Investor Report
RBS Citizens Financial Group, Inc.
September 30, 2012
To the holders of the 4.15% Subordinated Notes due 2022
Issued under, and pursuant to the terms of, an indenture dated as of September 28, 2012 between RBS Citizens Financial Group, Inc. and The Bank of New York Mellon, as Trustee
RBS Citizens Financial Group, Inc. is a subsidiary of The Royal Bank of Scotland Group plc. This Quarterly Report is being provided to the holders of the 4.15% Subordinated Notes due 2022 (the “Subordinated Notes”) issued by RBS Citizens Financial Group, Inc. under the terms of the Subordinated Note Indenture dated as of September 28, 2012 between RBS Citizens Financial Group, Inc., as issuer, and The Bank of New York Mellon, as trustee, as amended, supplemented or modified from time to time. This Report is not intended for any other purpose.
Management’s Discussion & Analysis of Financial Condition & Results of Operations and Condensed Consolidated Interim Financial Statements (unaudited)
September 30, 2012
Table of Contents
Page
Management’s Discussion & Analysis of Financial Condition & Results of Operations
Selected Financial Data……………………………………………………………………………… 1 Forward-Looking Statements………………………………………………………………………... 2 Introduction………………………………………………………………………………………….. 3 Executive Overview…………………………………………………………………………………. 3 Net Income…………………………………………………………………………………………... 5 Net Interest Income………………………………………………………………………………….. 5 Noninterest Income………………………………………………………………………...... 7 Noninterest Expense…………………………………………………………………………………. 8 Provision for Income Taxes………………………………………………………………...... 9 Securities Available-for-Sale (“AFS”)…………………………………………………………….... 10 Loans and Leases……………………………………………………………………………………. 11 Allowance for Credit Losses & Nonperforming Assets…………………………………………...... 11 Non-Core Assets…………………………………………………………………………………...... 13 Deposits……………………………………………………………………………………………… 14 Borrowed Funds……………………………………………………………………………………... 15 Derivatives…………………………………………………………………………………………... 15 Capital Resources……………………………………………………………………………………. 16 Critical Accounting Policies………………………………………………………………………… 18 Off-Balance Sheet Arrangements…………………………………………………………………… 22 Enterprise Risk Management………………………………………………………………………... 22
Independent Accountants’ Review Report………………………………………………………. 26
Consolidated Financial Statements (Unaudited)
Consolidated Balance Sheets ……………………………………………………………...... 27 Consolidated Statements of Operations …………………………………………………………...... 28 Consolidated Statements of Changes in Stockholder’s Equity……………………………………………….. 29 Consolidated Statements of Cash Flows...…………………………………………………………...... 30
Notes to Consolidated Financial Statements (Unaudited) Note 1: Significant Accounting Policies…………………………………………………………...... 31 Note 2: Securities……………………………………………………………………………………. 36 Note 3: Loans and Leases…………………………………………………………………………… 39 Note 4: Allowance for Credit Losses, Nonperforming Assets, and Concentrations of Credit Risk.... 40 Note 5: Goodwill and Intangible Assets…………………………………………………………….. 47 Note 6: Mortgage Banking……………………………………………………………………...... 47 Note 7: Deposits………………………………………………………………………………...... 49 Note 8: Borrowed Funds…………………………………………………………………………….. 50 Note 9: Income Taxes……………………………………………………………………………….. 51 Note 10: Derivatives………………………………………………………………………………… 52 Note 11: Commitments, Guarantees and Contingencies…………………………………………….. 56 Note 12: Divestitures……………………………………………………………………………….... 59 Note 13: Related Party Transactions………………………………………………………………… 59 Note 14: Fair Value Measurements………………………………………………………………...... 60 Note 15: Regulatory Matters……………………………………………………………………...…. 65 Note 16: Supplemental Cash Flow Information……………………………………………………... 66 Note 17: Subsequent Events…………………………………………………………………………. 66
RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Selected Financial Data
The following tables present RBS Citizens’ selected consolidated historical financial information. You should read this information together with the Consolidated Financial Statements, related notes, and the other information included elsewhere in this document. The data for the three and nine months ended September 30, 2012 and 2011 and at September 30, 2012 and December 31, 2011 have been derived from the RBS Citizens’ unaudited and audited Consolidated Financial Statements. The Company has prepared the unaudited Consolidated Financial Statements on the same basis as the audited Consolidated Financial Statements.
Three Months Ended Nine Months Ended September 30 September 30 (dollars in millions) 2012 2011 2012 2011 OPERATING DATA: Net interest income . $810 $838 $2,455 $2,497 Provision for credit losses . 109 201 311 698 Noninterest income . 422 407 1,277 1,266 Noninterest expense . 791 843 2,561 2,481 Net income . 209 130 542 379 OTHER DATA: . Return on average tangible assets . 0.71 % 0.44 % 0.62 % 0.43 % Return on average tangible common equity . 6.49 4.32 5.78 4.34 Net interest margin . 2.88 2.97 2.93 2.98
September 30, December 31, (dollars in millions) 2012 2011 BALANCE SHEET DATA: Total assets . $131,580 $129,654 Securities . 21,341 23,352 Total loans and leases . 86,941 86,795 Allowance for loan and lease losses . 1,347 1,698 Goodwill and other intangible assets . 11,322 11,324 Deposits . 96,481 92,888 Federal funds purchased and securities sold under agreements to repurchase . 3,241 4,152 Borrowed funds . 4,699 6,342 Stockholder's equity . 24,109 23,393 OTHER DATA: Allowance for loan and lease losses as a % of total loans and leases 1.55 % 1.96 % Allowance for loan and lease losses as a % of nonperforming loans and leases 74 95 Nonperforming loans and leases as a % of total loans and leases 2.08 2.06 Capital ratios Tier 1 14.1 13.9 Total 15.7 15.1 Leverage ratio 11.9 11.6
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) provides information that management believes will assist in understanding the financial performance of RBS Citizens Financial Group, Inc. and its subsidiaries (“RBS Citizens” or the “Company”). You should read the following discussion and analysis of the Company’s consolidated financial position and results of operations together with the Consolidated Financial Statements and the Notes to Consolidated Financial Statements.
Forward-Looking Statements
The information included in this report contains certain forward-looking statements. These forward-looking statements may relate to the Company’s financial condition, results of operations, plans, objectives, future performance and business, including, but not limited to, statements with respect to expected earnings levels, the adequacy of the allowance for credit losses, delinquency trends, market risk and the impact of interest rate changes, capital market conditions, capital adequacy and liquidity, the effect of legal proceedings, and new accounting standards on the Company’s financial condition and results of operations. All statements contained herein that are not clearly historical in nature are forward-looking, and the words “anticipate,” “believe,” “continues,” “expect,” “estimate,” “intend,” “project” and similar expressions and future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may,” or similar expressions are generally intended to identify forward-looking statements. Forward-looking statements are not guarantees of future performance, are based on management’s current expectations and, by their nature, involve certain risks, uncertainties, estimates and assumptions by management that are difficult to predict. Various factors, some of which are beyond the Company’s control, could cause actual results to differ materially from those expressed in, or implied by, such forward-looking statements. Factors that might cause such a difference include, but are not limited to: the rate of growth in the economy and employment levels, as well as general business and economic conditions;
changes in interest rates and market liquidity, as well as the magnitude of such changes, which may reduce interest margins, impact funding sources and affect the ability to originate and distribute financial products in the primary and secondary markets;
changes in federal bank regulatory and supervisory policies, including required levels of capital;
the impact of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd Frank Act”) on the Company’s businesses, business practices and costs of operations;
the relative strength or weakness of the consumer and commercial credit sectors and of the real estate markets in the markets in which the Company’s borrowers are located;
competition in the financial services industry;
additional Federal Deposit Insurance Corporation (“FDIC”) assessments; and
legislative, tax, accounting or regulatory changes.
Other possible events or factors that could cause results or performance to differ materially from those expressed in such forward-looking statements include the following: negative economic conditions that adversely affect the general economy, housing prices, the job market, consumer confidence and spending habits which may affect, among other things, the level of nonperforming assets, charge-offs and provision expense;
adverse movements and volatility in debt and equity capital markets;
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
changes in market rates and prices, which may adversely impact the value of financial assets and liabilities;
liabilities resulting from litigation and regulatory investigations;
the Company’s ability to grow its core businesses;
decisions to downsize, sell or close units or otherwise change the Company’s business mix; and
management’s ability to identify and manage these and other risks.
All forward-looking statements included in this document are based upon information available to the Company as of the date of this document, and other than as required by law, including the requirements of applicable securities laws. The Company assumes no obligation to update or revise any such forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.
Introduction
RBS Citizens is a Bank Holding Company (“BHC”) and Financial Holding Company (“FHC”) headquartered in Providence, Rhode Island, and through its subsidiaries has more than 1,400 branches, approximately 3,600 branded ATMs, and almost 19,000 employees. Its two bank subsidiaries, RBS Citizens, N.A. and Citizens Bank of Pennsylvania, operate a twelve-state branch network under the Citizens Bank brand in Connecticut, Delaware, Massachusetts, New Hampshire, New Jersey, New York, Pennsylvania, Rhode Island and Vermont; and under the Charter One brand in Illinois, Michigan and Ohio. RBS Citizens is a wholly-owned subsidiary of The Royal Bank of Scotland Group plc (“RBS Group” or “RBSG”). On December 1, 2008, the United Kingdom (“UK”) Government became the ultimate controlling party of RBS Group. The UK Government’s shareholding is managed by UK Financial Investments Limited, a company wholly-owned by the UK Government. RBS Group reports the results of RBS Citizens’ core businesses as “U.S. Retail and Commercial-Core” in its published financial statements in accordance with International Financial Reporting Standards (“IFRS”), as defined by the International Accounting Standards Board. The financial position and results of operations included herein are prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) and represent all of RBS Citizens’ assets, including its non-core assets. RBS Citizens’ non-core assets include those loans and other assets that management considers to be outside the Company’s core business strategy. See the “Non-Core Assets” section below for further detail.
Executive Overview
RBS Citizens’ reported pre-tax income for the third quarter of 2012 of $332 million, as compared to a pre-tax income of $201 million in the third quarter of 2011. The quarter marked the Company’s ninth consecutive quarter of pre- tax income from continuing operations. The quarter’s performance was driven by stable revenues on a smaller base of interest earning assets, improved expenses, and greatly improved credit.
Total revenues of $1.2 billion were essentially unchanged from a year ago reflecting challenges in the broader economy, most notably the low rate environment which has limited opportunities for spread expansion. Increases in mortgage banking fees and gains on the sale of securities more than offset declines in customer deposit fees and service charges on ATM and debit card transactions.
Expenses remain a keen area of management focus. Noninterest expenses of $791 million for the third quarter declined $52 million, or 6%, from $843 million one year ago driven by a reduction in rewards program expense and reduced costs associated with the management of nonperforming assets.
The provision for credit losses for the third quarter was $109 million compared with $201 million one year ago, and $132 million in the prior quarter. Credit trends continued to improve across every asset class. Net charge-offs for the 3
RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS quarter of $245 million included new regulatory guidance requiring loans discharged under Chapter 7 bankruptcy and not reaffirmed by the borrowers, to be charged-off to their collateral value and considered nonaccrual, regardless of their delinquency status. Approximately 90% of the loans impacted by this regulatory guidance were fully performing at the time they were deemed collateral dependent and charged-off to their collateral value.
Excluding the impact of the new regulatory guidance, net charge-offs during the quarter would have been $174 million compared with $277 million in the prior year and $248 million in the prior quarter.
RBS Citizens’ total average balance sheet remained substantially unchanged. This was due to strong growth in commercial lending which was nominally offset by declines in the investment portfolio and consumer assets, particularly home equity loans. Total demand deposits and money market accounts increased by 18% from December balances, but were offset by declines in other interest bearing deposits, particularly checking with interest and term deposits which declined by 21% and 14%, respectively. The decrease in checking with interest was primarily attributable to a shift to demand deposits resulting from the Company’s program to exit certain government banking markets.
RBS Citizens’ capital position remains strong both in terms of quantity and quality of capital. The Company’s Basel I Tier 1 Common Equity ratio ended the quarter at 13.8%, while the Basel I Tier 1 Capital ratio ended the quarter at 14.1%. On September 28, 2012 RBS Citizens issued $350 million of 4.150% subordinated notes due in 2022 in a private offering. The offering represented RBS Citizens’ first such offering.
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Results of Operations
Net Income
Net income was $542 million for the nine months ended September 30, 2012, compared to $379 million for the nine months ended September 30, 2011. Lower levels of provision for loan and lease losses due to improved asset quality, and a gain on sale of RBS Citizens’ investment in Visa Inc. shares, contributed to higher net income. The Company accrued and paid $138 million in 2012 to settle litigation related to overdraft fee practices.
Net Interest Income
The following tables show the major components of net interest income and net interest margin:
Three Months Ended September 30, 2012 September 30, 2011 Increase (Decrease) Average Income/ Yields/ Average Income/ Yields/ Average Yields/ (dollars in millions) Balances Expense Rates Balances Expense Rates Balances Rates Assets Investments $23,981 $148 2.47% $24,786 $189 3.04% ($805) (0.57%) Commercial 27,660 218 3.12 24,520 197 3.19 3,140 (0.07) Commercial real estate 6,867 49 2.79 8,151 58 2.78 (1,284) 0.01 Leases 3,221 28 3.50 3,077 29 3.75 144 (0.25) Total commercial loans 37,748 295 3.10 35,748 284 3.15 2,000 (0.05) Home equity lines of credit 17,771 126 2.80 17,418 121 2.75 353 0.05 Residential mortgage 9,558 101 4.24 9,742 113 4.63 (184) (0.39) Home equity loans 7,904 117 5.89 10,232 152 5.91 (2,328) (0.02) Automobile 8,442 68 3.19 7,548 82 4.33 894 (1.14) Student and other installment loans 3,951 54 5.42 4,798 64 5.31 (847) 0.11 Credit cards 1,640 41 9.95 1,564 39 9.79 76 0.16 Total retail loans 49,266 507 4.08 51,302 571 4.42 (2,036) (0.34) Total loans 87,014 802 3.64 87,050 855 3.89 (36) (0.25) Loans held for sale 537 4 3.09 320 3 3.63 217 (0.54) Total earning assets 111,532 954 3.39 112,156 1,047 3.70 (624) (0.31) Loan loss reserve (1,469) (1,876) 407 Goodwill and other intangibles 11,323 11,340 (17) Other non earning assets 6,695 7,121 (426) Total non earning assets 16,549 16,585 (36) Total assets $128,081 $128,741 ($660) Liabilities and Stockholder's Equity Checking with interest $13,515 $3 0.08% $16,046 $4 0.09% ($2,531) (0.01%) Money market & savings 41,933 31 0.29 37,734 23 0.25 4,199 0.04 Term deposits 13,257 44 1.33 16,176 103 2.52 (2,919) (1.19) Total interest bearing deposits 68,705 78 0.45 69,956 130 0.73 (1,251) (0.28) Customer repos and fed funds purchased 2,282 34 5.77 2,901 20 2.65 (619) 3.12 Borrowed funds - other 5,379 32 2.36 8,137 59 2.83 (2,758) (0.47) Total borrowed funds 7,661 66 3.38 11,038 79 2.81 (3,377) 0.57 Total interest bearing liabilities 76,366 144 0.75 80,994 209 1.01 (4,628) (0.26) Total demand deposits 24,997 21,637 3,360 Other liabilities 2,614 2,787 (173) Equity 24,104 23,323 781 Total liabilities and equity $128,081 $128,741 ($660) Net interest income $810 $838 ($28) Net interest margin 2.88% 2.97% (0.09%)
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Nine Months Ended September 30, 2012 September 30, 2011 Increase (Decrease) Average Income/ Yields/ Average Income/ Yields/ Average Yields/ (dollars in millions) Balances Expense Rates Balances Expense Rates Balances Rates Assets Investments $24,019 $490 2.72% $24,730 $570 3.08% ($711) (0.36%) Commercial 27,003 640 3.16 23,499 581 3.31 3,504 (0.15) Commercial real estate 7,207 151 2.75 8,460 181 2.82 (1,253) (0.07) Leases 3,207 85 3.54 2,882 84 3.88 325 (0.34) Total commercial loans 37,417 876 3.12 34,841 846 3.25 2,576 (0.13) Home equity lines of credit 17,764 372 2.79 17,006 349 2.74 758 0.05 Residential mortgage 9,609 315 4.37 9,729 343 4.70 (120) (0.33) Home equity loans 8,444 374 5.90 10,902 484 5.93 (2,458) (0.03) Automobile 8,139 208 3.41 7,579 263 4.64 560 (1.23) Student and other installment loans 4,100 165 5.36 5,040 201 5.32 (940) 0.04 Credit cards 1,624 123 10.09 1,577 115 9.75 47 0.34 Total retail loans 49,680 1,557 4.18 51,833 1,754 4.52 (2,153) (0.34) Total loans 87,097 2,433 3.71 86,674 2,600 3.99 423 (0.28) Loans held for sale 514 12 3.16 336 10 3.83 178 (0.67) Total earning assets 111,630 2,936 3.49 111,740 3,180 3.79 (110) (0.30) Loan loss reserve (1,565) (1,927) 362 Goodwill and other intangibles 11,324 11,348 (24) Other non earning assets 6,787 7,184 (397) Total non earning assets 16,546 16,605 (59) Total assets $128,176 $128,345 ($169) Liabilities and Stockholder's Equity Checking with interest $13,491 $8 0.08% $16,125 $12 0.10% ($2,634) (0.02%) Money market & savings 40,799 91 0.30 37,483 67 0.24 3,316 0.06 Term deposits 13,875 204 1.96 16,994 283 2.23 (3,119) (0.27) Total interest bearing deposits 68,165 303 0.59 70,602 363 0.69 (2,437) (0.10) Customer repos and fed funds purchased 2,620 67 3.36 3,792 149 5.18 (1,172) (1.82) Borrowed funds - other 6,000 111 2.43 7,912 171 2.85 (1,912) (0.42) Total borrowed funds 8,620 178 2.72 11,704 320 3.61 (3,084) (0.89) Total interest bearing liabilities 76,785 481 0.82 82,306 683 1.09 (5,521) (0.27) Total demand deposits 24,861 20,750 4,111 Other liabilities 2,716 2,261 455 Equity 23,814 23,028 786 Total liabilities and equity $128,176 $128,345 ($169) Net interest income $2,455 $2,497 ($42) Net interest margin 2.93% 2.98% (0.05)
For the three month period ended September 30, 2012, net interest income was $810 million and net interest margin was 2.88%. This reflects a decline of $28 million and 9 basis points (“bps”), respectively, when compared to the three month period ended September 30, 2011. The record low interest rate environment seen during the three month period ended September 30, 2012 adversely impacted net interest income and the net interest margin. Total investments and total loans declined $805 million and $36 million, respectively, and loan interest income decreased $53 million as mortgage refinancing activity picked up. Since these refinanced loans were generally higher yielding loans, the decline in loan volume caused a disproportionate decrease in interest income. Additionally, yields on the investment portfolio dropped 57 bps due to low reinvestment rates, increased premium amortization expense and portfolio sales. Yields on earning assets decreased a total of 31 bps compared to the same period last year.
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
For the nine month period ended September 30, 2012, net interest income was $2.5 billion and net interest margin was 2.93%. This reflects a decline of $42 million and 5 bps when compared to the nine month period ended September 30, 2011. Driven by historically low interest rates, yields on both earning assets and interest-bearing liabilities declined sharply compared to the prior year. On the asset side, while net average loan balances for the nine months ended September 30, 2012 increased $423 million compared to the same period in 2011, interest income on loans decreased $167 million. Yields on earning assets declined 30 bps compared to the same period last year. Additionally, yields on the investment portfolio dropped 36 bps from 2011. Declines are attributed to run-off and prepayment of higher-yielding, fixed rate assets and new originations of loans with lower yields as well as sales of higher yielding investment securities. In addition, the increase in prepayment speeds increased net premium amortization expense on investment securities. On the funding side, interest-bearing deposit expense was reduced by $60 million and deposit costs declined 10 bps. Many deposit products have hit pricing floors at or near zero, making any further rate reductions difficult and thus compressing margin. However, RBS Citizens’ cost of other borrowed funds improved $60 million, or 42 bps, due to maturing legacy fixed rate swaps that carried high pay-fixed interest rates.
