Banks. The Royal Bank of Scotland Group Plc. United Kingdom. Full Rating Report. Key Rating Drivers. Rating Sensitivities

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1 United Kingdom Full Rating Report Ratings The Royal Bank of Scotland Group plc; The Royal Bank of Scotland PLC; National Westminster Bank Plc Foreign Currency Long-Term IDR BBB+ Short-Term IDR F2 Viability Rating bbb+ Support Rating 5 Support Rating Floor NF The Royal Bank of Scotland International Limited Foreign Currency Long-Term IDR BBB+ Short-Term IDR F2 Support Rating 2 The Royal Bank of Scotland N.V. Foreign Currency Long-Term IDR BBB+ Short-Term IDR F2 Support Rating 2 Sovereign Risk Foreign-Currency Long-Term IDR AA Local-Currency Long-Term IDR AA Outlooks Foreign-Currency Long-Term IDR Sovereign Foreign-Currency Long-Term IDR Sovereign Local-Currency Long-Term IDR Financial Data Stable Negative Negative The Royal Bank of Scotland Group plc 31 Dec Dec 15 Total assets (USDbn) ,208.4 Total assets (GBPbn) Total equity (GBPbn) Operating profit (GBPm) ,031 Published net income -5,248-1,185 (GBPm) Comprehensive income -4,181-2,681 (GBPm) Operating ROAA (%) Operating ROAE (%) Internal capital generation (%) Common equity Tier 1 ratio (%) Tier 1 ratio (%) Fitch Core Capital/riskweighted assets (%) Related Research The Royal Bank of Scotland Group plc - Ratings Navigator (February 2017) Fitch Affirms Royal Bank of Scotland Group at BBB+ ; Outlook Stable (February 2017) 2017 Outlook: UK Banks (December 2016) Analysts Joanna Drobnik, CFA joanna.drobnik@fitchratings.com Christian Scarafia christian.scarafia@fitchratings.com Key Rating Drivers Improved Risk Profile: The Royal Bank of Scotland Group plc s (RBSG) ratings primarily reflect the group s significantly improved risk profile and acceptable capitalisation that provides a sizable buffer for expected conduct charges, but also the group s weak performance and the remaining challenges it faces. Significant Challenges Remain: Challenges that need to be addressed include uncertainty over the timing and size of potential fines for legacy US residential mortgage-backed securities (RMBS) activities, meeting the remaining state-aid obligation following the failure to divest branches grouped under Williams & Glyn (W&G) by the end-2017 deadline, weak profitability and the restructuring of the group. Acceptable Capitalisation: The group s common equity Tier 1 (CET1) ratio dropped by 210bp to 13.4% at end-2016, but it remained above the medium-term target of 13%, providing a cushion for the expected conduct charges. The fall was mainly due to a US RMBS-related provision, restructuring costs, a dividend payment to the government and the accelerated payment to the group s pension fund, partially offset by the continuing deleveraging of its Capital Resolution division. The Fitch Core Capital (FCC) ratio reduced to 14.7% at end Profitability Is a Key Weakness: Profitability is under significant pressure from high conduct and restructuring costs. We expect the group to continue to report losses in 2017 and possibly in Longer-term profitability should be stronger and less volatile if the group s turnaround strategy is successful. For now, the continuing restructuring of the group weighs on our overall assessment of the group s company profile, management and strategy relative to UK peers. Reduced Impaired Loans: RBSG s gross impaired loan ratio of 3.1% at end-2016 is still higher than its UK peers, but the results of the 2016 Bank of England stress-test indicated that the asset quality of RBSG s core domestic portfolio would be resilient to a severe stress. A large portion of problem assets are in its Irish subsidiary, Ulster Bank Ireland DAC. Improved Funding and Strong Liquidity: The group s funding is more balanced than it was in the past, with an improved balance between the maturities of assets and liabilities, a much reduced reliance on wholesale funding and a large, high-quality liquidity buffer. We expect active wholesale issuance to meet minimum requirement for own funds and eligible liabilities (MREL), set at 23.5% of the group s risk-weighted assets (RWAs), by Holdco and Opco Ratings Equalised: RBSG s ratings are primarily based on its role as a holding company and reflect the absence of holding company double leverage. Rating Sensitivities Disruptive Fine or Litigation: RBSG s ratings could be downgraded if the imposed fines are materially higher than expected, or if litigation or reputation risk proves particularly disruptive, or if consequences of the delayed divestment of W&G prove detrimental to the group s franchise and business model. A negative rating action could also be triggered by a severe and structural deterioration of the operating environment following the UK s decision to leave the EU. Medium-Term Rating Upside: An upgrade of the group s Issuer Default Ratings (IDRs) and Viability Rating (VR) would require the removal of the uncertainties around the expected fine, remaining state-aid obligation and still material execution risk from restructuring the group, assuming that the group maintains good capitalisation and reaches a sound profitability. 7

