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Financial Statements

Independent Auditors’ Report

To the Board of Directors and Shareholders of
Alliance & Leicester plc
Leicester, United Kingdom:

We have audited the accompanying consolidated balance sheets of Alliance & Leicester plc and its subsidiaries (the “Company”) as of 31 December 2008 and 2007, and the related Consolidated Income Statements, the Consolidated Statements of Total Recognised Income and Expenses, and the Consolidated Cash Flow Statements for each of the three years in the period ended 31 December 2008. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company as of 31 December 2008 and 2007, and the results of its operations and its cash flows for each of the three years in the period ended 31 December 2008 in conformity with International Financial Reporting Standards (“IFRS”) as adopted by the European Union and IFRSs as issued by the International Accounting Standards Board.

Deloitte LLP
Chartered Accountants
London, United Kingdom
19 March 2009

Financial Statements

Consolidated Balance Sheet

As at 31 December 2008 and 2007


			2008			2007⁽¹⁾
	Notes		£m			£m

Assets
Cash and balances at central banks		11		1,553			3,471
Trading assets		12		—			1,439
Derivative financial instruments		13		2,876			970
Financial assets designated at fair value		14		63			891
Loans and advances to banks		15		1,239			2,885
Loans and advances to customers		16		51,402			55,056
Available-for-sale securities		18		1,658			12,773
Held-to-maturity securities				—			213
Loan and receivable securities		18		14,250			210
Macro hedge of interest rate risk				713			38
Intangible assets		19		17			116
Property, plant and equipment		20		223			252
Operating lease assets		21		348			284
Current tax assets				17			—
Deferred tax assets		22		626			5
Other assets		23		259			299
Retirement benefit obligations		31		4			53

Total assets				75,248			78,955

Liabilities
Deposits by banks		24		11,516			18,512
Deposits by customers		25		39,765			29,976
Derivative financial instruments		13		1,533			791
Financial liabilities designated at fair value		26		728			4,027
Debt securities in issue		27		17,477			21,879
Subordinated liabilities		28		1,436			711
Other liabilities		29		631			702
Provisions		30		34			—
Current tax liabilities				1			5
Deferred tax liabilities		22		278			—
Retirement benefit obligations		31		21			28

Total liabilities				73,420			76,631

Equity
Innovative tier 1		33		311			311
Preference shares		34		294			294
Minority interest		35		—			4

				605			609

Share capital		34		328			210
Share premium account		34		724			125
Capital redemption reserve		35		90			90
Reserve for share based payments		35		—			26
Available-for-sale reserve		35		(293	)		(143	)
Cash flow hedging reserve		35		164			(14	)
Retained earnings		35		210			1,421

Total ordinary shareholders’ equity				1,223			1,715

Total liabilities and equity				75,248			78,955


(1)		The 2007 Balance Sheet has been reclassified as described in the Accounting Policies.

Notes 1 to 44 are an integral part of these Consolidated Financial Statements.

The Financial Statements were approved by the Board on 19 March 2009 and signed on its behalf by:

Antonio Lorenzo
Chief Financial Officer

Financial Statements

Consolidated Statement of Recognised Income and Expense

For the years ended 31 December 2008, 2007 and 2006


			2008			2007			2006
	Notes		£m			£m			£m

Actuarial (losses)/gains on retirement benefit obligations		31		(60	)		56			50
Losses on available-for-sale securities		35		(241	)		(220	)		(2	)
Gains/(losses) on cash flow hedges taken directly to equity				259			15			(58	)
Tax on items taken directly to equity				2			46			4

Net loss recognised directly in equity				(40	)		(103	)		(6	)
Losses/(gains) on available-for-sale securities transferred to profit or loss on sale		35		14			(1	)		(1	)
Impairment loss transferred to profit or loss		35		18			11			—
Cash flow hedges transferred to profit or loss				(11	)		(7	)		(2	)

Net transfers to profit				21			3			(3	)
(Loss)/profit for the year				(918	)		296			450

Total recognised income and expense for the year				(937	)		196			441
Attributable to:
Equity holders of the parent				(973	)		156			424
Innovative tier 1 holders				17			17			17
Preference shareholders				19			19			—
Minority interest				—			4			—

Consolidated Cash Flow Statement

For the years ended 31 December 2008, 2007 and 2006


			2008			2007⁽¹⁾			2006⁽¹⁾
	Notes		£m			£m			£m

Net cash flow from operating activities
(Loss)/Profit for the year				(918	)		296			450
Adjustments for:
Non-cash items included in net profit				901			430			147
Change in operating assets				(411	)		(7,496	)		(8,837	)
Change in operating liabilities				4,059			9,119			4,113
Income taxes received/(paid)				21			(54	)		(81	)

Net cash flow from operating activities		36		3,652			2,295			(4,208	)

Net cash flows from/(used in) investing activities
Acquisition of subsidiaries, net of cash acquired				(19	)		(173	)		—
Disposal of subsidiaries, net of cash disposed				—			94			328
Purchase of tangible and intangible fixed assets				(241	)		(186	)		(155	)
Proceeds from sale of tangible and intangible fixed assets				48			31			72
Purchase of non-trading securities				(743	)		(4,219	)		(4,737	)
Proceeds from sale of non-trading securities				2,660			2,215			4,049

Net cash flow from/(used in) investing activities				1,705			(2,238	)		(443	)

Net cash flow (used in)/from financing activities
Issue of debt securities				4,066			9,210			11,868
Repayment of debt securities				(11,346	)		(7,581	)		(6,550	)
Issue of ordinary shares				701			18			22
Issue of preference shares				—			—			294
Repurchase of ordinary shares				—			(194	)		(151	)
Preference dividend paid				(19	)		(19	)		—
Interest paid on innovative tier 1				(17	)		(17	)		(18	)
Dividends paid				(229	)		(241	)		(235	)

Net cash flow (used in)/ from financing activities				(6,844	)		1,176			5,230

Net (decrease)/increase in cash and cash equivalents				(1,487	)		1,233			579

Cash and cash equivalents at beginning of the year				3,856			2,623			2,044

Cash and cash equivalents at the end of the year				2,369			3,856			2,623


(1)		The 2007 and 2006 Cash Flow Statements have been reclassified as described in the Accounting Policies.

Notes 1 to 44 are an integral part of these Consolidated Financial Statements.

Financial Statements

Accounting Policies

International Financial Reporting Standards

The Consolidated Financial Statements of Alliance & Leicester plc (the ‘Company’, and together with its subsidiaries, the ‘Group’) have been prepared in accordance with International Financial Reporting Standards (‘IFRS’) as approved by the International Accounting Standards Board (‘IASB’), and interpretations issued by the International Financial Reporting Interpretations Committee (‘IFRIC’) of the IASB that, under European Regulations, are effective and available for early adoption at the Group’s reporting date. The Group has complied with IFRS as issued by the IASB in addition to complying with its legal obligation to comply with IFRS as adopted for use in the European Union.

Disclosures required by IFRS 7 ‘Financial Instruments: Disclosure’ relating to the nature and extent of risks arising from financial instruments can be found in the ‘Risk Management’ report which is included in Note 44 of these Consolidated Financial Statements.

Recent Developments

In 2008, the Group adopted the following new or revised IFRS:

a)		IAS 39 ‘Financial Instruments: Recognition and Measurement’ and IFRS 7 ‘Financial Instruments: Disclosures’. On 13 October 2008, the IASB issued amendments to IAS 39 and IFRS 7 regarding the reclassification of financial instruments. The changes to IAS 39 permit an entity to reclassify, in limited circumstances, certain non-derivative financial assets out of the ‘fair value through profit and loss’ and ‘available-for-sale’ categories into ‘loans and receivable securities’, ‘available-for-sale’ and ‘held-to-maturity’. In addition, the amendments to IFRS 7 require expanded disclosures about these assets. The amendments became effective on 1 July 2008. The impact of the adoption of the amendments to IAS 39 and IFRS can be found in Note 18.

b)		‘Amendment to IFRS2: Share based payments — vesting conditions and cancellations’. The amendment requires share option awards lapsing due to a failure to meet the service condition to be treated as cancellations rather than forfeitures. The impact on the Group’s results has been immaterial.

In addition, the Group applied IFRIC 11 ‘IFRS 2 — Group and Treasury Share Transactions’. On 30 November 2006 IFRIC issued IFRIC 11 which requires that treasury share transactions are treated as equity-settled, and share-based payments involving equity instruments of the parent should be treated as equity-settled where the obligation is from the parent to the employee and cash-settled when the obligation is from the subsidiary to the employee. This is consistent with the Group’s previous practice and therefore the application of IFRIC 11 did not have a material impact on the Group’s profit or loss or financial position.

Future Developments

The Group has not yet adopted the following new or revised IFRS or IFRIC Interpretations, which have been issued but which are not yet effective for the Group:

a)		IAS 23 ‘Borrowing Costs’ — On 29 March 2007, the IASB issued an amendment to IAS 23 ‘Borrowing costs’ which removes the option to expense borrowing costs incurred during the acquisition, construction or production of a qualifying asset. The Group does not expect the adoption of the amendment to IAS 23 to have a material impact on the Group’s profit or loss or financial position. The amendment to IAS 23 is effective for periods beginning on or after 1 January 2009.

b)		IAS 1 ‘Presentation of Financial Statements’ — On 6 September 2007, the IASB issued an amendment to IAS 1 ‘Presentation of Financial Statements’ which changes the way in which non-owner changes in equity are required to be presented. It also changes the titles of primary financial statements as they will be referred to in IFRS but does not require that these be renamed in an entity’s financial statements. The Group does not expect the adoption of the amendment to IAS 1 to have an impact on the financial statements. The amendment to IAS 1 is effective for periods beginning on or after 1 January 2009.

c)		IFRS 3 ‘Business Combinations’ — On 10 January 2008, the IASB issued an amendment to IFRS 3 ‘Business Combinations’ which clarifies and changes certain elements of accounting for a business combination, including measurement of contingent consideration, step acquisition and intangible assets and also widens the scope of this standard. There are also associated amendments to IAS 27, IAS 28 and IAS 31. The amendment to IFRS 3 is effective for periods beginning on or after 1 July 2009.

Basis of preparation

The Financial Statements have been prepared under the historical cost convention, as modified by the revaluation of available-for-sale financial assets, financial assets and financial liabilities held at fair value through profit or loss, financial assets and liabilities in fair value hedges, and all derivative contracts, and on the going concern basis.

Certain balances in the 2007 Consolidated Balance Sheet have been reclassified. This has resulted in the following changes:

a)		Amounts previously shown as ‘Net investment in finance leases and hire purchase contracts’ are now included within ‘Loans and advances to customers’.

b)		Amounts previously shown as ‘Prepayments and accrued income’ are now included within ‘Other assets’.

c)		Amounts previously shown as ‘Accruals and deferred income’ are now included within ‘Other liabilities’.

d)		‘Financial liabilities designated at fair value’ are now shown as a separate balance sheet heading. Previously, these amounts were included within ‘Deposits by banks’, ‘Deposits by customers’ and ‘Debt securities in issue’.

Such reclassifications do not impact Total Assets, Total Liabilities or Equity and align the presentation of the balance sheet with the other UK businesses owned by Banco Santander, S.A.

Financial Statements

Accounting Policies continued

Certain items in the 2007 and 2006 Consolidated Cash Flow Statements have been reclassified. This has resulted in the following changes:

a)		Issue and repayment of debt securities moved from net cash flow used in operating activities to financing activities;

b)		Additions and disposals of investment securities fair valued through profit or loss moved from net cash flow used in investing activities to net cash flow used in operating activities.

The consequence of these changes was that, for the Group, net cash flow from operating activities decreased from £3,442m to £2,295m in 2007 and from £2,353m to an outflow of £4,208m in 2006, net cash flow used in investing activities increased from £1,757m to £2,238m in 2007 and fell from £1,486m to £443m in 2006 and net cash outflow used in financing activities of £452m changed to net cash inflow from financing activities of £1,176m in 2007 and an outflow £288m to an inflow of £5,230m in 2006.

The Group believes that both the presentation adopted in the prior periods, and the presentation adopted in the current period, are acceptable alternatives under IAS 7. The Group considers that the current presentation is preferable as it is more reflective of the manner in which the business is monitored by new management and is consistent with the presentation adopted by the other UK businesses owned by Banco Santander, S.A.

Consolidation

Subsidiaries, which are those companies and other entities (including Special Purpose Entities) over which the Group, directly or indirectly, has power to govern the financial and operating policies, are consolidated. The existence and effect of potential voting rights that are presently exercisable or presently convertible are considered when assessing whether the Group controls another entity.

Subsidiaries are consolidated from the date on which control is transferred to the Group and are no longer consolidated from the date that control ceases. The purchase method of accounting is used to account for the acquisition of subsidiaries. The cost of an acquisition is measured at the fair value of the assets given up, shares issued or liabilities undertaken at the date of acquisition, plus directly attributable acquisition costs. The excess of the cost of acquisition over the fair value of the tangible and intangible net assets of the subsidiary acquired is recorded as goodwill. Inter-company transactions, balances and unrealised gains on transactions between Group companies are eliminated; unrealised losses are also eliminated unless the cost cannot be recovered. The accounting reference date of the Company and its subsidiary undertakings is 31 December, with the exception of those leasing and investment companies which, because of commercial considerations, have various accounting reference dates. The Financial Statements of these subsidiaries have been consolidated on the basis of interim Financial Statements for the period to 31 December.

Foreign currency translation

Items included in the Financial Statements of each entity of the Group are measured using the currency that best reflects the economic substance of the underlying events and circumstances relevant to that entity (‘the functional currency’). The Consolidated Financial Statements are presented in pounds sterling, which is the functional currency of the parent.

Income statements and cash flows of foreign entities are translated into the Group’s reporting currency at average exchange rates for the year and their balance sheets are translated at the exchange rates ruling on 31 December. Exchange differences arising from the translation of the net investment in foreign entities are taken to shareholders’ equity. When a foreign entity is sold, such exchange differences are recognised in the income statement as part of the gain or loss on sale.

Foreign currency transactions are translated into the functional currency of the Company at the exchange rates prevailing at the dates of the transactions. Foreign exchange gains and losses resulting from the settlement of such transactions and from the translation of monetary assets and liabilities denominated in foreign currencies are recognised in the income statement unless deferred in equity under the cash flow hedge.

Revenue recognition

(a) Interest income and expense

Income on financial assets that are classified as loans and receivables or available-for-sale, and interest expense on financial liabilities other than those at fair value through profit and loss are determined using the effective interest method. The effective interest rate is the rate that discounts the estimated future cash payments or receipts over the expected life of the instrument or, when appropriate, a shorter period, to the net carrying amount of the financial asset or financial liability. When calculating the effective interest rate, the future cash flows are estimated after considering all the contractual terms of the instrument excluding future credit losses. The calculation includes all amounts paid or received by the Group that are an integral part of the overall return, direct incremental transaction costs related to the acquisition, issue or disposal of the financial instrument and all other premiums or discounts. Interest income on assets classified as loans and receivables or available-for-sale, interest expense on liabilities classified at amortised cost and interest income and expense on hedging derivatives are recognised in net interest income in the income statement.

(b) Fee and commissions income

Fees and commissions that are not an integral part of the effective interest rate are recognised when the service has been provided. For retail products, fee and commission income consists principally of collection services fees, commission on foreign currencies, and fees for non-banking financial products. Revenue from these income streams are recognised as earned when the service is provided.

Net trading and other income comprises all gains and losses from changes in the fair value of financial assets and financial liabilities held for trading, together with related interest income, expense and dividends. It also includes income from operating lease assets, and profits/(losses) on the sales of fixed assets and subsidiary undertakings.

Financial Statements

Accounting Policies continued

(d) Financial assets and liabilities held at fair value through profit or loss

Financial assets and liabilities held for trading, and financial assets and financial liabilities designated as fair value through profit or loss are recorded at fair value. Changes in fair value of trading assets and liabilities including trading derivatives are recognised in the income statement as net trading and other income together with dividends and interest receivable and payable. Changes in fair value of assets and liabilities designated as fair value through profit or loss are recognised in net trading and other income together with dividends, interest receivable and payable and changes in fair value of derivatives managed in conjunction with these assets and liabilities. Changes in fair value of derivatives in a designated hedging relationship are recognised in net trading and other income along with the fair value of the hedged item.

Pensions and other post retirement benefits

Group companies have various pension schemes. The schemes are generally funded through payments to trustee-administered funds as determined by periodic actuarial calculations. A defined benefit plan is a pension plan that defines an amount of pension benefit to be provided, usually as a function of one or more factors such as age, years of service or compensation. A defined contribution plan is a pension plan under which the Group pays fixed contributions as they fall due into a separate entity (a fund) and will have no legal or constructive obligations to pay further contributions if the fund does not hold sufficient assets to pay all employee benefits relating to employee service in the current and prior periods.

The liability recognised in respect of defined benefit pension plans is the present value of the defined benefit obligation at the balance sheet date, less the fair value of plan assets. The defined benefit obligation is calculated annually by independent actuaries using the projected unit credit method. Full actuarial valuations of the Group’s principal defined benefit schemes are carried out every year. The Group is responsible for the actuarial valuations and in doing so considers or relies in part on a report of a third party expert. The present value of the defined benefit obligation is determined by the estimated future cash outflows using interest rates of high quality corporate bonds, which have terms to maturity approximating the terms of the related liability. The Group’s consolidated income statement includes the current service cost of providing pension benefits, the expected return on schemes’ assets net of expected administration costs, and the interest cost on the schemes’ liabilities. Actuarial gains and losses arising from experience adjustments and changes in actuarial assumptions are taken directly to reserves and recognised in the statement of recognised income and expense. Past-service costs are charged immediately to the income statement, unless the changes are conditional on the employees remaining in service for a specified period of time, known as the vesting period. In this case, the past-service costs are amortised on a straight-line basis over the average period until the benefits become vested.

For defined contribution plans, the Group pays contributions to trustee-administered funds as they fall due. Once the contributions have been paid, the Group has no further payment obligations. The regular contributions constitute net periodic costs for the year in which they are due and as such are included in staff costs.

Post-retirement medical benefit liabilities are determined using the Projected Unit Credit Method, with actuarial valuations updated at each year-end. The expected benefit costs are accrued over the period of employment using an accounting methodology similar to that for the defined benefit pension scheme.

Share-based payments

Prior to the acquisition of Alliance & Leicester by Banco Santander, S.A., share options were satisfied by the issue of new Alliance & Leicester shares. The Group engaged in equity-settled share-based payment transactions in respect of services received from certain of its employees. Shares of the Company were allotted by the Company for the Share Option Plan, the ShareSave plan, the Restricted Share plan, the Share Incentive Plan, awards granted under the Long Term Incentive Plan and Deferred Bonus Plans to satisfy share options as they vested. All awards granted under the Alliance & Leicester share plans were accounted for as equity-settled share-based payment transactions. The fair value of the services received is measured by reference to the fair value of the shares or share options initially on the date of the grant. The cost of the employee services received in respect of the shares or share options granted was recognised in the income statement within administration expenses, over the period that the services are received, which is the vesting period. The fair value of the options granted under the Share Option Plan, the Restricted Share plan, awards granted under the Long Term Incentive Plan and senior manager Deferred Bonus Plan were determined using option pricing models, which take into account the exercise price of the option, the current share price, the risk free interest rate, the expected volatility of the Company’s share price over the life of the option, the dividend growth rate and other relevant factors.

Non-market vesting conditions are taken into account by adjusting the number of shares or share options included in the measurement of the cost of employee service so that ultimately, the amount recognised in the income statement reflects the number of vested shares or share options. Further details on the Schemes can be found in Notes 38 and 40.

Goodwill and other intangible assets

Goodwill represents the excess of the cost of an acquisition over the fair value of the Group’s share of the net identifiable assets of the acquired subsidiary, associate, or business at the date of acquisition. Goodwill on the acquisition of subsidiaries and businesses is included in Intangible assets. Goodwill on acquisitions of associates is included as part of Investment in associates. Goodwill is tested for impairment at each balance sheet date, or more frequently when events or changes in circumstances dictate. It is carried at cost less accumulated impairment losses. Gains and losses on the disposal of an entity include the carrying amount of goodwill relating to the entity sold.

Negative goodwill is recognised immediately in the income statement.

Goodwill arising on acquisitions before the date of transition to IFRS has been retained at the previous UK GAAP amounts, subject to being tested for impairment at 31 December 2003. Goodwill written off to reserves under UK GAAP prior to the introduction of FRS 10 ‘Goodwill and Intangible Assets’ in 1998 has not been reinstated and is not included in determining any subsequent profit or loss on disposal.

Financial Statements

Accounting Policies continued

Software development costs are capitalised when they are associated with identifiable and unique software products that are expected to provide future economic benefits and the cost of these products can be measured reliably. Internally developed software meeting these criteria and externally purchased software are classified in intangible assets on the balance sheet, unless the software is an integral part of the related computer hardware, in which case it is treated as property, plant and equipment as described below. Computer software is amortised over 1 to 5 years. Costs associated with maintaining software programmes are expensed as incurred.

Property, plant and equipment

Property, plant and equipment include owner-occupied properties, office fixtures and equipment. Property, plant and equipment are carried at cost less accumulated depreciation and accumulated impairment losses. A review for indications of impairment is carried out at each reporting date. Gains and losses on disposal are determined by reference to the carrying amount and are reported in net trading and other income. Repairs and renewals are charged to the income statement when the expenditure is incurred.

Software development costs are capitalised when they are associated with identifiable and unique software products that are expected to provide future economic benefits and the cost of these products can be measured reliably. Internally developed software meeting these criteria and externally purchased software are classified in property, plant and equipment on the balance sheet where the software is an integral part of the related computer hardware. Costs associated with maintaining software programmes are expensed as incurred. Classes of property, plant and equipment are depreciated on a straight-line basis over their useful life as follows:



Owner-occupied properties		Not exceeding 75 years
Office fixtures and equipment		3 to 15 years

Depreciation is not charged on freehold land and assets under construction.

Financial assets

The Group classifies its financial assets as: financial assets at fair value through profit or loss, loans and receivables, available-for-sale and held-to-maturity financial assets. Management determines the classification of its investments at initial recognition. Financial assets that are classified at fair value through profit or loss, which have not been designated as such or are not accounted for as derivatives or assets classified as ‘available-for-sale’, may subsequently in rare circumstances, be reclassified to the available-for-sale, loans and receivables or held to maturity categories. In order to meet the criteria for reclassification, the asset must no longer be held for the purpose of selling or repurchasing in the near term and must also meet the definition of the category into which it is to be reclassified had it not been required to classify it at fair value through profit or loss at initial recognition. The reclassified value is the fair value of the asset at the date of reclassification.

(a) Financial assets at fair value through profit or loss

Financial assets are classified at fair value through profit or loss if they are either held for trading or otherwise designated at fair value through profit or loss on initial recognition. A financial asset is classified as held for trading if it is a derivative or it is acquired principally for the purpose of selling in the near term, or forms part of a portfolio of financial instruments that are managed together and for which there is evidence of short-term profit taking.

In certain circumstances financial assets other than those that are held for trading are designated at fair value through profit or loss where this results in more relevant information because it significantly reduces a measurement inconsistency that would otherwise arise from measuring assets or recognising the gains or losses on them on a different basis, where the assets are managed and their performance evaluated on a fair value basis, or where a financial asset contains one or more embedded derivatives which are not closely related to the host contract.

Trading assets, derivative financial instruments and financial assets designated at fair value are classified at fair value through profit or loss, except where in a hedging relationship. They are derecognised when the rights to receive cash flows from the asset have expired or when the Group has transferred substantially all the risks and rewards of ownership.

(b) Loans and receivables

Loans and receivables are non-derivative financial assets with fixed or determinable payments, that are not quoted in an active market, and which are not classified as available-for-sale or fair value through profit or loss. They arise when the Group provides money or services directly to a customer with no intention of trading the loan. Loans and receivables are initially recognised at fair value including direct and incremental transaction costs. They are subsequently valued at amortised cost, using the effective interest method. They are derecognised when the rights to receive cash flows have expired or the Group has transferred substantially all of the risks and rewards of ownership. Loans and receivables includes Loans and advances to banks, Loans and advances to customers and Loan and receivable securities.

Available-for-sale investments are non-derivative financial investments that are designated as available-for-sale and are not categorised into any of the other categories described. They are initially recognised at fair value including direct and incremental transaction costs. They are subsequently held at fair value. Gains and losses arising from changes in fair value are included as a separate component of equity until sale when the cumulative gain or loss is transferred to the income statement. Interest is determined using the effective interest method. Gains and losses arising on securities prior to reclassification in the available-for-sale reserve is being recognised on a straight-line basis over the period to maturity of the assets, which is considered to be immaterially different to using the effective interest rate basis.

Income on investments in equity shares and other similar interests is recognised in the income statement as and when dividends are declared and interest is accrued. Impairment losses and foreign exchange translation differences on monetary items are recognised in the income statement. The investments are derecognised when the rights to receive cash flows have expired or the Group has transferred substantially all the risks and rewards of ownership.

Financial Statements

Accounting Policies continued

(d) Held-to-maturity

Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments and fixed maturity that an entity has the positive intention and ability to hold to maturity. Held-to-maturity investments are initially recognised at fair value including direct and incremental transaction costs. They are subsequently valued at amortised cost, using the effective interest method. They are derecognised when the rights to receive cash flows have expired or the Group has transferred substantially all of the risks and rewards of ownership. Were the Group to sell, other than an insignificant amount of held-to-maturity assets, the entire category would be tainted and reclassified as available-for-sale.

The Group has adopted the amendment to IAS39 published on 13 October 2008, and where permitted, has reclassified financial assets held-for-trading and available-for-sale assets to loans and receivables with effect from 1 July 2008 (see Note 18).

Offsetting financial assets and liabilities

Financial assets and liabilities including derivatives are offset and the net amount reported in the balance sheet when there is a legally enforceable right to set off the recognised amounts and there is an intention to settle on a net basis, or realise the asset and settle the liability simultaneously.

