Non-Core and GRG Divisional Risk a
Committee -
24 October 2012

Deloitte 2012 management letter

 

Author:
Deloitte LLP

 

Purpose of paper:

To present Deloitte's 2012 management letter for the Non-Core division and GRG at The
Royal Bank of Scotland Group or "the Group").

 

Points tor noting:

We continue to report detailed control observations that we identify trom our audit work
through the Group's SOX reporting process. This management letter provides our
high level views and perspectives, together with certain recommendations, on areas of

the Non-Core Division and GRG's operations where we are able to offer insight from
our audit work.

2. We confirm that none of the matters revised in this management letter represent
material weaknesses or significant deficiencies in internal control over financial
reporting which would be reportable under

3. Management's responses to our recommendations are provided under each point

raised (page 2 to 5) and in Appendix 1 (page 7 to 13) we provide an update on the
recommendations that we made last year.

 

Action requested:
The contents of this paper are tor noting.

 

Governance roadmap:

- Non-Core Division and GRG Risk and Audit Committee members and attendees.

 

 

 

 

Information Classification: Secret

 

 

The Royal Bank of Scotland Group plc –
Non-Core Division and GRG
2012 management letter

24 October 2012

 Contents

1. 
  

Introduction and business context

1 
  

2. 
  

Non-Core Division

2 
  

3. 
  

Global Restructuring Group

3 
  

4. 
  

Responsibility statement

6 
  

Appendix 1 – Update on prior year recommendations

7 
  

 1. Introduction and business context
1.1 Introduction
As part of our audit we test certain internal controls over financial reporting, both for the purpose of our
audit of the financial statements and to provide an opinion on the Group’s internal control over financial
reporting, as required by Section 404 of the Sarbanes-Oxley Act (“SOX”).
As we have done in prior years, we will continue to report any detailed internal control weaknesses that
we identify from our audit work through the Group’s SOX reporting processes, with significant matters
reported to and evaluated by the SOX Executive Steering Committee and escalated to the Group Audit
Committee when required. This report sets out our high level observations on the Non-Core Division
and GRG’s operations, both in the areas of controls over financial reporting and other areas where we
are able to offer insight. We focus on high level observations and key themes arising.
1.2 Business context
Non-Core Division
While the Non-Core Division has continued to make progress in reducing its balance sheet exposures,
inevitably the pace of reduction will slow given market conditions, the external appetite for “riskier”
assets and the fact that remaining assets include those which are more difficult to dispose of.
Management will therefore have to continue to carefully balance requirements to meet disposal targets
with the optimal method to realise value, which may be to hold them for a longer period.
It is imperative that in this business context that there continues to be appropriate focus on the risk
management and control on remaining assets, in particular portfolios which may not be actively
managed on a day to day basis. In respect of the financial books and records, the Non-Core division
remains largely reliant on systems and processes in underlying donor divisions. These underlying
processes have been commented on in the relevant separate management letters. We have
commented in this document on the processes that occur under the direct control of Non-Core
management and the overall control environment to collate information from donor divisions.
Global Restructuring Group
Loans managed by GRG are c.£37.5bn at the 31 September 2012 compared to c. £42.4bn as at the
2011 year end with the decrease of GRG exposures primarily due to run off of the Non-Core portfolio in
line with the Group’s objectives. Due to the uncertain economic conditions the decreasing trend in loans
managed by GRG relating to a particular business sector is partially offset by adverse business
conditions in other sectors such as secondary and tertiary property, shipping and care homes.

