds over minimum capital requirement under Pillar *Past due items for commercial specialised lending are risk weighted at 0% as prescribed by CRD IV, these loans also attract an expected loss of 50% of the balance [Past due is defined in Section 7.1.6]. Page 8 of 40

11 4.3 Movements in RWA m Position as at 31 December ,123.2 Increase due to net mortgage book growth 15.0 Decrease due to net treasury book reduction 4.4 Movement in risk profile (changes in existing assets) (102.4) Increase due to Other Assets 2.5 Change in impact of netting 3.1 Increase in Operational Risk 12.4 Increase of CVA 5.3 Position as at 31 December ,063.5 Page 9 of 40

12 5. Continued Impact of Basel III The new regulatory rules, referred to as Capital Requirement Regulation (CRD IV) took effect across Europe on 1 January The key impacts to the Group are outlined below. 5.1 Quality of Capital The objectives of the rules are to increase the ability of financial institutions to deal with shocks and stresses related to financial and economic factors. To achieve the objectives the definition of capital has been restated and in particular includes specific requirements relating to the ability of firms to absorb losses. CET 1 is regarded as the highest quality of capital and Basel III rules state that a greater proportion of the Pillar I capital requirement must be met from CET 1 (as of 1 January % of the total 8.0%). As a result of the more stringent rules on loss absorbency the Group s Permanent Interest Bearing Shares (PIBS) no longer qualify as Tier 1 capital. The rules allow for instruments that are no longer eligible for inclusion in Tier 1 to be grandfathered (phased) out of eligibility over the 8 years between 1 January 2014 and 1 January The Group can recognise a maximum of 80% of the carrying value of the PIBS during 2014 and this percentage will continue to reduce by 10% per year. In addition, the Group s subordinated debt does not qualify for inclusion as Tier 2 capital and could be similarly grandfathered. However the Group s subordinated debt is already being amortised on a straight line basis due to the maturity of the instrument in June The grandfathering rules allow any Tier 1 capital that exceeds the Tier 1 capital grandfathering limit to be included as Tier 2 capital provided the maximum Tier 2 capital grandfathering limit is not exceeded. Due to the grandfathering limit being based on the notional amount of subordinated debt the Group will be able to include some of its ineligible PIBS as Tier 2 capital during the grandfathering period as shown in the table in Appendix A. 5.2 Impact The continued impact of Basel III has been fully assessed to demonstrate that the Group will remain well capitalised. A draft pro-forma below shows the Group s capital position prepared in accordance with the Basel III rules to date, transitional rules for the coming year and the final position. Page 10 of 40

13 Common Equity Tier 1 (CET1) capital: instruments and reserves Notes Transitional Basel III Adjustments Basel III Rules Final Basel III Rules m m m m General Reserves Common Equity Tier 1 (CET1) capital before regulatory adjustments Common Equity Tier 1 (CET1) capital: regulatory adjustments Additional value adjustments (negative amount) (0.5) - (0.5) (0.5) Intangible assets (net of related tax liability) (negative amount) (1.7) - (1.7) (1.7) Unrealised (Losses)/Gains from Available for Sale Assets Negative amounts resulting from the calculation of expected loss amounts (Expected losses less provisions) (29.8) - (29.8) (29.8) Exposure amount of the following items which qualify for a RW of 1250%, where the institution opts for the deduction alternative (1.0) - (1.0) (1.0) Total regulatory adjustments to Common Equity Tier 1 (CET1) (33.0) 2.6 (30.4) (30.4) Common Equity Tier 1 (CET1) capital Amount of qualifying items referred to in Article 484 (4) phased out from AT (6.0) Additional Tier 1 (AT1) capital before regulatory adjustments 48.0 (6.0) Intangible assets (net of related tax liability) (negative amount) Negative amounts resulting from the calculation of expected loss amounts Additional Tier 1 (AT1) capital 48.0 (6.0) Tier 1 capital (T1 = CET1 + AT1) (3.4) Amount of qualifying items referred to in Article 484 (5) phased out from T Tier 2 allowance of Grandfathered AT Tier 2 (T2) capital before regulatory adjustments Negative amounts resulting from the calculation of expected loss amounts Total regulatory adjustments to Tier 2 (T2) capital Tier 2 (T2) capital (T2 less regulatory adjustments) Total capital (TC = T1 + T2) Total risk weighted assets 2, , ,063.5 Page 11 of 40