Sale and repurchase agreements (including stock borrowing and lending)

Securities sold subject to a linked repurchase agreement (‘repos’) are retained in the Financial Statements as trading assets and the counterparty liability is included in amounts ‘Deposits by banks’ or ‘Deposits by customers’ within trading liabilities as appropriate. Securities purchased under agreements to resell (‘reverse repos’) are recorded as ‘Loans and advances to banks’ or ‘Loans and advances to customers’ within trading assets as appropriate. The difference between the sale and repurchase price is treated as trading income in the income statement. Securities lent to counterparties that are collateralised by cash are also retained in the balance sheet. Securities borrowing and lending transactions collateralised with other securities are not recognised in the balance sheet.

Derivative financial instruments

Transactions are undertaken in derivative financial instruments (‘derivatives’), which include interest rate, cross currency, other index-related swaps, forwards, caps, floors and swaptions, as well as credit default and total return swaps. Derivatives are contracts or agreements whose value is derived from one or more underlying indices or asset values inherent in the contract or agreement, which require no or little initial net investment and are settled at a future date.

Derivatives are initially recognised at fair value on the date on which a derivative contract is entered into and are subsequently re-measured at their fair value. Fair values are obtained from quoted market prices in active markets, including recent market transactions, and valuation techniques, including discounted cash flow models and option pricing models as appropriate. All derivatives are carried as assets when fair value is positive and as liabilities when fair value is negative, except where netting is permitted.

Certain derivatives embedded in other financial instruments, are treated as separate derivatives when their economic characteristics and risks are not closely related to those of the host contract and the hybrid contract is not carried at fair value through profit or loss. These embedded derivatives are measured at fair value with changes in fair value recognised in the income statement. Contracts containing embedded derivatives are not subsequently reassessed for separation unless there has been a change in the terms of the contract which significantly modifies the cash flows, or where assets have been reclassified where they are reassessed at the time of reclassification.

Hedge accounting

The Group designates certain derivatives as hedging instruments of the fair value of recognised assets or liabilities or firm commitments (fair value hedge). The Group also designates cash flow hedges to hedge exposures to variability in cash flows, such as variable rate financial assets and liabilities. Hedge accounting is used for derivatives designated in this way provided certain criteria are met.

At the time a financial instrument is designated as a hedge, the Group formally documents the relationship between the hedging instrument(s) and hedged item(s). Documentation includes risk management objectives and the strategy in undertaking the hedge transaction, together with the methods that will be used to assess the effectiveness of the hedging relationship. Accordingly, the Group formally assesses, both at the inception of the hedge and on an ongoing basis, whether the hedging derivatives have been and will be highly effective in offsetting changes in the fair value of the hedged items. A hedge is normally regarded as highly effective if, at inception and throughout its life, the Group can expect, and actual results indicate, that changes in the fair value of the hedged items are effectively offset by changes in the fair value of the hedging instrument, and actual results are within a range of 80% to 125%.

The Group discontinues hedge accounting when it is determined that: a derivative is not, or has ceased to be, highly effective as a hedge; when the derivative expires, or is sold, terminated, or exercised; or when the hedged item matures or is sold or repaid. On discontinuance of hedge accounting amortisation of the adjustment to the hedged item is included in net trading and other income.

The hedge adjustment for fair value hedges is classified in the balance sheet in the same category as the hedged item, unless it relates to a macro hedging relationship where the hedge adjustment is recognised as a macro hedge on the face of the balance sheet.

Financial Statements

Accounting Policies continued

For fair value hedges, changes in the fair value of the hedged risk and hedged item are recognised in net trading and other income. For cash flow hedges the effective portion of change in the fair value of the hedging instrument is recognised in equity, and recycled to profit or loss in the periods when the hedged item will affect profit or loss. Hedge ineffectiveness represents the amount by which the changes in the fair value of the hedging derivative differ from changes in the fair value of the hedged item. Such gains and losses are recorded in current period earnings within net trading and other income. Gains and losses on components of a hedging derivative that are excluded from assessing hedge effectiveness are also included in net trading and other income.

Securitisation transactions

The Group has entered into certain arrangements where undertakings have issued mortgage-backed securities or have entered into funding arrangements with lenders in order to finance specific loans and advances to customers. As the Group has retained substantially all the risks and rewards of the underlying assets, all such financial instruments continue to be held on the Group balance sheet, and a liability recognised for the proceeds of the funding transaction.

Impairment of financial assets

At each balance sheet date the Group assesses whether, as a result of one or more events occurring after initial recognition, there is objective evidence that a financial asset or group of financial assets classified as available-for-sale or loans and receivables have become impaired. Evidence of impairment may include indications that the borrower or group of borrowers have defaulted, are experiencing significant financial difficulty, or the debt has been restructured to reduce the burden to the borrower.

(a) Retail assets carried at amortised cost

Impairment losses are assessed individually for the financial assets that are individually significant and individually or collectively for assets that are not individually significant. Balance sheet provisions are maintained at the level that management deems sufficient to absorb probable incurred losses in the Group’s loan portfolio from homogeneous portfolios of assets and individually identified loans.

A provision for observed losses is established for all past due loans after a specified period of repayment default where it is probable that some of the capital will not be repaid or recovered through enforcement of any applicable security. Once a loan misses a payment (breach of contractual terms) an assessment of the likelihood of collecting the principal and overdue payments is made. This assessment is generally made using statistical techniques based on historic experience. These determinations are supplemented by various formulaic calculations and the application of management judgement.

For individually assessed assets, the Group measures the amount of the loss as the difference between the carrying amount of the asset or group of assets and the present value of the estimated future cash flows from the asset or group of assets discounted at the original effective interest rate of the asset.

In making collective assessment for impairment, financial assets are assessed for each portfolio segmented by similar risk characteristics. For each risk segment, future cash flows from these portfolios are estimated through the use of historical loss experience. The historical loss experience is adjusted for current observable data, to reflect the effects of current conditions not affecting the period of historical experience, based on observable data. The loss is discounted at the effective interest rate, except where portfolios meet the criteria for short term receivables.

Loans that are part of a homogeneous pool of similar loans are placed on default status based on the number of months in arrears, which is determined through the number of missed payments or the number of months in collection. Loans that are not part of a homogeneous pool of similar loans are analysed based on the number of months in arrears on a case-by-case basis and are placed on default status when the probability of default is likely.

Generally, the length of time before an asset is placed on default status for provisioning is when one payment is missed. However, for assessing the level of non-performing asset repayment default depends on the nature of the collateral that secures the advances. On advances secured by residential property, the default period is three months.

On unsecured advances, such as personal term loans, the default period is generally four missed payments (three months in arrears). Exceptions to the general rule exist with respect to revolving facilities, such as bank overdrafts, which are placed on default upon a breach of the contractual terms governing the applicable account.

A provision for inherent losses is made for loan losses that have been incurred but have not been separately identified at the balance sheet date because the loan is not yet past due. An example of this situation is where a borrower is experiencing financial difficulties at the reporting date, e.g. due to loss of employment, although the borrower has not yet missed a payment. In these circumstances, an impairment loss had been incurred at the reporting date. The provision for inherent losses is determined on a portfolio basis based on management’s best estimate of the current position based on past experience adjusted by current trends. These statistical techniques involve the following (i) estimation of a period of time called the emergence period, which is discussed below, (ii) assessment of the number of accounts that go into arrears over the emergence period, and (iii) application of the provision methodology outlined for observed provisions to these accounts identified as impaired as a result of this exercise. Accounts that suffered credit deterioration after the reporting date are accordingly excluded from the statistical analysis.

The emergence period

This is the period which the Group’s statistical analysis shows to be the period in which losses that had been incurred but have not been separately identified at the balance sheet date, become evident as the loans turn into past due. Based on the Group’s statistical analysis at 31 December 2008, the emergence period was two months for unsecured lending, three months for current accounts and 12 months for secured lending. The longer emergence period for secured lending reflects the fact that a customer is more likely to default on unsecured debt before defaulting on secured lending. The factors considered in determining the length of the emergence period for unsecured lending are recent changes in customers’ debit/credit payment profiles and credit scores. The factors considered for secured lending are the frequency and duration of exceptions from adherence to the contractual payment schedule.

Financial Statements

Accounting Policies continued

Once a financial asset or a group of financial assets has been written down as a result of an impairment loss, subsequent interest income continues to be recognised on an effective interest rate basis, though on the asset value after provisions have been deducted.

Impairment losses are recognised in the income statement and the carrying amount of the financial asset or group of financial assets is reduced by establishing an allowance for impairment losses. If in a subsequent period the amount of the impairment loss reduces and the reduction can be ascribed to an event after the impairment was recognised, the previously recognised loss is reversed by adjusting the allowance. A write-off is made when all collection procedures have been completed and is charged against previously established provisions for impairment.

Recoveries of loan losses are not included in the loan loss allowance, but are taken to income and offset against charges for loan losses. Loan loss recoveries are classified in the income statement as Impairment losses on loans and advances to customers.

(b) Corporate assets

Impairments for these assets are assessed on both an individual and a collective basis. For individual assets impairment reviews are conducted monthly for those assets on the Bank’s Watchlist, with a particular focus on the following scenarios: (1) where an asset has a payment default which has been outstanding for 90 days or more; (2) where non-payment defaults have occurred and/or where it has become evident that some sort of workout or rescheduling exercise is to be undertaken; or (3) where, for example with Real Estate Finance, it has become evident that the value of the Bank’s security is no longer considered adequate.

In such situations a full review of the expected future cash flows in relation to the relevant asset, appropriately discounted, will be undertaken with the result compared with the current net book value of the asset. Any shortfall evidenced as a result of such a review, particularly where the shortfall is likely to be permanent, will lead to a suitable impairment recommendation.

Collective impairments are also looked at for portfolios where it is felt that market events, either specific or general, are likely to determine that losses are already inherent in a portfolio notwithstanding that these events may not have manifested themselves in specific defaults or other triggers that would lead to an individual impairment assessment. The amount of any such collective impairment will, for each portfolio concerned, represent management’s best estimate of likely loss levels and will take into account inter alia estimates of future actual default rates and likely recovery levels.

Treasury assets (including derivative financial instruments, financial assets designated at fair value, loans and advances to banks, available-for-sale securities and loan and receivable securities) are assessed individually for impairment. A provision is made when management obtains information that suggests losses in the underlying portfolios will prevent the assets making payments in accordance with their contractual terms.

For available-for-sale assets, the cumulative loss is measured as the difference between the acquisition cost and the current fair value, less any impairment loss previously reported in the income statement. If in a subsequent period, the fair value of a debt instrument classified as available-for-sale increases and the increase is due to an event occurring after the impairment loss was recognised in the income statement (with objective evidence to support this), the impairment loss is reversed through the income statement.

For assets carried at amortised cost, the Group measures the amount of the loss as the difference between the carrying amount of the asset or group of assets and the present value of the estimated future cash flows from the asset or group of assets discounted at the original effective interest rate of the assets.

Impairment of non-financial assets

At each balance sheet date, or more frequently when events or changes in circumstances dictate, property, plant and equipment and intangible assets (including goodwill) are assessed for indicators of impairment. If indications are present, these assets are subject to an impairment review. The impairment review comprises a comparison of the carrying amount of the asset or cash generating unit with its recoverable amount: the higher of the asset’s or cash-generating unit’s fair value less costs to sell and its value in use. Net selling price is calculated by reference to the amount at which the asset could be disposed of in a binding sale agreement in an arm’s length transaction evidenced by an active market or recent transactions for similar assets, less costs to sell. Value in use is calculated by discounting the expected future cash flows obtainable as a result of the asset’s continued use, including those resulting from its ultimate disposal, at a market based discount rate on a pre-tax basis.

The carrying values of fixed assets and goodwill are written down by the amount of any impairment and the loss is recognised in the income statement in the period in which it occurs. Impairment of a cash generating unit is allocated first to goodwill and then to other assets held within the unit on a pro-rata basis. An impairment loss recognised in an interim period is not reversed at the balance sheet date. A previously recognised impairment loss relating to a fixed asset may be reversed in part or in full when a change in circumstances leads to a change in the estimates used to determine the fixed asset’s recoverable amount. The carrying amount of the fixed asset will only be increased up to the amount that it would have been had the original impairment not been recognised. Impairment losses on goodwill are not reversed. For conducting impairment reviews, cash generating units are the lowest level at which management monitors the return on investment on assets.

Leases

The Group as lessor — Operating lease assets are recorded at deemed cost and depreciated over the life of the asset after taking into account anticipated residual values. Operating lease rental income and depreciation is recognised on a straight-line basis over the life of the asset. Amounts due from lessees under finance leases and hire purchase contracts are recorded as receivables at the amount of the Group’s net investment in the leases. Finance lease income is allocated to

Financial Statements

Accounting Policies continued

The Group as lessee — The Group enters into operating leases for the rental of equipment or real estate. Payments made under such leases are charged to the income statement on a straight-line basis over the period of the lease. When an operating lease is terminated before the lease period has expired, any payment to be made to the lessor by way of penalty is recognised as an expense in the period in which termination takes place.

If the lease agreement transfers the risk and rewards of the asset, the lease is recorded as a finance lease and the related asset is capitalised. At inception, the asset is recorded at the lower of the present value of the minimum lease payments or fair value and depreciated over the estimated useful life. The corresponding rental obligations are recorded as borrowings. The aggregate benefit of incentives, if any, is recognised as a reduction of rental expense over the lease term on a straight-line basis.

Income taxes, including deferred taxes

The tax expense represents the sum of the income tax currently payable and deferred income tax.

Income tax payable on profits, based on the applicable tax law in each jurisdiction, is recognised as an expense in the period in which profits arise. Taxable profit differs from net profit as reported in the income statement because it excludes items of income or expense that are taxable or deductible in other years and it further excludes items that are never taxable or deductible.

The liability for current tax is calculated using tax rates that have been enacted or substantively enacted by the balance sheet date. Deferred income tax is provided in full, using the liability method, on income tax losses available to carry forward and on temporary differences arising between the tax bases of assets and liabilities and their carrying amounts in the Financial Statements. Deferred tax liabilities are generally recognised for all taxable temporary differences and deferred tax assets are recognised to the extent that it is probable that taxable profits will be available against which the assets may be utilised as they reverse. Such deferred tax assets and liabilities are not recognised if the temporary difference arises from goodwill and the initial recognition of other assets (other than in a business combination) and liabilities in a transaction that affects neither the taxable profit nor the accounting profit. Deferred tax is calculated at the tax rates that are expected to apply in the period when the liability is settled or the asset is realised, based on rates enacted or substantially enacted at the balance sheet date. Deferred tax is charged or credited in the income statement, except when it relates to items charged or credited directly to equity, in which case the deferred tax is also dealt with in equity. Deferred tax liabilities are recognised for taxable temporary differences arising on investments in subsidiaries except where the Group is able to control reversal of the temporary difference and it is probable that it will not reverse in the foreseeable future.

The Group reviews the carrying amount of deferred tax assets at each balance sheet date and reduces it to the extent that it is no longer probable that sufficient taxable profits will be available to allow all or part of the asset to be recovered.

Deferred and current tax assets and liabilities are only offset when they arise in the same tax reporting group and where there is both the legal right and the intention to settle on a net basis or to realise the asset and settle the liability simultaneously.

Cash and cash equivalents

For the purposes of the cash flow statement, cash and cash equivalents comprise balances with less than three months’ maturity from the date of acquisition, including cash and non-restricted balances with central banks, treasury bills and other eligible bills, loans and advances to banks, and short-term investments in securities.

Financial liabilities

Financial liabilities are initially recognised when the Group becomes contractually bound to the transfer of economic benefits in the future. Financial liabilities are classified at fair value through profit or loss if they are either held for trading or otherwise designated at fair value through profit or loss on initial recognition. A financial liability is classified as held for trading if it is a derivative or it is incurred principally for the purpose of selling or being unwound in the near term, or forms part of a portfolio of financial instruments that are managed together and for which there is evidence of short-term profit taking.

In certain circumstances financial liabilities other than those that are held for trading are designated at fair value through profit or loss where this results in more relevant information because it significantly reduces a measurement inconsistency that would otherwise arise from measuring assets and liabilities or recognising the gains or losses on them on a different basis, or where a financial liability contains one or more embedded derivatives which are not closely related to the host contract. These liabilities are initially recognised at fair value and transaction costs are taken directly to the income statement. Gains and losses arising from changes in fair value are included directly in the income statement. All other financial liabilities are initially recognised at fair value net of transaction costs incurred. They are subsequently stated at amortised cost and the redemption value recognised in the income statement over the period of the liability using the effective interest method.

Derivative financial instruments and Financial liabilities designated at fair value are classified as fair value through profit or loss, unless in a hedge relationship. Deposits by banks, Deposits by customers, Debt securities in issue (unless designated at fair value). Subordinated liabilities are classified as amortised cost.

Borrowings

Borrowings, including subordinated liabilities, are recognised initially at fair value, being the proceeds (fair value of consideration received) net of transaction costs incurred. Borrowings are subsequently stated at amortised cost or fair value dependent on designation at initial recognition.

Share capital

Financial Statements

Accounting Policies continued

Provisions

Provisions are recognised for present obligations arising as consequences of past events where it is more likely than not that a transfer of economic benefits will be necessary to settle the obligation, and it can be reliably estimated. When a leasehold property ceases to be used in the business, provision is made where the unavoidable costs of the future obligations relating to the lease are expected to exceed anticipated rental income. The net costs are discounted using market rates of interest to reflect the long-term nature of the cash flows.

Contingent liabilities are possible obligations whose existence will be confirmed only by certain future events or present obligations where the transfer of economic benefit is uncertain or cannot be reliably measured. Contingent liabilities are not recognised but are disclosed unless they are remote.

Financial guarantee contracts

The Group accounts for guarantees that meet the definition of a financial guarantee contract at fair value on initial recognition. In subsequent periods, these guarantees are measured at the higher of the initial fair value less cumulative amortisation and the amount that would be recognised as a provision as described in the Accounting Policies above.

Dividends

Dividends on ordinary shares are recognised in equity in the period in which the right to receive payment is established.

Critical accounting policies and areas of significant management judgement

The preparation of the Group’s Consolidated Financial Statements requires management to make estimates and judgements that affect the reported amount of assets and liabilities at the date of the Financial Statements and the reported amount of income and expenses during the reporting period. Management evaluates its estimates and judgements on an ongoing basis. Management bases its estimates and judgements on historical experience and on various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

The following estimates and judgements are considered important to the portrayal of the Group’s financial condition.

(a) Provisions for loans and advances

The Group estimates provisions for loans and advances to customers, treasury investment securities and loans and advances to banks with the objective of maintaining balance sheet provisions at the level believed by management to be sufficient to absorb actual losses (‘observed provisions’) and inherent losses (‘incurred but not yet observed provisions’) in the Group’s loan portfolio from homogeneous portfolios of assets and individually identified loans in connection with loans and advances to banks and loans and advances to customers. The calculation of provisions on impaired loans and advances is based on the likelihood of the asset being written off (or repossessed in the case of mortgage loans) and the estimated loss on such a write-off. These assessments are made using statistical techniques based on historic experience. These determinations are supplemented by various formulaic calculations and the application of management judgement.

The Group considers accounting estimates related to provisions for loans and advances ‘critical accounting estimates’ because: (i) they are highly susceptible to change from period to period as the assumptions about future default rates and valuation of potential losses relating to impaired loans and advances are based on recent performance experience, and (ii) any significant difference between the Group’s estimated losses (as reflected in the provisions) and actual losses will require the Group to take provisions which, if significantly different, could have a material impact on its future income statement and its balance sheet. The Group’s assumptions about estimated losses are based on past performance, past customer behaviour, the credit quality of recent underwritten business and general economic conditions, which are not necessarily an indication of future losses.

Provisions for loans and advances, less amounts released and recoveries of amounts written off in previous years are charged to the line item ‘Impairment losses’ in the income statement. The provisions are deducted from the ‘Loans and advances to banks’, ‘Loan and receivable securities’ and the ‘Loans and advances to customers’ line items on the balance sheet. If the Group believes that additions to the provisions for such credit losses are required, then the Group records additional provisions for credit losses, which would be treated as a charge in the line item ‘Impairment losses on loans and advances to customers’ in the income statement.

The Consolidated Financial Statements for the year ended 31 December 2008 include a provision charge for loans and advances in connection with retail lending for an amount equal to £274m and commercial lending for an amount equal to £275m. The provision for retail lending increased reflecting higher default rates in the unsecured portfolios and increased reserving due to a further general deterioration in economic conditions. The provision for commercial lending reflected the current economic down turn and the impact this is having on the corporate sector. In calculating the retail and commercial lending provisions, within the Retail Banking and Corporate Banking segments, a range of outcomes was calculated based principally on management’s conclusions regarding the current economic outlook relative to historic experience. Had management used different assumptions regarding the current economic outlook, a larger or smaller provision for loans and advances would have resulted that could have had a material impact on the Group’s reported loss on continuing operations before tax in 2008. Specifically, if management’s conclusions as to the current economic outlook were different, but within the range of what management deemed to be reasonably possible economic outlooks, the provision charge for loans and advances in the Retail Banking segment could have decreased in 2008 from an actual provision charge of £274m by up to £22m, with a potential corresponding reduction in the Group’s loss before tax on continuing operations in 2008 of up to 2%, or increased by up to £29m, with a potential corresponding increase in the Group’s loss before tax on continuing operations in 2008 of up to 2%.

Financial Statements

Accounting Policies continued

The range within Retail Banking is based on differing assumptions of the loss per case and loss factor per case. In Corporate Banking the provision charge for loans and advances in the Corporate Banking segment could have decreased in 2008 from an actual provision charge of £275m by up to £51m, with a potential corresponding reduction in the Group’s loss before tax on continuing operations in 2008 of up to 4%, or increased by up to £29m, with a potential corresponding increase in the Group’s loss before tax on continuing operations in 2008 of up to 2%.

The actual provision charge for retail lending of £274m (2007: £85m, 2006: £97m) and commercial lending of £275m (2007: £15m, 2006: £8m)) in 2008 was based on what management estimated to be the most probable economic outlook within the range of reasonably possible assumptions.

The provision charge for Treasury assets (investment securities, loans and advances to banks and the Conduit shown in loans and advances to customers) of £485m (2007: £153m, 2006 £nil) was based on management’s assessment of impairment of each individual asset based on data available at 31 December 2008. A detailed analysis of Treasury assets by type of instrument, credit structure, credit rating and geography can be found in the Risk Management Report in Note 44.

(b) Valuation of financial instruments

Financial instruments that are classified at fair value through profit or loss (including those held for trading purposes) or available-for-sale, and all derivatives, are stated at fair value. The fair value of such financial instruments is the estimated amount at which the instrument could be exchanged in a current transaction between willing, knowledgeable parties, other than in a forced or liquidation sale.

Initial measurement

The best evidence of the fair value of a financial instrument at initial recognition is the transaction price unless the instrument is evidenced by comparison with other observable current market transactions in the same instrument or based on a valuation technique whose variables include significant data from observable markets. Any difference between the transaction price and the value based on a valuation technique where the inputs are not based on data from observable current markets is not recognised in profit or loss on initial recognition. Subsequent gains or losses are only recognised to the extent that they arise from a change in a factor that market participants would consider in setting a price.

Subsequent measurement

Fair value hierarchy

The Group applies the following fair value hierarchy that prioritises the inputs to valuation techniques used in measuring fair value. The hierarchy establishes three categories for valuing Financial Instruments, giving the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities and the lowest priority to unobservable inputs. The three categories are: quoted prices in active markets (Level 1), internal models based on observable market data (Level 2) and internal models based on other than observable market data (Level 3). If the inputs used to measure an asset or a liability fall to different levels within the hierarchy, the classification of the entire asset or liability will be based on the lowest level input that is significant to the overall fair value measurement of the asset or liability. The Group categorises assets and liabilities measured at fair value within the fair value hierarchy based on the inputs to the valuation techniques as follows:

Level 1:		Unadjusted quoted prices for identical assets or liabilities in an active market that the Group has the ability to access at the measurement date. Level 1 measurements include equity securities and debt securities.

Level 2:		Quoted prices in markets that are not active, quoted prices for similar assets or liabilities, inputs other than quoted market prices for the asset or liability that are observable either directly or indirectly for substantially the full term, and inputs to valuation techniques that are derived principally from or corroborated by observable market data through correlation or other statistical means for substantially the full term of the asset or liability. Level 2 measurements include, debt securities, exchange rate derivatives, interest rate derivatives, equity and credit derivatives.

Level 3:		Inputs to the pricing or valuation techniques that are significant to the overall fair value measurement of the asset or liability are unobservable. The Group has no Level 3 assets and liabilities.

The Group assesses active markets for equity instruments based on the average daily trading volume both in absolute terms and relative to the market capitalisation for the instrument. The Group assesses active markets for debt instruments based on both the average daily trading volume and the number of days with trading activity. The Group assesses active markets for exchange traded derivatives based on the average daily trading volume both in absolute terms and relative to the market capitalisation for the instrument. Market activity and liquidity is discussed in the relevant monthly Risk Forum as well as being part of the daily update given by each business at the start of the trading day. This information, together with the observation of active trading and the magnitude of the bid-offer spreads allow consideration of the liquidity of a financial instrument. All underlying assets and liabilities are reviewed to consider the appropriate adjustment to mark the mid price reported in the trading systems to a realisable value. This process takes into account the liquidity of the position in the size of the adjustment required. These liquidity adjustments are presented and discussed at the monthly Risk Forum.

In determining the appropriate measurement levels, the Group performs regular analyses on the assets and liabilities. All underlying assets and liabilities are regularly reviewed to determine whether a position should be regarded as illiquid; the most important practical consideration being the observability of trading. Where the bid/offer spread is observable, this is tested against actual trades. If trades are not observed, the bid/offer spread is disregarded as a sign of liquidity and the position is regarded as illiquid.

Changes in the observability of significant valuation inputs during the reporting period may result in a reclassification of certain assets and liabilities within the fair value hierarchy.

Financial Statements

Accounting Policies continued

Financial instruments valued using observable market prices

If a quoted market price in an active market is available for an instrument, the fair value is calculated based on the market price.

Financial instruments valued using a valuation technique

In the absence of a quoted market price in an active market, management uses internal models to make its best estimate of the price that the market would set for that financial instrument. In order to make these estimations, various techniques are employed, including extrapolation from observable market data and observation of similar financial instruments with similar characteristics. Wherever possible, valuation parameters for each product are based on prices directly observable in active markets or that can be derived from directly observable market prices. Valuation parameters for each type of financial instrument are discussed below.