1 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

 2. Non-Core Division
Non-Core Markets
The Non-Core Markets business of the Division has historically provided many significant judgements
and challenges due to the illiquid and complex nature of the assets held. Over the past 18 months,
management have completed a number of disposals and transactions which have significantly derisked
the business including Project Woodford (the disposal of substantially all of the exotic credit business),
commutations with monolines and Credit Derivative Product Companies, Project Purple (the
restructuring of the White Knight transactions) and the disposal of a substantial proportion of the asset
backed securities portfolio. While complexities remain, these transactions have helped to reduce the
level of subjectivity within the Division.
In our prior year management letter we made two observations on the IPV sources of prices and the
credit valuation adjustment approach to both monolines and CDPCs in the Non-Core Markets business.
We are satisfied that both, the enhancements management has made to their processes and the
reduction of risk in respect of these areas has addressed these observations and further details are
provided in Appendix 1.
Divisional wind down
The non-core division is scheduled to finish at 31 December 2013 with the remaining assets transferred
to other core divisions and the Group. Management is on schedule to meet the target of £40 billion of
assets remaining at that point. The closure of the Division poses management with a challenge to ensure
that an appropriate level of resource is retained to throughout the remaining life of the Division. There is
a risk that key personnel will leave prior to completion, which may leave the Division without the
necessary level of key staff to maintain a satisfactory control environment. This risk is further
compounded by the restructuring and contraction of other core divisions, reducing the employment
prospects remaining within the Group.
Deloitte observation 1
We recommend that management ensure that all ‘key’ staff are appropriately identified and action taken
to retain these individuals. This action may include identifying future opportunities in core divisions to
continue managing these assets from 1 January 2014 and using secondment arrangements in non-core
and structuring compensation packages to incentivise remaining at the Division until completion.
Management Response:
We recognise the increased risk relating to the retention of key staff during the remaining life of NonCore Division and a significant issue has been formally raised to manage and monitor mitigating actions.
Clear “rampdown” plans have been developed for the department and succession plans defined for all
critical staff. A review of all contract staff has been undertaken and where appropriate, contractual end
dates will be aligned with expected sign-posted exit dates.
Talent profiling is being actively managed and all staff assessed within the “Talent” and “Valued
Contributor” populations have personal action plans and updated personal career profiles. The
management team will continue the regular review of this information to identify stretch opportunities and
enable transition planning back to Core roles.

2 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

 3. Global Restructuring Group
Timing of recognition of specific provisions and IFRS 9 adoption
In our 2010 Management letter to this Committee, we recommended that management considers
aligning the approach RBS takes to recognising specific impairments more closely to peer group
practice, such that for those credits where an impairment event is seen, but where sufficient information
to determine with confidence a highly accurate estimate of the incurred loss that has been suffered is
not yet available, a “best estimate” of impairment is recorded earlier in the assessment process and
subsequently adjusted where appropriate as more and better information is obtained.
We also acknowledged that the risk of financial statement misstatement has been mitigated by the
appropriateness of the level of the specific provisions taken once established, combined with the level of
provision made for latent and collective losses and a symmetrical approach to any release of provisions.
Throughout 2011 and 2012 we have reported to this Committee that the processes for GRG specific
provisioning have been consistent. We have continued to note a small number of cases where RBS has
not recorded a specific provision where an impairment event is seen but there is insufficient information
to be able to establish a highly accurate estimate of the incurred loss. The quantum of the latent overlay
has, in the round, enabled us to conclude that the total provisioning is sufficient.
Deloitte observation 2
The currently scheduled mandatory date of adoption of IFRS 9 is 1 January 2015. This will introduce an
expected loan loss model in place of the current incurred loss model. The introduction of IFRS 9 will lead
to an increase in provisioning levels for RBS and its peer group. We anticipate that IFRS 9 may have a
larger impact on RBS in relation to specific provisions than its peer group who have recognised
estimates of provisions earlier. The impact of IFRS 9 on the non-specific provisioning levels, and hence
overall provisioning levels of RBS vis-a-vis its peers remains uncertain given the differing peer group
methodologies in place for calculation of non-specific provisions.
Whilst the final version of IFRS 9 is yet to be published (now expected in early 2013), we recommend
that Management consider the potential effect of IFRS 9 on overall provisioning in level in both the “good
book” and GRG before its mandatory introduction.
In addition Management will need to ensure that there is an appropriate implementation plan which
includes consideration as to how to source the data that will be required in order to adopt IFRS 9 such
as the weighted average life of a portfolio, weighted average age of assets in a portfolio and expected
loss data. The data quality of existing credit risk processes to meet the requirements of Sarbanes Oxley
should also be considered. Other items to consider with regard to IFRS 9 implementation include parallel
runs alongside the current provisioning methodology prior to the date of adoption and the division of
responsibilities between group, divisional and GRG finance and credit teams.
We anticipate that the adoption of IFRS 9 may have a larger impact on RBS in relation to specific
provisioning than its peer group who generally recognise specific provisions earlier. Whilst the final
version of IFRS 9 is yet to be published (expected in early 2013), we recommend that Management
consider the potential effect of IFRS 9 on overall provisioning in both the “good book” and GRG before
its mandatory introduction. Management should also develop a detailed implementation plan.
Management response:
We are aware that the implementation of IFRS9 will have an impact on provisioning levels. However, the
Group are not proposing to do any detailed work on this until it becomes clear what the final standard will
be proposing. There is currently uncertainty as to exactly what the IASB will propose, especially in the
light of the FASB going in a different direction, and it is therefore unclear whether there will be a
converged standard and when this will be. As soon as the standard has been finalised, we will work with
GCA to ensure there is an appropriate implementation plan as well as ascertain the impact of the
adoption of this standard.
3 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

