Banks

www.fitchratings.com 7 April 2017

United Kingdom

The Royal Bank of Scotland Group Plc Full Rating Report

Key Rating Drivers

Improved Risk Profile: The Royal Bank of Scotland Group plc’s (RBSG) ratings primarily

reflect the group’s significantly improved risk profile and acceptable capitalisation that provides

a sizable buffer for expected conduct charges, but also the group’s weak performance and the

remaining challenges it faces.

Significant Challenges Remain: Challenges that need to be addressed include uncertainty

over the timing and size of potential fines for legacy US residential mortgage-backed securities

(RMBS) activities, meeting the remaining state-aid obligation following the failure to divest

branches grouped under Williams & Glyn (W&G) by the end-2017 deadline, weak profitability

and the restructuring of the group.

Acceptable Capitalisation: The group’s common equity Tier 1 (CET1) ratio dropped by 210bp

to 13.4% at end-2016, but it remained above the medium-term target of 13%, providing a

cushion for the expected conduct charges. The fall was mainly due to a US RMBS-related

provision, restructuring costs, a dividend payment to the government and the accelerated

payment to the group’s pension fund, partially offset by the continuing deleveraging of its

Capital Resolution division. The Fitch Core Capital (FCC) ratio reduced to 14.7% at end-2016.

Profitability Is a Key Weakness: Profitability is under significant pressure from high conduct

and restructuring costs. We expect the group to continue to report losses in 2017 and possibly

in 2018. Longer-term profitability should be stronger and less volatile if the group’s turnaround

strategy is successful. For now, the continuing restructuring of the group weighs on our overall

assessment of the group’s company profile, management and strategy relative to UK peers.

Reduced Impaired Loans: RBSG’s gross impaired loan ratio of 3.1% at end-2016 is still

higher than its UK peers, but the results of the 2016 Bank of England stress-test indicated that

the asset quality of RBSG’s core domestic portfolio would be resilient to a severe stress. A

large portion of problem assets are in its Irish subsidiary, Ulster Bank Ireland DAC.

Improved Funding and Strong Liquidity: The group’s funding is more balanced than it was in

the past, with an improved balance between the maturities of assets and liabilities, a much

reduced reliance on wholesale funding and a large, high-quality liquidity buffer. We expect

active wholesale issuance to meet minimum requirement for own funds and eligible liabilities

(MREL), set at 23.5% of the group’s risk-weighted assets (RWAs), by 2022.

Holdco and Opco Ratings Equalised: RBSG’s ratings are primarily based on its role as a

holding company and reflect the absence of holding company double leverage.

Rating Sensitivities

Disruptive Fine or Litigation: RBSG’s ratings could be downgraded if the imposed fines are

materially higher than expected, or if litigation or reputation risk proves particularly disruptive, or

if consequences of the delayed divestment of W&G prove detrimental to the group’s franchise

and business model. A negative rating action could also be triggered by a severe and structural

deterioration of the operating environment following the UK’s decision to leave the EU.

Medium-Term Rating Upside: An upgrade of the group’s Issuer Default Ratings (IDRs) and

Viability Rating (VR) would require the removal of the uncertainties around the expected fine,

remaining state-aid obligation and still material execution risk from restructuring the group,

assuming that the group maintains good capitalisation and reaches a sound profitability.

Ratings

The Royal Bank of Scotland Group plc; The Royal Bank of Scotland PLC; National Westminster Bank Plc Foreign Currency

Long-Term IDR BBB+ Short-Term IDR F2

Viability Rating bbb+ Support Rating 5 Support Rating Floor NF

The Royal Bank of Scotland International Limited Foreign Currency Long-Term IDR BBB+ Short-Term IDR F2 Support Rating 2

The Royal Bank of Scotland N.V. Foreign Currency Long-Term IDR BBB+ Short-Term IDR F2 Support Rating 2

Sovereign Risk

Foreign-Currency Long-Term IDR AA Local-Currency Long-Term IDR AA

Outlooks

Foreign-Currency Long-Term IDR Stable Sovereign Foreign-Currency Long-Term IDR

Negative

Sovereign Local-Currency Long-Term IDR

Negative

Financial Data

The Royal Bank of Scotland Group plc

31 Dec 16

31 Dec 15

Total assets (USDbn) 982.5 1,208.4 Total assets (GBPbn) 798.7 815.4 Total equity (GBPbn) 42.3 48.2 Operating profit (GBPm) -451 1,031 Published net income (GBPm)

-5,248 -1,185

Comprehensive income (GBPm)

-4,181 -2,681

Operating ROAA (%) -0.05 0.11 Operating ROAE (%) -1.00 1.94 Internal capital generation (%)

-16.44 -3.26

Common equity Tier 1 ratio (%)

13.40 15.50

Tier 1 ratio (%) 17.70 19.10 Fitch Core Capital/risk-weighted assets (%)

14.70 16.21

Related Research

The Royal Bank of Scotland Group plc - Ratings Navigator (February 2017)

Fitch Affirms Royal Bank of Scotland Group at ‘BBB+’; Outlook Stable (February 2017)

2017 Outlook: UK Banks (December 2016)

Analysts

Joanna Drobnik, CFA +44 20 3530 1318 joanna.drobnik@fitchratings.com

Christian Scarafia +44 20 3530 1012 christian.scarafia@fitchratings.com

Banks

The Royal Bank of Scotland Group Plc

April 2017 2

Operating Environment

Brexit-Driven Uncertainty a Key Challenge

RBSG’s business is anchored in the UK (AA/Negative; Macro Prudential Indicator of MPI 1 –

low risk), where it operates through two main banks: RBS and National Westminster Bank Plc

(NatWest, an RBS subsidiary). The group is also exposed to the Irish operating environment

(A/Stable; Macro Prudential Indicator of MPI 1 – low risk) through Ulster Bank Ireland DAC.

