BoS half-year news release

Bank of Scotland plc

2020 Half-Year Results

Member of the Lloyds Banking Group

FORWARD LOOKING STATEMENTS

This document contains certain forward looking statements within the meaning of Section 21E of the US Securities Exchange Act of 1934, as amended, and section 27A of the US Securities Act of 1933, as amended, with respect to the business, strategy, plans and/or results of Bank of Scotland plc together with its subsidiaries (the Group) and its current goals and expectations relating to its future financial condition and performance. Statements that are not historical facts, including statements about the Group's or its directors' and/or management's beliefs and expectations, are forward looking statements. Words such as 'believes', 'anticipates', 'estimates', 'expects', 'intends', 'aims', 'potential', 'will', 'would', 'could', 'considered', 'likely', 'estimate' and variations of these words and similar future or conditional expressions are intended to identify forward looking statements but are not the exclusive means of identifying such statements. Examples of such forward looking statements include, but are not limited to: projections or expectations of the Group's future financial position including profit attributable to shareholders, provisions, economic profit, dividends, capital structure, portfolios, net interest margin, capital ratios, liquidity, risk-weighted assets (RWAs), expenditures or any other financial items or ratios; litigation, regulatory and governmental investigations; the Group's future financial performance; the level and extent of future impairments and write-downs; statements of plans, objectives or goals of the Group or its management including in respect of statements about the future business and economic environments in the UK and elsewhere including, but not limited to, future trends in interest rates, foreign exchange rates, credit and equity market levels and demographic developments; statements about competition, regulation, disposals and consolidation or technological developments in the financial services industry; and statements of assumptions underlying such statements. By their nature, forward looking statements involve risk and uncertainty because they relate to events and depend upon circumstances that will or may occur in the future. Factors that could cause actual business, strategy, plans and/or results (including but not limited to the payment of dividends) to differ materially from forward looking statements made by the Group or on its behalf include, but are not limited to: general economic and business conditions in the UK and internationally; market related trends and developments; fluctuations in interest rates, inflation, exchange rates, stock markets and currencies; any impact of the transition from IBORs to alternative reference rates; the ability to access sufficient sources of capital, liquidity and funding when required; changes to the credit ratings of the Group or any of the Group's immediate or ultimate parent entities; the ability to derive cost savings and other benefits including, but without limitation as a result of any acquisitions, disposals and other strategic transactions; the ability to achieve strategic objectives; changing customer behaviour including consumer spending, saving and borrowing habits; changes to borrower or counterparty credit quality; concentration of financial exposure; management and monitoring of conduct risk; instability in the global financial markets, including Eurozone instability, instability as a result of uncertainty surrounding the exit by the UK from the European Union (EU) and as a result of such exit and the potential for other countries to exit the EU or the Eurozone and the impact of any sovereign credit rating downgrade or other sovereign financial issues; political instability including as a result of any UK general election; technological changes and risks to the security of IT and operational infrastructure, systems, data and information resulting from increased threat of cyber and other attacks; natural, pandemic (including but not limited to the coronavirus disease (COVID-19) outbreak) and other disasters, adverse weather and similar contingencies outside the control of the Group or any of the Group's immediate or ultimate parent entities; inadequate or failed internal or external processes or systems; acts of war, other acts of hostility, terrorist acts and responses to those acts, geopolitical, pandemic or other such events; risks relating to climate change; changes in laws, regulations, practices and accounting standards or taxation, including as a result of the exit by the UK from the EU, or a further possible referendum on Scottish independence; changes to regulatory capital or liquidity requirements and similar contingencies outside the control of the Group or any of the Group's immediate or ultimate parent entities; the policies, decisions and actions of governmental or regulatory authorities or courts in the UK, the EU, the US or elsewhere including the implementation and interpretation of key legislation and regulation together with any resulting impact on the future structure of the Group; the ability to attract and retain senior management and other employees and meet its diversity objectives; actions or omissions by the Group's directors, management or employees including industrial action; changes to the Group's post-retirement defined benefit scheme obligations; the extent of any future impairment charges or write-downs caused by, but not limited to, depressed asset valuations, market disruptions and illiquid markets; the value and effectiveness of any credit protection purchased by the Group; the inability to hedge certain risks economically; the adequacy of loss reserves; the actions of competitors, including non-bank financial services, lending companies and digital innovators and disruptive technologies; and exposure to regulatory or competition scrutiny, legal, regulatory or competition proceedings, investigations or complaints. Please refer to the latest Annual Report on Form 20-F filed by Lloyds Banking Group plc with the US Securities and Exchange Commission for a discussion of certain factors and risks together with examples of forward looking statements. Lloyds Banking Group may also make or disclose written and/or oral forward looking statements in reports filed with or furnished to the US Securities and Exchange Commission, Lloyds Banking Group annual reviews, half-year announcements, proxy statements, offering circulars, prospectuses, press releases and other written materials and in oral statements made by the directors, officers or employees of Lloyds Banking Group to third parties, including financial analysts.

