Report of the Skilled Person on the Proposed Ring-fence Transfer Scheme of Lloyds Banking Group. Prepared by Michael John Lloyd FCA, FCT

Transcription

1 Report of the Skilled Person on the Proposed Ring-fence Transfer Scheme of Lloyds Banking Group Prepared by Michael John Lloyd FCA, FCT 24 November 2017 Michael John Lloyd FCA, FCT 01/215

2 Table of Contents Section Page 1. Introduction 3 2. Conclusion on the Statutory Question 7 3. Overview of the Ring-fencing Transfer Scheme 8 4. Role and approach of the Skilled Person Approach to ring-fencing Implications for Commercial Banking customers Implications for Retail Banking customers Implications for Consumer Finance customers Other Relevant Persons Capital, liquidity and funding Governance and risk management Operational continuity arrangements Recovery and resolution planning Information technology and payment implications Taxation implications Pension arrangements Communications approach 171 Appendix 1: PRA Statement of Policy and FCA Finalised Guidance cross reference 179 Appendix 2: Information sources 187 Appendix 3: Glossary 191 Appendix 4: Credit rating definitions /215

3 1. Introduction The Skilled Person 1.1 When an application is made to the Court (under Section 107 of the Financial Services and Markets Act 2000 ( FSMA )), in respect of a Ring-fencing Transfer Scheme ( RFTS ), it has to be accompanied by a report on the terms of the RFTS ( Scheme Report ) from an independent skilled person ( Skilled Person ). This is a requirement of Section 109A of the FSMA and the Scheme Report must be made in a form approved by the Prudential Regulation Authority ( PRA ), having consulted the Financial Conduct Authority ( FCA ). 1.2 I have been appointed as the Skilled Person to provide the required Scheme Report on the proposed RFTS to transfer business from Lloyds Bank plc ( LB plc ) and Bank of Scotland plc ( BoS plc ), together known as the Transferors to Lloyds Bank Corporate Markets plc ( LBCM or the Transferee ), (the Scheme ). I have been appointed by LB plc and my appointment has been approved by the PRA, following consultation with the FCA. In this Scheme Report, I will refer to Lloyds Banking Group plc as LBG plc" and to LBG plc and its subsidiaries, subsidiary undertakings and their associated entities and businesses, together as the Group. 1.3 I am a Fellow of the Institute of Chartered Accountants in England and Wales ( ICAEW ) and a Fellow of the Association of Corporate Treasurers ( FCT ), having qualified in 1984 and 1995 respectively. I have been a partner in the Banking and Capital Markets practice of Deloitte LLP ( Deloitte ) 1 since I have specialised in audits and advisory assignments of banks, capital markets and corporate treasury clients for over 25 years and have led the global external audits of major banks such as The Royal Bank of Scotland Group plc and Royal Bank of Canada. From 2010 until July 2017 I was a director of the Corporate Trustee of the Deloitte UK Pension Scheme and a member of that Scheme s Investment Committee. Additionally, I am a member of the ICAEW Financial Services Faculty Board and the Chair of the ICAEW s Banking Committee. These roles are to support the objectives of the ICAEW to provide policy recommendations to policymakers in the United Kingdom ( UK ) and internationally on accounting and regulatory matters relating to financial services firms, including banks. I also represent the ICAEW on the banks working group of Accountancy Europe, the representative organisation for the accountancy profession in Europe. Independence 1.4 Neither I, nor my immediate family, hold any policies, investments, shareholdings or have any other financial interests with any of the companies in the Group and neither I nor my immediate family have held any such financial interests in the past five years. I have not advised the Group on any significant project in the past that I believe would affect the subject matter of this Scheme Report and I have had no significant assurance, advisory or other formal appointment with the Group in the past five years. 1.5 Partners and staff of Deloitte have advised, and continue to advise, the Group on various assignments. These assignments are sufficiently remote from the subject matter of this Scheme Report, and I do not believe that any of these assignments could reasonably be thought to compromise my independence, create a conflict of interest or compromise my ability to report on the proposed Scheme. 1.6 Deloitte has not acted as external auditor to the Group. Deloitte does not hold any financial interest in any of the companies in the Group that could reasonably be thought to compromise 1 Deloitte LLP is the United Kingdom affiliate of Deloitte NWE LLP, a member firm of Deloitte Touche Tohmatsu Limited, a UK private company limited by guarantee ("DTTL"). DTTL and each of its member firms are legally separate and independent entities. DTTL and Deloitte NWE LLP do not provide services to clients. Please see to learn more about our global network of member firms. 03/215

4 my independence. Deloitte has not acted for the Transferors or any other entity within the Group on developing any aspects of the Scheme, and Deloitte has not carried out any of the calculations or the development of any of the financial models connected with the Scheme. Regulatory and professional guidance 1.7 This Scheme Report has been prepared in accordance with the PRA Policy Statement 10/16 The Implementation of ring-fencing: the PRA s approach to ring-fencing transfer schemes ( PRA Policy Statement ) and the FCA s Finalised Guidance 16/1 Guidance on the FCA s approach to the implementation of ring-fencing and ring-fencing transfer schemes ( FCA Finalised Guidance ), both of which were issued in March Appendix 1 details how these requirements have been complied with within this Scheme Report. The scope of my Scheme Report 1.8 My terms of reference have been agreed with LB plc and were provided to both the PRA and the FCA. 1.9 The Scheme will be submitted to the Court for sanction under Part VII of the FSMA. If approved, it is expected that the Scheme will become operative and take effect on the Effective Date. This Scheme Report considers the statutory question ( Statutory Question ) specified in Section 109(A) of the FSMA as to (a) whether persons other than the transferor concerned are likely to be adversely affected by the scheme, and (b) if so, whether the adverse effect is likely to be greater than is reasonably necessary in order to achieve whichever of the purposes mentioned in Section 106B(3) is relevant. Section 4 of this Scheme Report describes my approach to answering this Statutory Question I am required to comment on the proposed Scheme and my Scheme Report is not concerned with all possible alternatives to the Scheme. My Scheme Report assesses whether the Group could have considered making alternative group arrangements within the proposed Scheme that would have both met the requirements of the Ring-fencing Regime and resulted in fewer adverse effects, or adverse effects that would have had a lesser effect on the relevant stakeholders, than are likely to arise under the Scheme as proposed. This is a requirement of Section 5.9 of the PRA Policy Statement To the best of my knowledge, I have taken into account what I consider to be all relevant and significant facts in assessing the effect of the Scheme and in preparing this Scheme Report. In order to reflect any updated financial information or circumstances nearer to the date of the Sanction Hearing, I will provide a supplementary report, if required, setting out any updated opinions in respect of the Scheme ( Supplementary Report ) In reporting on the Scheme as a Skilled Person, I recognise that I owe a duty to the Court to assist on matters within my expertise. This duty overrides any obligation to the Group from whom I have received instructions. I believe that I have complied, and confirm that I will continue to comply, with this duty. I also confirm that I am aware of the duties and requirements regarding experts set out in Part 35 of the Civil Procedure Rules, its associated Practice Direction and the Guidance for the Instruction of Experts in Civil Claims. I confirm that I have made clear which facts and matters referred to in this Scheme Report are within my own knowledge and which are not. Those that are within my own knowledge I confirm to be true. The opinions I have expressed represent my true and complete professional opinions on the matters to which they refer In my work, I have been assisted by other partners and staff of Deloitte, including specialists with subject matter expertise across a range of areas relevant to this Scheme Report, who have all acted under my direction and control. In preparing this Scheme Report, I have shared draft versions with the PRA, the FCA and with the Group and their legal advisers and discussed the contents of those drafts of this Scheme Report. My discussions of the content of draft reports with the Group and their legal advisers has been to confirm matters of factual accuracy and my 04/215

5 discussions with the PRA and FCA have been for the purpose of facilitating the PRA s approval of the form of this Scheme Report. The opinions in this Scheme Report are my own. Limitations of the work performed 1.14 In performing my review and preparing this Scheme Report I have relied on data and other information provided to me, both written and verbally, by directors and employees of the Group. I have reviewed the data and information for consistency and reasonableness using my knowledge of the UK banking industry and asked the Group to explain, confirm and/or clarify aspects of the data and information where I considered necessary. The data and information have not been subject to independent audit verification by Deloitte or me. All of my questions have been answered to my satisfaction. To the extent that any information on which I have relied in this Scheme Report is subsequently identified to be inaccurate, it may be necessary for me to revise my conclusions I note that the economic position of the Group at the Effective Date cannot be predicted with certainty at this time and may therefore differ from that shown in this Scheme Report. I will continue to keep the position under review in the period leading up to the Sanction Hearing, and will prepare further information in my Supplementary Report, if required Financial information, data and written information on which I have relied on is listed in Appendix In preparing my Scheme Report, I have had access to confidential information. Confidential information includes data such as financial forecasts, capital projections and internal risk limits which is not in the public domain. I have considered all confidential information with which I have been provided, but in some instances I have not included in my Scheme Report such information that has led to my conclusions for reasons of confidentiality. Limitations on the use of this Scheme Report 1.18 This Scheme Report will be addressed to the Court and has been prepared solely for the use of the Group, the PRA, the FCA and the Court, and solely for the purpose of assisting the Court in determining whether the Scheme should be sanctioned. It should not be used, reproduced or circulated for any other purpose, save as set out in paragraphs 1.20 and No liability (including in respect of my summary of this Scheme Report) is accepted to any person other than the Group except in so far as any liability arises to the Court from the giving of evidence. No other party is entitled to rely on this Scheme Report for any purpose whatsoever For the avoidance of doubt, Deloitte and I have excluded liability to avoid us having potential liability to an unlimited number of people. Without this exclusion, neither Deloitte nor I would be able to do this work. If you are concerned with the content of this Scheme Report or any part of my analysis, you should take urgent advice and, if you wish to raise an objection with the Court in connection with the effect of the Scheme upon you, raise the matter with the Court under one of the procedures set out on the Group ring-fencing microsite: or otherwise by contacting your usual contact within the Group This Scheme Report should be considered in its entirety, as parts taken in isolation may be misleading. A copy of this Scheme Report will be provided to the following parties: The Court, to assist in determining whether the Scheme should be permitted; and The PRA and the FCA, for the purposes of the performance of their statutory obligations under the FSMA A copy of this Scheme Report will be made available to customers of the Group or to any other potentially affected persons as part of the communications process the Group will carry out to bring the Scheme to the attention of such persons, whether by way of being published on the 05/215

6 websites of the Group companies or entities, posted to such persons, made available for inspection at the offices of those companies or entities solicitors or by any other method. My summary of this Scheme Report will be made available by the Group to its shareholders, customers, policyholders or others with an interest in the Scheme. No other summary of this Scheme Report may be made without the prior written consent of Deloitte and/or me. Form of my Scheme Report 1.22 I draw the following statements to the attention of any subsequent reader/recipient of this Scheme Report and my summary thereof: This Scheme Report, and any summary report I produce, do not constitute financial or professional advice to any recipient; and To the fullest extent possible by law, Deloitte disclaims any liability arising out of your use (or non-use) of this Scheme Report and its contents, including any action or decision taken as a result of such use (or non-use) My Scheme Report is structured as follows: Section 2 contains my conclusion on the Statutory Question; Section 3 provides an overview of the Scheme; Section 4 explains the role of the Skilled Person and the approach I have taken in carrying out my analysis and reaching my conclusions; Section 5 provides an overview of the process through which the Group reached its ringfencing decision and the alternative models that were considered by the Group; Sections 6, 7, 8 and 9 deal with customer cohorts across Commercial Banking, Retail Banking, Consumer Finance, as well as Other Relevant Persons, and I set out my analysis and conclusions on how they are affected by the Scheme. Each section is written so that customers and/or Other Relevant Persons of the relevant areas can understand the significant implications of the Scheme for them. This approach means that there may be some repetition across these sections; Section 10 provides key information relating to the capital, liquidity and funding positions of the Group and certain other legal entities pre- and post-scheme; Section 11 deals with governance arrangements for the RFB Sub-group and LBCM and I set out my analysis and conclusions on how they are affected by the Scheme; Sections 12 and 13 deal with operational continuity and recovery and resolution planning and I set out my analysis and conclusions on how they are affected by the Scheme; Section 14 deals with information technology considerations and payment implications and I set out my analysis and conclusions on how they are affected by the Scheme; Section 15 considers any tax implications of the Scheme; Section 16 deals with pension schemes within the Group and I set out my analysis and conclusions on how they are affected by the Scheme; and Section 17 deals with the plans for communicating the Scheme to customers and Other Relevant Persons, and my views on those plans Further information is given in the appendices. 06/215

7 2. Conclusion on the Statutory Question 2.1 For the reasons set out in the rest of my Scheme Report, I am satisfied that either: (a) the Scheme is not likely to adversely affect any persons other than the Transferors or, (b) where the Scheme is likely to have an adverse effect, that the effect is no greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. 2.2 The rest of this Scheme Report sets out the detail of and rationale for my conclusions. 2.3 I will keep these matters under review until the date of the Sanction Hearing and will draw any significant developments or changes that are relevant to my conclusions to the attention of the Court in a Supplementary Report, if required. 07/215

8 3. Overview of the Ring-fencing Transfer Scheme Introduction 3.1 In this section, I explain why the Group is required to implement an RFTS. I also set out the purpose and timing of the Scheme and an overview of the principal changes that will arise as a result of the Group s Scheme. 3.2 I also set out, at a high level, those changes that the Group is making, not under the Scheme but in order to comply with the broader requirements of the Ring-fencing Regime. This is because I have taken into account the context in which the Scheme is taking place and reflected how other parts of the wider group restructuring, as referred to in paragraph 3.41, being carried out by the Group might affect my analysis. In particular, while it is not within my scope to opine on transfers or other activities performed outside of the Scheme, I have considered whether those activities have any effect on my conclusions in respect of the Scheme. Why are banks implementing ring-fencing? 3.3 In response to the financial crisis, which started in 2007, the UK Government commissioned Sir John Vickers 2 to consider structural and other reforms to the UK banking sector to improve the resilience and resolvability 3 of banks, as well as to promote financial stability and competition. The Independent Commission on Banking ( ICB ) reported in September 2011 and recommended that banks with retail and small and medium sized enterprise 4 deposits be required to ring-fence their retail and business banking from more complex banking, such as wholesale and investment banking. The UK Government determined that only banks with core deposits over 25bn would be required to implement a ring-fence. 3.4 The Financial Services (Banking Reform) Act 2013 ( the Banking Reform Act ) implemented the recommendations of the ICB and the key recommendations of the Parliamentary Commission on Banking Standards ( PCBS ), which reviewed the professional standards and culture in the banking industry. 3.5 The intention of ring-fencing, according to the UK Government, is to protect retail banking from risks unrelated to the provision of retail banking services and to help ensure that banking groups can be resolved in an orderly manner, thereby avoiding taxpayer liability, minimising the risk of loss to retail customers and maintaining the continuous provision of necessary retail banking services. The Government has stated that the legislation is intended to have the effect of 2 Sir John Vickers is a British economist who chaired the Independent Commission on Banking ( ICB ). The ICB was asked to consider structural and related non-structural reforms to the UK banking sector to promote financial stability and competition following the financial crisis. 3 The Bank of England ( BoE ) has a remit to maintain financial stability: to protect and enhance the resilience of the UK financial system. As part of achieving that, firms must be able to fail in an orderly way without causing systemic consequences or critical disruption to economic activity. Resolution is the process by which the authorities can intervene to manage the failure of a firm. This process includes three stages: Stabilisation phase: Once a firm has entered resolution, the BoE must decide on the most appropriate method to stabilise the firm. This may be through transferring some of its business to a third party or through bail-in to recapitalise the failed firm. Restructuring phase: Once the firm has been stabilised, it will need to restructure to address the causes of failure and restore confidence. Exit from resolution: This is the end of the BoE s involvement with a firm in resolution either the firm will cease to exist or they will be restructured and no longer require liquidity support. Source: Bank of England News Release All those companies defined as small or medium in the Companies Act /215

9 making it easier to manage the failure of either the Ring-fenced Body ( RFB ) or the Non Ringfenced Body ( NRFB ), without the requirement for a bail-out from Government. In turn, this is intended to reduce the severity and frequency of any future financial crises. Relevance of ring-fencing to the Group 3.6 Under the Banking Reform Act, FSMA, statutory instruments and associated rules and guidance set by the PRA and FCA (together the Ring-fencing Regime ), banks that perform a wide range of activities are required to separate parts of their investment and retail banking activities so that they are conducted by separate legal entities. 3.7 The FSMA (Ring-fenced Bodies and Core Activities) Order 2014 ( RBCAO ) 5 and Sections 142A and 142B of the FSMA 6 set the thresholds for classification of RFBs. The Excluded Activities and Prohibitions Order 2014 ( EAPO ) 6 and Sections 142D and 142E of the FSMA set out restrictions that are classified as excluded activities and prohibitions. These excluded activities and prohibitions together are termed the Perimeter Rules, as they classify what activities can and cannot be conducted by the RFB after 1 January 2019 (the Statutory Deadline ). The threshold and relevant restrictions are summarised below. Threshold 3.8 The threshold for an RFB is a bank with an average of 25bn of core deposits 7 or more for a three-year period. Core deposits are defined as all deposits except: Deposits by an individual with assets (money and transferable securities) of at least 250,000 where the individual has provided a declaration of eligibility; Qualifying organisation or qualifying group member 8 ; Non-European Economic Area ( non-eea ) deposits 9 ; and Deposits made by Relevant Financial Institutions ( RFIs ) LB plc (the First Transferor ) and BoS plc (the Second Transferor) (together, the Transferors ) have each held an average level of core deposits that has exceeded 25bn during the preceding three year period i.e. during the period 1 January 2014 to 31 December This 25bn threshold applies to the wider Group as a whole (i.e. even if the First Transferor or the Second Transferor individually held less than 25bn of core deposits, they would each still be classified as an RFB if the threshold is met by UK banks within the same group, on a group wide basis). The Transferors are UK incorporated entities accepting deposits from retail customers, Small and Medium Sized Enterprises ( SME ) and other corporates through branches based in European Economic Area ( EEA ) states. The Transferors will, based on current projections, be RFBs from 1 January 2019 under the provisions of the Ring-fencing Regime. Excluded Activities 3.10 The EAPO includes two categories of excluded activities as listed below that may not be conducted by an RFB (together the Excluded Activities ) that are relevant to this Scheme: 5 As amended by the FSMA (Ring-fenced Bodies, Core Activities and Prohibitions) (Amendment) Order Sections 142A to 142Z1 were inserted into the FSMA by the Banking Reform Act. 7 Core deposits are defined in Article 2(2) of the RBCAO with further information provided in Articles 3 and 4 of the RBCAO. 8 A qualifying organisation which is a body corporate or partnership is one which meets one or more of the following criteria: (i) a turnover of not less than 6.5m, (ii) a balance sheet total of not less than 3.26m; and (iii) not less than 50 employees (Article 4 of RBCAO). A qualifying organisation which is not a body corporate or organisation is one which has a gross income for the relevant financial year of more than 6.5m (Article 5 of RBCAO). A qualifying group member is any organisation which is a member of the same group as a qualifying organisation (Article 8 of RBCAO). 9 Deposits that are not held with the UK deposit-taker in an EEA account, i.e. the deposit is not held in an account opened at a branch of the UK deposit-taker opened in an EEA state. 10 RFIs as defined in Article 2 of the EAPO. 09/215

10 Dealing in investments as principal in broad terms, this means buying, selling, subscribing for or underwriting securities or contractually based investments (other than as an agent for another party) as defined in the FSMA (Regulated Activities) Order 2001, subject to the amendments set out in the EAPO; and Dealing in commodities as principal in broad terms, this means buying or selling commodities (meaning any goods of a fungible nature that are capable of being delivered including metals and their ores and alloys, agricultural products and energy such as electricity) The RFB is not permitted to perform any Excluded Activity, unless stipulated as a specific exemption within the EAPO. The EAPO sets out various exemptions whereby an RFB is deemed not to carry on an Excluded Activity Exemptions in relation to dealing in investments as principal will apply if the RFB buys, sells, underwrites or subscribes for investments under, but not limited to, the following circumstances 11 : For the purpose of managing its own risk 12 (including changes in interest or foreign exchange rates, default risk and liquidity risk); For the purpose of managing its liquidity (i.e. liquid assets held from time to time); Corporate acquisitions (acquiring shares in a company that thereafter becomes a subsidiary undertaking of the Transferors, or in which the Transferors hold a participating interest); For the purpose of swapping debt for equity; For the purpose of acquiring investments in the form of debt financing structures, provided that they are held to maturity; For the purpose of taking and realising security interests, including entering into title transfer collateral arrangements; For the purpose of complying with clearing requirements imposed by a recognised clearing house or EEA central counterparty; For the provision of certain simple customer derivatives with customers of the Transferors that are not RFIs and subject to compliance with limits imposed by the EAPO on the size of the derivatives book, including the Relevant Risk Requirement Limit ( RRR Limit ); and For its own securitisations and covered bond arrangements and its own conduits in accordance with Article 7 of the EAPO Additionally, there is a transitional provision ( Grandfathering 13 ) permitting the RFB to retain or sell investments after the Statutory Deadline, provided that (a) the investment in question was acquired before the Statutory Deadline, and (b) the investment is due to mature by 31 December 2020 (hereinafter referred to as short-dated ). The Transferors intend to make use of this provision to allow the retention by the Transferors of certain customer derivatives, subject to optionality, which is described in more detail in paragraphs 6.15 to Separately, the Transferors have identified the possibility that some counterparties may seek to make a technical argument that holding investments following the Statutory Deadline does not of itself constitute dealing in those investments for the purposes of the EAPO, and therefore the Transferors could continue to hold existing investments that exist prior to the Statutory Deadline provided it does not subsequently sell them. However, to adopt this approach would not appear to satisfy the Transferors needs to have freedom to deal in such investments (given that they would be required to hold the investment until maturity), and (if 11 For a complete list of the exemptions to excluded activities refer to the EAPO. 12 This includes exposure by any of the following: the RFB; the RFB s subsidiaries, the RFB s sponsored structured finance vehicles; any conduit vehicle of the RFB; any related undertaking of the RFB; and any other RFB within the group (Article 6.1 of the EAPO). 13 Article 21 of the EAPO. 10/215

11 necessary) to mitigate the risks associated with holding such investments. The Transferors have therefore determined that all such investments will be transferred to the Transferee prior to the Statutory Deadline, save where it can rely on an exemption (including Grandfathering) under the EAPO Exemptions in relation to dealing in commodities will apply in various circumstances (including certain of the circumstances listed under paragraph 3.12), including a circumstance by which an RFB 14 enters into a transaction so as to limit the extent to which it could be adversely affected by various factors (for example, interest rates, foreign exchange rates and commodity prices) I understand that the Transferors do not currently carry out dealings in commodities other than dealings that would be exempt under the EAPO, and that they intend to maintain this approach after the Statutory Deadline. The main restriction that will have an effect on the scope of the Transferors existing business (post-statutory Deadline) is therefore the requirement that the Transferors do not deal in investments as principal. Prohibitions 3.17 The EAPO also stipulates three categories of activities that are subject to prohibition and which therefore cannot be undertaken by the RFB: Access to interbank payment systems: accessing interbank payment systems indirectly 15 ; Exposures to RFIs: the RFB is not allowed to have an exposure to RFIs, their securities or other financial instruments (apart from in limited circumstances, see paragraph 3.19); and Interests in non-eea branches/subsidiaries: maintaining or establishing a branch in a non-eea member state, or having a participating interest in an undertaking that has been formed or incorporated in a non-eea member state Limited exemptions to these prohibitions include: Exposures to interbank payment systems: access to IBPS; indirect access 17 through another RFB within the group; Exposures to RFIs: there are a number of available exemptions including but not limited to: exposures linked to payment services, trade finance, own risk management, liquidity management, own securitisation and covered bond vehicles, conduit lending, repo transactions, infrastructure and a number of specified ancillary exposures; and Interests in non-eea branches/subsidiaries: non-eea service companies I understand 19 that all business classified as Excluded Activities or prohibited under the terms of the EAPO and not otherwise subject to an exemption will be either ceased by the Transferors, or transferred to LBCM or its subsidiaries; the Group s Insurance Sub-group; or the Equity Investments Sub-group. 14 This includes exposure by any of the following: the RFB; the RFB s subsidiaries, the RFB s sponsored structured finance vehicles; any conduit vehicle of the RFB; any related undertaking of the RFB; and any other RFB within the group (Article 6.1 of the EAPO). 15 Defined in Article 13 of the EAPO. 16 A subsidiary should, in most cases, qualify as a participating interest but these are separate legal tests. 17 The exemption to the prohibition of indirect access to an IBPS is described as: The RFB accesses the IBPS through an intermediary which is another RFB that is a direct participant in the IBPS and is also a member of the same group as the first RFB; or The RFB is not eligible to become a direct participant in the IBPS under the rules governing that system; or The PRA has, following an application made to it under the EAPO, granted permission for the RFB to access the IBPS via an intermediary (i.e. in exceptional circumstances). 18 Non-EEA undertakings that are ancillary services undertakings within the meaning of the Capital Requirements Regulation ( CRR ). 19 First Witness Statement of Mark George Culmer. 11/215

12 Height of the ring-fence 3.20 The Ring-fencing Regime also enables the PRA to set rules governing the way in which the Transferors interact with other members of the Group, including (i) their Ring-fenced Affiliates (as such term is defined in the rules made by the PRA and further described in paragraph 3.24); and (ii) the interaction between the Transferors and their Ring-fenced Affiliates, and other members of the Group. These rules (the Height Rules ) include, but are not limited to: Conflicts: the Transferors and other members of the RFB Sub-group must be able to act independently of the other members of the Group, and any conflicts should be identified and managed; Intra-group transactions: these should be managed on an arm s length basis, as if conducting business with an unrelated third party; Governance: in broad terms, the Board of each of the Transferors and other Ring-fenced Affiliates should not comprise the same individuals as the Board of other entities within the Group, including LBCM, and no more than one-third of the Board members of the Transferors or Ring-fenced Affiliates should be directors of other entities within the Group; and Netting arrangements: in the event of default by any party, third parties must not be allowed to net off amounts owed by the third party to the Transferors and other members of the RFB Sub-group against amounts owed to the same third party by any other member of the Group, other than Ring-fenced Affiliates of the Transferors In order to comply with the Height Rules, the Transferors will need to put in place new policies and arrangements so as to maintain an appropriate level of independence between the Transferors, the Ring-fenced Affiliates and the rest of the Group. These policies and procedures are dealt with in greater detail in Section 11 of this Scheme Report. Purpose of the Scheme 3.22 The main purpose of the Scheme is to enable the Group, which will include RFBs, to restructure its businesses to comply with the Ring-fencing Regime by the Statutory Deadline, as well as to achieve the regulatory objectives to improve the resilience and resolvability of the Group and promote financial stability The Scheme will constitute an RFTS under Section 106B of the FSMA, as I understand the following criteria all apply: Each of the Transferors is an authorised person in the United Kingdom within the meaning of the FSMA and each of the Transferors has the necessary permissions to carry out regulated activities pursuant to Part 4A of the FSMA, including permission to deal in investments as principal, in order to lawfully carry on the Transferring Business. The Transferee will, by the Effective Date, be an authorised person in the United Kingdom within the meaning of the FSMA (with no restrictions connected to its authorised status) and will have by the Effective Date the necessary permissions to carry out regulated activities pursuant to Part 4A of the FSMA in order to lawfully carry on the Transferring Business once transferred pursuant to the Scheme. The purpose of the Scheme is to enable the Transferors to carry on core activities as ringfenced bodies in compliance with the ring-fencing provisions pursuant to Sections 106B(1)(b) and 106B(3)(a) of the FSMA. For the purposes of Section 106B(1) of the FSMA, the Scheme is neither an excluded scheme under Section 106B(4) of the FSMA nor an insurance business transfer scheme under Section 105 of the FSMA First Witness Statement of Mark George Culmer. 12/215

13 3.24 As part of this restructuring, the Transferors, along with their subsidiaries and associated undertakings, will form a sub-consolidation group, i.e. the RFB Sub-group as defined in paragraph 3.37, for the purpose of meeting capital and liquidity requirements. Any member of the sub-consolidation group of which the RFB is a member, other than the RFB itself, is defined as the Ring-fenced Affiliate 21. All such Ring-fenced Affiliates are similarly bound by a number of the Ring-fencing Regime provisions and requirements that affect the RFB. Should a Ringfenced Affiliate be deemed in breach of any of the EAPO requirements, the PRA s expectation is that such a Ring-fenced Affiliate should be removed from the sub-consolidation group prior to the Statutory Deadline The Group intends to conduct a single scheme rather than multiple schemes to enable transfer of assets, liabilities and customers from the Transferors to the Transferee, LBCM If approved, in broad terms the Scheme will transfer from the Transferors to the Transferee: Derivatives business which cannot be conducted within the Transferors (subject in some cases to permitted exceptions such as for own risk management) and some simple customer derivative business (which may be conducted within the Transferors but which has been selected for transfer in any case, for example to ensure consistency of treatment for groups of customers (see paragraph 3.27)), with treatment depending on customer categorisation. Special rules (including in some cases the offer by the Group of optionality to clients) apply to derivatives entered into prior to 1 January 2019, that mature prior to 1 January 2021, and which are therefore eligible to benefit from the transitional (or Grandfathering) provisions for such trades; Certain loan and liquidity facilities (and certain sub-participations entered into in connection with such facilities) that involve an exposure to an RFI or that the relevant Transferor would be prohibited from holding under the EAPO; Liquidity facilities provided by the Transferors to RFIs to support the credit ratings of transferrable securities; Trade finance instruments where the customer that grants the counter-indemnity, or is subject to the reimbursement obligations in favour of the Transferor, is an RFI, and the corresponding counter-indemnity or reimbursement obligations themselves; Receivable Purchase Arrangements which create a prohibited exposure to an RFI; and Certain other assets and liabilities, such as guarantees, security, data, claims, receivables and other rights attributable to the Transferring Business. The Scheme will also duplicate certain parts of the contractual arrangements between customers and the relevant Transferor. Further detail on the Transferring Business is set out within the Group s Scheme Document The scope of the Transferring Business in respect of derivatives is greater than strictly necessary for compliance with the Ring-fencing Regime. This approach has been taken to ensure consistency of treatment for groups of customers and to provide the Transferors with adequate headroom to continue further business (in accordance with the RRR Limit of the EAPO, which is explained in paragraph 6.10) The Group has conducted a detailed due diligence exercise to identify the complete range of relevant transactions, assets, liabilities and product types within each business unit of the Group. The Group has then considered to what extent each type of transaction, asset, liability, and product type is affected by the Perimeter Rules. This process has been referred to as the Perimeter Due Diligence. Additionally, the Group has undertaken a transferability due diligence analysis to capture the issues linked to transferring the relevant products/business, once the perimeter has been established. 21 As per the Ring-fenced Bodies Part of the PRA Rulebook. 13/215

14 3.29 The transfer of business under the Scheme will involve the transfer of business from LB plc and BoS plc to LBCM The proposed legal entity structure of LBCM after the Statutory Deadline is illustrated in Diagram I have provided an overview of the pre- and post-scheme organisation in Diagrams 3.3 and 3.4. Diagram 3.1: LBCM structure LLOYDS BANKING GROUP PLC LLOYDS BANK CORPORATE MARKETS plc LLOYDS MERCHANT BANK ASIA LTD LLOYDS HOLDINGS (JERSEY) LTD NEW LBCM JERSEY BRANCH LLOYDS BANK (GIBRALTAR) LTD LLOYDS AMERICA SECURITIES CORPORATION NEW LBCM US BRANCH NEW LBCM SINGAPORE BRANCH BLACK HORSE OFFSHORE LIMITED LLOYDS BANK INTERNATIONAL LTD LLOYDS CORPORATE SERVICES (JERSEY) LTD LLOYDS INVESTMENT FUND MANAGERS LTD LLOYDS SECURITIES INC. EXISTING GUERNSEY BRANCH EXISTING ISLE OF MAN BRANCH NOMINEES (JERSEY) LTD LLOYDS NOMINEES (GUERNSEY) LTD Key: Jurisdiction of Incorporation United States Gibraltar Singapore Guernsey Jersey EXISTING GUERNSEY BRANCH EXISTING ISLE OF MAN BRANCH EXISTING ALDERNEY BRANCH Entities with Banking Licences Branches with Banking Licences Branches without Banking Licences 3.31 As part of the Scheme, some assets and liabilities that are linked to the transactions and contracts mentioned in paragraph 3.26 will also be transferred from the Transferors to the Transferee The majority of assets will be transferred at net book value, as they represent a transfer from one part of the business to another, as opposed to a sale to or purchase from an unconnected third party. Depending on the accounting treatment used, this will be either the fair value or amortised cost of the asset. Liabilities will also be transferred at net book value. Historical liabilities relating to the actions or omissions of the Transferors with respect to any Transferring Business, including with respect to the origination of products, will be excluded from transfer through the Scheme and will not be assumed by LBCM The precise asset and liability values to be transferred via the Scheme will be subject to change up until the point the Scheme is effected. Table 3.1 shows indicative values of assets and liabilities to be transferred via the Scheme based on the Group s forecasted transfer values at the point of transfer on the Effective Date. 22 The Group has not announced any further changes that may arise due to the UK leaving the European Union ( EU ). 14/215

15 Table 3.1: RFTS transfers 23 Assets bn Loans and Advances to Customers 6.0 Loans and Advances to Banks 0.0 Collateral Posted 5.2 Other Customer Assets (Derivatives) 13.5 Total Assets 24.7 Liabilities bn Collateral Received 3.7 Other Customer Liabilities (Derivatives) 12.9 Total Liabilities 16.6 Timing of the Scheme 3.34 The Directions Hearing is expected to take place on 4 December 2017, with the final hearing for the Court to decide whether to sanction the Scheme currently scheduled for 27 March In order to comply with the Ring-fencing Regime requirements, the Scheme will need to become effective by the Statutory Deadline. It is proposed that the Scheme should take effect at hours on the Effective Date. Other changes not as a result of the Scheme - Corporate reorganisation 3.36 In addition to the Scheme, the Group will implement a Group-wide reorganisation in order to put in place a legal entity structure that is compliant with the requirements of the Ring-fencing Regime prior to the Statutory Deadline (the Reorganisation ). The Reorganisation will be carried out both before and after the Effective Date of the Scheme The Group s Reorganisation will establish four separate and distinct sub-groups being: RFB Sub-group, containing: (i) LB plc and BoS plc; and (ii) EEA branches/subsidiaries which carry out permitted/mandated activities; Non Ring-fenced Bank Sub-group (the NRFB Sub-group ), containing LBCM and its subsidiaries performing excluded/prohibited banking activities and certain permitted activities 24 ; Insurance Sub-group (the Insurance Sub-group ), containing Scottish Widows Group Limited and its relevant subsidiaries carrying on insurance-related activities (Scottish Widows Ltd ( SWL ), Lloyds Bank General Insurance Holdings Ltd, Scottish Widows Financial Services Holdings, HBoS Financial Services Ltd, Halifax Financial Services (Holdings) Ltd, Legacy Renewal Company Ltd, Halifax General Insurance Services Ltd, 23 The table herein has been extracted from the First Witness Statement of Mark George Culmer and shows only those assets and liabilities that are expected to transfer via the Scheme and not the full balance sheet of LBCM at the point of transfer on the Effective Date. 24 In addition to the transfer of legal entities as set out above, the Transferors non-eea banking business will also have to be transferred. The Transferee will set up branches in non-eea jurisdictions, and the Transferors non-eea banking business will then be transferred from their own non-eea branches to the Transferee s branches. The Transferors will thereafter close such non-eea branches to ensure compliance with the prohibition within EAPO. 15/215

16 Lloyds Bank Insurance Services Ltd, Lloyds Bank General Insurance Ltd and St. Andrews Insurance plc); and Equity Investments Sub-group (the Equity Investments Sub-group ), containing LBG Equity Investments Limited and its relevant subsidiaries, including Uberior Investments Limited, Lloyds Development Capital (Holdings) Limited, LDC (Managers) Limited, Housing Growth Partnership Manager Limited and certain strategic and other investments and shareholdings of the Group. LBG Equity Investments Limited is held directly by the Parent Company In addition, a small number of funding entities are proposed to be held (separately from the above sub-groups) directly or indirectly by the Parent Company A summary of these changes is illustrated in Diagram 3.2. The current and target structures of the Group are set out in Diagrams 3.3 and 3.4 respectively. Diagram 3.2: Overview of the target structure LLOYDS BANKING GROUP PLC RFB SUB-GROUP NRFB SUB-GROUP INSURANCE SUB-GROUP EQUITY INVESTMENTS SUB- GROUP Key legal entities Key legal entities Key legal entities Key legal entities Lloyds Bank plc and Bank of Scotland plc EEA branches/subsidiaries which carry out permitted activities Key assets/products All mandated activities (core services/activities) Vast majority of deposit taking (not just individuals and SMEs) Permitted products assets/products which: (i) are not captured by prohibitions or excluded activities; and (ii) fall into the exemptions to prohibitions or excluded activities Lloyds Bank Corporate Markets plc Non EEA entities: The United States Singapore Crown Dependencies Key assets/products All excluded/prohibited banking activities Products that Transferors choose not to provide (even though Transferors are not prevented from offering these under the Ringfencing Regime) Term deposits for Global Corporates ( GC ) and Financial Institutions ( FI ) which are also offered by Transferors (the client has the choice of which entity to use) Scottish Widows Group Limited and its relevant subsidiaries Key assets/products Insurance business Lloyds Development Capital (Holdings) Limited and its subsidiaries The Housing Growth Partnership group Uberior Investments Limited and its subsidiaries Other strategic minority interests, including Banco de Sabadell and Standard Life Aberdeen Key assets/products All excluded/prohibited equity investment activities 3.40 Diagrams 3.3 and 3.4 set out the actual and proposed Group-wide structure pre- and post- Scheme respectively: 16/215

17 Diagram 3.3: Group-wide structure (Current) 25 LLOYDS BANKING GROUP PLC Capital Vehicles* Lloyds Bank plc Lloyds Bank Corporate Markets plc LBG Equity Investments Ltd HBOS plc Bank of Scotland plc Lloyds Merchant Bank Asia Ltd Lloyds America Securities Corporation Lloyds Securities Inc. Lloyds Bank Subsidiaries Ltd*** Lloyds Holdings (Jersey) Ltd Lloyds Bank (Gibraltar) Ltd Scottish Widows Group Ltd Lloyds Development Capital (Holdings)Ltd Housing Growth Partnership Group** Uberior Investments Ltd Lloyds Bank International Ltd Nominees (Jersey) Ltd Black Horse Offshore Ltd Lloyds Corporate Services (Jersey) Ltd Lloyds Investment Fund Managers Ltd Lloyds Nominees (Guernsey) Ltd Halifax General Insurance Services Ltd Lloyds Bank General Insurance Holdings Ltd Lloyds Bank Insurance Services Ltd Scottish Widows Ltd Lloyds Bank General Insurance Ltd Scottish Widows Services Ltd Key: box colour shows end location sub group RFB NRF Insurance Equity Investments Dual (FCA & PRA) regulated UK Banking Licence Holder Solo (FCA) regulated Non UK Banking Licence Holder *Represents four companies incorporated for capital management purposes, being LBG Capital Holdings Limited, LBG Capital No.1 plc, LBG Capital No.2 plc and Bank of Scotland Capital Funding L.P. **LBG Equity Investments Ltd holds a number of investments and interests in partnerships and entities that constitute the Housing Growth Partnership Group. ***Lloyds Bank Subsidiaries Ltd ( LBSL ) is an intermediate Holding Company for the Group. It has a number of other subsidiaries which are being transferred around the Group and/or in the process of liquidation. The end location of LBSL is yet to be determined. Note that the Group has other regulated entities in addition to those shown in the chart above. 25 Current Group Structure - LBCM currently has no subsidiaries and no existing group entities will be transferred to it until after the Scheme becomes effective. 17/215