The Group did not make any material changes to the valuation techniques or internal models it used during the years ended 31 December 2008 and 2007. The Group developed a discounted cash flow model during 2008 for credit default swaps the effect of which was immaterial.

The following table summarises the fair values at 31 December 2008 and 2007 of the asset and liability classes accounted for at fair value, by the valuation methodology used by the Group to determine their fair value. The table also discloses the percentages that the recorded fair values of financial assets and liabilities represent of the total assets and liabilities, respectively, that are recorded at fair value in the balance sheet:

At 31 December 2008


						Internal models
		Quoted prices				based on market
		in active markets				observable data

										Total				Valuation
Balance sheet category		£m		%		£m		%		£m		%		technique

Assets
Derivative assets	Exchange rate contracts		—		—		1,818		40		1,818		40		A
	Interest rate contracts		—		—		1,058		23		1,058		23		A&B
	Equity & credit contracts		—		—		—		—		—		—

Financial assets at FVTPL	Debt securities		—		—		63		1		63		1		A

Available-for-sale	Debt securities		1,648		36		—		—		1,648		36		—
financial assets	Equity securities		—		—		10		—		10		—		B

Total assets at fair value			1,648		36		2,949		64		4,597		100

Liabilities
Derivative liabilities	Exchange rate contracts		—		—		357		16		357		16		A
	Interest rate contracts		—		—		1,164		51		1,164		51		A&B
	Equity & credit contracts		—		—		12		1		12		1		A

Financial liabilities at FVTPL	Debt securities in issue		—		—		728		32		728		32		A

Total liabilities at fair value			—		—		2,261		100		2,261		100

At 31 December 2007

						Internal models
		Quoted prices				based on market
		in active markets				observable data

										Total				Valuation
Balance sheet category		£m		%		£m		%		£m		%		technique

Assets
Trading assets	Debt securities		1,439		9		—		—		1,439		9		—

Derivative assets	Exchange rate contracts		—		—		273		2		273		2		A
	Interest rate contracts		—		—		697		4		697		4		A&B

Financial assets at FVTPL	Debt securities		—		—		891		6		891		6		A

Available-for-sale	Debt securities		—		—		12,770		79		12,770		79		A
financial assets	Equity securities		—		—		3		—		3		—		B

Total assets at fair value			1,439		9		14,634		91		16,073		100

Liabilities
Derivative liabilities	Exchange rate contracts		—		—		309		6		309		6		A
	Interest rate contracts		—		—		482		10		482		10		A&B

Financial liabilities at FVTPL	Debt securities in issue		—		—		4,027		84		4,027		84		A

Total liabilities at fair value			—		—		4,818		100		4,818		100

Valuation techniques

The main valuation techniques employed in the Group’s internal models to measure the fair value of the financial instruments disclosed above at 31 December 2008 and 2007 are set out below. In substantially all cases, the principal inputs into these models are derived from observable market data.

Financial Statements

Accounting Policies continued

a)		In the valuation of financial instruments requiring static hedging (for example interest rate and currency derivatives), the ‘present value’ method is used. Expected future cash flows are discounted using the interest rate curves of the applicable currencies. The interest rate curves are generally observable market data and reference yield curves derived from quoted interest rates in appropriate time bandings, which match the timings of the cash flows and maturities of the instruments.

b)		In the valuation of financial instruments exposed to interest rate risk that require either static or dynamic hedging (such as interest rate futures, caps and floors, and options), the present value method (futures), Black/Scholes model (caps/floors) and the Hull/White model (Bermudan options) are used. These types of model are widely accepted in the financial services industry. The significant inputs used in these models are observable market data, including appropriate interest rate curves, volatilities, correlations and exchange rates. In the valuation of equity financial instruments requiring dynamic hedging (principally equity securities, options and other structured instruments), proprietary stochastic volatility models are used. These types of models are widely accepted in the financial services industry. Observable market inputs are used in these models to generate variables such as the bid/offer spread, foreign currency exchange rates, credit risk, volatility, correlation between indices and market liquidity as appropriate.

The fair values of the financial instruments arising from the Group’s internal models take into account, among other things, contract terms and observable market data, which include such factors as bid-offer spread, interest rates, credit risk, exchange rates, the quoted market price of raw materials and equity securities, volatility and prepayments. The main assumptions taken into account when internal models use information other than market data can be found in the table below.

In all cases, when it is not possible to derive a valuation for a particular feature of an instrument, management uses judgement to determine the fair value of the particular feature. In exercising this judgement, a variety of tools are used including proxy observable data, historical data and extrapolation techniques. Extrapolation techniques take into account behavioural characteristics of equity markets that have been observed over time, and for which there is a strong case to support an expectation of a continuing trend in the future. Estimates are calibrated to observable market prices when they become available.

The estimates thus obtained could vary if other valuation methods or assumptions were used. The Group believes its valuation methods are appropriate and consistent with other market participants. Nevertheless, the use of different valuation methods or assumptions, including imprecision in estimating unobservable market inputs, to determine the fair value of certain financial instruments could result in different estimates of fair value at the reporting date and the amount of gain or loss recorded for a particular instrument. Most of the valuation models are not significantly subjective, because they can be tested and, if necessary, recalibrated by the internal calculation of and subsequent comparison to market prices of actively traded securities, where available.

The Group considers that the accounting estimate related to the valuation of financial assets and financial liabilities including derivatives where quoted market prices are not available is a ‘critical accounting estimate’ because: (i) it is highly susceptible to change from period to period because it requires management to make assumptions about interest rates, volatility, exchange rates, the credit rating of the counterparty, valuation adjustments and specific features of the transactions and (ii) the impact that recognising a change in the valuations would have on the assets reported on its balance sheet as well as its net profit/(loss) could be material.

Changes in the valuation of financial assets and financial liabilities including derivatives where quoted market prices are not available are accounted for in the line item ‘Net trading and other income’ in the income statement and the Trading assets, Financial assets designated at fair value, Financial liabilities designated at fair value and Derivative financial instruments line items in the Group’s balance sheet.

The Group trades in a wide variety of financial instruments in the major financial markets and therefore considers a range of interest rates, volatility, exchange rates, counterparty credit ratings, valuation adjustments and other similar inputs, all of which vary across maturity bands. These are chosen to best reflect the particular characteristics of each transaction. Had management used different assumptions regarding the interest rates, volatility, exchange rates, the credit rating of the counterparty, and valuation adjustments, a larger or smaller change in the valuation of financial assets and financial liabilities including derivatives where quoted market prices are not available would have resulted that could have had a material impact on the Group’s reported profit on continuing operations before tax in 2008. Due to the individual nature of these contracts, the Group does not believe generally it is appropriate to apply a global adjustment to management’s estimates, as it would not give a meaningful sensitivity with respect to financial instrument fair values based on data other than market prices. Sensitivities have been given with respect to key management estimates where they can be separately identified. Further information about sensitivities (including value-at-risk) to market risk arising from financial instrument trading activities can be found in the Risk Management Report in Note 44.

(c) Provisions for misselling

The Group estimates provisions for misselling with the objective of maintaining reserve levels believed by management to be sufficient to absorb current estimated probable losses in connection with compensation from customers who claim reimbursement of payment protection insurance (‘PPI’). The calculation of provisions for misselling is based on the estimated number of claims that may be received, of those, the number that will be upheld, and the estimated average settlement per case. These assessments are based on management’s estimate for each of these three factors. In certain instances, the extent to which the Group is required to uphold claims is driven by binding legal decisions or precedents, as described in Note 32 Contingent liabilities and commitments.

The Group considers accounting estimates related to misselling provisions ‘critical accounting estimates’ because: (i) they are highly susceptible to change from period to period per the three factors above, and (ii) any significant difference between the Group’s estimated losses as reflected in the provisions and actual losses will require the Group to take provisions which, if significantly different, could have a material impact on its future income statement and its balance sheet.

Financial Statements

Accounting Policies continued

Provisions for misselling are charged to the line item ‘Provisions for other liabilities and charges’ in the income statement. The provision is included in the ‘Provisions’ line item on the balance sheet. If the Group believes that additions to the misselling provision are required, then the Group records additional provisions, which would be treated as a charge in the line item ‘Provisions for other liabilities and charges’ in the income statement.

The Consolidated Financial Statements for the year ended 31 December 2008 include a provision charge for misselling in the Retail Banking segment for an amount equal to £38m (2007: £nil, 2006: £nil). The balance sheet provision increased from £nil in 2007 to £34m in 2008, reflecting the PPI provision. In calculating the misselling provision within the Retail Banking segment, management’s best estimate of the provision was calculated based on conclusions regarding the number of claims that may be received, of those, the number that will be upheld, and the estimated average settlement per case. Had management used different assumptions regarding these factors, a larger or smaller provision for misselling would have resulted in the Retail Banking segment that could have had a material impact on the Group’s reported profit before tax in 2008.

Specifically, if management’s conclusions as to the number of claims that will be received, of those, the number that will be upheld, and the estimated average settlement per case were different, but within the range of what management deemed to be reasonably possible, the provision charge for misselling (excluding bank charges) in the Retail Banking segment could have decreased in 2008 by up to £25m, with a potential corresponding decrease in the Group’s loss before tax in 2008 of up to 2%, or increased by up to £16m, with a potential corresponding increase in the Group’s loss before tax in 2008 of up to 1%. The actual charge in 2008 was based on what management estimated to be the most probable number of claims that will be received, of those, the number that will be upheld, and the estimated average settlement per case within the range of reasonably possible outcomes. With respect to the reimbursement of bank charges, the legal and regulatory position continues to evolve and remains unclear, as described in Note 32 Contingent liabilities and commitments. As a result, management remain unable to quantify reliably a meaningful sensitivity or range of possible outcomes.

(d) Pensions

The Group operates a funded and an unfunded defined benefit pension scheme as described in Note 31 to the Consolidated Financial Statements. The assets of the funded scheme are measured at their fair values at the balance sheet date. The liabilities of the schemes are estimated by projecting forward the growth in current accrued pension benefits to reflect inflation and salary growth to the date of pension payment, discounted to present value using the interest rate applicable to high quality AA rated corporate bonds of the same currency and term as the scheme liabilities. Any surplus or deficit of scheme assets over liabilities is recognised in the balance sheet as an asset (surplus) or liability (deficit). An asset is only recognised to the extent that the surplus can be recovered through reduced contributions in the future or through refunds from the scheme. In determining the value of scheme liabilities, assumptions are made by management as to mortality, price inflation, discount rates, pension increases, and earnings growth. Financial assumptions are based on market conditions at the balance sheet date and can generally be derived objectively. Demographic assumptions require a greater degree of estimation and judgement to be applied to externally derived data.

The Group considers accounting estimates related to pension provisions ‘critical accounting estimates’ because: (i) they are highly susceptible to change from period to period, and (ii) any significant difference between the Group’s estimates of the scheme liabilities and actual liabilities could significantly alter the amount of the surplus or deficit recognised in the balance sheet and the pension cost charged to the income statement. The Group’s assumptions principally about mortality, but also about price inflation, discount rates, pension increases, and earnings growth, are based on past experience and current economic trends, which are not necessarily an indication of future experience.

Pension service costs are charged to the line item ‘Administration expenses’, with the interest cost on liabilities and the expected return on scheme assets included within ‘Net trading and other income’ in the income statement. The provision is included in the ‘Retirement benefit obligations’ line item in the balance sheet. If the Group believes that increases to the pensions cost are required, then the Group records additional costs that would be treated as a charge in the line item Administration expenses or Net trading and other income in the income statement.

The Consolidated Financial Statements for the year ended 31 December 2008 include current year defined benefit service cost of £19m (2007: £20m, 2006: £22m) and a pension scheme deficit of £7m (2007: £42m surplus). The changes compared to the prior years reflect reductions in scheme membership, salary reviews, changes in pension increases, changes in mortality assumptions, changes in price inflation assumptions and changes in discount rates. In calculating the current year service cost and deficit, a range of outcomes was calculated based principally on management’s estimates regarding mortality, price inflation, discount rates, pension increases, and earnings growth. Had management used different assumptions principally regarding mortality, but also price inflation, discount rate, pensions increases and earnings growth, a larger or smaller charge for pension costs would have resulted that could have had a material impact on the Group’s reported profit on continuing operations before tax in 2008. Specifically, if management’s conclusions as to mortality, price inflation, discount rates, pensions increases and earnings growth were different, but within the range of what management deemed to be reasonably possible conclusions, the charge for pension costs could have decreased in 2008 from an actual pension charge of £10m (2007: £9m, 2006: £15m) by up to £10m (2007: £9m, 2006: £15m), with a potential corresponding decrease in the Group’s loss before tax in 2008 of up to 1% (2007: 2% increase in profit, 2006, 3% increase in profit), or increased by up to £5m (2007: £5m, 2006: £5m), with a potential corresponding increase in the Group’s loss before tax in 2008 of up to 0% (2007: 1% decrease in profit, 2006: 1% decrease in profit). The actual current year service pension charge of £19m (2007: £20m, 2006: £22m) in 2008 was based on what management estimated to be the most probable mortality, price inflation, discount rates, pensions increases and earnings growth within the range of reasonably possible values. In addition, if management’s conclusions as to mortality, price inflation, discount rates, pensions increases and earnings growth were different, but within the range of what management deemed to be reasonably possible conclusions, the value of the deficit at the year end could have moved in 2008 from an actual deficit of £7m (2007: £42m surplus) to a surplus of up to £117m (2007: surplus of up to £207m), or increased to a deficit of up to £90m (2007: deficit of up to £67m).

Financial Statements

Accounting Policies Continued

(e) Deferred tax

The Group recognises deferred tax assets with respect to tax losses carried forward to the extent that it is probable that future taxable profits will be available against which the unused tax losses and unused tax credits can be utilised. At 31 December 2008 the Group has recognised such deferred tax assets in full. As at 31 December 2008 this amounted to £368m (2007: £nil). The value of the deferred tax asset is based on management’s best estimate of the amount that will be recoverable in the foreseeable future. This estimate is based on management’s assessment of future taxable profits that are expected to arise over this period.

The Group considers accounting estimates related to deferred tax assets ‘critical accounting estimates’ because: (i) they are highly susceptible to change from period to period as the assumptions about future taxable profits represent forward-looking estimates which are inherently vulnerable to changes in economic and market conditions, and (ii) any significant shortfall between the Group’s estimated taxable profits and actual taxable profits could require the Group to take charges which, if significant, could have a material impact on its future income statement and its balance sheet. The Group’s assumptions about estimated future taxable profits are based on assumptions about future performance within the Abbey National plc group, of which Alliance & Leicester plc has become a part, and general economic conditions, which are not necessarily an indication of future performance.

Changes to the value of deferred tax assets are charged to the line item ‘Tax credit/(charge)’ in the income statement. The changes in deferred tax assets are deducted from the ‘Deferred tax assets’ line item on the balance sheet.

The Consolidated Financial Statements for the year ended 31 December 2008 include a charge for changes in the value of deferred tax assets arising in connection with the non recoverability of taxable losses of £nil. If management estimates of future tax profits were not met, it is possible that the deferred tax asset would still be recovered, but over a longer period, therefore it is not possible to quantify reliably a meaningful sensitivity or range of possible outcomes. Under current UK tax legislation, the tax losses in respect of which deferred tax assets have been recognised do not expire.

Financial Statements

Notes to the Financial Statements

1. Segments

The principal activity of the Group is financial services. The Group’s business is managed and reported on the basis of the following segments:

•		Retail Banking

•		Corporate Banking

•		Treasury & Group Items

In 2008, the Commercial Bank business was renamed Corporate Banking, and the Treasury business was combined with Group items for segmental reporting purposes. The segmental analyses for 2007 and 2006 have been amended to reflect these changes.

The Group’s segments are strategic business units that offer different products and services. They are managed separately because each business requires different technology and marketing strategies. The Group has three segments. Retail Banking offers a range of personal banking, savings and mortgage products and services. Corporate Banking offers business banking services principally to small and medium-sized UK companies and commercial loans to larger Corporate customers. It also contains operations in run down. Treasury & Group Items consist of assets and liabilities required to support the liquidity and funding requirements of the Group, Asset and Liability Management activities, Group Capital and shared services.

The segment information below is presented on the basis used by the Company’s Board to evaluate performance, in accordance with IFRS 8. The Company’s Board reviews discrete financial information for each of its segments, including measures of operating results and assets. The segments are managed primarily on the basis of their results, which are measured on a ‘trading’ basis. The trading basis differs from the statutory basis (described in the Accounting Policies section) as a result of the application of various adjustments. Management considers that the trading basis provides the most appropriate way of reviewing the performance of the business.

The segmental analyses for 2007 and 2006 have been amended to reflect this basis of reporting, to ensure a relevant comparison can be made. The adjustments are:

•		Reorganisation and other items — Comprise implementation costs in relation to the strategic change cost reduction projects, costs arising from the acquisition by Banco Santander S.A., refinement of the credit provisioning methodology and effective interest rate assumptions described in Note 2 and 8 respectively, as well as certain other costs and income of a one-off nature. Management needs to understand the underlying drivers of the cost base that will remain after these exercises are complete, and does not want this view to be clouded by these costs, which are managed independently.

•		Depreciation of operating lease assets — The operating lease businesses are managed as financing businesses and, therefore, management needs to see the margin earned on the businesses. Residual value risk is separately managed. As a result the depreciation is netted against the related income.

•		Hedging and certain other mark-to-market variances — The balance sheet and income statement are subject to mark-to-market volatility including that arising from the accounting for elements of derivatives deemed under IFRS to be ineffective as hedges. Where appropriate, such volatility is separately identified to enable management to view the underlying performance of the business.

•		Treasury impairment losses — During 2008, Alliance & Leicester incurred significant losses on its investment securities. These are managed separately and are considered exceptional due to their size and the current global credit crisis. Investments in structured investment vehicles were written off during 2008 and losses were incurred on some investments in bank floating rate notes.

Transactions between the business segments are on normal commercial terms and conditions. The accounting policies
of the segments are the same as those described in the summary of significant accounting policies. Internal charges and transfer pricing adjustments have been reflected in the performance of each business. Revenue sharing agreements are used to allocate external customer revenues to a business segment on a reasonable basis. Funds are ordinarily reallocated between segments, resulting in funding cost transfers disclosed in total trading income. Interest charged for these funds is based on the Group’s cost of capital.

Interest receivable and interest payable have not been reported separately. The majority of the revenues from the segments presented below are from interest and the Company’s Board relies primarily on net interest revenues to both assess the performance of the segment and to make decisions regarding allocation of segmental resources.

Segment assets and liabilities comprise operating assets and liabilities, being the majority of the balance sheet.

Financial Statements

Notes to the Financial Statements continued

a) Segmental information

Retail

Corporate

Treasury &

Group

Banking

Group

Total

Adjustments

Total

2008

£m

Net interest income

570

195

(112

)

653

(269

)

384

Non-interest income

215

252

(19

)

448

)

440

Total trading income

785

447

(131

)

1,101

(277

)

824

Administration expenses

(216

)

(253

)

(203

)

(672

)

(255

)

(927

)

Depreciation/amortisation

(26

)

(20

)

(48

)

(66

)

(114

)

Total trading expenses

(242

)

(273

)

(205

)

(720

)

(321

)

(1,041

)

Impairment losses

(129

)

(51

)

—

(180

)

(853

)

(1,033

)

Provisions for other liabilities and charges

—

(38

)

(38

)

Trading profit/(loss) before tax

414

123

(336

)

201

(1,489

)

(1,288

)

Adjust for:

Reorganisation and other items

(366

)

(202

)

(322

)

(890

)

Hedging and certain other mark-to-market variances

—

(114

)

(114

)

Treasury losses and impairment

—

(485

)

(485

)

Profit/(loss) before tax

(79

)

(1,257

)

(1,288

)

Average number of staff

2,937

813

3,184

6,934

—

6,934

Total assets

40,898

9,954

24,396

75,248

—

75,248


																Provisions
													Impairment			for other
	Net			Non						Depreciation			losses on			liabilities
	interest			interest			Administration			and			loans and			and			Adjustments
	income			income			expenses			amortisation			advances			charges			before tax
Adjustments comprise:	£m			£m			£m			£m			£m			£m			£m

Reorganisation and other items		(269	)		40			(255	)		—			(368	)		(38	)		(890	)
Depreciation on operating lease assets		—			66			—			(66	)		—			—			--
Hedging and certain other mark-to-market variances		—			(114	)		—			—			—			—			(114	)
Treasury losses and impairment		—			—			—			—			(485	)		—			(485	)

		(269	)		(8	)		(255	)		(66	)		(853	)		(38	)		(1,489	)

Changes in interest and exchange rates mean that period on period comparisons of gross interest and other trading income and expense are not meaningful and therefore management only considers these items on a net basis. Similarly, management considers the trading income generated by each segment on the basis of the margin earned on the customer relationship. There is therefore no split that is meaningful of trading income between external customers and intra-Group. No analysis of total trading income from external customers and intra-Group is therefore presented.


	Retail			Corporate			Treasury &									Group
	Banking			Banking			Group			Total			Adjustments			Total
2007	£m			£m			£m			£m			£m			£m

Net interest income		599			169			36			804			(3	)		801
Non-interest income		276			253			(1	)		528			97			625

Total trading income		875			422			35			1,332			94			1,426

Administration expenses		(220	)		(252	)		(171	)		(643	)		—			(643	)
Depreciation/amortisation		(22	)		(21	)		(14	)		(57	)		(74	)		(131	)

Total trading expenses		(242	)		(273	)		(185	)		(700	)		(74	)		(774	)

Impairment losses		(85	)		(15	)		—			(100	)		(153	)		253

Trading profit/(loss) before tax		548			134			(150	)		532			(133	)		399
Adjust for:
Reorganisation and other items		31			48			(17	)		62
Hedging and certain other mark-to-market variances		—			—			(42	)		(42	)
Treasury losses and impairment		—			—			(153	)		(153	)

Profit/(loss) before tax		579			182			(362	)		399

Average number of staff		3,261			726			3,236			7,223			—			7,223

Total assets		46,693			8,414			23,848			78,955			—			78,955

Financial Statements

Notes to the Financial Statements continued


															Provisions
												Impairment			for other
	Net			Non					Depreciation			losses on			liabilities		Adjustments
	interest			interest			Administration		and			loans and			and		before
	income			income			expenses		amortisation			advances			charges		tax
Adjustments comprise:	£m			£m			£m		£m			£m			£m		£m

Reorganisation and other items		(3	)		65			—		—			—			—		62
Depreciation on operating lease assets		—			74			—		(74	)		—			—		—
Hedging and certain other mark-to-market variances		—			(42	)		—		—			—			—		(42	)
Treasury losses and impairment		—			—			—		—			(153	)		—		(153	)

		(3	)		97			—		(74	)		(153	)		—		(133	)


	Retail						Treasury &									Group
	Banking			Corporate			Group			Total			Adjustments			Total
2006	£m			Banking			£m			£m			£m			£m

Net interest income		621			104			56			781			—			781
Non-interest income		291			311			6			608			87			695

Total trading income		912			415			62			1,389			87			1,476

Administration expenses		(353	)		(270	)		(34	)		(657	)		(24	)		(681	)
Depreciation/amortisation		(17	)		(21	)		(4	)		(42	)		(79	)		(121	)

Total trading expenses		(370	)		(291	)		(38	)		(699	)		(103	)		(802	)

Impairment losses		(97	)		(8	)		—			(105	)		—			(105	)
Provisions for other liabilities and charges		—			—			—			—			—			—

Trading profit/(loss) before tax		445			116			24			585			(16	)		569
Adjust for:
Reorganisation and other items		—			—			(24	)		(24	)
Hedging and certain other mark-to-market variances		—			—			8			8

Profit/(loss) before tax		445			116			8			569

Average number of staff		3,286			732			3,261			7,279			—			7,279


													Provisions
											Impairment		for other
	Net		Non					Depreciation			losses on		liabilities
	interest		interest		Administration			and			loans and		and		Adjustments
	income		income		expenses			amortisation			advances		charges		before tax
Adjustments comprise:	£m		£m		£m			£m			£m		£m		£m

Reorganisation and other items		—		—		(24	)		—			—		—		(24	)
Depreciation on operating lease assets		—		79		—			(79	)		—		—		—
Hedging and certain other mark-to-market variances		—		8		—			—			—		—		8

		—		87		(24	)		(79	)		—		—		(16	)

No geographical analysis is presented because substantially all of the Group’s activities are in the UK.

2. Net interest income


	Group
	2008		2007		2006
	£m		£m		£m

Interest and similar income:
Loans and advances to banks		242		212		156
Loans and advances to customers		2,987		3,029		2,442
Other interest earning financial assets		803		926		517

Total interest and similar income		4,032		4,167		3,115

Interest expense and similar charges:
Deposits by banks		1,017		511		295
Deposits by customers		1,262		1,269		948
Debt securities in issue		1,219		1,372		1,004
Other interest bearing financial liabilities		150		214		87

Total interest expense and similar charges		3,648		3,366		2,334

Net interest income		384		801		781

The mortgage effective interest rate assumptions were adjusted, reflecting the change in approach to the management of the mortgage portfolio going forward, resulting in a £187m reduction in net interest income in 2008 compared to 2007.

Financial Statements

Notes to the Financial Statements continued

3. Net fee and commission income


	Group
	2008		2007		2006
	£m		£m		£m

Fee and commission income:
Insurance products		53		103		105
Retail products		418		414		419

Total fee and commission income		471		517		524

Fee and commission expense:
Other fees paid		79		33		27

Total fee and commission expense		79		33		27

Net fee and commission income		392		484		497

4. Net trading and other income


	Group
	2008			2007			2006
	£m			£m			£m

Net trading and funding of other items by the trading book		(7	)		(19	)		(1	)
Income from operating lease assets		88			94			100
Excess on sale of credit cards to MBNA		16			20			27
Expense on assets held at fair value through profit or loss		(11	)		(8	)		(2	)
Expense on liabilities held at fair value through profit or loss		(1	)		—			—
Losses on derivatives managed with assets and liabilities held at fair value through profit or loss		—			(1	)		(2	)
Mark-to-market losses on credit default swaps		(115	)		(2	)		—
Hedge ineffectiveness and other		78			57			76

		48			141			198

5. Administration expenses


	Group
	2008		2007		2006
	£m		£m		£m

Staff costs:
Wages and salaries		221		220		214
Social security costs		20		22		20
Pensions costs: — defined contribution plans		10		9		9
— defined benefit plans		15		17		18
Other personnel costs		74		7		24

		340		275		285
Property, plant and equipment expenses		39		41		41
Information technology expenses		42		39		34
Intangible and tangible assets write offs		163		—		—
Other administrative expenses		343		288		321

		927		643		681

Other personnel costs include restructuring costs.