 3. Global Restructuring Group (continued)
Governance and valuation of the property portfolio
RBS holds a significant property portfolio through its West Register property vehicles (fair value of
£3.2 bn as at 30 June 2012). Property is purchased by West Register where taking ownership of the
asset is expected to maximise recoveries (which occurs where the West Register bid exceeds those
from third parties). The paper presented to the DRAC in July 2012 sets out the Governance process for
GRG provisions and West Register Property Acquisition including the separation of governance between
provisioning in GRG and property purchase by West Register.
We note that the fair values of the property portfolio are updated twice a year (at the half year and at
each year end).
Deloitte Observation 3
We note that the current business model whereby RBS originates property loans and in certain
instances purchases the underlying properties, gives rise to the potential reputational risk of a perceived
conflict of interest.
In addition, during Q1 2012, we noted one instance where the level of provisioning for a particular loan
was determined by the level of the internal bid from West Register rather than the highest external bid. If
the external bid had been used to determine the provision this would have given rise to a larger provision
being recognised. However subsequently in Q2, the bid from West Register was withdrawn with a
consequent increase in provision being recognised.
Whilst we acknowledge that there are Chinese walls in place between West Register and the GRG
relationship managers, the examples above highlight the importance of the Chinese walls being strictly
enforced in order to manage reputational risk and avoid any suspicions that the level of West Register
bid was being used to influence provisioning levels. Whilst in practice we do not believe that West
Register bids are being used to influence provisioning levels based on our testing of the fair values of the
properties that were acquired by West Register, we would recommend that Management are able
clearly to outline the controls and oversight within West Register and GRG and, in particular, the barrier
to prevent inappropriate transfer within GRG. In addition the position of the Global Head of GRG acting
as both Chairman of the West Register Asset Purchase Committee and Chairman of the divisional
provisioning committees could create the perception that the Chinese Walls are not fully robust and we
recommend that this committee considers whether this arrangement continues to be appropriate or how
the differing objectives of each committee could be segregated.
We believe that the updating of valuations each six months should be appropriate for the majority of
property assets. However for sizeable property portfolios, and particularly those where circumstances
change during the year, we would recommend that more frequent valuations or indexed revaluations
are carried out which would ensure more accurate reporting at Q1 and Q3.
We note that the current business model whereby RBS originates property loans and in certain
instances purchases the underlying properties, gives rise to the potential reputational risk of a perceived
conflict of interest. We would recommend that Management are able clearly to outline the controls and
oversight within West Register and GRG and, in particular, the barrier to prevent inappropriate transfer
within GRG. We also would recommend that more frequent valuations or indexed revaluations are
carried out which would ensure more accurate reporting at Q1 and Q3 rather than the current exercise of
valuation being updated twice a year particularly where the asset is sizeable or where circumstances
have changed during the reporting period.