18 Diagram 3.4: Group-wide structure (Target) LLOYDS BANKING GROUP PLC Capital Vehicles* Lloyds Bank plc Lloyds Bank Corporate Markets plc Scottish Widows Group Ltd LBG Equity Investments Ltd Scottish Widows Services Ltd HBOS plc Lloyds Merchant Bank Asia Ltd Lloyds America Securities Corporation Lloyds Holdings (Jersey) Ltd Lloyds Bank (Gibraltar) Ltd Lloyds Development Capital (Holdings)Ltd Uberior Investments Ltd Bank of Scotland plc Lloyds Securities Inc. Lloyds Bank International Ltd Black Horse Offshore Ltd Lloyds Corporate Services (Jersey) Ltd Lloyds Investment Fund Managers Ltd Housing Growth Partnership Group** Nominees (Jersey) Ltd Lloyds Nominees (Guernsey) Ltd Lloyds Bank General Insurance Holdings Ltd Scottish Widows Ltd Halifax General Insurance Services Ltd Lloyds Bank Insurance Services Ltd Lloyds Bank General Insurance Ltd Key: box colour shows end location sub group RFB NRF Insurance Equity Investments Dual (FCA & PRA) regulated UK Banking Licence Holder Solo (FCA) regulated Non UK Banking Licence Holder *Represents four companies incorporated for capital management purposes, being LBG Capital Holdings Limited, LBG Capital No.1 plc, LBG Capital No.2 plc and Bank of Scotland Capital Funding L.P. **LBG Equity Investments Ltd holds a number of investments and interests in partnerships and entities that constitute the Housing Growth Partnership Group. LBSL is not shown on this chart because it is no longer a core Lloyds Bank entity once its core subsidiaries are transferred to Lloyds Bank Corporate Markets plc. Lloyds Merchant Bank Asia Ltd will be deregulated as part of the programme. Note that the Group has other regulated entities in addition to those shown in the chart above. 18/215

19 Other changes not as a result of the Scheme wider changes 3.41 In addition to the Reorganisation referred to in paragraph 3.36, the Group is making a number of other changes in order to comply with the Ring-fencing Regime (together the wider group restructuring ). This includes changes to Information Technology ( IT ) systems, processes, contractual arrangements, roles and responsibilities of some employees and a large number of other changes. Whilst this Scheme Report may make reference to certain of those wider changes in order to provide context to the Scheme, I have not sought to describe or explain those changes in their entirety as this Scheme Report is only concerned with the Scheme itself. Costs of the Scheme 3.42 All costs and expenses incurred by the Group in preparing and implementing the Scheme (including the cost of the Skilled Person) will be borne by the Group Subject to the limitations in the Group s Scheme Document, the Group will also make payments of Reimbursed Amounts to its customers for a period of up to seven months following the Relevant Date in the following circumstances: (a) Fees or disbursements paid by customers to third party security agents or third party facility agents, or payable directly to such agents as customers, pursuant to a transferring loan facility, as a direct result of the identity of the lending counterparty being changed from the Transferor to the Transferee pursuant to the Scheme; (b) Fees paid by or on behalf of customers to third parties in connection with the transfer of any guarantee/security pursuant to the Scheme (including any fees paid by or on behalf of customers to third parties for or in connection with the registration of any such transfer of any guarantee/security); (c) Any other fees, to the extent not covered above, paid by or on behalf of customers to third parties for or in connection with the registration by or on behalf of customers of the transfer of any part of the Transferring Business; (d) Any fees paid by or on behalf of customers to re-book Transferring Derivative Transactions and/or Transferring Derivative Transaction Confirmations, to the extent that such rebooking is required as a direct result of the Scheme, and limited to itemised fees specific to only that part of customers business that is the Transferring Business pursuant to the Scheme, i.e. excluding blended, regular or periodic fees that may be payable by customers in the ordinary course of business in connection with the Transferring Business; and (e) To the extent not covered by the above-stated circumstances, any other fees paid by customers to third parties and which either of the Transferors is expressly and contractually bound to reimburse, provided that any conditions in the relevant contract relating to such reimbursement obligations may have been met by or on behalf of the customers and subject to any limitations specified in the contract on the relevant Transferors obligations. but in each case in (a) to (d) above to the extent that: Customers are required to pay such fees or disbursements, whether pursuant to existing binding contractual obligations or pursuant to applicable law; Such fees and disbursements have been reasonably and properly incurred and paid by or on behalf of customers as a direct result of the transfer of the Transferring Business from the Transferors to the Transferee pursuant to the Scheme; and Such fees and disbursements are properly evidenced by customers, to the reasonable satisfaction of the relevant Transferor, as having been incurred as a direct result of the transfer to the Transferee pursuant to this Scheme, and such evidence is delivered in full by the relevant customers to the relevant Transferor within the period that is seven months from the Relevant Date. 19/215

20 3.44 Legal costs will be covered under the definition of Reimbursed Amounts, as defined in paragraph 3.43, only where the Transferors are contractually obliged to reimburse customers for such costs under the terms of a transferring or duplicated agreement This proposal forms part of the Group s proposed approach to mitigating potential adverse effects arising from the Scheme. Handling information 3.46 To ensure that information continues to be handled appropriately once the Scheme takes effect, the Group is considering what protocols and procedures will need to be set up in order to control the way in which the Transferors and Transferee will handle information. Confidentiality, data protection and marketing preferences 3.47 The Scheme takes the following broad approach in respect of confidentiality (with full details being set out within the Group s Scheme Document): Provisions in agreements that prohibit certain information sharing are overridden if such information sharing is required to give effect to the Scheme; The Transferee shall continue to owe the same duties of confidentiality as those owed by the Transferors prior to the Effective Date in respect of relevant agreements; The Transferee will become a data controller in respect of relevant personal data and be under the same legal confidentiality duties, and enjoy the same rights, as the relevant Transferor was subject to or enjoyed in respect of it; Subject to the same being treated confidentially, after the Effective Date the Transferors and Transferee (and any persons authorised by them) shall be allowed access to any information that is reasonably requested by them connected with the administration, management and enforcement of assets and liabilities they hold; and Where a customer has provided marketing preferences to a Transferor prior to the Effective Date: (a) The prevailing market preference provided by that customer in relation to any product offered by the Transferee shall apply to both the relevant Transferor and the Transferee from the Effective Date; and (b) Both the relevant Transferor and the Transferee shall have the benefit of those marketing preferences on the same terms as the Transferor had prior to the Scheme In relation to assets and liabilities transferring or being duplicated under the Scheme, where the Transferors has the right to share information within the Group, the Transferee shall have the same rights to share information after the Relevant Date. Where the Transferors do not have such right, the Scheme allows the Transferors and Transferee to share such information between themselves for regulatory, accounting and reporting purposes or for the provision of services. Know Your Customer information ("KYC information") 3.49 For six months following the Effective Date, the Transferee will provide, upon reasonable request, any reasonable KYC information requested for the purpose of enabling any customers, agents or third parties to conduct KYC information checks Such KYC information will be provided in circumstances where the provision thereof and performance of KYC information checks is either: Pursuant to the standard policies or procedures of the requesting party; or otherwise Mandatory under any applicable laws or regulations; 20/215

21 and where the requesting party is either: Legally or contractually required to complete KYC information checks; or Entitled to demand such information as to enable it to conduct KYC information checks in relation to the transfer of the Transferring Business. Residual issues 3.51 It may not be possible, or the Group has stated that it would not be efficient or sufficiently certain, to transfer some types of documentation through the Scheme (for example, where such documents are governed by laws of jurisdictions other than England and Wales, Scotland or Northern Ireland). In such circumstances, a manual novation process will be used. Such a process may require that customers provide the consent to the novation, which could lengthen the required timescale. For example, certain syndicated loans, where LB plc or BoS plc are a security agent and there is an element of foreign law security, will not be transferred by the Scheme and will be novated. I understand that the Group will mitigate any such potential delay by commencing early negotiations with all affected customers The Scheme also includes provision for additional assets and liabilities that form part of the transferred business (the Residual Assets and the Residual Liabilities respectively) to be transferred at a point after the Effective Date. This provision takes account of the possibility of additional factors that may delay the transfer of certain assets and liabilities including: Ensuring that the transfer will be recognised under governing law in another jurisdiction; and Ensuring that linked products are transferred simultaneously If any Residual Assets or Residual Liabilities have not been transferred on or prior to on 30 December 2018, they will be automatically transferred (to the extent that the Court has jurisdiction to do so) to the Transferee at on 31 December 2018, with a carve-out for derivatives that can benefit from Grandfathering provisions. This is to ensure that all Transferring Business that would otherwise cause a breach of the EAPO has been transferred prior to the Statutory Deadline. 21/215

22 4. Role and approach of the Skilled Person Overview of the role of a Skilled Person 4.1 Section 109A of the FSMA requires that an application to the Court to effect a scheme is accompanied by a Scheme Report from an appropriately skilled person. Both the nomination of that skilled person and the form of the Scheme Report must be approved by the PRA, having consulted with the FCA, in accordance with the requirement of Section 3.2 of the PRA Policy Statement. This report is the Scheme Report for the Group s RFTS and my nomination as Skilled Person has been approved by the PRA, in consultation with the FCA. 4.2 The purpose of this Scheme Report is to assist the Court in reaching a decision as to whether to sanction the Scheme and, in particular, to address the following Statutory Question of: (a) Whether persons other than the transferor concerned are likely to be adversely affected by the Scheme; and (b) If so, whether the adverse effect is likely to be greater than is reasonably necessary in order to achieve whichever of the purposes mentioned in Section 106B(3) is relevant This section sets out my approach to fulfilling my obligation as the approved Skilled Person and, specifically, how I have answered the Statutory Question. In developing this approach, I have considered the requirements of the PRA Policy Statement and the FCA Finalised Guidance. Approach consideration of persons affected by the Scheme 4.4 The Statutory Question requires me to consider the potential effects of the Scheme on all persons other than the Transferors. In assessing the likely effects of the Scheme, I have considered separately the following groups of persons: Current customers with products transferring from either of the Transferors to the Transferee under, or whose products are being duplicated pursuant to, the Scheme (the Transferring Customers ). Transferring Customers are made up of a portion of the customers of the Commercial Banking division of the Group and are considered in Section 6 of my Scheme Report; Current customers of the Transferors with products that are not transferring under the Scheme (the Non-Transferring Customers ). Non-Transferring Customers are made up of all customers of the Retail Banking division and Consumer Finance sub-division of the Group, considered in Sections 7 and 8 of my Scheme Report respectively, and a portion of the customers of the Commercial Banking division of the Group, considered in Section 6 of my Scheme Report; and Other persons who are not current customers of the Transferors, but who may be directly or indirectly affected by the Scheme ( Other Relevant Persons ), considered in Section 9 of my Scheme Report. 4.5 The scale and diverse nature of the Group and its operations means that there are a number of persons or groups of persons who could potentially be affected by the Scheme. While it is not possible to consider the individual circumstances of each person, I have considered cohorts of customers and Other Relevant Persons with similar characteristics or sought to identify 26 The relevant purpose for the Scheme is, as stated in Section 106B(3)(a) of the FSMA, as follows: (a) Enabling a UK authorised person to carry on core activities as an RFB in compliance with the ring-fencing provisions. 22/215

23 persons with products or relationships with the Group who could potentially be adversely affected by the Scheme. The respective definitions of these cohorts are set out in each section. Approach Statutory Question My interpretation of part (a) of the Statutory Question 4.6 In my view, a key consideration in respect of part (a) of the Statutory Question is the interpretation of likely to be adversely affected and the interpretation of by the Scheme. I have set out my further consideration of these matters in paragraphs 4.7 to 4.25, which should be read in conjunction with the process diagram in Diagram 4.1. Consideration of likely 4.7 In interpreting the word likely in connection with part (a) of the Statutory Question, I have considered interpretations of the word likely used in relevant case law, where the conclusion was that likely should be interpreted as being a real possibility (which is somewhere in between possible and probable or more likely than not ). 4.8 There are multiple sources of other possible guidance as to how to interpret the word likely, including the ordinary dictionary definition, guidance in accounting literature and guidance from professions other than accounting. 4.9 The ordinary dictionary definition, according to the Oxford English Dictionary 27, of likely is having a high chance of occurring; probable From an accounting perspective, International Financial Reporting Standards ( IFRS ) and the United States Generally Accepted Accounting Principles ( US GAAP ) do not specifically define likely but do define probable by reference to likelihood, albeit that the definitions differ under each IFRS defines probable as "more likely than not to occur" 28 (i.e. "the probability that the event will occur is greater than the probability that it will not"). US GAAP defines probable as "likely to occur 29. While the assessment of these terms is subject to an entity s judgement in the context of preparing financial statements, "likely" under US GAAP is considered in my view a much higher threshold (i.e. approximately 80 percent) than "more likely than not" under IFRS (i.e. greater than 50 percent) I sought to consider guidance from other professions and I found the guidance issued by the Royal College of Obstetricians and Gynaecologists under Clinical Governance Advice No 7, issued in December 2008, on presenting information on risk to assist healthcare professionals when discussing risks with patients. They use the guidance set out in Table 4.1 to express the risk of an adverse event occurring in the following qualitative and quantitative terms International Accountiing Standard 37 Provisions, Contingent Liabilities and Contingent Assets, paragraph ASC (US GAAP), FASB Accounting Standards Codification Manual, paragraph ASC , Contingencies. 23/215

24 Table 4.1 Clinical Governance Advice No 7 presenting information on risk 30 Verbal description* Risk Risk description Very common 1/1 to 1/10 A person in family Common 1/10 to 1/100 A person in street Uncommon 1/100 to 1/1,000 A person in village Rare 1/1,000 to 1/10,000 A person in a small town Very rare Less than 1/10,000 A person in a large town * European Union ( EU ) - assigned frequency. Unit in which a single adverse event would be expected From my review of the above material, I conclude that that there is no consistent, quantitative interpretation of the word likely. Therefore it was my intention in my Scheme Report to apply my own qualitative and quantitative judgement based on the actual facts and explain where an assessment of likely was a critical consideration in determining my conclusions of whether a particular adverse effect was likely to occur. Whilst this was my approach, having completed my Scheme Report, I did not identify any effects of the Scheme where making an assessment of likely was a critical factor in itself in enabling me to reach my conclusion. In many cases the effect was certain to occur, at least for one or more affected persons or customers, and this was the critical factor for me in reaching my conclusion. Consideration of adversely affected 4.14 In my opinion, the starting point for consideration of part (a) of the Statutory Question is that any adverse effect must be from the perspective of the customer or Other Relevant Person The Scheme has the potential to affect a large number of different groups of persons in a number of different ways. When considering these potential effects of the Scheme, I have not limited my analysis to a particular type of adverse effect. In respect of customers of the Group, I have considered four categories of potential adverse effects, namely; financial, product, transitional and operational, which are defined in Table 4.2. I have not sought to categorise possible adverse effects on Other Relevant Persons as the type of effect may vary, rather I have considered all those possible adverse effects that I regard may be relevant to each Other Relevant Person. My analysis has been supported by both quantitative and qualitative information produced by me, and information I have received from the Group, which is set out in Appendix 2 of this Scheme Report /215

25 Table 4.2 Type of adverse effect Effect type Financial Product Transitional Operational Description The quantifiable monetary effect of a change arising from the proposed implementation of the Scheme under the Group s design that affects a customer in their dealings with the bank. Changes to and/or curtailment of products previously available to customers of the Transferors compared to the future product offering from (i) LBCM or (ii) the Transferors and LBCM arising from the Group s proposed implementation of the Scheme. The differential effects identified during the customer journey from the current relationship state with the RFBs to a future state with (i) LBCM; or (ii) the Transferors and LBCM arising from the proposed implementation of the Scheme under the Group s design. Changes to processes and procedures arising from the proposed implementation of the Scheme under the Group s design that affect customers in their relationship interaction with the Group Furthermore, I have considered both the effect at the point in time at which the Scheme is to be effected and the potential ongoing effect of the Scheme. As would be the case with any forward-looking analysis, commercial and market developments make it impossible for me to be definitive as to the effect of the Scheme in the future, but I have considered whether the Scheme, in my opinion, makes an adverse effect more likely in the future (for example, by weakening governance or exposing affected persons to materially greater risk of loss). Given that future customers and Other Relevant Persons do not currently have any direct or indirect interests in the Group, I am satisfied that it is not possible for the Scheme to have an adverse effect on these persons. To the extent that these persons become customers or Other Relevant Persons in the future, they will do so in the knowledge of the effect of the Scheme and so will not be affected by the Scheme. Consideration of the Scheme 4.17 The Statutory Question is framed by reference to the effect of the Scheme itself on potentially affected persons. However, I am aware that the Group has been carrying out a large programme of activities, including wider group restructuring, to support compliance with the relevant Ring-fencing Regime. The effect of the Scheme will depend, to an extent, on these wider group restructuring activities. I have set out high level detail on aspects of this wider group restructuring in Section 3 of this Scheme Report Given the potential interdependencies of the effects of the Scheme with the wider group restructuring activities of the Group, I do not consider that it would be appropriate to limit my analysis solely to the effect of the Scheme in isolation. For example, where part of the wider group restructuring is not directly affected by the Scheme, but has a potential effect on the ongoing viability of a legal entity to which business is being transferred under the Scheme, I consider that this is included within the scope of this Scheme Report In reflecting on the potential effect of these wider activities of the Group within the assessment of the Scheme, I have not sought to form a conclusion on the effect of these activities themselves as these are matters solely within the responsibility of the Board of Directors of LBG plc. Rather, I have considered whether these wider activities have any bearing on my conclusions as to whether the Scheme itself complies with the requirements of the Statutory Question. 25/215

26 Adverse effects 4.20 The Statutory Question does not make any reference to materiality or the relative significance of an adverse effect. However, there are several references to material, materially or materiality in the relevant guidance issued by the PRA 31 and the FCA As an accountant, I have referred to numerous sources in accounting literature where the concept of what is material is defined, for example the International Accounting Standards Board s Conceptual Framework for Financial Reporting. This definition states that Information is material if omitting it or misstating it could influence decisions that users make on the basis of financial information about a specific reporting entity. In other words, materiality is an entityspecific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity s financial report. This definition highlights that materiality is both a quantitative and a qualitative consideration, and that it should be considered from the perspective of the users of that information In the context of this Scheme Report, I consider that the definition of what is considered material depends on the circumstances of each individual person (or, where appropriate, group of persons) rather than what is considered material from an accounting standpoint. The importance of considering materiality from the standpoint of the customer is also highlighted by the FCA which states that a Scheme Report should include where different groups of consumers are likely to be adversely affected differently by the scheme a comment on those differences where material to consumers Following this approach, it has not been appropriate to calculate a single value for materiality. In my view, such a value would be of little benefit as it would need to be reassessed in relation to each individual person In this Scheme Report, I have adopted a broad approach to my analysis and my consideration of whether an effect is material from the perspective of the affected person rather than from the perspective of the Group. Furthermore, there are several potential adverse effects that are entirely or largely qualitative in nature. For example, many of the operational adverse effects covered by the FCA Finalised Guidance highlighting the need to mitigate material disruptions of service to customers I have also considered the effect net of any mitigants that the Group has applied or the affected persons could reasonably be expected to apply themselves. For each adverse effect mentioned in this Scheme Report, where relevant for me to do so, I explain why I have classified the effect as being material or immaterial. 31 PRA Policy Statement. 32 FCA Finalised guidance 16/1. 33 FCA Finalised guidance 16/1, Section 36(3). 34 FCA Finalised guidance 16/1, Annex B Section 6. 26/215

27 Diagram 4.1: Process diagram for my interpretation of part (a) of the Statutory Question: Is there an effect of the Scheme that the persons affected may consider to be adverse? NO LIKELY ADVERSE EFFECT NO YES Is that effect likely to occur? NO LIKELY ADVERSE EFFECT NO YES Is that effect material/significant to the affected person(s) on a gross basis i.e. excluding any mitigants? NO LIKELY ADVERSE EFFECT NO YES Are there mitigants being applied by LBG plc, or other mitigating factors, such as the affected person s ability to mitigate and/or bear the effect themselves such that the effect would, on a net basis, be considered immaterial/insignificant? NO LIKELY ADVERSE EFFECT YES NO Conclude that there is a likely adverse effect and therefore consideration moves to part (b) of the Statutory Question My interpretation of part (b) of the Statutory Question Consideration of reasonably necessary 4.26 Part (b) of the Statutory Question requires consideration of whether an adverse effect is greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. I note that the term reasonably necessary is not defined in the legislation and that the necessity of any adverse effect will depend on the specific cause and nature of the effect The Group has developed a solution to comply with the Ring-fencing Regime. That solution is aligned to its business and commercial strategy and seeks to minimise the effects of the Scheme on the majority of its customers by transferring products held by a smaller portion of customers into a newly established NRFB. Transferred products will include products that are required to be moved to the NRFB in order to comply with the Ring-fencing Regime as well as products that are being moved in order to minimise certain adverse effects for customers. If one assumes that at least some of those customers with products being moved are likely to be adversely affected (i.e. the answer to part (a) of the Statutory Question is yes), the question then becomes whether the adverse effect is greater than is reasonably necessary to achieve the requirements of ring-fencing. 27/215

28 4.28 It is my understanding that the Group has not necessarily sought to minimise the absolute level of adverse effect suffered by all of its customers, nor has it sought to create the most equitable distribution of that adverse effect across its entire customer base. The Group has approached its solution to ring-fencing by taking into consideration its whole customer base, seeking to minimise the effect of ring-fencing on its Retail Banking, Consumer Finance and the majority of its Commercial Banking customers, as well alignment to its business and commercial strategy. Therefore, the situation may arise where one group of customers has suffered an adverse effect and another has not, and that is the result of a strategic decision by the Group In consideration of part (b) of the Statutory Question, my Scheme Report considers the Group s overall approach, strategy and solution to achieving ring-fencing and includes an assessment of the governance process applied by the Group to approve the selected solution, and consideration of the alternative structures that were available to the Group and my understanding of the rationale for not selecting those alternative structures. This is covered in Section 5 of this Scheme Report However, in addition to the above macro considerations, I also consider whether any particular adverse effect was reasonably necessary. This has been analysed on an individual basis in order to understand what alternative options might reasonably have been available to the Group to avoid that adverse effect. Approach design of the Scheme and consideration of alternatives 4.31 I have not been directly involved in the design or formulation of the Scheme. I have considered the Scheme proposed by the Group only in the form in which it is to be presented to the Court. Other than in my consideration of whether an adverse effect is reasonably necessary, my analysis has focused on the answer to the Statutory Question and not whether the Scheme is the optimal design for any given group of persons. In particular, I consider that it is outside the scope of my work to consider whether the design of the Scheme is likely to maximise shareholder value: this forms part of the responsibilities of the Directors of LBG plc. Approach multiple Transferors 4.32 Any identified adverse effect within this Scheme Report is in relation to both Transferors unless I explicitly state that the adverse effect is specific to just one of the Transferors. 28/215

29 5. Approach to ring-fencing Introduction 5.1 In this section, I set out my consideration of the Group s approach to ring-fencing, including consideration of the alternative structures that the Group could potentially have adopted in order to comply with the Ring-fencing Regime. In particular, I have considered the following: The key design principles adopted by the Group in shaping the target ring-fencing structure; The high-level structures considered by the Group as options for the ring-fencing structure; The assessment of the alternatives that has been undertaken by the Group and the conclusion reached on the proposed approach to ring-fencing; and The detailed design considerations and the implications for the approach to ring-fencing. 5.2 My analysis focuses on whether there are alternative, plausible arrangements and structures that could have met the requirements of the Ring-fencing Regime, but with fewer adverse effects, or adverse effects that would have had a lesser effect on the relevant stakeholders, than are likely to arise under the Scheme as proposed. 5.3 This provides me with a framework to assess whether I believe that identified adverse effects of the Scheme that require consideration under part (b) of the Statutory Question are greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. In general, I would not classify the identified adverse effects as greater than reasonably necessary where such effects are either: An unavoidable consequence of any ring-fencing structure; or A result of the choice of overarching ring-fencing structure, where that structure has been chosen with the intention of limiting the scope and scale of adverse effects on customers and Other Relevant Persons, as discussed in Sections 6, 7, 8 and 9 of my Scheme Report. 5.4 My analysis and conclusions in this section relate to the overarching ring-fencing structure adopted by the Group and the resultant high-level design of the Scheme. Throughout the rest of my Scheme Report, where I have identified likely adverse effects of the Scheme, I have considered whether a small change to the Scheme could mitigate or otherwise alleviate this effect, whilst remaining consistent with the overarching design discussed in this section. My approach to the analysis 5.5 My analysis is based on the information provided to me by the Group, including summaries of the intended design of the ring-fencing programme and the decision-making process followed to reach that proposal, as well as the Banking Licence Application ( BLA ) for LBCM. 5.6 I have also considered the Group s Scheme Document and the witness statements prepared by representatives of the Group for the purposes of the application to the Court to approve the Scheme. 5.7 Where relevant, I have requested additional information from the Group to assist my analysis, as well as raised questions to aid my understanding of the information provided. 29/215

30 Key design principles 5.8 In his witness statement 35, Mr. Mark George Culmer, as a Director of both LB plc and BoS plc, has stated that the particularly relevant factors in determining the choice of ring-fencing model were: Whether the model aligned with the objectives of the Group to be the Best Bank for Customers, in line with its strategy; and Whether the model would minimise the effect on customers of ring-fencing, and limit the effect to a relatively small cohort of customers. 5.9 In my opinion, these are consistent with the high-level design principles that, based on the information provided to me by the Group, appear to have underpinned the choice of ring-fencing structure, as follows: Compliance with the requirements of the legislation: as I would expect, the choice of ring-fencing structure has been shaped by the requirements of the Ring-fencing Regime and, particularly, the activities prohibited under EAPO; The expected effect on customers: the information provided includes clear consideration of the expected effect on customers of the various options available; and The commercial and strategic implications of the structure: the information provided includes consideration of how the ring-fencing options align with the Group s business model, as a UK-focused, retail and commercial bank. The information also considers the commercial viability of the resultant structure and, as part of this, the likely credit ratings of the various entities after the restructure I discuss how these high-level design principles have shaped the design of the more detailed ring-fencing proposal later in this section. High-level structures considered by the Group 5.11 As discussed in detail in Section 3, at a high level, the Ring-fencing Regime requires certain large UK banks (including the Group) to ring-fence parts of their retail and SME banking activity, separating that activity from the rest of their business such as wholesale banking, investment banking, complex hedging and market making For some products and services currently provided by the Group, such as certain corporate and institutional business, wealth management activities and simple derivatives business, the flexibility allowed by the Ring-fencing Regime could allow these to be undertaken by either the RFBs or NFRB. The exercise of this discretion has been a key focus in my analysis of the alternative structures considered Based on the information provided to me, the Group evaluated three possible high-level ringfencing design structures that it believed would achieve compliance with the Ring-fencing Regime: Wide RFBs and narrow NRFB model: under this model, as many products and services would be kept inside the RFBs as is permissible under the Ring-fencing Regime; RFBs only Group: this would seek to create the widest RFBs possible, with any prohibited business that could not be accommodated within them either to be exited, unwound or allowed to run-off. As part of this option, the Group considered whether it could enter into a partnership with other banks and institutions to provide prohibited products, thereby allowing customers to continue to have access to these products; and 35 First Witness Statement of Mark George Culmer. 30/215

31 Narrow RFBs and wide NRFB model: this option would create narrower RFBs, with all transactions with large Global Corporates ( GC ) (with turnover exceeding 500m), services to Financial Institutions ( FI ) and other wholesale lending business in the NRFB These structures are consistent with the range of possible constructs of the RFBs that I would have expected the Group to consider. In particular, the structures are reflective of the overarching requirements of the Ring-fencing Regime, whilst reflecting the relative importance of the Retail Banking operations to the Group. For example, I would not have viewed it as credible that the Group would have sought to exit or unwind all the business required to be held in LB plc and BoS plc. Notwithstanding the considerations relating to the specific design decisions underlying the high-level design, which I discuss in this section, I am satisfied that there was no other high-level design structures that the Group could reasonably have considered to meet the requirements of the Ring-fencing Regime. Assessment of the alternatives 5.15 Based on the research and analysis undertaken within the Group, the Board of LBG plc concluded that the wide RFBs and narrow NRFB model was the optimal option, as it is expected to minimise the strategic, operational, business and legal disruption to the Group s customers while complying with the regulatory requirements. In reaching this decision, the Group considered the consistency of the various options with the high-level design principles discussed above, as well as detailed analysis on the likely commercial and operational effects of each of the options considered. I have set out a summary of the Group s findings and analysis, and my conclusions thereon, in the following subsections. Customer effect 5.16 As set out above, the effect of ring-fencing on customers has been one of the key considerations for the Group in reaching a proposed ring-fence approach The RFBs only Group model would have resulted in customers with prohibited products and services no longer having access to these from within the Group. While the significance of this effect could have been reduced by operating a partnership model, where another bank outside of the Group or a joint venture provides the prohibited product or service, the Group considered that there would be a material adverse effect on the client experience due to customers having to deal with the complexity of interacting with the partnership provider or joint venture The Group s analysis also notes that providing customers with a consistent customer proposition was a factor in the choice of decision. As part of this, customers of both the NRFB and the RFBs will have a single Relationship Manager ( RM ), who will be able to source products from across both the RFBs and NRFB. Such a service model would have been more challenging or impractical under the RFBs only Group approach As discussed later in this section, the wide RFBs and narrow NRFB model was viewed by the Group as minimising disruption to customers, as it allows the Scheme to be structured in such a way to minimise the number of customers who are transferred. Operational effect 5.20 The Group also considered the expected operational implications of the choice of ring-fencing approach. Its intention is to operate a Shared Service Model ( SSM ) following implementation of ring-fencing. This reflects the Group s desire to avoid unnecessary duplication of systems and services, which would otherwise increase the one-off and ongoing cost of the changes. It also reduces the risk of the RFBs and NRFB competing for business The Group s analysis suggests that the cost of fully separating the systems would be substantial. In my view, the proposed approach, with a wide RFBs and narrow NRFB model, 31/215

32 reduces the likelihood that such a separation would be required, as the business in LBCM constitutes a relatively modest percentage of the overall Group business I discuss the SSM in more detail later in this section. Commercial and strategic implications 5.23 The Group s analysis also considered the effect of the choice of ring-fencing approach on the commercial position of the Group and whether the approach was consistent with its strategy In particular, the choice of a narrow or wide NRFB is expected to have a bearing on the eventual credit ratings of LBCM and, as discussed later in this section, the Group believes the choice of a narrow NRFB is more likely to lead to the target credit ratings being achieved than a wider NRFB. While there remains uncertainty on the final credit ratings of LBCM, two of the main credit rating agencies provided preliminary or expected ratings on 17 July 2017, with Standard & Poor s ( S&P ) and Fitch rating LBCM as A- and A respectively. Moody s provisional rating for LBCM of A2 was published on 7 November The credit rating is an important factor for customers and Other Relevant Persons that will have exposure to LBCM and has an effect on the commercial viability of LBCM, as discussed later in this section The Group s analysis, which supported the decision-making process, also considered financial implications, capital and funding sustainability, resilience under stress scenarios and competitive positioning The Group considered the consistency of the various ring-fencing approaches with its strategy. As a UK-focused, mainly retail bank, the Group s opinion was that a wide NRFB would be inconsistent with that strategy. Further, as noted above, the choice of a narrow NRFB is expected to result in less disruption to customers than would be the case for the RFBs only model or the narrow RFBs and wide NRFB model, which is in line with the stated strategy of being the Best Bank for Customers. Conclusions 5.28 While I have not sought to validate independently the analysis produced by the Group on which it has based its decision on the high-level proposed structure post-ring-fencing, I have considered the analysis undertaken and the stated rationale for the choice made. Based on the information I have seen, I am satisfied that the Group assessed a reasonable range of alternative high-level structures and has reached a decision that is supportable. In particular: Given the Group currently offers certain products and services that would be prohibited within an RFB, I am satisfied that it was unavoidable for the Group to make changes to its structure in order to comply with the Ring-fencing Regime; The choice of a wide RFBs and narrow NRFB model is expected to result in fewer customers being affected than either an RFBs only model or a narrow RFBs and wide NRFB model. Had the chosen approach resulted in the Group ceasing to offer prohibited products and services, or to fundamentally change the way in which they are offered, for example through a partnership model or joint venture, I would have expected this to be more disruptive to customers. In that scenario, the customers would have had to source alternative arrangements and would potentially have been unable to replicate the existing arrangements under similar terms. While there will be some changes to the products and services offered (as discussed in my consideration of the effects of the Scheme on Commercial Banking customers in Section 6), the expected changes are relatively minor in nature when compared to ceasing to offer those products and services to this segment of the market altogether. In my view, given the stated importance of limiting customer disruption, the choice of a wide RFBs and narrow NRFB model is a logical decision for the Group to reach; and 32/215

33 Governance The Group has considered the commercial and strategic implications of the choice of ringfencing approach. The chosen high-level design is, in the Group s opinion, most closely aligned to its areas of strategic focus of becoming the Best Bank for Customers and of delivering sustainable growth, as well as being expected to support the target credit ratings (a view supported by the preliminary or expected credit ratings). In my opinion, these are important and relevant factors for the Group to consider and I am satisfied that the conclusion reached reflects this As part of my analysis on this topic, I have considered the governance process followed by the Group in reaching its decision on its proposed approach to ring-fencing. My analysis has been high-level in nature as, although it is important that an appropriate governance process to support the decision has been followed, my main focus is on understanding the effect of that decision on customers and Other Relevant Persons The Group has provided me with a summary of the board meetings of the relevant entities within the Group where ring-fencing was discussed, as well as reports presented and discussed at those meetings, and an overview of the key decisions taken at those meetings. Between June 2013 and October 2016, there were 13 LBG plc Board meetings that covered ring-fencing. The early meetings (from mid-2013 onwards) were focused on the regulatory requirements and the proposed key design principles for ring-fencing. As the requirements became clearer, the reports presented and discussed reflect an increasing focus on the detailed aspects of the design, as well as the plans for implementing that design and the approval of key aspects of the approach. In particular, the LBG plc Board provided approvals related to: The submission to the PRA and the FCA on ring-fencing, an important document which sets out the key aspects of the Group s approach to ring-fencing; and The sign-off of the application to license LBCM by LBG plc s Chief Financial Officer ( CFO ), which is a core part of the approach to ring-fencing Based on the examples I have seen, the analysis presented to the boards or board committees of the relevant entities within the Group was both quantitative and qualitative and summarised the expected effects of the ring-fencing programme and how those would vary depending on the high-level approaches under consideration Based on the information I have seen, I am satisfied that the LBG plc Board was appropriately involved in the key decisions that have shaped the approach to ring-fencing. As I would have expected, the topic was frequently discussed, particularly in more recent years when the key decisions were being made. The information demonstrates that the LBG plc Board agreed the key high-level design principles at an early stage, which have been important in supporting the more detailed design decisions that have subsequently been taken. Detailed design considerations 5.33 In this subsection, I have considered some of the specific design considerations and the implications of these on the design of the Scheme and the approach to ring-fencing more generally. In particular, I have considered: How the requirements of the legislation have affected the decision on which products and services to transfer under the Scheme; The concept of the SSM and its implications for a narrow NRFB and governance; How the approach to ring-fencing could influence the credit ratings achieved by, particularly, LBCM; Whether the resulting design results in an NRFB that is commercially viable, in delivering an adequate return on the equity invested in it; and 33/215

34 What business transfers will arise under the Scheme and whether those transfers are to or from the RFBs. Requirements of the legislation Key requirements 5.34 Fundamentally, as set out in Section 3, the ring-fencing approach adopted will have to achieve compliance with the requirements of the Ring-fencing Regime. These requirements have been key in determining the design of the Scheme and the wider group restructuring and, in particular, the Group has highlighted four regulatory requirements that were of particular importance to the detailed design decisions that were taken: The RFB will be unable to maintain, establish or have a participating interest in a branch or entity in any country or territory outside the EEA; The RFB will be unable to continue to provide products or services which result in a prohibited exposure to an RFI; The RFB is not permitted to carry on certain activities, which means that certain products, including complex derivative transactions, cannot be offered by the RFB (unless there is an available exception); and The RRR Limit of Article 12 (1.a) of EAPO places limits on the extent of derivative activities that are allowed in the RFB, as set out later in this section The products and services offered to Retail Banking and Consumer Finance customers in the UK should be largely unaffected by these requirements, as they are permitted under the Ringfencing Regime (the exception to this, as discussed in Sections 7 and 8, relates to a very small number of RFIs in the Retail Banking division and Consumer Finance sub-division) In contrast, non-eea business will no longer be able to be held in the Transferors and actions will have to be taken to move these products and services. These changes are not being effected by the Scheme and are not a focus of my Scheme Report For UK business, the main group of customers affected by ring-fencing are in the Commercial Banking division. The majority of the prohibited products and services currently offered by the entities that will form the Transferors are provided to customers in that division. This is in line with what I would have expected, given the types of customers served by Commercial Banking and the relative complexity of the products and services that they access Commercial Banking was also the key area where the Group had substantial discretion as to whether the products and services should be provided by the Transferors or LBCM, because some of the products and services offered were neither required to be held nor prohibited from being held in the Transferors under the Ring-fencing Regime As a result, the key design decisions taken by the Group relate to customers in this segment and I have considered these in detail in the following subsections. My conclusions on the effect of the Scheme on Commercial Banking customers are set out in Section I note that, even within this customer segment, the Group s decision to implement a wide RFBs and narrow NRFB model will result in the majority of the products and services offered to Commercial Banking customers remaining unchanged and residing within the Transferors. As a result, it is only approximately 4,000 customer legal entities 36 (which represents approximately 36 The customer numbers are based on the Group s best estimate of the customers that would have their products transferred under or duplicated pursuant to the Scheme but do not account for (a) multiple fund entities within a customer group that may, or have, the option to participate within lending facilities where the Group data recognises only a single entity as the principal borrower; and (b) approximately 255 customers (across all divisions in the Group) whose products may be curtailed by the Group, but for avoidance of doubt will receive appropriate communications as per the First Witness Statement of Mark George Culmer. 34/215

35 1.4% of the total number of customer entities in Commercial Banking) who will have products transferred under or duplicated pursuant to the Scheme. Implications of ring-fencing on Commercial Banking 5.41 Diagram 5.1 summarises the movement of products, services and customers within Commercial Banking as a result of the Scheme. Additional information on this diagram is provided in paragraph Diagram 5.1: Commercial Banking product and customer booking view. SME SME RFI MM RFB MM GC RFI GC RFI FI FI RFI SME SME RFI MM LBCM MM GC RFI GC RFI FI FI RFI Lending Global Transaction Banking Variable rate loans Fixed rate loans Revolving Credit Facilities Business mortgages Inflation-linked loans Cash Management and Payments Overdrafts Asset Finance Invoice Finance Trade Finance & Supply Chain Trade Services CB Markets Traded Products Foreign exchange Rates Commodities Repurchase Agreements Money Markets Liabilities Management Credit Spot foreign exchange Permitted Products Excluded Products Permitted Products Excluded Products CB Markets Financing Bonds Asset Securitisation Conduit Strategic Debt Finance Loan Markets Warehouse Financing Term Securitisation Key: Product not offered Permitted exposure booked to RFB Excluded exposure booked to LBCM Non-EEA exposure booked to LBCM international branches Permitted exposure booked to LBCM based on strategic booking choice Product not planned to be offered Product booked under exceptions in EAPO Future proposition to be determined Source: Information provided by the Group Diagram 5.1 demonstrates that the majority of the product types that will be transferred are required to be transferred by the Ring-fencing Regime. This is in line with the Group s highlevel choice of a wide RFBs and narrow NRFB model. The main discretion exercised by the Group relates to the exceptions to this rule, which are shown by the boxes coloured red. These 35/215