Except as required by any applicable law or regulation, the forward looking statements contained in this document are made as of today's date, and the Group expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward looking statements contained in this document to reflect any change in the Group's expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based. The information, statements and opinions contained in this document do not constitute a public offer under any applicable law or an offer to sell any securities or financial instruments or any advice or recommendation with respect to such securities or financial instruments.

CONTENTS

FINANCIAL REVIEW

Principal activities

Bank of Scotland plc (the Bank) and its subsidiaries (together, the Group) provide a wide range of banking and financial services in the UK and overseas.

The Group's revenue is earned through interest and fees on a broad range of financial services products including current and savings accounts, personal loans, credit cards and mortgages within the retail market; loans and other products to commercial, corporate and asset finance customers; and private banking.

Review of results

Income statement

The Group's profit before tax for the six months ended 30 June 2020 was £11 million, down from £962 million in the six months to 30 June 2019 and profit for the period was £180 million, down from £625 million in the first half of 2019 with both being impacted by a significantly increased impairment charge in the period of £1,465 million.

In the challenging external environment total income fell by £170 million, to £2,846 million in the six months to 30 June 2020 compared to £3,016 million in the six months to 30 June 2019, and was impacted by both lower net interest income and lower other income.

Net interest income of £2,634 million in the half-year to 30 June 2020 was down 3 per cent on the half-year to 30 June 2019 reflecting the lower rate environment, actions taken to support customers including free overdrafts and reduced levels of customer demand during the coronavirus pandemic.

Other income of £212 million in the half-year to 30 June 2020 was £97 million lower compared to £309 million in the half-year to 30 June 2019 as a result of lower customer activity and a subdued demand during the coronavirus lockdown period.

Total operating expenses reduced by £471 million to £1,370 million in period compared to £1,841 million in the half-year to 30 June 2019 with a £234 million decrease in regulatory provisions and a £237 million decrease in other operating expenses. Regulatory provisions comprised £98 million for the six months to 30 June 2020 relating to a number of items across existing programmes; the £280 million charge for PPI in the first half of 2019 was not repeated. Other operating expenses were £237 million lower at £1,272 million in the half-year to 30 June 2020 compared to £1,509 million in the half-year to 30 June 2020, driven by continued cost discipline, efficiencies gained through digitalisation and other process improvements and a reduction in costs recharged to the Group by fellow Lloyds Banking Group undertakings.

The impairment charge increased significantly in the first six months of the year to £1,465 million compared to a charge in the six months to 30 June 2019 of £213 million. The additional charge was primarily driven by updates to the Group's economic outlook and provisions taken on existing restructuring cases where recovery strategies have been directly impacted by the coronavirus outbreak.

The Group recognised a tax credit of £169 million in the period, primarily as a result of an uplift in the value of deferred tax assets of £182 million following the announcement by the UK Government that it would maintain the corporation tax rate at 19 per cent, which was substantively enacted on 17 March 2020. 

FINANCIAL REVIEW (continued)

Balance sheet and capital

Total assets at 30 June 2020 were £1,079 million lower at £374,695 million compared to £375,774 million at 31 December 2019 with increases in balances due from fellow Lloyds Banking Group undertakings being more than offset by reductions in the mortgage and credit card books as customer demand reduced during the coronavirus lockdown as well as lower derivative assets.

Total liabilities were £1,236 million lower at £361,448 million at 30 June 2020 compared to £362,684 million at 31 December 2019 with increases in customer deposits which have been driven by growth in current accounts as a result of reduced consumer spending during the coronavirus lockdown period, being more than offset by reductions in amounts owed to fellow Lloyds Banking Group undertakings and lower derivative financial liabilities.