14 Basel III Adjustments Transitional Basel III Rules Final Basel III Rules Capital ratios and buffers Common Equity Tier 1 (as a percentage of total risk exposure amount) 18.2% 0.1% 18.3% 18.3% Tier 1 (as a percentage of total risk exposure amount) 20.5% -0.1% 20.4% 18.3% Total capital (as a percentage of total risk exposure amount) 22.5% 0.1% 22.6% 18.3% Institution specific buffer requirement Common Equity Tier 1 available to meet buffers after the 8% minimum requirement (as % of risk exposure amount) 11.8% 7.5% Amounts below the thresholds for deduction (before risk weighting) Deferred tax assets arising from temporary differences Applicable caps on the inclusion of provisions in Tier 2 Cap on inclusion of credit risk adjustments in T2 under standardised approach Cap for inclusion of credit risk adjustments in T2 under IRB approach Capital instruments subject to phaseout arrangements (only applicable between 1 Jan 2014 and 1 Jan 2022) Current cap on AT1 instruments subject to phase out arrangements 48.0 (6.0) Amount excluded from AT1 due to cap Current cap on T2 instruments subject to phase out arrangements 51.7 (6.5) Amount excluded from T2 due to cap 12.0 (11.5) Notes and General Information on Basel III Impacts 1. As per PRA policy statement on implementing capital standards (PS 7/13) unrealised gains can only be included in CET1 from 1 January As per the PRA s transitional provisions the Group s PIBS will grandfather out of eligibility of Tier 1 and therefore only 80% of the value at 31 December 2012 can be recognised during 2014 and 70% during See Appendix A. 3. Under Basel III, as per Article 487, the Group can recognise any Tier 1 capital that exceeds the Tier 1 capital grandfathering limit as Tier 2 capital, provided the maximum Tier 2 capital grandfathering limit is not exceeded. As the Group s subordinated debt is amortising on a straight line basis due to the maturity in June 2016 it creates an allowance the Group can utilise. See Appendix A. Given the phasing of both capital requirements and target levels, in advance of needing to comply with the fully loaded end state requirements, the Group will have the opportunity to continue to generate additional capital from earnings and take management actions to mitigate the impact of Basel III. Ineligible Additional Page 12 of 40

15 Tier 1 and Tier 2 capital, which qualifies for grandfathering under the transitional relief, will be replaced through annual profits. 5.3 Leverage Basel III introduced a non-risk based leverage ratio to supplement the risk based capital requirements. The ratio shows Tier 1 capital as a proportion of on and off balance sheet assets. The ratio does not distinguish between the credit quality of loans and acts as a primary constraint to excessive lending in proportion to the capital base. The minimum ratio must be 3%, this means that for every 1m of eligible capital we can have up to 33m of assets. The leverage ratio does not become a binding component until 1 January A Counter-Cyclical Leverage Ratio Buffer (CCLB) will be phased in under these regulations at the same rate as the Counter-Cyclical Capital Buffer (CCyB), resulting in a possible minimum leverage requirement of 3.875% in The ratio and its components are disclosed in more detail below. Notes Basel III 2014 Basel III 2013 Basel II 2013 m m m Total Balance Sheet as per Statement of Financial Position 7, , ,058.1 Adjusted for: Add back of provisions Potential future credit exposure for swaps Off balance sheet exposures with a 50% CCF-Commercial lending commitments Off balance sheet exposures with a 100% CCF-Retail commitments Regulatory adjustment for Goodwill and Intangibles (1.7) (4.4) (4.4) Regulatory adjustments for AVA (0.5) (0.6) - Regulatory adjustments for Deferred Income (1.0) - - Provision Deductions (29.8) (29.9) (14.9) Leverage Exposure 7, , ,376.0 Tier 1 capital (final Basel III rules) Tier 1 capital (transitional position) Leverage ratio using tier 1 Capital (final Basel III rules) 5.02% 4.43% 4.59% Leverage ratio using transitional Tier 1 Capital % 5.24% 5.39% Notes and General Information on Leverage 1. During 2014 the Group revised its approach to calculating the leverage exposure value. For comparability to December 2014 the same methodology has been applied to the Basel III equivalent of December The transitional position represents the Tier 1 capital and Leverage ratio at 31 December 2014 following Basel III transitional provisions. Page 13 of 40