36 reflect strategic decisions made by the Group to transfer Permitted Derivatives traded by GC and FI customers and certain foreign exchange rate products While the individual products themselves are not prohibited, the Permitted Derivative instruments are being transferred under the Scheme to achieve compliance with the RRR Limit set out in the EAPO. The RRR Limit restricts the derivative exposure of the Transferors and is discussed further in the subsection that follows The foreign exchange rate products transferring to LBCM are a mixture of permitted and prohibited derivative instruments that the Group would typically expect to be held by customers to help manage their risk exposures. Retaining all of these in the Transferors could lead to some customers having their products split across two banks. I discuss the likely effects of including these products within LBCM in more detail in Section 6. RRR Limit and implications for ring-fencing design 5.45 The EAPO sets out quantitative limits for the Relevant Risk Requirement ( RRR ), which is a measure of the market risk capital requirement for the relevant positions. This acts as a constraint on the level of derivative activity within the RFBs. In particular, the following limits are set: Net RRR Limit: the RRR attributable to: (a) All transactions entered into which meet the conditions in Articles 9 to 11 of the EAPO (which set out the Permitted Derivatives); and (b) Any investments traded by the RFB that meet the conditions of Article 6(1) of the EAPO, for the purpose of hedging risks arising in relation to the transactions referred to in (a) (provided that those investments are hedged separately from any other investments entered into by the RFB under Article 6(1) of the EAPO); is at all times less than 0.5% of the RFB s own funds (defined as the sum of Tier 1 and Tier 2 Capital). The Net RRR Limit constrains the market risk associated with derivatives; Gross RRR Limit: the sum of the RRR attributable to each individual transaction with an account holder under Articles 9 to 11 of the EAPO is at all times less than 25% of the credit risk capital requirement of the RFBs. In calculating the sum of the RRR, no RRR may be set off against any other RRR. The Gross RRR Limit constrains the volume of derivatives; and RRR Limit for Options: the sum of the RRR attributable to the transactions entered into by the RFB under Article 11 of the EAPO (i.e. options and swaptions) is at all times less than 20% of the sum of the RRR attributable to the transactions entered into by the RFB under Articles 9 to 11 of the EAPO. The RRR Limit for options constrains the complexity of the derivatives I note that these RRR Limit requirements: Relate to derivative types specified in Articles 9 to 11 of EAPO; Do not include positions kept in the RFB as a result of the Grandfathering exemption (as discussed later in this subsection); Are expected to be complied with at all times; and Are applicable separately to each RFB (i.e. on a per-legal-entity basis) As part of the analysis to determine the proposed form of LBCM, the Group has considered the effect of retaining the various sections of Permitted Derivatives on the RRR Limit of the Transferors. I have not sought to verify the calculations performed and note that the values will depend on the holding at a given date and under market conditions at that time. Notwithstanding this, I view the analysis as helpful in supporting the consideration of the design of the Transferors and LBCM. 36/215

37 5.48 In theory, in the absence of the RRR Limit, all Permitted Derivatives transacted with non-rfi customer entities in the five Commercial Banking segments (SME, Mid-Markets ( MM ), GC, FI and Client Asset Management ( CAM )) could remain in the Transferors. However, if the Transferors were to do so, the analysis performed by the Group suggests that the RRR Limit would be breached by several times the regulatory limit. This would prevent the Transferors from complying with applicable regulations and, therefore, necessitates the transfer of some Permitted Derivatives to LBCM, with the Group proposing to transfer all derivatives (subject to application of the Grandfathering rules) held by customers in the FI segments and all derivatives held by customers in the GC 37 segment with a maturity date after 31 December 2020, and subject, in each case, to the application of optionality granted to these customers in respect of any short-dated derivatives This inclusion of FI customers reflects the Group s view on: The relatively large volume of derivatives held by FI customers and, therefore, the importance of moving these to comply with the RRR Limit; The expected relative financial sophistication of the customers and, therefore, their ability to understand the effects of a transfer under the Scheme; and The tendency of these customers to collateralise derivatives, which limits the extent of customer exposure to the entity in which they are held, mitigating the effect of exposure to an entity with a potentially lower credit rating However, based on the Group s analysis, moving the FI derivatives in isolation would not be sufficient to keep the entities within the Transferors within the RRR Limit The Group s analysis also highlighted that transferring all of the GC derivatives (other than those with a maturity date up to and including 31 December 2020) to LBCM would address the expected breach of the RRR Limit. The Group has not identified a subset of the derivatives held by the GC segment that could be retained within the Transferors while maintaining compliance with the RRR Limit. Such an approach would have created an artificial split within the GC segment, under which not all similar customers would have been treated equally (for example, if one customer was able to retain the product in the Transferors, but another was not able to do so). Furthermore, holding the maximum permitted amount of GC derivatives in the Transferors (whilst maintaining compliance with the RRR Limit) could limit the ability of the Transferors to enter into new Permitted Derivatives in the future, which could be detrimental to the interests of the Transferors customers Retaining the SME, MM, CAM and Commercial Real Estate Private Group ( CRE Private Group ) Permitted Derivative instruments (where not held by RFIs) is expected to allow the RFBs to meet the RRR Limit, while also providing headroom within these limits to avoid restricting the business that could be carried out by the Transferors with these customers in future As a result, the Group has decided to transfer to LBCM all the derivatives held by customers in the FI segments and those held by customers in the GC segment (excluding CRE Private Group) with a maturity date after 31 December 2020, while keeping in the Transferors all Permitted Derivatives transacted with non-rfi entities of the SME, MM, CRE Private Group and CAM segments and short-dated derivatives held by customers in the GC segment, subject to offering an option on Grandfathering or otherwise transferring certain transactions (these options are detailed in paragraphs 6.15 to 6.17 and 6.95). This allows the Transferors to meet the RRR Limit requirements and, as noted in paragraph 5.52, provides room for future derivatives activity of non-rfi entities for SME, MM, CRE Private Group and CAM customers. 37 Excludes Commercial Real Estate Private Group ( CRE Private Group ) customers belonging to the GC segment as they will be treated like MM customers from a transferring derivatives perspective (for example, Permitted Derivatives will not transfer subject to certain optionality). 37/215

38 5.54 The Group also considered moving some credit exposures from BoS plc to LB plc to comply with the RRR Limit requirements. However, in such a case, the effect on LB plc s RRR metrics would still not be sufficient to meet the RRR Limit requirements Based on my analysis, I am satisfied that the Group had to transfer some of the Permitted Derivative exposure to LBCM. As the proposed transfers are dependent on the customer segmentation model used by the Group, I have considered the reasonableness of the customer segmentation applied by the Group. The allocation of customer groups to the five Commercial Banking segments, namely GC, FI, MM, SME and CAM, is based upon a range of factors, including but not limited to turnover, lending size, having other banking relationships, geographic and product needs and sector specific requirements. The criteria applied to allocate a customer group to the five segments will not be changed as a result of the Scheme and I have considered the approach adopted by the Group to assess the Transferring Customers against the Group s criteria for inclusion in each segment. This analysis did not highlight any areas where customers were allocated out of line with the criteria; however, I noted two customer groups that required further analysis: Customers in the independent upstream oil and gas business have been allocated to the GC segment despite meeting the turnover/lending size criteria for allocation to the MM segment. This exception has been made to service better the distinct financing and hedging needs of these customers from LBCM s oil and gas industry specialists which, given the complexity of the product requirements for this customer group, I am satisfied is a reasonable approach; and There are 16 Special Purpose Vehicles ( SPVs ) related to infrastructure projects (15 GC entities and one FI customer entity) that are characterised as not sophisticated according to Markets in Financial Instrument Directive ( MIFID ) rules. These entities are part of much larger customer groups that meet the criteria for allocation to the GC and FI segments, where the customer group would be considered sophisticated. As a result, I am satisfied that this allocation is reasonable As a result, I am satisfied that it is reasonable for the Scheme to treat customers within a segment in a consistent way. While there was discretion to meet RRR Limit requirements, the model reduces the risk of splitting the customer groups in a way that is inconsistent with the Group s current classification of customer groups and avoids treating customers of a similar type inconsistently. Further, I believe that it would be impractical to design the Scheme at a customer-by-customer level and that the segmentation approach is a necessary solution to this practical problem. The design decisions made reflect the expected characteristics of those segments (as discussed elsewhere in Sections 5 and 6 of this Scheme Report) and I am satisfied that this is a reasonable approach Given that the assessment of compliance with the RRR Limit will depend on a number of factors, which will vary over time, including the business held within the Transferors, I expect to revisit this analysis in my Supplementary Report to determine whether the planned transfers under the Scheme are still expected to result in compliance with the RRR Limit. Grandfathering 5.58 Article 21 of the EAPO includes a transitional provision which states: A ring-fenced body does not carry on an excluded activity or contravene a prohibition imposed by this Order by holding or selling any investments on or after 1st January provided that: The investment in question was created or acquired by the ring-fence body before 1st January 2019; and The period remaining until the investment matures is less than 2 years at 1st January Therefore, derivatives that are entered into before 1 January 2019 and mature before 1 January 2021 do not need to be transferred to comply with the Ring-fencing Regime. This rule is referred 38/215

39 to as Grandfathering. I discuss this further in paragraphs 6.15 to 6.17 as part of my consideration of the effects of the Scheme on Commercial Banking customers Nearly all of the Category 1 Customers (as defined in paragraph 17.14) have, from the end of January 2017 onwards, been receiving communications about the Scheme through their relationship managers (referred to as Stage 1 and Stage 2 communications). These communications are currently expected to continue until 30 November 2017 and in any event will have been completed no later than the date on which Category 1 Customers receive the individual notifications to be sent to those customers following the Directions Hearing I have reviewed the template Stage 2 communication documents dated July 2017 which cover Grandfathering and its implications. They were tailored for each client, listing all their trades which are subject to Grandfathering and requesting that they let their RM (and also communicate to a dedicated ring-fencing ) know by 28 February 2018 if they wish to opt out of the default position. Taken together with the later formal communications in relation to the Scheme, as discussed in Section 17, I am satisfied that customers have sufficient time to make an informed decision The default Grandfathering position reflects the Group s view on the likely balance of advantages and disadvantages of transferring or not transferring these exposures before it is necessary to do so from the affected customers perspectives. Given that the application of Grandfathering is the customer s choice, I am satisfied that the proposed approach does not lead to any adverse effects for the customers with derivatives that mature before 1 January SSM 5.63 Following the Effective Date, the Group will be providing products and services from a new bank, namely LBCM. In order to limit the duplication of infrastructure and functions that would occur if LBCM was to provide these products and services by relying only on services, infrastructure and functions that it owns directly, the Group is intending to utilise an SSM. Under this model, the critical infrastructure and functions for service provision are held within the Transferors, which will then provide these services to LBCM (as well as the Insurance Subgroup and Equity Investments Sub-group) I expect this model to reduce both the one-off and the ongoing cost implications of ring-fencing, relative to a model where all the services were duplicated in LBCM or where all infrastructure and services were moved to a separate subsidiary. I also expect this model to reduce the complexity of the implementation of the Scheme, and the Ring-fencing Regime more broadly, as it reduces the scale of the operational change required to provide critical services to both the Transferors and LBCM after the Effective Date In addition, the Group has highlighted that it expects this model to help ensure operational continuity, as critical functions will be provided uninterrupted, irrespective of the financial health of LBCM or the other parts of the Group more generally. This is expected to support the efficient and robust delivery of services in the event of a recovery or resolution scenario. This is further discussed in Section 12 of this Scheme Report As part of this model, the Group s proposed structure includes a single customer RM model, where one RM is able to access products from both the Transferors and LBCM in order to serve customer needs most effectively. The Group has identified that such an approach should help ensure consistency of approach and outcomes and help to avoid the situation where the Transferors and LBCM could compete against each other to offer the same products. This single RM is further discussed in paragraph I note that the approach leads to a dependence on the Transferors by LBCM, which could lead to challenges in the viability of LBCM as a stand-alone bank should the Transferors fail. I also note that the overall approach to ring-fencing, and particularly the relative size of the 39/215

40 Transferors, the heavy alignment to the Group and that the Transferors will provide the critical services, could potentially lead to governance challenges, as it could be difficult to split the interests of the Transferors and LBCM I consider this matter in some detail in Section 11 in this Scheme Report, but note that LBCM will have its own governance framework, which will be led by the LBCM Board. This governance framework will include senior executives with responsibility for the oversight of intra-group sourcing, including discharging all relevant regulatory responsibilities and will include mechanisms for the identification and escalation of issues relating to the services being received by LBCM. The Group is also introducing Ring-fence Control Teams ( RFCTs ) which will specifically monitor ring-fencing compliance, including in relation to the independence of decision-making Overall, I recognise the benefits of the SSM and am satisfied that it is a reasonable approach to meeting the requirements of the Ring-fencing Regime. Credit rating 5.70 The credit rating of an entity is a forward-looking opinion regarding the creditworthiness of a borrower with respect to their financial obligations. These are often provided by a rating agency (such as S&P, Fitch or Moody s), but some stakeholders will develop their own internal view of creditworthiness The credit ratings of LBG plc and the other entities within the Group that are rated are important to stakeholders, such as fixed income investors who hold tradable issuances, customers who have exposure to the various banks within the Group through derivative holdings and other creditors. This is because the credit ratings are an indication of the rated entity s ability to repay debt and of the likelihood of that entity defaulting on their borrowings I expect the design of the Transferors and LBCM to have an effect on the credit ratings of the relevant entities and, potentially, on the Group. For example, if LBCM is not as well capitalised as the Transferors or was structured in such a way as to affect its commercial viability (under a bottom-up assessment, as detailed in paragraph 5.79) or was not deemed to be a sufficiently important part of the wider group (under a top-down assessment), then I would expect it to potentially have a correspondingly lower rating. As a result, the preliminary or expected credit ratings and the effect of these on LBCM and the Transferors structures has been an important consideration for the Group in designing the ring-fencing solution. Credit ratings of LBG plc and the Transferors 5.73 Whilst the credit rating agencies are yet to confirm what the credit ratings applicable to LBG plc will be post-scheme, I have not seen anything to suggest that a change (and particularly a significant change) to this rating as a result of ring-fencing is likely. This is also true for the Transferors Similarly, while I do not have insight into the different approaches that individual stakeholders would use to develop their own view on the LBG plc and Transferors creditworthiness, I have no reason to expect any significant change to the current rating as a result of the Scheme. Credit ratings of LBCM 5.75 The Group expects that the creditworthiness of LBCM will be considered by customers and by market participants to be lower than that of the Transferors prior to the Scheme. I believe that it is reasonable to expect that LBCM, with a narrow business model and greater susceptibility to certain stress situations, will be considered riskier than the Transferors I recognise that it could be possible to hold additional capital in LBCM in order to improve its ability to withstand shocks and, potentially, its creditworthiness. However, in my view, it is far 40/215

41 from certain that such a move would be sufficient to address the more fundamental perceptions of the riskiness of LBCM post-scheme. Consistent with this view, in their note from 17 July 2017, S&P indicate that they do not believe that the rating on LBCM would be sensitive to additional capital being held. Further, injecting capital in this way would result in a reduction in the Return on Equity ( RoE ) measure of profitability, potentially reducing the ability of LBCM to function as a commercially viable company, as discussed further in the following subsection As an indication of the expected change, based on preliminary or expected ratings, the Group currently expects the credit ratings of LBCM to be equivalent to A2 from Moody s, A- from S&P and A from Fitch, which is lower than the Transferors current credit ratings at Aa3 (Moody s), A (S&P)/ A+ (Fitch). While this remains subject to confirmation, I believe it to be indicative of the likely outcome I note that the current preliminary or expected credit ratings would still be classified as investment grade (specifically, the preliminary rating is higher than the BBB- (in S&P terms) minimum threshold), which I would expect to be an important consideration for many customers and other stakeholders The rating achieved will depend on, amongst other things, whether LBCM is assessed using a top-down approach (where the rating would be based on the ratings of the entities in the Group, adjusted for the significance of the subsidiary to its operations) or a bottom-up approach (where the rating would be based more heavily on the financial and operational position of the subsidiary itself, adjusted for potential support from the Group) One of the reasons for the design chosen, and specifically the narrow NRFB, was to maximise the likelihood that the Group would be expected to support LBCM (assuming that providing such support did not endanger the Transferors). Should such support be forthcoming, the creditworthiness will be underpinned to some extent by the credit rating of LBG plc. A wide NRFB would limit the ability of the Group to support LBCM in times of stress, as the size of support required could exceed the support available. This is less likely for a narrow NRFB. A top-down approach has been used by both S&P in its preliminary rating and Fitch in its expected rating. This is also in line with the public guidance provided by S&P on its methodology for rating bank subsidiary companies Moody s provisional rating for LBCM of A2 was published on 7 November 2017 and is based on a bottom-up approach, adjusted for potential support from the Group I would expect the internal views developed by other stakeholders to be based on similar considerations to those of the rating agencies Given the element of subjectivity in all credit rating decisions, it is not possible for me to know the credit ratings of LBCM or any other entity with certainty, nor stakeholders own assessments of the credit ratings, prior to such time as the credit rating agencies and stakeholders have completed their analysis. However, based on the disclosures by the rating agencies to date, I am satisfied that such uncertainty would be applicable regardless of the design of LBCM given that it is a new entity that has not yet been formally rated Where the credit ratings have a particular bearing on my analysis I have considered how my conclusions could change based on the credit ratings and, where relevant, have included additional analysis to demonstrate the effect on my conclusions I will continue to monitor the credit ratings of LBG plc, the Transferors and LBCM and the expected effect of ring-fencing on their credit ratings and will provide an update in my Supplementary Report on the Scheme, if required. 41/215

42 Commercial viability 5.86 The design of the Scheme and the wider group restructuring will have an effect on the commercial viability of the Transferors and LBCM in the future. In my opinion, it is important to the ongoing provision of service to customers that they are held in an entity that is not only able to meet its regulatory capital requirements (as discussed in Section 10 of this Scheme Report), but also one that is expected to provide an adequate return to its owners. Failure to do so could result in the shareholder deciding to dispose of or wind down the business, including ceasing to continue to offer products and services to existing customers In considering the potential implications of the design choices on viability, I have analysed viability as measured by the ability of the relevant entity to generate profits relative to the level of shareholder equity held in the entity. This RoE measure can be compared against the expected cost of raising equity to give an understanding of the ongoing commercial attractiveness of owning or investing in a given entity. Where a company is not expected to be able to generate an RoE at least in line with its cost of raising equity over the medium-term, then its commercial viability is in question While this section focuses on commercial viability purely in relation to the RoE, I expect that it is only one of a number of factors that would be relevant in the Group s assessment of the ongoing viability of LBCM post-scheme. In particular, I note that limiting the customer effect of ring-fencing was a key consideration for the Group in designing the approach to ring-fencing and that it identified strategic reasons why it wanted to continue to provide the products and services that will be offered by LBCM. As a result, it is possible that the Group could continue to operate LBCM even if it is not generating an RoE in excess of its cost of equity The Group has produced projected RoE figures for LBCM under three potential credit ratings. The results highlight the current expectation that the RoE of LBCM will be lower than the target for the Group. As the Transferors are expected to be the dominant part of the Group, and given current market and operational conditions, I expect the RoE of the Transferors to be higher than that of LBCM. These projections are commercially sensitive and I have not included them in this Scheme Report The Group has confirmed that only the Group s cost of equity is considered when making business decisions and that individual businesses and business decisions are measured against their ability to generate an RoE that exceeds this cost of equity. There is not a separate cost of equity applicable to entities within the Group. The projections show that the expected RoE for LBCM is higher than the expected cost of equity for the Group over the longer term, provided that the credit rating is A- or A (S&P equivalent) Based on the central case in the analysis produced by the Group, LBCM is expected to, at least, be able to meet the assumed cost of equity from 2019 onwards. While there is uncertainty in these projections, I am satisfied that LBCM is expected to be commercially viable. Structure of the transfers under the Scheme 5.92 The Group intends to effect the narrow NRFB structure by means of various corporate restructuring activities and the Scheme itself, which legally transfers business out of the Transferors into LBCM I note that, as an alternative to transferring from the Transferors to LBCM, the business required to be ring-fenced could be transferred out to a new RFB, with the retained business in LB plc and BoS plc forming the NRFB. I note that such an approach would result in the significant majority of the Group s business, including the retail business, transferring under the Scheme. While I have not analysed the potential consequences of this alternative approach in detail, I would expect such an approach to increase the scope for adverse operational effects (simply because more customers would need to transfer between legal entities), as well as potentially increasing the scope for confusion within the retail customer group. In addition, under this 42/215

43 alternative, it would not be possible for that new RFB to receive services under an SSM operated by LB plc (which would be an NRFB, and therefore outside that new RFB s sub-group, in that scenario) and key contracts would therefore have to be transferred to the new RFB to comply with the Ring-fencing Regime on servicing arrangements, with a consequential operational effect for customers, other third parties and other Group entities Given these potential complications with the alternative structure, I am satisfied that the approach taken by the Group in designing the Scheme to transfer business out of the entities that will form the RFBs is consistent with the wider aim of minimising disruption to customers. Overall opinion 5.95 Overall, I am satisfied that the choice of ring-fencing structure, by minimising adverse effects to a relatively small cohort of customers, is consistent with the principles adopted by the Group. This choice has been supported by the consideration of a wide range of possible alternative structures and the analysis and governance on the likely outcomes under the various structures. In general terms, I am satisfied that the design chosen is reasonable in nature, such that any identified adverse effect arising as a direct result solely of the high-level design of the ringfencing programme, and the Scheme, will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. Elsewhere in this Scheme Report I analyse in detail whether any specific changes could have been made to the design of the Scheme to reduce or eliminate adverse effects on customers or Other Relevant Persons without representing a change to the high-level structure discussed in this section. 43/215

44 6. Implications for Commercial Banking customers Introduction 6.1 In this section, I consider the likely effect of the Scheme on the Commercial Banking customers of the Group. My conclusions in this section focus on the likely effect of the Scheme itself and my analysis has also considered other restructuring activities being undertaken in order to achieve compliance with the Ring-fencing Regime, to determine whether those activities have any effect on my conclusions in respect of the Scheme. 6.2 Whilst this section of my Scheme Report considers the specific effect of the Scheme on Commercial Banking customers, certain other sections of my Scheme Report consider other effects of the Scheme that may be applicable to all customers, and Other Relevant Persons. Therefore, this section does not contain all effects of the Scheme that may be relevant to Commercial Banking customers and consequently my Scheme Report should be read in its entirety. 6.3 Some of the potential adverse effects considered in this section of my Scheme Report involve products that may be considered to be complex. Given regulatory requirements with respect to the sale of these products it can be assumed that the customers involved in such transactions are financially sophisticated. Consequently, some of the explanations used are technical in nature as they should only be applicable to customers that are familiar with the relevant products. Definition of Commercial Banking, its customers and products 6.4 Commercial Banking customers are defined by the Group as any business with a turnover greater than 1m, who hold products or services offered by the Group ( Commercial Banking customers). The Group divides the Commercial Banking customer base into five main segments, which are defined by their sub-segments, as shown in Table /215

45 Table 6.1: Commercial Banking customer segments as at 20 October 2017 Segment Sub-segment Customer definition Small and Medium Sized Enterprises ( SME ) Mid-Markets ( MM ) Global Corporates ( GC ) Financial Institutions ( FI ) Business Business Education, Charities and Government Social Housing Business Business Commercial Real Estate ( CRE ) CRE Private Group Banks Insurance Pensions, Wealth and Stockbrokers Financial Sponsors Institutional Investors Intermediaries Turnover of 1m - 25m or Lending of 75k m Turnover of 25m - 750m (or up to 500m in London) Higher and further education institutions, charities and local government organisations Housing Associations who build and manage more than 1,000 residential housing units Turnover in excess of 750m (or 500m in London) Real Estate companies with asset values in excess of 25m or the Group lending in excess of 12.5m Subset of CRE consisting of entrepreneurs and smaller property companies Banks (including correspondent, agency, UK challenger banks and other international banks) and Building Societies UK-based life, non-life and composite insurance companies, international insurers with a UK presence and brokers UK-based pension administrators, wealth managers and stockbrokers Private market investment managers (and funds) Asset Managers and Sovereign, Supranational and Agency bodies Brokerage firms, clearing and settlement firms, exchanges and market data firms Specialist lenders and debt purchasers Number of customer entities with products transferring, or contracts being duplicated, under the Scheme* ,493 Specialist Finance Group Subsidiaries The Group entities Government UK central Government and Bodies Government Bodies Client Asset Management ( CAM ) 30 TOTAL 3,449 Source: Information provided by the Group. * Includes customer entities with products subject to mandatory transfers, optional transfers and duplicating empty agreements. 45/215

46 6.5 Commercial Banking customers use a wide variety of financial products and this typically varies by the segments identified. For example, an SME s needs are generally simpler than that of a large FI and this is reflected in the complexity of products that they require. The products or services provided by the Group to Commercial Banking customers are summarised in Table 6.2. Table 6.2: Commercial Banking products Product business Product Family Brief Description Lending Variable rate loans Debt with interest linked to a benchmark such as the London Interbank Offered Rate ( LIBOR ) Fixed rate loans Debt with a fixed interest rate Revolving Credit Facilities Flexible funding with committed facilities Business mortgages Funding secured against commercial property Global Transaction Banking Markets Traded Products Markets Financing Inflation-linked loans Cash Management and Payments Overdrafts Asset Finance Debt with interest linked to the Retail Price Index ( RPI ) Processing payments and managing cash flows Business overdrafts for short-term funding Funding for assets such as vehicles or equipment Invoice Finance Funding using invoices as collateral Trade Finance and Funding and financing which facilitate domestic Supply Chain and international trade Trade Services Products to mitigate counterparty risk for customers trading internationally Foreign exchange Spot and derivative instruments Rates Interest rate and inflation products Commodities Spot and derivatives including: oil, coal, gas and power, metals and agriculture Repurchase Agreements Secured lending, stock lending/borrowing and total return swaps Money Markets Wholesale deposits, certificates of deposit and commercial paper Liabilities Management Fixed rate term deposits, variable rate term deposits, notice accounts and call accounts Credit Market making in corporate bonds and loans Bonds Originating and distributing bonds Asset Securitisation Financing secured on legally separated pools of assets (includes conduit, warehouse and term securitisation). a) Conduit Funding customer receivables with Asset backed Commercial Paper b) Warehouse Financing Funding customer assets or receivables generally from the bank s balance sheet c) Term Securitisation Strategic Debt Finance Loan Markets Source: Information provided by the Group. Sold to the bond markets Debt products for the purposes of corporate acquisitions, recapitalisations and refinancing Arrangement and/or underwriting of credit facilities, particularly where provided by multiple lenders 46/215

47 Non-Transferring Customers - Commercial Banking 6.6 The Group s decision to implement a wide RFBs and narrow NRFB model, as further described in Section 5 of this Scheme Report, designating LB plc and BoS plc within its RFB Sub-group, will result in the majority of the products and services offered to Commercial Banking customers remaining unchanged and continuing to reside within the Transferors. It is estimated by the Group that the majority of Commercial Banking customers (more than 98% of the total customer entities) will not have any products transferred under the Scheme. This includes customers of non-eea entities which may be transferring products but not via the Scheme. 6.7 For those non-transferring Commercial Banking customers, I am satisfied that they will not experience any adverse effect as a result of the Scheme. In particular, for these customers, I have not identified: Changes to the terms and conditions of the existing Commercial Banking products (for example, the economic terms will remain unchanged); and Significant changes to the way those customers will interact with the Group or the quality of the service provided. For example, the coverage of these customers by their RM and by product specialists will remain unchanged. 6.8 As part of the wider group restructuring, the Group will transfer other Commercial Banking business from the various non-eea entities and branches (including in the United States of America ( USA ), Singapore and the Crown Dependencies). Whilst these customers may experience a change, any such change will not be a result of the Scheme, which the Court is being asked to sanction, but will be as a consequence of complying with the broader Ringfencing Regime. Transferring Customers - Commercial Banking 6.9 Based on the information as at 20 October 2017, there would be 3,449 customer legal entities, mainly GC and FI customers that would have products transferred to LBCM, and/or have contracts duplicated, as a result of the Scheme. The Group estimates that, based on the likely growth in customers between 20 October 2017 and the Effective Date, the total number of affected customers on the Effective Date will be approximately 4,000. This represents approximately 1.4% of the total number of customer entities in Commercial Banking. It should be noted that this estimate does not account for: (i) multiple fund entities within a customer group that may, or have the option to, participate within lending facilities where the Group data recognises only a single entity as the principal borrower; and (ii) approximately 255 customers (across all divisions in the Group) whose products may be curtailed by the Group (which, in any event, is not a result of the Scheme) Customers will have products transferred to LBCM under the Scheme due to four key restrictions in the Ring-fencing Regime: An RFB must not maintain or establish a branch in any country or territory which is not an EEA member state, therefore products currently booked to the non-eea branches of the Transferors must be moved; An RFB cannot have any exposure to customer entities defined as an RFI, unless subject to exemptions such as holding the position for its own risk management or liquidity purposes; Some customer product types (such as complex derivatives) are prohibited from being held in an RFB (subject to Grandfathering optionality described in paragraph 6.15); and An RFB is required to comply with the RRR Limit set out in the EAPO. This is analysed in more detail in paragraphs 5.45 to A summary of the approach taken by the Group with respect to the division between the Transferors and LBCM is shown in Diagram /215

48 Diagram 6.1: Commercial Banking booking decision tree Source: Analysis by Skilled Person. * Subject to Grandfathering optionality see paragraph **Transferred to LBCM in order to meet the RRR Limit requirements of the EAPO - see paragraph *** Subject to some exemptions (for example, trade finance exemption). Exposure Bearing Products are from the bank s perspective (i.e. if closed out the customer owes money to the bank) The application of the decision tree (Diagram 6.1) by product and Commercial Banking segment is shown in Diagram 6.2, which illustrates which products are being moved and the rationale. 48/215

49 Diagram 6.2: Commercial Banking product and customer booking view SME SME RFI MM RFB MM GC RFI GC RFI FI FI RFI SME SME RFI MM LBCM MM GC RFI GC RFI FI FI RFI Lending Global Transaction Banking Variable rate loans Fixed rate loans Revolving Credit Facilities Business mortgages Inflation-linked loans Cash Management and Payments Overdrafts Asset Finance Invoice Finance Trade Finance & Supply Chain Trade Services CB Markets Traded Products Foreign exchange Rates Commodities Repurchase Agreements Money Markets Liabilities Management Credit Spot foreign exchange Permitted Products Excluded Products Permitted Products Excluded Products CB Markets Financing Bonds Asset Securitisation Conduit Strategic Debt Finance Loan Markets Warehouse Financing Term Securitisation Key: Product not offered Permitted exposure booked to RFB Excluded exposure booked to LBCM Non-EEA exposure booked to LBCM international branches Permitted exposure booked to LBCM based on strategic booking choice Product not planned to be offered Product booked under exceptions in EAPO Future proposition to be determined Source: Information provided by the Group The transfers to LBCM shown in Diagram 6.2 are due to the following reasons: Direct requirements of the Ring-fencing Regime shown by the light and dark blue boxes; and Strategic booking choices shown by the red boxes. These products are individually permitted to be booked to the RFB under the EAPO, but the Group has made a strategic decision to book them to LBCM. This includes: (a) Permitted Derivatives traded by GC (excluding CRE Private Group) and FI, which will be moved in order to comply with the RRR Limit in the EAPO. This is discussed in more detail in Section 5 of this Scheme Report; 49/215

50 (b) Foreign exchange spot transactions traded by RFIs, as it may not be practical for a customer managing their foreign exchange exposure to deal with two different banking entities. For example, combining derivatives such as forwards with spot transactions may be fundamental to a customer s hedging strategy; and (c) Liability management, which refers to deposit taking. Deposits will continue to be offered from the Transferors and will be offered from LBCM for Money Market accounts. No deposits will be transferred under the Scheme. It should be noted that some product categories (such as trade finance) include a range of products, some of which are permitted and booked in the Transferors, whilst others are excluded exposures which will be booked in LBCM As shown in Diagram 6.2 there are some products that are not planned to be offered by the Transferors or by LBCM post-scheme. This is discussed later under Product Curtailment (paragraph 6.136). Diagram 6.2 sets out the target booking structure and is not considering the effects of Grandfathering and client opt-in or opt-outs, which are further discussed in paragraph Effect of Grandfathering on the Scheme 6.15 Under Article 21 of the EAPO, prohibited derivatives that were executed before 1 January 2019 and mature before 1 January 2021 do not need to be transferred to LBCM. This is referred to as the Grandfathering exemption for which the Group has adopted the following default position by customer segment for all: SME, MM, CRE Private Group and CAM customers: the Grandfathering exemption will be applied, subject to a client opt-in for their prohibited derivatives to be included in the Scheme and transferred to LBCM. Further optionality will also be provided for some customers with derivatives split across the Ring-fence (see the Netting section, paragraph 6.89); GC customers (excluding CRE Private Group): the Grandfathering exemption will be applied, subject to a client opt-in for all (permitted and prohibited) derivatives to be included in the Scheme and transferred to LBCM; and FI customers: all derivative trades with FIs, other than those entered into by the Transferors for their own risk management purposes (see paragraph 3.12 for details of exemptions under the EAPO), will be moved to LBCM via the Scheme, subject to a client opt-out to keep all of those Grandfathered derivatives in either LB plc or BoS plc, where they are currently booked. The default Grandfathering position for FIs has been selected to maximise the extent of net settlement available to FIs, potentially outweighing the disadvantage of being exposed to LBCM with an expected weaker credit profile than the Transferors. This is explained further under the Netting subsection, paragraph In some cases the availability of netting might mean that a customer s exposure to LBCM is lower. It is, however, recognised that the analysis will not necessarily be the same for all FIs and therefore they will be given the ability to opt-out of the default position It is possible that exercising the client opt-in (in the case of SME, MM, GC or CAM customers) or keeping the default position (in the case of FI customers) may result in LBCM breaching its large exposures limit. This is explained in more detail in paragraph I have reviewed the template Stage 2 communication documents dated July 2017 which cover Grandfathering and its implications. They were tailored for each client, listing all their trades that are subject to Grandfathering and requesting that they let their RM know by 28 February 2018 if they wish to opt out of the default position. The Stage 2 communications are currently expected to continue until 30 November 2017 and, in any event, will have been completed no later than the date on which Category 1 Customers (as defined in paragraph 17.14) receive the individual notifications following the Directions Hearing. Consequently I am satisfied that 50/215

51 customers will have sufficient time to make an informed decision. Furthermore I understand that the Stage 3 communications will also cover the Grandfathering optionality and timescales. Scope of my work 6.18 As set out in Section 5 of this Scheme Report, in considering the likely effect of the Scheme on Commercial Banking customers of the Group, I have taken into account the context in which the Scheme is taking place and reflected how other parts of the wider group restructuring being carried out by the Group might affect my analysis. In particular, while it is not within my scope to opine on transfers or other activities performed outside of the Scheme (such as the transfer of legal entities out of LB plc or BoS plc into other sub-groups within the Group), I have considered whether those activities have any effect on my conclusions in respect of the Scheme I have approached the analysis for current Commercial Banking customers by considering all aspects of their banking with the Group across all products, and their related customer interactions, to identify where changes may occur as part of the Scheme or other changes made to comply with the Ring-fencing Regime. The potential effects could broadly be classified into the following four categories: Financial potential financial costs and other financial adverse effects deriving from the Scheme; Product adverse changes to the product offering to existing customers due to legislation or commercial decisions triggered by or as a consequence of the Scheme; Operational adverse changes to the customer operations prompted by: (i) the need to establish a new banking relationship with LBCM or (ii) a split banking proposition across the Transferors and LBCM; and Transitional adverse effects prompted by the need to establish a new banking relationship with LBCM These categories are intended to capture all the changes a customer could reasonably be expected to experience as a result of the Scheme or wider changes necessary as a result of the Ring-fencing Regime. The customer may continue to hold the same financial products but, by virtue of a change in their counterparty to LBCM, suffer from a quantitative effect (financial) or qualitative effect (operational and transitional) The effect on customers can be split into direct effects of the Scheme on implementation and those which arise in the future, driven by the business model adopted by the Group. 51/215

52 Main causes of possible adverse effects 6.22 I considered all aspects of the Scheme to identify what specific changes might possibly affect Commercial Banking customers. From my analysis I have identified that there are seven broad topics that are the main causes of potential adverse effects to Commercial Banking customers: LBCM credit profile; Split banking; LBCM size; LBCM funding strategy; Future business model; Product transfer; and Commercial decisions In this section, I summarise my analysis and set out my conclusions as follows: Category Main cause of potential adverse effect Specific areas of potential adverse effect Paragraphs LBCM credit profile Customer fair value 6.30 to 6.41 Regulatory capital from the customer perspective 6.42 to 6.53 Credit rating triggers 6.54 to 6.78 Set-off rights 6.80 to 6.88 Split banking Netting 6.89 to 6.96 Financial Credit lines 6.97 to 6.99 LBCM size Large exposure rules to LBCM funding strategy Future business model Customer monitoring or hedging of LBCM credit risk to Future business model of LBCM to Events triggered by the transfer of derivatives to Product transfer Transfer implications for trade finance to Contractual provisions being overridden to Product Commercial decisions Split banking Product curtailment to Product linking to Product alternatives information to Foreign law security Operational Split banking Operational effects to Transitional Product transfer Transitional effects to /215

53 LBCM credit profile Introduction 6.24 Customers with products being transferred to LBCM could potentially suffer from an adverse effect because, as explained in paragraphs 5.75 to 5.85, LBCM is expected to have a weaker credit profile than LB plc or BoS plc before the Scheme. As explained in paragraph 5.73, the Transferors credit rating is not expected to change as a result of the Scheme Public credit ratings from agencies such as Moody s, S&P and Fitch are commonly used by customers and market participants but are not the only source to assess credit exposure, with some undertaking their own analysis to evaluate credit risk. Determining creditworthiness does involve some subjectivity and judgement. The public guidance published by S&P and Fitch shows that their ratings for LBCM will be based on a top-down approach, which assumes implicit support from the wider Group. Given that this support will not be backed up by any contractual guarantee, a customer or market participant may place less reliance on that implicit support and conclude that the creditworthiness of LBCM is different to that represented by the public credit rating. For example, S&P analysis dated 17 July 2017 assigned LBCM a preliminary rating of A- but also assessed the stand-alone credit profile at BBB. Fitch published an expected rating on 17 July 2017, which was A In contrast Moody s uses a bottom-up approach, firstly analysing LBCM as a stand-alone entity and then adjusting for potential support from the Group. Moody s published a provisional rating on 7 November 2017 of A2, which is equivalent to the expected rating from Fitch and one notch better than S&P s preliminary rating. However, Moody s provisional rating is two notches weaker than their current rating for LB plc of Aa3 (as at the date of this Scheme Report), whereas S&P and Fitch are both one notch weaker than their current rating for LB plc (at A and A+ respectively). Please see Appendix 4 for a comparison of the rating scales across the three main agencies To understand how a customer s credit exposure may change, I considered the likely change in credit risk before and after the Scheme has been implemented. A key measure commonly used by risk management professionals to assess and evaluate credit risk is the probability of default ( PD ). Using data from Credit Default Swap ( CDS ) traded levels, I compared the PDs for various LBCM credit rating scenarios. The data included financial companies (mainly large universal banks) with credit ratings in the A and BBB range. Whilst this included a broad range of financial companies it increased the number of data points and in my view is a reasonable approach to take. The number of wholesale investment banks that may be considered directly comparable to LBCM is very limited. The results of the calculation are shown in Table 6.3, with the probabilities calibrated to a one year period. Table 6.3: The estimated probabilities of default based on CDS traded levels (based on data from February 2016 to April 2017) LBCM Rating Scenario (as per S&P rating scale) PD (over a one year period) A 1.19% A- 1.45% BBB+ 2.24% Source: Analysis using data from a third party vendor ( Markit ) LBCM s expected credit rating of A- represents an increase in the implied PD of 0.26% (1.45% minus 1.19%) from the current credit rating of LB plc and BoS plc. Although this increase appears modest, it provides evidence of a weakening in the credit profile of LBCM and the PD will increase for longer dated maturities because this risk of default increases as uncertainty and time increases. For example, a customer with a 30 year swap will have more reason to be concerned by the weaker credit profile of their counterparty over the life of their product than a customer with, say, a six month exposure. 53/215