Our assessment of its operating environment considers the UK’s sovereign rating as well the

economic environment in which the group operates and the framework that regulates and

supervises its activities. While the UK has benefited from a strong recovery since the last crisis,

we expect that GDP growth will reduce materially as the country prepares to leave the EU.

Fitch Ratings believes that uncertainty in the period until Brexit is likely to result in reduced

investment and consumption, with possible rises in unemployment, accelerating inflation and

falling asset values. We do not believe that these act as a constraint to RBSG’s VR. As the UK

private sector is highly indebted, deteriorating affordability could affect RBSG’s asset quality,

although the affordability should benefit from lower base rates for a longer period of time.

The group is regulated by the Prudential Regulation Authority and by the Financial Conduct

Authority, and its deposits are protected by the UK’s deposit insurance scheme. Fitch views

financial sector regulation in the UK as highly developed and transparent, with a focus on

strengthening capital, and, within the retail sector, on controlling household indebtedness and

mortgage affordability. Macro-prudential policy tools are being tested to ensure control over the

risk of the increase in base rates and the large portion of UK households’ wealth invested in

property. The UK regulatory environment has an effective bail-in regime enacted in domestic

legislation, which we expect will continue to be applied after the exit of the UK from the EU.

Company Profile

Transformation into UK-Focused Commercial Bank Is Progressing Well

In the UK, RBSG has leading market shares in commercial and SME banking as well as in

some segments of retail banking through its RBS and NatWest brands. It is also a leading

private bank in the UK through Coutts & Company (Coutts). Through Ulster entities, it has the

largest franchise in Northern Ireland and is the third-largest bank in Ireland. The group is active

in offshore banking through The Royal Bank of Scotland International Limited (RBSIL).

RBSG’s reshaped business model was implemented in 2014, aiming at improving returns and

splitting the group into three core business lines. Personal and Business Banking (PBB) serves

UK retail and SME businesses with turnover below GBP2 million and retail and commercial

customers in Ireland. Commercial and Private Banking (CPB) includes UK commercial and

mid-corporate clients, high-net-worth individuals and offshore banking through RBSIL.

Corporate and Investment Banking (CIB) was rebranded NatWest Markets (NWM) in

December 2016 and is undergoing a multiyear transformation, which was launched in 2015.

The business has a core focus on UK and western Europe corporates and global financial

institutions.

By end-2015, RBSG had substantially completed the run-down of RBS Capital Resolution

(RCR, established in 2013 to separate and wind down capital intensive assets) a year ahead of

schedule, with residual assets transferred to Capital Resolution (CR). CR was established in

February 2015 to sell and run down portions of CIB that were outside of the new business’s

scope. As part of this process, the US broker-dealer business, RBS Securities Inc. is being

materially reduced in size. RBSG plans to wind up CR by end-2017 and transfer any remaining

assets back into the rest of the group, mainly into NWM and CPB.

Related Criteria

Global Bank Rating Criteria (November 2016)

Global Non-Bank Financial Institutions Rating Criteria (March 2017)

Banks

The Royal Bank of Scotland Group Plc

April 2017 3

Divestment of Williams & Glyn Proved too Challenging

RBSG is required to fully separate and divest all RBS branches in England and Wales and all

NatWest branches in Scotland, referred to as W&G, by end-2017 to meet the EU state-aid

conditions imposed after its bail-out by the UK government. However, the W&G divestment

process has proven to be extremely complex and the bank announced that it would not be able

to meet the end-2017 deadline imposed by the EC.

Until early 2016, RBSG had been working towards establishing W&G as a separate licensed

bank and divesting it through an initial public offering or outright sale. This plan was abandoned

in 2016 and replaced by a plan to sell the business to another bank, which was also

unsuccessful. In February 2017, the commissioner responsible for EU competition policy has

proposed an alternative plan, which, if agreed, would bring a faster and more certain

conclusion to RBSG’s remaining state-aid obligations than the existing requirement to sell

W&G.

Under the proposed plan, RBSG would deliver a package to promote competition for banking

services to UK SMEs. This would include funding to help eligible challenger banks serve UK

SMEs, a fund that eligible challenger banks can access to increase their business banking

capabilities, funding to invest in fintech for business banking and access to RBSG branches for

the business customers of challenger banks.

RBSG took a GBP750 million provision in 2016 to provide for the proposed package and

expects to take additional restructuring charges in 2017 and 2018 to reincorporate the W&G

business into the RBS franchise. This is in addition to more than GBP1.7 billion that RBSG has

spent on W&G’s divestment programme over the past three years. Nevertheless, we believe

the ultimate cost of the new plan to RBSG, including the impact on its franchise, is likely to be

lower than under the previous plan.

International Presence Has Been Significantly Reduced

RBSG has gradually reduced its overseas presence since 2014. In October 2015, it completed

the sale of Citizens, a mid-sized US bank, a year ahead of schedule. In April 2016, it sold the

international segment of Coutts to focus on the UK part of the private banking business. The

group has also wound down non-UK transaction banking services and exited from 25 of the 38

countries where it had an international presence.

