Section E: Banking operations
E: Banking operations
The Group undertakes banking operations almost wholly through its subsidiary, Egg Banking plc. Financial information in respect of Egg Banking plc, together with amounts in respect of its former parent Egg plc and its associate IfOnline, have been included in this note. Note I6 shows details of the purchase of the minority interests in Egg plc in 2006. Note I8 includes details of the agreement in January 2007 to sell Egg Banking plc and its subsidiaries.
The Group has presented the income statement and balance sheet for banking operations in a format that demonstrates the characteristics and principal operations specific to a bank. The format is different from that of the Group consolidated income statement and balance sheet; however, total (loss) profit for the year and net assets remain the same. To understand how the amounts presented from banking operations are consolidated in the Group financial statements, refer to the primary segmental information for the income statement in note F1 and the primary segmental information for the balance sheet in note B5.
E1: Income statement for banking operations
The (loss) profit included in the Group consolidated income statement in respect of banking operations is as follows:| Note | 2006 £m |
2005 £m |
|
|---|---|---|---|
| Interest income | 783 | 893 | |
| Interest expense | (453) | (581) | |
| Net interest income | 330 | 312 | |
| Fee and commission income | 153 | 223 | |
| Fee and commission expense | (23) | (23) | |
| Other operating income | 8 | 16 | |
| Operating income | 468 | 528 | |
| General administrative expenses | (192) | (216) | |
| Impairment losses on loans and cash advances to customers | E5 | (384) | (241) |
| Other operating expenses | (37) | (27) | |
| Operating (loss) profit based on longer-term investment returns before restructuring costs | (145) | 44 | |
| Restructuring costs (part of £50m for Group) | (12) | – | |
| Short-term fluctuations in investment returns | 7 | – | |
| (Loss) profit before tax | (150) | 44 | |
| Tax attributable to shareholders’ profits | 45 | 1 | |
| (Loss) profit from continuing operations after tax | (105) | 45 | |
| Discontinued operations (net of tax) | F6 | – | 3 |
| (Loss) profit for the year | (105) | 48 | |
Of the (loss) profit for the year in 2006 and 2005, a loss of £2 million and a profit of £9 million, respectively, are attributable to minority interests in Egg.
Discontinued operations above relate to Egg France and Funds Direct and have been treated as discontinued operations in the Group’s consolidated income statement. For further information on discontinued operations, see note F6.
E2: Balance sheet for banking operations
Assets, liabilities and shareholders’ funds included in the Group consolidated balance sheet in respect of banking operations are as follows:
| 2006 £m |
2005 £m |
|
|---|---|---|
| Assets | ||
| Cash and balances with central banks | 6 | 7 |
| Loans and advances to banks | 903 | 718 |
| Securities purchased under agreement to resell | – | 200 |
| Loans and advances to customers | 6,193 | 7,430 |
| Investment securities | 1,976 | 2,117 |
| Derivative financial instruments | 78 | 50 |
| Other assets | 342 | 230 |
| Total assets | 9,498 | 10,752 |
| Liabilities | ||
| Deposits by banks | 2,220 | 2,452 |
| Customer accounts | 5,554 | 5,830 |
| Debt securities issued | 599 | 1,404 |
| Derivative financial instruments | 154 | 77 |
| Other liabilities | 228 | 160 |
| Subordinated liabilities | 451 | 451 |
| Total liabilities | 9,206 | 10,374 |
| Equity | ||
| Shareholders’ equity | 292 | 303 |
| Minority interests | – | 75 |
| Total equity | 292 | 378 |
| Total equity and liabilities | 9,498 | 10,752 |
E3: Risk management overview
Egg offers banking and credit card products and intermediated services. Through its normal operations, Egg is exposed to a number of risks, the most significant of which are credit, operational, liquidity, market and currency risk. The overall responsibility for risk management and the risk appetite of Egg is set by the Egg Board and responsibility for managing these risks resides with the Egg Executive Committee. The exposure to specific risks is monitored by the Executive Committee through separate committees: the retail credit committee is responsible for retail credit risk, the wholesale credit committee is responsible for wholesale credit risk, the operational risk committee is responsible for operational risk and the asset and liability committee (ALCO) is responsible for liquidity, market and currency risk.
Egg uses financial instruments including derivatives for the purpose of supporting the strategic and operational business activities and to reduce and eliminate the risk of loss arising from changes in interest rates and foreign exchange rates.
Surplus retail and wholesale liabilities are invested in debt securities, including certificates of deposits, government gilts and other high investment grade assets.
E4: Maturities of assets and liabilities and liquidity risk
Liquidity risk is defined for Egg as not having sufficient financial resources available to meet its obligations as they fall due or if such resources can only be secured at excessive cost. Egg uses various methods including predictions of daily cash positions to monitor and manage liquidity risk. Maturity mismatches between lending and funding are managed within internal risk policy limits. It ensures that it holds sufficient assets, which are immediately realisable into cash without significant exposure to market risk or costs, to cover a realistic estimate of retail funds that could be withdrawn. While a significant proportion of retail savings balances are on instant access terms, in practice the majority of such funds represent a relatively stable and consistent funding base for Egg.
