CREDIT OPINION January 17 Santander UK PLC Post Rating Action Update Update Summary Rating Rationale RATINGS Santander UK PLC Domicile United Kingdom Long Term Debt Type Senior Unsecured - Fgn Curr Long Term Deposit Type LT Bank Deposits - Fgn Curr Please see the ratings section at the end of this report for more information. The ratings and outlook shown reflect information as of the publication date. Contacts Dany Castiglione 44--7777 Vice President dany.castiglione@moodys.com On 1 December 16 we upgraded Santander UK Plc(Santander UK)'s issuer rating to from A1 and affirmed the bank s long-term deposit rating at. Additionally, we changed the outlook on the issuer rating to negative from stable, while the outlook on the long-term deposit rating continues to be negative. The upgrade of the bank's issuer rating was driven by the significant amount of unsecured debt issued by Santander UK's immediate parent's, Santander UK Group Holdings Plc (HoldCo), which added further loss absorbency below bank level senior unsecured creditors. Santander UK's deposits and senior unsecured debt ratings of /Prime are underpinned by: (1) the bank's a baseline credit assessment (BCA); () the results of our Advanced Loss Given Failure (LGF) analysis; () a moderate expectation of government support. HoldCo's issuer rating is. We also assign a (CR Assessment) of Aa(cr)/Prime(cr) to Santander UK. Santander UK's BCA of a is underpinned by: (1) its strong franchise in UK mortgage and saving products; () its solid earnings generation capacity and low earnings volatility, on the back of its mainly retail-driven business model; and () its robust capital and improved leverage levels. The BCA also incorporates the bank's: (1) increasing risk profile as it develops its Small and Medium Enterprises (SME) lending franchise; and () ongoing reliance on wholesale funding albeit mitigated by a sizable liquid asset buffer. Exhibit 1 Key Financial Ratios Maija Sankauskaite 44--7779 Associate Analyst maija.sankauskaite@moodys.com Laurie Mayers 44--777-558 Associate Managing Director laurie.mayers@moodys.com Nick Hill Managing Director Banking nick.hill@moodys.com -59 Source: Moody's Banking Financial Metrics
The rating also incorporates our view that Santander UK is independently managed with limited financial and direct operational connections to its parent, Banco Santander S.A. (A/(P)A Stable, ba). As a result, the rating of Santander UK is relatively insulated from potential rating pressure on its parent. Furthermore, since the bank is regulated by the UK Prudential Regulation Authority and is deemed to be a domestic systemically important institution, we believe the authority is unlikely to allow Santander UK's financial position to substantially weaken as a result of exposure to its parent. Credit Strengths Strong franchise in UK mortgage and saving products Low earnings volatility underpinned by the bank's conservative risk profile Solid capital levels supported by improving leverage metrics Improving funding profile and sufficient liquidity buffer Credit Challenges Exposure to riskier SME sector is increasing from a low base Reliance on wholesale funding persists Rating The negative outlook on long-term deposit and issuer ratings reflects our view that a prolonged period of uncertainty for the UK, which we expect to follow the outcome of the UK referendum with negative implications for the country s medium-term growth outlook, could result in a more challenging environment for the bank, resulting in a weaker operating profitability and some deterioration in asset quality metrics. Following the upgrade, the outlook on the issuer rating has been changed to negative from stable now aligning it with the outlook on the deposit rating to reflect negative pressure on Group s BCA. The outlook change takes into account the fact that the group s near term funding plans will not materially improve the protection to creditors of the operating entity over the outlook period. Factors that Could Lead to an Upgrade Santander UK s BCA could be upgraded if the bank: (1) shows a structural reduction in its reliance on market funding; () maintains its strong asset quality despite growth in its SME lending portfolio; and () continues to improve its solvency profile through material internal capital generation. A positive change in Santander UK's BCA would likely affect all ratings. Santander UK's deposit and senior debt ratings could also be upgraded if the bank or its holding company were to issue significant amounts of long-term debt and more subordinated debt. Factors that Could Lead to a Downgrade The bank's BCA could be downgraded due to: (1) a significant deterioration in its asset quality metrics; () a material weakening in profitability, which would reduce the bank's going-concern loss-absorption capacity; and () a deterioration in the bank's funding and liquidity position, including a further reduction in the quantity or quality of its liquidity buffer. A downward movement in Santander UK's BCA would likely result in downgrades of all ratings. Santander UK's long-term senior unsecured debt and deposit ratings could also be downgraded due to a change in the liability structure, most likely a reduction in the volume of debt that could be bailed in, which would increase loss-given-failure for these instruments. This publication does not announce a credit rating action. For any credit ratings referenced in this publication, please see the ratings tab on the issuer/entity page on www.moodys.com for the most updated credit rating action information and rating history. January 17