Divisional Breakdown Total income Impairment loss/release Operating loss/profit RWAs (GBPbn)

a

(GBPm) 2016 2015 2016 2015 2016 2015 2016 2015

UK Personal and Business Bankingb 5,290 5,200 -83 7 2,202 2,169 32.7 33.3

Ulster Bank RoIc

573 550 113 141 229 264 18.1 19.4 Personal and Business Banking 5,863 5,750 30 148 2,431 2,433 50.8 52.7 Commercial Banking 3,415 3,254 -206 -69 1,273 1,384 78.5 72.3 Private Banking 657 644 3 -13 149 113 8.6 8.7 RBS International 374 367 -10 0 195 211 9.5 8.3 Commercial and Private Banking 4,446 4,265 -213 -82 1,617 1,708 96.6 89.3 NatWest Markets 1,521 1,407 0 5 201 -55 35.2 33.1 Central items 120 377 0 -54 455 272 1.5 8.6 RBS core 11,950 11,799 -183 17 4,704 4,358 184.1 183.7 Capital Resolution -415 402 -253 725 -1,432 -412 34.5 49.0 Williams & Glyn 837 833 -42 -15 402 459 9.6 9.9 Total managed

d 12,372 13,034 -478 727 3,674 4,405 228.2 242.6

Total reported 12,590 12,923 -478 727 -4,082 -2,703 a Fully loaded Basel III

b Includes operations of Ulster Bank in Northern Ireland

c Ulster Bank DAC is a statutory entity, while Ulster Bank RoI is a divisional view.

d See table below for reconciliation between managed and reported operating profit

Source: RBSG, Fitch

Reconciliation Between Managed and Reported Operating Profit (GBPbn) 2016 2015

Managed 3,674 4,405 Own credit adjustment 180 309 Loss on redemption of own debt

-126 -263

Strategic disposals 164 -157 Restructuring costs -2,106 -2,931 Litigation and conduct costs

-5,868 -3,568

Write-down of goodwill - -498 Reported op profit/loss

-4,082 -2,703

Source: RBSG, Fitch

Williams & Glyn Divestment Costs Year (GBPm)

2014 378 2015 630 2016 706 Total 1,714

Source: RBSG, Fitch

Banks

The Royal Bank of Scotland Group Plc

April 2017 4

Ring-Fencing Will Add Complexity to Organisational Structure

The group structure has become simpler following the sale and wind down of international

operations. The requirement to establish a ring-fenced bank (RFB) in the UK will add some

complexity to the group’s organisational structure, but to a far lesser extent than at the more

internationally active UK banking groups, Barclays and HSBC. RBSG is targeting a “broad ring

fence”, under which the majority of activities (80% of RWAs), comprising UK and Irish-focused

banking services, will be housed inside the RFB. The non-ring-fenced group entities (NRFB)

will hold the remaining trading activities and the operations of RBSIL.

The implementation of the ring-fencing regime will significantly affect the management of the

group’s treasury operations, including internal and external funding arrangements. Each legal

entity will have to meet its own regulatory capital requirements, including Pillar 2A requirements,

and the RFB will have to meet the UK’s Systemic Risk Buffer. In addition, the establishment of

RFB and NRFB entities requires a significant legal and organisational restructuring.

Management and Strategy

We believe management has a high degree of depth and experience despite the large-scale

turnaround seen in the aftermath of the financial crisis. The new management team has been

in place since 2014 and includes individuals from inside and outside the group with significant

experience in the UK banking sector. Management has been responsible for developing the

group’s new strategy and further restructuring.

RBSG now has a consistent and clearly articulated strategy to become a simpler and stronger

bank, built around UK and Irish retail and commercial businesses. The group has completed

the second phase of its plan, centered on the transformation of its core businesses and the exit

from non-core businesses. The management team has been successful in achieving majority

its targets. However, there are still significant items outstanding, mainly satisfying final state-aid

obligations, NWM transformation and US RMBS investigation, which are likely to take

considerable time to resolve. We believe that meeting some of these targets will be challenging

and may be delayed.

In the medium term, RBSG targets net growth in PBB and CPB customer loans equal to at

least UK GDP growth, with a 3% target for 2017. On the other hand, NWM will see its business

much reduced and focused on supporting the group’s corporate clients. CR will continue to be

deleveraged with planned reduction in RWAs to between GBP15 billion and GBP20 billion

(excluding Alawwal Bank stake) and wind-up at end-2017.

Strategic Targets

KPI Long-Term Targets

CET1 ratio 13%

Cost/income ratio <50%

ROTE ≥12%

Source: RBSG, Fitch

End-2016 Simplified Legal Entity Structure

(Pre-Interim Transfers)

a Currently Adam & Co. plc

b New intermediate holding company established Jan 2017

c Currently RBS plc

Source: Fitch, Transaction documents

RBSG

RBS plc

NatWest Adam & Co.

Coutts & Company

RBS Securities Inc.

RBSILUlster Bank

Ltd.

Ulster DAC

100%

100%

100%100%100%

100%

44%

56%

RBSG

NatWest Holdings Limitedb

NatWest Markets plcc RBSIL

RBS plca

NatWest Ulster DAC

RBS Securities Inc.

Coutts &

CompanyUlster Bank Ltd.