Noninterest Income
The following table details the significant components of total noninterest income:
Three Months Nine Months Ended September 30 IncreaseEnded September 30 Increase 1 1 (dollars in millions) 2012 2011 (Decrease) 2012 2011 (Decrease) Service charges on deposits $141 $155 (9) % $423 $447 (5) % Net gains on sales of securities 52 24 NM 78 102 (24) Mortgage banking 49 - NM 135 25 NM ATM and debit card 41 78 (47) 127 225 (44) Other service fee income 38 39 (3) 110 110 - Trust and investment services revenue 32 34 (6) 98 99 (1) International fees 26 29 (10) 79 87 (9) Credit card fees 20 21 (5) 60 56 7 Bank-owned life insurance 13 12 8 38 36 6 Capital markets fee income 12 7 71 38 32 19 2 Other income (2) 8 NM 91 47 94 Total noninterest income $422 $407 4 % $1,277 $1,266 1 % 1 NM - not meaningful. Those changes over 100 percent were not considered to be meaningful. 2 Includes net impairment losses recognized in earnings, other net gains (losses), and other income Total noninterest income was $422 million for the three months ended September 30, 2012 and $1.3 billion for the nine months ended September 30, 2012, both up slightly from the prior year levels. Regulatory changes drove lower ATM and debit card revenue and lower deposit fees, mainly non-sufficient funds fees, partially offset by higher mortgage fees and net gains from the sale of securities. Mortgage banking fees increased $49 million and $110 million for the three and nine months ended September 30, 2012, respectively, compared to the three and nine months ended September 30, 2011. The increases in both periods were primarily driven by gains on sales of mortgage loans and lower impairment of mortgage servicing rights. ATM and debit card fees decreased $37 million, or 47%, and $98 million, or 44%, for the three and nine months ended September 30, 2012, respectively, compared to the three and nine months ended September 30, 2011. The decreases are primarily driven by implementation of The Durbin Amendment (see below) which limits the interchange fees that banks can charge to customers, and reduced overdraft fees resulting from Regulation E (see below). Capital markets fee income increased for the three and nine months ended September 30, 2012, $5 million, or 71%, and $6 million, or 19%, respectively, compared to the three and nine months ended September 30, 2011. The increase is due to increases in commercial syndication fees and referral fees. 7
RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The Durbin Amendment
The Durbin Amendment amended the Electronic Funds Transfer Act which, among other things, gave the Federal Reserve the authority to establish rules regarding interchange fees charged for electronic debit transactions by payment card issuers. In June 2011, the Federal Reserve issued a final rule that, among other things, established standards for determining whether an interchange fee received or charged by an issuer with respect to an electronic debit transaction is reasonable and proportional to the cost incurred by the issuer with respect to the transaction. These new standards took effect on October 1, 2011 and apply to issuers, such as RBS Citizens, that, together with their affiliates, have assets of $10 billion or more. Under the rule, the maximum permissible interchange fee for an electronic debit transaction is 21 cents per transaction and 4 basis points multiplied by the value of the transaction. The Federal Reserve also issued an interim final rule that allows for an upward adjustment of no more than one cent per transaction to an issuer’s debit card interchange fee if the issuer develops and implements policies and procedures reasonably designed to achieve the fraud-prevention standards set out in the interim final rule. The fraud-prevention adjustment was effective on October 1, 2011, concurrent with the debit card interchange fee limits.
Regulation E
The Federal Reserve also amended its Regulation E in a final rule that was issued in 2009 and became effective in the third quarter of 2010. This rule prohibits financial institutions from charging consumers fees for allowing overdrafts on ATM and debit card transactions, unless a consumer affirmatively consents, or opts in, to the overdraft service for those types of transactions. Consumers must be provided a notice that explains the financial institution’s overdraft services, including the fees associated with the services, and the consumer’s choice.
Noninterest Expense
The following table displays the significant components of noninterest expense: Three Months Nine Months Ended September 30 IncreaseEnded September 30 Increase (dollars in millions) 2012 2011 (Decrease) 2012 2011 (Decrease) Salaries and employee benefits $407 $408 (0) % $1,265 $1,210 5 % Equipment expense 86 86 - 257 254 1 Occupancy 83 87 (5) 242 253 (4) Outside services 76 90 (16) 239 243 (2) Promotional expense 22 25 (12) 64 78 (18) Other operating expense 117 147 (20) 494 443 12 Total noninterest expense $791 $843 (6) % $2,561 $2,481 3 %
Noninterest expense decreased $52 million, or 6%, in the three months ended September 30, 2012 compared to the three months ended September 30, 2011. Noninterest expense increased $80 million, or 3%, in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. The drivers for the increase were higher salaries and benefits and other operating expenses, offset by lower promotional and amortization of intangibles expense.
Outside services expense decreased $14 million, or 16%, in the three months ended September 30, 2012 compared to the three months ended September 30, 2011 due mainly to lower legal and consultant fees.
Promotional expense decreased $3 million, or 12%, in the three months ended September 30, 2012 compared to the three months ended September 30, 2011 due primarily to lower advertising costs of approximately $3 million. Additionally, promotional expense decreased $14 million, or 18%, in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, due to a $14 million decrease in advertising costs.
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Other operating expense decreased $23 million, or 17%, in the three months ended September 30, 2012 compared to the three months ended September 30, 2011. The main drivers for the decrease were an approximate $6 million decrease in credit cards rewards program expense, and a decrease in net other real estate owned and nonperforming assets expense of $12 million. Other operating expense increased $74 million, or 18%, in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011, reflecting a $138 million accrual to settle overdraft fee litigation and $3 million in one-time costs related to the sale of 57 New York branches. Offsetting the other operating expense increase, card rewards program expense decreased $23 million, and deposit insurance expense decreased $20 million. Nonperforming asset expense also decreased in the nine months ended September 30, 2012 compared to the nine months ended September 30, 2011. Excluding the impact of litigation and branch sale, noninterest expense declined by 2.5%
Provision for Income Taxes
The provision for income taxes was $123 million and $71 million, for the three months ended September 30, 2012 and 2011, respectively. The provision represents projected annualized effective tax rates of 37% and 35% for the three months ended September 30, 2012 and September 30, 2011, respectively. The provision for income taxes was $318 million and $205 million, for the nine months ended September 30, 2012 and 2011, respectively. The provision represents projected annualized effective tax rates of 37% and 35% for the nine months ended September 30, 2012 and September 30, 2011, respectively. The increase in the rate from 2011 to 2012 represents the incremental tax rate impact of a 2012 state tax settlement. The Company settled a state tax issue for the years 2003 through 2008 related to its real estate investment trust and various passive investment companies. Settlement of these uncertainties reduced the unrecognized tax benefit as of September 30, 2012 by $133 million.
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Analysis of Financial Condition
Securities Available-for-Sale (“AFS”)
RBS Citizens’ securities portfolio is managed to promote the maximization of return while maintaining prudent levels of quality, market risk and liquidity. Substantially all of the Company’s AFS securities are held for asset and liability management and liquidity management purposes. The table below presents RBS Citizens’ AFS portfolio. See further discussion of the Company’s AFS portfolio in the Consolidated Financial Statements.
September 30, 2012 December 31, 2011 Amort. Fair Amort. Fair Increase (dollars in millions) Cost Value Cost Value (Decrease) U.S. Treasury $15 $15 $15 $15 0 % State and political subdivisions 87 92 86 90 2 Other bonds, notes and debentures - - 1 1 (100) Mortgage-backed securities: Federal agencies and U.S. government sponsored entities 17,975 18,643 19,537 20,129 (7) Other 1,577 1,499 2,095 1,893 (21) Total mortgage-backed securities 19,552 20,142 21,632 22,022 (9) Total debt securities 19,654 20,249 21,734 22,128 (8) Marketable equity securities 5 7 8 10 (30) Other equity securities 12 12 12 12 - Total equity securities 17 19 20 22 (14) Total available-for-sale securities $19,671 $20,268 $21,754 $22,150 (8) %
The fair value of AFS securities decreased by $1.9 billion in the nine months ended September 30, 2012, or 8%, compared to December 31, 2011. U.S. Government-guaranteed and government sponsored entity issued mortgage-backed securities (“MBS”) comprise the majority of AFS holdings and are currently in excess of 90% of the total portfolio. Reinvestments have been directed predominantly into fixed rate products, and as of September 30, 2012, the AFS portfolio had an average life of 3.2 years. Given low long-term interest rates, additional reinvestment has been modest and at times focused on fulfilling Community Reinvestment Act requirements. Meanwhile, the “Other” non-agency MBS inventory, which ran-off during 2011, continued to do so in the first nine months of 2012 without reinvestment in this asset class. The market value of the portfolio has trended downward during the first nine months of 2012 due to slower reinvestment and slower than anticipated cash flows in the low rate environment.
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Loans and Leases
The following table shows the composition of total loans and leases. See further discussion of the Company’s loan and lease portfolio in the Consolidated Financial Statements.
September 30, December 31, Increase (dollars in millions) 2012 2011 (Decrease) Commercial $27,831 $25,770 8 % Commercial real estate 6,657 7,602 (12) Leases 3,218 3,164 2 Total commercial 37,706 36,536 3 Home equity lines of credit 16,777 16,666 1 Residential mortgages 9,535 9,719 (2) Home equity loans 5,476 6,766 (19) Home equity products serviced by others 3,134 3,624 (14) Automobile 8,734 7,571 15 Student and other installment 3,921 4,276 (8) Credit card 1,658 1,637 1 Total retail 49,235 50,259 (2) Total loans and leases $86,941 $86,795 0 %
Loan balances as of September 30, 2012, compared to December 31, 2011, reflected increases in commercial lending offset by declines in commercial real estate and home equity loans. In the first quarter of 2012, the Company purchased a portfolio of automobile loans with outstanding principal balances totaling $922 million. The following table is a summary of loans and leases by remaining maturity or repricing date:
September 30, December 31, Increase (dollars in millions) 2012 2011 (Decrease) Due in one year or less $45,675 $43,743 4 % Due after one year through five years 16,153 15,129 7 Due after five years 25,113 27,923 (10) Total loans and leases $86,941 $86,795 0 %
Allowance for Credit Losses & Nonperforming Assets
Overall Commercial Asset Quality
RBS Citizens’ commercial portfolio consists of traditional commercial and commercial real estate businesses. The portfolios are focused on high quality, in-footprint customers where the Company’s local delivery model provides for strong client connectivity with its bank subsidiaries. The core portfolio has experienced reasonable growth and sustained improvement in credit quality metrics since 2010. The majority of the growth has resulted from expansion of existing relationships and new client acquisition in the Company’s mid-corporate portfolio. Losses in the portfolio have been concentrated in commercial real estate and have moderated as underlying property values have stabilized and market supply and demand metrics have moved toward equilibrium. The trend of risk is stable and the trend of net charge-offs is improving.
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overall Retail Asset Quality
RBS Citizens’ retail portfolio focuses on the Company’s core footprint, targeting lower-risk products, owning (branch-based) or actively managing the origination channel (indirect auto), and maintaining conservative underwriting policies. The overall retail portfolio had a refreshed FICO score of 754 and real estate combined loan-to-value (“CLTV”) of 76.7% (excluding non-core home equity products, it was 73.0%) as of September 30, 2012. New origination portfolios continued to exhibit strong risk characteristics with an average FICO score of 779 and real estate CLTV of 64.5% in the third quarter of 2012. Asset quality continues to improve, which is reflected in downward trending delinquency and loss performance. Credit card and automobile net charge-off rates are near or below pre-crisis levels. The Company tightened credit policies in 2009 to address deteriorating economic conditions. The response included curtailing originations outside footprint states, focusing on branch-based originations, tightening FICO and loan- to-value (“LTV”) cutoffs, terminating third party mortgage broker channel, and enhancing collection activities. Over the past three years, RBS Citizens has intensely focused on organic / relationship lending and quarantined the few material purchased portfolios by including them in the non-core portfolio. The overall rate of delinquency more than 30 days improved 49 bps to 1.0% as of September 30, 2012 from 1.49% as of December 31, 2011, driven by favorable movement in residential mortgage, home equity, vehicle, and credit card. Further improvement in delinquencies and losses will depend on the pace of economic recovery, specifically related to unemployment and housing. Reserves and total loan coverage continued to trend down during the first nine months of 2012, but remained at levels commensurate with improvements in credit quality. Nonperforming loans increased due to recently issued Office of Comptroller of Currency (“OCC”) guidance regarding accounts that have been through a Chapter 7 Bankruptcy proceeding and not reaffirmed by the borrower; however, the reserve coverage for losses remains adequate as of September 30, 2012
Provision for Credit Losses
Due to recovering asset quality requiring lower reserve coverage and improving loss trends, the provision for credit losses for the nine months ended September 30, 2012 was $311 million, which was a 55% decrease from the same period in 2011. Net charge-offs were $685 million for the nine months ended September 30, 2012, which was a 18% decline compared to net charge-offs of $832 million for the nine months ended September 30, 2011. Included in third quarter net charge-offs are $71 million in write-offs related to the recently issued OCC guidance on Chapter 7 Bankruptcy. In addition, $274 million of performing loans were moved to nonaccrual status upon implementation of the new OCC guidance. Continued improvement in the credit cycle and a $131 million increase in loan assets at September 30, 2012 compared to the same period in 2011, allowed for measured reduction in the allowance for loan and lease losses.
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Non-Core Assets
In the second quarter of 2009, approximately $20.5 billion of assets were designated as non-core. These loans and other assets were designated as non-core assets principally because they are included in portfolios that are not considered to be strategic to the Company’s core business strategy (e.g., out of footprint, in asset classes and customer sets that were being de-marketed, or credit impaired.) Through September 30, 2012, the Company decreased non-core assets by more than two-thirds by actively managing down the portfolio.
The table below is a composition of RBS Citizens’ non-core assets as of the dates indicated:
(Date of Designation) September 30, December 31, June 30, Decrease Decrease (dollars in millions) 2012 2011 2009 from 2011 from 2009 Home equity products serviced by others $3,072 $3,583 $6,180 (14) % (50) % Commercial real estate 980 1,554 3,412 (37) (71) Student and other installment 898 1,173 4,763 (23) (81) Residential mortgages 715 933 1,467 (23) (51) Commercial 238 362 1,900 (34) (87) Home equity loans 191 226 384 (15) (50) Home equity lines of credit 144 162 231 (11) (38) Credit card 101 146 995 (31) (90) Automobile 62 140 769 (56) (92) Other assets 126 126 378 - (67) Total Non-Core Assets $6,527 $8,405 $20,479 (22) % (68) %
Since designating certain loans and other assets as non-core in 2009, RBS Citizens has reduced the balance in non- core assets: run-off of approximately $9 billion, including $1 billion of run-off in the first nine months of 2012;
net charge-offs of approximately $3.5 billion, including $308 million of net charge-offs in the first nine months of 2012;
$2 billion of transfers to RBS Citizens’ core portfolio, including the transfer of $1.6 billion of recreational vehicle (“RV”) and marine loans to the Company’s core portfolio in the fourth quarter of 2011; and
$1 billion of sales, including a $530 million sale of credit card receivables in the second quarter of 2010 and a $393 million sale of RV and marine loans in the third quarter of 2011.
Non-core assets are expected to continue to decline through a combination of the factors described above.
Retail Non-Core SBO Portfolio
The home equity products serviced by others (“SBO”) portfolio consists of purchased pools of home equity loans and lines of credit. This portfolio represents 8.8% of the entire real estate portfolio and 6.2% of the overall retail portfolio as of September 30, 2012. The SBO portfolio has experienced an annualized charge-off rate of 9% and a cumulative charge-off rate of 24.6% as of the third quarter of 2012, due to poor geographical concentrations, high second lien concentration (95%), and continued weakness in the housing sector, creating high loan-to-value exposure. SBO has been closed to new purchases since the third quarter of 2007 and is in run-off, with outstandings down to $3.1 billion as of
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
September 30, 2012 from $3.6 billion as of December 31, 2011 and a peak balance of $9.0 billion in July 2007. The performance of SBO continues to improve with delinquencies and losses decreasing year-over-year. The rate of delinquency greater than 90 days as of September 30, 2012 continued to trend lower at 1.9%, which was 4 bps lower than as of September 30, 2011. The continued improvement in performance is due to portfolio liquidation (the weakest loans have been charged-off), as well as more effective account servicing and collections, following a servicer conversion in 2009.
Commercial Non-Core Portfolio
The commercial non-core portfolio consists of commercial real estate and commercial loans that do not fit the current strategy of RBS Citizens due to geographic location, industry or product type. These loans have been actively managed down over the last three years. RBS Citizens has reported consistent reduction in commercial non-core balances and significant reductions in the net charge-offs attributed to this portfolio through September 30, 2012. The portfolio reduction has been accomplished through active remediation strategies, including individual note and portfolio sales, contractual repayments, successful refinancing by other institutions and net charge-offs. The bulk of the commercial non- core portfolio at September 30, 2012 was comprised of amortizing commercial real estate loans. The Company has a portfolio management process that revalues the underlying collateral coverage and has recognized losses proactively when the collateral values are not protective. The trend of loss has significantly decreased through September 30, 2012. The Company continues to work down the balance of this legacy portfolio.
Deposits
The table below presents RBS Citizens’ major components of deposits. See further discussion of the Company’s deposits in the Consolidated Financial Statements.
September 30, December 31, Increase (dollars in millions) 2012 2011 (Decrease) Demand $27,114 $23,040 18 % Checking with interest 13,683 17,328 (21) Regular savings 7,943 7,906 0 Money market accounts 34,469 29,184 18 Term deposits 13,272 15,430 (14) Total deposits $96,481 $92,888 4 %
Total deposits at September 30, 2012 were $96.5 billion, compared with $92.9 billion at December 31, 2011. Deposits remained stable overall but reflect a shift from higher-cost term deposits and government deposits and into demand and personal money market accounts. Checking with interest declined $3.6 billion, or 21%, and was primarily attributable to a $1.9 billion transfer of checking with interest deposits into demand deposits as part of a program to exit certain government banking markets. Additionally, term deposits decreased $2.2 billion, or 14%, reflecting the continued run-off of expensive term deposits, and money market accounts increased 18% from December 31, 2011.
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Borrowed Funds
The table below presents the Company’s borrowed funds. See further discussion of RBS Citizens’ borrowed funds in the Consolidated Financial Statements.
September 30, 2012 December 31, 2011 Increase (dollars in millions) Amount Rate Amount Rate (Decrease) Royal Bank of Scotland Group: Subordinated debt, due 2034, LIBOR + 1.50% with quarterly resets $289 1.96% $506 1.87% (43) % Other borrowings: Subordinated debt, due 2022 350 4.15% - - 100 FHLB fixed rate advances with original maturity under one year 500 0.27% 1,100 0.15-0.17% (55) FHLB variable rate advances with semi-annual resets, due 2013 3,500 0.26-0.32% 4,250 0.15-0.47% (18) FHLB fixed rate advances, due 2013 - 2033 27 0.00-6.60% 27 0.00-6.60% - Fixed rate, subordinated debt, due 2012 - - 401 6.38% (100) Other 33 various 58 various (43) Total borrowed funds $4,699 $6,342 (26) %
RBS Citizens’ structural liquidity is strong, as deposits exceed loans by $9.5 billion at September 30, 2012. Short- term unsecured borrowings are minimal and are offset by $2 billion in average excess reserves held at the Federal Reserve Bank (“FRB”) at September 30, 2012. Other borrowings include capital instruments and secured Federal Home Loan Bank (“FHLB”) advances. Additionally, asset liquidity is considered strong. At September 30, 2012, unencumbered high-quality securities totaled $15.1 billion; unused FHLB capacity was approximately $5.9 billion; and unencumbered loans pledged at the FRBs created additional contingent borrowing capacity of approximately $12.6 billion. Asset liquidity is projected to remain at historically high levels, providing access to funds as needed through repurchase agreements, collateralized borrowings, or asset sales. Additionally, there appears to be substantial capacity to grow deposits. While access to short-term wholesale markets is limited, the Company has been able to meet its funding needs for the medium term with deposits and collateralized borrowings.
Derivatives
Historically, RBS Citizens has used “plain vanilla” pay-fixed swaps to synthetically lengthen liabilities, offsetting duration in fixed-rate assets. With material prepayment of fixed-rate mortgages and home equity loans since 2008, these swaps were no longer needed. Most have been terminated or allowed to run-off. The assets and liabilities for derivatives designated as hedges reflect the market value of these hedge instruments. The Company also sells interest rate swaps and foreign exchange forwards to commercial customers, and offsets these transactions with RBS Group. The assets and liabilities for derivatives not designated as hedges reflect the market value of these transactions.
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The table below presents RBS Citizens’ derivative assets and liabilities. See further discussion of the Company’s derivative instruments in the Consolidated Financial Statements.
September 30, 2012 December 31, 2011 Notional Notional Increase 1 1 (dollars in millions) Amount Assets Liabilities Amount Assets Liabilities (Decrease) Derivatives designated as hedging instruments: Interest rate contracts $5,200 $1 $304 $9,200 $1 $476 (36) % Derivatives not designated as hedging instruments: Interest rate contracts 32,272 1,209 1,150 30,114 1,243 1,146 (39) Foreign exchange contracts 6,581 76 71 5,731 86 82 25 Other contracts 1,730 59 29 1,377 27 14 131 Total derivatives not designated as hedging instruments 1,344 1,250 1,356 1,242 (18) Gross derivative fair values $1,345 $1,554 $1,357 $1,718 (42) % Less: Counterparty netting2 (66) (66) (70) (70) Total derivative fair values $1,279 $1,488 $1,287 $1,648
1 The notional or contractual amount of interest rate derivatives and foreign exchange contracts is the amount upon which interest and other payments under the contract are based. For interest rate derivatives, the notional amount is typically not exchanged. Therefore, notional amounts should not be taken as the measure of credit or market risk as they tend to greatly overstate the true economic risk of these contracts. 2 Amounts represent the impact of legally enforceable master netting agreements that allow the Company to settle positive and negative positions.
