Directors' report

Business review - Risk management and control

Risk categorisation

The Group categorises risk under the following headings:

• Credit risk
• Market risk
• Foreign exchange risk
• Liquidity risk
• Management of current economic conditions
• Operational risk
• Social, Environmental and Ethical ('SEE') risks

Credit risk

Credit risk is the potential financial loss caused by a retail customer or wholesale counterparty failing to meet their obligations to us as they become due. This covers all exposures and includes credit risk on guarantees and irrevocable undrawn facilities.

The taking of credit risk in order to earn a return is a central feature of the Group's business. Risks arising from changes in credit quality and the recoverability of loans and amounts, due from counterparties, are inherent across most of the Group's activities. Adverse changes in the credit quality of borrowers or a general deterioration in UK economic conditions could affect the recoverability and value of the Group's assets and therefore its financial performance. As credit risk is the main risk to the Group, a credit risk framework has been established as part of the overall governance framework to measure, mitigate and manage credit risk within the Group's risk appetite. To a lesser degree, the Group is exposed to other forms of credit risk such as those arising from trading and settlement activities where the risk is a consequence of undertaking the activity, rather than a driver for it.

The Group's Credit Risk framework is based on the allocation of the Group's lending into four risk categories. These provide a sufficient level of detail to identify, monitor and manage the overall credit risk profile on a monthly basis. These categories are defined in relation to profitability as follows:

• medium risk: in the event of a markedly adverse economy, high levels of bad debts could result in significantly lower profits or losses being incurred;
• medium/low risk: a markedly adverse economy would cause substantial reductions in profitability, but profits would still be generated;
• Low risk: only modest reductions in profitability would be recorded even in the event of a markedly adverse economy; and
• Negligible risk: these are loans which have low risk of default and, more importantly, such high levels of security that, even in a markedly adverse environment, it would not be expected that any bad debt loss would be incurred.

The assignment of the loans to the different risk categories is based on an assessment of the relative risk of default and the strength of the underlying security (all retail customer lending being secured). The resulting risk profile is then projected forward based on planned advances, redemptions, seasoning and Board approved limits structured in line with the Group's risk appetite.

Within the Treasury banking book, minimum long-term or short-term credit ratings have been set for all counterparties.

The Group also maintains a structured finance portfolio that primarily consists of investments in asset backed securities ('ABS'). The credit risk is driven by the quality of the underlying securitised assets which, in turn, drives the demand for, and therefore marketability of, the issues. To limit credit risk and concentrations, overall investment in structured investments is capped with separate limits set for the ABS portfolio and other products, including principal rated only notes and Structured Investment Vehicles ('SIVs').

The limits on the amount of the investments portfolio, and the individual types of assets within it have been reduced for 2007 as part of the Group's approach to managing risk.

The Group is firmly committed to the management of credit risk in both its lending and wholesale money market activities. In its core lending activities, the Group employs sophisticated credit scoring, underwriting and fraud detection techniques that support sound credit decision making and work to minimise losses. A proactive approach to the identification and control of loan impairment is maintained in the Residential Lending Credit Risk and Credit Control areas, with challenge and oversight provided by the Group Financial Risk Management function.

Lending policies and limits are reviewed and approved annually by the Board. The CRC ensures that any exposure to credit risk, significant changes in policy, or expansion into new areas of business remain within overall risk exposure levels as agreed by the Board. Authorised credit risk limits for wholesale money market counterparties reflect the size, depth and quality of a counterparty's capital base and, where published, credit ratings assigned by the major credit rating agencies.

In addition to the credit risk governance framework outlined above, the Group takes security for funds advanced and, whilst these are concentrated in the UK, manages the diversification of its portfolios through limits around individual counterparties, types of counterparty, industry and geographic regions.

Market risk

Market risk is the potential adverse change in Group income or Group net worth arising from movements in interest rates, exchange rates or other market prices. Effective identification and management of market risk is essential for maintaining stable net interest income.

The most significant form of market risk to which the Group is exposed is interest rate risk. This typically arises from mismatches between the repricing dates of the interest-bearing assets and liabilities on the Group's balance sheet, and from the investment profile of the Group's capital and reserves. Treasury is responsible for managing this exposure within the risk exposure limits set out in the Balance Sheet Management policy, as approved by ALCO and the Board. This policy sets out the nature of the market risks that may be taken along with aggregate risk limits, and stipulates the procedures, instruments and controls to be used in managing market risk.