6. Depreciation and amortisation


	Group
	2008		2007		2006
	£m		£m		£m

Depreciation of property, plant and equipment excluding operating lease assets		32		46		37
Depreciation of operating lease assets		66		74		79
Amortisation of intangible assets		16		11		5

		114		131		121

Depreciation of property, plant and equipment, excluding operating lease assets, includes an asset write down of £9m in 2007 incurred by the Group in connection with the redevelopment of the Bootle administration site (2006: £nil).

Financial Statements

Notes to the Financial Statements continued

7. Audit and other services

The fees for audit and other services payable to the Company’s auditors, Deloitte LLP, are analysed as follows:


	Group
	2008		2007		2006
	£m		£m		£m

Audit fees:
Fees payable to the Company’s auditors for the audit of the Group’s annual accounts		0.8		0.4		0.4
Fees payable to the Company’s auditors and its associates for the audit of the Company’s subsidiaries pursuant to legislation		0.6		0.4		0.3

Total audit fees		1.4		0.8		0.7

Non-audit fees:
— Tax services		1.0		0.1		2.3
— Corporate finance services		0.2		—		0.1
— Other services		0.4		0.7		0.4

Total non-audit fees		1.6		0.8		2.8

Tax services relate to advisory and compliance services on the Group’s tax affairs, and include a fee in 2006 for taxation advice regarding the sale of the credit card business.

No information technology, internal audit, valuation and actuarial, litigation, recruitment and remuneration were provided by the external auditors during 2008.

Corporate finance service costs in 2008 related to work carried out to support the acquisition by Banco Santander, S.A.

Other services include accounting advice and assurance work on bond issues.

A framework for ensuring auditors’ independence has been adopted which defines unacceptable non-audit assignments, pre-approval of acceptable non-audit assignments and procedures for approval of other non-audit assignments by the Audit and Risk Committee. All services provided by the Group’s external auditors are either pre-approved or approved by the Committee.

8. Impairment losses


	Group
	2008			2007			2006
	£m			£m			£m

Impairment losses on loans and advances to customers		619			117			121
Recoveries of loans and advances to customers		(12	)		(17	)		(16	)

Total impairment losses on loans and advances to customers		607			100			105

Impairment losses on treasury investment securities and loans to banks		426			153			—

Detail of Treasury impairment losses can be found in the Risk Management Report in Note 44. Treasury investment securities include financial assets designated at fair value, available-for-sale securities and loan and receivable securities. Impairment losses on loans and advances to customers increased in 2008 to £607m. Such increase in impairment losses is the result of refinements to accounting estimates reflecting the state of the UK economy.

9. Taxation expense


	Group
	2008			2007			2006
	£m			£m			£m

Current tax:
UK corporation tax on profit of the year		—			104			78
Adjustments and reclassifications in respect of prior periods		(45	)		11			(29	)
Overseas taxation		1			1			1

Total current tax (credit)/charge		(44	)		116			50

Deferred tax (credit)/charge:
Current year		(340	)		(2	)		65
Adjustments and reclassifications in respect of prior periods		14			(11	)		4

Total deferred tax		(326	)		(13	)		69

Tax (credit)/charge for the year		(370	)		103			119

UK corporation tax is calculated at 28.5% (2007: 30%, 2006: 30%) of the estimated assessable profits for the year. The standard rate of UK corporation tax was reduced from 30% to 28% with effect from 1 April 2008. Taxation for other jurisdictions is calculated at the rates prevailing in the relevant jurisdictions.

Financial Statements

Notes to the Financial Statements continued

12. Trading assets


	Group
	2008		2007
	£m		£m

Debt securities		—		1,439

The Group applied the amendment to IAS 39 regarding the reclassification of financial assets. Details can be found in Note 18.

Debt securities can be analysed by type of issuer as follows:


	Group
	2008		2007
	£m		£m

Issued by public bodies:
— Government securities		—		26
Other debt securities		—		1,413

		—		1,439

Debt securities can be analysed by listing status as follows:


Group
	2008		2007
	£m		£m

Debt securities:
— Listed in the UK		—		868
— Listed elsewhere		—		538
— Unlisted		—		33

		—		1,439

13. Derivative financial instruments

All derivatives are required to be classified as held for trading (except where in a hedge relationship) and held at fair value through profit or loss. Derivatives are held for trading or for risk management purposes. The Group chooses to designate certain derivatives as in a hedging relationship if they meet specific criteria.

Derivatives held for trading purposes

Treasury is the only area of the Group actively trading derivative products and is additionally responsible for implementing Group derivative hedging with the external market. For trading activities, its objectives are to gain value by:

•		Marketing derivatives to end users and hedging the resulting exposures efficiently; and

•		The management of trading exposure reflected on the Group’s balance sheet.

Trading derivatives include interest rate, cross currency, equity, property and other index related swaps, forwards, caps, floors, swaptions, as well as credit default and total return swaps, equity index contracts and exchange traded interest rate futures and equity index options.

Derivatives held for risk management purposes

The main derivatives are interest rate and cross-currency swaps, which are used to hedge the Group’s exposure to interest rates and exchange rates. These risks are inherent in non-trading assets, liabilities and positions, including fixed-rate lending and structured savings products within the relevant operations throughout the Group, including medium-term note issues, capital issues and fixed-rate asset purchases.

The table in the Risk Management Report in Note 44 summarises activities undertaken by the Group, the related risks associated with such activities and the types of derivative used in managing such risks. Such risks may also be managed using natural offsets within other on-balance sheet instruments as part of an integrated approach to risk management.

Derivative products which are combinations of more basic derivatives (such as swaps with embedded option features), or which have leverage features, may be used in circumstances where the underlying position being hedged contains the same risk features. In such cases, the derivative used will be structured to match the risks of the underlying asset or liability. Exposure to market risk on such contracts is therefore hedged. The fair values of derivative instruments held both for trading and hedging purposes are set out in the following tables. The tables below show the contract or underlying principal amounts, positive and negative fair values of derivatives analysed by contract. Contract or notional amounts indicate the volume of business outstanding at the balance sheet date and do not represent amounts of risk. The fair values represent the amount at which a contract could be exchanged in an arm’s length transaction, calculated at market rates at the balance sheet date.

Financial Statements

Notes to the Financial Statements continued

Derivatives classified as held for trading or held for risk management purposes that have not been designated as in a hedging relationship are classified as derivatives fair valued through profit and loss in the table below. Derivatives that have been designated as in a hedging relationship are classified as derivatives held for hedging below:

Group

Contract/notional

Fair value

2008

amount

assets

liabilities

Derivatives fair valued through P&L

£m

Exchange rate contracts:

— Cross-currency swaps

6,044

1,729

(14

)

— Foreign exchange swaps and forwards

2,461

—

(337

)

8,505

1,729

(351

)

Interest rate contracts:

— Interest rate swaps

20,629

240

(223

)

— Caps, floors and swaptions

496

)

— Credit default swaps

—

(12

)

21,150

246

(236

)

Total derivative assets and liabilities

29,655

1,975

(587

)

Group

Contract/notional

Fair value

2008

amount

assets

liabilities

Derivatives held for hedging

£m

Exchange rate contracts:

— Cross-currency swaps

170

—

Interest rate contracts:

— Interest rate swaps

39,291

484

(828

)

Total derivative assets and liabilities held for hedging

39,461

557

(828

)

Accrued interest

—

344

(118

)

Total recognised derivative assets and liabilities

69,116

2,876

(1,533

)


	Group
	Contract/notional		Fair value		Fair value
2007	amount		assets		liabilities
Derivatives fair valued through P&L	£m		£m		£m

Exchange rate contracts:
— Cross-currency swaps		8,519		260		(265	)
— Foreign exchange swaps and forwards		2,407		—		(34	)

		10,926		260		(299	)

Interest rate contracts:
— Interest rate swaps		43,287		187		(92	)
— Caps, floors and swaptions		390		2		(1	)
— Futures (exchange traded)		275		—		—
— Credit default swaps		217		—		(2	)
— Forward rate agreements		1,446		—		—

		45,615		189		(95	)

Total derivative assets and liabilities		56,541		449		(394	)


	Group
	Contract/notional		Fair value		Fair value
2007	amount		assets		liabilities
Derivatives held for hedging	£m		£m		£m

Exchange rate contracts:
— Cross-currency swaps		206		7		—
Interest rate contracts:
— Interest rate swaps		32,960		128		(191	)

Total derivative assets and liabilities held for hedging		33,166		135		(191	)

Accrued interest		—		386		(206	)

Total recognised derivative assets and liabilities		89,707		970		(791	)

Gains/losses and transfers arising from fair value hedges included in Net trading and other income


	Group
	2008			2007			2006
	£m			£m			£m

Net gains/(losses):
On hedging instruments		(521	)		(224	)		173
On the hedged items attributable to hedged risk		509			220			(177	)
Transferred from the cash flow reserve		11			7			2
Other		21			(12	)		10

Hedge ineffectiveness		20			(9	)		8

Financial Statements

Notes to the Financial Statements continued

The Group hedges its exposures to various risks, including interest rate risk and foreign currency risk, in connection with certain mortgage assets and subordinated and senior debt securities in issue. The gains/(losses) arising on these assets and liabilities are included in the table above on a combined basis.

14. Financial assets designated at fair value


	Group
	2008		2007
	£m		£m

Debt securities		63		891

Financial assets are designated at fair value through profit or loss where this results in more relevant information because it significantly reduces a measurement inconsistency that would otherwise arise from measuring the assets or liabilities or recognising gains or losses on them on a different basis.

Debt securities represent holdings of asset-backed securities. They are managed, and their performance is evaluated, on a fair value basis in accordance with a documented investment strategy and information about them is provided internally on that basis to the Group’s key management personnel.

The maximum exposure to credit risk on the financial assets held at fair value through profit or loss at the balance sheet date was £97m (2007: £855m).

Debt securities can be analysed by listing status as follows:


	Group
	2008		2007
	£m		£m

Listed outside UK		38		861
Unlisted		25		30

		63		891

15. Loans and advances to banks


	Group
	2008		2007
	£m		£m

Placements with other banks		1,239		2,885
Amounts due from parent		—		—
Amounts due from subsidiaries		—		—

		1,239		2,885


	Group
	2008		2007
Repayable:	£m		£m

On demand		816		385
In not more than 3 months		77		2,319
In more than 3 months but not more than 1 year		346		2
In more than 1 year but not more than 5 years		—		179

		1,239		2,885

16. Loans and advances to customers


	Group
	2008			2007
	£m			£m

Advances secured on residential properties		37,665			42,788
Corporate loans		9,058			6,474
Finance leases		1,791			1,916
Other secured advances		57			75
Other unsecured advances		3,477			3,966
Amounts due from subsidiaries		—			—

Loans and advances to customers		52,048			55,219

Less: loan loss allowances		(646	)		(163	)

Loans and advances to customers, net of loan loss allowances		51,402			55,056

Financial Statements

Notes to the Financial Statements continued


	Group
	2008		2007
Repayable:	£m		£m

On demand		108		456
In no more than 3 months		831		1,021
In more than 3 months but not more than 1 year		3,262		2,341
In more than 1 year but not more than 5 years		10,282		5,568
In more than 5 years		36,919		45,670

Loans and advances to customers		51,402		55,056

The Group’s leasing subsidiary, Alliance & Leicester Commercial Finance plc and its subsidiaries, enters into finance lease and hire purchase arrangements with customers.



	2008			2007
Gross investment in finance leases and hire purchase contracts receivable	£m			£m

Within 1 year		333			344
Between 1-5 years		699			740
In more than 5 years		1,556			1,684

		2,588			2,768
Unearned future finance income on finance leases and hire purchase contracts		(797	)		(852	)

Net investment in finance leases and hire purchase contracts		1,791			1,916



	2008		2007
The net investment in finance leases and hire purchase contracts is analysed as follows:	£m		£m

Within 1 year		230		283
Between 1-5 years		484		583
In more than 5 years		1,077		1,050

Net investment in finance leases and hire purchase contracts		1,791		1,916

Included in the carrying value of Net investment in finance leases and hire purchase contracts is £48m (2007: £60m) residual value at the end of the current lease terms, which will be recovered through re-letting or sale.

The loans and advances to customers in the above table have the following interest rate structures:


	Group
	2008			2007
	£m			£m

Fixed rate		24,788			31,320
Variable rate		27,260			23,899
Less: loan loss allowances		(646	)		(163	)

		51,402			55,056

Movement in loan loss allowances:


	Group
	Loans secured						Other			Other
	on residential			Finance			secured			unsecured
	property			leases			advances			advances			Total
	£m			£m			£m			£m			£m

As at 1 January 2008		12			7			19			125			163
Charge to the income statement:
— Individually assessed		15			(3	)		77			147			236
— Collectively assessed		41			(3	)		114			219			371

		56			(6	)		191			366			607

Write-offs		(9	)		—			(4	)		(111	)		(124	)

At 31 December 2008		59			1			206			380			646

As at 1 January 2007		12			5			13			138			168
Charge to the income statement:
— Individually assessed		—			3			9			3			15
— Collectively assessed		1			—			—			84			85

		1			3			9			87			100

Write-offs		(1	)		(1	)		(3	)		(100	)		(105	)

At 31 December 2007		12			7			19			125			163

As at 1 January 2006		15			7			8			136			166
Charge to the income statement:
— Individually assessed		(1	)		—			5			3			7
— Collectively assessed		(3	)		—			—			100			97

		(4	)		—			5			103			104

Write-offs		1			(2	)		—			(101	)		(102	)

At 31 December 2006		12			5			13			138			168

Financial Statements

Notes to the Financial Statements continued

17. Securitisation of assets

Loans and advances to customers include portfolios of residential mortgage loans, which are subject to non-recourse finance arrangements. These loans have been purchased by, or assigned to, special purpose securitisation companies (‘Securitisation Companies’), and have been funded primarily through the issue of mortgage-backed securities (‘Securities’). No gain or loss has been recognised as a result of these sales. These Securitisation Companies are consolidated and included in the Group financial statements as subsidiaries.

The Company receives payments from the Securitisation Companies in respect of fees for administering the loans, and payment of deferred consideration for the sale of the loans. While any notes remain outstanding from a Securitised Company, the Company has no right or obligation to repurchase the benefit of any securitised loan from that Securitised Company, except if certain representations and warranties given by the Company at the time of transfer are breached.

Master Trust Structures

The Company makes use of a type of securitisation known as a master trust structure. In this structure, a pool of assets is assigned to a trust company by the asset originator, initially funded by the originator. A funding entity acquires beneficial interests in a share of the portfolios of assets with funds borrowed from qualifying special purpose entities, which at the same time issue asset-backed securities to third-party investors or the Company. The purpose of the special purpose entities is to obtain funding through the issue of asset-backed securities, or to use the asset-backed securities as collateral for raising funds. The share of the pool of assets not purchased from the trust company by the funding entity is known as the beneficial interest of the originator.

The Company established the Fosse Master Trust securitisation structure in 2006. Notes were issued by Fosse Master Issuer plc to third party investors and the proceeds loaned to Fosse Funding (No. 1) Limited, which in turn used the funds to purchase beneficial interests in mortgages held by Fosse Trustee Limited. The Company raised £2,505m in 2006, £2,502m in 2007 and £396m in 2008 from securitisations involving the Fosse Master Trust.

The Company established the Langton Master Trust securitisation structure on 25 January 2008. Notes are issued by Langton Securities (2008-1) plc, Langton Securities (2008-2) plc and Langton Securities (2008-3) plc to the Company, either for the purpose of creating collateral to be used for funding or for subsequent transfer of Notes to investors outside the Group. Each entity loaned the proceeds of the Notes issued to Langton Funding (No.1) Limited, which in turn used the funds to purchase a beneficial interest in the mortgages held by Langton Mortgages Trustee Limited.

The Company and its subsidiaries are under no obligation to support any losses that may be incurred by the Fosse and Langton Companies or holders of the Securities and do not intend to provide such required support. Holders of the Securities are only entitled to obtain payment of principal and interest to the extent that the resources of the Companies are sufficient to support such payments, and the holders of the Securities have agreed in writing not to seek recourse in any other form.

Bracken Securities plc

In October 2007 the Company securitised £10,367m of residential mortgage assets to Bracken Securities plc. Notes of £10,367m were issued by Bracken Securities plc to the Company, either for the purpose of creating collateral to be used for funding or for subsequent transfer of Notes to investors outside the Group.

Outstanding balances of assets securitised and non-recourse finance at 31 December 2008 were as follows:


		Gross assets		Non-recourse		Issued to A&L
	Closing date	securitised		finance		as collateral
Securitisation company	of securitisation	£m		£m		£m

Fosse Master Issuer plc	28 Nov 2006		1,833		1,909		—
Fosse Master Issuer plc	1 Aug 2007		1,935		2,035		—
Fosse Master Issuer plc	21 Aug 2008		360		387		—
Bracken Securities plc	11 Oct 2007		7,841		—		8,168
Langton Securities (2008-1) plc	25 Jan 2008		1,812		—		1,844
Langton Securities (2008-2) plc	5 Mar 2008		1,979		—		2,013
Langton Securities (2008-3) plc	17 Jun 2008		3,549		—		3,611

Beneficial interest in Fosse Master Trust			2,472		—		—
Beneficial interest in Langton Master Trust			773		—		—

The securitisation vehicles have cash deposits totalling £655m, which have been accumulated to finance the redemption of a number of Securities issued by the Securitisation Companies. The Securitisation Companies’ contractual interest in advances secured on residential property is therefore reduced by this amount. The Company does not own directly, or indirectly, any of the share capital of any of the above Securitisation Companies or their parents.

Financial Statements

Notes to the Financial Statements continued

A summarised aggregated income statement for the years ended 31 December 2008, 2007 and 2006 and a summarised aggregated balance sheet at 31 December 2008 and 2007 for the above companies are set out below:

Income statement for the year ended 31 December


	Securitisation companies
	2008			2007			2006
	£m			£m			£m

Net interest income		(8	)		15			—
Other operating expenses		—			(1	)		—
Fair value movements on derivatives		(50	)		(18	)		2
Administrative expenses		(12	)		(2	)		—
Impairment losses on loans and advances		(2	)		—			—
Taxation (credit)/charge		(1	)		2			(1	)

(Loss)/profit for the year		(73	)		(4	)		1

Balance sheet as at 31 December


	Securitisation companies
	2008			2007
	£m			£m

Derivative financial instruments		1,083			166
Loans and advances to banks		1,059			1,154
Loans and advances to customers		4,099			4,468

Total assets		6,241			5,788

Deposits by banks		411			381
Debt securities in issue		5,470			4,855
Other liabilities		436			555

Total liabilities		6,317			5,791
Retained earnings		(76	)		(3	)

Total liabilities and equity		6,241			5,788

Included within loans and advances to customers are £3,222m (2007: nil) of mortgage advances assigned to a bankruptcy remote special purpose entity, Alliance & Leicester Covered Bonds LLP. These loans provide security to issues of covered bonds made by the Company. On 15 April 2008, the Company issued £500m of covered bonds, under its covered bond programme, which were held by the Company at 31 December 2008. A further £2,000m of covered bonds were issued on 9 October 2008 and were held by the Company at 31 December 2008. These are not included in the table above.

18. Available-for-sale securities and loan and receivable securities

Available-for-sale securities:


			Group
	2008		2007
	£m		£m

Debt securities		1,648		12,770
Equity securities		10		3

		1,658		12,773

Maturities of debt securities:


	Group
	2008		2007
	£m		£m

Due in less than 3 months		1,644		739
Due in more than 3 months but less than 1 year		—		825
Due in more than 1 year but not more than 5 years		4		7,521
Due in more than 5 years		—		3,685

		1,648		12,770

Debt securities include £1,644m of Treasury Bills. Equity securities do not bear interest and are all unlisted.

The movement in available-for-sale securities can be summarised as follows:


	Group
	£m

At 1 January 2008		12,773
Additions		2,078
Disposals (sale and redemption)		(2,385	)
Transfers		(13,436	)
Movement in fair value		(251	)
Other movements		2,879

At 31 December 2008		1,658

Financial Statements

Notes to the Financial Statements continued


	Group
	£m

At 1 January 2007		10,483
Additions		3,954
Disposals (sale and redemption)		(1,991	)
Movement in fair value		(199	)
Other movements		526

At 31 December 2007		12,773

Loan & receivable securities

Loan and receivable securities were £14,250m at the end of 2008 (2007: £210m) for Group and £14,321m for 2008 (2007: £13m) for Company.

The Group applied the amendment to IAS 39 regarding the reclassification of financial assets out of ‘fair value through profit & loss’ and ‘available-for-sale’ categories into ‘loans & receivables’. On 1 July 2008, the amount reclassified out of ‘available-for-sale’ and into ‘loans & receivables’ was £13,436m. If these assets had remained as ‘available-for-sale’, the pre-tax impact on the ‘available-for-sale’ reserve would have been a charge of £1,018m based on exit prices for these debt securities rather than their recoverable values. The pre-tax charge to the ‘available-for-sale’ reserve on these assets in 2008 prior to the reclassification was £264m (2007: £210m). The amount reclassified out of ‘held-for-trading’ and into ‘loans & receivables’ was £732m. If these assets had remained as ‘held-for-trading’ a £54m fair value loss would have been recognised in the income statement. The loss recognised in income in 2008 on these assets prior to the reclassification was £6m (2007: £20m). There has been no change in the way net interest income is recognised in the income statement on these assets reclassified. The reclassifications were made as there was no active trading market in the assets. The reduction in the carrying value of the reclassified assets prior to their reclassification is expected to be recovered over the period to maturity of the assets. This is being recognised on a straight-line basis over the period to maturity, which is considered to be immaterially different to using an Effective Interest Rate basis.

The assets were reclassified as the Group identified that a rare circumstance of extreme market illiquidity had arisen. At the date of reclassification, management had the intention to hold the assets for the foreseeable future or until maturity, and the assets would have met the ‘loans and receivables’ classification had they not originally been required to be classified as held-for-trading or designated as available-for-sale.

19. Intangible assets

a) Goodwill


	Group
	2008		2007
	£m		£m

Cost
At 1 January		11		5
Acquisitions		11		6

At 31 December		22		11

Accumulated impairment
At 1 January		2		2
Impairment losses		20		—

At 31 December		22		2

Net book value		—		9

Impairment of goodwill

A review of the economic value of goodwill was carried out at the balance sheet date. The goodwill of the Group’s balance sheet is now considered fully impaired.

b) Other intangibles


	Group
	Software			Intangible assets
	development cost			under development			Total
	£m			£m			£m

Cost
At 1 January 2008		54			71			125
Additions		14			52			66
Disposals		(22	)		(123	)		(145	)

At 31 December 2008		46			—			46

Accumulated amortisation/impairment
At 1 January 2008		18			—			18
Charge for the year		16			—			16
Disposals		(5	)		—			(5	)

At 31 December 2008		29			—			29

Net book value		17			—			17

Financial Statements

Notes to the Financial Statements continued


	Group
	Software		Intangible assets
	development cost		under development		Total
	£m		£m		£m

Cost
At 1 January 2007		38		20		58
Additions		16		51		67
Disposals		—		—		—

At 31 December 2007		54		71		125

Accumulated amortisation/impairment
At 1 January 2007		7		—		7
Charge for the year		11		—		11
Disposals		—		—		—

At 31 December 2007		18		—		18

Net book value		36		71		107

Disposals include the costs capitalised in relation to the development of a new banking engine which have been written off following the acquisition of the Company by Banco Santander, S.A. as it intends to implement its global banking system, Partenon.

20. Property, plant and equipment (excluding operating lease assets)

Group

Owner-occupied

Office fixtures

properties

and equipment

Total

£m

Cost:

At 1 January 2008

360

440

800

Additions

Disposals

)

(207

)

(208

)

At 31 December 2008

363

242

605

Accumulated depreciation:

At 1 January 2008

184

364

548

Depreciation charge for the year

Disposals

)

(206

)

(207

)

Impairment

—

At 31 December 2008

190

192

382

Net book value

173

223


	Group
	Owner-occupied			Office fixtures
	properties			and equipment			Total
	£m			£m			£m

Cost:
At 1 January 2007		354			426			780
Additions		12			32			44
Disposals		(6	)		(18	)		(24	)

At 31 December 2007		360			440			800

Accumulated depreciation:
At 1 January 2007		170			355			525
Depreciation charge for the year		10			26			36
Disposals		(4	)		(18	)		(22	)
Impairment		8			1			9

At 31 December 2007		184			364			548

Net book value		176			76			252

At 31 December 2008 capital expenditure contracted, but not provided for was £nil (2007: £2m) in respect of property, plant and equipment. Of the carrying value as at 31 December 2008, £nil (2007: £6m) related to assets under construction.

The cost of office fixtures and equipment held under finance leases was £26m (2007: £26m).

At the balance sheet date, the Group had contracted with lessees for the following future minimum lease payments in leases relating to freehold properties:


	Group
	2008		2007
Leases which expire	£m		£m

Within 1 year		—		—
Between 1-5 years		3		4
In more than 5 years		5		5

Total		8		9

Financial Statements

Notes to the Financial Statements continued

21. Operating lease assets


				Group
	2008			2007
	£m			£m

Cost
At 1 January		355			492
Additions		152			84
Disposals		(32	)		(221	)

At 31 December		475			355

Depreciation and impairment
At 1 January		71			192
Charge for the year		66			74
Disposals		(10	)		(195	)

At 31 December		127			71

Net book value		348			284

At the balance sheet date, the Group had contracted with lessees for the following minimum lease payments:


			Group
	2008		2007
	£m		£m

Within 1 year		81		61
Between 1-5 years		133		110
In more than 5 years		17		21

Total		231		192

22. Deferred tax

Deferred taxes are calculated on temporary differences under the liability method using the tax rates expected to apply when the liability is settled or the asset is realised.