Capital Resources
As a BHC and a FHC, RBS Citizens is subject to regulation and supervision by the Federal Reserve. The two primary subsidiaries of RBS Citizens are its two insured depository institutions, RBS Citizens, N.A., a national banking association whose primary federal regulator is the OCC, and Citizens Bank of Pennsylvania, a Pennsylvania-charted savings bank regulated by the Department of Banking of the Commonwealth of Pennsylvania and supervised by the FDIC as its primary federal regulator. RBS Citizens is currently subject only to requirements to maintain a minimum total risk-based capital (or “Total Capital”) ratio, Tier 1 Capital ratio, and Tier 1 Leverage ratio. The minimum standards for the Total Capital ratio (the ratio of the Company’s “Total Capital,” or the sum of its Tier 1 and Tier 2 Capital, to total risk-weighted assets) and Tier 1 Capital ratio (the ratio of the Company’s Tier 1 Capital to total risk-weighted assets) are 8.0% and 4.0%, respectively. The minimum Tier 1 Leverage ratio (the ratio of a banking organization’s Tier 1 Capital to total adjusted quarterly average assets, as defined for regulatory purposes) is 3.0% for BHCs that either have the highest supervisory rating or have implemented the Federal Reserve’s risk-adjusted measure for market risk. The minimum Tier 1 Leverage ratio for all other BHCs is 4.0%, unless a different minimum is specified by the Federal Reserve.
RBS Citizens and its subsidiary banks continue to anticipate implementation of the Basel III regime in the U.S., including as proposed, in part, in the three Notice of Proposed Rulemaking (“NPRs”) published by the U.S. banking agencies in the Federal Register on August 30, 2012. New regulatory capital requirements are expected to include a five- year phase in of new regulatory capital minimums for purposes of capital adequacy and to begin sometime after the first quarter of 2013 as well as certain changes and additions to the regulatory ratios under the FDIC’s prompt corrective action framework beginning in 2015. In addition, the NPRs outline a plan to adopt a new “standardized” methodology for calculating general risk-based capital requirements that will apply to all BHCs and insured depository institutions beginning in 2015. 16
RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
By targeting all regulatory ratios to fully phased-in Basel III minimums, including required capital conservation buffers and an additional cushion for various uncertainties, RBS Citizens maintains strong ratios compared to its current regulatory minimums. In addition, the Company believes that it is well-positioned for the implementation of Basel III. The table below provides a comparison of RBS Citizens’ regulatory ratios as of September 30, 2012, calculated under both current Basel I and proposed Basel III methodologies, including application of the “standardized approach” to risk- weighting assets used in Basel III calculations, versus current and proposed regulatory minima.
Regulatory Ratios as of September 30, 2012 Basel I vs. Basel III Rules
Pro Forma Basel III Ratios and Requirements (including Regulatory Ratio Basel I Ratios and Requirements adoption of U.S. Standardized Approach Risk-Weighted Assets)
Well-Capitalized Required Minimum + Well-Capitalized Actual Pro Forma Required Minimum for Purposes Required Capital Minimum for Purposes Basel I Basel III Minimum of Prompt Corrective Conservation Buffer for of Prompt Corrective Ratio Ratio Action Non-Leverage Ratios Action
Common Equity Tier 1 Not Capital to Risk Weighted 13.80% Not Applicable 12.30% 7.00% 6.50% Applicable Assets
Tier 1 Capital to Risk 14.10% 4.00% 6.00% 12.30% 8.50% 8.00% Weighted Assets
Total Capital to Risk 15.70% 8.00% 10.00% 14.10% 10.50% 10.00% Weighted Assets
Tier 1 Capital to Average Total Assets (Tier 1 11.90% 3.00% 5.00% 11.70% 4.00% 5.00% Leverage)
In addition, the Federal Reserve has issued proposed rules that would be applicable to BHCs, including RBS Citizens, with total consolidated assets of $50 billion or more. When issued in final form, these rules will implement further enhanced prudential standards for Systemically-Important Financial Institutions (“SIFIs”) under The Dodd-Frank Act, including with respect to risk-based capital requirements, leverage limits and liquidity requirements for certain large, interconnected financial institutions such as RBS Citizens. Assessment of capital adequacy for RBS Citizens and its subsidiary banks is an ongoing and integrated process. This assessment process annually feeds development of capital plans that are now submitted to the Federal Reserve under the Federal Reserve’s final rule, published in November 2011, requiring U.S. BHCs, including RBS Citizens, with $50 billion or more of total consolidated assets, to submit annual capital plans in which the Company must set forth a range of information. The Company refers to the capital analysis and review process provided for in the rule known as the “Capital Plan Rules.” Additionally, under the Capital Plan Rules, RBS Citizens may only take certain capital actions, including payment of dividends and repurchases of securities, in accordance with a capital plan that the Federal Reserve has reviewed and to which the Federal Reserve has not objected. RBS Citizens submitted its first annual capital plan under the Capital Plan Rules in January 2012. RBS Citizens’ capital adequacy assessment process begins with the Company’s risk appetite and risk management framework, which provides for the identification, measurement and management of material risks. Required capital is determined for actual / forecasted risk portfolios using applicable U.S. Basel I methodologies and any estimated impacts of outstanding regulatory proposals as they apply to future periods. The base case forecasting process is supplemented by key analytical frameworks, including integrated stress testing and an internal capital adequacy requirement, which builds on internally-assessed economic capital requirements. These supplemental frameworks enable the comprehensive assessment of capital adequacy versus unexpected loss. RBS Citizens’ Capital Adequacy Process is supported by a robust governance framework. This process includes: 1) capital management policies and procedures, which document internal capital
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS adequacy metrics and limits and a comprehensive capital contingency plan, as well as 2) the active engagement of both the legal entity boards and senior management in oversight and decision-making. Prior to June 2012, RBS Citizens had not paid a common dividend since December 2007. Given sustained profitability throughout 2011, strong capital levels, and the stabilized economic environment, the Company incorporated quarterly dividends and other capital distributions in the 2012 capital plan that was submitted to the Federal Reserve in January 2012. This plan was submitted in accordance with requirements of the Capital Plan Rules, and the Federal Reserve made no objection to these actions. RBS Citizens’ Board of Directors expects to continue to review quarterly earnings performance and to consider declaring quarterly dividends that are consistent both with regulatory requirements under the Capital Plan Rules and with internal policy standards. To date, RBS Citizens has completed the following capital actions for 2012: Common dividends of $40 million and $55 million were declared and paid in June 2012 and September 2012, respectively;
$206 million of floating rate junior subordinated deferrable interest debentures due March 4, 2034 were redeemed June 27, 2012;
$8 million of 10.18% junior subordinated deferrable interest debentures due June 8, 2031 were redeemed July 2, 2012;
$8 million of 10.875% junior subordinated deferrable interest debentures due March 8, 2030 were redeemed on September 8, 2012; and
$350 million of 4.15% Tier 2 qualifying subordinated notes due September 28, 2022 were issued under Rule 144A / Reg S on September 28, 2012.
Critical Accounting Policies
RBS Citizens’ Consolidated Financial Statements are prepared in accordance with U.S. GAAP. The preparation of financial statements in conformity with U.S. GAAP requires RBS Citizens’ to establish accounting policies and make estimates that affect amounts reported in the Company’s Consolidated Financial Statements. Note 1 of the Notes to the Consolidated Financial Statements, which is incorporated by reference into this MD&A, describes the significant accounting policies used in the Consolidated Financial Statements. An accounting estimate requires assumptions and judgments about uncertain matters that could have a material effect of the Consolidated Financial Statements. Estimates are made using facts and circumstances known at a point in time, and changes in those facts and circumstances could produce results substantially different from those estimates. The most significant accounting policies and estimates and their related application are discussed below.
Allowance for Credit Losses Management’s estimate of probable credit losses in RBS Citizens’ loan portfolios is recorded in the allowance for loan and lease losses and the reserve for unfunded lending commitments. The Company evaluates the adequacy of the allowance for loan and lease losses by performing reviews of certain individual loans and leases, analyzing changes in the composition, size and delinquency of the portfolio, reviewing previous loss experience, and considering current and anticipated economic factors. The allowance is maintained at a level which management considers to be adequate based on the results of this evaluation, and is established through charges to earnings in the form of a provision for credit losses. Amounts determined to be uncollectible are deducted from the allowance and subsequent recoveries, if any, are added to the allowance. While management uses available information to estimate loan losses, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review RBS Citizens’ allowance for credit losses. Such agencies may require the Company to
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS recognize changes to the allowance based on their judgment of information available to them at the time of their examination. The allowance for loan and lease losses includes allocated and unallocated reserves. The allocated reserve is attributable to certain individual impaired loans and to pools of loans. The reserve for pools of loans is calculated using models sensitive to credit factors such as loan payment status and historical loss rates adjusted to reflect current conditions. The unallocated reserve provides a supplemental contingency for the allocated reserve and protects against latent or embedded losses in the overall loan portfolio and model imprecision. It reflects factors that apply to the portfolio as a whole and that are difficult to attribute to individually impaired loans or to groups of loans. These factors include changing underwriting criteria, changes in the types and mix of loans originated, industry concentrations and evaluations, allowance levels relative to selected overall credit criteria and other economic indicators used to estimate probable incurred losses. In addition to the allowance for loan and lease losses, the Company also estimates probable credit losses associated with off-balance sheet financial instruments such as letters of credit, financial guarantees and binding unfunded loan commitments. Off-balance sheet commitments are subject to individual reviews and are analyzed and segregated by risk according to the Company’s internal risk rating scale. These risk classifications, in conjunction with historical loss experience, economic conditions and performance trends within specific portfolio segments, result in the estimate of the reserve for unfunded lending commitments. Additional information regarding RBS Citizens’ allowance for credit losses can be found in the Notes to the Consolidated Financial Statements. Nonperforming Loans and Leases Commercial loans, commercial real estate loans, and leases are generally placed on nonaccrual status when contractually past due 90 days or more, or earlier if management believes that the probability of collection is insufficient to warrant further accrual. Some of these loans and leases may remain on accrual status when contractually past due 90 days or more if management considers the loan collectible. A loan may be returned to accrual status if (1) principal and interest payments have been brought current, and the Company expects repayment of the remaining contractual principal and interest, (2) the loan or lease has otherwise become well-secured and in the process of collection, or (3) the borrower has been making regularly scheduled payments in full for the prior six months and it’s reasonably assured that the loan or lease will be brought fully current within a reasonable period. Residential mortgages are generally placed on nonaccrual status when past due 120 days, or sooner if determined to be collateral-dependent. Residential mortgages are returned to accrual status when principal and interest payments become less than 120 days past due and when future payments are reasonably assured. Home equity loans and lines of credit, home equity products serviced by others, automobile loans, and other installment loans are generally placed on nonaccrual status when past due 90 days or more. Loans less than 90 days past due may be placed on nonaccrual status upon the death of the borrower, surrender or repossession of collateral, or bankruptcy. Non-guaranteed student loans are placed on nonaccrual status when they become 90 days past due or in the event of fraud, bankruptcy, or the borrower’s death. A loan may be returned to accrual status if the loan becomes less than 15 days past due. Guaranteed student loans are not placed on nonaccrual status. Credit card balances are placed on nonaccrual status when past due 90 days or more. They are restored to accruing status if they subsequently become less than 90 days past due. Cash receipts on nonaccruing loans and leases are generally applied to reduce the unpaid principal balance. Impaired Loans Loans and leases are generally placed on nonaccrual status when certain delinquency thresholds have been reached, or earlier if management believes the probability of collection is sufficient to warrant further accrual. Delinquency thresholds vary by loan type. Generally, a loan that has been partially charged-off may not be returned to accrual status. A loan is considered to be impaired when it is probable that the Company will be unable to collect all of the contractual interest and principal payments as scheduled in the loan agreement. Impaired loans include nonaccruing larger balance (greater than $3 million carrying value) non-homogenous commercial and commercial real estate loans, and restructured loans which are deemed troubled debt restructurings (“TDRs”). A loan is identified as a TDR when the Company grants the borrower a concession the Company would not otherwise make in response to the borrower’s financial difficulties. Concessions granted in TDRs for all classes of loans may include lowering the interest rate, forgiving a portion of principal, extending the loan term, lowering scheduled payments for a specified period of time, principal forbearance, or 19
RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS capitalizing arrearages. A rate increase can be a concession if the increased rate is lower than a market rate for debt with risk similar to that of the restructured loan. Additionally, TDRs for commercial loans and leases may also involve creating a multiple note structure, accepting non-cash assets, accepting an equity interest, or receiving a performance-based fee. In some cases a TDR may involve multiple concessions. The financial effects of TDRs for all loan classes may include lower income (either due to a lower interest rate or a delay in the timing of cash flows), larger loan loss provisions, and accelerated charge-offs if the modification renders the loan collateral-dependent. In some cases interest income may increase if, for example, the loan is extended or the interest rate is increased as a result of the modification. Impairment evaluations are performed at the individual loan level, and consider expected future cash flows from the loan, including, if appropriate, the realizable value of collateral. Impaired loans which are not TDRs are nonaccruing, and loans involved in TDRs may be accruing or nonaccruing. Consumer loans that are discharged in Chapter 7 Bankruptcy are deemed to be collateral-dependent and are charged-off to the value of the collateral, less cost to sell, and less amounts recoverable under a government guarantee. Collateral dependent consumer loans are moved to nonaccrual status regardless of the payment history. Cash receipts on nonaccruing impaired loans, including nonaccruing loans involved in TDRs, are generally applied to reduce the unpaid principal balance. Loans are generally restored to accrual status when principal and interest payments are brought current and when future payments are reasonably assured, following a sustained period of repayment performance by the borrower in accordance with the loan’s contractual terms. Nonaccruing loans for all classes that are modified in a TDR are generally returned to accrual status after the borrower has made payments of cash or cash equivalents under the revised terms for at least six months subsequent to the restructuring date, and if management believes that all contractual payments due under the revised terms are collectible. Fair Value The Company measures fair value using the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is based upon quoted market prices in an active market, where available. If quoted prices are not available, observable market-based inputs or independently sourced parameters are used to develop fair value, whenever possible. Such inputs may include prices of similar assets or liabilities, yield curves, interest rates, prepayments speeds, and foreign exchange rates. Assets and liabilities carried at fair value inherently result in a higher degree of financial statement volatility. RBS Citizens’ assets and liabilities carried at fair value include available-for-sale securities, private equity investments, and derivative instruments. In addition, the Company elects to account for its residential mortgages held-for-sale at fair value. The Company classifies its assets and liabilities that are carried at fair value in accordance with the three-level valuation hierarchy: Level 1. Quoted prices in active markets for identical assets or liabilities.
Level 2. Observable inputs other than Level 1 prices; examples include quoted prices for similar instruments, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by market data for substantially the full term of the asset or liability.
Level 3. Unobservable inputs that are supported by little or no market information and that are significant to the fair value measurement.
Classification in the hierarchy is based upon the lowest level input that is significant to the fair value measurement of the asset or liability. For instruments classified in Level 1 and 2 where inputs are primarily based upon observable market data, there is less judgment applied in arriving at the fair value. For instruments classified in Level 3, management judgment is more significant due to the lack of observable market data. RBS Citizens reviews and updates the fair value hierarchy classifications on a quarterly basis. Changes from one quarter to the next related to the observability of inputs in fair value measurements may result in a reclassification between the fair value hierarchy levels and are recognized based on period-ending balances. Fair value is also used on a nonrecurring basis to evaluate certain assets for impairment or for disclosure purposes. Examples of nonrecurring uses of fair value include MSRs accounted for by the amortization method, loan impairments for certain loans, and goodwill impairment. Additional information regarding RBS Citizens’ fair value measurements can be found in the Notes to the Consolidated Financial Statements. 20
RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Goodwill and Intangible Assets Goodwill is an intangible asset representing the difference between the purchase price of an acquired business and the net fair value of its assets and liabilities. Goodwill is not amortized, but is subject to an annual impairment test. The goodwill impairment analysis is a two-step test. The first step, used to identify potential impairment, involves comparing each reporting unit’s fair value to its carrying value including goodwill. If the fair value of a reporting unit exceeds its carrying value, applicable goodwill is deemed to be not impaired. If the carrying value exceeds fair value, there is an indication of impairment and the second step is performed to measure the amount of impairment. The second step involves calculating an implied fair value of goodwill for each reporting unit for which the first step indicated impairment. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination, which is the excess of the fair value of the reporting unit, as determined in the first step, over the aggregate fair values of the individual assets, liabilities and identifiable intangible assets as if the reporting unit was being acquired in a business combination. If the implied fair value of goodwill exceeds the goodwill assigned to the reporting unit, there is no impairment. If the goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss recognized cannot exceed the amount of goodwill assigned to a reporting unit, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment losses is not permitted. Significant judgment is applied when goodwill is assessed for impairment. This judgment includes developing cash flow projections, selecting appropriate discount rates, identifying relevant market comparables, incorporating general economic and market conditions, and selecting an appropriate control premium. The selection and weighting of the various fair value techniques may result in a higher or lower fair value. Judgment is applied in determining the weightings that are most representative of fair value. Due to current economic and other uncertainties, it is possible that RBS Citizens’ estimates and assumptions may adversely change in the future. The Company may be required to record goodwill impairment losses in future periods, whether in connection with the Company’s next annual impairment testing or prior to that time, if any changes constitute a triggering event. Additional information regarding RBS Citizens’ goodwill impairment tests can be found in the Notes to the Consolidated Financial Statements.
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Off-Balance Sheet Arrangements
The following table presents RBS Citizens’ outstanding off-balance sheet commitments. See further discussion of the Company’s off-balance sheet arrangements in the Consolidated Financial Statements.
September 30, December 31, Increase (dollars in millions) 2012 2011 (Decrease) Commitment amount: Undrawn commitments to extend credit $53,271 $49,347 8 % Financial standby letters of credit 3,880 4,259 (9) Performance letters of credit 160 146 10 Commercial letters of credit 102 105 (3) Marketing rights 57 60 (5) Risk participation agreements 32 33 (3) Residential mortgage loans sold with recourse 17 13 31 Fund investment commitments 5 14 (64) Total $57,524 $53,977 7 %
Enterprise Risk Management
RBS Citizens defines risk appetite as the maximum limit of acceptable risk, beyond which the Company would be unable to achieve its strategic objectives, or would assume an unacceptable amount of risk in order to do so. RBS Citizens’ risk appetite contains four main objectives (i.e., maintain capital adequacy of 7% post-stress Tier 1 common, deliver stable earnings growth, maintain stable and efficient access to funding and maintain stakeholder confidence) and their associated measures. By including the capital adequacy target of 7% post-stress Tier 1 common within the risk appetite, RBS Citizens has made an explicit linkage between the risk appetite and the capital adequacy process. The Company considers the 7% post-stress Tier 1 common requirement when reviewing both the adequacy of capital targets and the post-stress buffer. As an additional control, and in line with RBS Citizens’ risk appetite, it has also implemented an earnings volatility target, that requires the Company to remain profitable under severe stress events and appropriately capitalized under extreme stress events. As a banking organization regulated under U.K. law, RBS Group exercises enterprise-wide management over all of its subsidiaries, including RBS Citizens. Therefore, RBS Citizens must also manage its risks consistent with the maximum limit of risk acceptable to RBS Group. Pursuant to a cease and desist order entered into by RBS Group with the Federal Reserve and certain state banking supervisors in 2011 (the “Cease and Desist Order”), RBS Group was required to strengthen its U.S. corporate governance structure and develop an enterprise-wide risk management program, among other requirements with respect to its U.S. operations, which include RBS Citizens.