Total equity has increased by £157 million from £13,090 million at 31 December 2019 to £13,247 million at 30 June 2020, with total comprehensive income for the period of £215 million and other movements more than offsetting distributions on other equity instruments of £80 million.

The Bank's common equity tier 1 capital ratio increased to 14.0 per cent1 (31 December 2019: 13.5 per cent) and the tier 1 capital ratio increased to 18.5 per cent1 (31 December 2019: 18.2 per cent), as the impact of the impairment charge on the Bank's profits was largely mitigated through the increase in IFRS 9 transitional relief for capital. The resultant increase in the capital ratios was offset in part by an increase in deferred tax assets deducted from capital and an increase in risk-weighted assets. The total capital ratio reduced to 21.7 per cent1 (31 December 2019: 22.0 per cent), largely reflecting the reduction in the regulatory value of tier 2 capital instruments and the increase in risk-weighted assets, offset in part by the increase in tier 1 capital and an increase in eligible provisions.

Risk-weighted assets increased by £1,310 million, or 2 per cent, to £62,643 million at 30 June 2020 compared to £61,333 million at 31 December 2019, largely reflecting the impact of credit migrations and retail model calibrations, offset in part by the reduction in lending balances.

FINANCIAL REVIEW (continued)

Capital position at 30 June 2020

Following a change in approach the capital position of Bank of Scotland plc is now presented on the basis of the Bank where previously this was presented on the basis of the Group. Prior year comparatives reflect the position of the Bank at 31 December 2019.

The Bank's capital position as at 30 June 2020, incorporating profits for the period that remain subject to formal verification in accordance with the Capital Requirements Regulation and applying CRD IV transitional rules and IFRS 9 transitional arrangements, is set out in the following section.

Capital ratios (Bank)

FINANCIAL REVIEW (continued)

PRINCIPAL RISKS AND UNCERTAINTIES

The significant risks faced by the Group are detailed below. There has been no change to the description of these risks since disclosed in the Group's 2019 Annual Report and Accounts.

The external risks faced by the Group may also impact the success of delivering against the Group's long-term strategic objectives. They include, but are not limited to the coronavirus pandemic, global macro-economic conditions, regulatory developments and the exit of the UK from the European Union.

Through the coronavirus pandemic, the Group has offered help and support to customers with a range of measures, for example with payment holidays and government lending schemes, and continues to actively monitor the outcomes to ensure fair customer treatment. Support has been prioritised for those customers in the most vulnerable situations and those who need help urgently. The Group has also been required to take a series of unprecedented actions to protect colleagues, and has been proactive in limiting the impact with a number of mitigating actions to support colleagues' safety and wellbeing. Transition planning, including continued engagement with colleagues, remains a key focus in ensuring that the Group continues to protect colleagues and services to customers as the situation continues to evolve, and any lessons learned from the pandemic can be embedded into our future working practices.

The Group's key cyber controls have continued to operate effectively during the coronavirus pandemic. During this period, the Group has also enhanced monitoring of key suppliers to protect the services received by Group and its ability to protect and maintain service to customers. The Group continues to work with the regulators constructively with regular engagement to ensure they are aware of the impacts on, and mitigating actions taken by the Group.

The Group's principal risks and uncertainties are reviewed and reported regularly to the Board in alignment with Lloyds Banking Group's Enterprise Risk Management Framework. Climate risk is being proposed to be introduced as a principal risk category, reflecting the focus in this key area, and work already undertaken by the Group.

Change / Execution - The risk that, in delivering the change agenda, the Group fails to ensure compliance with laws and regulation, maintain effective customer service and availability, and/or operate within the Group's approved risk appetite.

Data - The risk that the Group fails to effectively govern, manage, and control data (including data processed by third party suppliers) leading to unethical decisions, poor customer outcomes, loss of value to the Group and mistrust.

Operational Resilience - The risk that the Group fails to design resilience into business operations, underlying infrastructure and controls (people, process, technology) so that it is able to withstand external or internal events which could impact the continuation of operations, and fails to respond in a way which meets customer and stakeholder expectations and needs when the continuity of operations is compromised.

Strategic - The risks which result from strategic plans which do not adequately reflect trends in external factors, ineffective business strategy execution, or failure to respond in a timely manner to external environments or changes in stakeholder behaviours and expectations.