The matching and controlled mismatching of the maturities and interest rates of assets and liabilities is fundamental to the management of a bank. It is unusual for banks ever to be completely matched since business transacted is often of uncertain terms and of different types.
The following table analyses the assets and liabilities of Egg into relevant maturity groupings based on the remaining period at the balance sheet date to the contractual maturity date.
| At 31 December 2006 | Up to 1 month £m |
From 1 month to 3 months £m |
From 3 months to 1 year £m |
From 1 year to 5 years £m |
5 years and over £m |
Total £m |
|---|---|---|---|---|---|---|
| Assets | ||||||
| Cash and balances with central banks | 6 | – | – | – | – | 6 |
| Loans and advances to banks | 876 | – | – | 2 | 25 | 903 |
| Loans and advances to customers | 1 | 2,725 | 42 | 1,338 | 2,087 | 6,193 |
| Investment securities | 466 | 696 | 176 | 266 | 372 | 1,976 |
| Derivative financial instruments | 61 | – | 17 | – | – | 78 |
| Other assets | 68 | 159 | 41 | 74 | – | 342 |
| Total assets | 1,478 | 3,580 | 276 | 1,680 | 2,484 | 9,498 |
| Liabilities | ||||||
| Deposits by banks | 18 | – | 516 | 1,686 | – | 2,220 |
| Customer accounts | 5,427 | 3 | 68 | 56 | – | 5,554 |
| Debt securities issued | – | – | 553 | 46 | – | 599 |
| Derivative financial instruments | 56 | – | – | 98 | – | 154 |
| Other liabilities | 117 | 68 | 43 | – | – | 228 |
| Subordinated liabilities | – | – | – | – | 451 | 451 |
| Total liabilities | 5,618 | 71 | 1,180 | 1,886 | 451 | 9,206 |
| Net liquidity gap | (4,140) | 3,509 | (904) | (206) | 2,033 | 292 |
| At 31 December 2005 | Up to 1 month £m |
From 1 month to 3 months £m |
From 3 months to 1 year £m |
From 1 year to 5 years £m |
5 years and over £m |
Total £m |
|---|---|---|---|---|---|---|
| Assets | ||||||
| Cash and balances with central banks | 7 | – | – | – | – | 7 |
| Loans and advances to banks | 636 | 50 | – | 5 | 27 | 748 |
| Securities purchased under agreement to resell | 200 | – | – | – | – | 200 |
| Loans and advances to customers | – | 3,343 | 40 | 1,421 | 2,626 | 7,430 |
| Investment securities | 157 | 439 | 633 | 352 | 536 | 2,117 |
| Derivative financial instruments | – | – | 50 | – | – | 50 |
| Other assets | 3 | 4 | 91 | 125 | 7 | 230 |
| Total assets | 1,003 | 3,836 | 814 | 1,903 | 3,196 | 10,752 |
| Liabilities | ||||||
| Deposits by banks | 157 | – | – | 2,295 | – | 2,452 |
| Customer accounts | 5,667 | 13 | 110 | 40 | – | 5,830 |
| Debt securities issued | – | 3 | 798 | 603 | – | 1,404 |
| Derivative financial instruments | 77 | – | – | – | – | 77 |
| Other liabilities | 8 | 34 | 118 | – | – | 160 |
| Subordinated liabilities | – | – | – | – | 451 | 451 |
| Total liabilities | 5,909 | 50 | 1,026 | 2,938 | 451 | 10,374 |
| Net liquidity gap | (4,906) | 3,786 | (212) | (1,035) | 2,745 | 378 |
E5: Losses on loans and advances
The following table details the movements in the allowance for losses on loans and advances to customers held by Egg in 2006 and 2005. The aggregate loss on loans at the end of the year and the charge during the year have been included in the consolidated financial statements.
| 2006 £m |
2005 £m |
|
|---|---|---|
| Balance at the beginning of the year | 335 | 250 |
| Amounts written off | (201) | (161) |
| New and additional provisions | 384 | 241 |
| Transition adjustment to reflect adoption of IAS 39 at 1 January 2005 | – | 5 |
| Balance at the end of the year | 518 | 335 |
E6: Market risk
Interest rate risk
The primary market risk to which Egg is exposed is interest rate risk. Interest rate risk arises in Egg as a result of fixed rate, variable rate and non-interest bearing assets and liabilities. Exposure to interest rate movements arises when there is a mismatch between interest rate sensitive assets and liabilities.
The composition of interest rate risk is closely monitored and managed on a day-to-day basis by the treasury function where professional expertise and systems exist to control it. This is primarily done via asset and liability models that look at the sensitivity of earnings to movements in interest rates to measure overall exposure which may then be hedged in accordance with the policy limits set by the ALCO.