100%

100% 100%

100%

100%100%100%

100% 100%

Ring-fenced

Bank

New Entity Re-Named Existing Entity

2019 Proposed Simplified Ring-Fenced Legal Entity Structure

Banks

The Royal Bank of Scotland Group Plc

April 2017 5

The group plans to generate about 90% of income from its UK operations and to reduce

operating costs by a further GBP2 billion over the next four years, in addition to the

GBP3.1 billion reduction achieved since January 2014. Long-term targets have been set and

the group plans to achieve these mainly through continuing investment in IT platforms and

application simplification, NWM restructuring and the run-down of CR.

Risk Appetite

Improving Internal Controls

RBSG has simplified its risk function, enhanced accountability and responsibilities, and made

significant progress in improving its overall risk profile. The risk-appetite framework is now

better aligned to FSB’s guidance on risk culture and is expected to be fully implemented and

embedded across the group by end-2017. Risk-appetite statements are in place for all strategic

and material risks (such as credit, market, operational, conduct, pension, reputational,

concentration, financial crime and IT resilience risks), all business franchises, all functions and

some major operating legal entities. There are a range of risk limits for individual asset classes,

products, industries and countries. Control has been embodied into enterprise risk

management, which looks at key company risks in aggregate, and aims to ensure that risks are

controlled consistently across the group.

The group has refocused its business on its core franchises in the UK and Ireland and this

simplified business model makes effective risk management more easily achievable. The

progress that has been made in de-risking the business is evident in the impaired loans/gross

loans ratio, which has fallen to 3.1% at end-2016 from 9.5% at end-2013. While this is largely

due to deleveraging of non-core assets and has been assisted by benign UK economic

conditions, it also reflects more conservative underwriting standards.

Legacy Conduct Risk

Despite significant progress made during 2015 and 2016, RBSG continues to face heightened

operational risk through numerous reviews and investigations by authorities in numerous

jurisdictions and business areas, which are difficult to quantify precisely. Regulatory

investigations and litigation include the mis-selling of US RMBS, mis-selling payment protection

insurance (PPI) in the UK, LIBOR and foreign-exchange (FX) setting practices in the US and

the UK, mis-selling of swap to SMEs in the UK and a lawsuit over UK 2008 capital raising.

Overall litigation costs and fines, and customer redress taken by RBSG between 2011 and

2016 amounted to GBP18.5 billion. We expect further material misconduct costs, primarily from

further fines and similar charges related to the US RMBS investigation. Unused balance-sheet

provisions at end-2016 totalled GBP11 billion, split GBP6.8 billion related to US RMBS,

GBP1.3 billion related to PPI, GBP1.1 billion related to other customer redress and GBP1.9

billion related to litigation and other regulatory proceedings.

As a result of the legacy conduct issues, RBSG has strengthened its conduct and compliance

functions and implemented remediation programmes to reduce and mitigate the group’s material

operational risks. Nevertheless, operational risks will remain elevated during the group

restructuring particularly with respect to the implementation of the UK ring-fencing regime and the

restructuring of NWM business. These carry significant execution and delivery risk and are being

delivered against the backdrop of cost challenges, putting significant pressure on the group’s

ability to maintain effective internal controls. However, the bank has shown that it has been able

to control these risks well and it has made significant investments to strengthen its IT platforms.

Modest Market Risk with Adequate Controls

The group’s exposure to market risk has reduced significantly, reflecting disposals of volatile

assets and the exit from a wide range of trading activities, including the downscaling of

activities at the group’s US broker dealer. The majority of RBSG’s traded market risk exposure

arises in NWM and CR. The majority of its non-traded market risk exposure (interest-rate risk in

the banking book, structural FX positions and equity positions) arises mainly from retail and

0

1,000

2,000

3,000

4,000

5,000

6,000

7,000

20

11

20

12

20

13

20

14

20

15

20

16

Source: RBSG, Fitch

Litigation and Conduct Costs(GBPm)

Banks

The Royal Bank of Scotland Group Plc

April 2017 6

commercial banking activities. The group’s earnings are adversely sensitive to a reduction in

short-term interest rates, with a 100bp fall in interest rates reducing next year’s net interest

income by about GBP378 million (equivalent to 0.8% of total equity) at end-2016.

Market risk is managed centrally and appetite is expressed in the form of policy statements,

dealing authorities and limits based on value-at-risk (VaR) and stressed VaR, positions,

sensitivity analyses and stress testing.

In March 2016, RBSG made a single payment of GBP4.2 billion to the RBSG Group Pension

Fund, instead of a series of annual contributions up to 2023, removing an element of pension

risk. The next valuation date will take place at end-2018. This provides increased certainty on

contribution commitments and the pension balance-sheet position and improves capital

planning.

Financial Profile

Asset Quality

As a result of the continuing deleveraging, the group’s gross loans and advances reduced by

65% between 2008 and 2015. Last year saw, for the first time since 2008, an increase in gross

loans and advances, of 4%, to GBP327 billion, as healthy growth in core retail and commercial

businesses more than offset the disposals of non-core assets. The geographical profile of

lending has also changed significantly, especially following the disposal of Citizens, with UK

lending now accounting for 93% of gross loans, with the remainder almost entirely in Ireland.