2 Operating Environment Brexit-Driven Uncertainty a Key Challenge RBSG s business is anchored in the UK (AA/Negative; Macro Prudential Indicator of MPI 1 low risk), where it operates through two main banks: RBS and National Westminster Bank Plc (NatWest, an RBS subsidiary). The group is also exposed to the Irish operating environment (A/Stable; Macro Prudential Indicator of MPI 1 low risk) through Ulster Bank Ireland DAC. Our assessment of its operating environment considers the UK s sovereign rating as well the economic environment in which the group operates and the framework that regulates and supervises its activities. While the UK has benefited from a strong recovery since the last crisis, we expect that GDP growth will reduce materially as the country prepares to leave the EU. Fitch Ratings believes that uncertainty in the period until Brexit is likely to result in reduced investment and consumption, with possible rises in unemployment, accelerating inflation and falling asset values. We do not believe that these act as a constraint to RBSG s VR. As the UK private sector is highly indebted, deteriorating affordability could affect RBSG s asset quality, although the affordability should benefit from lower base rates for a longer period of time. The group is regulated by the Prudential Regulation Authority and by the Financial Conduct Authority, and its deposits are protected by the UK s deposit insurance scheme. Fitch views financial sector regulation in the UK as highly developed and transparent, with a focus on strengthening capital, and, within the retail sector, on controlling household indebtedness and mortgage affordability. Macro-prudential policy tools are being tested to ensure control over the risk of the increase in base rates and the large portion of UK households wealth invested in property. The UK regulatory environment has an effective bail-in regime enacted in domestic legislation, which we expect will continue to be applied after the exit of the UK from the EU. Company Profile Transformation into UK-Focused Commercial Bank Is Progressing Well In the UK, RBSG has leading market shares in commercial and SME banking as well as in some segments of retail banking through its RBS and NatWest brands. It is also a leading private bank in the UK through Coutts & Company (Coutts). Through Ulster entities, it has the largest franchise in Northern Ireland and is the third-largest bank in Ireland. The group is active in offshore banking through The Royal Bank of Scotland International Limited (RBSIL). RBSG s reshaped business model was implemented in 2014, aiming at improving returns and splitting the group into three core business lines. Personal and Business Banking (PBB) serves UK retail and SME businesses with turnover below GBP2 million and retail and commercial customers in Ireland. Commercial and Private Banking (CPB) includes UK commercial and mid-corporate clients, high-net-worth individuals and offshore banking through RBSIL. Corporate and Investment Banking (CIB) was rebranded NatWest Markets (NWM) in December 2016 and is undergoing a multiyear transformation, which was launched in The business has a core focus on UK and western Europe corporates and global financial institutions. By end-2015, RBSG had substantially completed the run-down of RBS Capital Resolution (RCR, established in 2013 to separate and wind down capital intensive assets) a year ahead of schedule, with residual assets transferred to Capital Resolution (CR). CR was established in February 2015 to sell and run down portions of CIB that were outside of the new business s scope. As part of this process, the US broker-dealer business, RBS Securities Inc. is being materially reduced in size. RBSG plans to wind up CR by end-2017 and transfer any remaining assets back into the rest of the group, mainly into NWM and CPB. Related Criteria Global Bank Rating Criteria (November 2016) Global Non-Bank Financial Institutions Rating Criteria (March 2017) 2