4 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

 3. Global Restructuring Group (continued)
Management response:
We covered the details of the controls in place between GRG relationship managers and West Register
at the Q2 DRAC. The conclusion per the discussion at that time concluded that the controls and
safeguards were operating effectively. There is however a continued reputational risk around perception
of the process of provisioning and property acquisition both being overseen by the Head of GRG, who
chairs both the Divisional Provision Committees and the APP (Asset Purchase Proposition) 'A'
committee *.
We would welcome discussion at DRAC to ascertain if this is a risk they are willing to accept.
* The 'A' committee is for property acquisitions over £5m

5 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

 4. Responsibility statement
The observations that we set out in this report are those that have arisen during the course of our audit
work to date that we considered appropriate to bring to your attention. Our 2012 audit is ongoing. If
further matters arise that we consider need to be brought to your attention we will do so. Our audit was
not designed to identify all matters that may be relevant to the members of the Non-Core Division and
GRG Risk and Audit Committee and this letter is not necessarily a comprehensive statement of all
deficiencies which may exist in internal control or of all improvements which may be made.
This report has been prepared for the Non-Core Division and GRG Risk and Audit Committee, together
with the directors and management of The Royal Bank of Scotland Group plc and its subsidiaries, and
we therefore accept responsibility to you alone for its contents. We accept no duty, responsibility or
liability to any other parties, since this report has not been prepared, and is not intended, for any other
purpose. It should not be made available to any other parties without our prior written consent.

Deloitte LLP
Chartered Accountants
London
24 October 2012

6 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

 Appendix 1 – Update on prior year
recommendations
We set out below an update on recommendations that we provided last year. Where still relevant or
pertinent in the current year we have included in this year’s management letter.

1. IPV Sources of Pricing
In our prior year management letter, we recommended that the Division looked to reduce its reliance
on consensus pricing services and lead manager quotes by obtaining alternative pricing information
such as recent traded prices.
The Division has engaged Blackrock to provide asset analysis on a quarterly basis. The Blackrock
information provides an intrinsic analysis of the expected cash flows under optimistic, base and
stress cases. This information is primarily used to inform asset disposal decisions, but also provides
useful benchmarks to ensure that lead manager quotes are within a reasonable range.
Whilst we recognise that the Blackrock information is not necessarily indicative of the fair value of
assets, we believe that it could be better integrated into the independent price verification process on
a quarterly basis. We also continue to believe that there are further steps the Division could take to
obtain alternative pricing sources, such as INTEX modelling as used widely by the mortgage
business in the US or more systematically monitoring trading activity in the market, including
indicative quotes received. Where this is not possible, comparisons between prices received from
lead managers for similar types of assets would be beneficial.
Deloitte Observation
We recommend that for each specific asset management consider pricing evidence from more than
one source to validate the primary pricing source being used.
2012 update: In advance of the 2011 year-end, Management sought to expand the range of pricing
sources used for the pricing of asset backed securities, to include new pricing vendors and INTEX
modelling. The use of these pricing sources has continued throughout 2012 and the increased
disposal activity in the period has also provided increased pricing transparency and comfort on the
level of marking of the portfolio.