Key Indicators Exhibit Santander UK Group Holdings plc (Consolidated Financials) [1] Total Assets (GBP million) Total Assets (EUR million) Total Assets (USD million) Tangible Common Equity (GBP million) Tangible Common Equity (EUR million) Tangible Common Equity (USD million) Problem Loans / Gross Loans (%) Tangible Common Equity / Risk Weighted Assets (%) Problem Loans / (Tangible Common Equity + Loan Loss Reserve) (%) Net Interest Margin (%) PPI / Average RWA (%) Net Income / Tangible Assets (%) Cost / Income Ratio (%) Market Funds / Tangible Banking Assets (%) Liquid Banking Assets / Tangible Banking Assets (%) Gross loans / Due to customers (%) 66 15 14 1 1 Avg. 68,666.,8. 59,15. 1,674.6 15,51. 16,94. 14. 1.4.6 1. 51.7 9..5 1.4 6,15. 5,915. 8,69.9 1,71. 17,6.4 18,749.9.8 14.8 1.8 1.4.6.4 51. 5.5 19.5 1. 5,989. 5,998.5 94,475.5 11,41.5 14,76. 17,795. 1. 1.9 14. 1.4.5.8 5.5 7.5 1. 1.8 51,8.,7.4 416,189.9 9,788.6 11,765.7 16,1.5 1.1 18. 1..4 54.6.1 1.8 16.5 -.4.4-4.84 9.4 9.4 1.54.95 14.6 14.45 1.45.66.75 5.85 8.5.75 1.5 [1] All figures and ratios are adjusted using Moody's standard adjustments [] Basel III - fully-loaded or transitional phase-in; IFRS [] Basel II; IFRS [4] Compound Annual Growth Rate based on IFRS reporting periods [5] IFRS reporting periods have been used for average calculation [6] Basel III - fully-loaded or transitional phase-in & IFRS reporting periods have been used for average calculation Source: Moody's Financial Metrics Detailed Rating Considerations The data in the following sections is sourced from the consolidated Santander UK Group (which includes Holdco and Santander UK)'s financial statements unless otherwise stated. Strong franchise in the UK mortgage and saving products supported by strong brand recognition Santander UK ranks among the largest providers of financial services to retail customers in the country, having a sizeable and established residential mortgage franchise. Additionally, the bank has been gradually expanding its corporate lending footprint to continue diversifying its source of revenues, in particular toward the SME sector, which will also support improvements in its profitability metrics. Santander UK also has a significant market share of deposits in the country. The bank continues to strengthen its retail banking franchise, growing a loyal and more stable customer base through the development of its 1-- Current Account strategy. The bank is a key subsidiary of Banco Santander, with its total assets accounting for 7% of the group's assets as at end-september 16 (9% at end-15) and also contributing around 6% of its reported attributable profit in the first nine months of 16 (% in full year 15). Under the Banking Reform Act, to comply with the ring-fencing requirements in the UK, Santander UK will pursue a wide ring-fence structure, whereby the bank will serve its retail, commercial and corporate customers from the same legal entity. Low earnings volatility underpinned by conservative risk profile Santander UK's profitability is characterized by several positive elements, including: (1) strong earnings generation capacity, owing to its solid franchise in UK, being the fifth largest financial institution in the country; () low earning volatility, on the back of its mainly retail business model; () small impact from legacy issues compared to peers; and (4) resilient and stable track record over the last 5 years. However we also note the following weaknesses: (1) limited earnings diversity, with net interest income still accounting for a large part of total revenues; and () moderately low efficiency, with cost-to-income ratio slightly higher compared to rated peers. Improving January 17