RBS Citizens maintains a governance structure that delineates the responsibilities for risk management activities, as well as governance and oversight of those activities, by management and the Board of Directors. Board members have access to executive management and are provided frequent and periodic management updates, including reports from Risk Management, Finance and Treasury, and RBS Group Internal Audit. Managing risk is an essential component of RBS Citizens’ business. Risk identification and monitoring are key elements in overall risk management. The following principal risks, which have been incorporated into RBS Citizens’ risk management program, consistent with RBS Group’s enterprise-wide risk management program and the governance standards imposed by the Cease and Desist Order, include:
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Credit Risk
Credit risk represents the potential for default or loss resulting from an obligor’s failure to meet the terms of any contract with RBS Citizens’, or its subsidiaries, or failure otherwise to perform as agreed. Credit risk arises from all activities where success depends on counterparty, issuer, or borrower performance. Credit Policy administers the Credit Approval Framework that controls the underwriting and approval of new business for the Company. Risk Policy Committees govern all changes to the consumer and commercial credit policies. The Credit Approval Framework vests credit authority in select individuals throughout the Company. Transactions must be approved by designated personnel and the level of approval escalates based on the size and complexity of the transaction. RBS Citizens is currently focused on streamlining and simplifying the Credit Policy and supporting procedures without compromising asset quality and sound lending processes. Credit Portfolio Management oversight resides with assigned retail and commercial credit officers who are focused on transactions and portfolio management capabilities. Concentration limits for asset classes and sectors are formally approved by the Risk Policy and Risk Concentration Risk Committees and approved by the Chief Credit Officer. Credit officers are responsible for monitoring the performance of assigned portfolios, credit policy compliance and adherence to concentration limits. Credit officers, partner with the line of business to conduct regular portfolio reviews to identify and remediate risks and to execute on portfolio management strategies, including decisions on sales of assets, participation levels, leveraged lending arrangements and watched asset reviews. A recovery group of credit professionals is engaged in the restructuring, remediation and collection of stressed loan relationships. An independent model validation function delivers objective validation assessments for all models in the decision support framework. RBS Citizens’ Risk Architecture Center of Excellence centralizes all activities associated with the oversight of risk systems, data, analytics, and reporting. Risk Architecture manages a single, integrated roadmap of projects to enhance its risk and capital management capabilities, inclusive of key risk initiatives around the regulatory reform agenda. These include Basel II, economic capital enhancements, comprehensive capital analysis and review, stress testing and Dodd-Frank Act compliance. Relationship managers are responsible for all aspects of the credit relationship including sales negotiations, profitability, underwriting, regulatory compliance, documentation, portfolio administration, and problem loan identification. Relationship managers seek to ensure that the proper probability of default and loss given default ratings are assigned to the credit at all times and continuously monitored and managed based on all information received. Relationship management also entails oversight and liaison with other areas of RBS Citizens whenever appropriate, particularly in deteriorating scenarios. Relationship management teams may be comprised of team leaders, relationship managers, portfolio management analysts, underwriters and lending analysts. Every member of the team plays a critical role and shares a significant level of responsibility, however, the relationship manager assigned to the credit ultimately is charged with the primary credit stewardship responsibilities and accountability.
Interest Rate Risk
Interest rate risk is the risk to earnings or capital arising from movement of interest rates. It arises from differences in the maturity and / or re-pricing of assets and liabilities, including the impact of interest-rate-related options embedded in bank products. The primary objectives of interest rate risk management are to identify the nature and estimate the magnitude of interest rate risk in the structural (non-trading) balance sheet, place limits on that risk reflecting risk tolerance, and then manage the risk within those limits. All of RBS Citizens’ interest rate risk measures are within current limits. RBS Citizens’ structural interest rate risk position is asset-sensitive. Net interest income would benefit from rising rates, as loan assets would generally re-price upward faster than customer deposits. Adverse exposure to declining rates is limited by the low starting level of rates. The primary drivers of this adverse exposure include prepayment risk for mortgage-related assets, pricing floors on retail deposits, and rollover risk for fixed-rate assets, all of which become magnified at low interest rate levels. Given the prolonged period of low interest rates, the cumulative impact of rollover risk grows.
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Liquidity Risk
Liquidity risk is defined as the risk that RBS Citizens or any of its subsidiaries / affiliates are unable to meet their contractual or potential payment obligations in a timely manner. This risk can be broken down into asset liquidity risk and funding liquidity risk. Asset liquidity risk arises when changes in the market conditions make the liquidation of certain assets difficult and substantially reduces the liquidation value of such assets. Funding liquidity risk refers to the inability of the Company to honor its payment obligations due to difficulties raising funds from counterparties and / or depositors. RBS Citizens’ considers the effective and prudent management of wholesale funding and liquidity to be fundamental to the health and strength of the Company. Liquidity risk is measured and managed within approved policy guidelines as determined by the Board of Directors, the RBS Citizens Asset and Liability Management Committee and RBS Group Asset Liability Committee. The Wholesale Funding and Liquidity unit monitors various key liquidity metrics for each bank and RBS Citizens on stand-alone and consolidated bases daily. Net overnight position, free securities, internal liquidity, available FHLB capacity, and total asset liquidity are calculated on a spot basis and forecasted monthly over a one-year horizon. This forecast is intended to identify emerging balance sheet trends and inform funding decisions. RBS Citizens’ stress testing indicates that sufficient liquidity would be maintained even in a long and severe crisis. The Company’s inherent liquidity risk is moderate, due to RBS Citizens’ stable core deposits and significant high-quality assets. Asset liquidity, which remains at historic high levels, is comprised primarily of unencumbered securities and unused FHLB capacity. Other wholesale funding includes stable FHLB advances as well as certain other cost-advantaged funding. Precautionary excess cash balances are generally maintained at the FRB. As traditional sources of wholesale funding remain relatively limited, RBS Citizens’ continues to manage with no reliance on wholesale markets, with ample liquidity due to stable deposits, and with contingent liquidity provided by high quality assets.
Market Risk
Market risk is defined as the risk of loss resulting from changes in market prices as a result of changes in rates, credit and liquidity or general economic conditions. Market risk at RBS Citizens is limited to the risk of loss resulting from derivative products entered into to meet the financing needs of the Company’s customers. To effectively eliminate the market risk associated with customer derivative products, RBS Citizens simultaneously enters into offsetting derivative agreements with RBS Group. Additionally, RBS Citizens enters into foreign exchange contracts on behalf of customers for the purpose of hedging exposure related to cash orders, loans, and deposits denominated in a foreign currency. The primary risks associated with these transactions arise from exposure to changes in foreign currency exchange rates and the ability of the counterparties to meet the terms of the contract. To effectively eliminate the market risks associated with these risks, the Company simultaneously enters into offsetting foreign exchange contracts with RBS Group.
Operational Risk
Operational risk represents the possibility that inadequate or failed systems and internal controls or procedures, human error, fraud or external influences such as disasters, can cause losses. RBS Citizens’ risk management framework is embedded in the business through the Three Lines of Defense Model which defines responsibilities and accountabilities. The business units (including business areas and support functions) are the First Line of Defense and are accountable for owning and managing, within a defined risk appetite, the risks which exist in their business area. These include establishing and maintaining risk assessments to identify and assess the material risks that arise in their area of responsibility, complying with relevant RBS Group Policies, testing and certifying the adequacy and effectiveness of their controls on a regular basis, establishing and documenting operating procedures, establishing and owning a governance structure for identifying and managing risk, and for defining and approving an appropriate risk appetite. The Second Line of Defense includes independent monitoring and control functions accountable for owning and developing the risk and control frameworks and tools which the business uses to discharge its responsibilities. Monitoring and control functions include the management and oversight of risk, financial management and valuation, and legal and regulatory compliance. The Second Line is appropriately independent from the business and is accountable for overseeing and challenging the First Line of Defense on the effective management of its risks. Second Line of Defense accountability includes communication, training and awareness, providing expert support and advice to the business on risk management. This includes interpreting and complying with the risk policy standards and risk management framework, conducting
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RBS CITIZENS FINANCIAL GROUP, INC. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS suitable reviews to focus on ensuring First Line compliance with policies and responsibilities, providing relevant management information and escalating concerns where appropriate. The RBS Citizens Executive Risk Committee actively considers the inherent, material risks of the business / organization. This committee analyzes the risk profile and seeks confirmation that the risks are being appropriately identified, assessed and mitigated to the desired level. RBS Citizens Internal Audit is the Third Line of Defense and provides independent assurance over the key risks to the Company, which includes an assessment of the entire control framework.
Compliance Risk & Legal Risk
Compliance and legal risk represents the potential for loss resulting from violations of or non-conformance with laws, rules, regulations, prescribed practices, existing contracts or ethical standards. RBS Citizens has established policy standards that seek to ensure RBS Citizens works within all relevant laws and regulations applicable in all jurisdictions where it does business.
Strategic Risk
Strategic risk is the current and prospective impact on earnings or capital arising from adverse business decisions, improper implementation of decisions, or lack of responsiveness to industry changes. This risk is a function of the compatibility of an organization’s strategic goals, the business strategies developed to achieve those goals, the resources deployed against these goals, and the quality of implementation. The resources needed to carry out business strategies are both tangible and intangible. They include communication channels, operating systems, delivery networks, and managerial capacities and capabilities. The Company’s internal characteristics must be evaluated against the impact of economic, technological, competitive, regulatory, and other environmental changes. There is risk in the ability to deliver upon strategic initiatives in light of a slow economic recovery and a flat yield curve. However, actions have been taken to mitigate against this risk by working to optimize loan pricing and maintain conservative underwriting. Moreover, the Company is growing the fee income business and the commercial loan portfolio to drive revenue while maintaining cost discipline. The Company is positioned for a rising rate environment, but at the same time seeks alternative sources of revenue in this low rate environment. The Company will continue to run-off non- core loans and focus on organic growth as well as maintain strong capital ratios. To date, the revenue and expense impact of new regulations have been mitigated; however, as new rules are implemented, the costs of compliance will impact the Company and the entire industry.
Reputational Risk
Reputational risk is the potential for loss arising from negative public opinion. RBS Citizens manages reputational risk through various policies and processes which are embedded throughout the Company. These processes are both proactive and reactive in nature and include communications and branding strategies, extensive compliance training and strong regulatory relations, liquidity and capital adequacy planning, operational process and systems monitoring, and robust incident management protocols to address issues as they arise.
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INDEPENDENT ACCOUNTANTS’ REVIEW REPORT
To the Board of Directors and Stockholder of RBS Citizens Financial Group, Inc. Providence, Rhode Island
We have reviewed the accompanying condensed consolidated balance sheet of RBS Citizens Financial Group, Inc. and subsidiaries (“the Company”) as of September 30, 2012, and the related condensed consolidated statements of operations, for the three- and nine-month periods ended September 30, 2012 and 2011, and changes in stockholder’s equity and cash flows for the nine-month periods ended September 30, 2012 and 2011. This condensed financial information is the responsibility of the Company’s management.
We conducted our reviews in accordance with standards established by the American Institute of Certified Public Accountants for reviews of interim financial information. A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with auditing standards generally accepted in the United States of America, the objective of which is the expression of an opinion regarding the financial information taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to such condensed consolidated interim financial information for it to be in conformity with accounting principles generally accepted in the United States of America.
We have previously audited, in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet as of December 31, 2011, and the related consolidated statements of operations, changes in stockholder’s equity, and cash flows for the year then ended (not presented herein); and in our report dated February 21, 2012, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2011 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
January 18, 2013
RBS CITIZENS FINANCIAL GROUP, INC. CONSOLIDATED BALANCE SHEETS
September 30, December 31, 2012 2011 (in millions, except share data) (unaudited) ASSETS: Cash and due from banks $6,054 $3,694 Interest-bearing deposits in banks 502 231 Securities available-for-sale, at fair value 20,268 22,150 Other investment securities 1,073 1,202 Loans held-for-sale, at lower of cost or fair value 594 564
Loans and leases 86,941 86,795 Less: Allowance for loan and lease losses 1,347 1,698 Net loans and leases 85,594 85,097
Goodwill 11,311 11,311 Other intangibles 11 13 Derivative assets 1,279 1,287 Premises and equipment 1,212 1,164 Bank-owned life insurance 1,290 1,257 Due from broker 823 - Other assets 1,569 1,684 TOTAL ASSETS $131,580 $129,654
LIABILITIES AND STOCKHOLDER’S EQUITY: LIABILITIES: Deposits $96,481 $92,888 Federal funds purchased, securities sold under agreements to repurchase, and short-term borrowings 3,241 4,152 Borrowed funds 4,699 6,342 Derivative liabilities 1,488 1,648 Federal, state and local taxes payable 248 180 Deferred taxes, net 222 15 Other liabilities 1,092 1,036 TOTAL LIABILITIES 107,471 106,261
STOCKHOLDER’S EQUITY: Preferred stock: $1.00 par value, 30,000 shares authorized, no shares outstanding at September 30, 2012 and December 31, 2011 - - Common stock: $.01 par value, 5,000 shares authorized, 3,382 shares issued and outstanding at September 30, 2012 and December 31, 2011 - - Additional paid-in capital 18,568 18,568 Retained earnings 5,800 5,353 Accumulated other comprehensive loss (259) (528) TOTAL STOCKHOLDER'S EQUITY 24,109 23,393 TOTAL LIABILITIES AND STOCKHOLDER’S EQUITY $131,580 $129,654 The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
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RBS CITIZENS FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
Three Months Ended Nine Months Ended September 30, September 30, (unaudited) (unaudited) (in millions) 2012 2011 2012 2011 INTEREST INCOME: Interest and fees on loans and leases: Consumer $365 $419 $1,120 $1,296 Commercial 246 226 725 665 Residential mortgage 101 113 315 343 Commercial real estate 49 58 151 181 Credit card 41 39 123 115 Loans held for sale 4 3 12 10 Investment securities 147 188 487 565 Interest-bearing deposits in banks 1 1 3 5 Total interest income 954 1,047 2,936 3,180 INTEREST EXPENSE: Deposits 78 130 303 363 Federal funds purchased, securities sold under agreement to repurchase 34 20 67 149 Borrowed funds 32 59 111 171 Total interest expense 144 209 481 683 Net interest income 810 838 2,455 2,497 Provision for credit losses 109 201 311 698 Net interest income after provision for credit losses 701 637 2,144 1,799 NONINTEREST INCOME: Service charges on deposits 141 155 423 447 Net gains on sales of securities available for sale 52 24 78 102 Mortgage banking 49 - 135 25 ATM and debit card 41 78 127 225 Other service fee income 38 39 110 110 Trust and investment services revenue 32 34 98 99 International fees 26 29 79 87 Credit card fees 20 21 60 56 Bank-owned life insurance 13 12 38 36 Capital markets fee income 12 7 38 32 Other-than-temporary impairment: Total other-than-temporary impairment losses 43 (24) (102) (167) Portions of loss recognized in other comprehensive income (before taxes) (49) 18 84 155 Net impairment losses recognized in earnings (6) (6) (18) (12) Other net gains (losses) - (8) 67 4 Other income 4 22 42 55 Total noninterest income 422 407 1,277 1,266 NONINTEREST EXPENSE: Salaries and employee benefits 407 408 1,265 1,210 Equipment expense 86 86 257 254 Occupancy 83 87 242 253 Outside services 76 90 239 243 Promotional expense 22 25 64 78 Other operating expense 117 147 494 443 Total noninterest expense 791 843 2,561 2,481 Income before income tax expense 332 201 860 584 Income tax expense 123 71 318 205 NET INCOME $209 $130 $542 $379
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
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RBS CITIZENS FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDER'S EQUITY
Additional Accumulated Other Preferred Common Paid-in Retained Comprehensive (in millions) Stock Stock Capital Earnings Income (Loss) Total Balance at December 31, 2010 $0 $0 $18,538 $4,847 ($691) $22,694 Capital contribution - - 20 - - 20 Comprehensive income: Net income - - - 379 - 379 Other comprehensive income - - - - 289 289 Total comprehensive income for the nine months ended September 30, 2011 668 Balance at September 30, 2011 (unaudited) - - 18,558 5,226 (402) 23,382
Balance at December 31, 2011 - - 18,568 5,353 (528) 23,393 Dividend to parent - - - (95) - (95) Comprehensive income: Net income - - - 542 - 542 Other comprehensive income - - - - 269 269 Total comprehensive income for the nine months ended September 30, 2012 811 Balance at September 30, 2012 (unaudited) $0 $0 $18,568 $5,800 ($259) $24,109
Net Unrealized Net Unrealized Defined Accumulated Other Gains (Losses) on Gains (Losses) on Benefit Comprehensive (in millions) Derivatives Securities Pension Plans Income (Loss) Balance at December 31, 2010 ($642) $163 ($212) ($691) Net unrealized derivative instrument losses arising during the period, net of taxes (103) - - (103) Reclassification adjustment for net derivative losses included in net income, net of taxes 251 - - 251 Net unrealized securities gains arising during the period, net of taxes - 201 - 201 Reclassification of net securities gains to net income, net of taxes - (57) - (57) Defined benefit pension plan curtailment, net of taxes - - (3) (3) Balance at September 30, 2011 (unaudited) (494) 307 (215) (402)
Balance at December 31, 2011 (426) 251 (353) (528) Net unrealized derivative instrument losses arising during the period, net of taxes (25) - - (25) Reclassification adjustment for net derivative losses included in net income, net of taxes 167 - - 167 Net unrealized securities gains arising during the period, net of taxes - 213 - 213 Reclassification of net securities gains to net income, net of taxes - (86) - (86) Balance at September 30, 2012 (unaudited) ($284) $378 ($353) ($259)
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
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RBS CITIZENS FINANCIAL GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
Nine Months Ended September 30, 2012 2011 (in millions) (unaudited) (unaudited) OPERATING ACTIVITIES Net income $542 $379 Adjustments to reconcile net income to net cash provided by operating activities: Provision for credit losses 311 698 Originations of mortgage loans-held-for-sale (4,070) (2,454) Proceeds from sales of mortgage loans-held-for-sale 4,040 2,875 Amortization of terminated cash flow hedges 74 114 Depreciation, amortization and accretion 339 312 Impairment of mortgage servicing rights 14 42 Securities impairment 18 12 Loss on other investment securities 11 - Deferred income taxes 51 3 Loss on disposal / impairment of premises and equipment 12 3 Gain on sales of: Securities available-for-sale (76) (102) Other investment securities (78) (8) Premises and equipment (2) (2) (Increase) decrease in: Accrued interest receivable 22 27 Other assets 41 (60) Increase (decrease) in: Other liabilities 59 (607) Federal, state, and local income taxes payable 68 176 Interest payable (5) (3) Net cash provided by operating activities 1,371 1,405 INVESTING ACTIVITIES Investment securities: Purchases of securities available-for-sale (5,371) (8,286) Proceeds from maturities and paydowns of securities available-for-sale 4,973 5,064 Proceeds from sales of securities available-for-sale 1,644 3,176 Purchases of other investment securities (1) (31) Proceeds from sales of other investment securities 180 43 Net increase in short-term investments (271) (59) Net decrease in cash collateral - 1,485 Net increase in loans and leases (847) (670) Net increase in bank-owned life insurance (33) (30) Net cash payments for divestiture activities (309) - Premises and equipment: Purchases (247) (228) Proceeds from sales 3 10 Net cash provided by activities (279) 474 FINANCING ACTIVITIES Net increase (decrease) in deposits 3,917 (19) Net decrease in federal funds purchased and securities sold under agreements to repurchase (911) (1,121) Proceeds from borrowed funds 23,319 15,986 Repayments of borrowed funds (24,962) (15,824) Dividends paid to parent (95) - Capital contribution - 20 Net cash provided by (used in) financing activities 1,268 (958) Increase in cash and cash equivalents 2,360 921 Cash and cash equivalents at beginning of period 3,694 4,918 Cash and cash equivalents at end of period $6,054 $5,839
The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
1. SIGNIFICANT ACCOUNTING POLICIES The accounting and reporting policies of RBS Citizens Financial Group, Inc. and subsidiaries conform to U.S. GAAP. The Company is ultimately a wholly-owned subsidiary of The Royal Bank of Scotland Group plc. On December 1, 2008, the UK Government became the ultimate controlling party of RBSG. The UK Government’s shareholding is managed by UK Financial Investments Limited, a company wholly owned by the UK Government. The Company's principal business activity is banking, conducted through its subsidiaries RBS Citizens, N.A.; Citizens Bank of Pennsylvania; RBS Asset Finance, Inc. and CCO Investment Services Corp. The following is a summary of the significant accounting policies of the Company: Basis of Presentation The Consolidated Financial Statements include the accounts of the Company. All material intercompany transactions and balances have been eliminated. The Company has evaluated its unconsolidated entities and does not believe that any entity in which it has an interest, but does not currently consolidate, meets the requirements for a variable interest entity to be consolidated. The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the provision for credit losses, recognition of goodwill and intangible assets arising from acquisitions, evaluation and measurement of impairment of goodwill and intangible assets, evaluation of unrealized losses on securities for other-than- temporary impairment, accounting for income taxes, the valuation of available-for-sale securities, and derivatives. Securities Investments in debt and equity securities are carried in three portfolios: available-for-sale, trading account assets and other investment securities. Management determines the appropriate classification at the time of purchase. Securities in the available-for-sale portfolio will be held for indefinite periods of time and may be sold in response to changes in interest rates, changes in prepayment risk, or other factors in managing the Company’s asset / liability strategy. Gains and losses on the sales of securities are recognized in earnings and are computed using the specific identification method. Security impairments (i.e. declines in the fair value of securities below cost) that are considered by management to be other-than- temporary are recognized in earnings as realized losses. However, the determination of the impairment amount is dependent on the Company’s intent to sell (or not sell) the security. If the Company intends to sell the impaired security, the impairment loss recognized in current period earnings equals the difference between the instrument’s fair value and amortized cost. If the Company does not intend to sell the impaired security, and it is not likely that the Company will be required to sell the impaired security, the credit-related impairment loss is recognized in current period earnings and equals the difference between the amortized cost of the security and the present value of the expected cash flows that have currently been projected. Securities available-for-sale are carried at fair value, with unrealized gains and losses reported in other comprehensive income (“OCI”) as a separate component of stockholder’s equity, net of taxes. Premiums and discounts on debt securities are amortized or accreted using a level-yield method over the estimated lives of the individual securities. The Company uses actual prepayment experience and estimates of future prepayments to determine the constant effective yield necessary to apply the interest method of income recognition. Estimates of future prepayments are based on the underlying collateral characteristics of each security and are derived from market sources. Judgment is involved in making determinations about prepayment expectations and in changing those expectations in response to changes in interest rates and macroeconomic conditions. The amortization of premiums and discounts associated with mortgage-backed securities may be significantly impacted by changes in prepayment assumptions. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading account assets and are carried at fair value. Realized and unrealized gains and losses on such assets are reported in noninterest income on the consolidated statements of operations. Trading account assets are reported in other assets on the consolidated balance sheets. Other investment securities are comprised mainly of FHLB stock and FRB stock, which are carried at cost; and venture capital investments, which are carried at fair value, with changes in fair value recognized in noninterest income. For securities that are not publicly traded, estimates of fair value are made based upon review of the investee’s financial