The movement on the deferred tax account is as follows:


				Group
	2008			2007
	£m			£m

At 1 January		(5	)		142
Income statement credit — continuing operations		(326	)		(13	)
(Charged)/credited to equity		(3	)		22
Deferred tax on acquisitions and disposals		(14	)		(156	)

At 31 December		(348	)		(5	)

Deferred tax assets and liabilities are attributable to the following items:


				Group
	2008			2007
	£m			£m

Deferred tax liabilities
Provision for loan impairment and other provisions		—			—
Accelerated tax depreciation		(193	)		(210	)
Cash flow hedging		(64	)		6
Other temporary differences		(21	)		—

		(278	)		(204	)


			Group
	2008		2007
	£m		£m

Deferred tax assets
Pensions and other post-retirement benefits		20		3
Accelerated book depreciation		202		190
Provision for loan impairment and other provisions		22		14
Other temporary differences		14		2
Tax losses carried forward		368		—

		626		209

In 2007, the deferred tax asset of £209m was netted against the deferred tax liability of £204m to show a net asset of £5m for Group.

Financial Statements

Notes to the Financial Statements continued

The deferred tax assets scheduled above have been recognised in the Group on the basis that sufficient future taxable profits are forecast within the foreseeable future, in excess of the profits arising from the reversal of existing taxable temporary differences, to allow for the utilisation of the assets as they reverse. Under current UK tax legislation, the tax losses in respect of which deferred tax assets have been recognised do not expire. The benefit of the tax losses carried forward in the Company may only be realised by utilisation against the future taxable profits of the Company. In 2008, deferred tax assets and liabilities are not offset as it is uncertain whether there will be an intention to settle on a net basis or to realise the asset and settle the liability simultaneously.

The deferred tax charge in the income statement comprises the following temporary differences:


							Group
	2008			2007			2006
	£m			£m			£m

Accelerated tax depreciation		(16	)		—			38
Pensions and other post-retirement benefits		—			11			16
Provision for loan impairment and other provisions		(8	)		5			14
Tax losses carried forward		(309	)		—			—
Other temporary differences		7			(29	)		1

		(326	)		(13	)		69

At the balance sheet date the aggregate amount of the temporary differences associated with undistributed earnings of subsidiaries for which deferred tax liabilities have not been recognised is £149m (2007: £141m). No liability has been recognised in respect of these differences because the Group is in a position to control the timing of the reversal of the temporary differences and it is probable that such differences will not reverse in the foreseeable future.

23. Other assets


			Group
	2008		2007
	£m		£m

Trade and other receivables		171		215
Prepayments		74		66
Accrued income		14		18

		259		299

24. Deposits by banks


			Group
	2008		2007
	£m		£m

Items in the course of transmission		178		259
Sale and repurchase agreements		8,816		13,029
Amounts due to subsidiaries		—		—
Other deposits		2,522		5,224

		11,516		18,512


			Group
	2008		2007
	£m		£m

Repayable:
On demand		1,279		639
In not more than 3 months		6,897		7,521
In more than 3 months but not more than 1 year		517		4,196
In more than 1 year but not more than 5 years		2,823		6,063
In more than 5 years		—		93

		11,516		18,512

Financial Statements

Notes to the Financial Statements continued

25. Deposits by customers


			Group
	2008		2007
	£m		£m

Retail deposits		24,978		23,312
Amounts due to subsidiaries		—		—
Amounts due to fellow subsidiary		8,741		—
Wholesale deposits by customers		6,046		6,664

		39,765		29,976

Repayable:
On demand		28,435		24,600
In no more than 3 months		8,025		3,513
In more than 3 months but no more than 1 year		3,119		1,465
In more than 1 year but not more than 5 years		95		248
In more than 5 years		91		150

		39,765		29,976

26. Financial liabilities designated at fair value


			Group
	2008		2007
	£m		£m

Due to other banks		153		876
Due to customers		252		782
Debt securities in issue		323		2,369

		728		4,027

Financial liabilities are designated at fair value through profit or loss where this results in more relevant information because it significantly reduces a measurement inconsistency that would otherwise arise from measuring assets and liabilities or recognising the gains or losses on them on a different basis. The ‘fair value option’ has been used where debt securities in issue would otherwise be measured at amortised cost, and the associated derivatives used to economically hedge the risk are held at fair value. No material amount of the movements in the fair value of the above debt securities in issue reflects any element of the Group’s own credit risk. The amount that would be required to be contractually paid at maturity of the debt securities in issue above is £14m (2007: £4m) higher than the carrying value.

27. Debt securities in issue


			Group
	2008		2007
	£m		£m

Bonds and medium-term notes		16,814		17,887
Other debt securities in issue		663		3,992

		17,477		21,879

A breakdown, by issue currency, of the above is as follows:


								Group
						2008		2007
	Interest Rate			Maturity		£m		£m

Euro		0.00% — 1.99	%	Up to 2010			260		474
		2.00% — 3.99	%	Up to 2010			1,637		10
					2011 — 2019		1,939		365
		4.00% — 4.99	%	Up to 2010			443		1,899
					2011 — 2019		193		992
					2030 — 2039		—		382
					2040 — 2049		—		—
					2050 — 2059		—		1,299
		5.00% — 7.99	%	Up to 2010			406		663
					2011 — 2029		148		367
					2030 — 2039		139		—
					2040 — 2059		2,105		48

Financial Statements

Notes to the Financial Statements continued


								Group
						2008		2007
	Interest Rate			Maturity		£m		£m

US Dollar		0.00% — 1.99	%	Up to 2010			—		618
					2011 — 2039		95		—
		2.00% — 3.99	%	Up to 2010			753		—
		4.00% — 6.87	%	Up to 2010			390		2,861
					2011 — 2019		743		542
					2030 — 2040		—		454
					2041 — 2059		1,650		1,241

Pounds Sterling		0.00% — 1.99	%	Up to 2010			—		142
		2.00% — 4.99	%	Up to 2010			3,048		600
					2011 — 2019		427		205
		5.00% — 5.99	%	Up to 2010			57		178
					2011 — 2019		18		1
					2041 — 2059		—		1,431
		6.00% — 6.87	%	Up to 2010			636		4,354
					2011 — 2019		95		316
					2041 — 2060		1,388		1,194

Other currencies		0.00% — 5.99	%	Up to 2010			852		971
					2011 — 2019		40		32
		6.87% — 7.99	%	Up to 2010			—		225
		7.00% — 8.99	%		2011 — 2040		15		15

							17,477		21,879

28. Subordinated liabilities


			Group
	2008		2007
Dated subordinated liabilities:	£m		£m

9.75% Subordinated notes 2008		—		81
5.875% Subordinated notes 2031		191		162
5.25% Subordinated notes 2023		171		154
Subordinated floating rate EURIBOR notes 2013		—		55
Subordinated floating rate EURIBOR notes 2017		145		110
Subordinated floating rate USD LIBOR notes 2015		102		75
Subordinated floating rate EURIBOR notes 2017		97		74
9.625% Subordinated notes 2023		399		—

Total dated subordinated liabilities		1,105		711


			Group
	2008		2007
Undated subordinated liabilities:	£m		£m

Subordinated floating rate USD LIBOR notes (USD 100m)		69		—
Subordinated floating rate USD LIBOR notes (USD 220m)		151		—
Subordinated floating rate EURIBOR notes (EUR 115m)		111		—

Total undated subordinated liabilities		331		—

Total subordinated liabilities		1,436		711

The subordinated floating rate notes pay a rate of interest related to the LIBOR of the currency of denomination.

In 2008, the subordinated notes due 2008 and 2013 were redeemed in full.

The undated USD 100m floating rate notes are redeemable at par, at the option of the Company, on 1 November 2013 and each interest payment date thereafter.

The undated USD 220m floating rate notes are redeemable at par, at the option of the Company, on 17 December 2013 and each interest payment date thereafter.

The undated EUR 115m floating rate notes are redeemable at par, at the option of the Company, on 17 December 2013 and each interest payment date thereafter.

The subordinated liabilities are redeemable in whole at the option of the Company, on any interest payment date, in the event of certain tax changes affecting the treatment of payments of interest on the subordinated liabilities in the UK, at their principal amount together with any accrued interest.

Subordinated liabilities in issue are repayable:


			Group
	2008		2007
	£m		£m

In more than 3 months but no more than 1 year		—		81
In more than 5 years		1,105		630
Undated		331		—

		1,436		711

Financial Statements

Notes to the Financial Statements continued

29. Other liabilities


			Group
	2008		2007
	£m		£m

Trade and other payables		600		660
Deferred income		31		42

		631		702

Trade and other payables include £40m of finance lease obligations mainly relating to a lease and leaseback of Group property. The maturity of net obligations under finance leases are as follows:


			Group
	2008		2007
	£m		£m

Within 1 year		4		4
Between 1-5 years		21		21
In more than 5 years		15		19

		40		44

Future minimum lease payments are:


			Group
	2008		2007
	£m		£m

Within 1 year		6		5
Between 1-5 years		27		19
In more than 5 years		17		22

		50		46

At the balance sheet date, the Group had contracted with lessees for the following future minimum lease payments on sub-leases:


			Group
	2008		2007
Leases which expire	£m		£m

Within 1 year		1		1
Between 1-5 years		2		2
In more than 5 years		—		1

		3		4

During the year, £3m (2007: £3m, 2006: £3m) was incurred as a finance lease interest charge.

30. Provisions


	Group
	Misselling
	£m

At 1 January 2008		—
Additional provisions		38
Provisions utilised		(4	)

At 31 December 2008		34


To be settled:	£m

Within 12 months		34

The charge disclosed in the income statement in respect of provisions for other liabilities and charges of £38m (2007: nil, 2006: nil), comprises the additional provisions of £38m (2007: £nil).

The misselling provision comprises various claims with respect to product misselling. In calculating the misselling provision, management’s best estimate of the provision was calculated based on conclusions regarding the number of claims that will be received, of those, the number that will be upheld, and the estimated average settlement per case. Further information on misselling provisions can be found in ‘Critical Accounting Policies’ within the Accounting Policies section.

The provision in 2007 was nil for Group.

Financial Statements

Notes to the Financial Statements continued

31. Retirement benefit obligations

The amounts recognised in the balance sheet were as follows:


	Group
	2008			2007
	£m			£m

Assets
Funded defined benefit pension scheme		4			53
Liabilities
Unfunded benefit obligation		(11	)		(11	)
Post-retirement medical benefits		(10	)		(17	)

Total liabilities		(21	)		(28	)

A one percentage point movement in medical cost trends would increase or decrease the post-retirement medical benefit liability by £1m (2007: £1m).

Defined Contribution Pension schemes

An expense of £10m (2007: £9m, 2006: £9m) was recognised for defined contribution plans in the year, and is included in staff costs classified within administration expenses in the income statement. None of this amount was recognised in respect of key management personnel for the years ended 31 December 2008, 2007 and 2006 (see Note 40).

Defined Benefit Pension schemes

The Group operates one defined benefit pension scheme, the Alliance & Leicester Pension Scheme, covering 31% (2007: 33%) of the Group’s employees. The defined benefit section of this scheme closed to new entrants on 31 March 1998 and has a defined contribution section for employees who joined the Company after this date. As the defined benefit section of the scheme is closed to new entrants, under the projected unit method, the current service cost when expressed as a percentage of pensionable salaries, will gradually increase over time.

Formal actuarial valuations of the assets and liabilities of the schemes are carried out on a biennial basis by an independent professionally qualified actuary and updated for accounting purposes at each balance sheet date. The latest formal actuarial valuation was made as at 31 March 2008 and updated to 31 December 2008 by a qualified independent actuary.

The total amount charged to the income statement was determined as follows:


							Group
	2008			2007			2006
	£m			£m			£m

Current service cost		19			20			23
Expected return on pension scheme assets		(84	)		(81	)		(72	)
Interest cost		75			70			64

		10			9			15

The net (liability)/asset recognised in the balance sheet was determined as follows:


	Group
	2008			2007			2006			2005			2004
	£m			£m			£m			£m			£m

Present value of funded defined benefit obligation		(1,209	)		(1,324	)		(1,327	)		(1,305	)		(1,119	)
Fair value of plan assets		1,213			1,377			1,311			1,230			1,060

		4			53			(16	)		(75	)		(59	)
Unfunded benefit obligation		(11	)		(11	)		(10	)		(9	)		(8	)

		(7	)		42			(26	)		(84	)		(67	)

Movements in the defined benefit obligations during the year were as follows:


				Group
	2008			2007
	£m			£m

Balance at 1 January		(1,335	)		(1,337	)
Current service cost		(19	)		(20	)
Interest cost		(75	)		(70	)
Employee contributions		(2	)		(2	)
Past service cost		—			—
Actuarial gain		170			57
Actual benefit payments		41			37

Balance at 31 December		(1,220	)		(1,335	)

Financial Statements

Notes to the Financial Statements continued

Movements in the present value of fair value of scheme assets during the year were as follows:


				Group
	2008			2007
	£m			£m

Balance at 1 January		1,377			1,311
Expected return on scheme assets		84			81
Actuarial (loss) on scheme assets		(230	)		(3	)
Company contributions paid (regular)		17			19
Company contributions paid (special)		3			3
Employee contributions		2			2
Actual benefit payments		(40	)		(36	)

Balance at 31 December		1,213			1,377

The rate used to discount the retirement benefit obligation is determined to reflect duration of the liabilities based on the annual yield as at 31 December of the Sterling 15+ year AA Corporate Bond iBoxx Index, representing the market yield of high quality corporate bonds on that date.

The amounts recognised in the statement of recognised income and expense for each of the five years indicated was as follows:


	Group
	2008			2007			2006			2005			2004
	£m			£m			£m			£m			£m

Actuarial (gain)/loss on scheme liabilities		(170	)		(57	)		(34	)		130			36
Actuarial loss/(gain) on scheme assets		230			3			(13	)		(108	)		(30	)

		60			(54	)		(47	)		22			6

There was an actuarial gain during the year of £nil (2007: £2m, 2006: £3m) on the Group’s post-retirement medical benefits liability.

The actual return on scheme assets was a loss of £146m (2007: £78m gain, 2006: £85m gain). Cumulative net actuarial gains of £13m (2007: £73m) have been recognised in the Consolidated Statement of Recognised Income and Expenses.

The Group’s pension schemes did not directly hold any equity securities of the Company or any of its related parties at 31 December 2008. In addition, the Group does not hold insurance policies over the schemes, and has not entered into any significant transactions with the schemes.

The principal actuarial assumptions used for the Group were as follows:


	2008		2007		2006
	Nominal per		Nominal per		Nominal per
	annum		annum		annum
	%		%		%

To determine benefit obligations:
— Discount rate for scheme liabilities (pensioners)		6.4		5.9		5.2
— Discount rate for scheme liabilities (non-pensioners)		6.4		5.6		5.2
— General salary increase		3.5		3.8		3.5
— General price inflation		3.0		3.3		3.0
— Expected rate of pension increase		3.0		3.3		3.0

To determine net periodic benefit cost:
— Discount rate (pensioners)		5.9		5.2		5.2
— Discount rate (non-pensioners)		5.6		5.2		5.2
— Expected rate of pension increase		3.0		3.3		3.0
Expected rate of return on plan assets:
— Equities		7.8		7.8		7.5
— Bonds		5.0		5.0		4.5
— Properties		6.4		6.2		—

The mortality assumption used in preparation of the valuation as at 31 December 2008 was the PA 92 series base tables (as published by the Institute and Faculty of Actuaries) with allowance for future improvements in life expectancy in line with the medium cohort projections, subject to minimum rates of improvement of 1.0% per annum for males and 0.5% per annum for females.

The Group determined its expense measurements above based upon long-term assumptions taking into account target asset allocations of assets set at the beginning of the year, offset by actual returns during the year. Year-end obligation measurements are determined by reference to market conditions at the balance sheet date. Assumptions are set in consultation with third party advisors and in-house expertise.

The trustees of the schemes are required under the Pensions Act 2004 to prepare a statement of investment principles. The principal duty of the trustees is to act in the best interests of the members of the schemes and they have developed the following investment objectives for their defined benefit sections:

•		To maintain a portfolio of suitable assets of appropriate quality, suitability and liquidity which will generate income and capital growth to meet, together with new contributions from members and the employers, the cost of current and future benefits which the pension fund provides, as set out in the trust deed and rules;

•		To limit the risk of the assets failing to meet the liabilities, over the long-term and on a shorter-term basis as required by prevailing legislation;

Financial Statements

Notes to the Financial Statements continued

•

To minimise the long term costs of the pension fund by maximising the return on the assets while having regard to the objectives shown above.

The statement of investment principles has set the long-term target allocation of plan assets at 25% Equities, 25% alternative return-seeking assets (including Property), 25% Bonds and 25% Gilts. Approximately 20% of the Scheme’s liabilities have been hedged by interest rate swaps and other liability-matching assets.

The expected rates of return by asset class used to calculate the expected return for 2008 are Equities 7.8% (2007: 7.75%, 2006: 7.50%), Bonds/Gilts 5.0% (2007: 4.95%, 2006: 4.50%) and Property 6.4% (2007: 6.2%, 2006: n/a). The overall long term rate of return on the assets employed has been determined after considering projected movements in asset indices.

The categories of assets in the scheme as a percentage of total scheme assets for Group are as follows:


	2008		2007
	%		%

UK equities		23		27
Overseas equities		18		20
Corporate bonds		19		18
Government Fixed Interest		21		19
Government Index Linked		10		10
Property		6		3
Others		3		3

		100		100

The Group currently expects to contribute £17m to its defined benefit pension schemes in 2009. The benefits expected to be paid in each of the next five years, and in the aggregate for the five years thereafter are:


Year ending 31 December:	£m

2009		42
2010		41
2011		46
2012		50
2013		54
Five years ended 2018		333

32. Contingent liabilities and commitments

The estimated maximum exposure in respect of contingent liabilities and commitments granted is:


			Group
	2008		2007
	£m		£m

Guarantees given to subsidiaries		—		—
Guarantees given to third parties		202		244
Formal standby facilities, credit lines and other commitments with original term to maturity of:
— 1 year or less		380		353
— More than 1 year		1,595		1,504

		2,177		2,101

Unauthorised overdraft fees

The Group, in line with other UK banks and building societies, levies charges on current account customers, for example when a customer goes overdrawn (if they did not have an arranged overdraft facility) when a customer exceeds their agreed overdraft limit, or when the bank refuses to pay an item if the customer does not have sufficient funds in their account. UK banks and building societies believe these fees customers pay are fair and clearly set out in account terms and conditions.

In common with other banks in the United Kingdom, Alliance & Leicester plc has received claims and complaints from a large number of customers relating to the legal status and enforceability of current and historic contractual terms in personal current account agreements relating to unarranged overdraft and unpaid item charges (‘Relevant Charges’) and seeking repayment of Relevant Charges that had been applied to their accounts in the past. The claims and complaints are based primarily on the common law penalty doctrine and the Unfair Terms in Consumer Contract Regulations 1999 (the ‘Regulations’). Because of the High Court test case referred to below, most existing and new claims in the County Courts are currently stayed and there is also a UK Financial Services Authority (‘FSA’) waiver of the complaints handling process and a standstill of Financial Ombudsman Service decisions.

On 27 July 2007, following discussions between the Office of Fair Trading (‘OFT’), the Financial Ombudsman Service, the FSA and major UK banks, the OFT issued proceedings in a test case against the banks which was intended to determine certain preliminary issues concerning the legal status and enforceability of contractual terms relating to Relevant Charges.

Financial Statements

Notes to the Financial Statements continued

The preliminary trial concluded on 8 February 2008 and the judgement was handed down on 24 April 2008. The High Court held that the contractual terms relating to unarranged overdraft charges currently used by the Group (i) are not unenforceable as penalties, but (ii) are not exempt from assessment for fairness under the Regulations. At a subsequent court hearing on 22 and 23 May 2008, the judge granted test case banks permission to appeal his decision that unarranged overdraft charges are assessable for fairness under the Regulations. Alliance & Leicester plc is not a test case bank but will abide by the outcome of the appeal. The appeal hearing concluded in November 2008 and on 26 February 2009 the Court of Appeal upheld the judge’s decision and rejected the appeal. The test case banks are now likely to take the appeal to the House of Lords. In October 2008 the High Court also delivered its judgement to the effect that terms and conditions previously used by the test case banks are not capable of being penalties but are assessable for fairness under the Regulations. Depending on the outcome of an appeal to the House of Lords, further hearings may be required in order for the Court to determine the fairness of the charges.

The issues relating to the legal status and enforceability of the Relevant Charges are complex. The Company maintains that its Relevant Charges are fair and enforceable and believes that it has a number of substantive and credible defences. The Group cannot, however, at this stage predict with any certainty if, or for how long, the stays, waiver and standstill referred to above will remain in place. Nor can it at this stage predict with any certainty the timing or substance of the final outcome of the customer claims and complaints, any appeals and any further stages of the test case. It is unable reliably to estimate the liability, if any, which may arise as a result of or in connection with these matters or its effect on the Group’s consolidated net assets, operating results or cash flows in any particular period.

Financial Services Compensation Scheme

The Financial Services Compensation Scheme (FSCS), the UK’s statutory fund of last resort for customers of authorised financial services firms, pays compensation if a firm is unable to meet its obligations as they fall due. As a result of the failure of a number of deposit-taking institutions during the second half of 2008, the FSCS now stands as a creditor of Bradford & Bingley plc and the administrations of Heritable Bank, Kaupthing Singer & Friedlander and Landsbanki “Icesave”. The FSCS has borrowed from HM Treasury to fund the compensation costs associated with those failures. These borrowings are currently on an interest-only basis until September 2011.

The FSCS fulfils its obligations by raising management expenses levies and compensation levies on the industry. In relation to compensation relating to protected deposits, each deposit-taking institution contributes towards these levies in proportion to their share of total protected deposits, subject to a threshold set by the Financial Services Authority establishing the maximum that the FSCS can levy for compensation in any one year. The limit on the FSCS management expenses for the three years from September 2008 in relation to the above-mentioned failures has been capped at £1bn per annum. The FSCS has the power to raise levies on firms who have ceased to participate in the scheme and are in the process of ceasing to be authorised (so called ‘exit levies’) for the amount that the firm would otherwise have been asked to pay during the relevant levy year. The Group has accrued for its share of management expenses levies for the 2008/9 and 2009/10 levy years in the amount of £21m.

The FSCS will receive funds from asset sales, surplus cash flow, or other recoveries from each of the above-named banks. These recoveries will be used to reduce the principal amount outstanding on the FSCS’s borrowings. Only after the interest-only period which is expected to end in September 2011 will a schedule for repayment of any remaining principal outstanding (after recoveries) on the borrowings be agreed between the FSCS and HM Treasury. It is expected that, from that point, the FSCS will begin to raise compensation levies (principal repayments) relating to the above-named banks. As a consequence, the amount of the principal which the FSCS will levy to deposit-taking institutions is not yet known and is unlikely to be determined until 2011. No provision for compensation levies, which could be significant, has been made in these Consolidated Financial Statements.

Regulatory

The Group engages in discussion, and fully co-operates with the UK Financial Services Authority in their enquiries, including those exercised under statutory powers, regarding its interaction with past and present customers and policyholders both as part of the UK Financial Services Authority’s general thematic work and in relation to specific products and services.

Obligations under stock borrowing and lending agreements

Obligations under stock borrowing and lending agreements represent contractual commitments to return stock borrowed. These obligations totalling £2,795m at 31 December 2008 (2007: £2,049m) are offset by a contractual right to receive stock under other contractual agreements.

Other off-balance sheet commitments

The Group has commitments to lend at fixed interest rates which expose it to interest rate risk.

Operating lease commitments


			Group
	2008		2007
	£m		£m

Rental commitments under operating leases expiring:
— No later than 1 year		1		1
— Later than 1 year but no later than 5 years		7		10
— Later than 5 years		64		69

		72		80

Financial Statements

Notes to the Financial Statements continued

At 31 December 2008, the Group held various leases on land and buildings, many for extended periods, and other leases for equipment, which require the following aggregate minimum lease payments:


	Group
Leases expiring year ended 31 December:	£m

2009		1
2010		1
2011		1
2012		3
2013		2
Total thereafter		64

Group rental expense comprises:


							Group
	2008			2007			2006
	£m			£m			£m

In respect of minimum rentals		12			12			12
Less: sub-lease rentals		(1	)		(1	)		(1	)

		11			11			11

33. Innovative tier 1

On 22 March 2004, the Company issued £300m of innovative tier 1 capital securities. At the end of 2008, the balance sheet value of £311m included the accrued coupon. The tier 1 securities are perpetual securities and pay a coupon on 22 March each year, with the first coupon paid on 22 March 2005. At each payment date, the Company can decide whether to declare or defer the coupon indefinitely. If a coupon is deferred then the Company may not pay a dividend on any share until it next makes a coupon payment. The Company can be obliged to make payment in the event of winding up.

The coupon is 5.827% per annum until 22 March 2016. Thereafter the coupon steps up to a rate, reset every five years, of 2.13% per annum above the gross redemption yield on a UK Government Treasury Security. The tier 1 securities are redeemable at the option of the Company on 22 March 2016 or on each payment date thereafter. No such redemption may be made without the consent of the Financial Services Authority. In 2008, 2007 and 2006 the coupon of £17.5m was paid.

34. Share capital and preference shares


	Ordinary
	shares of
	50 pence
	each
	£m

Share capital
Authorised share capital
At 1 January 2008		388
Increase		—

At 31 December 2008		388

At 1 January and 31 December 2007		388

Issued and fully paid share capital
At 1 January 2008		210
Shares issued		118

At 31 December 2008		328

At 1 January 2007		219

At 31 December 2007		210

The Company has one class of ordinary shares which carry no right to fixed income. The ordinary shares in issue at 31 December 2008 reflect the investment made by Abbey National plc on 17 December 2008 and subscription for 234,113,712 shares.


	Ordinary
	shares of
	50 pence
	each
	£m

Share premium account
At 1 January 2008		125
Shares issued		599

At 31 December 2008		724

At 1 January 2007		106

At 31 December 2007		125

Financial Statements

Notes to the Financial Statements continued

Preference shares

On 24 May 2006, the Company issued £300m fixed/floating rate non-cumulative callable preference shares, resulting in net proceeds of £294m. The preference shares entitle the holders to a fixed non-cumulative dividend, at the discretion of the Board, of 6.22% per annum payable annually from 24 May 2007 until 24 May 2019 and quarterly thereafter at a rate of 1.13% per annum above three month sterling LIBOR. The preference shares are redeemable only at the option of the Company on 24 May 2019 or on each quarterly dividend payment date thereafter. No such redemption may be made without the consent of the Financial Services Authority.