54 6.29 The adverse effect of a weaker LBCM credit profile is the increased risk that a customer will not receive all the money they are owed as and when it falls due. I have considered where customers might suffer an adverse effect, whether temporary or more longer lasting, as a result of this increase in credit risk which can be summarised across three distinct areas: Customer fair value; Customer regulatory capital; and Credit rating triggers. Customer fair value 6.30 I have considered the potential adverse change in fair value of financial products held by current Commercial Banking customers before and after the Scheme. Fair value is a measure at a point in time of the market price that would be received for a financial product in an orderly transaction between market participants The fair value of financial products is driven by a variety of factors, which can broadly be divided into those that are independent of the counterparty (for example, interest rates, foreign exchange rates, commodity prices) and those that are dependent on the financial situation of the counterparty (i.e. the greater risk of default of LBCM) Customers could be affected by a change in the creditworthiness from the Transferors to LBCM as a result of the Scheme for the following products: Derivatives. If the derivatives are collateralised, the customer is largely protected from a counterparty that defaults since the cash or securities held as collateral can (in the case of collateral provided by way of a title transfer collateral arrangement) be taken into account and netted against the derivatives exposure or (in the case of collateral provided by way of a security interest) be taken possession of or sold to make good any loss. The match may not be perfect as: (a) There is usually an uncollateralised first tranche (called the threshold amount ) which represents the amount of net exposure that a party is willing to bear in relation to the other party before it requires the delivery of collateral. In other words, it is the uncollateralised credit risk a party is willing to bear in relation to the other party; (b) There is a minimum transfer amount (below which collateral is not moved), used to avoid the administrative burden of moving collateral when the change in derivative value may be considered small or immaterial. This helps to reduce the potential drain on cash or other liquid securities; and (c) The value of securities held as collateral is not reviewed continuously. They are typically recalculated daily to cover the fair value movements in the value of the derivatives (longer periods may be agreed with customers that are more operationally constrained). If changes are made to cover the change in fair values of the previous day, the collateral held against the credit exposure will not be updated for intraday movements. Repurchase agreements. Customers may have some exposure to LBCM through repurchase agreements but these are unlikely to be material as they will be collateralised and short-term. In addition, repurchase transactions in place at the time of the Scheme will not be transferred; and Deposits. Deposits in place at the time of the Scheme will not be transferred. Non-EEA deposits will have to move to LBCM to comply with the Ring-fencing Regime but they are subject to laws of jurisdictions other than England and Wales or Scotland. Consequently local law transfer mechanisms (which may include novations) will need to be used for these deposits. In the future LBCM will take deposits from customers but this is only planned for 54/215

55 money market accounts as other accounts would require a cash management and payments platform. For collateralised trades the difference between the collateral and the exposure is only significant in the rare event of a severe market disruption that causes prices to move dramatically in a short period of time. Consequently, I am satisfied that, in practice, only customers with uncollateralised derivatives have the realistic likelihood of being materially exposed to changes in the risk of counterparty default by LBCM The main effect of a change in fair value is an unrealised loss rather than an actual realised loss, or cash loss. A realised loss only occurs if the counterparty defaults on its obligations or if the customer sells the derivative to a third party at a loss Second order effects, or indirect impacts, of the change of the counterparty and the potential change in derivative fair values include the possibility that such changes may trigger the discontinuation of hedge accounting or generate volatility in a customer s own income statement as a result of the transfer of derivatives to LBCM under the Scheme. This increase in volatility could have negative consequences for a customer as various stakeholders, such as investors or suppliers may view them as riskier entities with less stable cash flows and therefore be less willing to invest in or trade with these customers. Hedge accounting is an accounting method that allows an entity, when it has entered into a transaction, to eliminate or reduce the income statement volatility that would otherwise arise if the hedged item (the element being hedged) and the hedging instrument (the derivative) were accounted for separately (i.e. without the application of hedge accounting). In instances where a derivative is moved to LBCM it may result in the termination of the original hedge relationship and may require designation of a new hedge relationship from the customer. Such a move may therefore give rise to hedge accounting ineffectiveness. The termination of a hedging relationship may also be triggered by a greater than permissible increase in the hedge ineffectiveness (i.e. changes in fair values of the hedged item that are not being sufficiently offset by changes in the fair value of the hedging instrument). Any of these situations might create increased volatility in the financial results of the customer and cause an adverse effect Table 6.4 sets out the number of Commercial Banking customers expected to be affected by a change in fair value, split by segments of the Commercial Banking unit, as quantified by the Group. While analysis has been performed with respect to customers that have positive exposures based on 30 June 2017 data, it should be acknowledged that their position on the Effective Date is subject to market movements and may change. Due to the Group s business model, which is focused on core banking products, a relatively small percentage of the Group s customers have entered into derivatives and the majority of these are collateralised. Additionally, due to the low interest rate environment there has recently been subdued customer demand to hedge their exposure with interest rate derivatives. Table 6.4: Number of customers potentially affected by fair value changes as at 30 June 2017 Segment Number of customer entities with Number of these customer entities derivatives transferring to LBCM with uncollateralised positive exposure SME 5 0 MM 36 2 GC FI CAM 31 1 Source: Information provided by the Group I conclude that an adverse effect is likely for customers with uncollateralised derivatives transferred to LBCM with a positive exposure as its credit rating is expected to be lower than LB plc or BoS plc before the Scheme. 55/215

56 Significance of the adverse effect 6.37 I have considered the significance of the adverse effect from the customer s perspective. For example, if a customer recognises a reduction in the fair value of a derivative as a loss in its own income statement, the effects would depend on the customer s specific situation. In many cases the effect might be small and immaterial but in some instances could be material and there may be second order effects that might result in the customer facing a potentially undesirable situation, such as a need to raise capital, breaching existing debt clauses or losing the trust of key stakeholders (for example, lenders, investors, customers, suppliers, etc.). The effect and significance of the change in fair value will vary from customer to customer. It is not possible for me to predict how significant the changes in fair value will be for each customer. This is because it is dependent on each customer s own circumstances, including their overall profitability and future plans. However, the following considerations are pertinent to making an assessment of the likely effect: The fair value of these financial products are, by their nature, subject to variability over the life of the financial product, due to the prices/rates of the underlying market variables (for example, interest rates) and the estimates on non-performance of the counterparty, regardless of the Scheme. This fluctuation is inclined to be more pronounced in financial products with a volatile underlying market variable, or those with a long maturity and/or counterparties with volatile credit risk profiles. As a result, customers holding these derivatives are always exposed to fluctuations in their fair values and should be aware that the fair values of these products are inherently volatile; The change in fair value as a result of the Scheme is expected to be relatively minor in the context of historical market movements and the absence of a severe market disruption. The component of the fair value of derivatives that reflects the creditworthiness of the counterparty is usually referred to as the Credit Valuation Adjustment ( CVA ). Where the data exists, a common method for calculating CVA is from current prices in the CDS market. A bank s CDS levels are driven by creditworthiness and the graph in Figure 6.1 illustrates the historical levels in the CDS of LB plc and the four largest British banks since 2005; Figure 6.1: Historical CDS levels of the four largest UK banks (Moody s/s&p/fitch credit ratings) Source: Bloomberg. 56/215

57 It can be seen that LB plc s CDS market prices, since 2007, have experienced movements that are notably many times greater in magnitude than its current differential against its competitors with a different rating. In particular, LB plc s CDS levels were more than 300bps higher as a result of the financial crisis and increased around 50bps in response to Brexit. In normal market conditions, I would expect the movement in fair value, as a direct result of the Scheme, to be smaller than some of these historical fluctuations. Conclusion with respect to customer fair value 6.38 Customers with uncollateralised derivatives being transferred to LBCM will experience a decline in fair values if LBCM has, or is perceived to have, a weaker credit rating. The Group expects this to be the case. Although for most customers with derivatives being transferred I do not expect the change in fair values to be significant, it is not possible for me to determine how significant the change will be for each customer, nor any second order effects, as it depends on their own individual circumstances and perception of LBCM s credit profile. It is possible that it will be material to some customers In terms of the specific adverse effect to fair value, I have considered whether the Group could undertake actions to reduce or eliminate the adverse effect. In particular, whether LBCM could offer to collateralise the derivative positions affected. Whilst this would act as a mitigant, customers may not wish to do so because its implementation may bring negative effects that could outweigh the benefits, such as: Customers not having the systems or resources to manage the operational burden of collateralised derivatives; It may pose unexpected liquidity challenges to customers having to post substantial amounts of collateral (in the form of cash or liquid securities) to LBCM following a large adverse movement in the valuation of their derivatives with LBCM; and It would raise issues with respect to not treating customers consistently. The customers most likely to decide to undertake the collateralisation are those with a positive exposure to LBCM. Giving customers the option to collateralise later when they know if it is beneficial or not would arguably put such customers in a better position than the customers that collateralise from inception. In addition, the amounts posted by LBCM may not be commensurate with the increase in credit risk stemming from the Scheme. The movement in derivative values due to the transfer might be relatively small when compared to changes driven by the underlying securities market values or the movement in LB plc s own credit risk, as measured by CDS levels This would take me to answering part B of the Statutory Question for any customers that do suffer a material adverse effect. In Section 5 of this Scheme Report, I analyse the Group s approach to its design of LBCM and paragraphs 5.75 to 5.85 consider its credit rating. From that analysis I am satisfied with the approach taken by the Group in designing LBCM and that there are no reasonable alternative Scheme structures that would have achieved the Group s design principles for ring-fencing and resulted in a better credit profile of LBCM relative to the Transferors. To the extent that customers have uncollateralised prohibited derivatives being transferred I am therefore satisfied that any adverse effect will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA For Permitted Derivatives of GC (excluding CRE Private Group) and FI customers also being transferred in order to comply with the RRR Limit, I have considered whether the Group could have adopted a different approach, or transferred other customers Permitted Derivatives to LBCM instead of those Permitted Derivatives of GC and FI customers, to achieve compliance with this requirement. The only other reasonably possible solution would be for the Group to transfer sub-segments of GC and FI customers Permitted Derivatives instead. However, not transferring all the derivatives entered into by all customers in the same segment would mean inconsistent treatment of customers with similar characteristics. The appropriateness of the 57/215

58 customer classifications is discussed in paragraphs 5.56 to Additionally, a partial transfer may not leave sufficient room for future SME and MM derivative business to be conducted by the Transferors. I concur with that position and am satisfied that any adverse effect on GC and FI customers of Permitted Derivatives being transferred will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. Regulatory capital from the customer perspective 6.42 I have considered the potential effect of the Scheme on those Commercial Banking FI customers that are required to hold minimum capital levels because they are regulated (for example, banks, insurance and asset management entities in the FI segment). An FI s capital represents its ability to absorb financial losses without becoming insolvent. The calculation of regulatory capital requirements is highly technical and depends on whether the FI is a bank, an insurer or an asset manager. To place into context the quantitative effect on these entities I have focused my analysis on bank customers, but the effect is likely to be similar for other types of FI customers. Minimum regulatory capital requirements for banks operating in the UK are set by the PRA in the form of minimum capital ratios (refer to Section 10 of this Scheme Report for further detail) For these groups of customers the expected weaker creditworthiness of LBCM relative to that of LB plc or BoS plc before the Scheme is likely to result in the customer recognising a larger amount of Risk Weighted Assets ( RWAs ) than those pre-scheme. This is because exposures to LBCM would be measured in relation to its weaker credit risk profile, leading to an adverse effect of lower capital ratios as a result of larger RWAs (bank capital ratios are calculated as the ratio between the capital held by the bank and its RWAs) I have reviewed the types of financial products entered into by customers with the Group and note that, although repos and collateralised derivatives may create a credit exposure for these customers to LBCM, the RWA effect will be minimal due to their collateralised nature, resulting in very limited exposure to LBCM. RWAs on uncollateralised derivatives being transferred to LBCM are likely to be more significantly affected by the Scheme I noted that the Group has identified 549 customer entities as at 30 June 2017 from the FI segment whose derivatives will be transferred to LBCM as part of the Scheme. Of these, 165 of the entities have uncollateralised derivatives. It is relevant to note that within the FI segment there are entities that are not subject to minimum capital requirements For customers that are affected, I assessed the two different methodologies that exist for the calculation of RWAs on derivatives amongst banks, namely the Standardised Approach and the Internal Ratings Based ( IRB ) approach. The Group has quantified the RWAs effect for banks using the Standardised Approach by comparing the RWAs under a pre-scheme credit rating of A with the RWAs under two credit rating scenarios for LBCM, namely: A- and BBB At the Scheme implementation, the Group expects the credit rating of LBCM to be lower than LB plc s current credit rating of A. If LBCM is rated A-, the Group has quantified that there would be no effect on the RWAs of these entities under the Standardised Approach. This is because the RWA calculations using these methodologies do not differentiate between A and A- credit ratings and consequently there would be no adverse effect However, if LBCM is rated BBB+, there would be an increase in the RWA measurement for the transferred positions under the Standardised Approach. The key components of the RWA calculation are the Counterparty Credit Risk ( CCR ) which will increase by 25% and the CVA which will increase by 100% as a result of moving from A to BBB+. The Group has quantified that this results in a 76% increase in the total RWA measurement across all FI customers for the derivatives transferred (based on 31 December 2016 data). The likely effect for each affected customer could be lower due to portfolio effects (such as derivatives with offsetting 58/215

59 exposures within the same portfolio resulting in a lower overall exposure) and any hedges that the customer may already have against the Group. It is not possible to assess what effect this has on the actual capital, as that is dependent on each customer s individual capital position It is also not possible to calculate the actual effect on RWAs for banks that use the IRB approach as it depends on their own models. However, in contrast to the Standardised Approach, banks that apply the IRB approach are expected to differentiate between ratings of A and A- and therefore an increase in RWAs is likely to occur Insurance and asset management entities are also subject to minimum capital requirements. The insurance sector regulatory capital is based on a total balance sheet approach, incorporating assets and liabilities. Therefore, the quantification of the effect on an insurer s capital stemming from the transfer of uncollateralised derivatives to LBCM is not feasible as it would require knowledge of the individual asset/liability situation of the customer. The approach to calculating regulatory capital ratios of asset management entities is in essence similar to that for banks, being calculated by dividing the eligible capital by the risks to which the entity is exposed. Conclusion with respect to regulatory capital 6.51 It is possible that some customers may experience an adverse effect in their regulatory capital levels as a result of the transfer of uncollateralised derivatives to LBCM as part of the Scheme. Whilst some customers may perceive the adverse effect as material, I cannot conclude on the materiality of any such adverse effects due to the different methodologies that FIs are permitted to use by their regulator to calculate capital requirements for uncollateralised derivatives, the uncertainty regarding LBCM s credit rating and the specific circumstances of each customer This would lead me to part B of the Statutory Question for any customers that do suffer a material adverse effect. Section 5 of this Scheme Report analyses the Group s approach to its design of LBCM and paragraphs 5.75 to 5.85 consider its credit rating. From that analysis I am satisfied that the approach taken by the Group in designing LBCM was reasonable and that there were no reasonable alternative Scheme structures that would have achieved the Group s design principles for ring-fencing and resulted in a better credit profile of LBCM relative to the Transferors. To the extent that customers have uncollateralised prohibited derivatives being transferred, I am satisfied that any adverse effect will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA For Permitted Derivatives of FI customers also being transferred in order to comply with the RRR Limit, I have considered whether the Group could have transferred other customers Permitted Derivatives to LBCM and whether the customer classifications are appropriate (see paragraphs 5.56 to 5.57). The only other reasonable alternative would be for the Group to transfer sub-segments of FI customers Permitted Derivatives. However, not transferring all the derivatives entered into by all customers in the same segment would mean inconsistent treatment of customers with similar characteristics. Additionally, a partial transfer may not leave sufficient room for future SME and MM derivative business to be conducted by the Transferors. I concur with that position and am satisfied that any adverse effect on FI customers of Permitted Derivatives being transferred will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. Credit rating triggers 6.54 I have considered the potential triggering of credit rating clauses in contracts currently held by Commercial Banking customers as a result of the Scheme. Credit rating triggers are provisions in transactions which allow, or require, a defined action to be taken, if one of the counterparties credit rating declines below a predetermined level. The action is referred to as a credit rating event. It is normally triggered when there is a reduction in an entity s credit rating. 59/215

60 6.55 Credit rating triggers often appear in the terms and conditions of legal documentation for financial products that the customer has directly with the Group, or through a third party contract. For example, if a customer invests its own clients money, there may be internally imposed restrictions on the credit rating of the counterparties with whom they may transact. However, unless the Group has been informed it is not possible to know a customer s own internal policies or details of agreements they hold with their own clients In theory, clauses that may be triggered by the Scheme could exist in the terms and conditions of a large variety of contracts. As such, I am reliant on the Group s own due diligence to identify the contracts it holds with customers that may result in an adverse effect. I am aware that the Group has embarked on an extensive review of its legal documents. This consisted of a multistage process with all the documents related to business being transferred drawn from a variety of sources, including repositories and physical storage facilities. Where documents could not be located the RMs were contacted together with, in appropriate cases, external parties. These documents were reviewed by external lawyers, who completed a detailed questionnaire. The outcome of this process is shown in Table 6.5. Table 6.5: Contractual clauses potentially relevant to the Scheme Financial products Derivatives Liquidity facilities supporting bond securitisations Third party contracts Source: Information provided by the Group. Clauses identified by the Group due diligence that are potentially relevant to the Scheme Credit Event upon Merger Termination Event for which an event includes the transfer of all or substantially all of the Transferor s assets (or, in the case of a 2002 ISDA Master Agreement, a substantial part of the assets comprising the business conducted by the relevant party as at the date of the International Swaps and Derivatives Association Master Agreement ( ISDA Master Agreement )) and the creditworthiness of the transferee is materially weaker. Credit Rating Triggers identified under Termination Events. Collateral-related Triggers. Minimum rating requirements for hedge counterparties. Credit Rating Triggers identified for liquidity facilities supporting the ratings of certain notes issued by securitisation SPVs. Not part of the Group s due diligence (as the Group is not privy to these contracts) The clauses identified in the due diligence process, along with the possibility of other clauses in third party contracts, will be analysed separately in the following subsections: Derivatives Derivatives; Liquidity Facilities for Securitisations; and Third party contracts with Credit Rating Triggers The standard documentation for derivatives, known as an ISDA Master Agreement (see paragraph 6.89) contains a Credit Event upon Merger ( CEUM ) provision which applies where a party amalgamates, consolidates, merges, or transfers all or substantially all of its assets (or, in the case of a 2002 ISDA Master Agreement, a substantial part of the assets comprising the business conducted by the relevant party as at the date of the ISDA Master Agreement) to another entity and the creditworthiness of the surviving or transferee entity is materially weaker than that of the transferor immediately prior to such action. The occurrence of a CEUM constitutes a Termination Event. 60/215

61 6.59 A CEUM event will be triggered, in the context of the Scheme, if (i) one of the Transferors is deemed to have transferred all or substantially all of its assets (or, in the case of a 2002 ISDA Master Agreement, a substantial part of the assets comprising the business conducted by the Transferors as at the date of the relevant ISDA Master Agreement) to LBCM (such an event would be deemed a Designated Event ), and (ii) the creditworthiness of LBCM following the transfer is materially weaker compared to the creditworthiness of the Transferors immediately prior to the occurrence of the Designated Event It should be noted that the clause is qualitative so different opinions may exist as to whether the CEUM event will be triggered by the Scheme. For example, it is unclear whether a one or two notch downgrade in the credit rating actually amounts to a material weakening of the creditworthiness. If it was triggered the customer would have the right to terminate the contract and the Group will preserve this right pursuant to the Scheme. Therefore, in my opinion, the existence of the CEUM clause cannot be considered an adverse effect as customers are better placed having an option which they can exercise at their own discretion Other credit related triggers were found in the derivatives contracts that are referred to as Additional Termination Event ( ATE ) clauses. They allow the entities involved to terminate bilateral derivative contracts early at the prevailing fair value, protecting these entities, if the credit rating of the counterparty falls below the trigger level. In some cases, the documentation provides for LBCM to undertake remedial measures to avoid the trigger of a credit ratingsrelated ATE. The Group is not proposing to override these ATEs (or any remedial measures required to be undertaken upon a breach of the ratings trigger) pursuant to the Scheme. Table 6.6 quantifies the number of customers identified to be subject to ATEs. Table 6.6: Number of customers with ATEs (as at 30 June 2017) Segment Number of entities with credit rating triggers in derivatives documentation Trigger: A- Trigger: BBB+ SME 0 0 MM 1 0 GC 2 0 FI TOTAL Source: Information provided by the Group If the ATE clause were to oblige a customer to terminate the derivative and find a new counterparty, this could lead to an adverse effect because the customer might not be able to enter into a new contract on the same terms and conditions as the existing contract. However, all of the ATE clauses found by the Group were at the customer s option. In this case, the customer can choose whether to terminate the contract based on its own considerations. The customer is in a better position having an option than not and, therefore, in my view, the ATE itself cannot be considered to be an adverse effect. The customer will still suffer an adverse effect as they are exposed to a riskier entity but this is not specific to the ATE. Consequently, I conclude that it is unlikely that there will be any adverse effects to customers due to ATE clauses in derivative contracts being triggered by the Scheme Trigger events also exist with respect to collateral such that if the counterparty credit rating falls below a certain level then LBCM would need to make an additional collateral posting. This helps to protect the customer and can act as a partial mitigant. The Group does not propose to override or amend this obligation and therefore the relevant Transferor will meet its collateral obligations in respect of customers/counterparties in accordance with the terms of the relevant agreement. 61/215

62 Liquidity facilities for securitisations 6.64 The Group has entered into transactions where the customer entities are SPVs set up for securitisation transactions. These securitisation structures were set up by a variety of GC and FI clients as a means of raising secured funding against assets they placed into the SPV. The assets used include residential and commercial mortgages as well as whole businesses, like utility companies. Securitisation structures are typically financed by rated bonds or commercial paper of varying maturities issued to institutional investors in the capital markets. A liquidity facility is often provided by a bank to the SPV to provide it with access to liquidity in the event it suffers a short-term funding deficit. These liquidity facilities are a structural element of asset backed securitisation financings and an important consideration for the rating agencies when rating the debt issued. As such, these facilities contain ratings triggers relating to the liquidity facility lender to protect the overall creditworthiness of the securitisation notes held by third party investors. To date the Group identified 39 of these liquidity facilities that will be transferred under the Scheme It can be assumed that the customers affected by this potential adverse effect connected with securitisations are financially sophisticated and familiar with the structures they set up with the Group. In almost all cases where LB plc has provided liquidity facilities, they are required to be transferred under the Scheme to LBCM because the SPVs have RFI status under the EAPO as referred to in Section 3 of this Scheme Report. There is an exception for liquidity facilities relating to certain infrastructure financing structures where they are allowed to be retained in the Transferors. The Group intends to take advantage of this exemption for a small number of liquidity facilities Where a trigger occurs, the terms of the securitisation structure require the Issuer SPV to seek a replacement liquidity facility with another bank of the requisite credit rating on commercially reasonable terms. If a suitable replacement is not available on commercially reasonable terms, the Issuer SPV may be required to fully draw down the liquidity facilities, with the cash proceeds maintained by the bank named in the liquidity structure. This occurs in 36 instances where the short-term requisite rating of LBCM is equivalent to A-1+ or lower and three instances where the long-term requisite rating is equivalent to BBB or lower. The drawing provisions are part of the contractual arrangements and therefore must be complied with unless otherwise negotiated. Of these 39 liquidity facilities, if triggered, seven customer entities will pay LIBOR plus a drawn margin that is higher than the undrawn margin, 20 will pay LIBOR plus an unchanged margin and 12 may have no increase in costs on drawdown (subject to paragraph 6.70) As the credit rating of LBCM is expected to be lower than LB plc before the Scheme, where applicable, this will trigger the requirement of the liquidity facilities to be drawn down (unless an alternative provider can be found). I understand that LBCM intends to comply with its obligations to fund such drawdowns under the liquidity facilities I have considered the materiality and significance of the adverse effect from the customers perspective for each of the financial products identified with credit rating triggers. If the SPV customers are required to draw down on a liquidity facility this may lead to a direct financial adverse effect of an increase in costs for fees and interest charges which can, to an extent, be quantified. An estimate of the additional monetary cost can be calculated as: Drawn amount x ((LIBOR + Drawn margin) Undrawn margin). Where Drawn margin is the credit margin applied over the LIBOR, multiplied by the drawn amount to arrive at the interest cost of the amount. The SPV may be able to generate extra income from holding the additional cash provided under the liquidity facility, but it is not possible to determine whether this will be the case and, in any event, any income is likely to be less than the increased borrowing costs. 62/215

63 6.69 The additional costs are shown in Table 6.7 for the customers affected based on June 2017 data. For these 39 liquidity facilities the total committed amount that could be drawn is c. 1.5bn. Table 6.7: Cost to customers of drawing securitisation liquidity facilities Segment Number of customer entities with Credit Ratings Triggers in their liquidity facilities Estimated total monetary cost to customers per annum Short-term trigger Long-term trigger Short-term trigger Long-term trigger A-1+ or lower* BBB or lower* A-1+ or lower* BBB or lower* SME MM GC m 0 FI m CAM m 0.9m * Or equivalent rating from Moody s/fitch. Source: Information provided by the Group Additionally, many liquidity facilities permit the lender to pass on its higher costs to the borrower, through increased margins. Where the liquidity facility is drawn it may increase costs to the SPV since the cost of borrowing from LBCM (a lower-rated entity) under the liquidity facility, will generally be higher than it was prior to the liquidity facility being transferred to LBCM (these potential additional costs are unknown and therefore are not included in Table 6.7) The increased cost from the liquidity facilities may reduce the cash available to the Issuer SPV to service the securitisation noteholders and other secured creditors. Therefore, I conclude that the relevant customers, noteholders and other secured creditors are likely to be adversely affected. Whilst it is not possible to determine how material the effect might be to the equity or debt investors of the SPV, it is important to note that these stakeholders may be able to mitigate the effect by finding an alternative provider of the liquidity facility with the same or better credit rating or by selling their notes. The pricing will be dependent on the prevailing market conditions and may be worse. It is not possible to determine how significant the additional cost will be for each customer, but it is possible that it might be material to some stakeholders. Third party contracts with credit rating triggers 6.72 As discussed in paragraph 6.54, credit rating triggers may be included in contracts between a customer of the Group and that customer s own clients. Given that the Group is not party to these contracts nor will it necessarily know whether they actually exist, I am unable to confirm or validate my views of the adverse effects. It should be noted that the communication strategy proposed may elicit evidence where these may exist since it gives customers the opportunity to raise any concerns arising from the Scheme with the Group The Commercial Banking customers that I consider to be most likely to be subject to specific restrictions and requirements are pension and investment funds. For example, ISDA Master Agreements with pension funds often contain provisions requiring the trustee to abide by the specific pension fund rules. Investment funds may be subject to quantitative and qualitative requirements in relation to the conduct of their transactions with banks, including counterparty eligibility criteria Furthermore, in relation to Trade Instruments issued by the Transferors at the request of their customers, the lower credit rating of LBCM could cause the customer to be in breach of the underlying contract between it and the beneficiary of the Trade Instrument (such as a letter of credit or guarantee). 63/215

64 6.75 While it is possible that a customer may have internal policies and controls with respect to the credit rating of its counterparties, I would assume in these cases that the customer has some flexibility to adjust their internal policies made at their own discretion. Consequently, they would be in no worse state than another customer without the formal policy. Both could suffer from an increase in risk of counterparty default, but this is not specific to any internal credit rating policy If a customer had contracted with its own clients or investors to only have counterparties above a certain rating threshold, they may be forced to terminate the contract and find a new counterparty. In this scenario the magnitude of adverse effect will depend on the customers ability to enter into a new contract on similar terms and conditions, or to novate the contract, which might be influenced by financial market conditions prevailing at the time. Conclusion with respect to credit rating triggers 6.77 I note above that adverse effects may exist as a result of the Scheme in the activation of Credit Rating Triggers in liquidity facilities for securitisation transactions and there may be other unknown third party credit rating requirements where a customer may be forced to take an action they would rather avoid This leads me to part B of the Statutory Question for any customers, noteholders or secured creditors that do suffer a material adverse effect. Section 5 of this Scheme Report analyses the Group s approach to its design of LBCM and paragraphs 5.75 to 5.85 consider its credit rating. From that analysis I am satisfied with the approach taken by the Group in designing LBCM and that there are no reasonable alternative Scheme structures that would have achieved the Group s design principles for ring-fencing and resulted in a better credit profile of LBCM relative to the Transferors. Liquidity facilities are being moved as part of the Scheme as the securitisation SPVs are classified as RFIs and are therefore required to be transferred in order to comply with the Ring-fencing Regime. Therefore I consider that the adverse effect to customers, noteholders and secured creditors as a result of Credit Rating triggers being activated will not be greater than reasonably necessary in order to achieve the relevant ringfencing purpose, as set out in Section 106B(3)(a) of the FSMA. Split banking Introduction 6.79 The Scheme results in some Commercial Banking customers having a split banking relationship with some financial products in the Transferors and some in LBCM. The main potential adverse effects as a result of a split banking relationship are: Set-off rights A reduction in the customer s ability to set off exposures arising from mutual debts with the Group across the ring-fence; Derivative netting sets may be broken; and A reduction in the availability of credit lines and the flexibility of allocating credit lines across products. A credit line is considered to be the risk limit approved by a bank to allow a customer to transact with it in products on which it may be exposed to the customer (for example, simple loans and derivatives) The Scheme may result in Commercial Banking customers experiencing a reduction in their set-off rights. Set-off is the right of a debtor to balance mutual debts with a creditor (for example, a bank). Where applicable, general law implied set-off rights for customers are based on the principle of same name, same rights and allow customers to set-off exposures for mutual debts with the same entity in the case of insolvency. In certain jurisdictions, including England, if a customer has exposure to a creditor that defaults, the customer would automatically have the right to set-off its mutual debts with the creditor. 64/215

65 6.81 Before the Scheme, if a customer had exposures to, say, LB plc and it subsequently defaulted, the customer would automatically have the right to offset its mutual debts with LB plc as the customer would have exposure to a single banking entity. Following the implementation of the Scheme, customers undertaking transactions with both the Transferors and LBCM may have mutual debts split across the ring-fence, preventing the customer from being able to set-off exposures as they are with separate banks. For example, if a customer has a loan from the Transferors and holds a derivative with a positive exposure to LBCM (i.e. the customer would be owed money if the derivative is closed out), then in the event that LBCM defaults, the customer will not be able to offset the loan with the derivative as they are with different legal entities In order for a customer to suffer this potential adverse effect they would need to have a positive exposure to one bank entity which defaults and a negative exposure to the other bank entity (i.e. the mutual debts need to be split across the ring-fence by the Scheme). Products that may bear a positive exposure are deposits and uncollateralised derivatives. Products that may bear a negative exposure are loans and uncollateralised derivatives. Given that customers will be able to transfer deposits between the two bank entities (i.e. to withdraw funds in deposits with the Transferors and to transfer these funds to deposits opened with LBCM), this potential adverse effect is confined to either: Customers having uncollateralised derivatives with a positive exposure being transferred to LBCM, where the customer also has loans (or uncollateralised derivatives with a negative exposure) from the Transferors; or Customers having uncollateralised derivatives with a negative exposure being transferred to LBCM and have uncollateralised derivatives with a positive exposure remaining with the Transferors Table 6.4 (paragraph 6.35) sets out the number of Commercial Banking customers that will have uncollateralised derivatives with positive exposures being transferred to LBCM, split by segments of the Commercial Banking unit, as quantified by the Group. The number of customers that might be affected by a change in set-off will be lower as it would require the customers to simultaneously have loans (or derivatives with negative exposures) from the Transferors. While analysis has been performed based on 30 June 2017 data, it should be acknowledged that their position on the Effective Date is subject to market movements and may change The PRA rules on ring-fencing prevent the Transferors from agreeing to allow counterparties to offset obligations owed to it by that counterparty against the obligations of LBCM to that counterparty, and therefore there is an inherent restriction on permitting offsetting arrangements post the Statutory Deadline. The Scheme seeks to turn off cross-entity set-off rights in order to comply with the Ring-fencing Regime This adverse effect would only be applicable in the case of insolvency of LBCM. As set out in Table 6.3, based on the S&P expected rating for LBCM of A- the implied PD is 1.45% over a one year period using historical CDS levels for comparable banks, which implies that the insolvency of LBCM is not expected. However, it is possible that a customer could perceive that they will suffer an adverse effect as a result of an increase in credit exposure due to a loss of set-off rights This leads me to part B of the Statutory Question for any customers that do suffer a material adverse effect. The natural structural mitigant would be to book all products of the customer in either the Transferors or LBCM. As described in Section 5 of this Scheme Report, the Group s ring-fencing design seeks to maximise the products remaining in the Transferors but, due to the Ring-fencing Regime, it is not possible to keep the prohibited products and those booked in non-eea jurisdictions in the Transferors. Therefore, the products being transferred to LBCM are a consequence of the Ring-fencing Regime, including those moved to meet the RRR Limit. Consequently, I consider that any material adverse effect on Commercial Banking customers 65/215

66 as a result of a loss of set-off rights will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA I also identified a related potential adverse effect in relation to Omnibus Guarantee and Set-off agreements ( OGSA ), which documents the cross-guarantees across multiple parties. Given that set-off cannot take place across the ring-fence the OGSA agreements must be duplicated for LBCM. If an OGSA contains a cap or limit on the maximum amount recoverable from the affiliate guarantors, then a duplication of the OGSA may result in a doubling of the maximum amount recoverable from the affiliate guarantors. To mitigate this effect, in relation to all OGSAs that specify a maximum amount recoverable, the Transferors and Transferee will provide an undertaking that it will not exercise or enforce its rights to the extent that the total amount recovered exceeds any maximum recoverable amounts specified in the OGSA. This undertaking from the Transferors and Transferee (in relation to OGSAs which specify a maximum amount recoverable) will apply until the relevant customer has indicated (whether in writing or otherwise) that it considers any of the Transferors or the Transferee to benefit from the maximum amount recoverable for each individual OGSA (or any alternative recovery limit or limits as the parties may agree) In some circumstances a Transferor or LBCM (as the case may be) will be the beneficiary of security both for itself and the Transferor or LBCM (as the case may be) post-scheme. This relates to a provision in some of the OGSAs providing that any security held by any affiliate guarantor from another affiliate guarantor will be held on trust for the Transferor or LBCM (as the case may be). As a result of the duplication of the OGSA, there could potentially be overlapping security trusts, one security trust in favour of a Transferor under the original OGSA and one in favour of the Transferee under the duplicate OGSA. To avoid this situation, the Scheme will have a provision that any security interest held by an affiliate guarantor is held on trust for the Transferor who will hold the benefit of such trust for the Transferee and the Transferor. In my view this provision and the undertaking with respect to maximum amounts recoverable will be effective in eliminating the potential adverse effects connected with OGSAs. Netting 6.89 The contracts for derivative transactions typically use a master agreement that sets out the terms on which parties may agree to enter into transactions. When they do so a confirmation supplement is produced, which sets out the specific details of the trade. The most commonly used master agreements follow a framework set by the International Swaps and Derivative Association ( ISDA ). The ISDA Master Agreement states that the ISDA Master Agreement and any Transactions entered into under it form a single agreement between the parties The Scheme will result in these netting sets being broken for Commercial Banking customers where their derivative trades will be split across the ring-fence. For GC (excluding CRE Private Group) and FI customers, post the Grandfathering period, all their derivative trades will reside in LBCM and therefore the netting set will remain intact. However, SME, MM, CRE Private Group and CAM segments prohibited derivatives will be booked in LBCM, whereas the default position is that Permitted Derivatives and short-dated prohibited derivatives will be booked in the Transferors, which will break the netting set into two smaller netting sets with each bank The close-out netting provisions in an ISDA Master Agreement are based on the premise that the ISDA Master Agreement and any Transactions entered into under it form a single agreement between the parties. If an Event of Default occurs, the non-defaulting party can choose to terminate all outstanding transactions resulting in a single net sum to be paid by one party to the other, such that the liquidator of an insolvent party will have to choose between enforcing and disclaiming the agreement as a whole. If some, but not all, of a counterparty s transactions are transferred to LBCM but others remain with the Transferors, this will have the effect of bifurcating the netting arrangements (sometimes referred to as splitting the netting set ), thereby limiting their scope. This means that the counterparty s exposure to the Transferors is replaced by separate exposures to the Transferors and LBCM. 66/215

67 6.92 The arrangements for the provisions of collateral are set out in an annex to the ISDA Master Agreement, which is referred to as the Credit Support Annex ( CSA ). This also works on the principle of a single agreement so that parties need to calculate the net amount payable across all outstanding transactions. It is possible that if a customer s netting set is bifurcated into the Transferors and LBCM there may be a requirement to post more collateral. This could apply to customers with a one way CSA who are required to post collateral but do not receive collateral. If such customers have a positive exposure post-transfer to the Transferors and a negative exposure to LBCM, or vice versa, they may have to post additional collateral to offset the exposures which previously cancelled out. The due diligence conducted by the Group identified 38 entities with one way CSAs with positions being transferred to LBCM. As at 30 June 2017, only three of these entities had positions where the customer may have to post more collateral as a result of the Scheme. One of these was a GC and the situation only occurs during the Grandfathering period if they adopt the default position of not transferring derivative trades that mature before 1 January They could avoid this adverse effect by electing to opt-out of the Grandfathering and transfer all their derivatives to LBCM. It should be noted, however, that the collateral requirements are dynamic and depend on market levels. Therefore, it is possible that, on the Effective Date, more of the customers with one way CSAs may have to post additional collateral as a result of the Scheme For customers with two way CSAs either party may be required to post collateral. Where the customer has split netting set and a two way CSA they may be required to post collateral or additional collateral in one entity as a result of the Scheme. Assuming no threshold amounts (see paragraph 6.31), this could be offset by collateral or additional collateral being received from the Group entity on the other CSA, resulting in a net position with the Group that is unchanged. The Scheme will duplicate CSAs as part of the duplication of the ISDA Master Agreements, accordingly, where the CSA contains a threshold amount and/or a minimum transfer amount, there will be a doubling of the aggregate threshold amount and the aggregate minimum transfer amounts between the customer and the Group. Consequently, where there are threshold amounts or minimum transfer amounts, for example, the net collateral posted could reduce which would be a benefit to the customer or could increase which would be an adverse effect to the customer Some customers will be adversely affected due to their netting sets being split as a result of the Scheme and therefore this leads me to part B of the Statutory Question. For FI and GC (excluding CRE Private Group) customers this could only apply during the Grandfathering period, for which the customers have the option to keep their netting sets intact. For FI customers, it is assumed this would be their preference and therefore the default position is for all derivative trades to be transferred to LBCM (except those being held by the Transferors for their own hedging). Provided they do not opt out of this default position, they will not suffer any adverse effect from the split in the netting set. Similarly, GC customers are able to avoid a split netting set by opting to move all their derivatives to LBCM SME, MM, CRE Private Group and CAM customers may, by accepting default actions, find themselves in a position where their derivatives are split across the ring-fence. This could occur where prohibited derivatives (not subject to Grandfathering) are transferred to LBCM to comply with the Ring-fencing Regime, but Permitted Derivatives remain with the Transferors. Customers in these segments have the option to opt out of the Grandfathering exemption and move their short-dated (maturity before 1 January 2021) prohibited derivatives to LBCM. Additionally, for those customers that do have a split netting set as at 1 December 2017, the Group will offer them the ability to transfer all their derivatives to LBCM, thereby keeping their netting set intact. The 1 December 2017 cut-off date was chosen as those customers transacting long-dated prohibited derivatives will receive disclosure about transfers to LBCM from this point. The timetable for this optionality will run in conjunction with that of the Grandfathering to ensure that, on the Effective Date, customers have the ability to keep all their derivatives in one entity. However, there are several reasons why these customers may not want to take advantage of this optionality. This includes: 67/215

68 The credit profile of LBCM is expected to be weaker than the Transferors which could reduce the fair value of those Permitted Derivatives transferred; Whilst customers may avoid a split netting set as a result of the Scheme, going forward, all Permitted Derivatives for SME, MM, CRE Private Group and CAM will be booked to the Transferors and therefore, in any event, the customer could end up at a later date with a split netting set; and For customers with CSAs with a threshold amount (see paragraph 6.32), the split netting set may result in them posting less collateral. As at 30 June 2017, there are 65 customer entities across SME, MM, CRE Private Group and CAM with a split netting set that would be offered the option to move all derivatives to LBCM. Additionally, as per the data available as at 30 June 2017, there are 10 customers from these segments that only have prohibited derivatives but who may have created a split netting set prior to, or as at, the Effective Date. They will also be offered the same optionality to mitigate the possibility of a split netting set Given the optionality that will be offered to customers, they can all avoid breaking their netting sets for existing trades, with the exception of the Transferors own hedging trades with FIs. Consequently, the adverse effects of a split netting set due to the Scheme can mostly be eliminated by ensuring all derivatives are in one entity. However, this does require the derivatives to be transferred to LBCM, which is expected to have a weaker credit profile and this could result in reduced fair values. As discussed in paragraph 6.40, this may be considered an adverse effect by some customers but I do not consider it to be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. Credit lines 6.97 The Scheme may result in Commercial Banking customers experiencing a reduction in the availability of credit lines as a result of the split of products across the ring-fence and/or a potentially lower appetite for credit risk by LBCM. In addition, customers may experience a reduction in the flexibility to allocate these lines across products as credit lines available in one bank are not available to be utilised in the other bank. An adverse effect may result in the customer not being able to transact with the Transferors or LBCM in the future, despite having credit lines available in the other entity As a result of the implementation of the Scheme, some customers will be provided credit lines from both the Transferors and LBCM. This would be the case where the customer has exposure bearing products provided from both the Transferors and LBCM (for example, the customer has a derivative that is remaining in the Transferors and has another derivative that is transferred to LBCM). Each bank would set their own credit lines independently based on their risk appetite and commercial considerations, such as the profitability and the risk profile of the customer and levels of concentration risk to which the bank is exposed in the sector or geography of the customer LBCM may decide to reduce credit lines across certain customers as a result of its notably smaller balance sheet size relative to that of LB plc pre-scheme. A smaller balance sheet would imply that the bank has less ability to take customer credit risk and, hence, to provide credit lines. However, I understand that the Group will not reduce any lines already utilised and consequently I do not consider that an adverse effect is likely. The exception will be credit line reductions to avoid customers exceeding the large exposures limit, which is covered in paragraph /215