internal capital generation and earning stability are key rating drivers, which translate into an assigned score of baa for the Profitability factor. The Group reported a statutory profit before tax of 1.6 billion in the first nine months of 16 compared to 1.4 billion the year before. The results mainly reflect a significant increase in non-interest income, while net interest income weakened somewhat and provisions for impairments almost doubled, albeit from a low level. Net interest income fell 1% in the first nine months of 16 compared to the previous year, affected by reducing standard variable rate mortgage balances and asset margin pressure. Non-interest income went up by 4% to 95 million, driven by higher fee income and a 119 million gain on the sale of its Visa Europe Limited shareholding. Total operating expenses remained unchanged at 1.8 billion, as investments in business growth and regulatory costs were counterbalanced by savings from simplification and digitalisation. Adjusting for the 55 million spending related to the implementation of the Banking Reform Act, operating expenses reduced by % in the period. Impairment losses on loans increased to 1 million from 5 million, largely due to the impairment of a single corporate loan, while provisions for other liabilities and charges declined 8% to 141 million, reflecting lower non-payment protection insurance (PPI) provisions. The group booked an additional million PPI charge related to a specific portfolio in the first nine months of 16, after taking a 45 million charge in the last quarter of 15. While the final policy decision in respect of the proposed deadline for customers to claim compensation is yet to be announced, we do not expect a significant increase in PPI provisions in 16, given the Group has historically been less affected by the matter than other large UK banks and already built up a substantial provision (a balance of 97 million remaining as of September 16). Solid capital levels supported by improving leverage metrics We have assessed Santander UK's Capital score at aa, in line with the macro-adjusted score. With the Tangible Common Equity (TCE) over Risk Weighted Assets (RWA) ratio of 14.% at end-june 16, Santander UK's robust capitalisation relative to low risk profile is the bank's key rating strength. We expect that the bank will continue to maintain its capital levels thanks to its demonstrated internal earnings generation capacity. The Group s fully-loaded Basel III common equity tier 1 (CET1) ratio declined to 11.1% as of September 16 from 11.6% as of December 15, adversely affected by a number of factors. Lower corporate yields applied to discount pension liabilities caused some of the Group s defined benefit pension schemes deficits to widen, leading to the profit retention after distributions being offset by a reduction in other comprehensive income. In addition to pension effects, Santander UK reported a negative market volatility impact on the AFS portfolio and Prudential Valuation Adjustments of fair value. RWA rose by 4% to 89.1 billion, reflecting lending growth and market-driven increases in the levels for credit, counterparty and market risk. Because of the points above, Santander UK's leaverage position slightly weakened as well. The bank's nominal leverage ratio, calculated as TCE over Tangible Assets declined to 4.8% at end-june 16 (end-15: 4.9%). As of end- September 16, Santander UK reported a regulatory end point Tier 1 leverage ratio of 4.%. Good asset quality, but exposure to riskier SME sector is increasing from a low base The bank presents a sound overall asset quality since the main components of its lending portfolio are prime residential mortgages. Santander UK also maintains conservative underwriting standards on mortgage lending with a low weighted average loan-to-value (LTV) ratio at 4% as of end- September 16. The weighted average LTV on new mortgages was 64% in the first nine months of 16. Overall, asset quality is a strength for Santander UK, as indicated by our assigned score for Asset Risk. We have made a two-notch negative adjustment to this factor to take into account the increasing exposure to SMEs and corporate lending, which, in our view, will somewhat increase the bank's risk profile. We further note the growth in these books has been accelerating. During 15,.5 billion of credit facilities were extended to UK companies, a 1% increase y-o-y, compared to 8% y-o-y growth at end-14. In the first nine months of 16, the net lending for these customer segments was 1.9 billion. We, however, positively note the bank is gaining market share from a low starting point with the objective of achieving growth while maintaining conservative underwriting standards. 4 January 17