3 Divisional Breakdown Total income Impairment loss/release Operating loss/profit RWAs (GBPbn) a (GBPm) UK Personal and Business Banking b 5,290 5, ,202 2, Ulster Bank RoI c Personal and Business Banking 5,863 5, ,431 2, Commercial Banking 3,415 3, ,273 1, Private Banking RBS International Commercial and Private Banking 4,446 4, ,617 1, NatWest Markets 1,521 1, Central items RBS core 11,950 11, ,704 4, Capital Resolution , Williams & Glyn Total managed d 12,372 13, ,674 4, Total reported 12,590 12, ,082-2,703 a Fully loaded Basel III b Includes operations of Ulster Bank in Northern Ireland c Ulster Bank DAC is a statutory entity, while Ulster Bank RoI is a divisional view. d See table below for reconciliation between managed and reported operating profit Reconciliation Between Managed and Reported Operating Profit (GBPbn) Managed 3,674 4,405 Own credit adjustment Loss on redemption of own debt Strategic disposals Restructuring costs -2,106-2,931 Litigation and conduct -5,868-3,568 costs Write-down of goodwill Reported op profit/loss -4,082-2,703 Divestment of Williams & Glyn Proved too Challenging RBSG is required to fully separate and divest all RBS branches in England and Wales and all NatWest branches in Scotland, referred to as W&G, by end-2017 to meet the EU state-aid conditions imposed after its bail-out by the UK government. However, the W&G divestment process has proven to be extremely complex and the bank announced that it would not be able to meet the end-2017 deadline imposed by the EC. Until early 2016, RBSG had been working towards establishing W&G as a separate licensed bank and divesting it through an initial public offering or outright sale. This plan was abandoned in 2016 and replaced by a plan to sell the business to another bank, which was also unsuccessful. In February 2017, the commissioner responsible for EU competition policy has proposed an alternative plan, which, if agreed, would bring a faster and more certain conclusion to RBSG s remaining state-aid obligations than the existing requirement to sell W&G. Under the proposed plan, RBSG would deliver a package to promote competition for banking services to UK SMEs. This would include funding to help eligible challenger banks serve UK SMEs, a fund that eligible challenger banks can access to increase their business banking capabilities, funding to invest in fintech for business banking and access to RBSG branches for the business customers of challenger banks. Williams & Glyn Divestment Costs Year (GBPm) Total 1,714 RBSG took a GBP750 million provision in 2016 to provide for the proposed package and expects to take additional restructuring charges in 2017 and 2018 to reincorporate the W&G business into the RBS franchise. This is in addition to more than GBP1.7 billion that RBSG has spent on W&G s divestment programme over the past three years. Nevertheless, we believe the ultimate cost of the new plan to RBSG, including the impact on its franchise, is likely to be lower than under the previous plan. International Presence Has Been Significantly Reduced RBSG has gradually reduced its overseas presence since In October 2015, it completed the sale of Citizens, a mid-sized US bank, a year ahead of schedule. In April 2016, it sold the international segment of Coutts to focus on the UK part of the private banking business. The group has also wound down non-uk transaction banking services and exited from 25 of the 38 countries where it had an international presence. 3

4 End-2016 Simplified Legal Entity Structure (Pre-Interim Transfers) RBSG 2019 Proposed Simplified Ring-Fenced Legal Entity Structure RBSG 56% RBS plc NatWest Adam & Co. NatWest Markets plc c RBSIL NatWest Holdings Limited b RBS Securities Inc. 44% RBSIL Ulster Bank Ltd. Coutts & Company RBS Securities Inc. RBS plc a NatWest Ulster DAC Ulster DAC a Currently Adam & Co. plc b New intermediate holding company established Jan 2017 c Currently RBS plc Source: Fitch, Transaction documents Coutts & Company New Entity Ulster Bank Ltd. Re-Named Existing Entity Ring-fenced Bank Ring-Fencing Will Add Complexity to Organisational Structure The group structure has become simpler following the sale and wind down of international operations. The requirement to establish a ring-fenced bank (RFB) in the UK will add some complexity to the group s organisational structure, but to a far lesser extent than at the more internationally active UK banking groups, Barclays and HSBC. RBSG is targeting a broad ring fence, under which the majority of activities (80% of RWAs), comprising UK and Irish-focused banking services, will be housed inside the RFB. The non-ring-fenced group entities (NRFB) will hold the remaining trading activities and the operations of RBSIL. The implementation of the ring-fencing regime will significantly affect the management of the group s treasury operations, including internal and external funding arrangements. Each legal entity will have to meet its own regulatory capital requirements, including Pillar 2A requirements, and the RFB will have to meet the UK s Systemic Risk Buffer. In addition, the establishment of RFB and NRFB entities requires a significant legal and organisational restructuring. Strategic Targets KPI Long-Term Targets CET1 ratio 13% Cost/income ratio <50% ROTE 12% Management and Strategy We believe management has a high degree of depth and experience despite the large-scale turnaround seen in the aftermath of the financial crisis. The new management team has