UK lending is mostly in the form of residential mortgages and non-commercial real estate

(CRE) corporate and SME lending. UK mortgage loans increased by 11% in 2016 and

accounted for 42% of gross loans at end-2016. Non-CRE corporate and SME lending in the UK

increased by 5% in 2016, with the biggest growth in the finance leases, retail and wholesale,

hotels and restaurants, and utilities sectors, and accounted for 35% of gross loans at end-

2016. Unsecured personal lending in the UK continues to decline and accounted for just 4% of

gross loans at end-2016, reflecting a reduced appetite for this type of lending.

UK mortgages have been extended predominantly to prime residential borrowers and at

relatively conservative loan/value (LTV) ratios (end-2016: average LTV of 56% in the UK PBB

book, which includes Northern Ireland; the proportion of the portfolio with LTVs of more than

90% or with no index was 3.5%, in line with the rest of the market). More than a fifth of the

owner-occupied mortgages were interest only. The portfolio also includes GBP16.7 billion of

buy-to-let mortgages.

Irish mortgages at Ulster Bank RoI (Ulster RoI) accounted for above 4% of gross loans at end-

2016. The quality of the Irish book remains much weaker, where, despite significant

improvement, the average LTV was 76% at end-2016 (end-2012: 112%, including Northern

Ireland), and 31% of mortgages had LTVs of above 90% (end-2012: 66%, including Northern

Ireland), reflecting the dramatic fall in Irish property prices in the aftermath of the crisis.

Industry exposure remains concentrated, albeit to the lesser extent than in the past, with the

largest concentration to the property sector, mostly CRE in the UK. Overall, CRE exposure was

GBP26.3 billion at end-2016 and accounted for 78% of FCC. New CRE lending is extended to

support key customers and is focused on the UK market. The proportion of the book with LTVs

above 70% (10% at end-2016) has dropped significantly over recent years, due to accelerated

divestments of legacy assets, improvements in the economy and new lending extended at

lower LTVs. Exposures with LTVs greater than 100% are predominantly legacy deals and

accounted for less than 5% of the portfolio.

Loan Book Breakdown at End-2016

(GBPbn) Gross loans

REIL (%)

REIL coverage

(%)

Government 6.1 0.0 100

Finance 33.1 0.2 84 Mortgages 153.3 2.7 25 Unsecured personal

14.5 7.7 81

Property 34.8 3.9 36 Construction 4.2 6.2 52 Manufacturing 9.6 1.8 52 Finance leases

12.3 1.1 57

Retail, wholesale and repairs

12.8 2.2 64

Transport and storage

6.4 21.6 30

Health, education and leisure

11.5 3.3 34

Hotels, restaurants

6.1 3.5 51

Utilities 3.9 2.4 53 Other 18.8 3.9 54 Total 327.5 3.1 43

REIL: Risk Elements in Lending Source: RBSG, Fitch

Banks

The Royal Bank of Scotland Group Plc

April 2017 7

Transport includes exposure to shipping finance, which, in line with the de-risking of the balance

sheet, has reduced to GBP4.6 billion at end-2016 (end-2015: GBP6.8 billion). It is mostly

managed within CR and related to exposure secured by ocean-going vessels. Conditions in the

portfolio remained depressed in 2015 and 2016, resulting in a weakened collateral cover with an

overall LTV of the CR part of the portfolio at 102% (end-2015: 85%). RBSG has also been

reducing its exposures to the natural resources sectors, with oil and gas exposures amounting to

a modest GBP2.9 billion at end-2016, of which only about 5% was within CR. See table opposite

for a breakdown of other notable sub-sector corporate exposures at end-2016.

Asset quality has improved further in 2016, primarily reflecting further disposals in CR and a

portfolio sale in Ulster RoI, partially offset by a deterioration in the shipping portfolio. The

results of the 2016 Bank of England stress-testing indicated that the asset quality of RBSG’s

core domestic portfolio would be resilient to a severe stress. However, the group’s asset quality

remains weaker than generally seen at UK banks, with a high proportion of risk element in

lending (REIL; or non-performing loans) at Ulster RoI and within CR. The table above breaks

down asset quality by geography and product.

Loans that are past due by 90 days or more and that require active management to minimise

losses, classified as REIL but not impaired, were GBP1.2 billion at end-2016 and are included

in Fitch’s impaired loans ratios in the spreadsheets at the back of this report.

Other Earning Assets: Significantly De-Risked

RBSG holds a sizeable portfolio of debt securities (GBP73 billion at end-2016), mainly split

between available for sale and held for trading, with a small amount of held to maturity and

loans and receivables. Over 80% of the securities were issued by central and local

governments (of which almost half was in the UK and the US). The credit risk of the securities

continues to improve, with 98% of debt securities rated investment grade at end-2016 (93%, ‘A’

or above). Within the significantly reduced ABS portfolio (GBP7 billion at end-2016), 76% were

rated ‘A’ and above.

RBSG has a sizeable reverse repurchase (repo) agreements book (GBP42 billion at end-2016)

which is largely match-funded (via repo agreements, GBP32 billion). RBSG is also a significant

participant in the derivative markets – mainly interest-rate swaps. Counterparty credit risk is

mitigated via netting and collateral arrangements, together covering 95% of GBP247 billion

gross exposures at end-2016.