Credit - The risk that parties with whom the Group has contracted, fail to meet their financial obligations (both on and off balance sheet). For example observed, anticipated or unexpected changes in the economic environment could impact profitability due to an increase in delinquency, defaults, write-downs and/or expected credit losses.

PRINCIPAL RISKS AND UNCERTAINTIES (continued)

Regulatory and Legal - The risk of financial penalties, regulatory censure, criminal or civil enforcement action or customer detriment as a result of failure to identify, assess, correctly interpret, comply with, or manage regulatory and/or legal requirements.

Conduct - The risk of customer detriment across the customer lifecycle including: failures in product management, distribution and servicing activities; from other risks materialising, or other activities which could undermine the integrity of the market or distort competition, leading to unfair customer outcomes, regulatory censure, reputational damage or financial loss.

Operational - The risk of loss from inadequate or failed internal processes, people and systems, or from external events.

People - The risk that the Group fails to provide an appropriate colleague and customer-centric culture, supported by robust reward and wellbeing policies and processes; effective leadership to manage colleague resources; effective talent and succession management; and robust control to ensure all colleague-related requirements are met.

Capital - The risk that the Bank has a sub-optimal quantity or quality of capital or that capital is inefficiently deployed across Lloyds Banking Group.

Funding and Liquidity - Funding risk is the risk that the Group does not have sufficiently stable and diverse sources of funding or the funding structure is inefficient. Liquidity risk is the risk that the Group does not have sufficient financial resources to meet commitments when they fall due, or can only secure them at excessive cost.

Governance - The risk that the organisational infrastructure fails to provide robust oversight of decision making and the control mechanisms to ensure strategies and management instructions are implemented effectively.

Market - The risk that the Group's capital or earnings profile is affected by adverse market rates, in particular interest rates and credit spreads in the banking business, and credit spreads in Lloyds Banking Group's defined benefit pension schemes.

Model - The risk of financial loss, regulatory censure, reputational damage or customer detriment, as a result of deficiencies in the development, application and ongoing operation of models and rating systems.

Credit risk

Economic conditions have worsened in the first half of 2020 as the coronavirus crisis impact is felt. Given the challenging external environment and expectations of further economic deterioration, the impairment charge has increased significantly during the first half of 2020, predominantly driven by updates to the Group's economic outlook as well as the impact on restructuring cases and single name charges. As a result, expected credit loss allowances increased. There are a number of headwinds which have the potential to further impact the portfolios, including uncertainty around future UK and global economic conditions with a risk of an increase in unemployment and further business failures as the various UK Government schemes wind down in the third quarter, the risk of a second wave of the virus and further, perhaps deeper, measures worsening the economy and the financial health of customers. Outside of these, the possibility still remains of a no-deal end to the transition period of the UK exit from the European Union. In the context of the uncertainty, the Group's risk appetite and risk management approach continues to help ensure that the Group takes timely and proactive actions.

CONDENSED CONSOLIDATED HALF-YEAR FINANCIAL STATEMENTS

CONSOLIDATED INCOME STATEMENT (UNAUDITED)

CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME (UNAUDITED)

CONSOLIDATED BALANCE SHEET

CONSOLIDATED BALANCE SHEET (continued)

CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (UNAUDITED)

CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (UNAUDITED) (continued)

CONSOLIDATED STATEMENT OF CHANGES IN EQUITY (UNAUDITED) (continued)

CONSOLIDATED CASH FLOW STATEMENT (UNAUDITED)

Cash and cash equivalents comprise cash and balances at central banks (excluding mandatory deposits) and amounts due from banks with a maturity of less than three months.

NOTES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

1. Accounting policies, presentation and estimates

These condensed consolidated half-year financial statements as at and for the period to 30 June 2020 have been prepared in accordance with the Disclosure Guidance and Transparency Rules of the Financial Conduct Authority (FCA) and with International Accounting Standard 34 (IAS 34), Interim Financial Reporting as adopted by the European Union and comprise the results of Bank of Scotland plc (the Bank) together with its subsidiaries (the Group). They do not include all of the information required for full annual financial statements and should be read in conjunction with the Group's consolidated financial statements as at and for the year ended 31 December 2019 which were prepared in accordance with International Financial Reporting Standards (IFRS) as adopted by the European Union. Copies of the 2019 Annual Report and Accounts are available on the Lloyds Banking Group's website and are available upon request from Investor Relations, Lloyds Banking Group plc, 25 Gresham Street, London EC2V 7HN.