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED) results, condition and prospects. Other investment securities are reviewed at least annually for impairment, with valuation adjustments recognized in noninterest income. Loans and Leases Loans are reported at the amount of their outstanding principal, net of charge-offs, unearned income, deferred loan origination fees and costs, and unamortized premiums or discounts (on purchased loans). Deferred loan fees and costs and purchase discounts and premiums are amortized as an adjustment of yield over the life of the loan, using the level yield interest method. Unamortized amounts remaining upon prepayment or sale are recorded as interest income or gain (loss) on sale, respectively. Credit card receivables include billed and uncollected interest and fees. Leases are classified at the inception of the lease. Lease receivables, including leveraged leases, are reported at the aggregate of lease payments receivable and estimated residual values, net of unearned and deferred income, including unamortized investment credits. Lease residual values are reviewed at least annually for other-than-temporary impairment, with valuation adjustments recognized currently against noninterest income. Leveraged leases are reported net of non- recourse debt. Unearned income is recognized to yield a level rate of return on the net investment in the leases. Loans and leases are disclosed in portfolio segments and classes. The Company’s loan segments are commercial and retail. The classes of loans and leases are: commercial, commercial real estate, leases, home equity products serviced by others (i.e. certain purchased home equity loans and lines of credit), residential (i.e. residential mortgages and home equity loans and lines of credit), other secured retail (i.e. automobile loans, student loans, other installment loans), and unsecured retail (i.e. credit card). Allowance for Credit Losses Management’s estimate of probable losses in the Company’s loan portfolios is recorded in the allowance for loan and lease losses and the reserve for unfunded lending commitments. The Company evaluates the adequacy of the allowance for loan and lease losses by performing reviews of certain individual loans and leases, analyzing changes in the composition, size and delinquency of the portfolio, reviewing previous loss experience, and considering current and anticipated economic factors. The allowance is maintained at a level which management considers to be adequate based on the results of this evaluation, and is established through charges to earnings in the form of a provision for credit losses. Amounts determined to be uncollectible are deducted from the allowance and subsequent recoveries, if any, are added to the allowance. While management uses available information to estimate loan losses, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for credit losses. Such agencies may require the Company to recognize changes to the allowance based on their judgment of information available to them at the time of their examination. The allowance for loan and lease losses includes allocated and unallocated reserves. The allocated reserve is attributable to certain individual impaired loans and to pools of loans. The reserve for pools of loans is calculated using models sensitive to credit factors such as loan payment status and historical loss rates adjusted to reflect current conditions. The unallocated reserve provides a supplemental contingency for the allocated reserve and protects against latent or embedded losses in the overall loan portfolio and model imprecision. It reflects factors that apply to the portfolio as a whole and that are difficult to attribute to individually impaired loans or to groups of loans. These factors include changing underwriting criteria, changes in the types and mix of loans originated, industry concentrations and evaluations, allowance levels relative to selected overall credit criteria and other economic indicators used to estimate probable incurred losses. In addition to the allowance for loan and lease losses, the Company also estimates probable credit losses associated with off-balance sheet financial instruments such as letters of credit, financial guarantees and binding unfunded loan commitments. Off-balance sheet financial instruments are subject to individual reviews and are analyzed and segregated by risk according to the Company’s internal risk rating scale. These risk classifications, in conjunction with historical loss experience, economic conditions and performance trends within specific portfolio segments, result in the estimate of the reserve for unfunded lending commitments. The allowance for loan and lease losses and the reserve for unfunded lending commitments are reported on the consolidated balance sheets in the allowance for loan and lease losses and in other liabilities, respectively. Provision for credit losses related to the loans and leases portfolio and the unfunded lending commitments are reported in the consolidated statements of operations as provision for credit losses.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
Commercial loans and leases are charged-off to the allowance when there is little prospect of collecting either principal or interest. Charge-offs of commercial loans and leases usually involve receipt of borrower-specific adverse information. For commercial collateral-dependent loans, an appraisal or other valuation is used to quantify a shortfall between the value of the collateral and the recorded investment in the loan. Retail loan charge-offs are generally based on established delinquency thresholds rather than borrower-specific adverse information. For collateral-dependent retail loans, shortfalls between the collateral value and the recorded investment are promptly charged-off. Placing a loan or lease on nonaccrual status does not by itself require a partial or total charge-off; however, any identified losses are charged-off at that time. Nonperforming Loans and Leases Commercial loans, commercial real estate loans, and leases are generally placed on nonaccrual status when contractually past due 90 days or more, or earlier if management believes that the probability of collection is insufficient to warrant further accrual. Some of these loans and leases may remain on accrual status when contractually past due 90 days or more if management considers the loan collectible. A loan may be returned to accrual status if (1) principal and interest payments have been brought current, and the Company expects repayment of the remaining contractual principal and interest, (2) the loan or lease has otherwise become well-secured and in the process of collection, or (3) the borrower has been making regularly scheduled payments in full for the prior six months and it’s reasonably assured that the loan or lease will be brought fully current within a reasonable period. Residential mortgages are generally placed on nonaccrual status when past due 120 days, or sooner if determined to be collateral-dependent. Residential mortgages are returned to accrual status when principal and interest payments become less than 120 days past due and when future payments are reasonably assured. Home equity loans and lines of credit, home equity products serviced by others, automobile loans, and other installment loans are generally placed on nonaccrual status when past due 90 days or more. Loans less than 90 days past due may be placed on nonaccrual status upon the death of the borrower, surrender or repossession of collateral, or bankruptcy. Non-guaranteed student loans are placed on nonaccrual status when they become 90 days past due or in the event of fraud, bankruptcy, or the borrower’s death. A loan may be returned to accrual status if the loan becomes less than 15 days past due. Guaranteed student loans are not placed on nonaccrual status. Credit card balances are placed on nonaccrual status when past due 90 days or more. They are restored to accruing status if they subsequently become less than 90 days past due. Cash receipts on nonaccruing loans and leases are generally applied to reduce the unpaid principal balance. Impaired Loans A loan is considered to be impaired when it is probable that the Company will be unable to collect all of the contractual interest and principal payments as scheduled in the loan agreement. Impaired loans include nonaccruing larger balance (greater than $3 million carrying value) non-homogenous commercial and commercial real estate loans, and restructured loans which are deemed troubled debt restructurings (“TDRs”). A loan is identified as a TDR when the Company grants the borrower a concession the Company would not otherwise make in response to the borrower’s financial difficulties. Concessions granted in TDRs for all classes of loans may include lowering the interest rate, forgiving a portion of principal, extending the loan term, lowering scheduled payments for a specified period of time, principal forbearance, or capitalizing arrearages. A rate increase can be a concession if the increased rate is lower than a market rate for debt with risk similar to that of the restructured loan. Additionally, TDRs for commercial loans and leases may also involve creating a multiple note structure, accepting non-cash assets, accepting an equity interest, or receiving a performance-based fee. In some cases a TDR may involve multiple concessions. The financial effects of TDRs for all loan classes may include lower income (either due to a lower interest rate or a delay in the timing of cash flows), larger loan loss provisions, and accelerated charge-offs if the modification renders the loan collateral-dependent. In some cases interest income may increase if, for example, the loan is extended or the interest rate is increased as a result of the modification. Impairment evaluations are performed at the individual loan level, and consider expected future cash flows from the loan, including, if appropriate, the realizable value of collateral. Impaired loans which are not TDRs are nonaccruing, and loans involved in TDRs may be accruing or nonaccruing. Consumer loans that were discharged in Chapter 7 Bankruptcy are deemed to be collateral-dependent TDRs and are charged-off to the value of the collateral, less cost to sell, and less amounts recoverable under a government guarantee. Collateral dependent consumer loans are moved to nonaccrual status regardless of the payment history. Cash receipts on nonaccruing impaired loans, including nonaccruing loans involved in TDRs, are generally applied to reduce the unpaid principal balance. Loans are generally restored to accrual status when principal and interest payments are brought current and when future payments are reasonably assured, following a sustained period of repayment performance by the borrower in accordance with the loan’s contractual terms.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
Nonaccruing loans for all classes that are modified in a TDR are generally returned to accrual status after the borrower has made payments of cash or cash equivalents under the revised terms for at least six months subsequent to the restructuring date. Fair Value The Company measures fair value using the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is based upon quoted market prices in an active market, where available. If quoted prices are not available, observable market-based inputs or independently sourced parameters are used to develop fair value, whenever possible. Such inputs may include prices of similar assets or liabilities, yield curves, interest rates, prepayments speeds, and foreign exchange rates. A portion of the Company’s assets and liabilities are carried at fair value, including available-for-sale securities, private equity investments, and derivative instruments. In addition, the Company elects to account for its residential mortgages held-for-sale at fair value. The Company classifies its assets and liabilities that are carried at fair value in accordance with the three-level valuation hierarchy: Level 1. Quoted prices in active markets for identical assets or liabilities. Level 2. Observable inputs other than Level 1 prices, such as quoted prices for similar instruments; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by market data for substantially the full term of the asset or liability. Level 3. Unobservable inputs that are supported by little or no market information and that are significant to the fair value measurement. Classification in the hierarchy is based upon the lowest level input that is significant to the fair value measurement of the asset or liability. For instruments classified in Level 1 and 2 where inputs are primarily based upon observable market data, there is less judgment applied in arriving at the fair value. For instruments classified in Level 3, management judgment is more significant due to the lack of observable market data. The Company reviews and updates the fair value hierarchy classifications on a quarterly basis. Changes from one quarter to the next related to the observability of inputs in fair value measurements may result in a reclassification between the fair value hierarchy levels and are recognized based on period-ending balances. Fair value is also used on a nonrecurring basis to evaluate certain assets for impairment or for disclosure purposes. Examples of nonrecurring uses of fair value include mortgage servicing rights (“MSRs”) accounted for by the amortization method, loan impairments for certain loans, and goodwill impairment. Goodwill and Intangible Assets Goodwill is not amortized, but is subject to annual impairment tests. Goodwill is assigned to reporting units at the date the goodwill is initially recorded. A reporting unit is a business operating segment or a component of a business operating segment. Once goodwill has been assigned to reporting units, it no longer retains its association with a particular acquisition, and all of the activities within a reporting unit, whether acquired or organically grown, are available to support the value of the goodwill. The goodwill impairment analysis is a two-step test. The first step, used to identify potential impairment, involves comparing each reporting unit’s fair value to its carrying value including goodwill. If the fair value of a reporting unit exceeds its carrying value, applicable goodwill is deemed to be not impaired. If the carrying value exceeds fair value, there is an indication of impairment and the second step is performed to measure the amount of impairment. The second step involves calculating an implied fair value of goodwill for each reporting unit for which the first step indicated impairment. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination, which is the excess of the fair value of the reporting unit, as determined in the first step, over the aggregate fair values of the individual assets, liabilities and identifiable intangible assets as if the reporting unit was being acquired in a business combination. If the implied fair value of goodwill exceeds the goodwill assigned to the reporting unit, there is no impairment. If the goodwill assigned to a reporting unit exceeds the implied fair value of the goodwill, an impairment charge is recorded for the excess. An impairment loss recognized cannot exceed the amount of goodwill assigned to a reporting unit, and the loss establishes a new basis in the goodwill. Subsequent reversal of goodwill impairment losses is not permitted.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
Using a September 30 measurement date, the fair values of the Company’s reporting units are determined using a combination of income and market-based approaches. The Company tests other intangible assets for impairment at least annually, generally at September 30. Derivatives The Company is party to a variety of derivative transactions, including interest rate swap contracts, interest rate options, foreign exchange contracts, residential loan commitment rate locks, forward sale contracts, warrants and purchase options. The Company enters into contracts in order to meet the financing needs of its customers. The Company also enters into contracts as a means of reducing its interest rate and foreign currency risks and these contracts are designated as such when acquired based on management’s intent. The Company monitors the results of each transaction to ensure that management’s intent is satisfied. All derivatives, whether designated for hedging relationships or not, are recognized in the consolidated balance sheets at fair value. If a derivative is designated as a cash flow hedge, the effective portions of changes in the fair value of the derivative are recorded in accumulated OCI, a component of stockholder’s equity. The ineffective portions of cash flow hedges are immediately recognized as an adjustment to income or expense. For cash flow hedging relationships that have been discontinued, balances in OCI are reclassified to interest expense in the periods during which the hedged item affects income. If it is probable that the hedged forecasted transaction will not occur, balances in OCI are reclassified immediately to income. If a derivative is designated as a fair value hedge, changes in the fair value of the derivative and the changes in the fair value of the hedged item that are due to the hedged risk are recorded in income. Changes in the fair value of derivatives that do not qualify as hedges are recognized immediately in earnings. Derivative assets and derivative liabilities governed by master netting agreements are netted by counterparty on the balance sheet, and this netted derivative asset or liability position is also netted against the fair value of any cash collateral that has been pledged or received in accordance with a credit support annex (“CSA”). Income Taxes The Company uses an asset and liability (balance sheet) approach for financial accounting and reporting of income taxes. This results in two components of income tax expense: current and deferred. Current income tax expense approximates taxes to be paid or refunded for the current period. Deferred income tax expense results from changes in deferred tax assets and liabilities between periods. These gross deferred tax assets and liabilities represent decreases or increases in taxes expected to be paid in the future because of future reversals of temporary differences in the bases of assets and liabilities as measured by tax laws and their bases as reported in the Consolidated Financial Statements. Deferred tax assets are recognized for net operating loss carryforwards and tax credit carryforwards. Valuation allowances are recorded as necessary to reduce deferred tax assets to the amounts management concludes are more likely than not to be realized. The Company also assesses the probability that the positions taken or expected to be taken in its income tax returns will be sustained by taxing authorities. A "more likely than not" (more than 50 percent) recognition threshold must be met before a tax benefit can be recognized. Tax positions that are more likely than not to be sustained are reflected in the Company's Consolidated Financial Statements. Tax positions are measured as the largest amount of tax benefit that is greater than 50 percent likely of being realized upon settlement with a taxing authority that has full knowledge of all relevant information. The difference between the benefit recognized for a position and the tax benefit claimed on a tax return is referred to as an unrecognized tax benefit. New Accounting Pronouncements In July 2012, the OCC released new guidance requiring banks to charge-off consumer loans that were discharged in Chapter 7 bankruptcy proceedings and not reaffirmed by the borrowers (“Chapter 7 loans”). There is no impact to net income or stockholder’s equity.
In December 2011, the Financial Accounting Standards Board (“FASB”) issued an accounting standard update that provides an option to present the total of comprehensive income, the components of net income, and the components of OCI either in a single continuous statement of comprehensive income or in two separate but consecutive statements. In both choices, an entity is required to present each component of net income along with total net income, each component of OCI along with a total for OCI, and a total amount for comprehensive income. The amendments eliminate the option to present the components of OCI as part of the statement of changes in stockholder’s equity. The amendments do not change the
35
RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
items that must be reported in OCI or when an item of OCI must be reclassified to net income. The revised rules are effective for fiscal periods ending after December 15, 2012. There is no impact to net income or stockholder’s equity.
In July 2010, the FASB issued an accounting standard update which requires enhanced disclosures about the credit quality of financing receivables and the allowance for loan and lease losses. Certain enhanced activity-based restructured loan disclosures (such as the financial effects of the modifications and the amount of restructurings defaulted within the reporting period) are required for annual periods beginning on or after December 15, 2011 and are not expected to have a material impact to the Consolidated Financial Statements.
Revisions and Reclassifications of Prior Year Amounts Certain 2011 amounts have been reclassified in the Consolidated Financial Statements to conform to the current year presentation.
2. SECURITIES The following table provides the major components of securities at amortized cost and fair value: September 30, 2012 December 31, 2011 Gross Gross Gross Gross Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair (in millions) Cost Gains Losses Value Cost Gains Losses Value
Available-For-Sale Securities U.S. Treasury $15 $0 $0 $15 $15 $0 $0 $15 State and political subdivisions 87 5 - 92 86 4 - 90 Other bonds, notes and debentures - - - - 1 - - 1 Mortgage-backed securities: Federal agencies and U.S. government sponsored entities 17,975 669 (1) 18,643 19,537 593 (1) 20,129 Other 1,577 15 (93) 1,499 2,095 9 (211) 1,893 Total mortgage-backed securities 19,552 684 (94) 20,142 21,632 602 (212) 22,022 Total debt securities 19,654 689 (94) 20,249 21,734 606 (212) 22,128
Marketable equity securities 5 2 - 7 8 2 - 10
Other equity securities 12 - - 12 12 - - 12
Total equity securities 17 2 - 19 20 2 - 22 Total available-for-sale securities $19,671 $691 ($94) $20,268 $21,754 $608 ($212) $22,150
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The Company has reviewed its securities portfolio for other-than-temporary impairments. The following tables summarize those securities whose fair values are below carrying values, segregated by those that have been in a continuous unrealized loss position for less than twelve months, and those that have been in a continuous unrealized loss position for twelve months or longer:
September 30, 2012 Less than 12 Months 12 Months or Longer Total Number Gross Number Gross Number Gross of Fair Unrealized of Fair Unrealized of Fair Unrealized (dollars in millions) Issues Value Losses Issues Value Losses Issues Value Losses Mortgage-backed securities: Federal agencies and U.S. government sponsored entities 5 $67 ($1) - $0 $0 5 $67 ($1) Other 2 60 - 30 914 (93) 32 974 (93) Total mortgage-backed securities 7 127 (1) 30 914 (93) 37 1,041 (94) Total 7 $127 ($1) 30 $914 ($93) 37 $1,041 ($94)
December 31, 2011 Less than 12 Months 12 Months or Longer Total Number Gross Number Gross Number Gross of Fair Unrealized of Fair Unrealized of Fair Unrealized (dollars in millions) Issues Value Losses Issues Value Losses Issues Value Losses
State and political subdivisions - $0 $0 1 $1 $0 1 $1 $0 Other bonds, notes and debentures 1 1 - - - - 11 - Mortgage-backed securities: Federal agencies and U.S. government sponsored entities 10 272 (1) - - - 10 272 (1) Other 8 244 (11) 39 1,273 (200) 47 1,517 (211) Total mortgage-backed securities 18 516 (12) 39 1,273 (200) 57 1,789 (212) Total 19 $517 ($12) 40 $1,274 ($200) 59 $1,791 ($212)
For each debt security identified with an unrealized loss, the Company reviews the expected cash flows to determine if the impairment in value is temporary or other-than-temporary. If the Company has determined that the present value of the debt security’s expected cash flows is less than its amortized cost basis, an other-than-temporary impairment is deemed to have occurred. The amount of impairment loss that is recognized in current period earnings is dependent on the Company’s intent to sell (or not sell) the security.
If the Company intends to sell the impaired security, the impairment loss recognized in current period earnings equals the difference between the instrument’s fair value and its amortized cost. If the Company does not intend to sell the impaired security, and it is not likely that the Company will be required to sell the impaired security, the credit-related impairment loss is recognized in current period earnings and equals the difference between the amortized cost of the security and the present value of the expected cash flows that have currently been projected. 37
RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
In addition to these cash flow projections, several other characteristics of each security are reviewed when determining whether a credit loss exists and the period over which the debt security is expected to recover. These characteristics include: (1) the type of investment, (2) various market factors affecting the fair value of the security (e.g., interest rates, spread levels, liquidity in the sector, etc.), (3) the length and severity of impairment, and (4) the public credit rating of the instrument. The Company estimates the portion of loss attributable to credit using a cash flow model. The inputs to this model include prepayment, default and loss severity assumptions that are based on industry research and observed data. The loss projections generated by the model are reviewed on a quarterly basis by a cross-functional governance committee. This governance committee determines whether security impairments are other-than-temporary based on this review. The amortized cost and fair value of debt securities at September 30, 2012 by contractual maturity are shown below. Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Contractual maturities of mortgage-backed securities are not presented because actual maturities will differ due to prepayments of the underlying mortgages.