69 LBCM size Large exposure rules I have considered the potential effect of the relative size of LBCM as a result of the Scheme design and identified one potential adverse effect in respect of large exposure regulatory rules The large exposures rules set by the PRA are designed to limit the maximum loss a bank could face in the event of a sudden counterparty failure to a level that does not endanger the bank s solvency. With respect to its banking and trading book exposures, unless additional capital is held for trading book exposures, LBCM must ensure that the total amount of its exposure to any counterparty, group of connected clients or connected counterparties, does not exceed 25% of its eligible capital. The Scheme is likely to result in the exposure of some Commercial Banking customers exceeding LBCM s large exposures limit. As at 30 June 2017, I understand the Scheme, when implemented, would result in breaches of the large exposures limit for 14 customers across the GC and FI segments In any case, the customers affected by the large exposures limit are the large customers in the GC and FI segments, probably with access to several banks for similar products and services offered by Transferors and, as a result, likely to be able to mitigate any adverse effects. I understand the Group is in close contact with these customers to consider an appropriate course of action In order to minimise the need to reduce existing exposures, the Group has a set of options to be considered including, but not limited to: Assessing whether the large exposures situation will be automatically resolved by the runoff of existing transactions before the Effective Date; Requesting customers to deposit more of their own cash in line with European Market Infrastructure Regulation requirements with LBCM to offset exposure; Reducing uncommitted facilities and/or agreeing a plan to reduce overall facilities with the customer; and Other actions which may be considered include selling assets, allocating regulatory capital to a specific exposure and buying CDS protection on a specific exposure, where economically viable The Scheme Document makes provision for certain transactions with designated customer groups to be held back at the Effective Date, and transferred outside the Scheme, if transfer of the entire set of transactions for that group would immediately breach large exposure limits for LBCM. The customer may be asked to repay or refinance the facility at a lower level into LBCM before 1 January 2019 when compliance with the Ring-fence Regime is legally required Ultimately the customers affected cannot be forced to change their contract to reduce the exposure and I understand the Group has no intention of using the Scheme to do so. If the Group is unable to reduce these large exposures to below the regulatory threshold then LBCM would be required to make a deduction to its regulatory capital resources and the customers existing contract will remain in place. However, customers may still experience adverse effects if uncommitted facilities are cut, if they are asked to rebook trades with the Transferors or if their future business is restricted This leads me to part B of the Statutory Question for any customers that do suffer a material adverse effect. This is a result of the transfer of products to LBCM, which is an inherent consequence of the requirements of the Ring-fencing Regime, as discussed in more detail in Section 5 of this Scheme Report. The derivatives either need to be moved as they are prohibited products or despite being permitted, will be transferred to comply with the RRR Limit. 69/215

70 6.107 Based on the rationale above, I consider that the adverse effect caused by the reduction of exposures to customers exceeding the large exposures limits will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. LBCM funding strategy I have considered the potential effect of LBCM s chosen funding strategy and, in particular, the decision to be primarily financed via LBG plc, rather than raising the majority of its funding needs directly from the public markets. I identified one possible adverse effect of this decision in that it reduces the ability of a Commercial Banking customer to hedge their exposure to LBCM and this is discussed below. Paragraph provides further analysis of the funding profile and the implications for all stakeholders. Customer monitoring or hedging of LBCM credit risk Customers can hedge or monitor their credit exposure to a bank by buying or monitoring the price of CDS on that bank. This is only possible if there is an active CDS market on the bank, which generally requires the bank to have issued actively traded public bonds A CDS is a type of derivative instrument that can be thought of as a form of insurance (although it is technically not an insurance contract and works differently) that can be purchased to protect against a counterparty defaulting. A CDS is designed to transfer the credit exposure of a referenced public debt security, such as a bond, between two or more entities. The buyer of the CDS makes payments to its seller up until the maturity date of a contract. In return, the seller agrees that, in the event that the referenced security defaults, the seller will pay the buyer the full amount they are owed on that debt. Consequently, if the counterparty does not issue public debt securities, then the CDS market for LBCM will not exist and hedging is not possible LBCM is planning to establish a funding programme, in order to build a stand-alone funding market presence and diversify its funding sources. However, on the Effective Date, CDSs on LBCM will not be available to customers that seek to manage their credit risk exposure to LBCM. This situation is likely to continue until LBCM has a substantial amount of public bonds outstanding LB plc already has an active CDS market on a number of its public issued debt securities. Therefore, customers who want to actively manage or monitor their credit risk exposures to LB plc may continue to do so. However, there is no active CDS against BoS plc. Consequently, the potential adverse effect is limited to customers with transfers from LB plc to LBCM only The Scheme may adversely affect a customers ability to hedge or monitor their credit exposure to LBCM if they have, or potentially have, a positive exposure to LBCM (i.e. the customer will be owed money from LBCM if a financial product was terminated) and an intention to hedge or monitor this exposure. The only product that this could relate to are uncollateralised derivatives as deposits will not be transferred under the Scheme Table 6.4 sets out the number of customers with uncollateralised derivatives that will have a positive exposure to LBCM, based on 30 June 2017 data. It should be acknowledged that their position on transfer date is subject to market movements and may change As illustrated in Table 6.4, a minority of customers may be adversely affected by the Scheme in their ability to hedge their exposure to LBCM, until there is an active CDS market for LBCM debt. It is impossible to determine how many of these customers currently hedge their credit risk exposure to LB plc with CDSs. Typically, I would only expect that FIs and financially sophisticated GC customers might hedge their exposure or monitor CDS levels. Consequently, the actual number of affected customers could be significantly lower than the numbers illustrated in Table /215

71 6.116 Customers that are financially sophisticated that wish to hedge or reduce their exposure to LBCM may be able to do so by novating existing derivatives to other banks. However for some customers this might not be practical because of the terms of the derivatives and the availability of other counterparties to take over the transaction on similar terms. Conclusion with respect to customer monitoring or hedging of LBCM credit risk In my view, it is likely that the adverse effect will be immaterial for many customers as they do not actively hedge their positions or find other sources (such as rating agencies) sufficient for monitoring their credit risk. However, it is possible that some customers may currently hold CDS against LB plc to hedge their exposure and, on the Scheme implementation, will need to close out their position and will be unable to buy CDS against their new exposure to LBCM. This could result in the Scheme having a material adverse effect for some customers This leads me to part B of the Statutory Question for any customers that do suffer a material adverse effect. In Section 5 of this Scheme Report, I analyse the Group s approach to its design of LBCM and paragraphs 5.75 to 5.85 consider its credit rating. From that analysis I am satisfied with the approach taken by the Group in designing LBCM and that there are no reasonable alternative Scheme structures that would have achieved the Group s design principles for ringfencing and resulted in a better credit profile of LBCM relative to the Transferors. Additionally, LBCM is planning to establish a public bonds issuance programme so the adverse effect may be temporary. To the extent that customers have credit exposures being transferred and there is a lack of a CDS market on LBCM, I am satisfied that any adverse effect will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. Future business model Future business model of LBCM Commercial Banking customers will have their existing products transferred to LBCM on the same terms and conditions as they were entered into, with the exception of some operational changes (for example, LBCM's trade numbers and instructions for payments). The future business model of LBCM has the potential to affect some of those products in the future and will affect future transactions existing customers might want to enter into. The main areas where Commercial Banking customers of LBCM may suffer an adverse effect as a result of the Scheme and future business model are: In respect of setting of future interest rates on existing transactions; In future pricing of product renewals or new transactions that may be at different rates than they would have been prior to the Scheme; and In respect of the credit lines being approved for the customer in the future By virtue of the products and services that will be offered by LBCM, it will have a different business model to that of the Group before the Scheme. The narrower range of products and services it can offer customers and the consequential greater susceptibility to specific stress situations has the potential to affect customers of LBCM in terms of future pricing of transactions and the size of approved credit lines because: Its financial performance is likely to be more volatile compared to LB plc and BoS plc prior to the changes brought about to comply with the Ring-fencing Regime due to its lower diversification across products and customers, and its reliance on riskier activities such as derivatives. This will increase the targeted RoE for shareholders of LBCM compared to the broader based business with resulting lower volatility of returns of LB plc and BoS plc prior to the Scheme; 71/215

72 LBCM is likely to have a higher cost of funding due to the actual or perceived weaker creditworthiness of LBCM (as discussed in paragraph 5.75) which will increase its funding costs; and The relatively smaller size of LBCM s balance sheet These factors are likely to lead to future products being priced differently for customers of LBCM in order to achieve the targeted RoE compared to prior to the Scheme. Depositors and lenders to LBCM may benefit from higher pricing on interest-related products and customers borrowing from LBCM may experience higher costs. The pricing of derivative instruments may also change as a result of the future business model, but this is more difficult to assess because pricing for these products is driven not only by the business model and targeted return of the entity, but also by market forces and market rates Lending products use interest rates charged on one of three bases: Variable rate based on an internal derived reference rate, plus a spread for a customer s creditworthiness; Variable rate based on an externally derived reference rate, plus a spread for a customer s creditworthiness; and Fixed rate specified in the lending agreements with the customer. Fixed rates, variable rates referenced to externally derived rates and customers spreads are agreed when facilities are signed and will not change for the term of the lending or facility. In the case of committed facilities the standby margin is set at the point of issuance and not at the point of drawing. Therefore these rates will not be affected by the Scheme Under the terms of the existing agreements, it is only where reference is made to rates based on internally-derived rates, i.e. rates determined by entities within the Group, that LBCM has the ability to set a different rate to that which might have been set by the Transferors, but for the transfer of the relevant agreement pursuant to the Scheme. The Group identified the following scenarios where this may be the case for products being transferred: Liquidity facilities for securitisations may permit higher funding costs of LBCM to be passed onto the securitisation issuer; Default interest rates under an ISDA Master Agreement are based on the cost of funding of the payee, which could increase costs for a customer that defaults; Loan documents may contain market disruption or increased cost provisions, which allow the interest rate charged to the customer to be increased if the cost of funding of a lender or lenders exceeds a fixed benchmark; and Derivative transactions that are terminated early due to an event of default or termination event will be calculated in accordance with the terminology set out in the ISDA Master Agreement, which includes factors that may be driven by the creditworthiness of the Transferors and LBCM Credit lines for customers may be reduced in the future (after the Scheme has been implemented) as a result of LBCM having a relatively smaller balance sheet size than the Transferors. The risk appetite of LBCM is likely to be commensurate with its lower ability to withstand large credit losses. I understand there are no specific plans to reduce credit lines in the future due to the Ring-fencing Regime, except for those identified due to the Large Exposure considerations. However, credit facilities and risk appetite will be assessed dynamically by the Transferors and LBCM separately The future business model of LBCM will primarily affect new products and renewals which are not part of the Scheme. However, as discussed above, there are some products being transferred where interest costs or close-out costs may depend on LBCM s business model and, in particular, its creditworthiness and funding costs. This is a likely adverse effect and 72/215

73 therefore this leads me to part B of the Statutory Question. In all the cases identified the products being transferred are required to be so in order to comply with the Ring-fencing Regime. In the case of prohibited derivatives, this is a direct requirement and for Permitted Derivatives they are being transferred to comply with the RRR Limit requirements. During the Grandfathering period transfers will be at the customer s discretion. Consequently I am satisfied that these adverse effects in relation to the future business model of LBCM will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. Product transfer Events triggered by the transfer of derivatives The transfer of derivative trades could trigger certain events that may result in adverse effects, for customers under local rules, in the following scenarios: Tax implications: Derivative transfers could result in the crystallisation of taxable gains as they will be treated as a novation by some tax authorities (and it is not possible for the Scheme to avoid this treatment). To the extent this generates a tax payment for a customer it may be able to mitigate the effect through tax planning. However, it is not possible for me to have knowledge of customer s overall tax positions. Therefore, in my view this may result in a material adverse effect for some customers; Clearing and margin requirements: Customers may be subject to local rules regarding clearing and margin requirements which may result in adverse effects. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 ( Dodd-Frank ) in the USA introduced rules regarding the margin requirements for new derivative trades (if they are not cleared at a clearing house). This is the minimum amount the Federal Reserve Bank requires a customer to have on deposit, either in cash or approved securities as collateral with their counterparty. The rules did not apply to trades outstanding before the legislation was enacted. However, this benefit may be lost as the Scheme could potentially trigger an event so that a customer s existing derivative trades are treated like a new transaction and will be subject to the margin requirements. This will only impact clients classified as US Persons or US Person Lites under Dodd-Frank who have English law documents transferring through the Scheme. As at 30 September 2017, the Group identified 153 trades that would be impacted. In my view it is possible that this may represent a material adverse effect for some customers. It is also possible that the transfer of derivatives under the Scheme could result in the loss of grandfathering under other local derivatives clearing and margining rules; and Hedge accounting: As explained in paragraph 6.33 the change of the counterparty and the potential change in derivative fair values may trigger the discontinuation of hedge accounting This takes me to part B of the Statutory Question for the events explained above. The adverse effect is a result of derivatives being transferred to LBCM which is a direct requirement of the Scheme. Consequently I am satisfied that any adverse effect will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. Transfer implications for trade finance In relation to Trade Instruments issued by the Transferors at the request of their customers, the lower credit rating of LBCM could cause the customer to be in breach of the underlying contract between it and the beneficiary of the Trade Instrument, pursuant to which the customer was required to procure the issue of a letter of credit or guarantee. If such underlying contract prescribes an identity, rating or other requirement of the entity which issues the Trade Instrument, which is not met by the Transferee, the customer could be in breach of that 73/215

74 underlying contract which could potentially have an adverse effect from the perspective of the customer Trade Instruments may have claims made under them by purely making a demand in the required form. The physical instruments themselves may not be updated to reflect the transfer. As such there is a risk that the beneficiary of the instrument could, after the Effective Date, assign the benefit of that instrument to a third party without informing the third party that the issuing bank is LBCM and not the Transferor. This could be an adverse effect for the third party on the basis of the lower rating of LBCM versus the Transferor It is possible that any transfer of a Trade Instrument that has been pledged in favour of a third party might affect the validity of any existing security interest and leave the pledgee unsecured. This could result in an adverse effect to the pledgee and potentially the beneficiary if it had been required to grant security as part of a contract. There could also be an adverse effect for the pledgee on the basis of the lower rating of LBCM versus the Transferor These transfer implications for Trade Instruments all represent potential adverse effects that may be material, which takes me to part B of the Statutory Question. The adverse effect is a result of prohibited Trade Instruments being transferred to LBCM, which is a direct requirement of the Ring-fencing Regime. Consequently, I am satisfied that any adverse effect will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. Contractual provisions being overridden The legal documentation of some products being transferred contain prohibitions, restrictions or consent requirements that would normally entitle the customer to a contractual remedy for breaching the agreement, however, the Scheme will override some of these provisions. This could be considered as an adverse effect from the customer s perspective, as it may lead to a loss of remedy, such as a termination right. The clauses that will be overridden as part of the Scheme include: Restrictions or specific requirements for transfer: the Scheme may override prohibitions, transfer restrictions or requirements (including procuring prior written consent from the customer or relevant third parties, requirements to give notices or to enter into accession deeds) on the ability of a party to assign or transfer its rights and obligations pursuant to the product documents; Change of account: the Scheme may override restrictions on changing the accounts the parties use to receive payments or deliveries under the contract; and Confidentiality: the Scheme will override confidentiality clauses which would otherwise prevent the parties from disclosing certain information to third parties, such that the Transferors will be permitted to disclose such restricted information to LBCM. In order to mitigate this potential adverse effect, I have been informed that LBCM will adhere to the same confidentiality standards as applicable to the Transferors prior to the Scheme These changes in provisions are a consequence of the transfer of the products in order to comply with the Ring-fencing Regime and the customers will not be in a materially different situation as a result of the Scheme. For example, the confidentiality provisions for third parties outside of the Group will remain intact. As a result, I am satisfied that the overriding of contractual provisions does not represent a material adverse effect of the Scheme In the case of linked products with provisions in their documentation preventing the separate transfer of the underlying products, the transfer of one or more products to LBCM, while keeping one or more products in the Transferors could lead to LBCM or the Transferors having the right to terminate the linked product. The terms of the Scheme will prevent LBCM or the Transferors becoming entitled to exercise the right to terminate the linked product. 74/215

75 6.135 Provisions in product contracts may include representations and warranties provided by BoS plc, as to its place of incorporation. As this entity is incorporated under the laws of Scotland while LBCM is incorporated under the laws of England and Wales, LBCM will not be able to give these representations/warranties that it is incorporated under Scottish law following the product transfer to LBCM. In order to mitigate this potential adverse effect, references to BoS plc being incorporated under the laws of Scotland will be replaced with references to LBCM being incorporated under the laws of England and Wales. Commercial decisions Product curtailment I have considered the potential effect of the Scheme on Commercial Banking customers as a result of the Group curtailing its product offering at implementation of the Scheme. Whilst the Group s principle is to retain the current service provision wherever possible, there are several products that will no longer be offered to customers post-scheme. Product curtailment is important to customers, as those affected may need to either seek these products from other banks, forgo entering into them or migrate to other products The Group does not plan to offer the following products from LBCM: Overdraft facilities; Credit and charge cards; Consumer Finance products (however, Black Horse Offshore Limited ( BHOL ) will continue to offer these products whilst forming part of the NRFB Sub-group); Loans linked to the BoE base rate or fixed rate loans; Conduit lending facilities; Lending schemes offered by the UK Government; and Asset Finance and Invoice Finance These product curtailments will affect RFIs only as they are exposure bearing products which an RFI cannot hold with the Transferors. It should be noted that the Transferors intend to continue offering these products to non-rfi customers Overdraft facilities will not be offered by LBCM. Overdrafts allow the customer short-term access to credit where the relevant account has insufficient funds either to withdraw money or to meet outgoing payment obligations. The reason for this is that (i) this product cannot be offered to RFIs from the Transferors, and (ii) LBCM will not have a cash management and payments platform to process these products as its cost would be financially disproportionate in relation to the small number of customers involved. Any RFI customers making use of overdrafts will be asked to repay any outstanding borrowing on or prior to 1 January As a partial mitigant to the withdrawal of overdraft facilities, the affected customers that are RFIs will continue to access the cash management and payments platform with the Transferors utilising daylight facilities (i.e. credit facilities that must be settled by the end of the relevant business day, to avoid the Transferors incurring prohibited exposures to RFIs). In addition RFIs will also be able to access net nil sterling and multicurrency current account structures. Nonetheless, non-rfi customers will continue to have access to overdrafts from the Transferors Commercial credit cards and charge cards will not be provided from LBCM and will only be offered from the Transferors to non-rfi customers Other Consumer Finance products (except BHOL products) are discussed in Section 8 of this Scheme Report. 75/215

76 6.142 Some loan products will not be offered by LBCM. These are as follows. Fixed rate loans, which can be supported for existing trades but will not be offered as new business. The Group has identified only one customer, which is expected to have a fixed rate loan transferred under the Scheme; and Base rate loans for which the interest rate is based on external (for example, the Bank of England ( BoE )) or internal base rates. These can be supported for existing trades but will not be offered as new business. The Group has identified two customers that are expected to have base rate loans transferred under the scheme According to the Group, in order to offer such loans, LBCM would need to undertake operational changes (including to the relevant booking platform required to offer these products) which would be uneconomic in light of the very small number of customers who would be directly affected by this issue. For the very small number of RFI customers identified with existing base rate loans, these will be operationally managed manually in LBCM in order for the Group to fulfil its contractual obligations Due to the lack of necessary infrastructure LBCM will not offer products relating to Asset Finance and Invoice Finance to RFIs. However, the Transferors will continue to offer Asset Finance products to customers who are RFIs (other than SME RFIs) as long as they are able to rely on any exemptions as per the EAPO. The Transferors will not offer Invoice Finance to any RFIs LBCM has no plans to offer access to funding structures linked to lending schemes supported by the UK Government, for example, (i) Regional Growth Fund (an assisted asset purchase scheme providing grants to help businesses to acquire assets); (ii) Enterprise Finance Guarantee (to enable small businesses lacking security to borrow money with the assistance of a governmental guarantee); and (iii) Funding for Lending (designed to boost lending by banks and building societies to the UK economy by providing Government funding) For RFI customers, asset backed securitisation lending as principal will be offered directly from the LBCM balance sheet only and not via a conduit. As at September 2017, there are six transactions funded for RFI customers via Lloyds Bank s existing conduit. These RFI customers will be offered warehouse securitisation lending funded directly by LBCM to mitigate any potential adverse effect to these customers Customers affected by the withdrawal of these products will receive communication of the proposed changes in line with the communications plan set out in Section 17 of this Scheme Report. This communication, which will take place in advance of the Effective Date, will provide information on the changes to their banking products and should enable the customers affected by these product curtailments to make arrangements to repay any outstanding balances in advance of 1 January 2019 and to consider whether to make arrangements to access these products from alternative providers. It is reasonable to expect that such alternative arrangements would be available to the majority, if not all, of the affected RFIs Following the Effective Date, the Transferee does not intend to offer lending products and trade products (including receivables purchase agreements) as a new business to SME Customers who are RFIs given that setting up and operationalising the requisite infrastructure for such limited products in the Transferee would not be viable in light of the number of customers affected. In addition, to help mitigate the adverse impacts, customers that are affected by these restrictions concerning lending products and trade products will receive communications to advise them of the changes to their available banking products Whilst these product curtailments are likely to result in an adverse effect for these customers, any such change will not be as a result of the Scheme, which the Court is being asked to sanction, but is the result of a commercial decision taken as a consequence of complying with the broader Ring-fencing Regime and which will be implemented as part of the wider group restructuring. 76/215

77 Split banking Product linking I have considered the potential effect of the Scheme on Commercial Banking customers in terms of their ability to link financial products to reduce costs on implementation of the Scheme and subsequently Banks offer linked financial products in a large variety of ways. In the case of the Group, linked financial products take place in the form of: RPI loans RPI loans; and Deposits securing loans or derivatives A loan with interest payments linked to RPI is called an RPI loan. Certain customers operate with income based on RPI, and take out an RPI loan to hedge their exposure to future movements in RPI. Under the EAPO exposure-bearing products related to RPI are prohibited investments in the RFBs There are two types of RPI loan facilities offered to customers: Facilities offering RPI loans only. These will be transferred to LBCM under the Scheme, irrespective of whether they are drawn or not; and Facilities offering multiple drawing alternatives including: RPI loans, fixed interest rate loans or other variable interest rate loans (for example, LIBOR based). For these facilities if there is an outstanding RPI loan on the Effective Date, the entire facility will be transferred to LBCM under the Scheme. When no RPI loan is outstanding on the Effective Date the facility will not be transferred and customers will be informed that RPI loans can no longer be provided from the Transferors. Any customer wishing to draw an RPI loan under their facility would need to arrange the product through LBCM or an alternative provider For some RPI loans the underlying documents state that, upon transfer of the mortgage or security relating to the RPI loans, the principal money owed by the counterparty is increased in proportion to any increase in RPI in the month of the transfer. This could potentially result in an adverse effect as it could increase the principal amount owed by a customer. However, the Group s Scheme document will override the requirement that the principal amount is recalculated in the event of the transfer, therefore mitigating the potential adverse effect. Deposits securing loans or derivatives A deposit may be linked with a loan or a derivative in order to reduce the Group s exposure to a potential customer default. For example, for a deposit and a derivative transacted separately with the same customer, the Group could use the customer s deposit to secure fully a potential default of the customer on the derivative giving the Group set off rights over the deposit. The customer may not withdraw the deposited amount until the derivative is unwound or expires. By linking the deposit and the derivative, the Group is able to fully mitigate the credit risk of the customer and permits the customer to obtain more favourable pricing from the Group and utilise approved credit lines for other products. In addition, linking deposits and derivatives (or loans) allows a customer with a notably weak credit profile to enter into the derivative (or loan) when it may not have been able otherwise to transact with the Group As a result of the Scheme, an inability to link these deposits with loans or derivatives may result in increased product pricing from the Group or, in the case of customers with notably weak credit risk profiles, an inability to transact with the Group. 77/215

78 6.157 If the secured loan or derivative and the deposit are in the same bank (either the Transferors or LBCM), the customer will not experience a change as a result of the Scheme in its ability to link the loan or the derivative with the deposit If the secured loan or derivative is in one bank (for example, LBCM) and the deposit is in the other bank (for example, the Transferors) it may be possible to link the loan or derivative, but in some cases, it would be limited by the Ring-fencing Regime as, for instance, the Transferors could not allow a loan granted to a counterparty to be offset against a deposit with LBCM Subsequent to the Scheme implementation, both the Transferors and LBCM will be offering deposits to customers (although LBCM will only be offering certain types of money market deposits), while the only loans to be booked in LBCM will be those transacted with RFIs or RPI loans transacted with any non-rfis. Effective mitigants may be available to a customer seeking to secure a loan or a derivative in LBCM with a deposit. Firstly, it may be possible for a customer to place the deposit with LBCM and, as a result, have both products booked in LBCM. Secondly, the customer may enter into the linked products with another provider. Finally, the customer may place the deposit with the Transferors and formalise an agreement to link the deposit with the loan, by entering into such agreement on an arm s length basis. However, it might not be the case that all customers can mitigate the adverse effects. It is possible a customer is forced to take an action that leaves them in a worse position as a result of the Scheme This would take me to answering part B of the Statutory Question for any customers that do suffer a material adverse effect. In Section 5 of this Scheme Report, I analyse the Group s approach to its design of LBCM. From that analysis I am satisfied with the approach taken by the Group in designing LBCM and that there are no reasonable alternative Scheme structures that would have achieved the Group s design principles for ring-fencing and allowed customers to link all products. To the extent that customers have product links which must be broken I am therefore satisfied that any adverse effect will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. Product alternatives information I have considered the potential effect of the Scheme on Commercial Banking customers in terms of the quality of the information on product alternatives at implementation of the Scheme and subsequently Commonly customers take into account information on product alternatives provided by their banks when making decisions on financial products. In particular when raising financing through loans or hedging financial risks with derivatives The Scheme may have an adverse effect on the information on alternative products received by customers if a limited level of market insight and information, that could be instrumental in the customers decision-making, is provided by the Group. Information on alternative loan products Loans and other financial products are negotiated between the customer and the customer s RM at the Group. Prior to the Scheme, each customer has an RM that serves as their main point of contact and who provides the customer with pricing and other information on alternative types of loans (for example, variable rate vs. fixed rate loans, amortising vs. non-amortising notional) Post-Scheme, customers may transact with both the Transferors and LBCM. For example, an RFI entity of a customer group may have a loan booked in LBCM while a non-rfi entity of the same group may hold a loan booked in the Transferors. If each customer were covered by two RMs (one per bank) or if each customer were covered by a sole RM whose performance were measured in terms of the products being transacted by just one bank (the Transferors or 78/215

79 LBCM), the RM may emphasise the products offered by that bank while neglecting the products offered by the other bank Post-Scheme, I understand that the Group s delivery model to customers will be an integrated customer model. It will rely on a bank agnostic relationship management model in which customers have a single point of contact, the RM, when seeking products from the Group (including the Transferors and LBCM). As the RM will be shared by the Transferors and LBCM and performance will be measured against customer activity with the two banks, I conclude that the quality of the information on alternative products to be provided by the Group to the customer when raising financing is unlikely to be adversely affected by the Scheme. Information on alternative derivative products When products are notably complex, RMs rely on product specialists to transact with the customer. In the case of derivatives, each customer is currently covered by a derivatives salesperson. For example, where a SME has raised funding through a variable rate loan, the SME is exposed to rising interest rates and may consider hedging this exposure by entering into a derivative. The derivatives salesperson will provide the customer with different alternatives on how to hedge this exposure with derivatives, such as fixing the interest rate with an interest rate swap, limiting the maximum interest rate to be paid using a cap or limiting both the maximum and the minimum interest rate to be paid with a combination of a cap and a floor. The derivatives salesperson would provide insight about the advantages and disadvantages of these strategies, derivatives market flows and the bank s view on future interest rates, etc Post-Scheme, I understand that the Group s plan is to continue providing each customer with a primary derivatives salesperson. In the case of GC and FI customers, the salesperson will be offering all derivatives from LBCM, so there will be no effect on their information on alternative derivative instruments. In the case of SME and MM customers, the salesperson will be offering both permitted and prohibited derivatives in accordance with the customer needs. As the performance of the SME and MM customer derivatives salesperson will be measured against the overall customer derivatives activity with the two banks, I conclude the quality of the information on alternatives to be provided by the Group to the customer when entering into derivatives is unlikely to be adversely affected by the Scheme. Foreign law security Where security documents are governed by the law of a jurisdiction other than England and Wales, Scotland or Northern Ireland, they may not be effectively transferred via the Scheme, and in such case would need to be manually transferred in accordance with the law of that jurisdiction. If such transfer is not completed by hours on 30 December 2018, the underlying obligation will transfer to the Transferee without the benefit of such security. If such security is not manually transferred, the Group have identified that there is a risk that the Scheme may adversely affect the validity or enforceability of security governed by certain foreign jurisdictions and, as a result, an event of default under the underlying agreement may be triggered. In order to mitigate this potential adverse effect, the Group will endeavour to transfer any security which will require to be transferred manually on the Effective Date, or failing that, by hours on 31 December As this potential adverse effect can be mitigated through a manual transfer agreed with the customer, which the Group has confirmed they will endeavour to do, I believe it is reasonable to assume that customers can mitigate this adverse effect. Operational effects In this subsection I consider operational changes and the potential adverse effects arising from the proposed implementation of the Scheme under the Group s design. Operational changes are considered to be changes to processes and procedures that affects a customer s relationship or interaction with the bank. I discuss one-off transitional effects in the next subsection. 79/215

80 6.171 The operational effects that a customer may experience are administrative in nature. While the operational effects may result in customers suffering a financial effect due to increases in operating costs these are very difficult to quantify as they are highly dependent on each customer s situation. Consequently, my analysis in the following subsections is qualitative and focuses on the following two main areas: Customers conducting business with a new entity; and Customers potentially having a more complex banking relationship split across the ringfence There are no plans or requirements for a change to operational processes and procedures for Commercial Banking customers that remain exclusively in the Transferors. As a result, I am satisfied that they are not likely to suffer any material adverse operational effects Therefore I have confined my review to Commercial Banking customers that, as a result of the Scheme, will experience some or all of their financial products being transferred to LBCM. I have set out those circumstances where I consider these customers might expect to see a discernible change in their operations. Conducting business with a new entity (LBCM) Customers will need to conduct an end-to-end process review of their current processes to assess what changes will need to be made to documentation, controls and IT systems to reflect that they will be transacting with a new entity (LBCM). Examples of changes that customers may need to make include: Updating static data in their IT systems to include new LBCM contact details and standard settlement instructions ( SSI ), this will affect the ability to settle funds correctly; Interacting with new IT systems that may be required in LBCM; Participating in IT tests to ensure adjustments such as trade confirmations and third party exchange confirmations have been made correctly; Requesting their own customers or third parties to update their IT systems to reflect new LBCM data, for example customers agent banks testing payment instructions with LBCM; Some customers, mainly in the MM segment, use a website called CB Online to view their positions but this will not be initially available for LBCM; Customers may be required to provide additional information in order to comply with KYC regulatory requirements; and Customers will have to perform KYC checks on LBCM as a new entity, though this is not expected to be more extensive than they would have been required to perform for the Transferors before the Scheme. The Group has stated that they will undertake to provide, upon reasonable request, any reasonable KYC information requested by the customer for the period of up to six months following the Effective Date Given that the RFBs are prohibited from having non-eea branches, some products will need to be rebooked to the UK. An example is swingline facilities currently provided via the New York Branch of the RFB (which are similar to revolving lines of credit but drawn only to temporarily cover other debt payments). Whilst the facility will still be held with LB plc, customers will undergo some operational changes to reflect the change in the booking location. Complexity of a split banking relationship Customers may perceive that they have a more complicated banking relationship as a result of the Scheme and this may give rise to a range of potential adverse operational effects. I describe these below: 80/215

81 Customers may perceive that there is an increased risk of operational errors stemming from having a split customer proposition (for example, confirmation and settlements being split between the Transferors and LBCM); Customers may not understand why their derivatives are being booked in both the Transferors and LBCM and will require this to be explained; Customers with derivatives split between the Transferors and LBCM may need to manage multiple payments that were previously under a single Master Agreement; Customers may experience a rise in operational costs due to the additional time and effort required to deal with increased documentation as a result of transacting with both the Transferors and LBCM; Customers may find that it takes longer for them to be on-boarded, to obtain approval for and to execute transactions, as a result of having a split banking relationship; Customers may experience increased complexity of transferring deposits and managing liabilities (for example, repaying loans) when it crosses the ring-fence (from Transferors to LBCM and vice versa); Customers, commonly FIs, may need to set up credit lines to operate with LBCM; Customers may need to change their processes, for example customer systems would need to be updated so that any collateral required from customers is posted to the account of LBCM; and Customers will need to amend their internal processes to meet the requirement to share security (assets used as collateral) between the Transferors and LBCM through security trust structures. This is explained in more detail below. Security trust structures There are scenarios, post-scheme, where security (which for this purpose also includes guarantees and certain other forms of credit support) will need to be shared between the relevant Transferor and LBCM to secure liabilities owed to both banks. The security needs to be shared where certain products are transferred to LBCM via the Scheme and other products remain with the Transferor. The security also needs to be shared where a security is provided in relation to an ISDA Master Agreement or other existing agreement that is being duplicated pursuant to the Scheme. In such situations, the Group intends to use the Scheme to create a security trust arrangement (where permitted by law) between the Transferors and LBCM (i) for existing products that are transferred to LBCM via the Scheme and the existing products that are remaining with the Transferor and/or; (ii) in relation to any existing agreement being duplicated pursuant to the Scheme, for all liabilities owed to the Transferor under transactions under the existing agreement (including all existing transactions remaining with the Transferor at the Relevant Date and all new transactions entered into between the Transferor and the customer under the existing agreement on or after the Relevant Date) and for all liabilities owed to LBCM under transactions under the duplicated agreement (including all transactions transferred to LBCM pursuant to the Scheme and all new transactions entered into between LBCM and the customer under the duplicated agreement on or after the date that the duplicated agreement is created). The relevant Transferor will act as security trustee holding the benefit of the security as security trustee for the Transferor and LBCM. Any other security trust required post-scheme that is not covered by this security trust created pursuant to the Scheme will need be created through a separate contractual arrangement in each case outside the Scheme These security trust provisions for existing products and/or any existing agreement being duplicated pursuant to the Scheme will apply to existing products and, in relation to an existing agreement being duplicated pursuant to the Scheme, all transactions under the existing agreement and the duplicated agreement, with the relevant clients and no customer consent will be required. However, customers may experience impacts from a time or cost perspective (for example, costs of obtaining independent legal advice) as a result of having to make arrangements with the security trustee and may incur registration fees. Additionally the 81/215

82 customer will need to interact with both the relevant Transferor and LBCM in relation to security held under the shared security structure The security will be shared on the basis of equal ( pari-passu ) ranking, pro-rata distribution and joint enforcement rights. An inter-creditor agreement will be put in place between the security trustee, the Transferors and LBCM to govern aspects of the shared security relationship. In effect the Transferors and LBCM will be two separate banks dealing with the same customer, which is analogous to the security agreements used with syndicated loans provided by a group of banks. The Group s intention is to structure security trusts so that, if a customer were to default, the Group s access to assets which are subject to the security would be in the same proportion as before the Scheme In order to mitigate adverse effects, the RM assigned to the customer will be a single point of contact with responsibility for alleviating any administrative complexity that may arise as a result of the security arrangements involving multiple beneficiaries and a security trustee arrangement. The changes brought about by the new security trust arrangement will be communicated to customers. No additional security will be required to be provided by a customer for the creation of the new security trust arrangement (it being noted that the existing security will continue to cover the existing products, and, in the case of a security securing a customer s obligations under an existing agreement that is duplicated pursuant to the Scheme, the customer s obligations under both the existing agreement and the duplicated agreement (including all the customer s obligations under any new transactions entered into by the customer under the existing agreement or the duplicated agreement)). Re-registration costs, if incurred, will be reimbursed. It is possible that, if a customer were to default, the Transferors or LBCM may be more incentivised to close out the product to ensure it crystallises its share of the security. However, in my view this is an unlikely scenario given the Group s structure with single RMs. Consequently, I am satisfied that the proposed security trust structures will not have any material adverse effect on customers. It should also be noted that the Ring-fencing Regime requires that each of the Transferors must ensure that its share of any collateral provided by counterparties would not cease to be available to the relevant Transferor as a result of the acts, omissions, or insolvency of, or actions taken in relation to LBCM. Reduction of the operational effects The SSM, as discussed in paragraph 5.20, and the associated governance arrangements have been designed such that a single RM will manage these customer relationships so as to minimise any operational, transitional or administrative adverse effects that may otherwise be suffered by customers as a result of the Scheme and their split banking relationships. Customers will deal with one RM so should not experience any material difference in their relationship coverage and there is no additional incentive for the RM to sell particular products. Additionally the SSM has been designed under a no optionality principle so that there is no discretion in the allocation of products to one side of the ring-fence perimeter or the other. An exception is deposits which will be offered from LBCM for money market accounts and the customer can choose where they decide to deposit money based on independent price quotes. Consequently I am satisfied there are no conflicts of interest with the design of the SSM The activities as performed under the SSM on behalf of the Transferors and LBCM will be centralised where possible, for example: On-boarding of customers at Group level in an entity-agnostic manner minimising the burden on the customer; Analysis of customers will be performed in an entity-agnostic manner to help ensure each bank treats customers fairly and consistently; Single RM contact to manage a customer s relationship, including a primary Commercial Banking market salesperson so that information on all appropriate products are shown to clients; 82/215

83 The service provision structure enables LBCM to benefit from tried and tested, standardised processes that currently support the Group s various brands; and Services provided from the Transferors to LBCM will be delivered to the same standard performance metrics and service levels as prior to implementation of the ring-fence Changes to servicing and settlement arrangements are considered a necessary operational effect that will be supported through access to specific teams that provide support to customers and counterparties to minimise any adverse effects. In addition, I have reviewed all the planned communications up to Stage 2 of 4 and am satisfied that the Group is taking steps that will help to mitigate any potential operational effect on customers. Conclusion with respect to operational effects Whilst some customers will experience some operational changes as a result of the Scheme, I am satisfied that the Group is doing everything reasonably possible to mitigate the effect. In my view none of the issues identified are material relative to changes a customer may experience in dealing with any new counterparty and, consequently, they are not likely to be materially adversely affected by the Scheme. Transitional effects In this section, I consider transitional effects and the potential adverse effects arising from the proposed implementation of the Scheme under the Group s design. Transitional effects include the differential effects identified during the customer journey from the current relationship state with the Transferors to a future state with either (i) LBCM, or (ii) the Transferors and LBCM, arising from the proposed implementation of the Scheme under the Group s design. This analysis focuses exclusively on the one-off effects required when financial products are transferred, rather than longer term, ongoing changes, which are considered elsewhere in this section In my view, any customer that is subject to the Scheme could inevitably experience some transitional effects. As a minimum, the Group needs to inform customers of the Scheme and what this means for them in terms of any transfer of financial products and actions they may need to take. The design of the Scheme defines how many financial products are transferred to LBCM and, therefore, influences the degree to which customers are affected by the transition Similar to the operational changes discussed in the prior subsection, the transitional effects are administrative in nature. Customers could suffer a financial loss due to increases in operating costs but these are difficult to quantify, as it is highly dependent on each customer s situation. Consequently, my analysis is qualitative As discussed in the prior subsection on operational effects, there are no plans or requirements for a change to operational processes and procedures for Commercial Banking customers that remain exclusively in the Transferors. As a result, I am satisfied that they are not likely to suffer any material adverse transitional effects Therefore I have confined my review to Commercial Banking customers that will be subject to the Scheme and will witness some or all of their financial products being transferred to LBCM and/or their contractual arrangements being duplicated under the Scheme. I have set out below circumstances where I believe customers could, in principle, experience transitional effects: Branding: inadequate explanations provided to customers about changes in branding result in customers not understanding changes, and downstream adverse effects; SSI: customers are required to change their SSI to ensure correct settlement of payments; Re-papering: some financial products that are transferred to LBCM will inevitably require customers to enter into new documentation with LBCM; 83/215