35. Retained earnings and other reserves

Movements in retained earnings were as follows:


				Group
	2008			2007
	£m			£m

At 1 January		1,421			1,558
(Loss)/profit for the year		(954	)		256
Post-tax actuarial movement on retirement benefit obligations		(45	)		42
Transfer from share based payment reserve		17			—
Repurchase of share capital		—			(194	)
Equity dividends paid		(229	)		(241	)

At 31 December		210			1,421

Movements in minority interest were as follows:


				Group
	2008			2007
	£m			£m

At 1 January		4			—
Share of profit		—			4
Disposal		(4	)		—

At 31 December		—			4

Analysis of dividends paid is as follows:


	Group
	Pence per
	Share

Ordinary shares (equity):
2006 interim		17.6
2006 final		36.5
2007 interim		18.8
2007 final		36.5
2008 interim		18.0

Movements in capital redemption reserve were as follows:


			Group
	2008		2007
	£m		£m

At 1 January		90		80
Repurchase of share capital		—		10

At 31 December		90		90

Movements in share based payment reserve were as follows:


				Group
	2008			2007
	£m			£m

At 1 January		26			21
Share option costs charged to profit		8			8
Equity and reserves transfer		(32	)		(3	)
Deferred tax		(2	)		(5	)
Current tax		—			5

At 31 December		—			26

Financial Statements

Notes to the Financial Statements continued

Movements in available-for-sale reserve were as follows:


				Group
	2008			2007
	£m			£m

At 1 January		(143	)		4
Net losses from changes in fair value		(241	)		(220	)
Net losses/(gains) transferred to profit on disposal		14			(1	)
Impairment loss transferred to Income Statement		18			11
Deferred tax		59			63

At 31 December		(293	)		(143	)

The available-for-sale reserve is being amortised on a straight-line basis over the period to maturity, which is considered to be immaterially different to using an Effective Interest Rate basis. The estimated cash flows on the assets are the carrying value plus the available-for-sale reserve. These assets are not impaired as at 31 December 2008.

Movements in cash flow hedging reserve were as follows:


				Group
	2008			2007
	£m			£m

At 1 January		(14	)		(20	)
Gains from changes in fair value		259			15
Transferred to net profit — hedge ineffectiveness		(11	)		(7	)
Deferred tax		(70	)		(2	)

At 31 December		164			(14	)

The cash flow hedging reserve arises on cash flow hedges of interest rate risk on a portfolio of variable rate assets. The hedged interest rate cash flows on the underlying portfolio are expected to occur on a reducing basis over a period of approximately five years from the balance sheet date.

36. Cash flow statement

a) Reconciliation of (loss)/profit after tax to net cash inflow from operating activities:


							Group
	2008			2007			2006
	£m			£m			£m

(Loss)/profit for the year		(918	)		296			450
Non-cash items included in net profit
Increase in prepayments and accrued income		(4	)		(27	)		(10	)
Decrease in accruals and deferred income		(36	)		(1	)		(145	)
Depreciation and amortisation		114			118			120
Provisions for liabilities and charges		15			(16	)		(9	)
Provision for impairment		1,033			253			105
Other non-cash items		(221	)		103			86

		(17	)		726			597
Changes in operating assets and liabilities

Net decrease/(increase) in trading assets		1,439			(286	)		(846	)
Net increase in derivative assets		(1,905	)		(279	)		(121	)
Net decrease/(increase) in financial assets designated at fair value		828			482			(1,042	)
Net decrease/(increase) in loans and advances to banks and customers		5,114			(6,845	)		(6,901	)
Net (increase)/decrease in other assets		(5,887	)		(568	)		73
Net increase in deposits by banks and deposits by customers		2,794			13,468			3,869
Net increase in derivative liabilities		990			123			205
Net (decrease)/increase in financial liabilities designated at fair value		(3,299	)		(4,873	)		506
Net increase/(decrease) in debt issued		3,603			580			(741	)
Net (decrease)/increase in other liabilities		(29	)		(179	)		274

Net cash flow from operating activities before tax		3,631			2,349			(4,127	)
Income tax received/(paid)		21			(54	)		(81	)

Net cash flow from operating activities		3,652			2,295			(4,208	)

Financial Statements

Notes to the Financial Statements continued

b) Analysis of the balances of cash and cash equivalents in the balance sheet:


	Group
	2008		2007
	£m		£m

Cash and balances with central banks		1,553		3,471
Loans and advances to banks		816		385

Cash and cash equivalents		2,369		3,856

37. Collateral pledged and received

The Company pledges assets as collateral in the following areas of the business.

The Company enters into securitisation transactions whereby portfolios of residential mortgage loans are purchased by or assigned to special purpose securitisation companies, and have been funded through the issue of mortgage-backed securities. Holders of the securities are only entitled to obtain payments of principal and interest to the extent that the resources of the securitisation companies are sufficient to support such payments and the holders of the securities have agreed in writing not to seek recourse in any other form. At 31 December 2008, £22,582m (2007: £18,464m) of residential mortgage loans were so assigned.

In 2008, the Company also established a covered bond programme, whereby securities are secured by a pool of ring-fenced residential mortgages. At 31 December 2008, £3,222m of residential mortgage loans had been so secured.

Collateral is also provided in the normal course of derivative business to counterparties. As at 31 December 2008 £196m (2007: £164m) of such collateral in the form of cash had been pledged.

The Company enters into sale and repurchase agreements and similar transactions, which are accounted for as secured borrowings. Upon entering into such transactions, the subsidiaries pledge collateral equal to 100%-131% of the borrowed amount. The fair value of assets that were so pledged at 31 December 2008 was £21,133m (2007: £17,683m).

The Company also enters into purchase and resale agreements and similar transactions whereby the Company receives collateral. The Company is permitted to sell or re-pledge the collateral held. At 31 December 2008, the fair value of such collateral was £2,795m (2007: £2,049m) of which £2,763m (2007: £1,936m) was sold or re-pledged.

38. Share-based compensation

During the year ended 31 December 2008, the Group had seven share-based payment arrangements, including Share Incentive Plan (SIP) partnership shares. Following acquisition by Banco Santander, S.A., the Executive Directors of the Company participate in schemes as disclosed in the Annual Report & Accounts of Abbey National plc.

On the acquisition of the Company by Banco Santander, S.A., Alliance & Leicester shares held in the SIP were converted to Banco Santander shares on the same three for one basis, as all other shareholdings, and will remain in the SIP Trust under the terms of the SIP rules. Options held under the ShareSave Plan, share option plan and senior manager deferred bonus scheme became exercisable on 7 October 2008 and will lapse, if unexercised, on 7 April 2009. Executive deferred bonus scheme and Long-Term Incentive Plan (LTIP) shares all lapsed on 7 October 2008. Restricted share plan shares vested and were converted to Banco Santander, S.A. shares on acquisition in accordance with the scheme rules. Under the senior manager deferred bonus scheme, new Alliance & Leicester shares will be issued to satisfy deferred bonus scheme options that remain unexercised prior to 7 April 2009, after which all options will lapse.

The following table summarises the movement in the number of options over Alliance & Leicester shares between those outstanding at the beginning and end of the year, together with the changes in weighted average exercise price over the same period:

Executive

Restricted

Long term

Senior

deferred

incentive

manager

bonus

plan

plan (LTIP)

deferred

ShareSave

option plan

No. of

bonus⁽¹⁾

No. of shares

2008

Outstanding at 1 January

3,388,840

3,830,524

58,721

306,932

1,083,669

243,597

Granted

—

376,255

—

627,598

676,876

291,901

Lapsed

(2,768,842

)

(1,974,353

)

(32,514

)

(627,361

)

(1,736,241

)

(137,725

)

Exercised

(55,323

)

—

(26,207

)

(307,169

)

(24,304

)

(333,047

)

Outstanding at 31 December 2008

564,675

2,232,426

—

64,726

Exercisable at 31 December 2008

564,675

2,232,426

—

64,726

Weighted average exercise price in 2008

630.2p

n/a

525.5p

274.2p

525.5p

285.5p

Range of exercise prices for options

632p — 815p

544p — 1,093p

n/a

Weighted average remaining contractual

n/a

Weighted average fair value options

n/a

84p

n/a

390p

428p

1,553p

⁽²⁾

Financial Statements

Notes to the Financial Statements continued


							Executive			Restricted			Long term			Senior
							deferred			share			incentive			manager
				Share			bonus			plan			plan (LTIP)			deferred
	ShareSave			option plan			No. of			No. of			No. of			bonus
	No. of shares			No. of shares			shares			shares			shares			No. of shares

2007
Outstanding at 1 January		3,513,908			5,172,169			93,372			126,942			649,945			233,181
Granted		1,080,293			484,051			—			206,481			477,000			96,516
Lapsed		(469,530	)		(326,697	)		—			(25,542	)		(39,175	)		(28,862	)
Exercised		(735,831	)		(1,498,999	)		(34,651	)		(949	)		(4,101	)		(57,238	)

Outstanding at 31 December 2007		3,388,840			3,830,524			58,721			306,932			1,083,669			243,597
Exercisable at 31 December 2007		407,188			1,113,918			16,423			—			—			10,017
Weighted average exercise price in 2007		805.9p			1,118.8p			1,093.0p			1,100.0p			1,137.0p			1,128.9p
Range of exercise prices for options		364p — 815p			510p — 1,093p			n/a			n/a			n/a			n/a
Weighted average remaining contractual	2.2 years			0.7 years			0.2 years			2.0 years			1.4 years			1.4 years
Weighted average fair value options		195p			181p			n/a			917p			879p			2,593p	⁽²⁾


							Executive			Restricted			Long term		Senior
							deferred			share			incentive		manager
				Share			bonus			plan			plan (LTIP)		deferred
	ShareSave			option plan			No. of			No. of			No. of		bonus
	No. of shares			No. of shares			shares			shares			shares		No. of shares

2006
Outstanding at 1 January		3,761,897			6,260,765			182,622			—			234,817		212,657
Granted		843,008			556,350			—			129,008			415,128		113,340
Lapsed		(333,803	)		(196,547	)		—			(2,037	)		—		(15,288	)
Exercised		(757,194	)		(1,448,399	)		(89,250	)		(29	)		—		(77,528	)

Outstanding at 31 December 2006		3,513,908			5,172,169			93,372			126,942			649,945		233,181
Exercisable at 31 December 2006		112,304			929,732			—			—			—		5,984
Weighted average exercise price in 2006		1119.3p			1109.4p			1125.5p			1062.0p			n/a		1119.7p
Range of exercise prices for options		364.4p — 813p			510p — 900.5p			n/a			n/a			n/a		n/a
Weighted average remaining contractual	2.2years			0.9years			0.7years			2.6years			1.8years		0.4years
Weighted average fair value options		215p			140p			n/a			846p			742p		2468p


1.		The figures in the table relate to the level of bonus deferred, i.e. excluding the matching element.

2.		The option value includes the deferred share and the fair value of the matched element less the cash bonus foregone.

195,454 SIP partnership shares (2007: 126,924, 2006: 152,654) were issued during the year, at the prevailing market rate, at a weighted average price of 428p (2007: 977p) per share. All were converted to Banco Santander, S.A. shares on acquisition.

The estimated fair values are calculated by applying the following models:

•		The value of the share price option plus the present value of any deferred dividends. The assumptions used in the model are as follows:

•


Input		Assumption

Share price		Price at date of grant
Exercise price		Per scheme rules
Expected volatility		Estimated by calculating the annualised, exponential weighted monthly volatility of Alliance & Leicester share price over preceding two years
Option life		Per scheme rules
Risk free rate		Generated from LIBOR swap curve

39. Directors’ emoluments and interests

There were no loans, quasi loans and credit transactions entered into or agreed by the Company or its subsidiaries with persons who are or were Directors, Other Key Management Personnel and each of their connected persons during the year except as described below:


			Aggregate amount
	Number of		outstanding
Other Key Management Personnel Loans*	persons		£000

2008		2		217

2007		2		207


*		Other Key Management Personnel are defined as the Executive Committee of Alliance & Leicester and the Board and Executive Committee of Alliance & Leicester’s parent company, Abbey National plc who served during the year.

Financial Statements

Notes to the Financial Statements continued

40. Related party disclosures

Transactions with Directors, Other Key Management Personnel and each of their connected persons
Directors, Other Key Management Personnel and their connected persons have undertaken the following transactions with the Group in the course of normal banking.


				Amounts in respect of Directors, Other
	Number of Directors and			Key Management Personnel⁽¹⁾ and their
	Other Key Management			connected persons
2008	Personnel⁽¹⁾			£000

Secured loans, unsecured loans and overdrafts
Loans outstanding at 1 January		4			541
Net movements in the year		2			(324	)

Loans outstanding at 31 December		2			217

Deposit, bank and instant access accounts and investments
Deposits, bank instant access accounts and investments at 1 January⁽²⁾		10			850
Net movements in the year		(6	)		(580	)

Deposit, bank and instant access accounts and investments at 31 December		4			270

Life assurance policies
Life assurance policies at 1 January and 31 December		—			—


				Amounts in respect of Directors, Other
	Number of Directors and			Key Management Personnel⁽¹⁾ and their
	Other Key Management			connected persons
2007	Personnel⁽²⁾			£000

Secured loans, unsecured loans and overdrafts
Loans outstanding at 1 January		2			754
Net movements in the year		—			(420	)

Loans outstanding at 31 December		2			334

Deposit, bank and instant access accounts and investments
Deposits, bank instant access accounts and investments at 1 January		11			2,206
Net movements in the year		(1	)		(1,356	)

Deposit, bank and instant access accounts and investments at 31 December		10			850

Life assurance policies
Life assurance policies at 1 January and 31 December		—			—


(1)		In 2008, other Key Management Personnel are defined as the Executive Committee of the Company and the Board and Executive Committee of Alliance & Leicester’s parent company, Abbey National plc who served during the year.

(2)		In 2007, only the Board of Directors of the Company were Key Management Personnel.

Secured and unsecured loans are made to Directors, Other Key Management Personnel and their connected persons, in the ordinary course of business, with terms prevailing for comparable transactions and on the same terms and conditions as applicable to other employees and customers within the Group. Such loans do not involve more than the normal risk of collectability or present any unfavourable features. Amounts deposited by Directors, Other Key Management Personnel and their connected persons earn interest at the same rates as those offered to the market or on the same terms and conditions applicable to other employees within the Group.

No life assurance policies and investments were entered into by Directors, Other Key Management Personnel and their connected persons with the Company or its subsidiaries during the year.

Directors’ Remuneration

The aggregate remuneration received by the Directors of the Company in 2008 was:


	£

Salaries and fees		1,929,979
Performance-related payments		50,500
Other taxable benefits		38,674

Total remuneration excluding pension contributions		2,019,153
Pension contributions		186,170
Compensation for loss of office		931,037

These totals exclude emoluments received by Directors in respect of their primary duties as Directors or Officers of Abbey National plc or Banco Santander, S.A., in respect of which no apportionment has been made.

Financial Statements

Notes to the Financial Statements continued

Long Term Incentive Plans

During 2008, prior to the acquisition of the Company by Banco Santander, S.A., three Directors and six other Key Management Personnel received conditional awards of shares and options under the Alliance & Leicester Long Term Incentive Plan and the Company Share Option Plan respectively for a total fair value of £678,257. These awards and options were in respect of the Company’s ordinary shares. All Long Term Incentive Plan awards lapsed on 7 October 2008; all Company Share Option Plan options granted in 2008 remain unexercised as at 31 December 2008 and will lapse on 7 April 2009. On 7 October 2008, three Directors and four other Key Management Personnel exercised options under the Alliance & Leicester Deferred Bonus Plan. Alliance & Leicester Deferred Bonus Plan options outstanding as at 31 December 2008 will lapse on 7 April 2009. No further options were granted over the Company’s ordinary shares.

Remuneration of Highest Paid Director

In 2008, the remuneration, excluding pension contributions, of the highest paid Director was £663,936 (2007: £860,000) of which £25,000 (2007: £249,000) was performance related. The accrued pension benefit for the highest paid Director as at 31 December 2008 was £109,647 (2007: £108,155). A conditional award of shares was made to the highest paid Director under the Long-Term Incentive Plan during the year.

Retirement Benefits

Defined benefit pension plans are provided to certain of Alliance & Leicester’s employees. See Note 33 for a description of the plans and related costs and obligations. Retirement benefits are accruing for one Director under the Alliance & Leicester Defined Benefit Scheme (2007: three) in respect of his qualifying service to Alliance & Leicester.

Non-Executive Directors

Fees were paid to Non-Executive Directors in 2008 totalling £748,784 (2007: £906,000); this amount is included above in the table of Directors’ remuneration and excludes emoluments received by Terence Burns, Juan Rodriguez Inciarte, José Maria Carballo, José Maria Fuster, Rosemary Thorne and Keith Woodley, which are shown aggregated in the Report and Accounts of Abbey National plc.

Directors’ Interests and Related Party Transactions

In 2008, loans were made to four members of Alliance & Leicester’s Key Management Personnel, with the principal amount of £217,000 outstanding at 31 December 2008. No Directors had loans outstanding at 31 December 2008. See Note 39 for disclosures of deposits and investments made and insurance policies entered into by the Directors, Key Management Personnel and their connected persons with Alliance & Leicester at 31 December 2008.

In 2008 there were no other transactions, arrangements or agreements with the Group in which Directors or Key Management Personnel or persons connected with them had a material interest, other than options to subscribe for ordinary shares under the Alliance & Leicester Share Option Plans. No Director had a material interest in any contract of significance other than a service contract with the Company or any of its subsidiaries, at any time during the year. During 2008, no Directors exercised share options over shares in Banco Santander, S.A., the ultimate parent company of the Company (2007: none).

Remuneration of Key Management Personnel


	2008		2007		2006
	£m		£m		£m

Short-term employee benefits		3.7		3.6		4.6
Post-employment benefits		0.4		0.9		0.8
Other long-term benefits		—		—		—
Termination benefits		2.2		—		—
Share-based payments		2.3		1.1		0.9

		8.6		5.6		6.3

Company Share Option Plan

In 2008, Executive Directors and Other Key Management Personnel were granted options over shares in the Company under the Alliance & Leicester Company Share Option Plan. These options will lapse on 7 April 2009.

In 2005, three Executive Directors and five Other Key Management Personnel were granted options over shares in the Company. The amount of shares participants would receive at the end of the three-year period depended on the Earnings per Share performance of the Company in this period. The performance condition was not met and the options lapsed on 7 April 2008.

Deferred Bonus Scheme

In 2005 and 2004, three Executive Directors and five Other Key Management Personnel were granted deferred and matching options over shares in the Company under the Alliance & Leicester Deferred Bonus Scheme. The amount of matching shares Executive Directors would receive at the end of the three-year period depended on the Company’s Total Shareholder Return against a competitor benchmark group. The conditions attached to the matching shares were not met at the end of the three-year period and the matching options awarded to Executive Directors lapsed. During 2008, three Executive Directors exercised deferred options and four Key Management Personnel exercised deferred and matching options on 7 October 2008.

Financial Statements

Notes to the Financial Statements continued

Parent undertaking and controlling party

At 31 December 2008, the Company’s ultimate parent undertaking and controlling party was Banco Santander, S.A., a company incorporated in Spain. Banco Santander, S.A. is the parent undertaking of the largest Group of undertakings for which Group accounts are drawn up and of which the Company is a member. See Note 41 below for changes in Company ownership since 31 December 2008.

Copies of all sets of Group accounts, which include the results of the Company, are available from Abbey Secretariat, Abbey National House, 2 Triton Square, Regent’s Place, London NW1 3AN.

Transactions with related parties

During the year, the Group entered into the following transactions with related parties:


	Interest, fees and						Interest, fees and						Amounts owed by				Amounts owed
	other income received						other expenses paid						related parties				to related parties
	2008		2007		2006		2008		2007		2006		2008		2007		2008		2007
	£m		£m		£m		£m		£m		£m		£m		£m		£m		£m

Parent company		—		—		—		—		—		—		—		—		—		—
Fellow subsidiaries		3		—		—		38		—		—		149		—		9,465		—

		3		—		—		38		—		—		149		—		9,465		—

In addition, transactions with pension schemes operated by the Group are described in Note 31. Transactions with fellow subsidiaries mainly relates to funding received from Abbey National plc following the acquisition by Banco Santander, S.A. in 2008.

41. Events after the reporting date

On 9 January 2009, in order to optimise the capital, liquidity funding and overall financial efficiency of the enlarged group, Banco Santander, S.A. transferred all of its Alliance & Leicester plc shares to Abbey National plc in exchange for Abbey National plc ordinary shares. The result of this was to increase Abbey National plc’s holding of 35.6% of the Company’s equity voting interests to 100%. Accordingly, Abbey National plc is now the immediate parent company of Alliance & Leicester plc.

The Company has given a full and unconditional guarantee in respect of the unsubordinated liabilities of Abbey National plc incurred prior to 31 July 2012 under a deed poll guarantee entered into by the Company on 19 March 2009. Abbey National plc has given a reciprocal guarantee in respect of the unsubordinated liabilities of the Company incurred prior to 31 July 2012 on the same day. It has not yet been practicable to estimate the financial effect of the deed poll guarantee given by the Group due to its recent completion.

42. Financial instruments

Financial assets and financial liabilities are measured on an ongoing basis either at fair value or at amortised cost. The Accounting Policies Note describes how the classes of financial instruments are measured, and how income and expenses, including fair value gains and losses, are recognised. Each class of financial asset and liability on the balance sheet has a single measurement basis, which is described in the Accounting Policies Note.

The following tables analyse the fair value of financial instruments not measured at fair value in the balance sheet:

Group

Carrying

Surplus/

value

Fair value

(deficit)

2008

£m

Assets

Cash and balances at central banks

1,553

—

Loans and advances to banks

1,239

1,240

Loans and advances to customers

51,402

52,377

975

Held to maturity

—

Loans & receivables

14,250

13,153

(1,097

)

Liabilities

Deposits by banks

11,516

11,501

Deposits by customers

39,765

39,826

(61

)

Debt securities in issue

17,477

16,605

872

Subordinated liabilities

1,436

1,411

Financial Statements

Notes to the Financial Statements continued


	Group
	Carrying				Surplus/
	value		Fair value		(deficit)
2007	£m		£m		£m

Assets
Cash and balances at central banks		3,471		3,471		—
Loans and advances to banks		2,885		2,882		(3	)
Loans and advances to customers		55,056		55,121		65
Held to maturity		213		181		(32	)
Loans & receivables		210		210		—
Liabilities
Deposits by banks		18,512		18,426		86
Deposits by customers		29,976		29,979		(3	)
Debt securities in issue		21,879		21,507		372
Subordinated liabilities		711		680		31

The surplus/(deficit) in the table above represents the surplus/(deficit) of fair value compared to the carrying amount of those financial instruments for which fair values have been estimated.

Fair value measurement

The fair value of financial instruments is the estimated amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. If a quoted market price is available for an instrument, the fair value is calculated based on the market price. Where quoted market prices are not available, fair value is determined using pricing models which use a mathematical methodology based on accepted financial theories, depending on the product type and its components. Pricing models take into account the contract terms of the securities as well as market-based valuation parameters, such as interest rates, volatility, exchange rates and the credit rating of the counterparty. Valuation adjustments are an integral component of the fair value estimation process and are taken on individual positions where either the absolute size of the trade or other specific features of the trade or the particular market (such as counterparty credit risk, concentration or market liquidity) require more than the simple application of pricing models. Further information on fair value measurement can be found in ‘Critical Accounting Policies’ within the Accounting Policies section.

Fair value management

The fair value exposures, as tabled above, are managed by using a combination of hedging derivatives and offsetting on balance sheet positions. The approach to specific categories of financial instruments is described below.

Assets:

Cash and balances at central banks/Loans and advances to banks

The carrying amount is deemed a reasonable approximation of the fair value, because they are short term in nature.

Loans and advances to customers

Loans and advances to personal customers are made both at variable and at fixed rates. As there is no active secondary market in the UK for such loans and advances, there is no reliable market value available for such a significant portfolio.

a) Variable rate

The Directors believe that the carrying value of the variable rate loans may be assumed to be their fair value.

b) Fixed rate

Certain of the loans secured on residential properties are at a fixed rate for a limited period, typically two to five years from their commencement. At the end of this period these loans revert to the relevant variable rate. The excess of fair value over carrying value of each of these loans has been estimated by reference to the market rates available at the balance sheet date for similar loans of maturity equal to the remaining fixed period.

Loan and receivable securities

Where reliable prices are available, the fair value of investment securities has been calculated using indicative market prices. Other market values have been determined using in-house pricing models.

Liabilities:

Deposits by banks

The carrying amount is deemed a reasonable approximation of the fair value, because it is short-term in nature.

Deposits by customers

The majority of deposit liabilities are payable on demand and therefore can be deemed short-term in nature with the fair value equal to the carrying value. However, given the long-term and continuing nature of the relationships with the Group’s customers, the Directors believe there is significant value to the Group in this source of funds. Certain of the deposit liabilities are at a fixed rate until maturity. The deficit of fair value over carrying value of these liabilities has been estimated by reference to the market rates available at the balance sheet date for similar deposit liabilities of similar maturities.

Financial Statements

Notes to the Financial Statements continued

Debt securities in issue and subordinated liabilities

Where reliable prices are available, the fair value of debt securities in issue and subordinated liabilities has been calculated using quoted market prices. Other market values have been determined using in-house pricing models.

Net gains and losses on financial instruments


	Group
	2008			2007			2006
	£m			£m			£m

Financial assets and liabilities at fair value through profit or loss on initial recognition		—			—			—
Financial assets and liabilities held for trading		(7	)		(19	)		(1	)
Loans and receivables		3,274			3,262			2,706
Available-for-sale		(14	)		1			1
Financial liabilities held at amortised cost		(3,532	)		(3,190	)		(2,282	)

		(279	)		54			424

43. Capital Management and Resources

Capital management and capital allocation

The Board is responsible for capital management strategy and policy and ensuring that capital resources are appropriately monitored and controlled within regulatory and internal limits. Authority for capital management flows to the Chief Executive and from him to specific individuals who are members of the Group’s Asset and Liability Management Committee (‘ALCO’).