been in place since 2014 and includes individuals from inside and outside the group with significant experience in the UK banking sector. Management has been responsible for developing the group s new strategy and further restructuring. RBSG now has a consistent and clearly articulated strategy to become a simpler and stronger bank, built around UK and Irish retail and commercial businesses. The group has completed the second phase of its plan, centered on the transformation of its core businesses and the exit from non-core businesses. The management team has been successful in achieving majority its targets. However, there are still significant items outstanding, mainly satisfying final state-aid obligations, NWM transformation and US RMBS investigation, which are likely to take considerable time to resolve. We believe that meeting some of these targets will be challenging and may be delayed. In the medium term, RBSG targets net growth in PBB and CPB customer loans equal to at least UK GDP growth, with a 3% target for On the other hand, NWM will see its business much reduced and focused on supporting the group s corporate clients. CR will continue to be deleveraged with planned reduction in RWAs to between GBP15 billion and GBP20 billion (excluding Alawwal Bank stake) and wind-up at end

5 Banks The group plans to generate about 90% of income from its UK operations and to reduce operating costs by a further GBP2 billion over the next four years, in addition to the GBP3.1 billion reduction achieved since January Long-term targets have been set and the group plans to achieve these mainly through continuing investment in IT platforms and application simplification, NWM restructuring and the run-down of CR. Risk Appetite Improving Internal Controls RBSG has simplified its risk function, enhanced accountability and responsibilities, and made significant progress in improving its overall risk profile. The risk-appetite framework is now better aligned to FSB s guidance on risk culture and is expected to be fully implemented and embedded across the group by end Risk-appetite statements are in place for all strategic and material risks (such as credit, market, operational, conduct, pension, reputational, concentration, financial crime and IT resilience risks), all business franchises, all functions and some major operating legal entities. There are a range of risk limits for individual asset classes, products, industries and countries. Control has been embodied into enterprise risk management, which looks at key company risks in aggregate, and aims to ensure that risks are controlled consistently across the group. The group has refocused its business on its core franchises in the UK and Ireland and this simplified business model makes effective risk management more easily achievable. The progress that has been made in de-risking the business is evident in the impaired loans/gross loans ratio, which has fallen to 3.1% at end-2016 from 9.5% at end While this is largely due to deleveraging of non-core assets and has been assisted by benign UK economic conditions, it also reflects more conservative underwriting standards. Litigation and Conduct Costs (GBPm) 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Legacy Conduct Risk Despite significant progress made during 2015 and 2016, RBSG continues to face heightened operational risk through numerous reviews and investigations by authorities in numerous jurisdictions and business areas, which are difficult to quantify precisely. Regulatory investigations and litigation include the mis-selling of US RMBS, mis-selling payment protection insurance (PPI) in the UK, LIBOR and foreign-exchange (FX) setting practices in the US and the UK, mis-selling of swap to SMEs in the UK and a lawsuit over UK 2008 capital raising. Overall litigation costs and fines, and customer redress taken by RBSG between 2011 and 2016 amounted to GBP18.5 billion. We expect further material misconduct costs, primarily from further fines and similar charges related to the US RMBS investigation. Unused balance-sheet provisions at end-2016 totalled GBP11 billion, split GBP6.8 billion related to US RMBS, GBP1.3 billion related to PPI, GBP1.1 billion related to other customer redress and GBP1.9 billion related to litigation and other regulatory proceedings. As a result of the legacy conduct issues, RBSG has strengthened its conduct and compliance functions and implemented remediation programmes to reduce and mitigate the group s material operational risks. Nevertheless, operational risks will remain elevated during the group restructuring particularly with respect to the implementation of the UK ring-fencing regime and the restructuring of NWM business. These carry significant execution and delivery risk and are being delivered against the backdrop of cost challenges, putting significant pressure on the group s ability to maintain effective internal controls. However, the bank has shown that it has been able to control these risks well and it has made significant investments to strengthen its IT platforms. Modest Market Risk with Adequate Controls The group s exposure to market risk has reduced significantly, reflecting disposals of volatile assets and the exit from a wide range of trading activities, including the downscaling of activities at the group s US broker dealer. The majority of RBSG s traded market risk exposure arises in NWM and CR. The majority of its non-traded market risk exposure (interest-rate risk in the banking book, structural FX positions and equity positions) arises mainly from retail and 5