84 Branding IT updates: customers will need to set up new data and systems as previously discussed in the operational effect subsection; Shared security: customers with split banking as a result of the Scheme may have security agreements in place such as cross guarantees or debentures. As discussed in paragraph the Group intends to utilise security trusts for this purpose. Establishing these structures may have some transitional effects; Syndicated Loans: the change of a Group entity within syndicated loan deals may require approvals from other lenders in the syndicate and from other borrowers in the loan. The Scheme will override the need to obtain borrower (and any lender, if any) consent; Collateral: recalculation of collateral using the ISDA CSA methodology and posting of additional collateral if required; Trade reporting: in order to ensure that the records of trade repositories are up to date, customers will need to notify relevant trade repositories of the transfer (or modification) of the derivatives pursuant to the Scheme; and Payment instructions: customers are required to change in their systems the details for payment to LBCM where applicable The Group plans to use the same master brand for the NRFB Sub-group as the Transferors. In my view this could create a greater risk of confusion among customers as they are less likely to appreciate the differences between the entities. However, this has been recognised by the Group, which has stated that they intend to deploy clear signposting and disclaimers so that customers are provided with a clear, transparent and unambiguous way of determining the entity with which they are due to trade. Specifically the Group noted the following actions: Signposting of LBCM s sub-group wherever a logo appears; Disclosure and risk warnings to make it clear that customers are engaging with LBCM, with the associated implications, so that it can be assessed before undertaking any risk; Use of bespoke disclaimers on all LBCM documentation; Legal footers to be updated for all LBCM documents; and References to the Transferors in documents need to be updated as appropriate In my view it is possible to use consistent branding, whilst providing customers with a transparent and unambiguous way of differentiating between the entities. The responsibility for this will primarily rest with the customer s RM. SSI As a result of customers transacting with a new entity (LBCM), customers static data will need to be changed. Static data changes include changes to SSI that include SWIFT Codes (a standard format for Business Identifier Codes ( BIC ) used to uniquely identify banks and FI globally). These codes are used when transferring money between banks, in particular for international wire transfers or SEPA ( Single Euro Payments Area ) payments. The approach to managing transitional changes will include system testing which, provided that customers confirm they have robustly tested settlement of funds to LBCM ahead of the Effective Date, should not cause any disturbance. As a result I am satisfied that the only adverse transitional effects that will occur are administrative in nature. 84/215

85 Re-papering The obligation to deliver new documents will be fulfilled by LBCM through its reliance on the SSM. I am satisfied that this is being set up in a manner which aims to minimise the input required by and, therefore, disruption to customers. For example in the case of derivatives, the Group plans to clone, for LBCM, all ISDA documents that are not empty i.e. with outstanding transactions, avoiding any need for the customer to intervene in the formalisation of the new agreements with LBCM. Additionally some ISDA documents that are empty will be cloned to facilitate trading for clients who do not have transferring trades. Furthermore, each customer will have an RM assigned who will be responsible for minimising any administrative complexity that may arise as a result of the transfer. In addition, the Group will put in place a communications process to bring the Scheme to the attention of these customers, as detailed in Section 17 of this Scheme Report. IT updates As explained in the operational effects subsection, the on-boarding of customers to LBCM may require changes to IT systems that require input from the customer. This is intended to use the same principles of the SSM whereby the time required from the customer is minimised. Shared security As explained in the operational effects subsection the Group plans to mitigate the effect of needing security to be split with the use of security trust structures. I am satisfied that this approach helps to mitigate the effect on customers as it minimises customer involvement as far as is practical. Syndicated Loans The Group has identified customers with split banking who have syndicated loan deals that will require migration. I am satisfied that the operational requirements will be minimised through the use of the SSM, so that the customer s time will only be used where strictly necessary and beneficial to them. Planned communications Customers have already received an initial communication about ring-fencing and information tailored to them about the potential effects, when the Scheme comes into effect. At the date of this Scheme Report, the bulk of the communication is yet to occur and therefore my review is focused on the Group s plans. In this regard the proposed initial communication programme can be summarised as follows: Stage 1: General awareness and disclosure (February to June 2017); Stage 2: Specific client effects plus initial migration plan (July to November 2017); Stage 3: The Scheme formal communication (following the Directions Hearing on 4 December 2017); and Stage 4: Prepare for migration (following the Sanction Hearing on 28 March 2018) Regarding customer communications in Stage 2, the Group plans to include (among other information) a breakdown of the list of entities that will be characterised as RFIs (for GC and FI customers), the agreements that will be subject to transfer to LBCM and the transactions which will be eligible for Grandfathering. Indicative objections and concerns will be tracked during this process. As these communications are run alongside the development of the Scheme they naturally may not be fully comprehensive. However, at Stage 3 there will be a full explanation of the migration mechanism and objection process. Then, for Stage 4, the Sanction Hearing outcome will be communicated to clients, with a detailed preparation for migration, including 85/215

86 on-boarding, entity change and end state service model. My review of all planned communications is contained in Section 17 of this Scheme Report. Conclusion with respect to transitional effects Whilst customers will experience some transitional effects as a result of the Scheme, I am satisfied that the Group is doing everything reasonably possible to mitigate those effects. In my view none of the issues identified are material relative to changes a customer may experience in dealing with any new counterparty and, consequently, they are not likely to be materially adversely affected by the Scheme. 86/215

87 7. Implications for Retail Banking customers Introduction 7.1 In this section, I consider the likely effect of the Scheme on the Retail Banking customers of the Group. 7.2 Whilst this section of my Scheme Report considers the specific effect of the Scheme on Retail Banking customers, certain other sections of my Scheme Report consider other effects of the Scheme that may be applicable to all customers, and Other Relevant Persons. Therefore, this section does not contain all effects of the Scheme that may be relevant to Retail Banking customers and consequently my Scheme Report should be read in its entirety. Definition of Retail Banking customers within the Group 7.3 The Retail Banking division of the Group offers retail products and services to approximately 38 million customers, the significant majority of whom (over 98%) are UK based. Retail Banking customers are primarily individuals, sole traders and small businesses, typically with a turnover of less than 1m. Small business customers are served through Retail Business Banking ( RBB ), which is a sub-division of the Group s Retail Banking division. The Consumer Finance sub-division is another sub-division of the Retail Banking division, which is considered separately in Section 8. Summary of the Scheme s effect on Retail Banking customers 7.4 As described in Section 5 of this Scheme Report, the Group s approach to ring-fencing has been to adopt a wide RFBs and narrow NRFB model, and in doing so has designated each of LB plc and BoS plc as Transferors. This approach will result in the products and services offered to Retail Banking customers not being transferred under the Scheme and the vast majority of them remaining unchanged. 7.5 However, 67 RBB customers meet the definition of an RFI under Article 2 of the EAPO and, therefore, the Transferors are not permitted to retain any exposure to these customers. Products currently provided to those RFI RBB customers that would result in a prohibited exposure post-ring-fencing will be withdrawn before the Statutory Deadline. 7.6 In addition, in order to comply with the Ring-fencing Regime, the Group legal entities and branches in non-eea locations, namely Jersey, Guernsey, Alderney and the Isle of Man, will be required to move outside of the RFB Sub-group and therefore, post-ring-fencing, customers of these legal entities and branches will be served from outside the RFB Sub-group. As set out in Section 3 of this Scheme Report, customer contracts with these non-eea legal entities and branches are not moving via the Scheme and will instead move outside of the RFB Sub-group as part of a wider group restructuring. Lloyds Bank Gibraltar Limited ( LGIB ), which is a Gibraltar based entity, will also be moved outside of the RFB Sub-group. Whilst this entity is within the EEA, the entity is being transferred out of the RFB Sub-group due to the close operational alignment with Lloyds Bank International Limited ( LBIL ) (a non-eea entity). 87/215

88 Scope of my analysis 7.7 The most significant retail products and services offered by the Group are current accounts, overdrafts, loans, credit cards, savings, investments and mortgages. These products are predominantly offered by LB plc and BoS plc. Within my assessment I have considered the potential financial, product, operational and transitional effects of the Scheme, as set out in paragraph In considering the likely effect of the Scheme on Retail Banking customers of the Group, I have taken into account the context in which the Scheme is taking place and reflected how other parts of the wider group restructuring being carried out by the Group might affect my analysis. In particular, while it is not within my scope to opine on transfers or other activities performed outside of the Scheme, such as the transfer of legal entities into other sub-groups within the Group, I have considered whether those activities have any effect on my conclusions in respect of the Scheme. 7.9 In conducting my analysis I have reviewed information produced by the Group that sets out how the Scheme and wider group restructuring will potentially affect Retail Banking customers. I have also reviewed other information made available to me on my request by the Group and other publically available information 38. My consideration of possible adverse effects of the Scheme 7.10 Based on my analysis of the information provided to me, I have not identified any likely adverse effects of the Scheme on Retail Banking customers. In particular, I have not identified any material changes to the: Terms and conditions of the existing Retail Banking products and services offered; Level of protection afforded by the Financial Services Compensation Scheme ( FSCS ); and Manner in which customers will interact with the Group or the quality of the service provided. My consideration of other relevant matters 7.11 As part of my analysis I have noted the following matters that are not an effect of the Scheme itself but that are a likely effect of compliance with the Ring-fencing Regime on Retail Banking customers and these matters are included here for completeness. RBB customers classified as RFIs 7.12 The Group has a small number of Retail Banking customers within the RBB Sub-group that, under the Ring-fencing Regime, will be classified as RFIs. The Group has completed a review of its RBB portfolio of customers and identified 67 customers that meet the definition of an RFI. An RFB is prohibited from having an exposure, which would include all lending products, to these RFIs After consideration of the respective options, and after discussion with the PRA and FCA, the Group has taken the decision to reclassify these 67 RFI customers as SME customers of the Commercial Banking business, with an offering that provides products from both the Transferors and LBCM. The Group expects to undertake this reclassification prior to the Directions Hearing scheduled for 4 December The Scheme will not transfer any products currently held by RBB RFI customers. 38 The information I have considered in preparing this Scheme Report is listed in Appendix 2. 88/215

89 7.15 However, there are certain other products that the Group currently offers to RBB RFIs that will no longer be offered to these customers All lending products, including credit cards, authorised and unauthorised overdrafts provided to RFIs would constitute an exposure and therefore be prohibited under the EAPO. As such these products cannot be offered to these RFI customers Where these RBB RFI customers hold an overdraft, they will be advised in a telephone conversation that their overdraft cannot be renewed and the Group will work with them to put a plan in place for repayment by 31 December Where these RBB RFI customers hold a credit or charge card, they will be advised in a telephone conversation that their card usage will stop from February 2018, and the Group will work with them to put a plan in place for repayment by 31 December This communication should enable the customers affected by this product curtailment to make arrangements to repay any outstanding balances in advance of the Statutory Deadline and to consider whether to make arrangements to access these products from alternative providers. It is reasonable to expect that such alternative arrangements would be available to the majority, if not all, of the affected RFIs Whilst this product curtailment is likely to result in an adverse effect for these customers, any such change will not be as a result of the Scheme, which the Court is being asked to sanction, but is the result of a commercial decision taken as a consequence of complying with the broader Ring-fencing Regime and will be implemented using a business as usual ( BAU ) process as part of the wider group restructuring. Customers of legal entities and branches in non-eea locations 7.21 The Group has a number of retail banking businesses based in non-eea locations. Given that products and/or services booked solely to non-eea locations are prohibited from being provided by an RFB under the Ring-fencing Regime, the business conducted in these areas will either have to cease, leading to a product curtailment, or be transferred to LBCM. The Group non-eea banking entities and branches with retail or consumer customers are: LBIL; and The Bank of Scotland Isle of Man branch In addition, LGIB will also be moved outside of the RFB Sub-group. Whilst this entity is within the EEA, the entity is being transferred out of the RFB Sub-group due to the close operational alignment with LBIL Customers of the entities and branches referred to in paragraphs 7.21 to 7.22 will not be transferred via the Scheme but will instead be transferred through the wider group restructuring. Whilst this change may result in an effect on the customers of these entities and branches, any such change will not be as a result of the Scheme, which the Court is being asked to sanction, but is a consequence of complying with the broader Ring-fencing Regime. Birmingham Midshires customers affected by a change to their payment mechanisms 7.24 Customer accounts within the businesses operating on the Birmingham Midshires platform currently use another UK bank to facilitate payments rather than those payments being facilitated through payment platforms owned by the Group. Under the Ring-fencing Regime this payment mechanism will no longer be allowed to operate in its current form and therefore will need to be changed. The Group s analysis shows that circa 97% of the inbound transactions currently facilitated by the other UK bank will be automatically redirected to a new in-house collections account and all outbound payments will also be automatically redirected to the 89/215

90 Conclusion Group s payment gateway. Where payments are automatically redirected, customers should experience no effect from this change. For those circa 3% of inbound transactions that cannot be automatically redirected, the Group will continue to work with the other UK bank as a separate project to ensure funds are re-directed appropriately. Whilst this change may result in a degree of inconvenience for the affected customers, any such change will not be as a result of the Scheme, which the Court is being asked to sanction, but is a consequence of the wider group restructuring in order to comply with the broader Ring-fencing Regime I have concluded that Retail Banking customers are not likely to be adversely affected by the Scheme. 90/215

91 8. Implications for Consumer Finance customers Introduction 8.1 In this section, I consider the likely effect of the Scheme on the Consumer Finance customers of the Group. 8.2 Whilst this section of my Scheme Report considers the specific effect of the Scheme on Consumer Finance customers, certain other sections of my Scheme Report consider other effects of the Scheme that may be applicable to all customers and Other Relevant Persons. Therefore, this section does not contain all effects of the Scheme that may be relevant to Consumer Finance customers and consequently my Scheme Report should be read in its entirety. Definition of Consumer Finance customers within the Group 8.3 The Consumer Finance sub-division of the Group, which forms part of the Retail Banking division but is managed separately, provides unsecured personal loans and credit/charge cards to approximately 10 million consumer and commercial customers, the significant majority of whom are UK based. The Consumer Finance sub-division acquired the MBNA credit cards business with approximately 2.3 million active customers on 1 June The Retail Banking division also has smaller sub-divisions, two of which provide motor finance products and International Mortgage Services (a closed book of mortgage loans which is in run off). For the purpose of my Scheme Report I have included these small sub-divisions of the Retail Banking division within the Consumer Finance sub-division. Summary of the Scheme s effect on Consumer Finance customers 8.4 As described in Section 5 of this Scheme Report, the Group s approach to ring-fencing has been to adopt a wide RFBs and narrow NRFB model, and in doing so it has designated each of LB plc and BoS plc within its RFB Sub-group. This approach will result in the vast majority of the products and services offered to Consumer Finance customers not being transferred under the Scheme and remaining unchanged. 8.5 However, as at 20 October 2017 the Group had identified that 231 Consumer Finance customers meet the definition of an RFI under Article 2 of the EAPO and, therefore, the Transferors are not permitted to retain any prohibited exposure to these customers. 8.6 In addition, in order to comply with the Ring-fencing Regime, where an exemption is not available, the Group legal entities and branches in non-eea locations will be required to move outside the Transferors and therefore, post-ring-fencing, customers of these legal entities and branches will be served from outside the RFB Sub-group. As set out in Section 3 of this Scheme Report, customer contracts with these non-eea legal entities and branches are not moving via the Scheme and will instead move outside the RFB Sub-group as part of the wider group restructuring. Scope of my analysis 8.7 The Consumer Finance products referred to in paragraph 8.3 are predominantly offered by LB plc and BoS plc, with the exception of those being offered to customers of Cardnet Merchant 91/215

92 Services Ltd, Lex Autolease Ltd, Black Horse Ltd 39 and MBNA Ltd. However, within my assessment I have considered the potential financial, product, operational and transitional effects of the Scheme, as defined in paragraph 4.15, on all of these products. 8.8 In considering the likely effect of the Scheme on Consumer Finance customers of the Group, I have taken into account the context in which the Scheme is taking place and reflected how other parts of the wider group restructuring being carried out by the Group might affect my analysis. In particular, while it is not within my scope to opine on transfers or other activities performed outside of the Scheme, such as the transfer of legal entities out of LB plc into other sub-groups within the Group, I have considered whether those activities have any effect on my conclusions in respect of the Scheme. 8.9 In conducting my analysis I have reviewed information prepared by the Group that sets out how the Scheme and wider group restructuring will affect Consumer Finance customers. I have also reviewed other information made available to me on my request by the Group and other publicly available information. My consideration of possible adverse effects of the Scheme 8.10 Based on my analysis of the information provided to me, I have not identified any likely adverse effects of the Scheme on Consumer Finance customers. In particular, I have not identified any material changes to the: Terms and conditions of the existing products and services offered by the Consumer Finance sub-division; and Manner in which customers will interact with the Group or the quality of the service provided. My consideration of other relevant matters 8.11 As part of my analysis I have noted the following matters that are not an effect of the Scheme itself but that are a likely effect of compliance with the Ring-fencing Regime on Consumer Finance customers and these matters are included here for completeness. Consumer Finance customers classified as RFIs 8.12 The Group has a small number of Consumer Finance customers that, under the Ring-fencing Regime, will be classified as RFIs. The Group has completed a review of its portfolio of Consumer Finance customers and identified 231 customers that meet the definition of an RFI. The Transferors are prohibited from having a prohibited exposure to these RFIs Of the 231 identified RFIs: 19 hold a commercial credit card; 169 hold a corporate or business charge card; 42 are within Lex Autolease, which provides leasing, fleet management and funding; and One is in Black Horse Onshore, which provides motor finance through a network of dealers In respect of the 19 RFI customers who hold a commercial credit card and the 169 RFI customers who hold a charge card, the Group has taken the decision not to offer these products in LBCM and instead to work with these customers to explore resolution options, such as novating to non-rfi entities of the customer group. If no resolution can be found the Group will terminate the agreement with the identified RFI. The Group envisages that these types of 39 Black Horse Limited provides point of sale finance and wholesale lending for motor dealing stocking and fleet finance facilities to fleet operators. Pursuant to an agency agreement in 2013, Black Horse Limited acts as agent for LB plc, so LB plc is the lender for all products offered by Black Horse Limited under the Black Horse brand. Therefore, even if a customer enters into an arrangement with Black Horse Limited, the business generated by Black Horse Limited (in its capacity as agent) is booked to the balance sheet of LB plc. 92/215

93 customers will be able to find alternative credit or charge cards readily available through other providers who are not restricted in selling to RFIs For the 42 RFI customers who have a leasing service with Lex Autolease, the Group has taken the decision not to offer these products in LBCM and is looking to rely on an exemption that permits Lex Autolease to offer leasing to all business clients (RFI and non-rfi) from within the RFB Sub-group. Future business for these RFIs and to new RFIs should be covered by this exemption, therefore there is no product curtailment anticipated unless this exemption becomes inapplicable in the future In respect of the one RFI identified in the Black Horse Onshore portfolio, a resolution option has been agreed with the intermediary, that addresses the Group s exposure to the RFI and therefore the contract will be maintained within the Transferors Whilst any resulting product curtailment is likely to result in an adverse effect for these customers, any such change will not be as a result of the Scheme, which the Court is being asked to sanction, but is the result of a commercial decision taken as a consequence of complying with the broader Ring-fencing Regime and which will be implemented as part of the wider group restructuring. Customers of legal entities and branches in non-eea locations 8.18 BHOL is a Jersey regulated Consumer Finance business of the Group. Given that products and/or services booked solely to non-eea locations are prohibited from being provided by an RFB under the Ring-fencing Regime, the business conducted in these areas will either have to cease, leading to a product curtailment, or be transferred to LBCM The Group has taken the decision to transfer BHOL to LBCM via a transfer of all of the shares in its intermediate Parent Company, Lloyds Holding (Jersey) Ltd, to LBCM. Customers of BHOL will not be transferred via the Scheme but will instead be transferred through the wider group restructuring via a share transfer. Any such change will not be as a result of the Scheme, which the Court is being asked to sanction, but as a consequence of complying with the broader Ringfencing Regime. Conclusion 8.20 I have concluded that Consumer Finance customers are not likely to be adversely affected by the Scheme. 93/215

94 9. Other Relevant Persons Introduction 9.1 In this section, I have considered the effect of the Scheme on Other Relevant Persons. The Ring-fencing Regime requires consideration of the effect on persons other than the Transferor who may be adversely affected by the Scheme. This definition includes customers of the Group, considered in Sections 6, 7 and 8, but also a wide range of other parties. 9.2 In paragraph 9.12, I have set out the groups of persons that I have included within my analysis. 9.3 In making my assessment I have taken into account the context in which the Scheme is taking place and reflected how other parts of the wider group restructuring being carried out by the Group might affect my analysis. In particular, while it is not within my scope to opine on transfers or other activities performed outside of the Scheme, such as the transfer of legal entities from LB plc into other sub-groups within the Group, I have considered whether the existence of those activities has any effect on my conclusions in respect of the Scheme. For example, if the completion of the Scheme was dependent on a legal entity transfer or if the effect of the Scheme varied depending on the outcome of a ring-fencing activity being carried out as part of wider group restructuring, then I have reflected this in my assessment of the potential effect on Other Relevant Persons. Scope of Other Relevant Persons 9.4 In my assessment of the effect of the Scheme on Other Relevant Persons, I have considered the likely adverse effects on what I have evaluated as all potentially affected classes of persons: the definition in the legislation is broad and I have not sought to limit the persons who are potentially within scope. This section sets out my consideration of the key groups of Other Relevant Persons. 9.5 I have considered persons in the broad sense and have included legal entities as well as individuals. 9.6 I have considered the implications for counterparties of the Transferors, irrespective of whether the relationships are being transferred to LBCM. Given the number of customers in the retail and commercial divisions who are potentially affected persons and the range of products held by those customers, I have considered them separately in Sections 6, 7 and 8 of this Scheme Report and have not included them in this section. Similarly, I have considered the potential effects of the Scheme and ring-fencing, more generally, on the occupational pension arrangements of the Group separately in Section 16 of this Scheme Report, given the wide range of potentially affected stakeholders relating to those arrangements. 9.7 Except where otherwise indicated, I have considered the effects of the Scheme on significant groups or cohorts of persons with homogenous characteristics who I would expect to be affected by the Scheme in the same manner, as it would be impractical to assess the effects on all individual persons separately. Process for identifying cohorts of Other Relevant Persons 9.8 As part of its internal analysis of the effect of the Scheme, the Group has set out the different cohorts of persons who, in its opinion, fall within the scope of Other Relevant Persons. 9.9 Rather than rely on these definitions, I have performed an independent analysis to identify the groups of Other Relevant Persons that I believe could be affected by the Scheme and have set out my groupings in paragraph My categories and sub-groups reflect that I am considering 94/215

95 the Scheme in the context of the wider group restructuring (for example, the scope of potentially affected persons includes those who may be affected by the establishment of LBCM and implementation of the SSM) To help ensure that my consideration of Other Relevant Persons is sufficiently broad, I have cross-checked my groupings against the Group s corresponding categorisation. This did not highlight any gaps in my set of Other Relevant Persons I also note that both the FCA and the PRA, in their published materials on ring-fencing, highlight some groups of persons that they expect to be included within the analysis. I have considered these materials in defining the Other Relevant Persons in the scope of my review and, in particular: Sections 1.13 to 1.17 of the FCA Finalised Guidance and paragraph 33 of the general guidance within that Financial Guidance; and Section 5.6 of the PRA s Statement of Policy Taking into account all of the abovementioned information, my final categories of Other Relevant Persons are as follows: Persons with a direct financial interest in the Group and sub-groups: (a) Shareholders; (b) Creditors; and (c) Fixed income investors. Other parties with an indirect financial interest in the Group and sub-groups: (a) Employees; (b) Users and providers of Financial Market Infrastructure ( FMI ); and (c) Third party suppliers and intermediaries. Other legal entities in the Group, joint ventures and partnerships. Competitors using the Group s facilities. Regulatory, government and financial bodies: (a) Regulatory authorities: PRA and FCA; (b) FSCS; and (c) Tax authorities: Her Majesty s Revenue and Customs ( HMRC ) and other overseas tax authorities. Future customers and future Other Relevant Persons. Customers of the Insurance Sub-group. Persons connected with customers For each category, I have considered whether the Scheme is likely to have an adverse effect on the persons affected by the Scheme and the results of my analysis are set out in the following subsections. Within this analysis, I have considered all types of potential effects, including operational, transitional and financial effects. 95/215

96 Assessment of potential effects Persons with a direct financial interest in the Group and sub-groups Shareholders 9.14 Shareholders, a person or company or other institution who own a share of the Group through share ownership, have a direct interest in the financial performance of the Group. The principal potential effect of the Scheme would be to affect the value of the shares held, but there could also be operational implications related to how these shareholders interact with the Group, for example, changes to the Group s Secretariat function In my analysis on Other Relevant Persons, I have given consideration to all types of shareholders including the following: External shareholders: the external shareholders who own ordinary shares in LBG plc. I consider the effects of the Scheme on these persons in this subsection; and Internal Group shareholders: the legal entities that own the ordinary shares of LB plc and BoS plc, directly and indirectly (i.e. LBG plc owning LB plc directly and BoS plc via LB plc and HBoS plc). In line with the Statutory Question, I have not considered the effect on Transferors as part of my analysis. I consider the effect on other Internal Group shareholders as part of my analysis of the effects of the Scheme on the other legal entities in the Group, as set out in paragraphs to As such, the remainder of this Shareholders section considers the effect on external shareholders only. Operational/transitional analysis 9.16 I have reviewed analysis produced by the Group, which sets out how the Scheme will affect the way that shareholders interact with the Group There are no plans to, or requirements to, change the processes or systems of the Group s Secretariat function, which is responsible for managing the administrative/regulatory interaction with external shareholders, to fit the post-ring-fencing structure of the Group As a result, I am satisfied that there is not likely to be any adverse operational or transitional effect on shareholders as a result of the implementation of the Scheme. Financial analysis 9.19 I have considered whether the Scheme is likely to have a financial effect on shareholders, either as a result of short-term effects on the quoted share price or as a result of a fundamental change in the value of the entities in which the shares are held The value of a particular entity to its shareholders can be influenced by its ability to pay a stream of dividends in the future. This will be affected by a large number of factors, including the level of revenue generated from existing products and services, the ability to sell new and profitable products and services and the level of expenses incurred in managing these activities. Given the nature of the change required to comply with the Ring-fencing Regime, all of these factors for an individual entity could be affected to some extent as discussed in the following subsections At a Group level, the level that is relevant to the external shareholders, ring-fencing is not, of itself, expected to lead to significant changes in the nature of the products and services held by the Group or offered by the Group in the future. It will change where products and services are held or sold within the Group but, other than as discussed below, I would not expect this to affect materially the overall position of the Group. 96/215

97 9.22 It is likely that there will be unavoidable inefficiencies as a result of having to run a separate LBCM entity, due to the costs of holding additional capital to support LBCM and limited duplication of roles and governance structures. A preliminary estimate by the Group of these incremental costs represented only a marginal increase within the context of the Group s total operating expenses ( 12.3bn in 2016), which I would not expect to have a material effect on the level of the Group dividends There are also one-off costs associated with implementing the Scheme and the wider group restructuring required to meet the relevant legislative requirements. In the Group s 2017 halfyear results to 30 June 2017, the cost of implementing ring-fencing was estimated to be 0.5bn to the end of These direct costs will be borne by the shareholders, but are not significant in the context of the market capitalisation of the Group (c. 44.9bn at 31 December 2016) Given one of the LBG plc Board s key responsibilities is to protect shareholder value, I also believe it is reasonable to conclude that the LBG plc Board has taken steps to design the Scheme in such a way that the likelihood of adverse effects on shareholders (among other persons) is minimised. Within the confines of the legislation, the LBG plc Board has an interest in making the Group as viable and as valuable a business as possible going forward. Their decision-making process behind choosing the adopted structure and their assessment of alternative ring-fencing structures are detailed in Section 5 of this Scheme Report Given these considerations, I am satisfied that, while it is likely that there will be some limited effect on underlying shareholder value as a result of the expenses incurred by the Group implementing ring-fencing and on an ongoing basis, this effect is small in relation to its market capitalisation The short-term measure of shareholder value, as captured by the listed share price, is volatile in nature and influenced by a wide range of factors including macroeconomic factors outside the direct control of the Group, such as the expectations of future performance. At the point of approval of the Scheme, the requirements for ring-fencing (and for the Scheme) will have been understood by the market for a number of years and the market will have had access to documents setting out the intended post-scheme position, including this Scheme Report. As a result, my expectation is that the share price prior to the approval of the Scheme will reflect the market s view of the effect of carrying out ring-fencing on the value of LBG plc s shares and I would not expect the approval of the Scheme to have a material additional effect on the share price Overall, I am satisfied that the Scheme, of itself, is not likely to have a material adverse effect on shareholder value for external shareholders of LBG plc. Creditors 9.28 Creditors who have extended credit to the Group, have an ongoing interest in receiving payments as they fall due and a claim on the Group s assets in the case of bankruptcy or default of the Group. As a result, I have considered whether the Scheme could have an effect on these persons, to the extent that it changes the Group s ability to meet these payments. Further, I have considered whether the Scheme could result in any operational or transitional effect on these persons, potentially as a result of changes to the way that the relationships are managed in future In my analysis in this subsection, I have considered the following groups of creditors: Creditors with non-product related contingent claims against the Group such as provisions and contingent liabilities. Examples include provisions made for committed restructuring activities and potential tax liabilities that may arise where HMRC adopts a different application of taxation law to the Group; Holders of guarantees and warranties issued by the Group; 97/215

98 Bond or other fixed income investors (covered separately in paragraphs 9.42 to 9.74); and Suppliers and third party intermediaries (covered separately in paragraphs to 9.115). Creditors with non-product related contingent claims against the Group and holders of guarantees and warranties issued by the Group Operational/transitional analysis 9.30 I have considered whether the Scheme is likely to have an effect on the way that these creditors interact with the Group, and have considered the Group s plans, as communicated to me, and made an assessment of the potential changes arising as a result of the Scheme Based on the material provided to me, there are no plans, or requirements, to change the processes or systems to fit the post-ring-fencing structure of the Group that could affect the way the Group interacts with creditors operationally The Group expects that non-product contingent claims, guarantees and warranties, as detailed within their 2016 annual financial results, will remain with their existing legal entity and, therefore, no change is expected to the way these will be handled by the Group. I will revisit this position in my Supplementary Report, if required, to consider any new non-product contingent claims, guarantees and warranties that have arisen since 31 December The Group has confirmed that other legal action and regulatory matters are subject to regular reassessment which may result in some of these liabilities, which relate to the Transferring Business, arising in LBCM. Such matters would include complaints and threatened or actual legal proceedings against the Group brought by or on behalf of current or former employees, customers, investors or other third parties, as well as legal and regulatory reviews, challenges, investigations and enforcement actions, both in the UK and overseas which may lead to the Group incurring a liability. All such material matters are periodically reassessed by the Group, with the assistance of external professional advisers where appropriate, to determine the likelihood of the Group incurring a liability. In those instances where it is concluded that it is more likely than not that a payment will be made, a provision is established to management s best estimate of the amount required at the relevant balance sheet date. In some cases it will not be possible to form a view, for example, because the allegations are unclear or because further time is needed to properly assess the merits of the case, and no provisions are held in relation to such matters. However, the Group does not expect any significant change in the way these would be handled by the Group. The Group has confirmed that any historic liabilities of the Transferors relating to assets transferring to LBCM as part of the Scheme will remain with the Transferors as excluded liabilities As a result, I am satisfied that there is not likely to be any material adverse operational or transitional effect as a result of the implementation of ring-fencing on these creditors. Financial analysis 9.35 I have considered whether the Scheme is likely to have a financial effect on creditors I note that the following financial analysis applies to creditors (as defined in this subsection) as well as other parties with a direct or indirect financial interest in the Group and sub-groups, such as fixed income investors, third party suppliers, intermediaries, employees as well as FMI providers and users. Consequently, I have not repeated the following analysis for each of these sub-groups The ability of an entity to pay obligations is at least partially reflected by the credit rating of LBG plc (and the various entities within the Group). This is particularly relevant for fixed income investors and I discuss it in detail in the fixed income investors subsection below. 98/215

99 9.38 I expect creditors (other than fixed income investors) to be primarily concerned with the Group s or the sub-groups ability to pay claims as and when they fall due, rather than the credit rating of the relevant counterparty. I would not expect this ability to be directly or materially affected by normal movements in their credit ratings The Scheme will transfer relatively riskier assets from the Transferors to LBCM. However, the transfer of assets is relatively small (the Group expects over 90% of loans and advances will sit within the RFB Sub-group). On 17 July 2017, Fitch assigned LBCM an expected credit rating of A, which is lower than LB plc and BoS plc s current credit ratings of A+. Similarly, S&P assigned LBCM a provisional rating of A-, which is lower than LB plc and BoS plc s current rating of A. Moody s provisional rating for LBCM of A2 was published on 7 November 2017, which is two notches weaker than their current rating for LB plc of Aa3. However, I do not consider it is likely that the change will have any material bearing on the Group s ability to meet its obligations to creditors While the credit rating agencies are yet to confirm what the final credit ratings applicable to the Group and the Transferors will be post-scheme, I have not seen anything to suggest that a change (and particularly a significant change) to this rating is likely. Indeed, the Moody s Credit Opinion on 7 July 2016 stated that they see few challenges for LB plc to implement the Ringfencing Regime and therefore fewer potential changes in its credit profile compared to its large UK competitors. Similarly, the S&P rating issued on 19 July 2017 stated that they consider it likely that Lloyds's ring-fencing plans will have no ratings impact for the rated entities. Lloyds Bank and Bank of Scotland are set to be within the ring-fence. I will continue to monitor the credit rating of the relevant entities in the Group and the expected effect of ring-fencing on it and will provide an update in my Supplementary Report on the Scheme As a result, and subject to any updates to the credit rating, I am satisfied that there is not likely to be any material effect as a result of the implementation of ring-fencing on creditors with a direct or indirect financial interest in the Group and its sub-groups. Fixed income investors 9.42 Fixed income investors are a particular subset of creditors, with a direct interest in the relevant issuers ability to meet the payments due in respect of the debt instruments held. While no change in such ability is expected, the Scheme could potentially have an effect on the credit rating of the relevant issuers in the Group and compliance with its covenants (conditions imposed by lenders, such as requirements to stay within certain financial limits or thresholds), which could have an effect on either the current valuation of the fixed interest investment, the order in which claims are paid or the likelihood of the payments being made, and I have considered that possibility as part of my analysis. I have also considered whether the Scheme is likely to have any operational effect on these investors In my analysis, I have given consideration to the following types of securities and fixed income investors: Fixed income investors: Holders of LBG plc issuances; Holders of other bank issuances: holders of securities issued by other bank entities within the Group, namely, LB plc and BoS plc, and HBoS plc; Holders of Insurance Sub-group issuances: SWL and Clerical Medical Finance plc debt; Holders of SPV issuances: holders of securities issued by SPVs such as subordinated debt programmes issued through limited partnership structures and asset backed securitisation programmes issued by orphan SPVs; and Other securities: senior unsecured debt, capital securities and preference shares, securitisation and covered bonds. 99/215

100 9.44 I note that the credit rating of the issuing entity is arguably of greater direct importance to fixed income security holders than for other creditors For bondholders, the credit rating not only provides an indication to the investors of the credit quality of the instruments they hold but also has a direct effect on the value of the securities. While some fixed income investors will hold the securities to maturity (in which case the only relevant factor is the likelihood of the issuer failing to make a payment), others will trade these assets and, as a result, effect on the short-term value are of greater importance. The credit rating is one of the key factors in influencing movements in this valuation. Holders of LBG plc issuances Operational analysis 9.46 I have considered whether the Scheme is likely to have an operational effect on holders of LBG plc issuances There are no plans, or requirements arising as a result of ring-fencing, including the Scheme, for any transfers of issuances between sub-entities or changes to operational processes and procedures, therefore, no change is expected to the way these would be handled by the Group As the debt will remain tied to the issuing entity, I am satisfied that there is not likely to be any adverse operational effect as a result of the implementation of ring-fencing on these fixed income investors. Financial analysis 9.49 I have considered whether the Scheme is likely to have an adverse financial effect on holders of LBG plc issuances. The considerations here are similar in nature to those for external shareholders of LBG plc At the point of approval of the Scheme, the requirements for ring-fencing will have been understood by the market for a number of years and the market will have had access to documents setting out the intended post-scheme position, including this Scheme Report. As a result, my expectation is that the price of the fixed income securities prior to the approval of the Scheme will reflect the market s view of the effect of complying with the Ring-fencing Regime on the value of the securities and I would not expect the approval of the Scheme to have a material additional effect on their value The sum of the sub-groups at a Group level will remain the same after the transfer of assets from the Transferors into LBCM. As no change to assets is expected at a Group level, I do not expect the overall consolidated credit risk profile of the Group to change Holders of LBG plc issuances are potentially more exposed to the losses of LBCM post-scheme as there could be some scenarios where they are affected financially earlier than they would be prior to the implementation of ring-fencing. However, these hypothetical scenarios and any associated financial effects are highly unlikely (see Section 13 of this Scheme Report for more details) I have, to date, not seen anything to suggest that the credit rating of LBG plc is likely to change as a result of the Scheme or ring-fencing more widely, but it will not be possible to confirm that until such time as the rating agencies have provided updated ratings that reflect the details of ring-fencing As a result, and subject to any updates to the credit ratings, I am satisfied that there is not likely to be any material adverse financial effect as a result of the implementation of ring-fencing on 100/215

101 these LBG plc issuance holders. I will continue to monitor the position of the credit ratings and will provide an update in my Supplementary Report, if required. Holders of other bank issuances Operational analysis 9.55 I have considered whether the Scheme is likely to have an operational effect on holders of other bank issuances Based on the current Group analysis, there are no plans, or requirement for any transfers of debt instruments between entities or changes to operational processes and procedures. The Transferors will continue to manage capital and regulatory requirements and internal targets Reviews performed by the Group s internal or external legal counsel have concluded that: No identified legal events of default or other contractual provisions in the terms and conditions of the issuances would be triggered as a result of executing the Scheme; and Some amendments may need to be made to some outstanding issuances. However, the holders of securities will have the opportunity to vote on any material amendments which are proposed by the relevant issuer in accordance with the terms of the relevant debt instruments, before they are implemented in the usual way As a result, I am satisfied that there is not likely to be any material adverse operational effect as a result of the implementation of ring-fencing on holders of other bank issuances. Financial analysis 9.59 I have considered whether the Scheme is likely to have an adverse financial effect on holders of other bank issuances At the point of approval of the Scheme, the requirements for ring-fencing will have been understood by the market for a number of years and the market will have had access to documents setting out the intended post-scheme position, including this Scheme Report. As a result, my expectation is that the price of the fixed income securities prior to the approval of the Scheme will reflect the market s view of the effect of carrying out complying with the Ringfencing Regime on the value of the securities and I would not expect the approval of the Scheme to have a material additional effect on their value. As set out in relation to external shareholders, I expect the effect of the Scheme on the ongoing operation of the Group, including its cost base, to be limited in nature, so I do not view it as likely that the Scheme will have a significant bearing on the quoted price of these securities over the longer term There is also no indication that the credit ratings of the Transferors are likely to change Whilst it is true that holders of LB plc and BoS plc (as well as HBoS plc) issuances no longer have a direct exposure to the risks in LBCM, they have more exposure to the Transferors than they did previously as they will be funding a higher proportion of these entities than they did in the former LB plc or BoS plc (or HBoS plc). As a result, they could potentially be funding a higher proportion of these entities than they did previously, however, I do not expect the effect to be material As a result, and subject to any updates to the credit ratings, I am satisfied that there is not likely to be any material adverse financial effect as a result of the implementation of ring-fencing on these fixed income investors. I will continue to monitor the position of the credit rating and will provide an update in my Supplementary Report, if required. 101/215