ALCO adopts a centralised capital management approach that is driven by the Group’s corporate purpose and strategy. This approach takes into account the regulatory and commercial environment in which the Group operates, the Group’s risk appetite, the management strategy for each of the Group’s material risks (including whether or not capital provides an appropriate risk mitigant) and the impact of appropriate adverse scenarios and stresses on the Group’s capital requirements. This approach is reviewed annually as part of the Group’s Internal Capital Adequacy Assessment Process (‘ICAAP’).

The Group manages its capital requirements, debt funding and liquidity on the basis of policies and plans reviewed regularly at ALCO and as part of the ICAAP process.

On an ongoing basis, and in accordance with the latest ICAAP review, the Group forecasts its regulatory and internal capital requirements based on the approved capital volumes allocated to business units as part of the corporate planning process and the need to have access to a capital buffer. Capital allocation decisions are made as part of planning based on the relative returns on capital using both economic and regulatory capital measures. Capital allocations are reviewed in response to changes in risk appetite and risk management strategy, changes to the commercial environment, changes in key economic indicators or when additional capital requests are received.

This combination of regulatory and economic capital ratios and limits, internal buffers and restrictions, together with the relevant costs of differing capital instruments and a consideration of the various other capital management techniques are used to shape the most cost-effective structure to fulfil the Group’s capital needs.

Capital adequacy

From 1 January 2007, the Group has managed its capital on a Basel II basis. Throughout 2008, the Group held capital over and above its regulatory requirements, and managed internal capital allocations and targets in accordance with its capital and risk management policies.

Group Capital


	31 December			31 December
	2008			2007
	£m			£m

Core tier 1 capital		1,352			1,846
Deductions from Core Tier 1 capital		(78	)		(180	)

Total Core Tier 1 capital after deductions		1,274			1,666
Other Tier 1 capital		605			605

Total Tier 1 capital after deductions		1,879			2,271

Tier 2 capital		1,306			655
Deductions from Tier 2 capital		(61	)		(64	)

Total Tier 2 capital after deductions		1,245			591

Deductions from total tier 1 and tier 2 capital		—			(5	)

Tier 3 capital		147			—

Total capital resources		3,271			2,857

Core Tier 1 capital includes £700m from ordinary shares issued to Abbey National plc in December 2008.

Financial Statements

Notes to the Financial Statements continued

44. Risk Management

This Risk Management report describes the Risk Governance Framework of Alliance and Leicester plc and includes more detail on the Company’s key risks, on a segmental basis or aggregated where relevant. It is divided into the following sections:

Introduction — A description of the Group’s Risk Governance Framework, including the three tiers of the Risk Governance structure.

Financial Risks and Risk Management — Group-wide disclosures about specific risks which do not originate in any single operating segment, such as operational risk and pension obligation risk, as well as Group-wide disclosures about market risk and concentrations of credit risk.

Discussion of Key Risks by Operating Segment — Detailed discussions about risk exposures, measurement information and management policies presented by operating segment:

•

Risks in Retail Banking — The risks in these segments include:

	•		Credit risk, including its management, an analysis of types and credit quality of retail lending, and disclosures relating to provisioning, arrears and recoveries.

	•		Market risk, including its management.

•

Risks in Corporate Banking — The risk in this segment consists of:

	•		Credit risk, including its management and mitigation.

	•		Market risk, including its management.

•

Risks in Treasury — The risks in this segment include:

	•		Credit risk, including its management, mitigation, and the disclosure of exposure by rating and geography.

	•		Market risk, including its management and disclosures on short-term market risk and structural market risk.

The Impact of the Current Credit Environment — Detailed disclosures include a description of the Group’s exposures to certain classes of financial assets and off-balance sheet entities.

Liquidity risk — A description of the liquidity risks the Group faces.

Introduction

The Group accepts that risk arises from its full range of activities, and actively manages and controls it. The management of risk is an integral part of the Group’s activities. Risk is defined as the uncertainty around the Group’s ability to achieve its business objectives and execute its strategy effectively. Risk constitutes the Group’s exposure to uncertainty and the consequent variability of return. Specifically, risk equates to the adverse impacts on profitability arising from different sources of uncertainty including Credit Risk (Retail), Credit Risk (Corporate), Credit Risk (Treasury), Market Risk, Operational Risk, Securitisation Risk, Concentration Risk, Liquidity Risk, Reputational Risk, Strategic Risk, Pension Obligation Risk, Group Risk and Regulatory Risk. Risk measurement is used to capture the source of the uncertainty and the magnitude of its potential effect on the profitability and solvency of the Group. Effective risk management and control is therefore of fundamental importance to the Group’s long-term success.

Understanding and controlling risk is a business imperative. The Company’s Risk Framework ensures that risk is managed and controlled on behalf of shareholders, customers, depositors, employees and the firm’s regulators. Effective and efficient risk governance and oversight provide management with assurance that the Group’s business activities will not be adversely impacted by risks that could have been reasonably foreseen. This in turn reduces the uncertainty of achieving the Group’s strategic objectives.

Authority for Risk Management flows from the Alliance & Leicester plc Board of Directors to the Chief Executive and from him to specific individuals. Formal standing committees are maintained for effective management or oversight. Their authority is derived from the person they are intended to assist.

Financial Statements

Notes to the Financial Statements continued

Risk Governance Framework

The diagram below shows the Risk Governance Framework in operation in respect of risk management and oversight.

The Risk Division at Banco Santander, S.A. reports to the President of the Comisión Delegada de Riesgos (Delegated Risk Committee or ‘CDR’).

The main elements of risk governance within the Group are as follows:

First tier of risk governance

Risk management is provided by the Board. It approves the Group’s risk appetite in consultation with Banco Santander, S.A. as appropriate, approves the strategy for managing risk and is responsible for the Group’s system of internal control. The Board is supported by the Chief Executive and Executive Management, who have primary responsibility for understanding, identifying, and owning the risks generated by their lines of business and establishing a framework for managing those risks within the Board-approved risk appetite of the Group. In addition, understanding, identifying, and owning the risks generated by the Group’s operations are the responsibility of the Divisional Heads and central functions. These functions provide technical support and advice to assist in the management and control of risk. Within this tier, there is a process for transaction review and approval within certain thresholds, discharged by the Credit Approval Committee. Transactions reviewed which exceed the threshold limits set are subject to prior review by Banco Santander, S.A.’s Risk Division before final approval by the Credit Approval Committee.

Risk Committee

This is a management committee, established under the authority of and chaired by the Chief Executive. The Risk Committee reviews risk issues, gives advice and recommendations to the Chief Executive, the Executive Committee or other parties as appropriate as well as makes decisions on risk issues within its sphere of responsibility.

Second tier of risk governance

Risk control is provided by the Board independently supported by the Risk Division. The roles of the Chief Risk Officer and the Risk Division include development of risk measurement methodologies, risk approval, risk monitoring, risk reporting and escalation of risk issues in line with the relevant risk policy for all risks across all lines of Retail Banking, Corporate Banking and Treasury business.

Dedicated Business Risk Oversight Fora (ROFs) advise and support the Chief Risk Officer in fulfilling his risk control responsibilities and help to ensure that risks are suitably understood, managed and controlled.

The Risk Division provides independent challenge to all business areas in respect of risk management and compliance with policies and advises the business when they are approaching the limits of the Group’s risk appetite.

The Board, as supported by the Risk Division, is responsible for ensuring compliance with Group policies and limits imposed by Banco Santander, S.A. including:

•		Group-wide risk policies;

•		Group-wide risk limits/parameters;

•		Approval processes relating to transactions that exceed local risk limits;

•		The systematic review of exposures to large clients, sectors, geographical areas and different risk types; and

•		Reporting to Banco Santander, S.A.

Financial Statements

Notes to the Financial Statements continued

Third tier of risk governance

Risk assurance provides independent objective assurance on the effectiveness of the management and control of risk across the Group. This is provided through the Non-Executive Directors, Internal Audit function and the Audit and Risk Committee.

Non-Executive Directors

The Non-Executive Directors are members of the Board who have a particular responsibility for constructively challenging and contributing to the development of strategy, scrutinising the performance of management in meeting agreed goals and objectives and monitoring reporting performance, and assuring themselves that the financial controls and systems of risk management are robust and defensible.

Internal Audit

The Internal Audit function supports the Audit and Risk Committee by providing independent and objective opinions on the effectiveness and integrity of the Group’s risk governance arrangements. It does this via a systematic programme of risk-based audits of the controls established and operated by the ‘first tier’ risk management functions and those exercised by the ‘second tier’ risk control functions.

The audit opinions and underlying rationale of findings and recommendations form the basis upon which the Audit and Risk Committee can take reasonable (but not absolute) assurance that the risk governance arrangements are fit for purpose and working properly. The Audit and Risk Committee also receive reports from management, the risk control functions and the external auditors to help them to discharge their risk governance oversight responsibilities.

Audit and Risk Committee

The Audit and Risk Committee is made up of Non-Executive Directors, and is a committee of the Board. The Committee has responsibility for:

•		The oversight of the risk governance framework;

•		Review of the effectiveness of the Group’s internal and external audit process;

•		Review of control policies and procedures including regulatory compliance and financial reporting;

•		The identification, assessment and reporting of risks; and

•		The risk governance structure and associated compliance with risk control policies and procedures.

Financial Risks and Risk Management

The financial risks affecting the Group are discussed below. Risks are generally managed through tailored management policies within the business division or operating segment in which they are originated.

Group-wide disclosures including about specific risks which do not originate in any single operating segment, are described separately at the beginning of this section, apart from liquidity risk which is discussed at the end of the section, following the detailed disclosures about the impact of the current credit environment.

Following the Group-wide disclosures are detailed discussions about risk exposures, measurement information and management policies presented by operating segment, being Retail Banking, Corporate Banking and Treasury.

Financial Instruments

The Group uses financial instruments to manage the structural balance sheet exposures that arise from its banking activities, in accordance with Risk policies and the Asset and Liability Management Committee’s direction. The Group also trades in financial instruments where it takes positions in traded and over the counter instruments, including derivatives, to take advantage of short-term market movements in the equity and bond markets and in currency and interest rates.

Credit Risk — Group-wide

Significant concentrations of credit risk

During 2008, the Group’s exposures to credit risk derived from its three segments of Retail Banking, Corporate Banking, and Treasury. Within Retail Banking, the most significant exposures to credit risk derive from the residential mortgage portfolio and unsecured personal lending businesses. Within Corporate Banking, significant exposures also derive from the commercial loans portfolio. Within Treasury, significant exposures result from its asset portfolio.

The residential mortgage portfolio comprises loans to private individuals secured against residential properties in the UK. This is a prime portfolio with total balance sheet exposure of £37.7bn at 31December 2008. The Unsecured Personal Loan portfolio comprises unsecured loans to private individuals issued in the UK. Total exposure stood at £3.4bn at 31 December 2008. The commercial loans portfolio in Corporate Banking comprises loans to companies and associated derivatives. The total exposure to this portfolio was £10.4bn at 31 December 2008.

Although Corporate Banking operations are based mainly in the UK, it has built up exposures to various entities around the world and is therefore exposed to concentrations of risk related to geographic area. A significant proportion of Corporate Banking exposures were to counterparties that reside in the EU. Treasury exposures result from its asset portfolio. At 31 December 2008 treasury investment securities stood at £14.3bn.

Financial Statements

Notes to the Financial Statements continued

Maximum exposure to credit risk

The following table presents the amount that best represents the Group’s estimated maximum exposure to credit risk at the reporting date without taking account of any collateral held or other credit enhancements:


	2008		2007
	£m		£m

Trading assets		—		1,439
Loans and advances to banks		1,239		2,885
Derivative financial instruments		2,876		970
Financial assets designated at fair value		63		891
Available-for-sale securities		1,658		12,773
Loan and receivable securities		14,250		210
Loans and advances to customers		51,402		55,056
Other		348		497

Third party exposures⁽¹⁾		71,836		74,721


(1)		In addition the Group is exposed to credit risk in respect of guarantees granted, loan commitments and stock borrowing and lending agreements. The estimated maximum exposure to credit risk is described in Note 32.

In managing the gross exposures, the Group uses the policies and processes described in the credit risk sections below. Collateral is also held in the form of security over the mortgaged property and through market standard collateral agreements in its treasury business.

Market risk — Group-wide

Market risk is the potential for loss of income or decrease in the value of net assets caused by movements in the levels and prices of financial instruments including interest rate and foreign currency risks. The Group accepts that market risk arises from its full range of activities. The Group aims to actively manage and control market risk by limiting the adverse impact of market movements whilst seeking to enhance earnings within clearly defined parameters. The Market Risk Manual, which is reviewed and approved by the Head of Wholesale Risk on an annual basis, sets the framework under which market risks are managed and controlled. Business area policies, risk limits and mandates are established within the context of the Market Risk Manual. Executive Directors are responsible for ensuring that they have sufficient expertise to manage the risks originated and retained with their business divisions. The business areas are responsible for ensuring that they have sufficient expertise to manage the risks associated with their operations. The independent Risk function, under the direction of the Head of Wholesale Risk, aims to ensure that risk-taking and risk control occur within the framework prescribed by the Market Risk Manual. The Risk function also provides oversight of all risk-taking activities through a process of reviews. The Group aims to ensure that exposure to market risks is measured and reported on an accurate and timely basis to senior management. In addition to the regular reporting for the purposes of active risk management, the Board also receives reporting of all significant market risk exposures on a monthly basis where actual exposure levels are measured against limits. Senior management recognise that different risk measures are required to best reflect the risks faced in different types of business activities. In measuring exposure to market risk, the Group uses a range of complementary measures, covering both value and income as appropriate.

Pension obligation risk — Group-wide

The Group has statutory funding obligations as the sponsoring employer for a defined benefit staff pension scheme. The scheme is managed by independent trustees in accordance with legislation and trust deeds and rules, for the benefit of members. The Group accepts that it is exposed to pension obligation risk that could give rise to an unexpected increase in the Group’s obligations to fund the scheme, either because of a loss of net asset value or because of changes in legislation or regulatory action. The principal risks to the net asset value of the scheme are an increase in the value of the liabilities arising from adverse changes in the longevity, inflation, and scheme assets being adversely affected by market movements. Further information on pensions can be found in ‘Critical Accounting Policies’ within the Accounting Policies section and in Note 31.

Risk management

The Chief Financial Officer is responsible for managing the Group’s exposure to pension obligation risk, in conjunction with the trustees. Further details of the funding arrangements for the pension schemes can be found in Note 31.

Risk Management in Retail Banking

Credit risk in Retail Banking

Credit risk is the risk that counterparties will not meet their financial obligations, which may result in the Group losing the principal amount lent, the interest accrued and any unrealised gains (less any security held). Credit risk occurs mainly in the Group’s loan and investment assets (including residential mortgages and secured lending, personal and business banking), and in derivative contracts. The Group actively manages and controls credit risk.

Financial Statements

Notes to the Financial Statements continued

Residential mortgages and secured lending

The Group lends on many types of property but only after a credit risk assessment of the borrower, including affordability modelling, and an assessment of the property are undertaken. The systems used to manage and monitor the quality of the mortgage assets are reviewed in accordance with policy to ensure they perform as expected. Residential lending is subject to lending policy and lending authority levels, which are used to structure lending decisions to the same high standard across the retail network, a process further improved by mortgage credit scoring, underwriter accreditation and regular compliance reviews. Details concerning the prospective borrower and the mortgage are subject to a criteria-based decision-making process. Criteria for assessment include credit references, loan-to-value ratio, borrower status, affordability and the mortgage credit score.

The majority of loans provided by the Group are secured on UK properties. All properties must be permanent in construction; mobile homes are not acceptable.

Prior to granting any first mortgage loan on a property, the Group has the property valued by an approved and qualified surveyor, who may be a Group employee. The valuation is based on set Royal Institute of Chartered Surveyors and Group guidelines. Normally, in the case of additional lending, when the total loan remains below 90% loan-to-value, the original property value is subject to indexation and no further survey is carried out. If the loan exceeds 90% loan-to-value, a revaluation is carried out by a qualified surveyor. In low risk re-mortgage cases where a reputable automated valuation within high confidence limits is available this may substitute for a surveyor’s valuation.

Progressively stricter lending criteria are applied to mortgages above a loan-to-value of 75%. Only 2% of new secured loan advances in 2008 were made with a loan-to-value of more than 90%. Loans with higher loan-to-value ratios carry a higher risk due to the increased likelihood that liquidation of the collateral will not yield sufficient funds to cover the loan advanced and costs of liquidation. These loans generally attract higher margins as a result.

Mortgage credit quality⁽¹⁾


	2008			2007

Loan-to-value analysis:
New business
> 90%		2	%		8	%
75% - 90%		36	%		36	%
< 75%		62	%		56	%
Average (at inception)		63	%		67	%
Average loan-to-value of stock (indexed)		49	%		46	%
New business profile:
First-time buyers		17	%		25	%
Home movers		44	%		45	%
Remortgages		25	%		24	%
Further advances		14	%		6	%
Average earnings multiple		3.1			3.3


(1)		Excludes any fees added to the loan, and only includes the drawn loan amount, not drawdown limits. Includes prime mortgage lending and excludes buy to let.

The residential mortgage portfolio has started to show an increasing trend of payment arrears with the deterioration in economic conditions. Credit quality remains strong, with the average loan to value (‘LTV’) on new business completions gradually reducing through the year, with the 4th quarter at 56% (Q3 08: 61% Q4 07: 65%). The indexed stock LTV increased to 49% as a result of declining house prices, mitigated by the reduction in new business LTVs. Credit criteria have been progressively tightened in response to the changing market environment. As a result, the LTV profile of new lending has improved significantly.

•		Arrears more than 90 days past due have increased from 0.47% in December 2007 to 0.83% at the end of 2008. In the same period, industry arrears more than 90 days past due are forecast by the UK Council of Mortgage Lenders to have increased from 1.10% to 1.88%.

•		Completions in excess of 75% LTV have fallen from 44% in 2007 to 38% in 2008.

Mortgage arrears and repossessions

Collections & Recoveries Department is responsible for all debt management initiatives on the secured portfolio for Retail Banking. Debt management strategies, which include negotiating repayment arrangements and concessions and debt counselling, can start as early as the day after a repayment is past due and will continue until legal action. Different collection strategies are applied to different segments of the portfolio subject to the perceived levels of risk, for example, loan-to-value, collections score and account characteristics.

If the agreed repayment arrangement is not maintained, legal proceedings may be taken and may result in the property being taken into possession. The Group sells the repossessed property at market price and uses the sale proceeds, net of costs, to pay off the outstanding value of the mortgage. The stock of repossessed properties held by the Group varies according to the number of new possessions and the buoyancy of the housing market.

The following tables set forth information on UK residential mortgage arrears, and properties in possession, at 31 December 2008 and 2007 for the Group compared to the industry average as provided by the Council of Mortgage Lenders (‘CML’), as well as the carrying amount of assets obtained as collateral.


	Group⁽¹⁾⁽²⁾
Mortgage arrears	(Percentage of total mortgage loans by number)

31 to 60 days in arrears
31 December 2007		0.65
31 December 2008		0.76

61 to 90 days in arrears

Financial Statements

Notes to the Financial Statements continued


	Group⁽¹⁾⁽²⁾
Mortgage arrears	(Percentage of total mortgage loans by number)

31 December 2007		0.28
31 December 2008		0.37


	Group		CML⁽²⁾
	(Percentage of total mortgage loans by number)

3 to 5 months in arrears
31 December 2007		0.29		0.62
31 December 2008		0.47		1.01

6 to 11 months in arrears
31 December 2007		0.13		0.35
31 December 2008		0.26		0.62

12 months or more in arrears
31 December 2007		0.05		0.13
31 December 2008		0.10		0.25


(1)		Alliance & Leicester data is not readily available for arrears less than 31 days.

(2)		Council of Mortgage Lenders data is not available for arrears less than 3 months — Data as at 31 December 2008.


	Group		CML⁽²⁾
Properties in possession	(Percentage of total mortgage loans by number)

31 December 2007		0.02		0.10
31 December 2008		0.03		0.21


Carrying amount of assets obtained as collateral		£m
31 December 2007		12
31 December 2008		16

Restructured loans

Some mortgage loans have had arrears capitalised. The value of capitalised arrears on loans was less than £1m in both 2008 and 2007.

Unsecured personal loans. The Group uses systems and processes to manage the risks involved in providing unsecured personal loans and overdraft lending or in granting bank account facilities. These include the use of application and behavioural scoring systems to assist in the granting of credit facilities as well as regular monitoring of scorecard performance and the quality of the unsecured lending portfolios. Behavioural scoring examines the lending relationships that a customer has with the Group and how the customer uses their bank account together with a monthly update of the customer’s external borrowing via credit bureaux. This information generates a score that is used to assist in deciding the level of risk (in terms of overdraft facility amount, card facilities granted and preferred unsecured personal loan value) for each customer that the Group is willing to accept. Individual customer scores are normally updated on a monthly basis. The Group has successfully extended the use of behavioural scoring into other areas of the business, including the refinement of debt management strategies and bank account transaction processing.

Unsecured personal loan arrears


	2008		2007
	£m		£m

Total unsecured personal loan arrears^{(1, 2)}		213		203
Total unsecured personal loan asset		3,534		4,041
Unsecured personal loan arrears as a % of asset		6.03		5.02


(1)		Unsecured personal loans include current account customers.

(2)		Unsecured personal loans are defined as the balances of accounts that are three or more months in arrears (> 4 instalments).

Provisions on loans and advances to customers

The charge for provisions on loans and advances to customers adjusts the balance sheet provisions to the level that management deems adequate to absorb actual and inherent losses in the Group’s loan portfolio from homogeneous portfolios of assets and individually identified loans. A proportion of the Group’s provisions on loans and advances to customers relate to loans and advances secured either by a first charge on residential property in the UK, or by other appropriate security depending on the nature of the loan.

		The Group’s provisioning policy is as follows. Further information is set out in the Accounting Policies section:

•		Observed provision — an observed provision is established for all past due loans after a specified period of repayment default where it is likely that some of the capital will not be repaid or recovered through enforcement of any applicable security. The length of the default period depends on the nature of the advance and is generally no more than three months. Once a loan misses a payment (breach of contractual terms) an assessment of the likelihood of collecting the principal and overdue payments is made. This assessment is generally made using statistical techniques developed on previous experience and on projections of current market conditions to the time the loss is expected to crystallise. These techniques estimate the propensity of loans to go to write-off and as a separate exercise, the loss incurred on written off debt is monitored. For advances secured on residential property the propensity of loans to reach repossession is determined, with repossessed properties assessed on an individual basis through the use of external valuation, anticipated disposal costs and the current exposure.

Financial Statements

Notes to the Financial Statements continued

•		Incurred but not yet observed provision — an incurred but not yet observed provision is made against loans which have not missed a payment but are known from past experience to have deteriorated since the initial decision to lend was made. Based on historical evidence, the number of accounts likely to default in the future, as a result of events present at the balance sheet date, are identified through use of statistical techniques. During the year, these statistical techniques were expanded and enhanced. In particular, further detailed examination is now performed on the losses that emerge over a defined period of time after the reporting date called the emergence period. This period is determined to ensure that only those accounts which have credit deterioration at the reporting date are captured and excludes accounts which will suffer credit deterioration after the reporting period. The emergence period is two to three months for unsecured lending and 12 months for secured lending. The provision methodology outlined for observed provisions is then applied to accounts identified as impaired in the performing portfolios.

•		Amounts written off — unsecured loans are written off when all internal avenues of collecting the debt have failed and the debt is passed onto external collection agencies. On secured loans, the write off takes place on ultimate realisation of collateral value, or from claiming on any mortgage indemnity guarantee or other insurance. All write offs are on a case by case basis, taking account of the exposure at the date of write-off, after accounting for the value from any collateral or insurance held against the loan. The write-off policy is regularly reviewed.

Security is realised in accordance with the Group’s internal debt management programme. Contact is made with customers with the aim to achieve a realistic and sustainable repayment arrangement. Litigation and/or enforcement of security is usually carried out only when the steps described above have been undertaken without success. As a result of the write-off policy, the provisions will be made a significant time in advance of the related write-off on all products. The exception to this rule is the discovery of fraud, where the exposure is written off once full investigations have been completed and the probability of recovery is minimal. The time span between the discovery and write-off will be a short period and may not result in a provision being raised.

Movements in provisions for impairment losses on loans and advances


	2008
	£m

Provisions at 1 January 2008		136
Amounts written off
Advances secured on residential properties — UK		(10	)
Unsecured personal advances — UK		(102	)

Total amounts written off		(112	)

Observed provisions charged against profit
Advances secured on residential properties — UK		46
Unsecured personal advances — UK		202

Total observed provisions charged against profit		248

Incurred but not yet observed provisions charged against profit		26

Total provisions charged against profit		274

Provisions at the end of the year		298

Recoveries


	2008
	£m

Advances secured on residential properties — UK		1
Unsecured personal advances — UK		13

Total amount recovered		14

Retail Banking non-performing loans and advances⁽¹⁾


	2008
	£m

Non-performing loans and advances that are impaired		186
Non-performing loans and advances that are not impaired		344

Total non-performing loans and advances⁽²⁾		530


Non-performing loans and advances as a percentage of loans and advances to customers⁽³⁾		1.29	%
Provision as a percentage of total non-performing loans and advances		56.2	%


(1)		Loans and advances are classified as non-performing typically when the counterparty fails to make payments when contractually due for three months or longer.

(2)		All non-performing loans are UK.

(3)		Loans and advances to customers include residential mortgages, unsecured personal loans and current account overdrafts.

Accounting estimates have been refined reflecting the state of the UK economy as described in Note 8. As a result, comparatives for 2007 are not available in the above format. Movement in provisions for 2007 can be found in Note 16.

In 2008, non-performing loans and advances as a percentage of loans and advances to customers was 1.29%. This reflects the impact of the deteriorating market environment on the performance of the unsecured personal loan and residential mortgage portfolio and a refinement in accounting estimates.

Interest income recognised on Retail Banking loans that are more than three months in arrears amounted to £14m (2007: £25m).

Financial Statements

Notes to the Financial Statements continued

Market risk in Retail Banking

Market risk is not taken within Retail Banking. Market risks arising in the Retail Banking division are transferred from the originating business to the Asset and Liability Management (‘ALM’) operation within Treasury and Group Items, where they can be managed in conjunction with exposures arising from the funding, liquidity or capital management activities. Funds received with respect to deposits taken are lent on to Treasury and Group Items on matching terms as regards interest rate repricing and maturity. Similarly, loans are funded through matching borrowings from Treasury and Group Items.