For the purpose of reducing interest rate risk, Egg uses a number of derivative instruments such as interest rate swaps and forward rate agreements (see note G3).
Financial assets and liabilities not held at fair value through profit and loss and the weighted average effective interest rate for those balances are provided below:
| 2006 £m |
2005 £m |
|
|||||
|---|---|---|---|---|---|---|---|
| Assets | |||||||
| Debt securities available-for-sale* | 1,935 | 5.3% | 2,046 | 4.6% | |||
| Loans and receivables | 7,096 | 9.0% | 8,148 | 7.5% | |||
| 9,031 | 10,194 |
| Liabilities | |||||||
|---|---|---|---|---|---|---|---|
| Banking customer accounts | 5,554 | 4.9% | 5,830 | 4.3% | |||
| Core structural borrowings of shareholder-financed operations | 451 | 6.2% | 451 | 8.5% | |||
| Operational borrowings attributable to shareholder-financed operations | 2,819 | 5.4% | 3,856 | 4.5% | |||
| 8,824 | 10,137 |
*Egg has also classified £41 million (2005: £71 million) of debt securities as fair value through profit and loss.
See note G2 for further information on interest rate risk.
Currency risk
The risks arising from assets and liabilities denominated in foreign currencies are managed by a separate treasury function within Egg and within agreed limits set by the ALCO. During the year, cash flows generated by the foreign currency assets and liabilities are hedged by using derivative contracts to manage exposure to exchange rate fluctuations.
At 31 December 2006, Egg held £357 million of assets and £1,751 million of liabilities with foreign currency exposure (2005: £539 million and £2,640 million respectively).
E7: Credit risk
Egg takes on exposure to credit risk, which is the risk that a counterparty will be unable to pay amounts in full when due. To limit this risk, Egg places limits on the amount of risk accepted in relation to a particular borrower, groups of borrowers, and to particular geographical segments. The acceptable risk levels are monitored regularly and reviewed where appropriate.
The following table identifies the geographical concentrations of credit risk, stated in terms of total assets and off-balance sheet items, held by Egg at 31 December 2006 and 2005:
| 2006 £m |
2005 £m |
|
|---|---|---|
| UK | 18,132 | 18,840 |
| Rest of Europe | 244 | 399 |
| Other | 243 | 380 |
| Total* | 18,619 | 19,619 |
*This includes £9,475 million (2005: £9,104 million) of off-balance sheet items, which mainly relate to unutilised credit limits on credit cards.
The following is a breakdown of the credit risk borne by Egg for financial assets and off-balance sheet items at 31 December 2006 and 2005:
| 2006 £m |
2005 £m |
|
|---|---|---|
| Loans and advances to banks | 903 | 718 |
| Securities purchased under agreement to resell | – | 200 |
| Investment securities | 1,970 | 2,117 |
| Loans and advances to customers | 6,711 | 7,765 |
| Allowances for impairment losses on loans and advances to customers | (518) | (335) |
| Fair value of derivative assets | 78 | 50 |
| Off-balance sheet items (including unutilised credit limits on credit cards) | 9,475 | 9,104 |
| Total credit risk net of allowances and provisions | 18,619 | 19,619 |
At 31 December 2006, Egg had certain credit-related commitments in the form of unused credit limits on credit cards of £9,458 million (2005: £9,061 million) and pre-approved but unused borrowing limits on mortgages and personal loans of £8 million and £9 million respectively (2005: £14 million and £29 million respectively) which are included in off-balance sheet items above. Egg is potentially exposed to a loss totalling these amounts, but it is unlikely that such a loss would arise as these credit facilities were granted only on the basis of the customers having achieved certain credit standards. Additionally, it is unlikely, should all these customers utilise their credit or borrowing limits, that all of them would default on their debt entirely.
Egg holds significant concentrations of credit risk with other financial institutions. At 31 December 2006, this was estimated at £8.7 billion (2005: £10.9 billion) of which £3.9 billion (2005: £5.7 billion) related to derivative financial instruments and £1.8 billion (2005: £2.3 billion) to credit default swaps. Egg also has significant credit exposure in asset-backed security products which totalled approximately £403 million at 31 December 2006 (2005: £496 million). With regard to loans and advances to customers, Egg has significant concentrations of credit risk in respect of its unsecured lending on credit cards, personal loans and mortgage lending secured on property in the UK.
Assets pledged as collateral and securitisation
Egg enters into securities lending arrangements, including repurchase agreements and over-the-counter derivative transactions as part of normal operating activities. Assets are pledged as collateral to support these activities. Collateral in respect of repurchase agreements was £nil and £5.2 million at 31 December 2006 and 2005, respectively. Collateral in respect of over-the-counter derivative transactions was £29.3 million and £30.9 million at 31 December 2006 and 2005, respectively. See note G4 where amounts relating to Egg have been included in the disclosure of these transactions on a Group basis.
For further information on Egg’s securitisation of credit card receivables, see note G4.