16 5.4 Capital Buffers To encourage adequate build-up of loss absorbing capital that can be used in times of stress Basel III requires the use of common equity capital buffers. A Capital Conservation Buffer (CCB) of 2.5% and a Counter-Cyclical Capital Buffer (CCyB) of up to 2.5% can be applied by regulators when macroeconomic conditions dictate. The decision on CCyB is made by the Financial Policy Committee (FPC) and on the 3 rd December 2014 the CCyB was set at 0%. Starting on 1 st January 2016 the CCB will be transitioned in to effect in 0.625% yearly increments, with the entirety of the 2.5% requirement applied on 1 st January In addition, globally systemically important banks are expected to hold a buffer of up to 2.5%. This is not expected to be applicable to the Group. The available Common Equity Tier 1 capital as a percentage of risk weighted assets to meet these buffers when they are implemented is shown in Section Capital Adequacy Through Transition Basel III Transitional Basel III Final Basel III Rules at m m m Total minimum Pillar 1 capital requirement Total own funds Excess of own funds over minimum capital requirement under Pillar Page 14 of 40

17 6. Risk Management Objectives and Policies 6.1 Overview The Group is primarily a producer and retailer of financial products, mainly in the form of mortgages, secured loans and savings. These products give rise to a financial asset or liability and are termed financial instruments. As well as mortgages, secured loans and savings, the Group also uses wholesale financial instruments to invest liquid asset balances, raise wholesale funding and to manage the interest rate risk arising from its operations. The Group s principal business objective is to provide Members with the benefits of a mutual organisation through the design, manufacture and delivery of attractive savings and mortgage products. The key risks to which the Group is exposed include strategic risk (including reputational risk), credit risk, liquidity risk, market risk, conduct risk, operational risk and pension obligation risk. Further detail on these risks can be found in Section 7 and in the Risk Management Report on pages of the 2014 Annual Report and Accounts. The ways in which the Group manages these risks include: Setting and maintaining a Board approved Statement of Risk Appetite; Using models and output from those models to help guide business strategies; Producing key risk information and indicators to measure and monitor performance; Using Management and Board Committees to monitor and control specific risks; and Using limits and triggers to control portfolio composition. 6.2 Risk Appetite The Group is a mutual organisation with no shareholders and is the custodian of its Members long term financial interests. The Members are entitled to take for granted that their money is safe. The Group s Board adopts a prudent attitude to risk when setting its risk appetite. There is no one single measure that defines the Board s Risk Appetite, but rather, a framework through which the Board has set overarching parameters within which the business is managed and performance monitored. The Board s Statement of Risk Appetite is expressed to reflect the strategy, overall objectives and business plans of the Group within the following broad categories: Capital; Profitability/Asset Quality (credit risk); Return on Capital; Liquidity/Funding. The framework includes business planning, capital planning, liquidity planning and risk management processes. Governance of these processes is achieved through the Group Management Committee (GMC), the Group Risk Committee and their subsidiary committees: Group Credit Risk Committee, Asset and Liability Committee, Group Operational Risk Committee and Model Governance Committee. The Risk Appetite statement and measures are reviewed at least annually or in the event that there are significant changes in strategy that require an adjustment to Risk Appetite. The Group has decided to omit disclosing key ratios and figures relating to its risk appetite, as they are considered to be proprietary information as per CRR article 432. Page 15 of 40

18 6.3 Risk Management Structure The Group adopts a three lines of defence model as the risk management structure. First line of defence primary responsibility for the identification, control, monitoring and mitigation of risk lies with operational areas across each business area. Second line of defence oversight and governance will be provided by the second line of defence through specialist support functions such as Group Risk and additionally through Risk Committees. The role of these functional specialists is to maintain and review policies, establish limits and qualitative standards which are consistent with the Group s risk appetite, monitor and report on compliance with those limits and standards, and generally to perform an oversight role in relation to the management of risk. Third line of defence the Group s internal audit function and audit committee is responsible for providing independent review of the effectiveness of the risk management structure and adherence to processes in the first and second lines. 6.4 Risk Governance The responsibility for the overall framework of risk governance and management lies with the Board of Directors. The Board is responsible for determining risk strategy, setting the Group s risk appetite and ensuring that risk is monitored and controlled effectively. It is also responsible for establishing a clearly defined risk management structure with distinct roles and responsibilities. Within that structure, line managers are responsible for the identification, measurement and management of the risks within their areas of responsibility. Further details on risk governance are included in the Risk Management Report on pages of the 2014 Annual Report and Accounts Board Committees The Board focuses on strategic issues, control of the business, review of operational and management performance, oversight of subsidiary companies and maintaining a system of effective corporate governance. The Board operates through its regular meetings and five committees Remuneration, Nomination, Audit, Customer and Conduct and Group Risk Committees. The Customer and Conduct Committee (CCC) is responsible for providing oversight of the Group s Business Conduct framework and strategy and is supported by the Customer Experience Forum. Key Conduct risks are reviewed by the Committee and reported to the Group Risk Committee. Further information on Board committee Terms of Reference can be found on the website This includes frequency of meetings, Committee functions and reporting to/from the committee. Terms of Reference are also held internally for all committees within the Group Group Risk Committee Chaired by a non-executive director the Committee is responsible for considering and recommending the Group s risk appetite, capital and liquidity adequacy to the Board. It is responsible for maintaining an appropriate governance structure to ensure that risks across the Group are identified and managed Page 16 of 40