Risk Management in Corporate Banking

Credit risk in Corporate Banking

Credit risk is the risk that counterparties will not meet their financial obligations resulting in Corporate Banking losing the monies lent, including any interest accrued, or having to close out transactions prematurely, which may incur losses after realising collateral held. Credit risk arises by Corporate Banking making loans, investing in debt securities or other financial instruments or entering into financing transactions or derivative contracts.

Managing credit risk

The Board has approved a set of risk appetite limits to cover different types of risk, including credit risk, arising in Corporate Banking. Subsequent to its acquisition, the management of Corporate Banking credit risk has been aligned with the processes and procedures used within Abbey National’s Corporate Banking unit. Alliance & Leicester’s credit risk appetite is therefore now measured and controlled by a maximum Economic Capital value, which is defined as the maximum level of unexpected loss that Alliance & Leicester is willing to sustain over a one-year period. Within these limits, credit mandates and policies are approved to cover detailed industry, sector and product limits. All transactions falling within these mandates and policies are accommodated under credit limits approved by the appropriate credit authority. Specific approval is usually required by the Credit Approvals Committee (a specific committee established under the authority of the Chief Executive) for any transaction that falls outside the mandates.

Analysis of credit exposures and credit risk trends are provided each month to the Corporate Banking Risk Oversight Forum, with key issues escalated to the Risk Committee as required. Large Exposures (as defined by the UK Financial Services Authority) are reported quarterly to the Risk Committee and the UK Financial Services Authority.

Credit risk on derivative instruments is calculated using the potential future mark-to-market exposure of the instruments at a 97.5% (95% prior to acquisition) statistical confidence level and adding this value to the current value. The resulting ‘loan equivalent’ or credit risk is then included against credit limits, along with other non-derivative exposures. In addition, there is a policy framework to enable the collateralisation of derivative instruments including swaps. If collateral is deemed necessary to reduce credit risk, any unsecured risk threshold, and the nature of any collateral to be accepted, is determined by management’s credit evaluation of the counterparty.

Corporate Banking has been targeted as an area where we aim to achieve controlled growth, mainly in the area of structured lending to the Real Estate, Education and Health sectors. Focus is being given to the control of credit risks within this expansion with, amongst other things, the development and implementation of robust Credit Policy Mandates and models covering both risk appetite and ratings.

The following tables provide details of provisions, recoveries, arrears and non-performing loans for the Corporate Banking portfolio as at 31 December 2008.

Movements in provisions for impairment losses on loans and advances:


	2008
	£m


Provisions at 1 January 2008		27

Amounts written off
Secured		(7	)
Unsecured		(10	)

Total amounts written off		(17	)

Observed provisions charged against profit
Secured		82
Unsecured		73

Total observed provisions charged against profit		155

Incurred but not yet observed provisions charged against profit		120

Total provisions charged against profit		275

Provisions at the end of the year		285

Financial Statements

Notes to the Financial Statements continued

Recoveries


	2008
	£m

Secured		—
Unsecured		1

Total amount recovered		1

Accounting estimates have been refined reflecting the state of the UK economy as described in Note 8. As a result, comparatives for 2007 and 2006 are not available in the above format. Movement in provisions for 2007 and 2006 can be found in Note 16.

Corporate Banking arrears


	2008		2007
	£m		£m

Total Corporate lending arrears		89		39
Total Corporate lending assets		9,948		8,157
Corporate lending arrears as a % of asset		0.89		0.48

Corporate Banking non-performing loans and advances


	2008		2007
	£m		£m

Non-performing loans and advances that are impaired		343		10
Non-performing loans and advances that are not impaired		—		—

Total non-performing loans and advances		343		10


Non-performing loans and advances as a percentage of loans and advances to customers		3.45		0.12
Provision as a percentage of total non-performing loans and advances		83		270

Market risk in Corporate Banking

Market risk is not taken within Corporate Banking. Market risks arising in the Corporate Banking division are transferred from the originating business to ALM within Treasury and Group Items, where they can be managed in conjunction with exposures arising from the funding, liquidity or capital management activities of ALM. Funds received with respect to deposits taken are lent on to Treasury and Group Items on matching terms as regards interest rate repricing and maturity. Similarly, loans are funded though matching borrowings from Treasury and Group Items.

Risk Management in Treasury

Credit risk in Treasury

Credit risk is the risk that counterparties will not meet their financial obligations resulting in Treasury losing the monies lent, including any interest accrued, or having to close out transactions prematurely, which may incur losses after realising collateral held. Credit risk arises by Treasury making loans, investing in debt securities or other financial instruments or entering into financing transactions or derivative contracts.

Managing credit risk in Treasury

The Alliance & Leicester Group Risk department has been integrated into the Abbey National plc Wholesale Credit Risk department where responsibility for the credit control of assets held by Treasury, as well as for all country, sovereign and financial institution exposures is managed. Risks are managed in accordance with limits, asset quality plans and criteria set out in the relevant policy statement.

Decisions are based on independent credit risk analysis, supplemented by the output of internal ratings tools and external rating agency analysis. An internal ratings model is used to grade financial institution exposures and to generate probability of default and expected loss. The Group uses external ratings supplemented by internal analysis to assess the risks associated with structured credit and securitisation investments. Individual exposures are reviewed at least annually. Asset quality monitoring is reported by regular executive and management reporting, and exception reporting against a range of asset quality triggers, which include expected loss analysis.

The Treasury investment portfolio is monitored for potential impairment as soon as an event occurs to suggest a counterparty’s creditworthiness merits attention. Once specific events give rise to a reasonable expectation that future anticipated cash flows may not be received, the asset originating these doubtful cash flows will be deemed to be impaired.

For structured investment vehicles (SIVs), Collateralised Debt Obligations (CDOs) and Collateralised Loan Obligations (CLOs) impairment is deemed to have occurred when one or more of the following events have occurred:

•		the vehicle has realised losses arising from sale of assets that make it probable that the note-holders will not receive principal and base coupon in full;

•		the vehicle has been restructured and the terms of the restructuring make it probable that the note-holders will not receive principal and base coupon in full;

Financial Statements

Notes to the Financial Statements continued

•		the Group expects to participate in a restructuring or refinancing of the vehicle which has been proposed by the vehicle’s manager or sponsor and the likely terms make it probable that the note-holders will not receive principal and base coupon in full;

•		the vehicle has entered into enforcement; or

•		the funding and market conditions are such that the vehicle is expected either to sell assets or restructure such that it is probable that the note-holders will not receive principal and base coupon in full.

Collateralised debt obligations (CDOs) containing sub-prime US mortgage assets and other structured credit assets are deemed impaired if estimated losses on the underlying assets exceed the level of credit support. Asset backed securities are assessed on an individual basis.

Credit risk mitigation

(i) Netting arrangements

The Group restricts its credit risk by entering into transactions under industry standard agreements which facilitate netting of transactions in the jurisdictions where netting agreements are recognised and have legal force. The netting arrangements do not generally result in an offset of balance sheet assets and liabilities for accounting purposes, as transactions are usually settled on a gross basis. However, there is scope for the credit risk associated with favourable contracts to be reduced by netting arrangements embodied in the agreements to the extent that if an event of default occurs, all amounts with the counterparty under the specific agreement can be terminated and settled on a net basis. Derivatives, repurchase and reverse repurchase transactions, stock borrowing/lending transactions and securities financing transactions are governed by industry standard agreements that facilitate netting.

(ii) Collateralisation

The Group also mitigates its credit risk to counterparties with which it primarily transacts financial instruments through collateralisation, using industry standard collateral agreements. Under these agreements, net exposures with counterparties are collateralised with cash, securities or equities. Exposures and collateral are revalued daily and collateral is adjusted accordingly to reflect deficits/surpluses. Collateral taken must comply with collateral parameters policy. This policy is designed to control the quality and concentration risk of collateral taken such that collateral held can be liquidated when a counterparty defaults. Cash collateral in respect of derivatives held at the year-end was £566m.

Treasury investments

Investment securities

Fair value &

Fair value

impairment

through

Balance sheet

reserves

income

value as at

Nominal

(pre-tax)

statements

Other

31.12.08

£m

Floating rate notes (FRN)

10,132

(182

)

(55

)

9,933

Asset backed securities (ABS)

4,001

(186

)

(25

)

(74

)

3,716

Collateralised debt obligations (CDO)

366

(15

)

(72

)

(115

)

164

Collateralised loan obligations (CLO)

352

(25

)

321

Principal protected notes (PPN)

)

Other

138

—

)

145

Total

15,031

(414

)

(165

)

(139

)

14,313

Investment securities include loan & receivable securities and financial assets designated at fair value.

Other includes discounts and premiums, accrued interest and amortisation of mark-to-market losses. The fair value of loan & receivable securities was £13.2bn compared to a balance sheet value of £14.3bn at 31 December 2008.

Analysis of provisions on investment securities


	2008
	£m

Provisions as at 1 January		122
Charge for the year: Increase in impairment		414
Amounts written off in period		(411	)

Provisions as at 31 December		125

Provisions on investment securities are all individual provisions. The total Treasury impairment loss charge for 2008 was £426m (Note 8). This includes a £12m charge for loans and advances to banks.

Financial Statements

Notes to the Financial Statements continued

Investment securities by credit rating of the issuer or counterparty⁽¹⁾

FRN

Other

Total

£m

AAA

—

3,809

2,333

176

2,509

6,596

170

6,766

BBB

712

789

Below BBB

292

148

440

Total

9,933

4,380

14,313



(1)		Internal ratings are applied to all exposures.

Floating Rate Notes

Fair value

Fair value &

Holding

through

impairment

Balance sheet

value as

reserves

through income

value as at

% of

Nominal

(pre-tax)

statements

Other

31.12.08

nominal

Country

£m

value

942

(21

)

(17

)

913

Italy

1,101

(10

)

—

1,099

100

Spain

2,338

(43

)

—

2,308

Rest of Europe

3,393

(62

)

(38

)

3,305

994

(36

)

—

(10

)

948

Rest of World

1,364

(10

)

—

1,360

100

Total

10,132

100

(182

)

(55

)

9,933

Fair value

Fair value &

Holding

through

impairment

Balance sheet

value as

reserves

through income

value as at

% of

Nominal

(pre-tax)

statements

Other

31.12.08

nominal

Credit rating

£m

value

2,350

(24

)

—

2,333

6,703

(127

)

—

6,596

BBB

735

(27

)

—

712

Below BBB

344

)

(55

)

292

Total

10,132

100

(182

)

(55

)

9,933

Asset-Backed Securities


					Fair value			Fair value &								Holding
					through			impairment						Balance sheet		value as
					reserves			through income						value as at		% of
	Nominal		Nominal		(pre-tax)			statements			Other			31.12.08		nominal
Country/Asset type	£m		%		£m			£m			£m			£m		value

UK
ABS		31		1		—			—			—			31		100
MBS		1,302		32		(29	)		(11	)		(7	)		1,255		96

US
ABS		962		24		(56	)		—			(25	)		881		92
MBS		393		10		(61	)		(11	)		(44	)		277		70

Rest of Europe
ABS		98		3		(3	)		—			1			96		98
MBS		929		23		(34	)		(3	)		3			895		96

Rest of World
ABS		36		1		—			—			—			36		100
MBS		250		6		(3	)		—			(2	)		245		98


Total		4,001		100		(186	)		(25	)		(74	)		3,716		93

Financial Statements

Notes to the Financial Statements continued


					Fair value			Fair value &								Holding
					through			impairment						Balance sheet		value as
					reserves			through income						value as at		% of
Credit Rating	Nominal		Nominal		(pre-tax)			statements			Other			31.12.08		nominal
/Asset type	£m		%		£m			£m			£m			£m		value

AAA
ABS		1,052		26		(56	)		—			(5	)		991		94
MBS		2,613		66		(102	)		(13	)		(28	)		2,470		95

AA
ABS		18		—		—			—			(3	)		15		83
MBS		105		3		(11	)		—			(9	)		85		81

A
ABS		83		2		(3	)		—			(13	)		67		81
MBS		38		1		(8	)		—			(1	)		29		76

BBB
ABS		17		—		—			—			(5	)		12		71
MBS		33		1		(6	)		—			(5	)		22		67

Below BBB
MBS		42		1		—			(12	)		(5	)		25		60

Total		4,001		100		(186	)		(25	)		(74	)		3,716		93

Collateralised Debt Obligations


								Fair value
								&						Balance
					Fair value			impairment						sheet		Original				Holding
					through			through						value as		exposure		Original		value as
					reserves			income						at		to sub-		credit		% of
	Nominal		Nominal		(pre-tax)			statements			Other			31.12.08		prime		enhancement		nominal
Country	£m		%		£m			£m			£m			£m		%		%		value

UK		24		7		(6	)		—			(1	)		17		—		27		71
Rest of Europe		3		1		—			—			—			3		—		—		100
US		339		92		(9	)		(72	)		(114	)		144		21		28		42

Total		366		100		(15	)		(72	)		(115	)		164		19		27		45


								Fair value
								&						Balance
					Fair value			impairment						sheet		Original				Holding
					through			through						value as		exposure		Original		value
					reserves			income						at		to sub-		credit		as % of
	Nominal		Nominal		(pre-tax)			statements			Other			31.12.08		prime		enhancement		nominal
Credit rating	£m		%		£m			£m			£m			£m		%		%		value


AAA		147		40		(12	)		—			(44	)		91		1		34		62
AA		38		10		(1	)		—			(19	)		18		10		35		47
A		11		3		—			—			(7	)		4		13		23		36
BBB		18		5		(2	)		(1	)		(8	)		7		14		8		39
Below BBB		152		42		—			(71	)		(37	)		44		41		21		29

Total		366		100		(15	)		(72	)		(115	)		164		19		27		45

Collateralised Loan Obligations


								Fair value &
					Fair value			impairment								Holding
					through			through						Balance sheet		value
					reserves			income						value as at		as % of
	Nominal		Nominal		(pre-tax)			statements			Other			31.12.08		nominal
Country	£m		%		£m			£m			£m			£m		value

UK		115		33		(5	)		(1	)		(1	)		108		94
Rest of Europe		47		13		(7	)		—			1			41		87
US		190		54		(13	)		—			(5	)		172		91

Total		352		100		(25	)		(1	)		(5	)		321		91

Financial Statements

Notes to the Financial Statements continued


					Fair value			Fair value &								Holding
					through			impairment						Balance sheet		value as %
					reserves			through income						value as at		of
	Nominal		Nominal		(pre-tax)			statements			Other			31.12.08		nominal
Credit rating	£m		%		£m			£m			£m			£m		value

AAA		276		78		(12	)		(1	)		(6	)		257		93
AA		42		12		(7	)		—			1			36		86
A		30		9		(4	)		—			—			26		87
BBB		4		1		(2	)		—			—			2		50
Below BBB		—		—		—			—			—			—		—

Total		352		100		(25	)		(1	)		(5	)		321		91

Other

Other investments total £145m. The majority of these are Corporate lending transactions were completed by the Corporate Bank.

Secured Loan to Conduit
As at 31 December 2008:


						Original		Original
		Nominal				credit		sub-prime		Original vintage
		value		Impairment		enhancement		exposure		Pre-2005		2005		2006		2007
Asset Type	Credit rating	£m		£m		%		%		%		%		%		%

ABS
US RMBS	AAA		46		—		32		—		39		61		—		—
(ALT-A)	AA		5		—		18		—		—		—		—		—

Total ABS			51		—		30		—		35		55		—		—


CLO
	AAA		442		—		24		—		99		—		—		1
	AA		33		—		29		—		82		18		—		—
	A		30		—		26		—		100		—		—		—

Total CLO			505		—		24		—		98		1		—		1


CDO
ABS CDO	AAA		19		—		24		36		100		—		—		—
	AA		26		—		28		44		100		—		—		—
	BBB		28		4		26		45		100		—		—		—
	Below BBB		45		17		30		65		100		—		—		—

			118		21		28		51		100		—		—		—

Synthetic CDO
	AAA		27		—		19		—		—		100		—		—
	A		76		6		10		—		32		68		—		—
	BBB		17		14		10		—		—		100		—		—
	Below BBB		34		31		5		—		—		100		—		—

			154		51		10		—		16		84		—		—

Other
	AAA		73		—		45		—		45		—		55		—
	AA		17		—		61		—		—		41		59		—
	A		11		—		49		—		—		100		—		—

			101		—		48		—		32		18		50		—

Total CDO			373		72		26		16		47		40		13		—

Total Conduit assets			929		72						74		19		6		1

The Group’s Conduit facility is currently funded by the Group via secured loans. The Group assesses impairment based on the performance of the underlying assets within the Conduit. The Conduit is not consolidated into the Group accounts on the basis that the Special Purpose Vehicles (SPVs) within the Conduit are not controlled by the Group.

Market risk

Market risk is the potential for loss of income or decrease in the value of net assets caused by movements in the levels and prices of financial instruments including interest rate and foreign currency risks. The Group’s exposure to market risk is governed by a policy approved by the Asset and Liability Management Committee (ALCO) and ratified by the Risk Committee. The policy sets out the nature of risk which may be taken, and applicable maximum risk limits. The Group risk limits are allocated by ALCO to all business units.

Risk division monitors compliance with market risk limits and reports excesses to ALCO or Risk Committee.

Financial Statements

Notes to the Financial Statements continued

Interest rate risk

Interest rate re-pricing risk mainly arises from mismatches between the re-pricing dates of the assets and liabilities on the Group’s balance sheet, changes in the value of non-linear interest rate positions such as interest rate caps, and from the investment of the Group’s reserves and non-interest and low interest rate liabilities. The Group has established a transfer pricing system which passes interest rate re-pricing risks that arise in the various Group businesses to Treasury. Treasury manages the Group’s overall interest rate risk within policy limits. In addition, strategic hedges are agreed by the ALCO for the investment of the Group’s reserves and non-interest and low interest rate liabilities. These hedges are transacted by Treasury.

Interest rate risk limits are expressed as the maximum principal amount which is re-priced during a given time period. In the case of Treasury, interest rate risk is measured and limited according to the market value impact of a one basis point shift in particular points on the yield curve. In addition, Value at Risk (VaR) is used to measure the Group’s total exposure to interest rate risks. The VaR measurement methodology calculates the potential loss, in market value terms, from existing risk positions as a result of movement in market interest rates. A variance-covariance VaR model is used based on historical volatility and correlation data and measures VaR to 95% confidence over a one month holding period. A separate model is used to calculate the VaR on positions, such as interest rate options, whose market value varies with changes in interest rates in a non-linear way.

Although it is a useful tool in measuring risk, VaR does contain some limitations:

•		It does not accurately measure extreme events;

•		The use of a 95% confidence level does not by definition include losses beyond this level of confidence;

•		It relies on the historical volatility and correlation data being similar to the volatility and correlation positions going forward.

The VaR of the Group’s non-trading book exposures are shown below:


	Group
	2008		2007
	£m		£m

Value at Risk		21.6		5.4

The above analysis excludes strategic hedges of Group reserves, non-interest and low interest rate liabilities. Interest rate exposures arising from basis risk, prepayment risk and pipeline risk are excluded from the above measure. These risks are measured using separate techniques and are regularly reported to the ALCO.

The Group’s trading activities were conducted through the Group’s Treasury division. Group Treasury’s control of, and approach to, market risk, with respect to its trading book activities, is defined by market risk tolerance levels documented in a policy approved by the Group Risk Committee (GRC). Market Risk in the trading book is measured and controlled through stop loss limits and interest rate and credit spread sensitivity limits. During 2008, Treasury assets which gave rise to credit spread sensitivity in the trading books were reclassified for accounting purposes as ‘Loans & Receivables’. Changes in fair value due to changes in credit spreads therefore ceased to impact profit or loss.


	Group
			2008				2007
	Sensitivity to a		Sensitivity to a 1bp		Sensitivity to a 1%		Sensitivity to a 1bp
	1% change in		change in credit		change in interest		change in credit
	interest rates		spread		rates		spread
	£m		£m		£m		£m

Highest		1.1		0.2		1.1		0.3
Lowest		0.4		0.1		0.5		0.2
Average		0.6		0.1		0.8		0.3
Exposure at 31 December		0.8		0.1		0.9		0.2

Foreign exchange risk

The Group’s policy is to have no material open foreign currency positions. The Group offers foreign exchange services to customers through both Treasury and Corporate Bank operations. Detailed limits and controls are established within those businesses to control the exposure. Corporate Bank clears its positions with Treasury in accordance with the policy of transferring market risk positions to Treasury wherever possible. The foreign exchange risks arising from Treasury’s wholesale funding and Treasury asset portfolio are hedged within Treasury’s limits.

Equity risk

The Group’s policy is to have no material exposure to equity price risk. Retail Banking sells third party stock market bonds. The equity and interest rate risks from these bonds are borne entirely by the third party. Alliance & Leicester International Limited sells stock market bonds to customers. Positions may arise in the management of such bonds due to mismatches between the hedging contracts and the underlying customer liabilities. Procedures are established to minimise these positions as tightly as is operationally practicable and to report open positions to ALCO on a monthly basis.

Inflation risk

The Group’s policy is to have no material exposure to inflation risk. This risk arises due to the exposure to inflation linked bonds and loans in Corporate Banking. It is the Group’s policy to fully hedge inflation risk, using inflation swaps or other effective hedge instruments.

Financial Statements

Notes to the Financial Statements continued

Derivatives

Derivative financial instruments (‘derivatives’) are contracts or agreements whose value is derived from one or more underlying indices or asset values inherent in the contract or agreement, which require no or little initial net investment and swaps are settled at a future date. They include interest rate, cross-currency swaps and forward rate agreements (see table below). Derivatives are used primarily for balance sheet management purposes.

The principal derivatives used in balance sheet risk management are interest rate swaps, forward rate agreements (FRAs), futures, interest rate options and foreign exchange contracts which are used to hedge the economic exposures arising from mortgage lending, personal and commercial loans, leasing, fixed rate savings products, funding and investment activities and foreign exchange services to customers.

The following table describes the significant activities undertaken, the related risks associated with such activities and the types of derivatives which are typically used in managing such risks. These risks may alternatively be managed using on-balance sheet instruments or natural hedges that exist in the balance sheet.


Activity	Risk	Type of hedge

Management of the return on variable rate assets financed by shareholders’ funds and net non-interest-bearing liabilities.	Reduced profitability due to falls in interest rates.	Receive fixed interest rate swaps.

Equity linked investment products.	Sensitivity to changes in equity indices and interest rates.	Equity linked futures and options.

Management of repricing profile of wholesale funding.	Reduced profitability due to adverse movement in wholesale interest rates when large volumes of wholesale funding are repriced.	Forward rate agreements.

Fixed rate lending and investments.	Sensitivity to increases in interest rates.	Pay fixed interest rate swaps.

Fixed rate retail and wholesale funding.	Sensitivity to falls in interest rates.	Receive fixed interest rate swaps.

Management of other net interest income on retail activities.	Sensitivity of income to changes in interest rates.	Interest rate swaps.

Investment and funding in foreign currencies.	Sensitivity to changes in foreign exchange rates.	Foreign exchange contracts, cross currency interest rate swaps.

Customer foreign exchange business.	Sensitivity to changes in foreign exchange rates.	Foreign exchange contracts.

Liquidity risk

Liquidity risk is the potential that the Group has insufficient financial resources to meet its payment obligations as they fall due, or can do so only at excessive cost. Liquidity risks arise throughout the Group’s businesses. Its primary business activity is commercial banking and, as such, it engages in maturity transformation, whereby it raises funds that may be withdrawn at short notice and lends them to customers at longer terms.

Following Banco Santander, S.A.’s acquisition of Alliance & Leicester plc in October 2008, the liquidity risks of Alliance & Leicester plc and Abbey National plc have been managed on a combined basis. For further information, please refer to the liquidity risk discussion in the Risk Management Report of Abbey National plc’s Consolidate Financial Statements. In 2008, Santander’s commitments to the UK Government and regulators to improve the Tier 1 ratio of the combined UK businesses were met using the additional £1bn of capital announced at the time of the acquisition of Alliance & Leicester plc, which was transferred into Abbey from Santander. This capital was in turn transferred to Alliance & Leicester plc in late December as planned.

The majority of funding is raised from retail deposits with the balance raised in wholesale markets. Alliance & Leicester plc now sources its wholesale funding from Abbey National plc.

Maturities of financial liabilities

The table below analyses the maturities of the undiscounted cash flows relating to financial liabilities of the Group based on the remaining period to the contractual maturity date at the balance sheet date. Deposits by customers are largely made up of retail deposits. In particular the ‘Demand’ grouping includes current accounts and other variable rate savings products. The ‘Up to 3 months’ grouping largely constitutes wholesale funding of wholesale assets of a similar maturity. This table is not intended to show the liquidity of the Group.


	Group
			Up to 3		3-12		1-5		Over 5
	Demand		months		months		years		years		Total
At 31 December 2008	£m		£m		£m		£m		£m		£m

Deposits by banks		1,279		6,908		544		3,006		—		11,737
Deposits by customers		28,436		8,050		3,179		114		91		39,870
Derivative financial instruments		—		405		436		400		198		1,439
Financial liabilities designated at fair value		—		321		336		26		70		753
Debt securities in issue		—		2,249		4,030		6,919		12,600		25,798
Subordinated liabilities		—		18		66		359		3,009		3,452

Total financial liabilities		29,715		17,951		8,591		10,824		15,968		83,049


	ABBEY NATIONAL PLC
Dated: 8 July 2009	By	/s/ Scott Linsley
		(Authorised Signatory)


	Group
			Up to 3		3-12		1-5		Over 5
	Demand		months		months		years		years		Total
At 31 December 2007	£m		£m		£m		£m		£m		£m

Deposits by banks		639		7,804		4,804		6,269		96		19,612
Deposits by customers		24,600		5,616		1,519		286		185		32,206
Derivative financial instruments		—		51		225		196		55		527
Financial liabilities designated at fair value		—		2,376		1,788		39		77		4,280
Debt securities in issue		—		4,560		4,145		10,490		14,365		33,560
Subordinated liabilities		—		12		102		128		932		1,174

Total financial liabilities		25,239		20,419		12,583		17,408		15,710		91,359