Santander UK had a.8% problem loan ratio, as calculated by Moody's as impaired loans over gross loans, at end- 15 (end-14: 1.%). The bank's reported non-performing loans (typically more than months in arrears) ratio was 1.54% at end-september 16, in line with 1.54% reported at end-15. The bank also exhibits strong problem loan coverage with Moody's calculated Loan Loss Reserves over Problem Loans ratio of 77% (reported non-performing loan coverage ratio of 8%) at end-15. We expect asset risk metrics to slightly deteriorate over the outlook period, amid a worsening operating environment. Santander Improving funding profile and sufficient liquidity buffer, although wholesale funding reliance persists Santander UK continues to rely on wholesale funding: our Market Funds over Tangible Banking Assets ratio stood at 8.1% as of endjune 16 (end-15: 5.%), resulting in a baa assigned score for Funding Structure. The wholesale funding is however well diversified and primarily composed of secured, long-term funding. This year Santander UK mainly issued unsecured senior debt notes, which accounted for 5.6 billion out of the total 8. billion medium term funding issued in 16. Being primarily a retail bank, customer deposits are Santander UK's main source of funding, accounting for about 7% of total funding at end- June 16. The bank's reported loan-to-deposit ratio was 118% as of end- September 16, down from 11% of end-15 (14% as of end-14). The composition and stability of the bank's deposit base continues to evolve positively as Santander UK keeps on replacing price-sensitive deposit customers with current account clients, which are more stable, usually having more than one product with the bank. Our ba assigned score for Liquidity Resources is a reflection of sizeable stock and high quality of Santander UK's liquid assets, which mitigates the bank's reliance on wholesale funding. Liquidity Coverage Ratio (LCR)-eligible liquid assets stood at 46.4 billion as of end- September 16, covering 4% of wholesale funds with a residual maturity of less than one year and resulting in a LCR of 19%. We expect on-balance-sheet liquidity to slightly decrease over the outlook period, given the high cost of holding liquid assets in the midst of low interest rate environment. Santander UK's resulting financial profile score is a. The assigned BCA of a is positioned in the middle of a scorecard-calculated BCA range of a-ba. Notching Considerations Loss Given Failure and additional notching Santander UK is subject to the UK implementation of the EU Banking Recovery and Resolution Directive (BRRD), which we consider to be an Operational Resolution Regime. We assume residual TCE of % and losses post-failure of 8% of tangible banking assets, a 5% run-off in preferred deposits, and assign a 5% probability to deposits being preferred to senior unsecured debt. These are in line with our standard assumptions. Particular to Santander UK, we assume the proportion of deposits considered junior at 1%, relative to our standard assumption of 6%, due to their largely retail-oriented depositor base. Our Advanced LGF analysis indicates that Santander UK's deposits are likely to face very low loss-given-failure, due to the loss absorption provided by subordinated debt and, potentially, by senior unsecured debt should deposits be treated preferentially in a resolution, as well as the substantial volume of deposits themselves. This results in a Preliminary Rating Assessment (PRA) of, two notches above the BCA. Santander UK's senior unsecured debt, issued at bank's level, is likely to face a very low loss-given-failure as well, due to the loss absorption provided by its own volume and the amount of debt subordinated to it. This results again in a PRA of, two notches above the BCA. The senior unsecured debt, issued at HoldCo level, is likely to face a high loss-given-failure due to the small amount of debt subordinated to it. This results in a PRA of ba, one notch below the BCA. Subordinated debt is also likely to face a high loss-given-failure due to its own very modest volume and the small amount of debt subordinated to it, resulting in the same PRA of ba. 5 January 17
Junior subordinated debt and preference shares are likely to face a high loss-given-failure, and they include additional downward notching from the BCA, reflecting the coupon suspension risk ahead of a potential failure and leading to a rating of (P)Baa for the junior subordinated MTN programme, Baa (hyb) for cumulative Preference shares and Baa (hyb) for non-cumulative Preference Shares. Government Support We expect a moderate probability of government support for Santander UK's deposits and senior debt, resulting in a one-notch uplift to the PRAs, and a long-term deposit and issuer ratings of. We consider the probability of government support for holding company liabilities to be low, leading to the HoldCo long-term issuer rating of. For junior securities, we continue to believe that the potential for government support is low and these ratings do not, therefore, include any related uplift. The CR Assessment is positioned at Aa(cr)/Prime(cr). The CR Assessment, prior to government support, is positioned three notches above Santander UK's BCA of ba, based on the cushion against default provided to the senior obligations represented by the CR Assessment by subordinated instruments. The CR Assessment also benefits from one notch of government support, in line with our support assumptions on deposits and senior unsecured debt. About Moody's Scorecard Our Scorecard is designed to capture, express and explain in summary form our Rating Committee's judgment. When read in conjunction with our research, a fulsome presentation of our judgment is expressed. As a result, the output of our Scorecard may materially differ from that suggested by raw data alone (though it has been calibrated to avoid the frequent need for strong divergence). The Scorecard output and the individual scores are discussed in rating committees and may be adjusted up or down to reflect conditions specific to each rated entity. 6 January 17