Amortized Fair (in millions) Cost Value Available-for-Sale Debt Securities Due in one year or less $19 $19 Due after one year through five years 28 30 Due after five years through ten years 21 23 Due after ten years 34 35 Mortgage-backed securities 19,552 20,142 Total $19,654 $20,249
Realized gains and losses on available-for-sale securities are shown below:
Nine Months Ended September 30, (in millions) 2012 2011 Gains on sale of debt securities $76 $110
Losses on sale of debt securities - (9) Gains on sale of marketable equity securities 2 1 Total $78 $102
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The amortized cost and fair value of securities pledged are shown below: September 30, 2012 December 31, 2011 Amortized Fair Amortized Fair (in millions) Cost Value Cost Value
Pledged against repurchase agreements $2,880 $3,012 $3,586 $3,710 Pledged against Federal Home Loan Bank borrowings 6 7 315 323 Pledged against derivatives, to qualify for fiduciary powers, and to secure public and other deposits as required by law 2,115 2,197 4,182 4,313
There were no securitizations of mortgage loans as of September 30, 2012. There were $62 million in securitizations for the year ended December 31, 2011. These securitizations included a substantive guarantee by a third party. The guarantor is the Federal National Mortgage Association (“Fannie Mae”) the purchaser of the underlying loans. These securitizations were accounted for as a sale of the transferred loans and as a purchase of securities. The securities received from Fannie Mae are classified as available-for-sale.
3. LOANS AND LEASES A summary of the loans and leases portfolio follows: September 30, December 31, (in millions) 2012 2011 Commercial $27,831 $25,770 Commercial real estate 6,657 7,602 Leases 3,218 3,164 Total commercial 37,706 36,536 Home equity lines of credit 16,777 16,666 Residential mortgages 9,535 9,719 Home equity loans 5,476 6,766 Home equity products serviced by others 3,134 3,624 Automobile 8,734 7,571 Student and other installment 3,921 4,276 Credit card 1,658 1,637 Total retail 49,235 50,259 Total loans and leases $86,941 $86,795
Mortgage loans serviced for others by the Company's subsidiaries are not included above, and amounted to $18.6 billion and $18.3 billion at September 30, 2012 and December 31, 2011, respectively. Loans pledged as collateral for FHLB borrowings and certain state and municipal deposits totaled $21.7 billion and $23.7 billion at September 30, 2012 and December 31, 2011, respectively. This collateral consists primarily of residential mortgages and home equity loans. Loans pledged as collateral to support the contingent ability to borrow at the FRB discount window, if necessary, totaled $17.2 billion and $16.0 billion at September 30, 2012 and December 31, 2011, respectively.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
4. ALLOWANCE FOR CREDIT LOSSES, NONPERFORMING ASSETS, AND CONCENTRATIONS OF CREDIT RISK
The allowance for loan and lease losses includes allocated reserves for the commercial and retail portfolios and unallocated reserves. Reserves for commercial and retail loans are calculated using models sensitive to historical loss rates, adjusted to reflect current economic conditions and risk characteristics. See Note 1 for a discussion of unallocated reserves.
Allocated reserves for commercial loans include a component attributable to individually impaired loans and a formula-based component for other loans and leases. Large nonaccruing loans and TDRs are assessed individually for impairment utilizing the present value of expected future cash flows, the current fair value of collateral, or the loan’s observable market price. For collateral-dependent impaired loans, the excess of the Company’s recorded investment in the loan over the fair value of the collateral less cost to sell is charged-off to the allowance for loan and lease losses. For other commercial loans assessed individually for impairment, the Company records an impairment allowance (or adjusts an existing allowance) for the excess of the recorded investment in the loan over the expected discounted cash flows or the loan’s observable market price.
For commercial loans not assessed individually for impairment and for leases, allocated reserves are developed using a formula-based methodology that considers the estimated probability of default, loss given default, and exposure at default. These factors consider the internal risk rating, loan tenor, and weighted average life.
Allocated reserves for retail loans include a component attributable to individually impaired loans identified as TDRs and a formula-based component for all other retail loans. Reserves for retail TDRs are developed using a pooled approach which considers the collateral dependence of TDR re-defaults. Therefore, impaired loans which are deemed collateral-dependent subsequent to loan modification are written down to fair market value less cost to sell. For impaired loans that are not collateral-dependent, reserves are developed using the present value of expected future cash flows, compared to the recorded investment in the loans. The formula-based approach for retail loans is calculated at the loan level and considers the estimated probability of default, loss given default, and exposure at default. When developing these factors, the Company may consider the loan product and collateral type, loan-to-value ratio, lien position, borrower’s credit, time outstanding, geographic location, and delinquency status.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The following is a summary of changes in the allowance for credit losses:
(in millions) Commercial Retail Unallocated Total Allowance for loan and lease losses as of January 1, 2012 $691 $816 $191 $1,698
Charge-offs (198) (666) - (864)
Recoveries 87 92 - 179
Net charge-offs (111) (574) - (685) Provision charged to income (32) 466 (100) 334 Allowance for loan and lease losses as of September 30, 2012 548 708 91 1,347
Reserve for unfunded lending commitments as of January 1, 2012 61 - - 61
Credit for unfunded lending commitments (23) - - (23)
Reserve for unfunded lending commitments as of September 30, 2012 38 - - 38 Total allowance for credit losses as of September 30, 2012 $586 $708 $91 $1,385
(in millions) Commercial Retail Unallocated Total Allowance for loan and lease losses as of January 1, 2011 $828 $1,021 $156 $2,005
Charge-offs (378) (1,008) - (1,386)
Recoveries 92 129 - 221
Net charge-offs (286) (879) - (1,165)
Sales/Other - - (33) (33) Provision charged to income 149 674 68 891 Allowance for loan and lease losses as of December 31, 2011 691 816 191 1,698
Reserve for unfunded lending commitments as of January 1, 2011 70 - - 70
Credit for unfunded lending commitments (9) - - (9)
Reserve for unfunded lending commitments as of December 31, 2011 61 - - 61 Total allowance for credit losses as of December 31, 2011 $752 $816 $191 $1,759
Included in the results above is the impact of interpretive guidance released by the OCC in July 2012 requiring banks to charge-off consumer loans that were discharged in Chapter 7 bankruptcy proceedings and not reaffirmed by the borrower. Per this guidance, Chapter 7 loans secured by collateral were deemed to be collateral-dependent TDRs and must be charged-off to the value of the collateral, less cost to sell. Those subject to government guarantees must be charged-off to the amount covered by the guarantee. These actions are required regardless of a loan’s favorable payment history. Further regulator interpretations required all collateral-dependent loans to be nonaccruing, regardless of the payment history.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The recorded investment in loans and leases based on the Company’s evaluation methodology is as follows:
September 30, 2012 December 31, 2011 (in millions) Commercial Retail Total Commercial Retail Total Individually evaluated $570 $832 $1,402 $720 $607 $1,327 Formula-based evaluation 37,136 48,403 85,539 35,816 49,652 85,468 Total $37,706 $49,235 $86,941 $36,536 $50,259 $86,795
The following is a summary of the allowance for credit losses by evaluation method: September 30, 2012 December 31, 2011 (in millions) Commercial Retail Unallocated Total Commercial Retail Unallocated Total Individually evaluated $65 $59 $0 $124 $94 $101 $0 $195
Formula-based evaluation 521 649 - 1,170 658 715 - 1,373
Unallocated - - 91 91 - - 191 191 Allowance for credit losses $586 $708 $91 $1,385 $752 $816 $191 $1,759
For commercial loans and leases, the Company utilizes regulatory classification ratings to monitor credit quality. Loans with a “pass” rating are those that the Company believes will be fully repaid in accordance with the contractual loan terms. Commercial loans and leases that are “criticized” are those that have some weakness that indicates an increased probability of future loss. For retail loans, the Company primarily uses the loan’s payment and delinquency status to monitor credit quality. The further a loan is past due, the greater the likelihood of future credit loss. These credit quality indicators for both commercial and retail loans are continually updated and monitored.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The recorded investment in classes of commercial loans and leases based on regulatory classification ratings is as follows: September 30, 2012 Criticized (in millions) Pass Special Mention Substandard Doubtful Total Commercial $26,106 $682 $796 $247 $27,831 Commercial real estate 5,215 677 385 380 6,657
Leases 3,105 88 25 - 3,218 Total $34,426 $1,447 $1,206 $627 $37,706
December 31, 2011 Criticized (in millions) Pass Special Mention Substandard Doubtful Total Commercial $23,936 $637 $876 $321 $25,770 Commercial real estate 5,555 677 832 538 7,602
Leases 3,047 107 10 - 3,164 Total $32,538 $1,421 $1,718 $859 $36,536
The recorded investment in classes of retail loans, categorized by delinquency status is as follows:
September 30, 2012 Past due fewer Past due 30 to Past due 90 days (in millions) Current than 30 days 89 days or more Total Residential $29,128 $1,428 $228 $1,004 $31,788 Home equity products serviced by others 2,755 213 70 96 3,134 Other secured retail 11,729 727 136 63 12,655 Unsecured retail 1,587 25 25 21 1,658 Total balance as of September 30, 2012 $45,199 $2,393 $459 $1,184 $49,235
December 31, 2011
Past due fewer Past due 30 to Past due 90 days (in millions) Current than 30 days 89 days or more Total Residential $31,015 $990 $427 $719 $33,151 Home equity products serviced by others 2,857 608 66 93 3,624 Other secured retail 10,891 743 158 55 11,847 Unsecured retail 1,556 23 33 25 1,637 Total balance as of December 31, 2011 $46,319 $2,364 $684 $892 $50,259
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
Nonperforming Assets A summary of nonperforming loans and leases by class follows:
September 30, 2012 December 31, 2011 Accruing and Total Accruing and Total 90 Days or Nonperforming 90 Days or Nonperforming More Loans and More Loans and (in millions) Nonaccruing Delinquent Leases Nonaccruing Delinquent Leases Commercial $136 $6 $142 $176 $1 $177 Commercial real estate 475 3 478 710 4 714
Leases 2 - 2 1 - 1 Total commercial 613 9 622 887 5 892
Residential 1,004 - 1,004 690 29 719 Home equity products serviced by others 96 - 96 93 - 93 Other secured retail 30 33 63 19 36 55 Unsecured retail 19 2 21 23 2 25 Total retail 1,149 35 1,184 825 67 892 Total $1,762 $44 $1,806 $1,712 $72 $1,784
Included in nonaccruing loans as of September 30, 2012, is $242 million of collateral dependent loans under the recent OCC guidance.
A summary of other nonperforming assets is as follows:
September 30, December 31, (in millions) 2012 2011 Other real estate owned, net of allowance: Commercial $45 $54 Retail 54 67 Total other real estate owned, net of allowance $99 $121
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
A summary of key performance indicators is as follows:
September 30, December 31, 2012 2011 Nonperforming commercial loans and leases as a percentage of total loans and leases 0.72 % 1.03 % Nonperforming retail loans as a percentage of total loans and leases 1.36 1.03 Total nonperforming loans and leases as a percentage of total loans and leases 2.08 % 2.06 %
September 30, December 31, 2012 2011 Nonperforming commercial assets as a percentage of total assets 0.51 % 0.73 % Nonperforming retail assets as a percentage of total assets 0.94 0.74 Total nonperforming assets as a percentage of total assets 1.45 % 1.47 %
The following is an analysis of the age of the past due amounts (accruing and nonaccruing):
September 30, 2012 December 31, 2011 30-89 Days 90 Days or Total Past 30-89 Days 90 Days or Total Past (in millions) Past Due more Past Due Due Past Due more Past Due Due Commercial $13 $142 $155 $13 $177 $190 Commercial real estate 49 478 527 64 713 777 Leases 3 2 5 5 2 7 Total commercial 65 622 687 82 892 974 Residential 228 1,004 1,232 427 719 1,146 Home equity products serviced by others 70 96 166 66 93 159 Other secured retail 136 63 199 158 55 213 Unsecured retail 25 21 46 33 25 58 Total retail 459 1,184 1,643 684 892 1,576 Total $524 $1,806 $2,330 $766 $1,784 $2,550
Impaired loans include (1) nonaccruing larger balance commercial loans (greater than $3 million carrying value) and (2) commercial and retail TDRs. Commercial TDRs were $260 million and $213 million on September 30, 2012 and December 31, 2011, respectively. Retail TDRs totaled $832 million and $607 million on September 30, 2012 and December 31, 2011, respectively. Commitments to lend additional funds to debtors owing receivables which were TDRs were $26 million and $52 million on September 30, 2012 and December 31, 2011, respectively.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
A summary of impaired loan information by class follows:
September 30, 2012 Impaired Loans Impaired Loans Without a Unpaid Total Recorded Average With a Related Allowance on Related Contractual Investment in Recorded (in millions) Allowance Impaired Loans Allowance Balance Impaired Loans Investment Commercial $178 $38 $42 $261 $220 $242 Commercial real estate 142 27 208 196 350 403 Total commercial 320 65 250 457 570 645 Residential 249 43 387 866 636 535 Home equity products serviced by others 130 11 20 126 150 144 Other secured retail 30 5 16 53 46 41 Total retail 409 59 423 1,045 832 720 Total as of September 30, 2012 $729 $124 $673 $1,502 $1,402 $1,365
December 31, 2011 Impaired Loans Impaired Loans Without a Unpaid Total Recorded Average With a Related Allowance on Related Contractual Investment in Recorded (in millions) Allowance Impaired Loans Allowance Balance Impaired Loans Investment Commercial $244 $43 $20 $268 $264 $277 Commercial real estate 353 51 103 596 456 570 Total commercial 597 94 123 864 720 847 Residential 305 49 128 519 433 393 Home equity products serviced by others 136 40 1 141 137 174 Other secured retail 37 12 - 37 37 44 Total retail 478 101 129 697 607 611 Total as of December 31, 2011 $1,075 $195 $252 $1,561 $1,327 $1,458
Concentrations of Credit Risk Most of the Company's business activity is with customers located in New England, New York, the Mid-Atlantic States of Pennsylvania, Delaware, and New Jersey, as well as the Midwestern States of Ohio, Michigan and Illinois. Generally, loans are collateralized by assets including real estate, inventory, accounts receivable, other personal property and investment securities. As of September 30, 2012 and December 31, 2011, the Company had a significant amount of loans collateralized by residential and commercial real estate. There are no significant concentrations to particular industries within the commercial loan portfolio. Exposure to credit losses arising from lending transactions may fluctuate with fair values of collateral supporting loans, which fail to perform according to contractual agreements. The Company's policy is to collateralize loans to the extent necessary; however, unsecured loans are also granted on the basis of the financial strength of the applicant and the facts surrounding the transaction. Certain loan products, including residential mortgages, home equity loans and lines of credit, and credit cards, have contractual features that may increase credit exposure to the Company in the event of an increase in interest rates or a decline in housing values. These products include loans that exceed 90% of the value of the underlying collateral (high
46
RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED) loan-to-value loans), interest-only and negative amortization residential mortgages, and loans with low introductory rates. Certain loans have more than one of these characteristics. The following table presents balances of loans with these characteristics:
September 30, 2012 December 31, 2011 Home Home Home Home Equity Equity Equity Equity Loans & Products Loans & Products Residential Lines of Serviced Credit Residential Lines of Serviced Credit (in millions) Mortgages Credit by Others Cards Total Mortgages Credit by Others Cards Total High loan-to-value $2,116 $5,185 $2,465 $0 $9,766 $2,254 $5,459 $2,657 $0 $10,370 Interest only/negative amortization 847 - - - 847 799 - - - 799 Low introductory rate - - - 114 114 - - - 73 73 Multiple characteristics & other 290 - - - 290 355 - - - 355 Total $3,253 $5,185 $2,465 $114 $11,017 $3,408 $5,459 $2,657 $73 $11,597
5. GOODWILL AND INTANGIBLE ASSETS Goodwill The carrying value of goodwill was $11.3 billion as of September 30, 2012 and December 31, 2011. The Company performs an annual test for impairment of goodwill at a level of reporting referred to as a reporting unit. The Company has identified the following reporting units based upon reviews of the structure of the Company’s executive team and supporting functions, resource allocations and financial reporting processes: Retail Banking Commercial Banking The Company performs annual goodwill impairment tests in accordance with the policy described in Note 1. No impairment was recorded in 2012 and 2011. The fair values of the reporting units are determined using a combination of income and market-based approaches. Other Intangibles The carrying amount of other intangibles was $11 million and $13 million as of September 30, 2012 and December 31, 2011, respectively. As of September 30, 2012, other intangibles consist of a trade name amortizing over 10 years, and a patent amortizing over 7 years. Amortization expense recorded in 2012 totaled $2 million compared to $25 million in the first nine months of 2011.
6. MORTGAGE BANKING In its mortgage banking business, the Company sells residential mortgage loans to government-sponsored entities and other parties, who may issue securities backed by pools of such loans. The Company retains no beneficial interests in these sales, but may retain the servicing rights of the loans sold. The Company is obligated to subsequently repurchase a loan if the purchaser, during a loan file review, discovers a standard representation or warranty violation such as noncompliance with eligibility requirements, customer fraud, or servicing violations.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
Changes related to mortgage servicing rights were as follows:
September 30, December 31, (in millions) 2012 2011 Mortgage servicing rights: Balance as of January 1 $215 $209 Amount capitalized 52 59 Amortization (51) (53) Carrying amount before valuation allowance 216 215 Valuation allowance for servicing assets: Balance as of January 1 58 16 Valuation impairment 14 42 Balance at end of period 72 58 Net carrying value of mortgage servicing rights $144 $157
Fair value, end of period $142 $155 The fair value of MSRs is estimated using a valuation model that calculates the present value of estimated future net servicing cash flows, taking into consideration actual and expected mortgage loan prepayment rates, discount rates, servicing costs, and other economic factors, which are determined based on current market conditions. The valuation model uses a static discounted cash flow methodology incorporating current market interest rates. A static model does not attempt to forecast or predict the future direction of interest rates; rather it estimates the amount and timing of future servicing cash flows using current market interest rates. The current mortgage interest rate influences the expected prepayment rate and therefore, the length of the cash flows associated with the servicing asset, while the discount rate determines the present value of those cash flows. Expected mortgage loan prepayment assumptions are obtained using the Andrew Davidson prepayment model. The Company periodically obtains third party valuations of its MSRs to assess the reasonableness of the fair value calculated by the valuation model. The key economic assumptions used to estimate the value of mortgage servicing rights are presented in the following table:
September 30, December 31, (dollars in millions) 2012 2011 Fair value $142 $155 Weighted average life (in years) 3.5 4.0 Weighted average constant prepayment rate 22.5% 20.6% Weighted average discount rate 10.5% 10.5%
Nine Months Ended September 30, (in millions) 2012 2011 Prepayment rate: Decline in fair value from 50 basis points adverse change in interest rates $11 $17 Decline in fair value from 100 basis points adverse change in interest rates $18 $23 Weighted average discount rate: Decline in fair value from 50 basis points adverse change $2 $2 Decline in fair value from 100 basis points adverse change $4 $4
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The key economic assumptions used in estimating the fair value of mortgage servicing rights capitalized during the year were as follows:
Nine Months Ended September 30, 2012 2011 Weighted average life (in years) 4.0 4.0 Weighted average constant prepayment rate 21.8% 18.4% Weighted average discount rate 10.5% 10.6%
A sensitivity analysis as of September 30, 2012 of current fair value to an immediate 50 basis point and 100 basis point adverse change in the key economic assumptions presents the decline in fair value that would occur if the adverse change were realized. These sensitivities are hypothetical. The effect of a variation in a particular assumption on the fair value of the mortgage servicing rights is calculated independently without changing any other assumption. In reality, changes in one factor may result in changes in another (for example, changes in interest rates, which drive changes in prepayment speeds, could result in changes in the discount rates), which might amplify or counteract the sensitivities. The primary risk inherent in the Company’s mortgage servicing rights is an increase in prepayments of the underlying mortgage loans serviced, which is dependent upon market movements of interest rates.