6 commercial banking activities. The group s earnings are adversely sensitive to a reduction in short-term interest rates, with a 100bp fall in interest rates reducing next year s net interest income by about GBP378 million (equivalent to 0.8% of total equity) at end Market risk is managed centrally and appetite is expressed in the form of policy statements, dealing authorities and limits based on value-at-risk (VaR) and stressed VaR, positions, sensitivity analyses and stress testing. In March 2016, RBSG made a single payment of GBP4.2 billion to the RBSG Group Pension Fund, instead of a series of annual contributions up to 2023, removing an element of pension risk. The next valuation date will take place at end This provides increased certainty on contribution commitments and the pension balance-sheet position and improves capital planning. Loan Book Breakdown at End-2016 (GBPbn) Gross loans REIL REIL coverage (%) (%) Government Finance Mortgages Unsecured personal Property Construction Manufacturing Finance leases Retail, wholesale and repairs Transport and storage Health, education and leisure Hotels, restaurants Utilities Other Total REIL: Risk Elements in Lending Financial Profile Asset Quality As a result of the continuing deleveraging, the group s gross loans and advances reduced by 65% between 2008 and Last year saw, for the first time since 2008, an increase in gross loans and advances, of 4%, to GBP327 billion, as healthy growth in core retail and commercial businesses more than offset the disposals of non-core assets. The geographical profile of lending has also changed significantly, especially following the disposal of Citizens, with UK lending now accounting for 93% of gross loans, with the remainder almost entirely in Ireland. UK lending is mostly in the form of residential mortgages and non-commercial real estate (CRE) corporate and SME lending. UK mortgage loans increased by 11% in 2016 and accounted for 42% of gross loans at end Non-CRE corporate and SME lending in the UK increased by 5% in 2016, with the biggest growth in the finance leases, retail and wholesale, hotels and restaurants, and utilities sectors, and accounted for 35% of gross loans at end Unsecured personal lending in the UK continues to decline and accounted for just 4% of gross loans at end-2016, reflecting a reduced appetite for this type of lending. UK mortgages have been extended predominantly to prime residential borrowers and at relatively conservative loan/value (LTV) ratios (end-2016: average LTV of 56% in the UK PBB book, which includes Northern Ireland; the proportion of the portfolio with LTVs of more than 90% or with no index was 3.5%, in line with the rest of the market). More than a fifth of the owner-occupied mortgages were interest only. The portfolio also includes GBP16.7 billion of buy-to-let mortgages. Irish mortgages at Ulster Bank RoI (Ulster RoI) accounted for above 4% of gross loans at end The quality of the Irish book remains much weaker, where, despite significant improvement, the average LTV was 76% at end-2016 (end-2012: 112%, including Northern Ireland), and 31% of mortgages had LTVs of above 90% (end-2012: 66%, including Northern Ireland), reflecting the dramatic fall in Irish property prices in the aftermath of the crisis. Industry exposure remains concentrated, albeit to the lesser extent than in the past, with the largest concentration to the property sector, mostly CRE in the UK. Overall, CRE exposure was GBP26.3 billion at end-2016 and accounted for 78% of FCC. New CRE lending is extended to support key customers and is focused on the UK market. The proportion of the book with LTVs above 70% (10% at end-2016) has dropped significantly over recent years, due to accelerated divestments of legacy assets, improvements in the economy and new lending extended at lower LTVs. Exposures with LTVs greater than are predominantly legacy deals and accounted for less than 5% of the portfolio. 6