Rating Methodology and Scorecard Factors Exhibit Santander UK Group Holdings plc Macro Factors Weighted Macro Profile Very Strong - Financial Profile Factor Historic Macro Ratio Adjusted Score Credit Trend Assigned Score Key driver #1 Key driver # Sector concentration Solvency Asset Risk Problem Loans / Gross Loans.9% aa Expected trend Capital TCE / RWA 14.% aa aa Expected trend Profitability Net Income / Tangible Assets.7% baa baa Earnings quality Expected trend Combined Solvency Score Liquidity Funding Structure Market Funds / Tangible Banking Assets 5.5% baa baa Extent of market funding reliance Expected trend Liquid Resources Liquid Banking Assets / Tangible Banking Assets 19.5% baa baa Quality of liquid assets Expected trend at-failure (GBP million) 77,975 155,779 14,16 1,56 19, 1,96 89 595, 95 7,99 66,96 % at-failure Combined Liquidity Score Financial Profile Business Diversification Opacity and Complexity Corporate Behavior Total Qualitative Adjustments Sovereign or Affiliate constraint: Scorecard Calculated BCA range Assigned BCA Affiliate Support notching Adjusted BCA Balance Sheet Other liabilities Deposits Preferred deposits Junior Deposits Senior unsecured bank debt Dated subordinated bank debt Junior subordinated bank debt Preference shares (bank) Senior unsecured holding company debt Dated subordinated holding company debt Equity Total Tangible Banking Assets 7 1% January 17 a baa in-scope (GBP million) 66,5 167,54 15,754 16,75 19, 1,96 89 595, 95 7,99 66,96 baa a A a-ba a a % in-scope 4.9% 6.9% 56.6% 6.% 7.1%.5%.%.%.8%.4%.% 1% 9.% 58.5% 5.8% 4.7% 7.1%.5%.%.%.8%.4%.% 1%
Debt class De jure waterfall De facto waterfall Notching LGF Assigned Additional Preliminary LGF notching Rating Instrument Sub- Instrument SubDe jure De facto notching guidance notching Assessment volume + ordination volume + ordination versus Subordination Subordination BCA 17.% 17.% 17.% 17.% aa (cr) Deposits 17.% 5.1% 17.% 1.% Senior unsecured bank debt 17.% 5.1% 1.% 5.1% 1 Dated subordinated bank debt.5%.5% ba Junior subordinated bank debt.5%.%.5%.% baa (hyb) Cumulative bank preference shares.%.%.%.% baa (hyb) Non-cumulative bank preference shares.%.%.%.% - baa (hyb) Senior unsecured holding company debt 5.1% 5.1% ba Dated subordinated holding company.5%.5% ba debt Holding company non-cumulative.%.%.%.% -4 ba (hyb) preference shares Instrument class Deposits Senior unsecured bank debt Dated subordinated bank debt Junior subordinated bank debt Cumulative bank preference shares Non-cumulative bank preference shares Senior unsecured holding company debt Dated subordinated holding company debt Holding company non-cumulative preference shares Loss Given Failure notching Additional Preliminary Rating Notching Assessment Government Support notching Local Currency Rating - aa (cr) ba baa (hyb) baa (hyb) baa (hyb) ba ba 1 1 1 Aa (cr) Baa (hyb) Baa (hyb) Baa (hyb) -- Foreign Currency Rating - Baa (hyb) -- -4 ba (hyb) Ba (hyb) -- Source: Moody's Financial Metrics 8 January 17
Ratings Exhibit 4 Category SANTANDER UK PLC Bank Deposits Baseline Credit Assessment Adjusted Baseline Credit Assessment Issuer Rating Senior Unsecured Subordinate Jr Subordinate Pref. Stock -Dom Curr Pref. Stock Non-cumulative -Dom Curr Other Short Term Moody's Rating /P a a Aa(cr)/P(cr) Baa (hyb) Baa (hyb) Baa (hyb) (P)P PARENT: SANTANDER UK GROUP HOLDINGS PLC Issuer Rating -Dom Curr Senior Unsecured Subordinate Pref. Stock Non-cumulative -Dom Curr Other Short Term Ba (hyb) (P)P- ABBEY NATIONAL NORTH AMERICA LLC Bkd Commercial Paper P ABBEY NATIONAL TREASURY SERVICES PLC (US BR.) Commercial Paper Aa(cr)/P(cr) P ABBEY NATIONAL TREASURY SERVICES PLC (PARIS) Aa(cr)/P(cr) ABBEY NATIONAL TREASURY SERVICES PLC Bank Deposits Senior Unsecured Shelf Bkd Subordinate MTN Bkd Preference Shelf Bkd Commercial Paper Bkd Other Short Term /P Aa(cr)/P(cr) (P) (P) (P)Baa P (P)P ABBEY NATIONAL TREASURY INTERNATIONAL LTD. Bkd Sr Unsec MTN Bkd Other Short Term (P) (P)P ABBEY NATIONAL CAPITAL LP I BACKED Pref. Stock Non-cumulative Baa (hyb) ABBEY NATIONAL CAPITAL TRUST I BACKED Pref. Stock Non-cumulative Baa (hyb) ALLIANCE & LEICESTER PLC Bank Deposits Issuer Rating Subordinate -Dom Curr /- Source: Moody's Investors Service 9 January 17
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