7. DEPOSITS The major components of deposits are as follows: September 30, December 31, (in millions) 2012 2011 Demand $27,114 $23,040 Checking with interest 13,683 17,328 Regular savings 7,943 7,906 Money market accounts 34,469 29,184 Term deposits 13,272 15,430 Total deposits $96,481 $92,888
The maturity distribution of term deposits as of September 30, 2012 is as follows: Year (in millions)
2013 $9,542 2014 2,270 2015 774 2016 426 2017 and thereafter 260 Total $13,272
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
8. BORROWED FUNDS The following is a summary of borrowed funds: September 30, 2012 December 31, 2011 (dollars in millions) Amount Rate Amount Rate Royal Bank of Scotland Group:
Subordinated debt, due 2034, LIBOR + 1.50% with quarterly resets $289 1.96% $506 1.87%
Other borrowings:
Subordinated debt, due 2022 350 4.15% - - FHLB fixed rate advances with original maturity under one year 500 0.27% 1,100 0.15-0.17% FHLB variable rate advances with semi-annual resets, due 2013 3,500 0.26-0.32% 4,250 0.15-0.47% FHLB fixed rate advances, due 2013 - 2033 27 0.00-6.60% 27 0.00-6.60% Fixed rate, subordinated debt, due 2012 - - 401 6.38% Other 33 various 58 various Total borrowed funds $4,699 $6,342
Advances, lines of credit and letters of credit from the FHLB are collateralized by pledged mortgages and pledged securities at least sufficient to satisfy the collateral maintenance level established by the FHLB. The required collateral maintenance level for FHLB advances was $6.9 billion and $8.1 billion at September 30, 2012 and December 31, 2011, respectively. The Company’s available FHLB borrowing capacity was $5.9 billion and $4.4 billion at September 30, 2012 and December 31, 2011, respectively. The Company can also borrow from the FRB discount window to meet short-term liquidity requirements. These potential borrowings are secured by investment securities and loans. At September 30, 2012, the Company’s unused secured borrowing capacity was $12.6 billion. Additionally, at September 30, 2012, the Company had available a $50 million line of credit with RBSG. The following is a summary of maturities for the Company’s borrowed funds at September 30, 2012:
Year (in millions)
2012 or on demand $500 2013 3,502 2014 6 2015 12 2016 4 2017 and thereafter 675 Total $4,699
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
9. INCOME TAXES Total income tax expense was as follows: Nine Months Ended September 30, (in millions) 2012 2011 Income tax expense $318 $205 Tax expense on changes in OCI 156 167 Total comprehensive income tax expense $474 $372
Components of income tax expense are as follows: (in millions) Current Deferred Total Nine months ended September 30, 2012 U.S. federal $188 $51 $239 State and local 79 - 79 Total $267 $51 $318 Nine months ended September 30, 2011 U.S. federal $173 $3 $176 State and local 29 - 29 Total $202 $3 $205
The effective income tax rate differed from the U.S. federal income tax rate of 35% in 2012 and 2011 as follows:
September 30, September 30, 2012 2011 Expected income tax rate 35.00 % 35.00 % Increase (decrease) resulting from: State income taxes (net of federal benefit) 5.95 3.24 Uncertain tax positions 0.02 0.08 Life insurance (1.56) (2.17) Tax-exempt interest (1.01) (1.19) Stabilization adjustment to expected annual rate (1.52) (0.04) Other 0.12 0.18 Effective income tax rate 37.00 % 35.10 %
The Company files income tax returns in the U.S. federal jurisdiction and various state and local jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal or state and local income tax examinations by major tax authorities for years before 2007.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:
September 30, December 31, (in millions) 2012 2011 Balance at the beginning of the period, January 1 $136 $104 Gross increases for tax positions related to prior years 29 48 Gross decreases for tax positions related to prior years - (6) Decreases for tax positions relating to settlements with taxing authorities (134) (10) Gross increases for tax positions related to the current years 3 - Balance at end of period $34 $136
Included in the total amount of unrecognized tax benefits at September 30, 2012 are potential benefits of $24 million that, if recognized, would affect the effective tax rate. The Company classifies interest and penalties related to unrecognized tax benefits as a component of income taxes. The Company accrued $13 million and $5 million of interest expense through September 30, 2012 and 2011, respectively. The Company had approximately $11 million and $43 million accrued for the payment of interest at September 30, 2012 and 2011, respectively. There were no amounts accrued for penalties as of September 30, 2012 and 2011, and there were no penalties recognized during, the nine months ended September 30, 2012 and year ended December 31, 2011. During the first nine months of 2012, the Company settled a state tax issue for the years 2003 through 2008 related to its real estate investment trust and various passive investment companies. Settlement of these uncertainties reduced the unrecognized tax benefit by $133 million.
10. DERIVATIVES In the normal course of business, the Company enters into a variety of derivative transactions in order to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates and foreign currency exchange rates. The Company does not use derivatives for speculative purposes. The Company’s derivative instruments are recognized on the consolidated balance sheets at fair value. Information regarding the valuation methodology and inputs used to estimate the fair value of the Company’s derivative instruments is described in Fair Value Measurements Footnote.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The following table identifies derivative instruments included on the consolidated balance sheets in derivative assets and derivative liabilities:
September 30, 2012 December 31, 2011 Notional Derivative Derivative Notional Derivative Derivative (in millions) Amount1 assets liabilities Amount1 assets liabilities Derivatives designated as hedging instruments: Interest rate contracts $5,200 $1 $304 $9,200 $1 $476 Derivatives not designated as hedging instruments: Interest rate contracts 32,272 1,209 1,150 30,114 1,243 1,146 Foreign exchange contracts 6,581 76 71 5,731 86 82 Other contracts 1,730 59 29 1,377 27 14 Total derivatives not designated as hedging instruments 1,344 1,250 1,356 1,242 Gross derivative fair values $1,345 $1,554 $1,357 $1,718 Less: Counterparty netting2 (66) (66) (70) (70) Total derivative fair values $1,279 $1,488 $1,287 $1,648
1 The notional or contractual amount of interest rate derivatives and foreign exchange contracts is the amount upon which interest and other payments under the contract are based. For interest rate derivatives, the notional amount is typically not exchanged. Therefore, notional amounts should not be taken as the measure of credit or market risk as they tend to greatly overstate the true economic risk of these contracts. 2 Amounts represent the impact of legally enforceable master netting agreements that allow the Company to settle positive and negative positions.
The Company’s derivative transactions are internally divided into three sub-groups: institutional, customer and residential loan. Institutional derivatives The institutional derivatives portfolio primarily consists of interest rate swap agreements that are used to hedge the interest rate risk associated with the Company’s investment securities and financing liabilities (i.e. borrowings, deposits, etc.). The goal of the Company’s interest rate hedging activities is to manage interest rate sensitivity so that movements in interest rates do not significantly adversely affect net interest income. The Company enters into certain interest rate swap agreements to hedge the market risk associated with fixed income securities. By entering into pay-fixed / receive floating interest rate swaps, the Company is able to minimize the variability in the fair value of these securities due to changes in interest rates. The Company also enters into certain interest rate swap agreements designed to hedge a portion of the Company’s borrowings and deposits. By entering into a pay-fixed / receive-floating interest rate swap, a portion of these liabilities is effectively converted to a fixed rate liability for the term of the interest rate swap agreement. Customer derivatives The customer derivatives portfolio consists of interest rate swap agreements and option contracts that are transacted to meet the financing needs of the Company’s customers. Offsetting swap and cap agreements are simultaneously entered into with RBSG that effectively eliminate the Company’s market risk associated with the customer derivative products. The customer derivatives portfolio also includes foreign exchange contracts that are entered into on behalf of customers for the purpose of hedging exposure related to cash orders and loans and deposits denominated in 53
RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED) foreign currency. The primary risks associated with these transactions arise from exposure to changes in foreign currency exchange rates and the ability of the counterparties to meet the terms of the contract. To manage these risks, the Company simultaneously enters into offsetting foreign exchange contracts with RBSG.
Residential loan derivatives The Company enters into residential loan commitments that allow residential mortgage customers to lock in the interest rate on a residential mortgage while the loan undergoes the underwriting process. The Company also uses forward sales contracts to protect the value of residential mortgage loans and loan commitments that are being underwritten for future sale to investors in the secondary market.
The Company has certain derivative transactions that are designated as hedging instruments described as follows: Derivatives designated as hedging instruments The majority of the Company’s institutional hedging portfolio qualifies for hedge accounting. This includes interest rate swaps that are designated in highly effective fair value and cash flow hedging relationships. The Company formally documents at inception all hedging relationships, as well as risk management objectives and strategies for undertaking various accounting hedges. Additionally, the Company uses dollar offset or regression analysis at the hedge’s inception, and at least quarterly thereafter to assess whether the derivatives are expected to be, or have been, highly effective in offsetting changes in the hedged item’s fair value or expected cash flows. The Company discontinues hedge accounting when it is determined that a derivative is not expected to be or has ceased to be effective as a hedge, and then reflects changes in fair value in earnings after termination of the hedge relationship. Fair value hedges The Company had previously utilized interest rate swaps to hedge the market risk associated with various fixed income security positions. These swaps were deemed to be highly effective fair value hedges of the underlying securities and are marked-to-market with changes in fair value reflected in earnings (other income). The previously hedged securities were classified as available-for-sale and were marked-to-market with changes in fair value reflected in OCI. The changes in fair value of the security associated with the risk being hedged (market risk) were then reclassified from OCI to earnings (other income) to offset the fair value changes of the hedging derivative.
The Company terminated its fair value hedging program during 2011. The following table summarizes certain information related to the Company’s fair value hedges through September 30, 2011:
The Effect of Fair Value Hedges on Net Income Amounts Recognized in Other Income for the Nine Months Ended September 30, 2011 (in millions) Derivative Hedged Item Hedge Ineffectiveness
Hedges of interest rate risk on investment securities using interest rate swaps($3) $3 $0
Cash flow hedges The Company enters into certain interest rate swap agreements designed to hedge a portion of the Company’s financing liabilities (including its borrowings and deposits). All of these swaps have been deemed as highly effective cash flow hedges. The effective portion of the hedging gains and losses associated with these hedges are recorded in OCI; the ineffective portion of the hedging gains and losses is recorded in earnings (other income). Hedging gains and losses on derivative contracts reclassified from OCI to current period earnings are included in the line item in the accompanying consolidated statements of operations in which the hedged item is recorded, and in the same period that the hedged item affects earnings. During the next 12 months, approximately $152 million of net loss (pre-tax) on derivative instruments included in OCI is expected to be reclassified to interest expense. Hedging gains and losses associated with the Company’s cash flow hedges are immediately reclassified from OCI to current period earnings (other net losses) if it becomes probable that the hedged forecasted transactions will not occur by the originally specified time period. There was no reclassification in 2011. 54
RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The following table summarizes certain information related to the Company’s cash flow hedges:
The Effect of Cash Flow Hedges on Net Income and Stockholder's Equity Amounts Recognized for the Periods Ended (in millions) September 30, 2012 September 30, 2011
Effective portion of loss recognized in OCI1 ($40) ($163) Amounts reclassified from OCI to interest expense2 264 397 Amounts reclassified from OCI to other losses3 1 - Ineffective portion of gain recognized in other income4 1 -
1 The cumulative effective gains and losses on the Company's cash flow hedging activities are included on the accumulated other comprehensive loss line item on the consolidated balance sheets. 2 This amount includes both (a) the amortization of effective gains and losses associated with the Company's terminated cash flow hedges and (b) the current reporting period's interest settlements realized on the Company's active cash flow hedges. Both (a) and (b) were previously included on the accumulated other comprehensive loss line item on the consolidated balance sheets and were subsequently recorded as adjustments to the interest expense of the underlying hedged item. 3 This amount represents hedging gains and losses that have been immediately reclassified from accumulated other comprehensive loss based on the probability that the hedged forecasted transactions would not occur by the originally specified time period. This amount is reflected in the other net gains (losses) line item on the consolidated statements of operations. 4 This amount represents the net ineffectiveness recorded during the reporting periods presented plus any amounts excluded from effectiveness testing. These amounts are reflected in the other income line item on the consolidated statements of operations.
Economic Hedges The Company’s customer derivatives do not qualify for hedge accounting. These include interest rate and foreign exchange derivative contracts that are transacted to meet the hedging and financing needs of the Company’s customers. Mark-to-market adjustments to the fair value of customer related interest rate contracts are included in customer derivatives in noninterest income. Mark-to-market adjustments to the fair value of foreign exchange contracts relating to foreign currency loans are included in commercial loan interest while all other foreign currency contract fair value changes are included in international fees. In both cases, the mark-to-market gains and losses associated with the customer derivatives are mitigated by the mark-to-market gains and losses on the offsetting interest rate and foreign exchange derivative contracts transacted with RBSG. The Company’s residential loan derivatives (including residential loan commitments and forward sales contracts) also do not qualify for hedge accounting. Mark-to-market adjustments to the fair value of residential loan commitments and forward sale contracts are included in noninterest income under mortgage banking.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The following table summarizes certain information related to the Company’s economic hedges:
The Effect of Customer Derivatives and Economic Hedges on Net Income Amounts Recognized in Noninterest Income for the Periods Ended September 30 (in millions) 2012 2011 Customer derivative contracts Customer interest rate contracts1 $278 $623 Customer foreign exchange contracts1 0 17 Residential loan commitments3 (15) (30)
Economic hedges Offsetting derivatives transacted with RBSG to hedge interest rate risk on customer interest rate contracts1 (280) (614) Offsetting derivatives transacted with RBSG to hedge foreign exchange risk on customer foreign exchange contracts2 1 (13) Forward sale contracts3 29 24 Total $13 $7
1 Reported in customer derivatives on the consolidated statements of operations. 2 Reported in international fees on the consolidated statements of operations.
3 Reported in mortgage banking on the consolidated statements of operations.
11. COMMITMENTS, GUARANTEES AND CONTINGENCIES Commitments Commitments to extend credit are agreements to lend to customers in accordance with conditions contractually agreed upon in advance. Generally, the commitments have fixed expiration dates or termination clauses and may require payment of a fee. Since many of these commitments are expected to expire without being drawn upon, the contract amounts are not necessarily indicative of future cash requirements. Fund investment commitments are agreements to invest previously agreed upon amounts of capital within particular timeframes into pools of investments in start-up companies. These investments are included in other investment securities on the consolidated balance sheets. When-issued securities are agreements to purchase securities that have been authorized for issuance but not yet issued. The fair value of when-issued securities is reflected in the consolidated balance sheets at trade date. During 2003, the Company entered into a 25-year agreement to acquire the naming and marketing rights of a baseball stadium in Pennsylvania. The Company paid $3 million in 2012 and 2011 and is obligated to pay $57 million over the remainder of the contract. Letters of Credit Standby letters of credit, both financial and performance, are issued by the Company for their customers. They are used as conditional guarantees of payment to a third party in the event the customer either fails to make specific payments (financial) or fails to complete a specific project (performance). Commercial letters of credit are used to facilitate the import of goods. The commercial letter of credit is used as the method of payment to the Company’s customers’ 56
RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED) suppliers. The Company’s exposure to credit loss in the event of counterparty nonperformance in connection with the above instruments is represented by the contractual amount of those instruments, net of the value of collateral held. Standby letters of credit and commercial letters of credit are issued for terms of up to ten years and one year, respectively. Generally, letters of credit are collateralized by cash, accounts receivable, inventory or investment securities. Credit risk associated with letters of credit is considered in determining the appropriate amounts of reserves for unfunded commitments. The Company recognizes a liability on the consolidated balance sheets representing its obligation to stand ready to perform over the term of the standby letters of credit in the event that the specified triggering events occur. The liability for these guarantees at September 30, 2012 and December 31, 2011 is $5 million and $4 million, respectively. Risk Participation Agreements Risk participation agreements (“RPAs”) are guarantees issued by the Company to other parties for a fee, whereby the Company agrees to participate in the credit risk of a derivative customer of the other party. Under the terms of these agreements, the “participating bank” receives a fee from the “lead bank” in exchange for the guarantee of reimbursement if the customer defaults on an interest rate swap. The interest rate swap is transacted as such that any and all exchanges of interest payments (favorable and unfavorable) are made between the lead bank and the customer. In the event that an early termination of the swap occurs and the customer is unable to make a required close out payment, the participating bank assumes that obligation and is now required to make this payment. RPAs where the Company acts as the lead bank are referred to as “participations-out”, in reference to the credit risk associated with the customer derivatives being transferred out of the Company. Participations-out generally occur concurrently with the sale of new customer derivatives. RPAs where the Company acts as the participating bank are referred to as “participations-in”, in reference to the credit risk associated with the counterparty’s derivatives being assumed by the Company. The Company’s maximum credit exposure is based on its proportionate share of the settlement amount of the referenced interest rate swap. Settlement amounts are generally calculated based on the fair value of the swap plus outstanding accrued interest receivables from the customer. The Company’s estimate of the credit exposure associated with its risk participations-in as of September 30, 2012 and December 31, 2011 is $34 million and $33 million, respectively. The current amount of credit exposure is spread out over 53 counterparties. Risk participations generally have terms ranging from 1-5 years; however certain outstanding agreements have terms as long as 10 years. Other Guarantees The Company has issued a guarantee to RBSG, for a fee, whereby the Company will absorb credit losses related to the sale of option contracts by RBSG to customers of the Company. There were outstanding option contracts with a notional value of $178 million and $1.2 billion at September 30, 2012 and December 31, 2011, respectively.
The following is a summary of outstanding commitments:
September 30, December 31, (in millions) 2012 2011 Commitment amount: Undrawn commitments to extend credit $53,271 $49,347 Financial standby letters of credit 3,880 4,259 Performance letters of credit 160 146 Commercial letters of credit 102 105 Marketing rights 57 60 Risk participation agreements 32 33 Residential mortgage loans sold with recourse 17 13 Fund investment commitments 5 14 Total $57,524 $53,977
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
Contingencies The Company operates in a legal and regulatory environment that exposes RBS Citizens to potentially significant risks. A certain amount of litigation ordinarily results from the nature of the Company’s banking and other businesses. The Company is a party to legal proceedings, including class actions, and the subject of investigations, reviews, and regulatory matters arising out of its normal business operations. In addition, the Company engages in discussions with relevant governmental and regulatory authorities on an ongoing and regular basis regarding various issues, and it is possible that any issues discussed or identified may result in investigatory or other action being taken. Litigation and regulatory matters may result in settlements, damages, fines, public or private censure, increased costs, required remediation, restriction on business activities, or other impact on the Company. In these disputes and proceedings, the Company contests liability and the amount of damages as appropriate. Given their complex nature, it may be years before some of these matters are finally resolved. Moreover, before liability can be reasonably estimated for a claim, numerous legal and factual issues may need to be examined, including through potentially lengthy discovery and determination of important factual matters, and by addressing novel or unsettled legal issues relevant to the proceedings in question. The Company cannot predict with certainty if, how, or when such claims will be resolved or what the eventual settlement, fine, penalty or other relief, if any, may be, particularly for claims that are at an early stage in their development or where claimants seek substantial or indeterminate damages. The Company recognizes a provision for a claim when, in the opinion of management after seeking legal advice, it is probable that a liability exists and the amount of loss can reasonably be estimated. In many proceedings, however, it is not possible to determine whether any loss is probable or to estimate the amount of any loss. Set out below are descriptions of significant legal matters involving the Company. Based on information currently available, the advice of legal and other counsel, and established reserves, management believes that the aggregate liabilities, if any, arising from these proceedings will not have a materially adverse effect on the Company’s consolidated financial position, consolidated results of operations or consolidated cash flows.
Overdraft Fee Litigation The Company is a defendant in consolidated putative class action lawsuits relating to overdraft fees charged by the Company, including the processing and posting of electronic debit transactions that result in overdraft fees charged to customers. The plaintiffs claim that overdraft fees resulting from point of sale and ATM transactions violate the duty of good faith implied in the Company's customer account agreement, are unconscionable, constitute an unfair trade practice, violate its banking authority and result in the conversion of the customers’ funds. On April 19, 2012, following a voluntary mediation, the Company reached a preliminary settlement of class claims asserted against the Company relating to the order in which transactions were posted to consumer bank accounts. Pursuant to the settlement, the Company has made a one- time payment of $138 million into a settlement fund. It will also pay costs to administer the settlement, including the costs of providing notice to the class (estimated at $2 million). The settlement fund will be used to make payments to class members who were allegedly charged additional overdraft fees because of the way in which the Company posted transactions to accounts between January 2002 and August 13, 2010. The settlement is subject to court final approval.
Fair Labor Standards Act Litigation The Company has been named in several purported class actions brought under the Fair Labor Standards Act (“FLSA”) and equivalent state statutes alleging that certain categories of branch employees were denied overtime for hours worked. Six of these suits are brought by current and former branch employees alleging that either: (1) they are / were in Assistant Branch Manager positions and were improperly classified as exempt under the FLSA thereby denying them pay for all hours worked, including overtime pay; or (2) they are / were properly classified as non-exempt tellers, bankers or the like but were told not to record all of their hours, had hours they entered deleted by their managers and / or were otherwise denied pay for hours worked, including overtime pay. Separately, the Company has been named in a lawsuit brought by current and former mortgage loan officers alleging that they were improperly classified as exempt under the FLSA and corresponding state laws and therefore denied pay for all hours worked, including overtime pay. These cases cover the entire thirteen state footprint. The cases are in varying stages of litigation. Only two of the cases have trial dates; the first is scheduled to begin in April 2013. The Company is vigorously defending these matters. The Company is unable to reliably estimate the liability, if any, that might arise or its effect on the Company’s consolidated financial position, consolidated results of operations or consolidated cash flows in any particular period. 58
RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
Mortgage Repurchase Demands The Company is an originator and servicer of residential mortgages and routinely sells such mortgage loans in the secondary market and to government-sponsored entities. In the context of such sales, the Company makes certain representations and warranties regarding the characteristics of the underlying loans and, as a result, may be contractually required to repurchase such loans or indemnify certain parties against losses for certain breaches of those representations and warranties. Between the start of January 2009 and the end of September 2012, the Company has received $117 million in repurchase demands in respect of loans originated, for the most part, since 2003. Of those claims presented, $34 million was paid to repurchase, indemnify, or make the investor whole. The Company cannot estimate what the future level of repurchase demands will be or the Company’s ultimate exposure, and cannot give any assurance that the historical experience will continue in the future. It is possible that the volume of repurchase demands will increase. Furthermore, the Company is unable to reliably estimate the liability, if any, that might arise or its effect on the Company’s consolidated financial position, consolidated results of operations or consolidated cash flows in any particular period.