Asset Quality and Impairment Allowances (Breakdown)

Gross loans REIL (NPLs) Provisions

(GBPm) 2016 (%)a +/− (%) 2015 (%)

a 2016 (%)

b 2015 (%)

b 2016 (%)

c 2015 (%)

c

UK Residential mortgages 137,427 42 11 123,653 39 943 0.7 1,083 0.9 143 15 158 15 Personal lending 14,198 4 -1 14,348 5 1,060 7.5 1,262 8.8 853 80 1,085 86 Property and construction 37,942 12 0 38,006 12 1,543 4.1 2,814 7.4 537 35 1,282 46 Other 115,833 35 5 110,193 35 3,133 2.7 2,198 2.0 1,299 41 1,182 54 Total UK

305,400 93 7 286,200 91 6,679 2.2 7,357 2.6 3,150 47 4,037 55

Europe Residential mortgages 15,548 5 12 13,908 4 3,144 20.2 2,550 18.3 872 28 844 33 Personal lending 265 0 -66 775 0 52 19.6 49 6.3 46 88 45 92 Property and construction 1,055 0 -47 1,993 1 85 8.1 1,008 50.6 84 99 966 96 Other 3,920 1 -45 7,148 2 279 7.1 1,011 14.1 165 59 864 85 Total Europe

20,788 6 -13 23,824 8 3,560 17.1 4,618 19.4 1,250 35 2,974 64

Rest of World 1,290 0 -75 5,087 2 71 5.5 181 3.6 55 77 127 70 Total gross loans 327,478 100 4 315,111 100 10,310 3.1 12,156 3.9 4,455 43 7,138 59 a Percentage of total gross loans;

b Percentage of gross loans;

c Coverage of impaired loans

Source: RBSG, Fitch

Banks

The Royal Bank of Scotland Group Plc

April 2017 8

0

0.3

0.6

0.9

1.2

1.5

0

10,000

20,000

30,000

40,000

50,000

20

08

20

09

20

10

20

11

20

12

20

13

20

14

20

15

20

16

(%)(GBPm)

Interest receivable (LHS)

Interest payable (LHS)

NIM (RHS)

Source: RBSG, restated by Fitch

Net Interest Revenue and Margin

Earnings and Profitability

RBSG has been loss-making since 2008, with a GBP5.2 billion net loss reported in 2016.

Subject to resolving or providing for all significant legacy issues in 2017, the group expects to

become profitable in 2018.

The loss reported in 2016 was largely due to GBP5.9 billion of additional conduct charges and

GBP2.1 billion of further restructuring costs. In addition, the group has paid the final dividend

access share (DAS) of GBP1.2 billion to the UK government, increasing the loss attributable to

ordinary shareholders. However, we consider the underlying profitability of the group’s core

businesses to be adequate. This should help RBSG to return to profit once the majority of

legacy conduct issues, especially with relation to US RMBS, have been resolved and the

restructuring has been implemented.

UK PBB, Commercial Banking (CB) and RBSIL are performing well on an underlying basis,

excluding restructuring and conduct costs, with strong returns on allocated equity, adequate

efficiency and positive outlook for both income and costs. Ulster RoI, Private Banking (PB) and

NWM, on the other hand, are being reposition for returns, with NWM’s transformation being the

biggest challenge. Ulster RoI stopped being loss making in 2014 but it is likely to continue to

suffer from low income in the medium term because of a high proportion of low-margin tracker

mortgages and a high cost base relative to the size of its core business.

Following the sale of its international business, PB is being repositioned to focus on UK

customers and became profitable in 2016.

The group’s total income continues to decline, in line with the shrinkage of the balance sheet. It

was down 3% yoy in 2016, mainly due to the reduced scale and resources in NWM and the

run-down of CR. We expect income to start to pick up from 2017 as the core businesses grow.

The net interest margin (NIM) has been improving since 2013, as a result of a better

management of funding costs and legacy funding rolling off, but remains low at 1.15% in 2016

(2015: 1.09%). Higher-yielding assets, such as credit card balances and personal unsecured

loans, have declined in volume while the proportion of lower-margin secured lending has

increased putting downward pressure on NIM.

The interest-rate cut in 2016 added additional pressure, but it has been partly offset by access

to cheap funding from the Bank of England’s GBP100 billion Term Funding Scheme. The

progressive replacing of maturing structural hedges, which added GBP1.3 billion to net interest

income, will also put pressure on NIM over the coming years.

Efficiency at the group remains low, with a Fitch-calculated cost/income ratio of 100% in 2016.

As a result of cost savings, underlying operating costs reduced by a further GBP1 billion in

2016 to GBP8.4 billion, with a further targeted reduction of GBP2 billion over the next four

years, of which GBP0.75 billion is planned for 2017.

Netted against the savings are restructuring costs which totalled GBP2.1 billion in 2016, of

which almost GBP1.5 billion related to the remaining state-aid obligations. From 2014 to 2016,

the group’s restructuring costs totalled GBP6.2 billion and RBSG is expecting additional

GBP2 billion over 2017 to 2019 (excluding W&G), of which GBP1 billion in 2017. Conduct costs

amounted to GBP5.9 billion in 2016 and included provisions in respect of US RMBS, PPI, the

UK 2008 capital raising and tracker mortgages in Ulster RoI.

RBSG recorded loan impairment charges (LICs) of GBP0.5 billion in 2016, mainly relating to the

legacy shipping portfolio within CR and a single name charge in the oil and gas portfolio within

CB. We expect that LICs will remain moderate in the short to medium term, as the overall credit

profile of the group has improved. However, in the long term LICs are likely to rise, as a result of

deteriorating economic environment, which is forecast after the decision to leave the EU.

