Retail Direct - 4 October 2004

Thank you, Chris, and good morning. Chris has already shown you that over half the income in Retail Direct comes from the Cards Business and he has explained there are two main areas to that, the card issuing side and the merchant acquiring. I am going to, first of all, take you through quickly those two elements of the business and how they fit together because a lot of people don’t quite understand how it works.

First of all, a customer will go to an issuing bank and get a credit card, then he would go to a merchant and obviously buy something with that credit card. This is where the merchant acquirer then comes in, they actually capture all those transactions and process them on behalf of the retailers. Then there is settlement with the issuing bank and that quite often goes through the schemes, Visa and Mastercard, and then the loop is closed by the fact that the customer will get a statement from the issuing bank. You carry on and the cycle goes round.

When you look at the issuing bank then, what are the sources of income and costs on that side of the business? You can see we have interest income on the borrowing from the cards, you get interchange income on all the spending on the cards and we have other fee income such as insurance, foreign exchange and when the customers use it to withdraw cash from ATMs.

On the costs side, we have got the funding balances, including the interest free periods when people are just transacting rather than borrowing. We have operations which encompasses when people open accounts, the call centres, the collections activity, we have our marketing and loyalty schemes and, of course, we have got bad debt provisions and fraud.

Looking at the Merchant Acquiring side of the business, the sources of income there are again a merchant service charge on all spending on cards. We get rental from the terminals we provide to merchants, and we provide 220,000 terminals in the UK to merchants. On the costs side, again we have our operations costs and the call centres, we have a lot of depreciation for those terminals, and we obviously have a lot of telecommunication lines to capture all that data from the retailers.

When you look at how the Cards Business income is split, just over a third of it comes from net interest on borrowing and the rest is split fairly evenly between interchange income on spending on the issuing side of the business, the merchant service charge income and then the other fee income I have already referred to.

How that splits in terms of the RBS financial statement: 63 per cent of it is non-interest income and just over a third is net interest income.

I am now going to focus on the card issuing side of the business. There is also commercial cards in here but I am primarily going to focus on personal cards. Looking at the customers, there are two types of customers broadly in credit cards, you have transactors and you have borrowers.

On the transactors side the cards are a convenient way of spending for them, they pay off their balance in full every month and, of course, they don’t incur an interest charge. The other end of the spectrum is that someone uses the card as a means of borrowing primarily and in that case they pay off the minimum monthly balance each month which typically is around 3 per cent and they get a monthly interest charge. Obviously people can move between transacting and borrowing at different stages in their life cycle.

Looking at our portfolio and how it is split, 71 per cent of our customer base are transactors and 29 per cent are borrowers.

Looking at how we go after those two types of credit card customers, on the transactors side largely it is the bank brands that are attractive to transactors. We have a very good loyalty scheme with Air Miles, it has been running for several years with NatWest and just more recently with RBS. On the borrowing side we have the MINT brand, a low interest rate and easy to do balance transfers, and it is very attractive for quality borrowers.

Looking at how they fit within, if you look at both average spending per account and average balance per account, you can see that NatWest has very high spending and medium balances per account in terms of the overall market; at the other end of the spectrum MINT has very high balances but much lower spending per account, and the Royal Bank of Scotland sits somewhere in between them.

Looking now at how we recruit our customers, first of all, the two bank brands. As you would expect, we get most of our customers through the bank branches. We automate the process as much as possible for the people at the front-end so they can see when they are opening a current account that the customer does not have a credit card, and it prompts them to start the sale process; also the regular customer service reviews. We incentivise people in the branches to sell credit cards and all the income and the direct costs of that process come into Retail Direct. Of course, customers can also apply by telephone, post or Internet.

This slide just reinforces the fact that 74 per cent of customers come through the branch network

MINT we launched in January 2004. I am sure many of you recall the adverts we put out in the early part of the year but I just like to show you one - you might not have seen them - just to give you a flavour of what it is about. (Video was then shown)

You can see the style is slightly irreverent.....(Laughter).....a bit innovative, a bit funky, and it has been very successful. On this slide, you can see the card on the left is minus a corner. That is a Mastercard, a brand card, and we got exclusivity in the UK during the launch period for this card and, indeed, we are still the only issuer in Europe that has that card. We have a lot of evidence that customers like it - it starts conversations in retailers and so on!

In the course of this year obviously we had a big book in RBS Advanta. We are migrating RBS Advanta on to the MINT cards during the course of this year.

How do we recruit credit cards in this side of the business? It is by direct marketing. We don’t have a branch network for this obviously, we have got to be very efficient in this side of the business. You can apply by Internet, telephone or post. From the RBS Advanta days - it is has been going nine years now - we have developed a lot of skills in direct mail, by acquisition of quality lists in the first place. We then pre-screened those lists for risk and then we have a continuous test and learn approach, every single mailing we put out which encompasses price tests, things like length of entry period and all the different creatives that we use. I was the Managing Director of this business from 1996 to 1999 when it was a joint venture.