7 Asset Quality and Impairment Allowances (Breakdown) Gross loans REIL (NPLs) Provisions (GBPm) 2016 (%) a +/ (%) 2015 (%) a 2016 (%) b 2015 (%) b 2016 (%) c 2015 (%) c UK Residential mortgages 137, , , Personal lending 14, , , , , Property and construction 37, , , , , Other 115, , , , , , Total UK 305, , , , , , Europe Residential mortgages 15, , , , Personal lending Property and construction 1, , , Other 3, , , Total Europe 20, , , , , , Rest of World 1, , Total gross loans 327, , , , , , a Percentage of total gross loans; b Percentage of gross loans; c Coverage of impaired loans Transport includes exposure to shipping finance, which, in line with the de-risking of the balance sheet, has reduced to GBP4.6 billion at end-2016 (end-2015: GBP6.8 billion). It is mostly managed within CR and related to exposure secured by ocean-going vessels. Conditions in the portfolio remained depressed in 2015 and 2016, resulting in a weakened collateral cover with an overall LTV of the CR part of the portfolio at 102% (end-2015: 85%). RBSG has also been reducing its exposures to the natural resources sectors, with oil and gas exposures amounting to a modest GBP2.9 billion at end-2016, of which only about 5% was within CR. See table opposite for a breakdown of other notable sub-sector corporate exposures at end Asset quality has improved further in 2016, primarily reflecting further disposals in CR and a portfolio sale in Ulster RoI, partially offset by a deterioration in the shipping portfolio. The results of the 2016 Bank of England stress-testing indicated that the asset quality of RBSG s core domestic portfolio would be resilient to a severe stress. However, the group s asset quality remains weaker than generally seen at UK banks, with a high proportion of risk element in lending (REIL; or non-performing loans) at Ulster RoI and within CR. The table above breaks down asset quality by geography and product. Loans that are past due by 90 days or more and that require active management to minimise losses, classified as REIL but not impaired, were GBP1.2 billion at end-2016 and are included in Fitch s impaired loans ratios in the spreadsheets at the back of this report. Other Earning Assets: Significantly De-Risked RBSG holds a sizeable portfolio of debt securities (GBP73 billion at end-2016), mainly split between available for sale and held for trading, with a small amount of held to maturity and loans and receivables. Over 80% of the securities were issued by central and local governments (of which almost half was in the UK and the US). The credit risk of the securities continues to improve, with 98% of debt securities rated investment grade at end-2016 (93%, A or above). Within the significantly reduced ABS portfolio (GBP7 billion at end-2016), 76% were rated A and above. RBSG has a sizeable reverse repurchase (repo) agreements book (GBP42 billion at end-2016) which is largely match-funded (via repo agreements, GBP32 billion). RBSG is also a significant participant in the derivative markets mainly interest-rate swaps. Counterparty credit risk is mitigated via netting and collateral arrangements, together covering 95% of GBP247 billion gross exposures at end

8 Banks Net Interest Revenue and Margin (GBPm) 50,000 40,000 30,000 20,000 10,000 0 Interest receivable (LHS) Interest payable (LHS) NIM (RHS) Source: RBSG, restated by Fitch (%) Earnings and Profitability RBSG has been loss-making since 2008, with a GBP5.2 billion net loss reported in Subject to resolving or providing for all significant legacy issues in 2017, the group expects to become profitable in The loss reported in 2016 was largely due to GBP5.9 billion of additional conduct charges and GBP2.1 billion of further restructuring costs. In addition, the group has paid the final dividend access share (DAS) of GBP1.2 billion to the UK government, increasing the loss attributable to ordinary shareholders. However, we consider the underlying profitability of the group s core businesses to be adequate. This should help RBSG to return to profit once the majority of legacy conduct issues, especially with relation to US RMBS, have been resolved and the restructuring has been implemented. UK PBB, Commercial Banking (CB) and RBSIL are performing well on an underlying basis, excluding restructuring and conduct costs, with strong returns on allocated equity, adequate efficiency and positive outlook for both income and costs. Ulster RoI, Private Banking (PB) and NWM, on the other hand, are being reposition for returns, with NWM s transformation being the biggest challenge. Ulster RoI stopped being loss making in 2014 but it is likely to continue to suffer from low income in the medium term because of a high proportion of low-margin tracker mortgages and a high cost base relative to the size of its core business. Following the sale of its international business, PB is being repositioned to focus on UK customers and became profitable in The group s total income continues to decline, in line with the shrinkage of the balance sheet. It was down 3% yoy in 2016, mainly due to the