Annual Report
and Accounts 2007

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• Presentation of information
• Forward–looking statements
• Description of business
• Competition
• Risk factors
• Financial highlights
• Summary consolidated income statement
• Analysis of results
• Divisional performance
• Consolidated balance sheet
• Cash flow
• Capital resources
• Risk and capital management
  • Governance
  • Risk and capital
  • Credit risk
  • Liquidity risk
  • Market risk
    • Market risk measurement methodology
    • Market risk controls
    • Currency risk
    • Pension obligation risk
    • Equity risk
  • Insurance risk
  • Operational risk
  • Regulatory risk and supervision

Market risk controls

All divisions which incur market risk in the course of their business are required to comply with the requirements of the Group's MRPS. The main risk management tools are delegated authorities, specifically hard limits and discussion triggers.

Limits form part of the dealing authorities and constitute one of the cornerstones of the market risk management framework. Their breach must be followed by appropriate action, as specified in detail in the MRPS. Upon notification of a limit breach, the appropriate body must take either of the following actions:

• instructions can be given to reduce positions so as to bring the Group within the agreed limits, or
• a temporary increase in the limit (for instance, in order to allow orderly unwinding of positions) can be granted, or
• a permanent increase in the limit can be granted.

Treasury

The Group's treasury activities include its money market business and the management of internal funds flow within the Group's businesses. Money market portfolios include cash instruments (principally debt securities, loans and deposits) and related hedging derivatives. VaR for the Group's treasury portfolios, which relates mainly to interest rate risk including credit spreads, was £5.5 million at 31 December 2007 (2006 – £1.5 million). During the year the maximum VaR was £6.4 million (2006 – £4.4 million), the minimum £1.3 million (2006 – £0.6 million) and the average £3.7 million (2006 – £2.4 million).

Retail and commercial banking

Non-trading interest rate risk can arise in these activities from a variety of sources, including where assets, liabilities and off-balance sheet instruments have different repricing dates.

Non-trading interest rate risk is calculated in each business on the basis of establishing the repricing behaviour of each asset, liability and off-balance sheet product. For many products, the actual interest rate repricing characteristics differ from the contractual repricing. In most cases, the repricing maturity is determined by the market interest rate that most closely fits the historical behaviour of the product interest rate. For non interest bearing current accounts, the repricing maturity is determined by the stability of the portfolio. The repricing maturities used are approved by Group Treasury and divisional asset and liability committees at least annually. Key conventions are reviewed annually by GALCO.

A static maturity gap report is produced as at the month-end for each business, in each functional currency based on the behaviouralised repricing for each product. It is Group policy to include in the gap report, non-financial assets and liabilities, mainly property, plant and equipment and the Group's capital and reserves, spread over medium and longer term maturities. This report also includes hedge transactions, principally derivatives.

Any residual non-trading interest rate exposures are controlled by limiting repricing mismatches in the individual business balance sheets. Potential exposures to interest rate movements in the medium to long term are measured and controlled using a version of the same VaR methodology that is used for the Group's trading portfolios but without discount factors. Net accrual income exposures are measured and controlled in terms of sensitivity over time to movements in interest rates.

Risk is managed within VaR limits approved by GALCO, through the execution of cash and derivative instruments. Execution of the hedging is carried out by the relevant division through the Group's treasury functions. The residual risk position is reported to divisional asset and liability committees, GALCO and the Board.

Non-trading interest rate VaR

Non-trading interest rate VaR for the Group's treasury and retail and commercial banking activities, including ABN AMRO on a fully consolidates basis, was £42.9 million at 31 December 2007 (2006 – £40.2 million) with the major exposure being to changes in longer term US dollar interest rates. During the year, the maximum VaR was £53.6 million (2006 – £98.7 million), the minimum £32.9 million (2006 – £40.2 million) and the average £43.2 million (2006 – £76.6 million).

Citizens was the main contributor to overall non-trading interest rate VaR. It invests in portfolios of highly rated and liquid investments, principally mortgage-backed securities issued by US Government-backed entities. This balance sheet management approach is common for US retail banks where mortgages are originated and then sold to Federal agencies for funding through the capital markets.

VaR, like all interest rate risk measures, has limitations when applied to retail banking books and the management of Citizens Financial Group's interest rate exposures involves a number of other interest rate risk measures and related limits. Two measures that are reported both to Citizens ALCO and the Board are:

• The sensitivity of net accrual earnings to a series of parallel movements in interest rates; and
• Economic value of equity (“EVE”) sensitivity to a series of parallel movements in interest rates.

The limits applied to these measures are set to parallel movements of +/-1% and +/-2%. The EVE methodology captures deposit re-pricing strategies and the embedded option risks that exist within both the investment portfolio of mortgage-backed securities and the consumer loan portfolio. EVE is the present value of the cash flows generated by the current balance sheet. EVE sensitivity to a 2% parallel movement upwards and downwards in US interest rates is shown below.

	Percent increase/(decrease) in Citizens EVE
2007	2% parallel upward movement in US interest rates %	2% parallel downward movement in US interest rates (no negative rates allowed) %
Period end	(6.4)	(9.7)
Maximum	(10.1)	(10.3)
Minimum	(4.5)	(3.0)
Average	(8.0)	(7.6)

2006
Period end	(9.6)	(7.2)
Maximum	(10.1)	(10.3)
Minimum	(8.4)	(1.9)
Average	(9.4)	(6.0)

For the Group, the other major structural interest rate risk arises from a low interest rate environment, particularly in sterling, sustained for a number of years. In such a scenario, deposit pricing may reach effective floors below which it is not practical to reduce rates further whilst variable rate asset pricing continues to decline. A sustained low rate scenario would also generate progressively reduced income from the medium and long term hedging of non-interest bearing liabilities.