It is ALCO's responsibility to approve strategies for managing market risk exposures and ensure that Treasury implements the strategies so that the exposures are managed within the Group's approved policy limits.

The Group assesses its exposure to interest rate movements using a number of techniques. However, there are two principal methods:

• a static framework that considers the impact on the current balance sheet of an immediate movement of interest rates; and
• a dynamic modelling framework that considers the projected change to both the balance sheet and product (mortgage and savings) rates over the following year under various interest rate scenarios.

The results of these analyses are presented to senior management in order to identify, measure and manage the Group's exposure to interest rate risk. The Group remained within all its interest rate risk exposure limits during the year and preceding year.

Limits are placed on the sensitivity of the Group balance sheet to movements in interest rates. Exposures are reviewed as appropriate by senior management and the Board with a frequency between daily and monthly, related to the granularity of the position. For example, the overall Group balance sheet interest rate risk exposure position is monitored monthly whilst several specific portfolios within the balance sheet are reviewed more frequently on a daily or weekly basis. This reflects the dynamics and materiality of the various portfolios.

Interest rate risk exposure is predominantly managed through the use of interest rate derivatives, principally interest rate swaps and interest rate futures contracts. Interest rate swaps are over-the-counter arrangements with highly rated banking counterparties, while futures contracts are transacted through regulated Futures Exchanges. The Group also uses asset and liability positions to offset exposures naturally wherever possible to minimise the costs and risks of arranging transactions external to the Group.

The Group established a limited trading book in January 2007. This is subject to a rigid risk limit framework that is reported daily. The framework includes stop loss limits for daily (£0.5m), monthly (£1m) and annual (£2m) trading losses. Any breaches of these limits are reported to the Group Finance Director immediately and to ALCO and the GRC.

Foreign exchange risk

As the Group does not actively seek foreign exchange exposures, with the net exposure to foreign currencies relating primarily to net interest income streams denominated in the foreign currencies, the limit placed on this risk is small in relation to the Group's other risk exposures. This exposure limit and the small range of foreign currencies it is related to are set out in the Balance Sheet Management policy that is approved by ALCO and the Board.

The Group raises and invests funds in currencies other than sterling. Accordingly, foreign exchange risk arises from activities related to the Group managing borrowing costs and investment returns. As with interest rate risk, Treasury is responsible for managing this exposure within the limits set out in the Group's policies.

Foreign currency exposure is measured daily by Treasury taking into consideration all nonsterling assets and liabilities. This exposure position broken down by individual foreign currency is then circulated to senior managers with an overall summary position provided to senior executives on a monthly basis.

Funds raised in foreign currency are generally converted to sterling using currency swaps. Residual foreign exchange risk is managed through the use of foreign exchange contracts. Bradford & Bingley Annual report & accounts 2007 21 Directors' report It is also managed by matching foreign currency denominated assets with liabilities denominated in the same foreign currency and vice versa.

The Group also has in place a number of committed liquidity facilities to support the Group's activities raising funds in foreign currencies at short notice. These facilities have not been drawn upon during the year or preceding year.

Liquidity risk

Liquidity risk is the risk that the Group, even if it has adequate capital, does not have sufficient funds to meet the Group's obligations as they fall due. A liquidity shortfall could be caused by many factors including:

• a shortfall in wholesale market liquidity;
• the withdrawal of customer deposits; and
• the drawdown of customer borrowings and growth of the balance sheet.

Liquidity risk management within the Group considers both the overall balance sheet structure and projected daily liquidity requirements, measuring the combined effect of asset and liability maturity mismatches across the Group and undrawn commitments and other contingent obligations.

The day-to-day management of liquidity is the responsibility of Treasury, which provides funding to, and takes surplus funds from, each of the Group's businesses as required.

Liquidity policy is approved by the Board and agreed within a framework established by the Financial Services Authority ('FSA'). The scope and nature of the Group's holdings of readily realisable liquid assets are always in excess of regulatory guidelines, after allowing for the potential outflow of funds.