reduced scale and resources in NWM and the run-down of CR. We expect income to start to pick up from 2017 as the core businesses grow. The net interest margin (NIM) has been improving since 2013, as a result of a better management of funding costs and legacy funding rolling off, but remains low at 1.15% in 2016 (2015: 1.09%). Higher-yielding assets, such as credit card balances and personal unsecured loans, have declined in volume while the proportion of lower-margin secured lending has increased putting downward pressure on NIM. The interest-rate cut in 2016 added additional pressure, but it has been partly offset by access to cheap funding from the Bank of England s GBP100 billion Term Funding Scheme. The progressive replacing of maturing structural hedges, which added GBP1.3 billion to net interest income, will also put pressure on NIM over the coming years. Cost Savings vs. Restructuring Costs Cost savings Restructuring costs (GBPm) 3,500 3,000 2,500 2,000 1,500 1, e Efficiency at the group remains low, with a Fitch-calculated cost/income ratio of in As a result of cost savings, underlying operating costs reduced by a further GBP1 billion in 2016 to GBP8.4 billion, with a further targeted reduction of GBP2 billion over the next four years, of which GBP0.75 billion is planned for Netted against the savings are restructuring costs which totalled GBP2.1 billion in 2016, of which almost GBP1.5 billion related to the remaining state-aid obligations. From 2014 to 2016, the group s restructuring costs totalled GBP6.2 billion and RBSG is expecting additional GBP2 billion over 2017 to 2019 (excluding W&G), of which GBP1 billion in Conduct costs amounted to GBP5.9 billion in 2016 and included provisions in respect of US RMBS, PPI, the UK 2008 capital raising and tracker mortgages in Ulster RoI. RBSG recorded loan impairment charges (LICs) of GBP0.5 billion in 2016, mainly relating to the legacy shipping portfolio within CR and a single name charge in the oil and gas portfolio within CB. We expect that LICs will remain moderate in the short to medium term, as the overall credit profile of the group has improved. However, in the long term LICs are likely to rise, as a result of deteriorating economic environment, which is forecast after the decision to leave the EU. 8

9 Capital Ratios a (GBPbn) Credit Counterparty Market Operational Total RWAs CET1 capital CET1 ratio (%) Tier 1 capital Tier 1 ratio (%) Total regulatory capital Total capital ratio (%) Leverage ratio (%) a Fully Loaded CRR Funding Breakdown (excl. derivatives) Secured debt MTNs Interbank Customer deposits (GBPbn) Liquid Assetsª (GBPbn) Cash and central bank balances FSA eligible government bonds Primary liquidity Secondary liquidity b Total buffer Carrying value ª By liquidity value b High quality assets eligible for discounting at central banks; breakdown not available Liquidity Metrics Sub debt CPs/CDs Repos Source: RGSB, Fitch (%) Stress outflow coverage a LCR NSFR ª Liquidity portfolio as a percentage of stressed outflows under the worst of three severe stress scenarios Capitalisation and Leverage The group s CET1 ratio fell 210bp in 2016 to 13.4%, mainly due to a US RMBS-related provision, further restructuring costs, the final DAS dividend and the accelerated contribution into the group s pension scheme, partially offset by the continuing deleveraging of CR. We believe that despite this reduction capital provides a sizeable cushion for the expected conduct and litigation charges. The group targets a normalisation of the CET1 ratio at about 13%, but we believe that achieving it will depend on the size and timing of the litigations claims related to US RMBS mis-selling. The results of the 2016 Bank of England stress revealed that RBSG did not meet its CET1 capital or Tier 1 leverage hurdle rates before additional Tier 1 (AT1) conversion. After AT1 conversion, it did not meet its CET1 systemic reference point or Tier 1 leverage ratio hurdle rate. To improve its capital position stress resilience RBSG has updated its capital plan, which incorporates further savings and reductions in RWAs across the group. This is in addition to actions already taken since end-2015, including an issuance of USD2.65 billion of AT1 in August RBSG estimates that its MREL will be equivalent to 23.5% of its RWAs by end The group plans to build up its MREL compliant debt through issuance of senior unsecured bailinable holding company debt with targeted annual issuance of GBP3 billion to GBP5 billion (GBP4.2 billion was issued in 2016). RBSG s regulatory leverage ratio is adequate and has improved significantly since end-2013, helped by the issuance of GBP4 billion AT1 capital notes in 2015 and 2016, and a reduction in leverage exposure in line with the deleveraging. The group reported a 5.1% leverage ratio at end-2016, 50bp lower than at end The drop was driven by lending