7 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

 Appendix 1 – Update on prior year
recommendations (continued)
2. Monoline and CDPC CVAs
Whilst commutations have reduced exposures, the calculation of the CVA against monoline and
CDPC counterparties still remain significant judgments which impact the Divisions results on a
quarterly basis.
During the year, management have increased the use of internally generated information in the
calculation of MBIA and no longer uses market implied probabilities of default. Whilst we understand
management’s rationale in this respect, there remains a need to document their continuing
appropriateness in light of movements in market implied inputs which can be significant from period
to period.
The CVA on WhiteKnight is calculated based off an economic hedge that was put in place a number
of years ago and the CVA on other CDPCs continues to be calculated using a cap and ratchet
mechanism. Whilst management continue to believe these methodologies are appropriate, there is
no formal documentation of the continuing appropriateness of their rationale on a quarterly basis.
Deloitte Observation
We recommend that the rationale of the adjustments noted above are formally documented and
updated at least on a quarterly basis:
-

-

In respect of monoline exposures where internally generated information is used, we recommend
that management embed the updating of the internal credit analysis into the quarterly reporting
process, including considering movements in CDS implied probabilities of default.
In respect of WhiteKnight, we recommend that management formally document why the level of the
economic hedge remains appropriate given market movements.
In respect of other CDPC, whilst external information is limited, we recommend that the cap and
ratchet mechanism is re-justified as this has led to the outcome being increasingly prudent.
2012 update: Since the date of our last Management Letter there have been a number of significant
commutations and restructures of both the exposures to Monolines and CDPCs which have both
reduced the Group’s exposures to these entities and provided additional information as to suitable
reserve levels.
Following significant commutations, primarily with MBIA, monolines exposures that are reserved
using internally generated information have significantly reduced.
In advance of the 2011 year-end, management performed necessary analysis to justify why the level
of the economic hedge was appropriate at that point. During the year the exposure to WhiteKnight
has been restructured and a new CVA methodology implemented which reflects the Division’s new
hedging strategy. In respect of CDPCs, management have recently performed additional
fundamental ‘break-up’ analysis of the CDPC structures and recent commutations have also
occurred which have provided additional pricing transparency.

8 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

 Appendix 1 – Update on prior year
recommendations (continued)
3. Financial Reporting Process
The Non-Core division is largely reliant on systems and processes within donor divisions. Non-Core
management perform a centralised review of the output and we note that this oversight process has
been enhanced during the current year with the implementation of additional more granular reviews
on a monthly and quarterly basis. This includes review of flash data, journals, reconciliations and
substantiation for the Non-Core group centre, review and challenge of financial data for each
donating division and the review and challenge of the Group reporting IMS pack and certain relevant
manual returns. This is in addition to the controls that existed at the 2010 year end which included
the review and challenge the monthly results with the donor divisions and monitoring of REIL and
NPL levels.
Aside from month end financial reporting, we also believe that management have the appropriate
level of focus on specific transactions and disposals as the recent Project Woodford transaction
illustrates.
Deloitte Observation
We support management’s continued focus in this area to exert sufficient review and challenge over
the donor divisions and help mitigate risks of inaccurate or incomplete financial reporting.
As the run-off of the Division’s assets and businesses continues and final exit dates approach, the
risk of key staff exiting the Group increases. We believe that management continue to be focused on
this risk and associated retention requirements. If the pace of disposal does reduce, this may
elongate the duration of the division and should this extend significantly, management may wish to
consider the replacement of tactical solutions with longer term strategic systems.
2012 update: We continue to support management’s focus in this area to exert sufficient review and
challenge over the donor divisions and help mitigate risks of inaccurate or incomplete financial
reporting.
Further, as the exit date for Non-Core is nearing, management should assess the risks associated to
the exit and may wish to consider the impact on the business.