19 effectively and for monitoring and reviewing internal and external risks including the assessment and quantification of all material prudential risks to support current and future estimation of regulatory capital requirements. Group Credit Risk Committee The Group Credit Risk Committee (GCRC) is a management committee, chaired by the Group Risk Director. The Committee is responsible for the management of the Group s Retail and Commercial credit risk in line with the Board approved Group Risk Appetite statement. The functions of the committee include review and approval of the Retail and Commercial credit risk policies together with the development of detailed limits and triggers for credit risks within the Group s overall risk appetite and for monitoring credit risk exposures. The Chairman of the Committee reports on the Committee s activities to the Group Risk Committee. Group Operational Risk Committee The Group Operational Risk Committee (GORC) is a management committee, chaired by the Group Risk Director. The Committee is responsible for the Operational Risk Framework and its implementation. The duties of the committee include the development and implementation of a robust operational risk framework and operational risk policies together with oversight of the key operational risk exposures facing the Group. The Chairman of the Committee reports on the Committee s activities to the Group Risk Committee. The Group Information Security Committee and Data Governance Committees report into the GORC and are responsible for providing specific oversight of these two key risks. Model Governance Committee The Model Governance Committee (MGC) is chaired by the Group Finance Director. The committee provides oversight of the models used by the Group to assess and quantify exposure to credit, liquidity and market risk. The main function of the committee is to review the construct and operation of models and modelling tools used across the Group and ensure they are fit for purpose. Formal minutes are submitted to the Group Risk Committee. The MGC is the designated committee for the approval of the IRB rating system Group Management Committee The Group Management Committee (GMC) is the principal management committee of the Group. It is chaired by the Group Chief Executive and membership includes all the Executive Directors. The functions of GMC are to agree strategy and policies for recommendation to the Board and agree new business initiatives and associated investment appraisal for submission to the Board for approval. This Committee is also responsible for overseeing strategy implementation, monitoring performance of the Society and its subsidiaries, and approving changes to administered interest rates for mortgage accounts. Page 17 of 40

20 Asset and Liability Committee The Asset and Liability Committee (ALCo) is chaired by the Group Finance Director. Its functions include monitoring the interest rate characteristics of retail, commercial and wholesale assets and liabilities, ensuring that the Group s liquidity meets the statutory obligations and remains within limits approved by the Board, monitoring the credit risk of assets held for liquidity purposes and monitoring the performance of the funding and liquid asset portfolios. The minutes and actions are reviewed by the Board, GMC and Group Risk Committee. Treasury Committee The Treasury Committee is chaired by the Group Finance Director. The committee has delegated responsibility for monitoring the Group s Treasury Counterparty Credit Risk, Liquidity Risk and Interest Rate Risk in line with the Risk Appetite as set by the ALCo, Group Risk Committee and Board. The minutes and actions are also reviewed by ALCo. Product Pricing Committee The Product Pricing Committee is chaired by the Customer Director. The main function of the committee is to approve retail mortgage and savings product pricing (new business and retention products) giving appropriate consideration to current market conditions and operational constraints. The committee aims to achieve net interest margin and volume targets contained in the Group s business plans, Board approved risk limits, and within the context of achieving fair outcomes for customers. This committee reports to ALCo and the Customer and Conduct Committee. 6.5 Stress Testing Group-wide stress tests are an integral part of the annual business planning process and annual review of risk appetite. Tests are designed to ensure that the Group s financial position and risk profile provide sufficient resilience to withstand the impact of severe economic stress on the market (systemic stress) or stress events that would only impact the Group (idiosyncratic stress). Stress testing also informs earlywarning triggers, management actions, contingency and recovery plans to mitigate potential stresses and vulnerabilities and as such is integral to the Group s risk management framework. The stress testing framework also includes reverse stress testing techniques which aim to identify circumstances under which the Group s business model is no longer viable, leading to a significant change in business strategy. Examples include extreme macroeconomic downturn scenarios (e.g. a breakup of the Euro area) and also targeted attacks on the Group (e.g. cyber threats). Stress testing is used to identify and review the potential effectiveness of management actions that would be taken to mitigate the impact of a stress. Page 18 of 40