102 Holders of Insurance Sub-group issuances 9.64 I am satisfied that there will be no effect on holders of Insurance Sub-group issuances as the Insurance Sub-group is not subject to the Scheme and will have its own board, risk appetite and capital requirements and I have seen no evidence to suggest that the credit rating of the Insurance Sub-group will change. Holders of SPVs 9.65 I have considered whether the Scheme is likely to have an adverse effect on holders of securities issued by SPVs such as subordinated debt issued through limited partnership structures and asset backed securitisation programmes issued by orphan SPVs. Operational analysis 9.66 SPVs may be affected by the wider group restructuring taken by the Group to implement the Scheme, however, the SPVs themselves and the business conducted by them will not be transferred via the Scheme The Group is continuing to analyse the likely effect of the Scheme on SPVs and has identified that there are seven transactions where amendments may be required to the transaction documents or where a restructure of the relevant transaction may be required. Any such required changes will be discussed with the affected persons, including the fixed income investors themselves, if relevant. Securitisation 9.68 I have considered whether the Scheme is likely to have a financial effect on holders of securities issued by the Group s securitisation SPVs There is also no indication that the credit ratings of the Transferors are likely to change (see financial analysis subsection on creditors, paragraphs 9.35 to 9.41, for more detail) As discussed in paragraph 9.67, the Group is continuing to analyse the likely effect of the Scheme on SPVs, as some limited changes may be required in a small number of cases. I currently have no reason to expect such changes to result in a material adverse effect on this group of fixed income investors. Covered bonds 9.71 I have considered whether the Scheme is likely to have a financial effect on covered bondholders The Group s due diligence identified no terms and conditions within the covered bonds that are not compliant with, or require amendment as a result of, the Ring-fencing Regime. As discussed in the financial analysis subsection on creditors, paragraphs 9.35 to 9.41, there is also no indication that the credit rating of the Transferors is likely to change. The Group has confirmed that all covered bond programmes will continue to remain within the Transferors and no intragroup funding facilities with LBCM exist within the transaction structures. Therefore, the rating of LBCM is not a relevant factor for covered bond holders Based on my analysis of the creditor hierarchy in paragraphs to 13.30, I am satisfied that there is not likely to be a material effect on the position of covered bondholders in the Group s creditor hierarchy due to the Scheme As a result, I am satisfied that there is not likely to be any material adverse financial effect as a result of the implementation of ring-fencing on covered bondholders. 102/215

103 Other parties with an indirect financial interest in the Group and sub-groups Employees 9.75 Employees who work for the Group may be affected by the operational, structural and financial changes to the Group. I have identified employees as Other Relevant Persons, as the Scheme could potentially have an effect on their job description, requirements and financial package such as their employing entity, employment contract, job location or other related matters. Employees will not transfer from the RFB Sub-group to the NRFB Sub-group as a result of the Scheme The Scheme, and ring-fencing more generally, will have an impact on how the Group is operated and managed, which could have an effect on employees. As discussed in reference to external shareholders, I do not expect this impact to be significant in nature and, specifically, am not aware of any plans to reduce the overall size of the business in any significant way. As a result, in general terms and subject to the considerations for specific groups of employees below, I do not believe it is likely that the Scheme will have a material adverse effect on employees In my analysis, I have considered separately the following groups of employees, as the likely effect of the Scheme differs for each: Category A: Employees of RFB Sub-group employing entities (for example, LB plc, BoS plc, HBoS plc and Scottish Widows Services Limited ( SWSL )) who under the expected form of the People Service Agreement ( PSA ), are expected to work exclusively for the NRFB Sub-group, and its subsidiaries (see paragraph 3.37 for information on the Insurance Sub-group and Equity Investments Sub-group); Category B: RFB Sub-group employees who work in a function that supports more than one part of the Group. These employees are under the direct supervision and control of the RFB Sub-group and will be providing services to NRFB Sub-group on behalf of the RFB Sub-group pursuant to a master intra-group agreement for the provision of such services by the RFB Sub-group; and Other employees: RFB Sub-group employees who will work exclusively for the RFB Subgroup There will also be some employees who will be employed directly by various NRFB Sub-group designated entities and will work exclusively for LBCM. These employees are based outside the UK in the Channel Islands, Gibraltar, the USA and Singapore. Other than my general considerations in 9.79, I do not consider these employees specifically, as the Scheme will not affect the transfer of non-eea business to LBCM. Category A employees 9.79 I have considered whether the Scheme is likely to have an effect on the manner in which Category A employees interact with the Group The Group expects that some Category A roles will be newly created for LBCM, but that the majority of roles and functions performed by Category A employees already exist in the Group today. Any vacancies will be advertised internally and externally and thus are filled voluntarily with terms and conditions and remuneration to reflect that role The Group also expects that existing Category A employees supporting LBCM will be provided with role profiles and the necessary Human Resources and line management support to fulfil those roles consistent with normal Group practice. There will be no changes to their underlying terms of employment such as pay, benefits, role level and job security. 103/215

104 9.82 The ability for the RFB Sub-group to honour the payments due to employees is unlikely to be affected by the Scheme (see financial analysis subsection on creditors, paragraphs 9.35 to 9.41, for more detail) The Group s underlying principle is that there will be no adverse effect to employees, and it does not expect any such adverse effect to arise For Category A employees, overall supervision and control is the responsibility of LBCM. As such, LBCM must ensure that they are fit and proper and therefore adequately trained to meet the needs of LBCM These employees will be required to undergo training to ensure they are adequately equipped to meet the needs of LBCM which will create some additional workload on employees. However, I consider training to respond to regulatory changes to be within the type of tasks that employees should expect to undertake regularly and on an ongoing basis As a result, I am satisfied that there is not likely to be any material adverse effect on Category A employees as a result of the Scheme. Category B employees 9.87 I have considered whether the Scheme is likely to have an effect on the way that Category B employees interact with the Group Little change is expected to the roles of Category B employees, as the Group expects the processes to be the same as they are currently There is likely to be some additional workload resulting from the need to support the new LBCM entity and reporting to LBCM management and the effect could be reasonably material on some employees There may be some transitional effect on Category B employees who will be required to undergo training to ensure they are adequately equipped to meet the needs of the Group Additional work and training could arise for any number of reasons other than the Scheme and wider group restructuring (for example, as a result of an acquisition) and I would expect it to be managed as part of the ongoing operation of the Group. In my opinion, this should mitigate the effect on any individual employees. I do not consider this to be a material adverse effect The ability for the RFB Sub-group to honour the payments due to employees is unlikely to be affected by the Scheme (see financial analysis subsection on creditors, paragraphs 9.35 to 9.41, for more detail) I understand that the Group plans no changes to the contract terms and conditions and therefore no changes to pay or benefits for any current or future Category B employees as a result of the Scheme or wider ring-fencing programme As a result, I am satisfied that there is not likely to be any material adverse effect on Category B employees as a result of the Scheme. Other employees 9.95 I understand that the Group plans no direct effect on the workload or activities of other employees such as those who work for the RFB Sub-group, who have no interaction with LBCM. As a result, I am satisfied that there is not likely to be any material adverse effect on these employees as a result of the implementation of the Scheme. 104/215

105 FMI 9.96 I have considered both the providers of and users of FMI as part of my analysis FMI providers deliver services in relation to the clearance and settlement of transactions as well as the movement of monies and securities for the Group. The Scheme could have some effect on the Group s membership and interaction with FMIs such as the need to set-up new access for LBCM. My analysis considers both FMI providers where: The Transferors will retain direct or indirect access (excluding where LBCM requires indirect access via the Transferors which is covered below); and LBCM will require direct access, indirect access through the Transferors or indirect access through third parties FMI users is a broad category of anyone who directly or indirectly uses FMI. For example, this would include the general public, who indirectly use FMIs when they initiate payments to the customers of LBCM. As any changes to the way the Group interacts with FMIs as a result of the Scheme could end up affecting FMI users, I have considered this group within my assessment of the effect on Other Relevant Persons. FMI providers where the Transferors will retain direct or indirect access (excluding where LBCM requires indirect access via the Transferors) 9.99 I have considered whether the Scheme is likely to have an effect on the way that these FMI providers interact with the Transferors The Transferors will maintain direct membership and indirect access with its existing FMI Providers and no operational and transitional changes are expected to the way the Transferors interacts with these FMIs No changes to contracts between these FMI providers and the Transferors are required and the Scheme is unlikely to have an effect on the Transferors ability to pay FMI providers in any material way (see financial analysis subsection on creditors, paragraphs 9.35 to 9.41, for more details) As a result, I am satisfied that there is not likely to be any adverse effect on these FMI providers as a result of the Scheme. FMI providers where LBCM will require direct or indirect access Operational/transitional analysis I have considered whether the Scheme is likely to have an operational or transitional effect on the way that these FMI providers interact with LBCM There are likely to be short-term operational and transitional effects on the FMI Providers as a result of implementing new access for LBCM. However, system infrastructure is already in place and transactions/product ranges are expected to remain the same as a result of the Scheme Consequently, I consider it likely that there will be adverse operational and transitional effects on these FMI providers if they accept the new business from LBCM. However, given the limited changes expected, I have no reason to expect these effects to be material in terms of the nature or scale of the changes As a result, I am satisfied that there is not likely to be any material adverse effect on these FMI providers as a result of the Scheme. 105/215

106 Financial analysis I have considered whether the Scheme is likely to have a financial effect on the way that these FMI providers interact with LBCM New contracts will be required for FMI providers where LBCM will require direct access and indirect access through third parties. The FMI providers or third parties will have the chance to negotiate terms and conditions and contracts will be entered into consensually by the FMI providers For FMI providers where LBCM will require indirect access through the Transferors, there are no changes to the existing contracts I have considered the expected financial position of LBCM in Section 10 of this Scheme Report and, as set out in that section, have no reason to believe that LBCM will not have a sustainable and viable business model. Further, as the FMI providers will be entering directly into contracts with LBCM, they should have the ability to decide whether the financial position of LBCM is sufficiently strong for them to provide services to As a result, I am satisfied that there is not likely to be any material adverse financial effect on these FMI providers as a result of the Scheme. FMI users I am satisfied that there will not be any material adverse effect on FMI users as a result of the Scheme as no changes are expected in the manner in which they use the FMI. Processing times will not be affected and no changes to account details will be required that could affect payments. Transaction volumes are not expected to change as a result of the Scheme and there is no effect on FMI stability expected or the Transferors ability to continue to comply with the existing fee structure obligations. Third party suppliers and intermediaries Third party suppliers provide goods and/or services to the Group and intermediaries refer business on to the Group for a fee or commission, such as those intermediaries who provide introductions across different areas of business, such as mortgages, commercial (hire purchase and leasing, discount factoring and lending), car financing, insurance and cards I have identified third party suppliers and intermediaries as Other Relevant Persons, as the Scheme could have an effect on the contracts and terms of conditions they have with the Group and sub-groups or on the way that the Group interacts with them In my analysis, I have given consideration to the following possible groups of third party suppliers and intermediaries: Suppliers whose contracts will remain with LB plc and whose services will be provided to the Transferors only; Intermediaries whose terms of business will remain with LB plc; Suppliers whose contracts will remain with LB plc but services will pass through to other parts of the Group; and Suppliers and intermediaries classified as being an RFI, who are no longer able to contract or retain terms of business with LB plc where such exposures to RFIs are prohibited under the EAPO. 106/215

107 Suppliers providing services to the Transferors only and intermediaries whose contracts and terms of business will remain with LB plc I have considered the following in assessing whether the Scheme is likely to have an effect on the way that these suppliers and intermediaries interact with the Group: There will be no requirement for this group of suppliers to change contracting parties from LB plc; There will be no requirement for these intermediaries to transfer their terms of agreement from LB plc; Consequently, these suppliers and intermediaries will continue to provide their goods and services and be paid in accordance with their terms and conditions; and The ability for the Transferors to honour the payments due to suppliers and intermediaries is unlikely to be affected by the Scheme (see financial analysis subsection on creditors, paragraphs 9.35 to 9.41, for more details) As a result, I am satisfied that there is not likely to be any material adverse effect as a result of the Scheme on these suppliers and intermediaries. All other suppliers and intermediaries Operational/transitional analysis The Group has performed due diligence to identify whether any contracts with suppliers and intermediaries will need to be amended as a result of the Scheme. No such requirement has been identified to date. If any such requirements were identified, the effect is likely to be shortterm and minimal (restricted to the transitional effect of establishing the new terms) for most suppliers/intermediaries as their underlying contracts and terms of business should remain unchanged. The effect would be greatest for any RFI suppliers/intermediaries whose contracts may need to be terminated The Group has performed due diligence to identity suppliers and intermediaries who are RFIs. For the contracts with suppliers and intermediaries who have been identified as RFIs, the Group has not identified a supplier or intermediary that they cannot apply an exemption to address any prohibited exposure nor does it anticipate having to cancel any of those supplier or intermediary contracts with these RFIs. The Group has not identified any third party suppliers and intermediaries that are expected to suffer any adverse effects as a consequence of the Scheme I am satisfied that there is not likely to be any material adverse operational or transitional effect as a result of the Scheme on these suppliers and intermediaries. Financial analysis I have considered whether the Scheme is likely to have a financial effect on other suppliers and intermediaries The ability to honour the payments due to suppliers and intermediaries is unlikely to be affected by the Scheme (see financial analysis subsection on creditors, paragraphs 9.35 to 9.41, for more details) Contracts or terms of business with suppliers and intermediaries, respectively, who are identified as being an RFI, may need to be terminated, the terms amended or transferred to a non-rfi entity. The Group is continuing to perform due diligence to identify suppliers and intermediaries who are RFIs. For the contracts with suppliers and intermediaries who have been identified as RFIs where due diligence is complete, the Group has not identified a supplier or intermediary that they cannot apply an exemption to address any prohibited exposure. The 107/215

108 Group does not anticipate having to cancel any of those supply or intermediary contracts with these RFIs If any adverse effects arise as a result of termination of RFI contracts, I am satisfied that any such effect will not be as a result of the Scheme, but will be the result of a decision taken as a consequence of complying with the broader Ring-fencing Regime. I have therefore not identified any likely material adverse effects of the Scheme on third party suppliers and intermediaries. Other legal entities in the Group, joint ventures and partnerships Other legal entities within the Group, as well as joint ventures and partnerships which are jointly owned or run by the Group and third parties, may be affected by operational, structural and financial changes to the Group as a result of the Scheme. The Scheme could affect the way the legal entities in the Group, joint ventures and partnerships interact with each other, for example necessitating the creation of additional governance structures In my analysis, I have given consideration to the following legal entities, joint ventures and partnerships: LBG plc: this is the ultimate Parent Company of the Group; RFB Sub-group (excluding the Transferors): the RFB Sub-group consists of the Transferors and other entities. In line with the Statutory Question, I have not considered the effect on Transferors as part of my analysis but have considered the effect on all other entities within the RFB Sub-group. These entities will be supported by the SSM; NRFB Sub-group: this consists of all entities due to be within the NRFB Sub-group that will be supported by the Transferors through the SSM and employees provided through the PSA; Insurance Sub-group: this consists of all entities due to be within the Insurance Sub-group. This sub-group is not expected to receive business through the Scheme. These entities will be supported by the Transferors and SWSL through the SSM; Equity Investments Sub-group: this consists of all entities due to be within the Equity Investments Sub-group. This sub-group is not expected to receive business through the Scheme. These entities will be supported by the Transferors through the SSM; Joint ventures and partnerships: jointly owned or managed with parties external to the Group; and SPVs including financing vehicles: used for specific purposes including raising finance for the Group. LBG plc, RFB Sub-group and NRFB Sub-group Operational/transitional analysis I have considered the following in assessing whether the Scheme is likely to have an operational or transitional effect on LBG plc, the RFB Sub-group (excluding the Transferors) and NRFB Sub-group: For LBG plc, the setup of LBCM and transfer of the Insurance Sub-group and Equity Investments Sub-group to LBG plc has necessitated changes to the Group s governance structure. While there are no changes expected at the LBG plc Board, there will be changes within the governance structure reporting into the LBG plc Board for the Insurance Subgroup and Equity Investments Sub-group boards and for the new Board of LBCM. These changes are discussed in detail in Section 11 of this Scheme Report; and The RFB Sub-group and NRFB Sub-group will be serviced by the SSM. There is an additional requirement to set up RFCTs to monitor the ring-fence perimeter and new procedures to maintain independence. 108/215

109 9.128 The additional governance structure and newly created RFCTs represent changes that are significant in nature, in terms of the additional administration and functionality. While the changes are not adverse in themselves (indeed, the RFCTs provide an additional layer of protection to the Transferors against knock-on effects from LBCM) they represent additional operational complexity These changes are a direct result of the design of the Scheme and are needed to effect the Ring-fencing Regime and, as a result, I consider these operational and transitional effects to be not greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA. Financial analysis I have considered the following in assessing whether the Scheme is likely to have a financial effect on the Group, the RFB Sub-group (excluding the Transferors) and NRFB Sub-group: The Scheme will have no adverse effect on the entities within the RFB Sub-group, with the exception of the Transferors, which are out of scope for the purpose of analysing adverse effects, as they do not form part of the Scheme; The value of equity held by internal shareholders (as defined in the Shareholders subsection) will be affected by similar considerations as those that are applicable to external shareholders. However, in this case, the effect on a given entity may be relatively more material, given that the Scheme and the wider group restructuring will have a disproportionate effect on the individual Group entities directly affected by the changes; The Scheme transfers assets and liabilities to LBCM and these transfers are intended to be at the recorded book value of those assets and liabilities at the time of the Effective Date. Whilst in many cases this book value will be close to fair value, which is an unbiased estimate of the market value of these assets and liabilities, that will not be the case for all assets and liabilities. This may result in a positive or negative financial effect on LBCM, depending on the difference between book value and fair value at the time of transfer. Any capital and liquidity considerations associated with the Scheme are addressed in Section 10 of this Scheme Report; There could be further effects on shareholder value, as a result of restrictions placed on the activities of each of the Transferors and LBCM by the Ring-fencing Regime or as a result of additional costs. However, while such effects may be material for some entities, regardless of the design of the Scheme, the splitting of the business and the additional governance overheads is a direct consequence of ring-fencing and such financial effects are necessary to limit exposure of the Transferors to LBCM; Financial effects could be experienced as a result of the relative credit rating of LBCM versus the Transferors (see Creditor hierarchy subsection, paragraphs to 13.30); For some Trade Instruments there is a potential risk to the enforceability of counterindemnities or reimbursement obligations. This could occur if the Scheme transfers the counter-indemnity or reimbursement obligation to LBCM but not the underlying instrument, which could happen if the instrument is governed by the laws of jurisdictions that are not recognised by the Scheme. Similarly the enforceability is at risk if the counter-indemnity or reimbursement obligation is cancelled and re-issued by LBCM, which may be necessary if it is governed by laws of a jurisdiction that is not recognised. The potential adverse effect can be minimised if the Trade Instrument documentation is drafted to allow for these situations or a replacement is issued; and Whilst it is likely that the NRFB Sub-group entities will experience a financial effect of the Scheme, any such effects are a consequence of the design decisions taken by the Group in order to comply with the Ring-fencing Regime. As a result, I am satisfied that these adverse effects will not be greater than reasonably necessary in order to achieve the relevant ringfencing purpose, as set out in Section 106B(3)(a) of the FSMA. 109/215

110 Insurance Sub-group and Equity Investments Sub-group I have considered the following in assessing whether the Scheme is likely to have an effect on the Insurance Sub-group and the Equity Investments Sub-group: The existing Insurance Sub-group and Equity Investments Sub-group are recipients of services from the Transferors, but to a lesser extent than the NRFB Sub-group. The services mainly consist of organisational support services and will continue to be provided under the same or similar terms to those that are currently operated; The Scheme will have no effect on the entities within the Equity Investments Sub-group and their customers as it does not form part of the Scheme; and The Insurance Sub-group also does not form part of the Scheme but all derivatives between the Transferors and the Insurance Sub-group which do not meet the purpose or product requirements to remain in the Transferors will be transferred to LBCM via the Scheme. The Insurance group will subsequently have derivative contracts with both RFB and LBCM, however, I have been informed that all contracts are collateralised with daily margining and therefore little impact is expected on the credit risk exposure As a result, I am satisfied that there is not likely to be any material adverse effect on the Insurance Sub-group and Equity Investments Sub-group as a result of the Scheme. Joint ventures and partnerships I have considered whether the Scheme is likely to have an effect on joint ventures and partnership arrangements As there are not expected to be any changes to the arrangements between the Group and joint ventures or partnerships, I am satisfied that there is not likely to be any adverse effect on joint ventures and partnerships as a result of the Scheme. Competitors using the Group s facilities Some of the Group s competitors use the Group s facilities, such as their FMIs. I have identified them as Other Relevant Persons, as any changes to the Group s FMI as a result of the Scheme could also affect these competitors In my analysis, I have given consideration to the following competitors using the Group s facilities: TSB Bank plc (divested in 2015): created following an order made by the European Commission on the Group to divest part of its business. TSB Bank plc continues to use the Group s online banking platform and other payment services through a transitional services agreement; and Sainsbury s Bank plc (transferred to J Sainsbury plc on 31 January 2014): initially a joint venture between J Sainsbury plc and BoS plc. A transitional services agreement is in place to allow Sainsbury s Bank plc to use the Group s facilities I have considered whether the Scheme is likely to have an effect on the way that competitors using the Group s facilities interact with the Group: The competitors currently access the FMI through memberships held by LB plc and BoS plc. In addition, TSB Bank plc uses the Group s online banking platform as well as data retrieval services; The Transferors will continue to support the competitor banks after the Scheme and no change is expected to the Transferors FMI memberships (as detailed in the FMI subsection above); 110/215

111 Existing operational procedures are in place to help ensure existing SLA will be complied with; and Based on the expected form of the Scheme, there is unlikely to be any material exposure of competitors using the Group s facilities to LBCM. I am satisfied that there is no material effect on the Transferors viability and ability to provide services in the future (see financial analysis subsection on creditors, paragraphs 9.35 to 9.41, for more details) As a result, I am satisfied that there is not likely to be any adverse material effect on competitors using the Group s facilities as a result of the Scheme. Regulatory, government and other financial bodies Regulatory authorities Regulatory authorities will be affected by the operational, structural and financial changes to the Group to accommodate the Scheme, such as the requirement to set up a banking licence and the assessment of the Statutory Question. Consequently, I have identified regulatory authorities as Other Relevant Persons In my analysis, I have given consideration to the following regulatory authorities: UK Financial Services PRA; UK Financial Services FCA; UK Other The Pensions Regulator (this is analysed in Section 16 of this Scheme Report); UK Other HMRC (This is analysed in Section 15 of this Scheme Report); Crown Dependency regulatory authorities; and Overseas regulatory authorities. UK Regulators (PRA and FCA) I have considered whether the Scheme is likely to have an effect on the way that regulatory authorities interact with the Group There is likely to be additional workload on the PRA and FCA as a result of implementing the Scheme such as increases in the level of reporting, monitoring and supervision required, as well as the additional one-off workload of LBCM applying for a banking licence. The effect is expected to be material, particularly over the short-term, as LBCM becomes established However, the requirement for the creation of LBCM is a direct consequence of the legislative requirements. Even if the NRFB Sub-group already had an authorised bank to which the Scheme would transfer business, there would be significant changes to the activities and permissions of that bank, which I would expect to require regulator engagement and approval. I consider these operational and transitional effects will not be greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA The Scheme is unlikely to affect the Transferors ability to pay UK Financial Regulators in line with their regulatory obligations (see financial analysis subsection on creditors, paragraphs 9.35 to 9.41, for more details) As a result, I am satisfied that there is not likely to be any material adverse financial effect on UK regulators as a result of the Scheme. 111/215

112 Non-UK regulators I am satisfied that there will not be any direct effect on Crown Dependency and other overseas regulatory authorities, as no non-uk business will be transferred via the Scheme. FSCS The FSCS protects customers eligible deposits when authorised entities, such as BoS plc and LB plc, fail. I have identified the FSCS as an Other Relevant Person, as the Scheme could affect the way they deal with the Group in the event that there is a change to the entities covered or the fees payable I have considered the following in assessing whether the Scheme is likely to have an effect on the FSCS: There are no plans to transfer any deposits under the Scheme and therefore there will not be any changes to FSCS arrangements for customers; and There are likely to be no changes to the fees payable or received As a result, I am satisfied that there is not likely to be any adverse effect on the FSCS as a result of the Scheme. Tax authorities The Group is required to submit tax returns and interacts with a number of tax authorities around the world. I have identified tax authorities as Other Relevant Persons as they may be affected by the entity changes within the Group which may lead to changes in tax requirements and payments I have considered the following tax authorities: UK tax authority HMRC; EEA tax authorities; Crown Dependency tax authorities; and Overseas tax authorities. UK tax authority HMRC I have considered the following when assessing whether the Scheme is likely to have an effect on the way that the HMRC interacts with the Group: The policies and procedures of the Group s Tax Function will remain unchanged; The Group will continue to use the existing processes and systems to prepare and submit the various tax returns. Therefore, HMRC will not see a change in the way it interacts with the Group; and The current processes and policies will be replicated to apply to LBCM, which will result in limited additional workload for the HMRC. The nature of the task that HMRC will be required to perform will not be new, so I do not expect the effect to be material As a result, I am satisfied that there is not likely to be any material adverse operational or transitional effect on UK tax authorities as a result of the Scheme I have assessed the financial effect of the Scheme on the HMRC in Section 15 of this Scheme Report. 112/215

113 EEA branches tax authorities I am satisfied that there will be no effect on the tax authorities of EEA Branches as a result of the Scheme as all EEA Branch activity is expected to remain within the RFB Sub-group and therefore will not be transferred via the Scheme. Crown Dependency and overseas tax authorities I am satisfied that there will be no adverse effect on Crown Dependency and overseas tax authorities as a result of the Scheme, as the non-uk business will not be transferred via the Scheme. Future customers and future Other Relevant Persons Given that future customers and Other Relevant Persons do not currently have any direct or indirect interests in the Group, I am satisfied that it is not possible for the Scheme to have an adverse effect on these persons. To the extent that these persons become customers or Other Relevant Persons in the future, they will do so in the knowledge of the effect of the Scheme and so will not be adversely affected by the Scheme. Customers of the Insurance Sub-group The policies held by customers of the Insurance Sub-group are not transferring under the Scheme Given this, I do not believe that the Scheme would change the level of benefits that customers would expect to receive, including the following key elements: Any of the terms and conditions of these policies; The funds available for policyholders to invest in; and The way that policies with discretionary benefits (such as with-profits policies) are expected to be managed Further, the Scheme will not change the fact that the Insurance Sub-group will continue to have to meet its own regulatory capital requirements and it does not, of itself, change the risk appetite framework that applies to that division. That framework specifies, amongst other things, the level of capital held in excess of the regulatory requirements and the level of liquidity targeted. These factors are important in maintaining the security of the customer benefits. In addition, the Scheme will not change the applicability of the FSCS to the business in the Insurance Subgroup Overall, I am satisfied that there are not likely to be any adverse effects on the customers of the Insurance Sub-group. Persons connected with customers The Group has identified certain Other Relevant Persons who are connected with customers, rather than being customers themselves: Securitisation noteholders and other secured creditors: where the Transferor has entered into a liquidity facility with a securitisation SPV, I have considered the potential adverse effects for holders of securitisation notes in paragraphs 6.64 to Where a Transferor has entered into a liquidity facility or a derivative with a securitisation SPV, the bankruptcy remote and limited recourse nature of the SPV may mean that the adverse effects on the customer (i.e. the SPV), which are identified throughout Section 6, are passed on to the holders of the SPV s notes and other secured creditors. I am satisfied that my 113/215

114 conclusion in respect of those customers extends to these identified persons connected with customers; Third party beneficiaries or pledgees of a Trade Instrument: I have considered the potential adverse effects for third party beneficiaries or pledgees of a Trade Instrument in paragraphs to 6.131; and Persons who have granted security or provided a guarantee to a Transferor; agents in bilateral or syndicated structures; third party syndicate members in syndicated structures; Governmental entities with consent or notification rights in respect of transfers or modifications of swaps between a Transferor and an SPV; and customers insurers (including monoline insurers): The potential adverse effect on these persons is in relation to: provisions in a contract with a customer being overridden by the Scheme, and the consequential effect this may have on a person connected to that customer; foreign law security issues; and certain transitional effects of the Scheme. The effect on customers of these contractual provisions being overridden is considered in paragraphs to 6.135; the effect on customers of foreign law security issues are considered in paragraph 6.169; and the relevant transitional effects on customers are considered in paragraphs to In each case I am satisfied that my conclusion in respect of those customers extends to these identified persons connected with customers. 114/215

115 10. Capital, liquidity and funding Introduction 10.1 In this section, I consider the effect of the Scheme on the capital and liquidity positions of the Group before and after the changes to determine whether I believe they are likely to lead to an adverse effect on any stakeholders. The Scheme is part of the wider group restructuring activities being undertaken to achieve compliance with the Ring-fencing Regime. I have provided an overview of these activities in Section 3 of this Scheme Report and, where relevant, have considered whether these wider group restructuring activities affect my conclusions on the Scheme itself I considered the effect of the Scheme on all stakeholders as the adequacy of capital and liquidity in the entities after the implementation of the Scheme has the potential to affect all stakeholders rather than any one single stakeholder group. Inadequate liquidity and funding could result in a bank not being able to meet its payment obligations. For example, bondholders not receiving full repayment of their investment, depositors not being able to withdraw their deposits or suppliers not being paid. Inadequate capital could result in a bank being unable to absorb losses and therefore be vulnerable to market stress The Group reports to the regulator its framework for capital management and liquidity management and compliance with regulatory requirements across its banking entities on a group consolidated basis. Capital requirements are met on a consolidated basis as well as for individual bank entities such as LB plc and BoS plc, and on what is referred to as a solo basis, whilst liquidity requirements are met via the PRA waiver at a consolidated domestic liquidity sub group (DoLSub) level Following the implementation of all the changes necessary to comply with the Ring-fencing Regime, capital will continue to be assessed on both a consolidated and solo basis, whilst liquidity will continue to be assessed on the basis of liquidity groups determined by the regulator. Although LB plc and BoS plc are separately regulated entities, for the purposes of drawing my conclusions I have focused on reviewing the effect of the Scheme on the following entities and not at the individual legal entity or solo level: The Group on a consolidated/dolsub basis; The RFB Sub-group; and LBCM To enable me to make a comprehensive assessment of the adequacy of capital and liquidity, I have used a variety of metrics for each of the three post-scheme groupings of entities, and compared each of them with the position of the Group prior to the implementation of the Scheme. The variety of metrics I have used to inform my analysis and assessment of the adequacy of capital and liquidity are discussed in more detail in paragraphs to The Scheme ultimately results in separation of entities to reduce the risk of failure of the RFB Subgroups across the consolidated group. It is my view, therefore, that assessing the effect on a range of different but relevant capital and liquidity measures at the respective group and subgroups consolidations, rather than at an individual entity by entity level, is a reasonable way in which to consider the potential for adverse effects arising from the implementation of the Scheme. 115/215

116 Approach capital and funding analysis 10.6 The structure of my analysis in this section covers the following: Area Description Paragraphs Background to the regulatory regime I summarise the key regulatory requirements that apply to banks, which have provided the background for my analysis and conclusions; 10.7 to Scope of my work Effect of the Scheme Potential adverse effects and conclusions Scope of my work and the information that I have reviewed; Effect of the Scheme presented as a factual account of the business model of each relevant banking entity and the resulting position for capital, liquidity and business model viability compared to the position before the Scheme for each entity as referred to in paragraph 10.4; and I considered each of the adverse effects that could potentially occur and present my reasons why I do not consider them to be material to to to Background to the regulatory regime 10.7 In this subsection I present relevant background to the regulatory regime in the UK to provide the context in which banks operate and against which I have assessed the financial position of post-scheme entities The PRA is responsible for the prudential regulation of the capital and liquidity position of banking entities. One of the objectives of the PRA is to promote the safety and soundness of the firms it regulates. The PRA s requirements are drawn from a common framework of European legislation for financial services firms, referred to as the Capital Requirements Directive IV and Capital Requirements Regulation (together referred to as CRD IV ), which itself reflects the European implementation of the global regulatory standards agreed by the Basel Committee on Banking Supervision ( Basel ) The following subsections discuss: Drivers of financial viability; Business model viability; Capital; Liquidity; and Stress testing. Drivers of financial viability A bank that has a weak capital position may not have the quality and/or quantity of capital to absorb unexpected losses when needed. The more capital a bank has, the more losses it can absorb during periods of stress before becoming insolvent and being unable to meet liabilities to depositors and creditors. 116/215

117 10.11 A bank with a weak liquidity position may not have the quality and/or quantity of readily available funding to meet its daily requirements, as well as the likely requirements over the longer term. This includes being able to repay demand depositors when requested Weak capital and liquidity positions have the potential to be exacerbated during times of stress and, in the absence of a bank having the tools to mitigate or reduce these risks, may result in the failure of a bank and it therefore being forced into liquidation or resolution 40. Such an outcome may have potentially material adverse effects on all stakeholders with exposure to the bank. Therefore a bank that has a weak capital or liquidity position may be perceived as riskier relative to a bank with a stronger capital or liquidity position In this subsection of my Scheme Report, I consider whether the capital and liquidity position of the three groupings post-scheme may be closer to failure than the capital and liquidity position of the consolidated group prior to the implementation of the Scheme. Business model viability To protect all stakeholders, the UK regulatory system mandates certain minimum levels of capital and liquidity required to be held at all times, expressed as ratios. The objective of such minimum requirements, when combined with other quantitative and qualitative requirements, is to promote the resilience of regulated banks, on a BAU basis and during a period of stress, to prevent failure A bank with a narrow business model may be more susceptible to vulnerabilities and therefore may have less capacity to offset potential risks than a bank with a wider business model. Therefore a bank that has a narrow business model may be perceived as riskier, relative to a bank with a wider business model The business model of a bank is a defining consideration in how the regulatory capital and liquidity requirements are established by regulatory authorities and adapted to different business models. Capital It is commonplace for regulated banks to have discussions with the PRA on meeting capital requirements, by reference to the Basel framework (as reflected in Capital Requirements Regulation ( CRR )) which categorises the regulatory requirements under three pillars I describe these pillars and additional capital requirements below: Pillar 1 minimum capital requirements; Pillar 2 supervisory review process; Pillar 3 market discipline; and Leverage ratio A bank with ratios measuring available capital, against those items listed in paragraph that are lower relative to the corresponding capital ratios of another bank may be perceived as riskier. Pillar 1 minimum capital requirements Pillar 1 provides details on the minimum capital requirements banks must hold and how these relate to the regulatory measure of risk. The regulatory measure of risk is referred to as RWAs. RWAs are computed by applying a weighting, reflecting the relative riskiness of the exposure, 40 Further detail of resolution is discussed in Section 13 of this Scheme Report. 117/215

118 to convert the exposure of a bank into a measure that regulators are able to apply consistently across banks Against the RWA measure, banks are required to hold a minimum level of capital resources to protect against unexpected losses. The minimum level of capital requirements is set at a level corresponding to 8% of a bank s RWAs As well as imposing a minimum level of capital, regulators require that the types of financial instruments used as capital must be of a specific quality. Minimum levels of capital fall into three broad categories: Common Equity Tier 1 ( CET1 ) which must be equal to at least 4.5% of RWAs; Total Tier 1 must be equal to at least 6% of RWAs; and Total capital, which must be equal to at least 8% of RWAs Subject to regulatory permissions, banks may employ either a Standardised Approach or an advanced IRB approach to computing RWAs. The Standardised Approach limits banks to applying generic industry average risk weights to their exposures. The advanced approach allows banks to use their own experience of losses on assets to compute RWAs using their own models and data Firms are required to secure regulatory waivers and authorisations before they are able to apply an advanced approach and must instead apply the relevant Standardised Approach for each risk type until the necessary regulatory approvals are secured. I have been advised that the applications have been submitted to the PRA to permit the existing advanced approaches employed by the Group and individual entities within the RFB Sub-group, to also be applied to LBCM after the implementation of the Scheme. Pillar 2 supervisory review process and capital buffers Pillar 2 requires banks to undertake their own Internal Capital Adequacy Assessment Process ( ICAAP ) to consider if they are exposed to any risks that are either not covered or not fully captured under Pillar 1, and to supplement the Pillar 1 capital requirements to reflect such risks The ICAAP is reviewed by the relevant regulator, the PRA in the case of the Group, as part of an annual Supervisory Review and Evaluation Process ( SREP ), in which the regulators appraise whether the bank s internal assessment is adequate. Following the SREP, including both a review of the ICAAP and any further interactions with a firm, the PRA may issue Individual Capital Guidance ( ICG ) specific to the bank, which may result in additional capital requirements being imposed in the form of Pillar 2A. Pillar 2A is the minimum capital requirement banks must hold to cover those risks that are not covered or not fully captured under the Pillar 1 requirements and will include the ICG for credit risk, market risk, operational risk, counterparty credit risk, credit concentration risk, interest rate risk in the banking book and pension obligation risk where applicable The PRA buffer, in the form of Pillar 2B, which is assessed and set by the PRA following a SREP, is an amount of capital that the PRA requires banks to hold in addition to their ICG to cover losses that may arise under a severe stress scenario plus any capital buffer set by the PRA for risk management and governance weaknesses. Pillar 2B capital buffer is forward looking, which considers risks banks may face over time, and seeks to ensure that banks can continue to meet the minimum capital requirements (i.e. Pillar 1 and Pillar 2A) during a period of stress. The PRA buffer does not duplicate the CRD IV capital buffer requirements. The CRD IV capital buffers are collectively the capital conservation buffer, countercyclical capital buffer, and the systemic risk buffer. After the applicable offset between the PRA buffer and CRD IV buffers, capital buffers are required to be held by banks in addition to the Pillar 1 and Pillar 2 capital requirements under the Base case. The objective of these buffers is to prevent and mitigate long-term non-cyclical systemic or macro prudential risks where there is a risk of 118/215

119 disruption in the financial system with the potential to have serious negative consequences for the financial system and the real economy. These capital buffers are available to be drawn down by banks under a stress event or adverse circumstances which require pre-notification to and prior approval from the regulators The Group disclosed its Pillar 2A ICG in its Report and Accounts for the year-ended 31 December The Group s Pillar 2B requirement was not disclosed publicly. Pillar 3 market discipline Pillar 3 requirements are intended to encourage greater transparency and comparability of information publically disclosed by banks. Banks typically publish their Pillar 3 reports on their websites, and are required to do so on at least an annual basis. The published details cover the quality and quantity of banks available capital resources, along with a breakdown of Pillar 1 capital requirements and associated RWAs, amongst other disclosures. Leverage ratio In addition to meeting prescribed regulatory capital requirements and ratios, a bank monitors how leveraged they are in relation to its consolidated assets (i.e. how much of its debt is used to finance its assets). The leverage ratio is calculated by dividing Tier 1 capital by the bank s exposures to customers and counterparties. The higher the ratio the greater the likelihood that a bank can withstand negative shocks to its balance sheet The PRA currently imposes a 3.25% leverage ratio requirement on PRA-regulated banks and building societies with total retail deposits equal to or greater than 50bn, whether on an individual or a consolidated basis, on a firm s financial year-end date. However, for cross-border groups the leverage framework will apply at the highest level of consolidation in the United Kingdom. Liquidity The regulatory liquidity regime is based on the principle that banks must have, at all times, adequate levels and appropriate quality of liquidity resources to meet outflows of cash as and when required. The aim being that banks must maintain a prudent and diversified funding profile to cover liabilities as they become payable in both BAU and stressed conditions. As a consequence, regulators expect banks to manage and control liquidity and funding risks comprehensively Regulators measure resilience of a bank s liquidity profile in a number of ways. I have explained each of these in the following subsections covering: Liquidity coverage ratio ( LCR ); Net stable funding ratio ( NSFR ); Overall liquidity adequacy rule ( OLAR ); and Supervisory Review and Evaluation Process A bank with liquidity ratios that are lower relative to another bank may be perceived as riskier. LCR The LCR seeks to address whether banks have sufficient unencumbered high quality liquid assets ( HQLA ) in their liquidity buffer to survive stressed liquidity conditions and which can be sold to realise cash to cover the bank s obligations over a period of 30 days. The LCR is calculated by dividing a bank s stock of HQLA by its expected net cash outflows during a period of stress, the result of which must be greater than or equal to 100%. 119/215