0

500

1,000

1,500

2,000

2,500

3,000

3,500

2014 2015 2016 2017e

Cost savings Restructuring costs

Source: RBSG, Fitch

Cost Savings vs. Restructuring Costs

(GBPm)

Banks

The Royal Bank of Scotland Group Plc

April 2017 9

Capitalisation and Leverage

The group’s CET1 ratio fell 210bp in 2016 to 13.4%, mainly due to a US RMBS-related

provision, further restructuring costs, the final DAS dividend and the accelerated contribution

into the group’s pension scheme, partially offset by the continuing deleveraging of CR. We

believe that despite this reduction capital provides a sizeable cushion for the expected conduct

and litigation charges. The group targets a normalisation of the CET1 ratio at about 13%, but

we believe that achieving it will depend on the size and timing of the litigations claims related to

US RMBS mis-selling.

The results of the 2016 Bank of England stress revealed that RBSG did not meet its CET1

capital or Tier 1 leverage hurdle rates before additional Tier 1 (AT1) conversion. After AT1

conversion, it did not meet its CET1 systemic reference point or Tier 1 leverage ratio hurdle

rate. To improve its capital position stress resilience RBSG has updated its capital plan, which

incorporates further savings and reductions in RWAs across the group. This is in addition to

actions already taken since end-2015, including an issuance of USD2.65 billion of AT1 in

August 2016.

RBSG estimates that its MREL will be equivalent to 23.5% of its RWAs by end-2022. The

group plans to build up its MREL compliant debt through issuance of senior unsecured bail-

inable holding company debt with targeted annual issuance of GBP3 billion to GBP5 billion

(GBP4.2 billion was issued in 2016).

RBSG’s regulatory leverage ratio is adequate and has improved significantly since end-2013,

helped by the issuance of GBP4 billion AT1 capital notes in 2015 and 2016, and a reduction in

leverage exposure in line with the deleveraging. The group reported a 5.1% leverage ratio at

end-2016, 50bp lower than at end-2015. The drop was driven by lending growth and the

reduction in Tier 1 capital.

Funding and Liquidity

RBSG has reshaped its balance sheet and improved the quality of its funding and liquidity (see

chart opposite). The group is largely funded by customer deposits, which account for about

70% of total funding excluding derivatives. The Fitch-calculated loans/deposits ratio was 93%

at end-2016. However, we expect the ratio to increase to the group’s medium-term target of

about 100%, as a result of lending growth from PBB and CPB, and a shift to greater MREL

issuance leading to lower requirement for customer deposits.

The use of wholesale funding continues to decline, running off broadly in line with the disposal

of non-core assets and RBSG continues to expect maturities to be greater than issuance

requirements. The group has also significantly extended the maturity profile of its wholesale

funding, with short-term wholesale funding reduced to GBP13.9 billion (excluding

GBP20.7 billion derivative collateral) at end-2016, representing 2.5% of funded assets

Asset encumbrance is modest and was at about 11% of the total balance sheet at end-2016.

The group has also increase the amount of unencumbered assets pre-positioned with various

central banks as collateral for liquidity facilities. These consist mostly of the liquidity portfolio

(see table opposite), other debt securities and loans.

The group’s liquidity position has been strong since the crisis, with a liquidity coverage ratio

(LCR) of 123% and an estimated net stable funding ratio (NSFR) of 121% at end-2016. The

excess liquidity also works as a cushion for imminent US RMBS litigation settlement. We

expect liquidity indicators to decline further once the US fine has been paid and other

uncertainty removed.

Capital Ratiosa

(GBPbn) 2016 2015 2014

Credit 162.2 166.4 264.7

Counterparty 22.9 23.4 30.4

Market 17.4 21.2 24

Operational 25.7 31.6 36.8

Total RWAs 228.2 242.6 355.9

CET1 capital 30.6 37.6 39.9

CET1 ratio (%) 13.4 15.5 11.2

Tier 1 capital 34.7 39.6 39.9

Tier 1 ratio (%) 15.2 16.3 11.2

Total regulatory capital

43.8 47.6 48.6

Total capital ratio (%)

19.2 19.6 13.7

Leverage ratio (%)

5.1 5.6 4.2

a Fully Loaded CRR

Source: RBSG, Fitch

Liquid Assetsª

(GBPbn) 2016 2015 2014

Cash and central bank balances

69.1 69.4 68.4

FSA eligible government bonds

26.1 25.8 25.7

Primary liquidity 95.2 95.2 94.1

Secondary liquidity

b 68.7 60.6 56.5

Total buffer 163.9 155.7 150.7

Carrying value 190.3 188.7 187.0

ª By liquidity value b High quality assets eligible for discounting at

central banks; breakdown not available Source: RBSG, Fitch

Liquidity Metrics

(%) 2016 2015 2014

Stress outflow coverage

a 139 227 186

LCR 123 136 112

NSFR 121 121 112

ª Liquidity portfolio as a percentage of stressed outflows under the worst of three severe stress scenarios Source: RBSG, Fitch

0

200

400

600

800

2012 2013 2014 2015 2016

Secured debt Sub debt

MTNs CPs/CDs

Interbank Repos

Customer deposits

Source: RGSB, Fitch

Funding Breakdown(excl. derivatives)

(GBPbn)

Banks

The Royal Bank of Scotland Group Plc

April 2017 10

Support

Support Possible but Unlikely

We believe that sovereign support for RBS and NatWest is possible but cannot be relied upon

to protect senior creditors. While we view the ability of the UK authorities to be strong, their

propensity to provide such support has reduced, as indicated by the legislation enacted to allow

resolution to take place through bail-in. Our opinion is reinforced by statements by the

regulatory authorities to the same effect.