The directors consider that it is appropriate to continue to adopt the going concern basis in preparing the condensed consolidated half-year financial statements. In reaching this assessment, the directors have considered the implications of the coronavirus pandemic upon the Group's performance and projected funding and capital position and also taken into account the impact of further stress scenarios. On this basis, the directors are satisfied that the Group will maintain adequate levels of funding and capital for the foreseeable future.

The accounting policies are consistent with those applied by the Group in its 2019 Annual Report and Accounts.

Future accounting developments

The IASB has issued a number of minor amendments to IFRSs effective 1 January 2021 and 1 January 2022 (including IFRS 9 Financial Instruments and IAS 37 Provisions, Contingent Liabilities and Contingent Assets). These amendments are not expected to have a significant impact on the Group.

Critical accounting estimates and judgements

The preparation of the Group's financial statements requires management to make judgements, estimates and assumptions that impact the application of accounting policies and the reported amounts of assets, liabilities, income and expenses. Due to the inherent uncertainty in making estimates, actual results reported in future periods may include amounts which differ from those estimates. Estimates, judgements and assumptions are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under the circumstances. The Group's significant judgements, estimates and assumptions are unchanged, compared to those applied at 31 December 2019, except as detailed below.

Allowance for impairment losses

At 30 June 2020 the Group's expected credit loss allowance (ECL) was £3,360 million (31 December 2019: £2,148 million), of which £3,227 million (31 December 2019: £2,092 million) was in respect of drawn balances. The calculation of the Group's ECL allowances and its provisions against loan commitments and guarantees under IFRS 9 requires the Group to make a number of judgements, assumptions and estimates.

Forward-looking information

The measurement of expected credit losses is required to reflect an unbiased probability-weighted range of possible future outcomes. In order to do this, the Group has developed an economic model to project a wide range of key impairment drivers using information derived mainly from external sources. These drivers include factors such as the unemployment rate, the house price index, commercial property prices and corporate credit spreads. The model-generated economic scenarios for the six years beyond 2020 are mapped to industry-wide historical loss data by portfolio. Combined losses across portfolios are used to rank the scenarios by severity of loss.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)

1. Accounting policies, presentation and estimates (continued)

Alongside a defined central economic scenario, reflecting the Group's base case assumptions used for medium-term planning purposes, three further economic scenarios are generated to represent the range of future outcomes. The upside, downside and severe downside scenarios are produced by averaging across a group of constituent scenarios around the 15th, 75th and 95th percentiles of the estimated loss distribution around the central case, with the central case expected to lie in the vicinity of the 45th percentile. These locations correspond to scenario weightings that allow for the inclusion of a relatively unlikely severe downside scenario associated with relatively large credit losses. At 31 December 2019 and 30 June 2020, the base case, upside and downside scenarios each carry a 30 per cent weighting, while the severe downside scenario is weighted at 10 per cent. The weights reflect the location of the economic scenarios on the estimated loss distribution.

Following review of the severe downside scenario generated by the modelled approach described above, a judgement was made to increase the severity of GDP and unemployment dispersion from the base case. Whilst the modelled approach gives an unbiased method of creating a loss distribution, it is built on historic experience that does not yet fully capture the unprecedented complexities of the current economic environment and the risk of inflated near-term shocks. The impact of this change has been reflected as a central overlay to reflect the incremental ECL estimated outside the core ECL calculation process. The following economic assumptions include both the modelled severe scenario - used in portfolio level ECL and staging assessment, and the adjusted severe downside - used to generate the final ECL through a central overlay in recognition of more adverse economic outcomes.

The key UK economic assumptions made by the Group are shown below. Compounded growth rates have been calculated on a geometric average basis, they were previously calculated on an arithmetic average basis:

Impact of economic assumptions

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)

1. Accounting policies, presentation and estimates (continued)

The five-year averages shown do not fully reveal the extent of peaks and troughs in the stated assumptions over the period. The tables below illustrate the variability of the assumptions from the start of the scenario period to the peak and trough.

Economic assumptions - start to peak

Economic assumptions - start to trough

The Group's base case economic scenario has been materially revised in light of the impact of the coronavirus pandemic in the UK and globally. The estimated impact reflects judgements on the net effect of restrictions on economic activity unprecedented in peacetime, large-scale and previously untried government interventions, and lasting behavioural changes by households and businesses.