Liquidity risk is assessed by means of a framework that determines the appropriate level of liquidity available at short-notice in conjunction with a series of stress tests and scenario analyses. The framework and scenarios were developed in conjunction with Group Risk and approved by ALCO and the Board. Included within the scenarios are specific counterparty, Group and financial market events that might, but are unlikely to occur.

The parameters and scenarios selected were determined through a combination of historical data analysis and professional judgement to generate the most severe possible liquidity drain. The stress tests and scenario analyses also consider the time period over which the liquidity demands are most strong, typically one week but also up to three months.

The liquidity risk framework is reviewed and approved by ALCO and the Board on an annual basis. Liquidity reporting is undertaken weekly and circulated to senior members of Group Risk and Group Finance.

Management of current economic conditions

The Group's funding policies and management have been severely tested during the liquidity problems that have emerged in the wholesale markets in the second half of 2007.

Whilst the committees responsible for managing liquidity meet on a scheduled basis, they are able to meet more frequently should the need arise. During September and October 2007, a combination of the BSMC and ALCO met on a daily basis to monitor the impact of the restricted market for wholesale funding impacting global markets. This joint committee reviewed daily cash-flow and balance sheet positions and plans to finance the bank through this period of extreme stress. Whilst conditions eased somewhat towards the end of the year, these daily liquidity updates continue to be circulated to members of both BSMC and ALCO.

As noted earlier, the Group has also arranged a number of committed liquidity facilities that are available to assist in the maintenance of liquidity levels. These are primarily used to support the Group's non-sterling funding activities and are available in a range of currencies. These facilities have not been drawn upon during the year or preceding year. For many years we have worked to diversify our funding base and build strong relationships. This proved very beneficial when we raised £2.5bn in private funding transactions in September and October, at a time when the public wholesale markets were effectively closed.

The Group has maintained its careful approach to funding and, in particular, had continued to invest in the network and build up retail deposits. We also continued to pursue a policy of pre-funding our net new lending and of holding sufficient liquidity for at least four months of continued operations without recourse to the wholesale money markets. At the year end these liquidity balances totalled £8.4bn (2006: £7.8bn).

In response to the unfolding liquidity crunch we took a number of steps to reduce immediate funding needs. We increased mortgage pricing to contain volumes and protect margin; raised savings pricing to attract additional customer deposits; reduced the level of mortgage portfolio acquisitions; and increased focus on lower risk lending. The Group continues to successfully fund the business, most recently with an agreed £2bn of committed term facilities which pre-fund maturing term financing into 2009, and an additional £1.2bn of retail savings deposits already raised in the first six weeks of 2008.

Operational risk

Operational risk is the potential risk of financial loss or impairment to reputation resulting from inadequate or failed internal processes and systems, from the actions of people or from external events.

Major sources of operational risk include:

• outsourcing of operations;
• dependence on key suppliers;
• IT security;
• internal and external fraud;
• implementation of strategic change;
• regulatory non-compliance (for example, mis-selling); and
• process errors and external threats such as the loss of a critical site.

The Group's business areas manage this risk through appropriate controls and loss mitigation actions including insurance. These actions include a balance of policies, appropriate procedures and internal controls to ensure compliance with laws and regulations. At a detailed level, risk and control assurance is facilitated by Group Risk, in conjunction with line managers, on the risks and control effectiveness within their areas of responsibility.

In addition, specialist support functions provide expertise in risk areas such as information security, health and safety, compliance, fraud management, security and business continuity management.

A process is in place for the recognition, capture, assessment analysis and reporting of risk events. This process is used to help identify where process and control requirements are needed to reduce the recurrence of risk events.

The Group has met the eligibility criteria for the adoption of the standardised approach to operational risk and assesses relevant income from prescribed business lines such as Retail Banking, Retail Brokerage and Commercial Banking. For each business line, the Group's average annual published relevant income based on the last three years is calculated. Capital is held to support operational risk for each business line at prescribed rates from 12% to 18% of its average annual relevant income.

Social, Environmental and Ethical ('SEE') risks

SEE risks are identified and considered by the Corporate Social Responsibility ('CSR') team in the Group HR function within our risk management and control policies.