9 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

 Appendix 1 – Update on prior year
recommendations (continued)
4. Management overlay within the M&IB latent loss provision
A latent loss provision is recognised in order to capture incurred losses that have yet to be identified
and reported at the balance sheet date. The GBM latent loss provision at the end of Q3 was £408m
(of which £211m related to Non-core) and consisted of £243m which was calculated by a model and
£165m representing a management overlay. We note that with the exception of Q2 2010 and Q3
2010, the management overlay has remained approximately constant over the last eighteen months.
Deloitte Observation
The component of the latent loss provision calculated by the model explicitly reflects the
characteristics of the underlying portfolios in GBM such as the probabilities of default, losses given
default and emergence periods. However the quantum of the management overlay cannot be
explicitly related back to the portfolio characteristics noted above and therefore it is difficult to
assess, in isolation, whether the amount of the overlay is appropriate.
Whilst we support the recognition of inherent uncertainty captured by the management overlay, we
recommend that the uncertainty should be captured in the Group’s models in order that it better
reflects the characteristics of the underlying portfolio at each balance sheet date. Without adopting
such an approach there is a risk that the level of the management overlay at any given balance sheet
date is unsupportable either in isolation or in the context of the Group’s total level of provisions.
The Financial Services Authority (“FSA”) has published finalised guidance in October 2011
(concluding on their consultation guidance of May 2011) which considers management overlays and
is in line with our recommendation in this area. Specifically the FSA note: “Therefore, while we
recognise and support the recognition of uncertainty by firms in applying overlays on a temporary
basis, we believe that an approach which segments aspects of portfolios ... is more transparent in
assessing a firm’s risk assessment.”
2012 update: Whilst this point continues to be relevant for 2012, we note the inherent difficulties of
capturing single name concentration risk in a model and therefore use of an overlay continues to be
appropriate. Further improvement could be made to the articulation of the risks that the M&IB overlay
is capturing.

10 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

 Appendix 1 – Update on prior year
recommendations (continued)
5. Internal controls over financial reporting identified within GRG under the Sarbanes-Oxley
(“SOX”) Act
The U.S. Sarbanes-Oxley Act of 2002 (“Section 404” or the “Act”) requires certain U.S. Securities
and Exchange Commission (“SEC”) registrants to make an annual assessment of internal controls
over financial reporting (“ICFR”) and provide an annual assertion on the effectiveness of their ICFR.
Section 404(b) of the Act requires that auditors of the financial statements of those companies also
attest to and report on management's assessment of the effectiveness of internal control over
financial reporting (“integrated audit”). As the Group auditors, we are required to perform an
integrated audit for the year ending 31 December 2011 in accordance with PCAOB Auditing
Standard No. 5 “An Audit of Internal Control over Financial Reporting (ICFR) that is integrated with
an Audit of Financial Statements” (“PCAOB AS5”). As a result of the integrated audit, we will express
two opinions: one on the effectiveness of ICFR, and a second on the financial statements. To
support our opinions, we perform tests of the design and operating effectiveness of relevant controls
which include controls within GRG (including the West Register Property Vehicles and the Structured
Investment Group).
Deloitte Observation
We do not expect to highlight a material weakness or significant deficiency in relation to the controls
over the West Register Property Vehicles (West Register) or the Strategic Investment Group (SIG)
as based on our testing conducted to date during the 2011 audit, appropriate controls are in place in
these areas.
We noted during the planning phase of our audit, however, that Management had not identified any
relevant controls for SOX purposes over the West Register or SIG despite the magnitude of the
property balances within West Register and the equity investments held within (c. £2.2bn and £616m
respectively as at 31 December 2010). Following communication of the point to GRG Management
and the Group SOX team, the GRG Business Risk and Controls Group have identified and
documented controls over the West Register and SIG for SOX purposes which are under review by
GRG Management before they are tested by the Assurance team. We support Management’s
response in the area and will test the documentation of the controls once finalised by GRG
Management.
In addition we note that for the thirteen existing controls that Management had identified as being
relevant for SOX purposes within GRG (which include controls over provisioning, credit stewardship
and physical and logical security) the controls are documented as the relevant SOX controls in the
form of test questions. We recommend that Management enhance the SOX framework by relating
the control activity to a control objective which mitigates against a stated risk as has been put into
place for the new controls identified above. The owner of each control should also be designated
within the SOX template.
2012 update: Following communication of the point to GRG Management last year and the Group
SOX team, the GRG Business Risk and Controls Group have identified and documented controls
over the West Register and SIG for SOX purposes which were reviewed by GRG Management and
were tested by the Assurance team. We support Management’s response in this area and consider
the point closed.