Although the UK economy has begun to recover as restrictions are eased, there is considerable uncertainty about the pace and eventual extent of the recovery. The Group's base case assumptions reflect an expectation of some enduring scarring as the economy works through the sharp contraction in economic activity in 2020. Consistent with this, and despite the support provided by the Government's Coronavirus Job Retention Scheme and other income and lending assistance, the base case outlook entails a rise in the unemployment rate and weakness in residential and commercial property prices. The Group considers that risks to its base case economic view lie in both directions, reflecting both epidemiological and other developments, including vis-à-vis the UK's transition to new trading arrangements with the European Union.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)

1. Accounting policies, presentation and estimates (continued)

Scenarios by year

Base Case Scenario by Quarter

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)

1. Accounting policies, presentation and estimates (continued)

Post-model adjustments

Limitations in the Group's impairment models or input data may be identified through the on-going assessment and validation of the output of the models. In these circumstances, management make appropriate adjustments to the Group's allowance for impairment losses to ensure the overall provision adequately reflects all material risks. These adjustments are generally determined taking into account the particular attributes of the exposure which have not been adequately captured by the primary impairment models.

Significant increase in credit risk

An assessment of whether credit risk has increased significantly since initial recognition considers the change in the risk of default occurring over the remaining expected life of the financial instrument. In determining whether there has been a significant increase in credit risk, the Group uses quantitative tests based on relative and absolute probability of default movements linked to internal credit ratings together with qualitative indicators such as watchlists and other indicators of historical delinquency, credit weakness or financial difficulty. These quantitative tests are carried out on both observed and forward-looking probabilities of default (PDs) to determine whether a customer has triggered the required deterioration appropriate for their PD at origination. For each major product grouping, models have been developed which utilise historical credit loss data to produce probabilities of default for each scenario; and it is the overall weighted-average forward-looking PD that is used to assist in determining the staging of financial assets.

There have been no changes to the quantitative or qualitative triggers used at 30 June 2020. The Group considers these to continue to perform adequately under the current economic conditions and notably with the widespread use of payment holidays. The use of a payment holiday in itself has not been judged to indicate a significant increase in credit risk, with the underlying long-term credit risk deemed to be driven by economic conditions and captured through the use of forward-looking models. These portfolio level models are capturing the anticipated volume of increased defaults and therefore an appropriate assessment of staging and expected credit loss.

Definition of default

The probability of default (PD) of an exposure, both over a 12 month period and over its lifetime, is a key input to the measurement of the ECL allowance. Default has occurred when there is evidence that the customer is experiencing significant financial difficulty which is likely to affect the ability to repay amounts due. The Group uses a 90 day past due backstop for all of its products except for UK mortgages where a backstop of 180 days past due is in place. The use of payment holidays is not considered to be an automatic trigger of regulatory default and therefore does not automatically trigger Stage 3. Days past due will also not accumulate on any accounts that have taken a payment holiday including those already past due.

Loss given default

The calculation of the ECL allowance also requires an estimate to be made of the loss that will be incurred in the event of a default. The loss given default (LGD) is based on market recovery rates and internal credit assessments. The LGD for customers utilising government funding schemes incorporates an appropriate level of recovery dependent upon the individual scheme and corresponding level of guarantee being used. The use of forecast collateral value indices in determining LGDs continues to be effective despite the temporarily low volumes of transactions upon which those indices are based.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)

1. Accounting policies, presentation and estimates (continued)

Financial instrument valuations

The Group categorises financial instruments carried on the balance sheet at fair value using a three level hierarchy. Financial instruments categorised as level 1 are valued using quoted market prices and therefore minimal estimates are made in determining fair value. The fair value of financial instruments categorised as level 2 and, in particular, level 3 is determined using valuation techniques which involve management judgement and estimates the extent of which depends on the complexity of the instrument and the availability of market observable information.

The principal judgements made by the Group in determining the fair value of its financial assets and liabilities classified as level 3 are primarily related to interest rate spreads and interest rate volatility. Further details on the valuation of level 3 assets and liabilities, including significant unobservable inputs used in the valuation models, together with the effects of reasonably possible alternative assumptions, are given in note 12.

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (continued)

2. Net fee and commission income