21 7. Principal Risk Measurement, Mitigation and Reporting 7.1 Credit Risk Overview Credit risk is the potential risk that a customer or counterparty will fail to meet their financial obligations to the Group as they become due. Credit risk arises primarily from loans to residential customers, loans to commercial customers and from the assets held by Group Treasury in order to meet liquidity requirements and for general business purposes. The controlled management of credit risk is critical to the success of the Group s lending strategy and investment portfolio management. The quality of individual lending decisions, subsequent management and control, together with the application of a credit policy that reflects the risk appetite of the business, has a direct impact on the achievement of the financial objectives of the Group. Each of the four business areas, residential first and second charge lending, commercial lending and treasury has its own Credit Risk Policy Statement setting out its risk appetite which includes policy scope, structures and responsibilities, definitions of risk and risk measurement and approach to monitoring. In addition, each business area has its own detailed procedure manual setting out operating rules and standards. Day-to-day management of credit risk is undertaken by specialist teams working in each business area using credit risk management techniques adopted as part of the Group s overall approach to measure, mitigate and manage credit risk in a manner consistent with the risk appetite approved by the Group Risk Committee (GRC) and Board. Credit risk portfolios are subject to regular stress testing to simulate outcomes and assess the potential impact on capital requirements. Further details of credit risk governance are included in the Risk Management Report on pages of the 2014 Annual Report and Accounts Exposures Exposure at Default (EAD) as shown in these credit risk disclosures is defined as the exposure value under regulatory definitions for capital purposes. EAD is an estimate of the expected utilisation of a credit facility and will be equal to or greater than the currently drawn exposure excluding any Basel III defined credit risk mitigation (CRM). EAD Pre- CRM* As at December 2014 EAD Post- CRM* As at December 2014 RWAs As at December 2014 Capital Required As at December 2014 m m m m Retail financial services 5, , Secured personal lending Commercial lending , , , Treasury Central governments or central banks Multilateral development banks Financial institutions* , , Other assets Total 7, , , *Credit Risk Mitigation (CRM) is relevant to the Group's Financial Institutions exposure, and includes netting and collateral agreements. Page 19 of 40

22 The geographical distribution of these exposures at 31 December 2014 is as follows: UK Supranational Entities Total EAD Pre-CRM m m m Retail financial services 5, ,166.6 Secured personal lending Commercial lending , ,555.7 Treasury Central governments or central banks Multilateral development banks Financial institutions , ,099.1 Other Assets Total 7, ,741.3 The following table shows the residual maturity of the exposures at 31 December The maturity of exposures is shown on a contractual basis. This does not take into account any monthly capital repayments receivable over the life of the exposure. Up to 12 months 1-5 years More than 5 years Total EAD Pre-CRM m m m m Retail financial services , ,166.6 Secured personal lending Commercial lending , ,555.7 Treasury Central governments or central banks Multilateral development banks Financial institutions ,099.1 Other assets Total , , ,741.3 Page 20 of 40