11 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

 Appendix 1 -- Update on prior year
recommendations (continued)

6. Valuation of investments held by the Strategic Investment Group

The Strategic Investments Group is the unit ol GRG with responsibility lor managing the upside
instruments that are negotiated by GRG as part of problem debt restructurings, SIG manages both listed
and unlisted investments including warrants and options, Management have classified equity
investments as either at lair value through profit and loss or available lor sale, in accordance with IAS 39
and therelore are required to measure these instruments at lair value,

Dela/rte Observation

We noted during our re riod ending 30 June 2011 that in determining the lair value ol a
listed equity investment management recorded a discount from the price quoted on the
Hong Kong stock exchange to take into account both the substantial shareholding held by the Group and
the restrictions that existed over the sale ol the equity under the terms ol the IPO in which the equities
became listed. We reported to the Group Audit Committee that although not material at a Group level,
the discount was not in compliance with the application ol IAS 39.

Whilst we have not noted any other evidence ol investments not being valued in accordance with IAS 39
we recommend that GRG Finance review the valuation ol the investments held by SIG in order to ensure
compliance.

2012 update: We note ma! is now being valued at its quoted price and have not noted any
evidence ol other investmen no eIng valued in accordance with IAS 39, we therelore consider the
point resolved,

12 Report to the Nomcore and GRG Risk and Audit Committee 2012 management lelter

Appendix 1 – Update on prior year
recommendations (continued)
7. The impact of forbearance strategies on loan impairment provisions relating to corporate
debt
There continues to be significant regulatory focus on forbearance and loan impairment as
exemplified by the finalised guidance on forbearance and impairment provisions published by the
FSA in October 2011 and the Group’s recently submitted information to the FSA regarding
forbearance on UK commercial real estate loans. While this guidance specifically related to
mortgages, in June 2011 the interim Financial Policy Committee advised the FSA to extend its
review of forbearance and associated provisioning practices across corporate sector exposures. We
therefore anticipate that the expectation of regulators will be that the sentiments expressed in the
guidance relating to mortgages should also be applied to corporate debt.
Deloitte Observation
We acknowledge that there are a number of challenges facing the Group and its peers in relation to
forbearance strategies on corporate debt. The definition of which loans are subject to forbearance
strategies is less clear than on retail portfolios due to the more bespoke nature of the product. The
identification of those loans subject to forbearance is non-trivial as these are currently not recorded
on the loan systems and therefore identification would require significant manual intervention.
Currently the Group do not explicitly take into account the impact of loan forbearance in their
individual loan assessments or calculation of latent provisions. We note that individual assessments
implicitly take into account forbearance strategies through the impact on future cash flows. We
believe that the Group is likely to face increasing regulatory challenge as to whether and how those
loans subject to forbearance strategies affect impairment calculations.
Consideration should also be given to disclosures in the Group annual report relating to corporate
debt concerning the description and types of forbearance, accounting policies relating to how loss
events under IAS 39 are interpreted in the context of forbearance, how loans are disaggregated into
pools reflecting the similar characteristics in the latent provisioning calculation, and how impairment
models are calibrated to take forbearance activities into account.
2012 update: RBS management has taken steps to collate information as to the exposures where
forbearance strategies were applied. Based on our substantive work at the 2011 year end, we do not
believe that any revision to the latent models would materially impact the Group’s results.

8. Adoption of IFRS 9
Point 7 raised above supersedes our prior year comments on this matter.

13 Report to the Non-Core and GRG Risk and Audit Committee – 2012 management letter

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