growth and the reduction in Tier 1 capital. Funding and Liquidity RBSG has reshaped its balance sheet and improved the quality of its funding and liquidity (see chart opposite). The group is largely funded by customer deposits, which account for about 70% of total funding excluding derivatives. The Fitch-calculated loans/deposits ratio was 93% at end However, we expect the ratio to increase to the group s medium-term target of about, as a result of lending growth from PBB and CPB, and a shift to greater MREL issuance leading to lower requirement for customer deposits. The use of wholesale funding continues to decline, running off broadly in line with the disposal of non-core assets and RBSG continues to expect maturities to be greater than issuance requirements. The group has also significantly extended the maturity profile of its wholesale funding, with short-term wholesale funding reduced to GBP13.9 billion (excluding GBP20.7 billion derivative collateral) at end-2016, representing 2.5% of funded assets Asset encumbrance is modest and was at about 11% of the total balance sheet at end The group has also increase the amount of unencumbered assets pre-positioned with various central banks as collateral for liquidity facilities. These consist mostly of the liquidity portfolio (see table opposite), other debt securities and loans. The group s liquidity position has been strong since the crisis, with a liquidity coverage ratio (LCR) of 123% and an estimated net stable funding ratio (NSFR) of 121% at end The excess liquidity also works as a cushion for imminent US RMBS litigation settlement. We expect liquidity indicators to decline further once the US fine has been paid and other uncertainty removed. 9

10 Support Support Possible but Unlikely We believe that sovereign support for RBS and NatWest is possible but cannot be relied upon to protect senior creditors. While we view the ability of the UK authorities to be strong, their propensity to provide such support has reduced, as indicated by the legislation enacted to allow resolution to take place through bail-in. Our opinion is reinforced by statements by the regulatory authorities to the same effect. In terms of legal provision, the EU s Bank Recovery and Resolution Directive has been transcribed into UK law and took effect on 1 January The bail-in powers, contained in the Financial Services (Banking Reform) Act 2013 (the 2013 Act) have also come into force and reinforce the provisions of the Banking Act 2009, under which a special resolution regime had already been set up. Debt Ratings The ratings of all subordinated debt and hybrid securities issued by RBSG group companies are notched down from the common VR assigned to individual group companies, reflecting Fitch s assessment of their incremental non-performance risk relative to their VRs (up to three notches) and assumptions around loss severity (one or two notches). These features vary considerably by instrument. Subordinated debt with no coupon flexibility is notched down once from the VR for incremental loss severity. Upper Tier 2 subordinated debt is notched down three times (once for loss severity and twice for incremental non-performance risk). Innovative and non-innovative legacy Tier 1 and preferred stock is notched down either four or five times, dependent on incremental non-performance risk (twice for loss severity and either two or three times for incremental non-performance risk). Contingent convertible capital notes are notched five times (twice for loss severity and three times for incremental nonperformance risk) given their fully discretionary coupon payment. 10

11 Peer Analysis 2016 RBSG LBG Nationwide a SGH Barclays Asset quality Impaired loans/gross loans Reserves for impaired loans/impaired loans LICs/average gross loans Growth of gross loans Profitability Operating profit/rwas NIM Cost/income LICs/pre-impairment operating 1, profit Operating ROE Operating ROA Capitalisation and leverage FCC/FCC-adjusted RWAs CET1 ratio b Total capital ratio c Leverage ratio Net NPLs/FCC Internal capital generation Funding and liquidity Loans/customer deposits Customer deposits/total funding (excluding derivatives) LCR NR NR NSFR NR NR NR NR NR NR NR = not reported LBG: Lloyds Banking Group plc, Nationwide: Nationwide Building Society; SGH: Santander UK Group Holdings plc; Barclays: Barclays plc In accordance with our internal criteria, we have reclassified certain elements of the banks consolidated statutory figures above and in the attached spreadsheets to improve comparability between peers. The main items reclassified as non-operating are US RMBS and PPI provisions, which are treated as non-recurring, non-operating losses a 2016 data relate to half-year figures ending 30 September Year-end 4 April b Fully loaded c Transitional Source: Fitch 11

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