120 Equation 1: LCR = h % The PRA has implemented the LCR on a phased basis with the requirement being at least 80% from 1 October 2015, at least 90% from 1 January 2017 and 100% or more from 1 January By the time the Scheme is implemented on the Effective Date the LCR will be required to be maintained at or above 100% HQLA is ranked into two tiers. Level 1 HQLA are the most liquid and can be sold for their full market value during BAU and stressed conditions. An example of Level 1 assets are deposits held with the central bank. Level 2 HQLA are considered to be liquid, but when sold realise less than their full market value. NSFR The NSFR requires banks to have funding with greater stability over the long-term (defined as one year) and to avoid mismatches between the bank s funding and its assets. In this way, long-term and less liquid assets are encouraged to be funded by long-term and more stable liabilities The NSFR is calculated by dividing a bank s holdings of available stable funding ( ASF ) by the required amount of stable funding ( RSF ), the result of which must be greater than or equal to 100%. ASF is that portion of capital and liabilities that are classified as stable over a one year period, while RSF is the portion of capital and liability that is necessary, dependent on the liquidity risk characteristics of the different assets that a bank holds. Equation 2: Net stable funding requirement = 100% The PRA is expected to provide confirmation regarding implementation timelines and expectations for UK regulated banks. As at the date of this Scheme Report, the NSFR has not been implemented in the UK. Basel have indicated the NSFR to be implemented at or greater than 100% The Group does not publicly disclose the LCR and NSFR metrics although I have been provided with them for the purposes of this Scheme Report and considered them as part of my analysis. OLAR The OLAR is a principle that requires banks to ensure they have adequate levels of liquidity resources (both in terms of amount and quality) to ensure that there is no significant risk that its liabilities cannot be met as they fall due and maintain a prudent funding profile considering both BAU and stressed conditions. For example, the OLAR would require, amongst other things, that a bank considers its structure and liquidity risk appetite and tailors the components of its liquidity risk management framework which would include: The ability to identify, measure, manage and monitor its liquidity and funding risks; The strategies, policies, processes and systems that enable the above considerations for risk management; Assessment over appropriate time horizons, such as short-term, medium to long-term and intraday, and also different stress scenarios; and Adequate systems for the allocation of liquidity costs, benefits and risks. 120/215

121 10.43 The OLAR therefore goes beyond simply meeting the LCR and NSFR requirements and considers the quantitative and qualitative aspects of the overall liquidity risk management framework. Compliance with the requirements of the OLAR are documented in the Internal Liquidity Adequacy Assessment Process ( ILAAP ), which is similar to the ICAAP, on at least an annual basis or where changes to a bank s operations materially change its liquidity profile. Liquidity supervisory review process As a part of the Liquidity Supervisory Review and Evaluation Process ( L-SREP ), the PRA reviews ILAAP submissions, and appraises whether a bank s internal assessment is adequate. Where a bank s own assessment of liquidity risk is considered to be insufficient, the PRA may issue firm-specific Individual Liquidity Guidance ( ILG ) on both quantitative and qualitative areas. The ILG will consider Pillar 2 requirements (for example, risks not captured by the LCR) As part of the overarching supervisory review process, the PRA has clarified that during periods of stress (actual or projected) banks are permitted to utilise their HQLA to meet their obligations and rebuild these buffers over a reasonable time to meet requirements. In using their HQLA during periods of stress banks are permitted to fall below the regulatory requirements of the LCR and ILG. During such periods of stress, banks are required to immediately notify the PRA and provide a plan for restoring their position to be above, or meet, regulatory requirements. The PRA will make a determination regarding this plan and decide upon a reasonable time period within which the bank shall return its position and rebuild its buffers Banks are therefore expected by regulators to have a risk management framework that clearly articulates the specific management actions, and a quantification of such, that would be employed to uplift their key liquidity metrics. Stress testing Stress testing aims to highlight a bank s vulnerabilities to adverse changes in the economic and business environment and to test whether the bank has adequate financial resources across a range of economic stress scenarios. Reverse stress testing facilitates contingency planning and it is a stress test that explores the specific vulnerabilities of a business by generating an extreme adverse scenario that would cause the bank to fail A bank that is more vulnerable to adverse changes and more susceptible to stress events may be perceived as riskier, relative to a bank that is not. Certain banks are required to participate in external industry-wide stress testing exercises by the BoE and the European Banking Authority ( EBA ). Both the BoE and the EBA published the results from their 2016 stress testing exercises, and neither revealed capital inadequacies for the Group based on its financial position as at 31 December Potential changes to the regulatory framework The CRR2/CRDV proposals are expected to bring changes in the regulatory capital framework for credit risk, market risk, liquidity risk and operational risk and are yet to be finalised. If such changes are finalised either during 2018, or beyond and if implemented within the time horizon of the ICAAP and ILAAP documents, further analysis may be required to be undertaken by the Group to ensure it will be able to meet CRR2/CRDV. Internal risk appetite limits To mitigate against the risk of breaches of regulatory requirements, banks set internal risk appetite limits above the minimum regulatory requirements. These limits are confidential and not disclosed to the public. These limits allow banks to proactively manage their capital and liquidity positions and have a forward looking view allowing banks to manage against a potential capital or liquidity stress in a proactive and prompt manner. Banks with a lower headroom or 121/215

122 lower excess between internal risk limits and minimum regulatory requirements may not be able to take proactive action in a timely manner When internal risk appetite limits are not met or are projected to be close or fall below the targets, reports are sent to the relevant board committees and/or board. Where a limit is narrowly met it is escalated internally to management and certain restrictions may be put in place or actions taken to mitigate the internal risk appetite limit being breached in the future. Where a limit is not met it is escalated to the board and actions are taken to regain compliance with the target. These internal risk appetite limits provide banks with a level of foresight and security over and above that required by minimum regulatory requirements. Management actions Management actions include those actions that are used to mitigate and/or remediate risks that arise during periods of stress. Examples include issuing additional term funding or restricting lending. These actions are intended to protect the financial viability of banks and mitigate potential adverse effects to stakeholders Management actions can be quantitative or qualitative in nature and these are documented by banks in their Contingency Funding Plan ( CFP ), which forms part of the liquidity risk management framework, and in the regulatory required recovery and resolution plan documents. The CFP is a liquidity crisis management document that is prepared as a response plan in the event of a financial emergency. Recovery documents include Recovery Plans which detail the measures a bank will take to restore its financial position following a significant deterioration of its financial position. Resolution documents include information provided by banks to support regulators resolution strategies of intervening to manage the failure of a bank Therefore a bank that does not clearly articulate specific management actions, and a quantification of such, that would be employed to mitigate or remediate any deterioration in capital and liquidity positions during stress may be perceived as risky. Scope of my work In my assessment of the potential effect on stakeholders based on the financial viability of the Group post-scheme, I outline below how I have considered each of the following aspects: Business model viability; Capital adequacy; and Liquidity adequacy In line with the PRA Policy Statement I have considered whether stakeholders could potentially be adversely affected as a result of being exposed to a relatively riskier entity than they were before the Scheme An important part of this analysis is my review of the capital positions from the base year 2016 to forecasted years 2020 of the pre- and post-scheme entities as set out in the respective confidential ICAAP documents which provide management forecasts. The ICAAP documents reflect decisions made by the Group as to which business lines will reside within the RFB Subgroup and LBCM and these capital positions have been projected back to 31 December 2016, and forward to 2020, on a pro-forma basis. I have also analysed the publicly disclosed Pillar 3 documents of the Group pre-scheme as at 31 December 2016 and 2017 half-year results as at 30 June These referenced documents are detailed in Appendix I have reviewed the liquidity position of the Group pre-scheme in its confidential ILAAP document and the high-level liquidity position of LBCM included within the BLA which the Group submitted to the PRA in order to obtain a banking licence for the new LBCM entity. I have also 122/215

123 analysed publicly available information on the Group prior to the implementation of the Scheme, in the 2016 annual report and 2017 half-year results as at 30 June When considering whether stakeholders face a particular adverse effect I applied my own qualitative and quantitative judgement. I have considered any potential adverse effects by identifying whether the financial position of each entity has deteriorated, whether any such deterioration is significant and whether any such deterioration is greater than reasonably necessary in order to achieve the relevant ring-fencing purpose, as set out in Section 106B(3)(a) of the FSMA I considered how the financial viability of each entity is expected to change as a consequence of the Group s Scheme structure and how all stakeholders may be affected, in particular how the financial position of each entity compares, or will compare based on future projections, against regulatory requirements. The objective is to assess whether the financial positions of the Group, the RFB Sub-group and LBCM are adequate to meet PRA s requirements and market expectations. Business model viability I have compared the financial position of the post-scheme entities with that of the Group pre- Scheme and considered the applicable regulatory requirements. I acknowledge there are difficulties associated with comparing information across banks with different business models as the risk drivers will differ, but note that this is not an uncommon practice, employed by market participants, analysts and regulators to allow for comparison using a consistent benchmark. It is my opinion that this an appropriate approach given the inherent limitations, such as the lack of comparable information, different risk drivers and different markets banks operate in that are available To allow for the specific nature of each entity, I also considered the appropriateness and feasibility of management actions outlined in the documents I have reviewed. The combination of both quantitative measures and qualitative narrative on management inform my conclusions on the potential for adverse effects on all stakeholders. Capital I have analysed the respective capital ratios of the post-scheme entities to determine whether there will be any potential adverse effect on stakeholders For each entity, the capital ratios have been projected by the Group across a five year period, under both a Base case (i.e. a BAU environment) and a stress case (i.e. where the business is exposed to some form of economic shock). The particular ratios compared for CET1, Tier 1 and Total capital ratio are: Liquidity The actual and projected capital ratios; and The surplus of actual ratios over regulatory requirements I have analysed the effect of changes in the liquidity position on stakeholders as a result of the Scheme, as follows: LCR and NSFR ratios; Composition of the liquid asset portfolio; Sources of funding available and used; Cost of funding for the entity; Approach to stress testing; and 123/215

124 Quality of the CFP. Effect of the Scheme In the following subsections I have presented an account of the business model viability of the post-scheme groupings and discuss the resulting effect on capital and liquidity compared to the position before the Scheme I have also specifically considered pension obligation risk as the manner in which the Group has chosen to structure the defined benefit ( DB ) pension schemes in responding to the Ringfencing Regime may create risks to the financial viability of the post-scheme entities that warrant specific consideration My analysis and conclusion on potential adverse effects are not presented here but reserved for the final subsection of this section The following subsections discuss: Business model viability; Capital; Liquidity; and Pension obligation risk. Business model viability The legislation governing an RFB has introduced restrictions on certain activities being undertaken by such entities. All activities undertaken by the Group prior to the implementation of the Scheme are classified as either permitted or prohibited under the Ring-fencing Regime The Group is proposing to comply with the Ring-fencing Regime by creating a wide RFBs and narrow NRFB model, whereby the Transferors will undertake most activities currently undertaken by the Group that are not prohibited under the legislation. The extent of the prohibited activities represents only a small proportion of the activities of the Group pre-scheme and these will be mostly undertaken by LBCM post-scheme. As discussed in Section 5 of this Scheme Report, to comply with the legislative requirements, the Group has chosen to create a narrow NRFB that will satisfy all regulatory requirements. As a result, LBCM will have a less diversified business model In the time leading up to the planned implementation of the Scheme, the Group is undertaking a number of initiatives to reorganise the Group s structure. These pre-scheme group adjustments are outside the scope of my review. However, the accounting principles applied to these pre-scheme related transfers, i.e. transferring assets at book value (which is the value at which they are carried on the bank s balance sheet) is relevant to the effect on the capital position of the post-scheme entities. The Group advised that the accounting principles to be employed to transfer assets from the Group to LBCM are intended to be executed at the prevailing book value. The majority of exposures being transferred to LBCM are derivatives, for which the book value will equal the fair value. The Group s policy is to hold surplus capital at the highest consolidated level in the Group, with subsidiary companies holding capital within an agreed capital risk appetite. Hence any additional cash received as consideration which may result in the subsidiary holding capital in excess of its capital risk appetite would be paid by dividend to LBG plc. Therefore, in aggregate, from a Group perspective there is no net benefit to the Transferors or the Transferee, regardless of whether the transfer of assets are made at book value or fair value within member entities of the Group, because the consideration for transfer of such assets is to be funded by dividends paid to LBG plc A bank with a less diversified business model is by its nature likely to be more vulnerable to particular stressed situations and more prone to volatility of earnings because if there are any 124/215

125 adverse changes in the area of business in which they operate they would have limited diversification benefits in the form of other channels of business to offset the adverse changes. As a consequence, stakeholders with exposures to either the RFB Sub-group or LBCM may perceive the entity that they will be facing as more risky relative to the entity they were exposed to before the changes were made to comply with the Ring-fencing Regime However, the RFB Sub-group, which will conduct most non-prohibited activities and which will have a comparatively more diversified business model than LBCM, is likely to be perceived by stakeholders of both the RFB Sub-group and LBCM as a relatively less risky business because if there are any adverse changes in the areas of business in which the RFB Sub-group operates it would have diversification benefits in the form of other channels of business to offset the adverse changes The possibility, however, does exist that a stressed environment may threaten the financial viability of the RFB Sub-group and cause it to fail but that does not affect LBCM s viability and vice versa Regardless of the business model a bank chooses to operate, banks operate on the basis of stakeholder confidence. If either the RFB Sub-group or LBCM is perceived as relatively riskier, stakeholders may have less confidence. Any scenario that causes a loss of reputation, and/or causes stakeholders to lose confidence, may result in financial viability being threatened. Capital In the subsections below I consider the capital position of each of the following groupings: The Group pre-scheme; The Group post-scheme; RFB Sub-group; and LBCM. The Group pre-scheme I have captured public information disclosed by the Group as part of its annual Pillar 3 disclosures (as at 31 December 2016) and 2017 half-year results (as at 30 June 2017) on a transitional basis. Transitional basis refers to those capital securities that previously qualified as Tier 1 or Tier 2 capital, but do not qualify under CRD IV, that can be included in Tier 1 or Tier 2 capital (as applicable) up to specified limits. Capital ratios on a transitional basis currently use phased-in provisions pending the full implementation of CRD IV. Table 10.1 shows that, as at 31 December 2016, the Group held capital resources of 46.1bn and as at 30 June 2017, the Group held capital resources of 45.2bn. 125/215

126 Table 10.1: Consolidated capital position of the Group pre-scheme as at 31 December 2016 and 2017 half-year results as at 30 June 2017 Capital Resources (1) As at 30 Jun 17 As at 31 Dec 16 CET1 capital Additional Tier 1 ( AT1 ) capital Less deductions from Tier 1 (1.3) (1.3) Total Tier 1 capital Tier 2 capital Total Capital Resources RWAs Common Equity Tier 1 ratio ( CET1 ratio ) (2) 13.5% 13.6% Tier 1 capital ratio (3) 16.6% 17.0% Total capital ratio (4) 20.8% 21.4% Source: Lloyds Banking Group Capital and Risk Management Pillar 3 Report as at 31 December 2016 (Page 21) Lloyds Banking Group 2017 half-year results as at 30 June 2017 (Page 43) Notes: (1) Different Tiers of capital resources are represented net of regulatory adjustments on a transitional basis. (2) CET1 ratio = CET1 capital/rwas. CET1 ratio in Jun 17 recognises dividend paid by the Insurance business in July 2017 in relation to its 2017 interim earnings. (3) Tier 1 capital ratio = Total Tier 1 capital/rwas. (4) Total capital ratio = Total capital resources/rwas Table 10.2 details how the Pillar 1 minimum requirements for the Group has been computed from the RWAs across different risk types. Table 10.2: Overview of the Group pre-scheme RWAs and the level of Pillar 1 minimum capital requirements, the Group pre-scheme maintained as at 31 December 2016 and 2017 half-year results as at 30 June 2017 As at 30 Jun 17 RWAs bn As at 31 Dec 16 RWAs bn As at 31 Dec 16 Minimum Capital Requirements bn bn bn Credit risk Counterparty credit risk Market risk Operational risk Amounts below Threshold for deduction (subject to 250% risk weight) (1) Total Source: Lloyds Banking Group Capital and Risk Management Pillar 3 Report as at 31 December 2016 (page 25) Lloyds Banking Group 2017 half-year results as at 30 June 2017 (Page 45) Notes: (1) As per Article 48 of CRR, Threshold RWAs reflect the element of significant investments and deferred tax assets that are permitted to be risk-weighted instead of being deducted from CET1 capital. Significant investments primarily arise from investments in the Group s Insurance business Figures in Table 10.2 shows that as at 31 December 2016 the 215.5bn of RWAs create a Pillar 1 capital requirement of 17.3bn. Compared with the 46.1bn of available capital resources in 126/215

127 Table 10.1, it is clear that the Group has an excess of capital resources prior to the Scheme as at 31 December In addition, the latest figures from the 2017 half-year results as at 30 June 2017 in Table 10.2 show that the 217.7bn of RWAs create a Pillar 1 capital requirement of 17.4bn. Compared with the 45.2bn of available capital resources in Table 10.1, the Group continues to have excess capital resources prior to the Scheme as at 30 June Under the BoE stress test exercise conducted in 2016 based on the Group s balance sheet as at December 2015, the Group s capital position after allowing for management actions was projected to have a 10.3% CET1 ratio, exceeding the hurdle rate of 7% set by the regulator for the purposes of this exercise. This compares with an actual CET1 ratio of 12.8% as at December The leverage ratio was projected to be 4.3% compared to a hurdle rate of 3% in the stress scenario. This compares with the actual leverage ratio of 4.8% as at December The results of this BoE stress test did not reveal capital inadequacies for the Group based on its financial position as at 31 December The Group post-scheme For the Group post-scheme, the projected capital ratios in the Base case are in excess of regulatory minimum levels. When compared with pre-scheme, forecast capital ratios of the Group under the Base case are in line with post-scheme projections. However, under the stressed case, projected capital ratios of the Group post-scheme are weaker than pre-scheme capital ratios, albeit still meeting the minimum regulatory required levels In the application of stress scenarios, each of the projected ratios for CET1, Tier 1 and Total capital ratios are above minimum regulatory levels The leverage ratio of the Group post-scheme exceeds the regulatory requirement set for leverage ratio under the Base case and under the stressed case. RFB Sub-group In the context of analysing the RFB Sub-group I have reviewed information on the levels and ratios of CET 1 capital, Tier 1 capital and Total capital under the Base case and compared these with the CET 1, Total Tier 1 and Total Capital ratios, respectively for the Group pre- Scheme. The comparison highlights that the RFB Sub-group overall has an improved capital position relative to both the pre-scheme and post-scheme Group positions Furthermore the excess over the risk appetite statement for the RFB Sub-group for each of these ratios is also improved for each of the years of the projection between 2017 and The Group has not carried out stress tests on the RFB Sub-group and therefore RFB Sub-group specific ratios and capital levels for the stressed case are not available. In the absence of such information I have considered applying reductions to the RFB Sub-group base case capital ratios, with similar percentage by which the Group 1-in-100 stress reduces the capital ratios of the Group, and in that scenario the capital ratios for the RFB Sub-group would remain above regulatory minimum levels. LBCM The comparison of capital ratios between LBCM and the Group pre-scheme implementation identifies that LBCM has lower ratios for total capital in both the base case and stress case scenarios The stress testing applied to LBCM is based on the Group 1-in-100 stress, against an A/A-1 starting credit rating with the impact of a further rating downgrade over the forecast period. Under the stressed case (Group 1-in-100 stress), LBCM is able to meet its risk appetite limits 127/215

128 for CET1, Tier 1 and Total Capital for the base year 2016 and the forecasted years In my view, the effect of the stressed scenario on the capital position of LBCM may be mitigated by the implementation of strategic management actions The Group has recognised that the Group 1-in-100 stress scenario does not fully explore the vulnerabilities of LBCM, and therefore additional sensitivities have been applied under the stress scenario in the year 2017, which include four key firm specific stresses that are aligned with the 1-in-100 stress approach, in terms of severity These additional sensitivities are specific to LBCM and may not be significant or material sensitivities in the context of the wider Group To explore the resilience of LBCM further as noted above, the 2017 ICAAP for LBCM investigates vulnerabilities that are not necessarily captured in the existing stress scenario. These additional areas of investigation identify that the capital position of LBCM remains above regulatory minimum requirements, but with less headroom above regulatory requirements than is the case for the Group pre-scheme. The reduction in headroom indicates that LBCM is a relatively riskier entity than the Group pre-scheme. Liquidity In the subsections below I considered the liquidity position of each of the following groupings in turn: The Group pre-scheme; The Group post-scheme; RFB Sub-group; and LBCM. The Group pre-scheme As well as considering the quantitative measure of LCR, I have reviewed the quality of the liquidity resources maintained by the Group pre-scheme. These are reflected in the split of assets in the liquid asset pool (i.e. HQLA) across liquid assets of varying degrees of quality as outlined in Tables 10.3 and HQLA is ranked into two tiers. Level 1 HQLA are the most liquid and can be sold for their full market value during BAU and stressed conditions. An example of Level 1 assets is cash held with the central bank. Level 2A and 2B HQLA are considered to be liquid, but when sold may realise less than their full market value. 128/215

129 Table 10.3: Liquidity portfolio LCR eligible assets of the Group pre-scheme as at 31 December 2015, 2016 and 2017 half-year as at 30 June 2017 Level 1 As at 30 Jun As at 31 Dec As at 31 Dec bn bn bn Cash and central bank reserves High quality government/mdb/agency bonds (1) High quality covered bonds Total Level 2 (2) Total LCR eligible assets Source: LBG plc Annual Report and Accounts 2016 as at 31 December 16. Liquidity Portfolio (page 157) and 2017 half-year results as at 30 June (1) Designated multilateral development bank ( MDB ). (2) Includes Level 2A and Level 2B Table 10.4: Liquidity portfolio LCR eligible assets by currency of the Group pre-scheme as at 31 December 2015 and 2016 As at 31 December 16 GBP* US dollar Euro Other Total bn bn bn bn bn Level Level Total As at 31 December 15 Level Level Total Source: LBG plc Annual Report and Accounts 2016 as at 31 December Liquidity Portfolio (page 157) *Great British Pounds ( GBP ) These tables show that the Group pre-scheme kept the majority of its HQLA portfolio in the highest quality liquid assets, i.e. Level 1 assets, with only marginal holdings in Level 2A and Level 2B (combined) in comparison. This positioning of liquid assets indicates that the Group pre-scheme had a conservative risk appetite to holding much smaller proportions of eligible lower quality liquid assets than the levels regulators would permit. The Group post-scheme I have been advised that the timing of production of the ILAAP documents for the Group post- Scheme are such that these documents are not available for my analysis. RFB Sub-group I have been advised that the timing of production of the ILAAP documents for the RFB Subgroup are such that these documents are not available for my analysis. 129/215

130 LBCM I have been advised that the timing of production of the full ILAAP document for LBCM are such that these documents are not available for my analysis. However, I did review the high-level liquidity position of LBCM included within the BLA Additional sensitivity analysis carried out by the Group to explore further the resilience of LBCM demonstrated some use of the liquid asset buffer at the low point of the stress, but BAU regulatory requirements were met within a year of the low point. However, the additional sensitivity applied exposed the vulnerabilities specific to LBCM, not least due to its narrower business model, and thus highlighted the reduced ability of LBCM to withstand a potential liquidity stress based on current assumptions. The risks are expected to be monitored, measured and managed through the funding and liquidity risk management framework, for example, via risk appetite and early warning indicators, similar to the framework presently followed by the Group LBCM's funding is projected to be drawn from offering non-retail financial products, in line with the Ring-fencing Regime, capital and funding from other Group entities, such as intercompany funding from LBG plc and LBIL, as well as the US certificate of deposit programme. Additional funding sources are also derived from Medium Term Note ( MTN ) issuance and European Commercial Paper ( ECP ) programmes Capital and minimum requirements for own funds and eligible liabilities ( MREL ) intercompany funding from LBG plc will be provided on an arm's length basis. MREL is a part of the BoE s regulatory resolution framework and determines the minimum loss-absorbing capacity that banks must satisfy on an interim basis from 1 January 2020 and final requirements being imposed from 1 January Intercompany funding from LBIL is subject to Jersey Financial Services Commission ( JFSC ) approval. Formal approval subject to conditions, was received from the JFSC on 18 October In addition to intercompany finding from LBIL, the Group is able to source funding from other sources, or raise funding contributions from existing sources of funds. This is achievable as the Group has prior experience of sourcing funding in much greater volumes from the existing investor base LBCM will adopt the same cost of funds approach currently being employed within the Group. To account for the legally distinct nature of LBCM and the Group post-scheme a separate set of funding rates will be applied for funding provided by LBG plc to LBCM LBCM funding rate is expected to be derived from the Group s funding rate, which is based on the cost of the Group senior unsecured wholesale market funding, plus an additional spread applied to reflect the expected lower credit rating of LBCM. Thereby, liquidity and funding costs for LBCM will be clearly segregated within the Group costs, in line with expectations of best practice cost of funding approach The analysis above highlights that LBCM has a different and potentially relatively riskier profile than the Group pre-scheme, given the expectation that the projected liquidity ratios result in some use of the liquid asset buffer at the low point of the stress scenario (with BAU regulatory requirements being met within a year of the low point of the stress scenario) and the sources of funding of LBCM having the potential to become more expensive than is the case for the Group pre-scheme. However, this can be seen to be partially mitigated by LBCM through management actions, expected higher levels of headroom in the LCR and NSFR projections being above regulatory requirements under the base case. The HQLA composition of LBCM is planned to be entirely Level 1 liquid assets, namely in cash reserves with central banks, which are considered to be the most liquid assets available. 130/215

131 Pension obligation risk Prior to the Scheme being implemented, each of the individual subsidiaries of LBG plc that are participating employers to a DB pension scheme, are legally responsible for the pension obligations associated with those schemes There are a number of alternative methods of quantifying the pension scheme liabilities (i.e. the obligation ), which differ mostly in the assumptions used to value the liabilities. I outline two sets of assumptions which are relevant for considering pension obligation risk below: Accounting: the accounting basis is used to determine the value of the pension scheme liability/asset to be disclosed in an entity s financial statements. The principle is that the assumptions should be a best estimate view of the future. The relevant international accounting standard is IAS19. Funding/Technical Provisions: The funding basis of assumptions is used to determine the value of the liabilities (defined as technical provisions for this purpose) which the pension scheme trustees deem necessary to provide for benefits already accrued. The funding basis differs to the accounting basis in that it is a prudent assessment of the liabilities and will usually therefore place a higher value on pension scheme liabilities than the accounting measure. It is the funding basis that determines the level of cash funding required from the pension scheme employer(s) For the purpose of considering pension obligation risk, the PRA is mainly concerned with the accounting measure. Despite the fact that actual pension obligations may be higher (i.e. to fund the higher, more prudent funding assessment of liabilities) for the purpose of this section, I consider funding obligations to be set relative to the accounting position since this is the inference of the PRA in using the accounting measure to determine pension obligation risk capital requirements. I also note that the accounting basis will determine the impact of the pension scheme on an entity s balance sheet and reserves, therefore having a direct impact on the available capital resources The pension fund obligation associated with the DB pension schemes was 45.8bn and the fair value of assets was 45.6bn as at 31 December 2016, including gains and losses arising from actuarial assumptions. In 2016 the aggregate liability (across all schemes, including any reduction in surplus of individual pension schemes) increased by 8.9bn and assets increased by 7.9bn resulting in a net accounting increase in the pension obligation of approximately 1bn. In light of these potentially large changes in the value of the pension fund obligation I outline below how the pension obligations will be borne after the Scheme is implemented and whether this has the potential to generate a potential adverse effect The DB pension schemes are closed to new members, however existing members can continue to accrue additional benefits through continued service giving rise to current obligations and future pension increases. However, under the Scheme the obligations to the DB pension schemes are being structured to be in line with the guiding principles set out by the Group with the aim of providing similar employee benefits, including DB pension provisions across the Group. As a result, all employees of the Group and the individual subsidiaries are being offered an opportunity to remain within their existing DB pension schemes to avoid the implementation of the Scheme adversely affecting the provision of pension benefits I have also considered that LB plc currently provides a financial guarantee to the Lloyds Bank Offshore Pension Scheme, which includes employees of LBIL as members of this scheme. Under the guarantee LB plc assumes responsibility to meet the pension obligations of LBIL to Lloyds Bank Offshore Pension Scheme, in the event that LBIL is unable to meet such obligations Post-Scheme, under the SSM it is expected that all past, current and future pension obligations will remain with the Transferors and that LBCM and other entities outside of the RFB Sub-group will be recharged an appropriate share of future costs, and potentially including those 131/215

132 associated with the accumulation of additional benefits, subject to the terms of the PSA. In the Transferors ICAAP under Pillar 2A assessment of pension risk obligations, severe market and longevity stresses have been applied specifically to the accounting position of the pension schemes to determine the potential effect on the value of assets and liabilities of the pension schemes, under a 1-in-200 year event. Based on the outcome of this assessment the Transferors will be required to hold adequate capital to cover the potential deficits of the different pension schemes, to which they have obligations, under a stressed scenario. Even though the Transferors are expected to hold sufficient regulatory capital to meet such requirements, the stakeholders of the Transferors bear a greater proportion of pension obligation risk than may have been strictly necessary had a different approach been taken While the vast proportion of pension obligations borne by the RFB Sub-group relate to those benefits already accumulated to date and the RFB Sub-group has the ability to recover costs from LBCM and other entities outside of the RFB Sub-group in the future, there still remains the possibility that the RFB Sub-group could be left unable to recover such costs if LBCM or other entities outside of the RFB Sub-group were to default or fail. Potential adverse effects and conclusions I have analysed the financial viability of the Group post-scheme, the RFB Sub-group and LBCM and considered any potential adverse effects to stakeholders From these considerations I have concluded that there are only two potential adverse effects to stakeholders that may arise from the change in financial viability of the post-scheme entities as follows: LBCM is perceived as a relatively riskier entity; and The RFB Sub-group will be responsible for all the DB pension obligation risk that might be borne by LBCM. LBCM is perceived as a relatively riskier entity In assessing capital adequacy, under the respective base case scenarios for LBCM and the Group pre-scheme, the projected ratios for CET1, Tier 1 and Total Capital for LBCM for the full period, 2016 through to 2020, are lower for LBCM than for the Group pre-scheme. Additionally, in comparing the ratio of capital resources to capital requirements, i.e. the capital coverage ratio, the ratio for LBCM is also lower than that for the Group pre-scheme. Based on these ratios this indicates that LBCM is a relatively riskier entity than the Group pre-scheme and all stakeholders may suffer an adverse effect by facing an entity that has a higher risk of failure, as a consequence of the Scheme While the above considerations highlight that LBCM is a relatively riskier entity, it must be noted that, for capital, the regulatory minimum requirements have been projected to be met in both BAU and a period of stress. Regulatory minimum requirements enforced by regulators exist to promote the safety and resilience of banks and protect all stakeholders, therefore suggesting that having met these requirements LBCM has a low probability of failure In assessing the liquidity position of LBCM, sensitivity analysis akin to a stress test carried out by the Group resulted in a liquidity position that makes some use of the liquid asset buffer, with BAU regulatory requirements being met within a year of the low point of the stress scenario. However, the additional sensitivity applied highlighted a reduced ability to withstand a liquidity stress based on current assumptions. This indicates that stakeholders of LBCM are exposed to a relatively riskier entity than the Group pre-scheme and stakeholders may suffer an adverse effect as a consequence of the Scheme I note that banks are permitted by the regulator to allow their LCR to fall below the regulatory requirements during stress and uplift this ratio over time. Banks achieve this by employing the 132/215

133 available management actions as detailed in the CFP, and recovery and resolution plan, documents. These actions would consider the vulnerabilities of LBCM and could be used to uplift the LCR above the regulatory requirements should it fall below them Finally, it must be acknowledged that the stakeholders of LBCM are likely to be entities and individuals that are more financially sophisticated, aware of the resulting risks of LBCM and potentially have a greater understanding of risk. Despite not being able to choose between the RFB Sub-group and LBCM at the time of the Scheme, it is likely that these stakeholders have access to multiple banks and will be able to move away from LBCM if they choose to In light of the mitigating considerations, which are (a) that regulatory capital minimum requirements are projected to be met, (b) following a stressed situation, LBCM is still forecast to meet regulatory liquidity requirements and (c) that LBCM stakeholders are likely to be sophisticated, have a greater understanding of risk and have access to multiple banks, I do not consider these potential adverse effects to be material. The RFB Sub-group will be responsible for all the DB pension obligation risk that might otherwise be borne by LBCM Pension obligation risk as stated earlier forms part of the Pillar 2A capital assessment of banks, and captures the applicable risks arising from DB pension obligations Pre-Scheme individual subsidiaries of the Group who are participating employers are legally responsible for their respective obligations to the DB pension schemes. Post-Scheme, pension obligation risk of the DB pension schemes will be, subject to regulatory confirmations, borne entirely by the RFB Sub-group, although costs in respect of those employees working outside of the RFB Sub-group will be recharged to the relevant entities, such as LBCM Post-Scheme, the regulatory capital requirements in relation to the RFB Sub-group s pension obligations are currently adequately met, however, they may not necessarily cover for the possibility that events could occur that are not envisaged in the stress test employed. Such events could include the default or failure of LBCM or other entities outside of the RFB Subgroup, whereby the RFB Sub-group would be unable to recover costs apportioned to such parties under the SSM Based on the analysis of the financial strength of LBCM, undertaken as part of this section, I consider the possibility of LBCM not being able to make payments (such as if LBCM were to default) on costs charged under the SSM, as being remote As such the pension liability borne by the RFB Sub-group in relation to employees that could otherwise have remained employees outside of the RFB Sub-group, is not material and does not present an adverse effect on customers and Other Relevant Persons in the context of the financial viability of the RFB Sub-group and its ability to meet pension obligations as and when they become due. 133/215

134 11. Governance and risk management Introduction 11.1 In this section, I consider the governance and risk management arrangements of the Transferors, LBCM and LBG plc, together the entities, in order to determine whether, in my opinion, the changes in these arrangements as a result of the Scheme could lead to an adverse effect on customers and Other Relevant Persons. Criteria and importance of an effective governance framework 11.2 An effective governance and risk management framework is necessary to ensure each entity, and the Group as a whole, is appropriately controlled and directed. Governance and risk management arrangements determine responsibilities across the Group and include the processes through which strategies, objectives and risk appetite are set and monitored. The rules governing the corporate governance and risk management regime of banks in the UK include those rules contained within the UK Listing Authority Listing rules, the UK Corporate Governance Code, the PRA s Senior Managers and Certification Regime and PRA Rulebook, and related guidance, including those aspects pertaining to the Ring-fencing Instrument The responsibilities of a board represent an important component of an effective governance framework. The LBG plc Board is collectively responsible for the long-term success of the Group. It achieves this by setting the strategy and overseeing delivery against it; establishing the culture, values and standards of the Group; ensuring that the Group manages risk effectively; monitoring financial performance and reporting; and ensuring that appropriate and effective succession planning arrangements and remuneration policies are in place. Scope of my review 11.4 I have read LBG plc s, the Transferors and LBCM s governance and risk management proposals, in conjunction with Section 5.8 of the PRA Policy Statement. In order to determine whether groups of persons could potentially be adversely affected, I have considered whether the changes in governance and risk management arrangements as a result of the Scheme could result in an adverse effect on customers and other stakeholders, including creditors, employees, bond holders and legal entities within the Group. In my assessment, I have considered whether any aspect of the corporate governance, risk management and regulatory regime could give rise to unmitigated conflicts of interest between the entities and therefore whether these conflicts could result in an adverse effect arising from the prioritisation of one Group entity over another Group entity In order to make this assessment, for each of the areas described in paragraphs 11.6 to 11.11, I have considered whether the Scheme could result in an adverse effect in respect of the: Ability for decisions to be taken independently; Influence and representation of the legal entity boards at the Group level; Capability and capacity of the boards and other individuals in key management positions to the extent that these roles have been confirmed. As at the date of this Scheme Report, the individuals who will be performing the roles of the Transferors RFB-only independent nonexecutive directors as described further in paragraph and LBCM internal nonexecutive directors, have not been confirmed; Level of control exercised; Level of risk created by the Scheme; and Form and frequency of reporting. 134/215

135 11.6 I have reviewed the proposed structure and composition of the boards and board committees following the Scheme. My assessment has included consideration of possible adverse effects that could arise from: Conflicts of interest that might exist as a result of the structure, including the effectiveness of the mechanisms in place to identify, manage, and resolve conflicts; Inappropriate skills and experience of the boards and board committees; Complexity in the organisation and structure of the boards and board committees and reporting lines; Infrequency with which the boards and board committees meet; Inadequate management information presented to the boards and board committees; and Other roles within the Group performed by the boards and board committees members I have reviewed the proposed risk management arrangements of LBCM and the Transferors, and reviewed their risk appetite statements. I have considered whether: The structure of the risk management arrangements give rise to potential conflicts of interest; The risk appetites of the entities will be set and monitored independently; The level of control exercised over the governance and risk management processes is adequate; and The level of risk in each of the entities is equivalent to that under the current structure I have reviewed the structure and composition of the three lines of defence model, being the three groups involved in effective risk management: first line operational teams; second line risk management team; and the third line internal audit. I have considered whether the capability and capacity of the senior management in each of these functions, the level of control they will exercise and the form and frequency of their reporting to the boards and board committees is appropriate I have reviewed the proposals in place for policy and operational changes to support activities relating to the Scheme, including risk management controls over the ring-fence perimeter, arm s length transactions, netting, collateral and outsourcing arrangements in order to determine the adequacy of the level of control over each of these activities Other than the areas I have identified as potential adverse effects in paragraph 11.11, I am satisfied that there is not likely to be any adverse effect arising from the governance and risk management arrangements as a result of the Scheme I have summarised my work in the following areas: Overview of governance arrangements, before and after the Scheme; Overview of risk management arrangements, before and after the Scheme; and Areas of potential adverse effect: (a) The independence of the Transferors from LBG plc; (b) The influence and independence of LBCM at the LBG plc Board; and (c) The ability of LBCM and the Transferors to operate independently within their own risk appetite limits. 135/215

136 Overview of governance arrangements At present, the Group s banking operations, comprising the operations of existing banking entities LBG plc, LB plc and BoS plc, are largely managed as a single business, with common board membership and chairmanship. The LBG plc Board comprises three executive directors and nine non-executive directors, as shown in Diagram Board meetings are held covering matters pertaining to all three banking entities, however, board attendees exercise their board responsibilities and decision-making powers only in relation to the boards for which they have legal membership and in line with relevant board terms of reference. Diagram 11.1: The board composition following the Scheme Source: Transferors governance modification application Under the Scheme, LBG plc will retain responsibility for the governance of the Group. Its board membership and responsibilities will remain unchanged from current arrangements, and will include the recent appointment on 25 July 2017 of Lord Lupton, Chairman of LBCM. Separate legal entity boards and the relevant board committees are already in place and operating for the Transferors and will be established for LBCM. These boards will sit beneath the LBG plc Board and board committees and will be siblings of each other and of the Insurance Subgroup and Equity Investments Sub-group. Section 3 of this Scheme Report, provides more information on the Group legal entity structure Following the Scheme, board meetings will be held covering matters pertaining to LBG plc and the Transferors concurrently, however, board attendees will only exercise their responsibilities in relation to matters pertaining to the entity or entities for which they have board membership. The Transferors RFB-only independent non-executive directors ( RFB-iNEDs ) will act as observers only at the concurrent board meetings where the matters discussed relate to LBG plc. Separate board meetings will be held in respect of LBCM. The majority of the LBCM Board members will not be members of the LBG plc or the Transferors boards The governance structure following the Scheme, including in respect of the concurrent board meetings for LBG plc and the Transferors, has been designed to replicate as far as possible 136/215