MERS Cases Counties in three states and the District of Columbia have now brought suit against MERSCORP, Inc., Mortgage Electronic Registration Systems, Inc. (“MERS”) and its shareholder financial institutions, including the Company, for its origination and securitization of mortgage loans using the MERS system. The counties allege that by registering properties in MERS’ name the banks fail to pay recording fees as required by state law when properties are transferred among them. The dismissal of plaintiff’s complaint in one state is on appeal. The other cases continue. The Company is vigorously defending these matters. The Company is unable to reliably estimate the liability, if any, that might arise or its effect on the Company’s consolidated financial position, consolidated results of operations or consolidated cash flows in any particular period.
12. DIVESTITURES On June 22, 2012, the Company completed the sale of 57 branches in New York. Assets and deposits totaled $16 million and $325 million, respectively. A gain of $4 million was recognized in other net gains, offset by approximately $4 million in one-time costs recognized in noninterest expense.
13. RELATED PARTY TRANSACTIONS The following is a summary of funds borrowed from RBSG: September 30, December 31, (in millions) Interest Rate Maturity Date 2012 2011 Subordinated debt Three month LIBOR + 1.50% March 2034 $289 $506
The Company maintains a $50 million revolving line of credit at September 30, 2012 and $75 million at December 31, 2011 with RBSG. This line of credit was not drawn upon at September 30, 2012 or December 31, 2011. The Company enters into interest rate swap agreements with RBSG for the purpose of reducing the Company’s exposure to interest rate fluctuations. As of September 30, 2012, the total notional amount of swaps outstanding was $5.2 billion which pay fixed rates ranging from 2.82% to 5.47% and receive overnight fed funds rate with maturities from 2012 through 2016. As of December 31, 2011, the total notional amount of swaps outstanding was $9.2 billion which pay fixed rates ranging from 2.82% to 5.47% and receive one or three month LIBOR with maturities from 2012 through 2016. In order to meet the financing needs of its customers, the Company enters into interest rate swap and cap agreements with its customers and simultaneously enters into offsetting swap and cap agreements with RBSG. The Company earns a spread equal to the difference between rates charged to the customer and rates charged by RBSG. The notional amount of these interest rate swap and cap agreements outstanding with RBSG was $16.7 billion and $14.9 billion at September 30, 2012 and December 31, 2011, respectively.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
Also to meet the financing needs of its customers, the Company enters into a variety of foreign currency denominated products, such as loans, deposits and foreign exchange contracts. To manage the foreign exchange risk associated with these products, the Company simultaneously enters into offsetting foreign exchange contracts with RBSG. The Company earns a spread equal to the difference between rates charged to the customer and rates charged by RBSG. The notional amount of foreign exchange contracts outstanding with RBSG was $3.7 billion and $3.4 billion at September 30, 2012 and December 31, 2011, respectively. The Company has issued a guarantee to RBSG for a fee, whereby the Company will absorb credit losses related to the sale of option contracts by RBSG to customers of the Company. There were outstanding option contracts with a notional value of $178 million and $1.2 billion at September 30, 2012 and December 31, 2011, respectively. Net expense recorded for amounts due to RBSG for the nine months ended September 30, 2012 and 2011 totaled $546 million and $746 million, respectively. The Company receives income for providing services and referring customers to RBSG. The Company also shares office space with certain RBSG entities for which rent expense and / or income is recorded in occupancy expense. The total fee income, net of occupancy expense, for the nine months ended September 30, 2012 and 2011 was $20 million and $19 million, respectively. In 2012 the Company paid $95 million in common stock dividends to RBSG. No dividends were paid in 2011. The Company, as a matter of policy and during the ordinary course of business with underwriting terms similar to those offered to the public, has made loans to directors and executive officers and their immediate families, as well as their affiliated companies. Such loans amounted to $93 million and $77 million at September 30, 2012 and December 31, 2011, respectively.
14. FAIR VALUE MEASUREMENTS As discussed in Note 1, the Company measures or monitors many of its assets and liabilities on a fair value basis. Fair value is used on a recurring basis for assets and liabilities for which fair value is the required or elected basis of accounting. Additionally, fair value is used on a nonrecurring basis to evaluate assets for impairment or for disclosure purposes. Nonrecurring fair value adjustments typically involve the application of lower of cost or market accounting or write-downs of individual assets. The Company also applies the fair value measurement guidance to determine amounts reported for certain disclosures in this note for assets and liabilities not required to be reported at fair value in the financial statements. Fair Value Option, Residential Loans Held-for-Sale The Company elected to account for residential loans held-for-sale at fair value. Applying fair value accounting to the residential mortgage loans held-for-sale better aligns the reported results of the economic changes in the value of these loans and their related hedge instruments. The fair value of residential loans held-for-sale is derived from observable mortgage security prices and includes adjustments for loan servicing value, agency guarantee fees, and other loan level attributes which are mostly observable in the marketplace. Credit risk is not material to the valuation since the loans are sold shortly after origination. Therefore, the Company classifies the residential loans held-for-sale in Level 2 of the fair value hierarchy. At September 30, 2012, the fair value carrying amount of residential loans held-for-sale and the aggregate unpaid principal amount that the Company is contractually entitled to receive at maturity are $594 million and $561 million, respectively. At December 31, 2011 the fair value carrying amount of residential loans held-for-sale and the aggregate unpaid principal amount that the Company is contractually entitled to receive at maturity were $564 million and $543 million, respectively. The amount of loans past due or nonaccruing is not material. The loans accounted for under the fair value option are initially measured at fair value when the financial asset is recognized. Subsequent changes in fair value are recognized in current earnings. The Company recognized a $4 million decrease and $1 million increase in mortgage banking noninterest income for the nine months ended September 30, 2012 and 2011, respectively. Interest income on residential loans held-for-sale is calculated based on the note rate of the loan and is recorded in interest income. Changes in fair value of the residential mortgages held for sale due to instrument-specific credit risk during the nine months ended September 30, 2012 and 2011 were not material.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
Recurring Fair Value Measurements The Company utilizes a variety of valuation techniques to measure its assets and liabilities at fair value. Following is a description of valuation methodologies used for significant assets and liabilities carried on the balance sheet at fair value on a recurring basis: Securities available-for-sale: The fair value of securities classified as “available-for-sale" is based upon quoted prices, if available. Where observable quoted prices are available in an active market, securities are classified as Level 1 in the fair value hierarchy. Classes of instruments that are valued using this market approach include debt securities issued by the U.S. Treasury. If quoted market prices are not available, the fair value for the security is estimated by using pricing models, quoted prices of securities with similar characteristics or discounted cash flows. These instruments are classified as Level 2 because they currently trade in active markets and the inputs to the valuations are observable. The pricing models used to value securities generally begin with market prices (or rates) for similar instruments and make adjustments based on the unique characteristics of the instrument being valued. These adjustments reflect assumptions made regarding the sensitivity of each security’s value to changes in interest rates and prepayment speeds. Classes of instruments that are valued using this market approach include residential and commercial collateralized mortgage obligations (“CMOs”), specified pool mortgage “pass-through” securities and other debt securities issued by U.S. Government-sponsored entities and state and political subdivisions. A significant majority of the Company’s Level 1 and 2 securities are priced using an external pricing service. The Company verifies the accuracy of the pricing provided by its primary outside pricing service on a quarterly basis. This process involves using a secondary external vendor to provide valuations for the Company’s securities portfolio for comparison purposes. Any securities with discrepancies beyond a certain threshold are researched and, if necessary, valued by an independent outside broker. In certain cases where there is limited activity or less transparency around inputs to the valuation model, securities are classified as Level 3. Residential loans held for sale: See the Fair Value Option discussion above. Derivatives: The majority of the Company’s derivatives portfolio is comprised of “plain vanilla” interest rate swaps, which are traded in over-the-counter markets where quoted market prices are not readily available. For these derivatives, fair value is determined utilizing models that use primarily market observable inputs, such as swap rates and yield curves. The pricing models used to value interest rate swaps calculate the sum of each instrument’s fixed and variable cash flows, which are then discounted using an appropriate yield curve (i.e. LIBOR or Overnight Index Swap curve) to arrive at the fair value of each swap. The models do not contain a high level of subjectivity as the methodologies used do not require significant judgment. The Company also considers certain adjustments to the modeled price which market participants would make when pricing each instrument, including a credit valuation adjustment that reflects the credit quality of the swap counterparty. The Company incorporates the effect of exposure to a particular counterparty’s credit by netting its derivative contracts with the collateral available and calculating a credit valuation adjustment on the basis of the net position with the counterparty. The determination of this adjustment requires judgment on behalf of Company management; however the total amount of this portfolio- level adjustment is not significant to the total fair value of the interest rate swaps in their entirety. Therefore, interest rate swaps are classified as Level 2 in the valuation hierarchy. The Company’s other derivatives include foreign exchange contracts. Fair value of foreign exchange derivatives uses the mid-point of daily quoted currency spot prices. A valuation model estimates fair value based on the quoted spot rates together with interest rate yield curves and forward currency rates. Since all of these inputs are observable in the market, foreign exchange derivatives are classified as Level 2 in the fair value hierarchy. Venture capital investments: The Company values its venture capital private equity fund investments based on its capital invested in each fund, which is adjusted by management each quarter, if necessary, to arrive at its estimate of fair value. Adjustments for a fund’s underlying investments may be based upon comparisons to public companies, industry benchmarks, current financing round pricing, earnings multiples of comparable companies, current operating performance and future expectations, or third party valuations. Since the inputs to the valuation are difficult to independently corroborate in the marketplace, and involve a significant degree of management judgment, venture capital investments are classified as Level 3 in the fair value hierarchy.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The following table presents assets and liabilities measured at fair value on a recurring basis at September 30, 2012:
(in millions) Total Level 1 Level 2 Level 3
Securities available-for-sale: Mortgage-backed securities $20,142 $0 $20,142 $0 State and political subdivisions 92 - 92 - Equity securities 19 7 12 - U.S. Treasury 15 15 - - Residential loans held for sale 594 - 594 - Derivative assets: Interest rate contracts - non hedged instruments 1,209 - 1,209 - Foreign exchange contracts - non hedged instruments 76 - 76 - Other contracts - non hedged instruments 59 - 59 - Interest rate contracts - hedged instruments 1 - 1 - Venture capital investments 6 - - 6 Total assets $22,213 $22 $22,185 $6
Derivative liabilities: Interest rate contracts - non hedged instruments $1,150 $0 $1,150 $0 Interest rate contracts - hedged instruments 304 - 304 - Foreign exchange contracts - non hedged instruments 71 - 71 - Other contracts - non hedged instruments 29 - 29 - Total liabilities $1,554 $0 $1,554 $0
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The following table presents assets and liabilities measured at fair value on a recurring basis at December 31, 2011:
(in millions) Total Level 1 Level 2 Level 3
Securities available-for-sale: Mortgage-backed securities $22,022 $0 $22,022 $0 State and political subdivisions 90 - 90 - Equity securities 22 10 12 - U.S. Treasury 15 15 - - Other debt securities 1 - 1 - Residential loans held for sale 564 - 564 - Derivative assets: Interest rate contracts - non hedged instruments 1,243 - 1,243 - Foreign exchange contracts - non hedged instruments 86 - 86 - Other contracts - non hedged instruments 27 - 27 - Interest rate contracts - hedged instruments 1 - 1 - Venture capital investments 57 - - 57 Total assets $24,128 $25 $24,046 $57
Derivative liabilities: Interest rate contracts - non hedged instruments $1,146 $0 $1,146 $0 Interest rate contracts - hedged instruments 476 - 476 - Foreign exchange contracts - non hedged instruments 82 - 82 - Other contracts - non hedged instruments 14 - 14 - Total liabilities $1,718 $0 $1,718 $0
Nonrecurring Fair Value Measurements The following valuation techniques are utilized to measure significant assets for which the Company utilizes fair value on a nonrecurring basis: Impaired Loans: The carrying amount of collateral-dependant impaired loans is compared to the appraised value of the collateral less costs to dispose. Any excess of carrying amount over the appraised value is charged to the allowance for loan and lease losses. MSRs: Mortgage servicing rights do not trade in an active market with readily observable prices. Therefore, the Company determines the fair value of mortgage servicing rights using a model that calculates the present value of estimated net future servicing income. The model utilizes assumptions that market participants use in estimating future net servicing income, including estimates of prepayment speeds, default rates, cost to service, discount rate, escrow earnings, contractual servicing fee income, and ancillary income. The discount rate is the required rate of return investors in the market would expect for an asset of similar risk. Mortgage servicing rights are classified as Level 3 since the valuation methodology utilizes significant unobservable inputs. Foreclosed assets: Foreclosed assets consist primarily of residential properties. Foreclosed assets are carried at the lower of carrying value or fair value less costs to dispose. Fair value is based upon independent market prices or appraised values of the collateral and is classified as Level 2.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The following table presents assets and liabilities measured at fair value on a nonrecurring basis and any gains (losses) recorded in earnings:
Nine Months Ended Carrying Value at September 30, 2012 September 30, 2012 (in millions) Total Level 1 Level 2 Level 3 Total Losses Impaired collateral dependent loans1 $539 $0 $144 $395 ($70) MSRs2 144 - - 144 (14) Foreclosed assets3 97 - 97 - (5)
Year Ended Carrying Value at December 31, 2011 December 31, 2011 (in millions) Total Level 1 Level 2 Level 3 Total Losses Impaired collateral dependent loans1 $488 $0 $488 $0 ($118) MSRs2 157 - - 157 (42) Foreclosed assets3 116 - 116 - (7)
1 In 2012, impaired loans for which collection is dependent on the loan’s collateral in the amount of $876 million were written down to $538 million resulting in an impairment charge of $70 million, which was charged to the allowance for loan and lease losses. In 2011, impaired loans for which collection is dependent on the loan’s collateral in the amount of $875 million were written down to their fair value of $488 million resulting in an impairment charge of $118 million, which was charged to the allowance for loan and lease losses. Fair value of the loans was based on the appraised value of the collateral. 2 In 2012, MSRs totaling $215 million were evaluated for impairment and written down to $144 million, resulting in an impairment charge of $14 million and a total cumulative valuation allowance of $72 million. In 2011, MSRs totaling $215 million were evaluated for impairment and written down to $157 million, resulting in an impairment charge of $42 million. 3 In 2012, foreclosed real estate accounted for at the lower of cost or fair value less costs to sell was written down to fair value of $97 million, resulting in impairment charges of $5 million. In 2011, foreclosed real estate accounted for at the lower of cost or fair value less costs to sell was written down to fair value of $116 million, resulting in impairment charges of $7 million.
Disclosures about Fair Value of Financial Instruments Following is a description of valuation methodologies used to estimate the fair value of financial instruments for disclosure purposes (these instruments are not recorded in the financial statements at fair value): Loans and leases: For loans and leases not recorded at fair value on a recurring basis, fair value is estimated by discounting the expected future cash flows using current rates which a market participant would likely use to value similar pools of loans. The internal risk weighted balances of loans are grouped by product type for purposes of this estimated valuation. For non-accruing loans, fair value is estimated by discounting management’s estimate of future cash flows with a discount rate commensurate with the risk associated with such assets. Other investment securities: The cost basis carrying value of other investment securities, such as FHLB stock and FRB stock, is assumed to approximate the fair value of the securities. As a member of the FHLB and FRB, the Company is required to hold FHLB and FRB stock. The stock can be sold only to the FHLB and FRB upon termination of membership, or redeemed at the FHLB’s or FRB’s sole discretion. Deposits: The fair value of demand deposits, checking with interest accounts, regular savings and money market accounts is the amount payable on demand at the balance sheet date. The fair value of term deposits is estimated by discounting the expected future cash flows using rates currently offered for deposits of similar remaining maturities. Federal funds purchased and securities sold under agreements to repurchase and borrowed funds: Rates currently available to the Company for debt of similar terms and remaining maturities are used to discount the expected cash flows of existing debt.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The following table is a summary of fair value for financial instruments not recorded at fair value in the Consolidated Financial Statements. The table excludes instruments that re-price within 90 days, for which carrying amounts approximate fair value, and financial instruments recorded at fair value on a recurring basis. The carrying amounts in the following table are recorded in the consolidated balance sheets under the indicated captions:
September 30, 2012 December 31, 2011 Total Level 1 Level 2 Level 3 Total Carrying Fair Carrying Fair Carrying Fair Carrying Fair Carrying Fair (in millions) Value Value Value Value Value Value Value Value Value Value
Financial Assets: Loans and leases $86,941 $87,515 $0 $0 $144 $144 $86,797 $87,371 $86,795 $83,851 Other investment securities 1,073 1,073 - - 1,073 1,073 - - 1,202 1,202
Financial Liabilities: Deposits 96,481 96,487 - - 96,481 96,487 - - 92,888 93,005 Federal funds purchased and securities sold under agreements to repurchase 3,241 3,241 - - 3,241 3,241 - - 4,152 4,152
Borrowed funds 4,699 4,688 - - 4,699 4,688 - - 6,342 6,356
15. REGULATORY MATTERS As a bank holding company, the Company is subject to regulation and supervision by the Federal Reserve Board of Governors (“FRBG”). The Company’s primary subsidiary bank, RBS Citizens, N.A., is a nationally chartered bank, regulated by the FRBG and supervised by the OCC while Citizens Bank of Pennsylvania is a state-chartered bank, regulated by the Pennsylvania Department of Banking and supervised by the FDIC. Under the regulatory capital adequacy guidelines of the Federal Deposit Insurance Corporation Improvement Act of 1991 (“FDICIA”), the Company and its banking subsidiaries must meet specific capital requirements. These requirements are expressed in terms of the following ratios: (1) Risk-based Total Capital (total capital / risk-weighted on-and off-balance sheet assets); (2) Risk-based Tier 1 Capital (tier 1 capital / risk weighted on- and off-balance sheet assets); and Tier 1 Leverage (tier 1 capital / adjusted average quarterly assets). To meet the regulatory capital requirements, the Company and its banking subsidiaries must maintain minimum Risk-based Total Capital, Risk-based Tier 1 Capital, and Tier 1 Leverage ratios. In addition, the Company must not be subject to a written agreement, order or capital directive with any of its regulators. Failure to meet minimum capital requirements can result in the initiation of certain actions that, if undertaken, could have a material effect on the Company’s Consolidated Financial Statements.
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RBS CITIZENS FINANCIAL GROUP, INC. NOTES TO CONSOLIDATED INTERIM FINANCIAL STATEMENTS (UNAUDITED)
The following table presents capital and capital ratio information: FDIC Requirements Minimum Classification as Actual Capital Adequacy Well-capitalized (dollars in millions) Amount Ratio Amount Ratio Amount Ratio As of September 30, 2012 Total Capital to Risk Weighted Assets $15,547 15.7% $7,932 8.0% $9,915 10.0% Tier 1 Capital to Risk Weighted Assets 13,955 14.1% 3,966 4.0% 5,949 6.0% Tier 1 Capital to Average Assets 13,955 11.9% 3,519 3.0% 5,864 5.0%
As of December 31, 2011 Total Capital to Risk Weighted Assets $14,914 15.1% $7,896 8.0% $9,870 10.0% Tier 1 Capital to Risk Weighted Assets 13,673 13.9% 3,948 4.0% 5,922 6.0%
Tier 1 Capital to Average Assets 13,673 11.6% 3,533 3.0% 5,888 5.0% In accordance with federal and state banking regulations, dividends paid by the Company’s banking subsidiaries to the Company itself are generally limited to the retained earnings of the respective banks. The Company paid RBS Group total common stock dividends of $95 million through September 30, 2012. There was no common stock dividend in 2011.
16. SUPPLEMENTAL CASH FLOW INFORMATION Supplemental cash flow information and non-cash activities are as follows: Nine Months Ended September 30, (in millions) 2012 2011 Supplemental cash flow information: Interest paid $507 $686 Income taxes paid 199 26
Supplemental schedule of noncash investing and financing activities:
Capital contribution for incentive compensation - 20
17. SUBSEQUENT EVENTS The Company has evaluated events that have occurred subsequent to September 30, 2012 through January 18, 2013, the date the Consolidated Financial Statements were issued. RBS Citizens offered a lump sum cash payout option to certain former employees to settle all future qualified defined benefit pension liabilities for such employees. Approximately 4,300 former RBS Citizens employees accepted the offer and collectively received a payout of $146 million. The Company recorded a $77 million charge to earnings in December 2012 and reduced the qualified defined benefit pension plan obligation by approximately $180 million as a result of the settlement. The Company is not aware of any other subsequent events which would require recognition or disclosure in the Consolidated Financial Statements.
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