23 7.1.2 Retail Financial Services Credit Risk Credit risk is inherent in the Group s retail mortgage book. Credit risk is assessed both for the Group s existing mortgage assets and also for mortgage lending to which the Group is committed, for example through a firm commitment to lend against a mortgage offer or through a facility to increase the amount of lending on an existing mortgage. The Group s residential loan portfolio is managed using a rating system which has been developed in line with the IRB approach to credit risk as described below. The following table shows the Group s exposure to first charge retail mortgages under IRB at 31 December 2014: Exposure at Default Estimate 2014 Exposure Weighted Average Loss Given Default 2014 Average Risk Weight 2014 Average Expected Loss 2014 PD Bands m % % % 0%<=PD<0.2% 3, % 6.2% 0.0% 0.2%<=PD<1% 1, % 22.9% 0.1% 1%<=PD<9.3% % 76.0% 1.0% 9.3%<=PD<26.47% % 156.3% 4.7% 26.47%<=PD<44.36% % 154.6% 11.4% 44.36%<=PD<100% % 88.7% 19.2% In default % 211.2% 12.6% Total 5, % 15.0% 0.3% IRB Approach Overview The Retail IRB ratings system is used to assess the credit risk exposure of the Group and the level of regulatory capital to be held. The models are built using: Probability of Default (PD) the probability of an obligor defaulting in the next 12 months; Exposure At Default (EAD) an estimate of the outstanding balance if the customer does default; Loss Given Default (LGD) an estimate of the outstanding balance not recovered and the costs associated with that recovery process. Expected loss for the next 12 months is a function of the models listed above. The PD model predicts the likelihood of a mortgage defaulting within the next 12 months. Default is defined as being six or more months in arrears, or earlier if there are other indicators that the borrower is unlikely to repay. The probability of default is calculated using a combination of the credit score obtained at the point of application, the behavioural score and the arrears status of the mortgage. This approach allows grade migration to occur as account performance is influenced by the economic cycle. The PD for retail mortgages uses a hybrid rating system that combines Point in Time (PiT) grade distributions with conservatively assessed long run default probabilities that are mapped for each grade. The LGD and EAD models calculate best estimate and downturn values. The downturn values are used when calculating the Pillar 1 capital requirement. The LGD model uses estimates of the ratio of the outstanding balance to property value, the current point in the house price cycle relative to the trough of the cycle, collections costs and the time that would be taken to take possession and realise the value of the property through sale to predict the loss on sale. The EAD value conservatively adjusts the current balance to allow for additional interest and fees that would be added to the balance prior to default. Where applicable the balance will also be increased by any available undrawn balance. It also includes any committed exposures, such as undrawn mortgage approvals. Page 21 of 40

24 The PD and LGD models were built using both internal data relating to the borrower and property, and external data obtained from credit reference agencies. Data from the 1990s was used to ensure that an appropriate long run average PD could be calculated, and that LGDs were adjusted for downturn conditions, such as those seen in the recession of the early 1990s. During 2014, 66 repossessed properties were sold. The actual losses on these properties were lower than the best estimates. This favourable loss experience arose as a result of the discount from the forced sale of a property being lower than that included in estimates of loss i.e. sale prices were higher than anticipated. The peak-to-trough house price reduction means that downturn LGD estimates add further conservatism to the calculation of regulatory capital requirements. Further to this, at an aggregate level, the actual default rate on the retail mortgage portfolio was lower than that predicted 12 months earlier. The models are also used within the Society for the following purposes: Pricing of credit risk into mortgage products; Providing a risk assessment, or credit score, of the mortgage applicants which is used in the decision-making process; Capital planning. IRB model governance The MGC is the designated committee through which authority to change the IRB Ratings System is obtained. The Committee receives regular management information on the performance of the individual components of the rating system and receives formal annual reviews of the accuracy, adequacy and use of the ratings system. Performance measures with trigger levels are set to ensure that any amendments or updates are made when necessary. Independent validation of the rating models is undertaken using a combination of MGC and external resource. All model developments and material adjustments are subject to assessment against a comprehensive validation framework, which incorporates all relevant requirements from CRD IV. For each rating system, the outcome of the validation process is fully documented, and then challenged by the MGC. The IRB models are operated by the Group Risk function through an integrated capital calculation system. The system is regularly backed-up, and can be operated in an event that would require the full or partial operation of the Society s business continuity plans. The Group has a Change Control Policy which specifies how model changes are approved, and procedures describing how physical systems changes are made. Retail Credit Risk Management A series of specific limits and thresholds have been established and reflect the Group s view of and appetite for risk in relation to the retail mortgage portfolio. These limits are calibrated to ensure that expected or potential losses are restricted to levels consistent with the Board s retail lending risk appetite. The Group Credit Risk Committee reviews comprehensive risk based information on a monthly basis and has appropriate controls in place to ensure that new lending complies with the Board s stated risk appetite. Limits and triggers are reviewed regularly by Group Risk Committee and annually by the Board, and adjusted in the light of prevailing external conditions and internal experience, which reflects the profile of new business written, portfolio performance, and trends in arrears and crystallised losses. Mortgage intake is monitored daily by reference to product type, Loan to Value (LTV) and channel. Criteria are adjusted, or products withdrawn, if trends are inconsistent with risk appetite. Page 22 of 40