In terms of legal provision, the EU’s Bank Recovery and Resolution Directive has been

transcribed into UK law and took effect on 1 January 2015. The bail-in powers, contained in the

Financial Services (Banking Reform) Act 2013 (the 2013 Act) have also come into force and

reinforce the provisions of the Banking Act 2009, under which a special resolution regime had

already been set up.

Debt Ratings

The ratings of all subordinated debt and hybrid securities issued by RBSG group companies

are notched down from the common VR assigned to individual group companies, reflecting

Fitch’s assessment of their incremental non-performance risk relative to their VRs (up to three

notches) and assumptions around loss severity (one or two notches).

These features vary considerably by instrument. Subordinated debt with no coupon flexibility is

notched down once from the VR for incremental loss severity. Upper Tier 2 subordinated debt

is notched down three times (once for loss severity and twice for incremental non-performance

risk). Innovative and non-innovative legacy Tier 1 and preferred stock is notched down either

four or five times, dependent on incremental non-performance risk (twice for loss severity and

either two or three times for incremental non-performance risk). Contingent convertible capital

notes are notched five times (twice for loss severity and three times for incremental non-

performance risk) given their fully discretionary coupon payment.

Banks

The Royal Bank of Scotland Group Plc

April 2017 11

Peer Analysis 2016 RBSG LBG Nationwide

a SGH Barclays

2016 2015 2016 2014 2016 2015 2016 2015 2016 2015

Asset quality Impaired loans/gross loans 3.15 3.88 1.84 2.09 0.60 0.68 0.70 0.75 1.63 1.93 Reserves for impaired loans/impaired loans

43.21 58.72 43.71 46.44 36.24 36.49 70.64 77.13 71.18 62.95

LICs/average gross loans 0.16 -0.26 0.13 0.09 0.04 0.05 0.03 0.03 0.57 0.49 Growth of gross loans 4.47 -10.87 0.44 -5.35 3.05 4.64 0.76 4.85 -1.67 -6.71 Profitability Operating profit/RWAs -0.20 0.42 2.28 2.82 3.70 3.99 2.18 2.09 0.78 0.75 NIM 1.15 1.09 1.27 1.56 1.44 1.60 1.47 1.54 0.96 1.05 Cost/income 100.26 98.69 66.58 61.59 58.12 57.09 57.74 59.45 76.04 81.00 LICs/pre-impairment operating profit

1,770.37 -239.14 13.29 5.83 5.46 5.04 3.39 3.54 45.48 44.02

Operating ROE -1.00 1.94 11.09 14.16 12.68 14.77 13.39 12.89 4.76 4.53 Operating ROA -0.05 0.11 0.59 0.76 0.59 0.68 0.65 0.64 0.23 0.21 Capitalisation and leverage FCC/FCC-adjusted RWAs 14.70 16.21 13.16 12.07 26.16 25.37 13.66 13.54 14.67 13.26 CET1 ratio

b 13.40 15.50 13.60 12.80 23.30 23.20 11.60 11.60 12.40 11.40

Total capital ratioc

22.90 24.70 21.40 21.50 33.80 30.90 17.30 17.40 19.60 18.60 Leverage ratio 5.10 5.60 5.00 4.80 4.00 4.20 4.10 4.00 4.60 4.50 Net NPLs/FCC 17.45 12.76 16.86 19.10 7.82 8.81 3.43 2.95 3.49 6.09 Internal capital generation -16.44 -3.26 1.08 -0.40 9.76 9.91 4.08 3.02 2.42 -1.79 Funding and liquidity Loans/customer deposits 92.54 91.34 111.79 109.87 124.18 123.69 116.55 122.41 93.91 96.63 Customer deposits/total funding (excluding derivatives)

70.91 70.08 70.26 69.97 71.48 74.72 65.89 67.14 57.87 58.32

LCR 123.00 136.00 NR NR 140.60 142.60 139.00 120.00 131.00 133.00 NSFR 121.00 121.00 NR NR 130.50 127.90 NR NR NR NR

NR = not reported

LBG: Lloyds Banking Group plc, Nationwide: Nationwide Building Society; SGH: Santander UK Group Holdings plc; Barclays: Barclays plc In accordance with our internal criteria, we have reclassified certain elements of the banks consolidated statutory figures above and in the attached spreadsheets to improve comparability between peers. The main items reclassified as non-operating are US RMBS and PPI provisions, which are treated as non-recurring, non-operating losses

a 2016 data relate to half-year figures ending 30 September 2016. Year-end 4 April

b Fully loaded

c Transitional

Source: Fitch

Banks

The Royal Bank of Scotland Group Plc

April 2017 12

Banks

The Royal Bank of Scotland Group Plc

April 2017 13

Banks

The Royal Bank of Scotland Group Plc

April 2017 14

Banks

The Royal Bank of Scotland Group Plc

April 2017 15

Banks

The Royal Bank of Scotland Group Plc

April 2017 16

The ratings above were solicited by, or on behalf of, the issuer, and therefore,

Fitch has been compensated for the provision of the ratings.

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