Looking at MINT, in the last couple of years we have seen quite a change of people more and more accepting that you should go to the Internet, there is choice for them to actually take their credit card, and what we have done for MINT - this slide shows the Home Page - we have built a very strong Internet thing for MINT in terms of applications and then full service online. That actually translated into us receiving an award earlier this year in terms of the best site in the UK for credit card applications and has come through in terms of the acquisition this year.

When you look at the customers we have recruited 41 per cent of them have come over the Internet and, as Chris was talking about earlier, we have seen that customers you recruit over the Internet stay with you more than direct mail and you have got more chance of actually building some loyalty with them because they are going on to the Internet continually to service their accounts. That also is cheaper for us, that customers are self-serving on the Internet.

Looking at the different profile of the three main brands, we do have some other brands but, as shown on this slide, these are three main ones that we have. You can see NatWest, a 7 per cent share of accounts in the UK but 10 per cent of the turnover and that is as a consequence of Air Miles which we have already talked about. MINT, on the other hand, a 3 per cent share of accounts but 5 per cent share of balances, and you can see RBS is pretty average across the piece. Credit quality on all our portfolios is prime and I am going to come back to that is just a minute.

Looking at how we manage credit risk, there are three stages of credit risk and this is very important obviously in the credit card side of the business. First of all, there is the point where you are actually attracting customers and scoring them to open accounts. The second stage is when you have the customer and you have got the ongoing monitoring of that account. Then the third stage is when some customers unfortunately get into problems.

The first stage in terms of customers applying for accounts, we have application scoring which is a highly automated process and it is used to predict an applicant’s probability of default. We use various sources of information in making that decision including the application form and credit bureaux.

I am just going to now cover credit bureaux and what we get from them. First of all, there are two major credit bureaux in the UK, Experian and Equifax, and we can use that information for credit scoring, identity checks - which is very useful for knowing your customer - and address verification which is very useful for identifying fraud. What we cannot use it for is marketing purposes, it is just not allowed.

The bureaux collect data on both customer attributes such as where you live and also behaviours, which is the profile you have in terms of your repayments etc. It is interesting to know and important that the bureaux don’t hold identical data. If you are a lender you could actually supply data to one bureaux and just get data back from one bureaux, and I will come back to that in a moment when we actually look at how we credit score.

The credit information supplied by lenders covers things like the number of credit applications, credit defaults, repayment history etc., and public information may capture all the electoral roll data, county court judgments and bankruptcies.

So RBS application credit scoring, we base it on various attributes, things like home ownership, time with existing bank, existing borrowing and that credit bureaux information. We base the initial credit limit based on the credit score and the amount of income that the customer earns.

Looking at the score cards, you can go to one of these bureaux and get a generic scorecard, but what we do is we build our own scorecards and we make them specific to the brands. You have seen that a NatWest customer is very different from a MINT customer, so we have different scorecards for those different customer bases. We build our scorecard using data from both bureaux, and that is important because we could make a better decision because we have got more data, and I think we are the only one in the UK that does this. I am not aware of anyone else that takes both bureaux data. We use our own experience which we have built up over many years to continually update those scorecards and so we benefit from all that past experience.

Setting the cut-offs, we look at a minimum credit score for each scorecard. Clearly there is a trade-off between pass rate and loss rate, if you have a higher pass generally you have higher losses and vice-versa. We vary the cut-offs continuously in light of our experience which we keep feeding back into the scorecards and we very much focus on lower risk and lower income - that is not the customer having lower income, that is us having lower income.

How that plays out, if you continue from sub-prime through to prime, MINT is our best quality base followed very closely by the two bank brands. When you look at this, and we purposely put ourselves here, at the lower end of the better quality of risk you will see lower risk, lower income, lower provisions and lower volatility - if you look at the other end and move into sub prime you will get higher risk, you will get higher income, you will get higher provisions and higher volatility - and we are very comfortable being at this end of the spectrum.

Now moving on to when we have accounts on board, we want to make sure the accounts maintain the quality they initially showed when we brought them on board, and so we have an ongoing credit scoring of active accounts. This is based on the account behaviour and it is calculated monthly for all accounts we have. We base it on factors such as the credit limit utilisation, how much of the credit they are using, the type of spending - if someone starts actually going to an ATM and withdrawing cash on their credit card it is indicative of higher risk - and also the pattern of repayments which is fairly obvious.

The next stage is when someone actually gets into trouble and starts missing payments on their credit card. We split this into early stage and late stage. The early stage is when they have missed their first payment and that triggers the process. At this stage we are still focusing on maintaining the relationship. A lot of customers just miss their first payment for reasons like they have gone on holiday; they have paid for years, no problem, it just so happens they have gone on holiday and forgot to pay their credit card balance. It is very important we differentiate the types of customers here that are making payments, so we prioritise the risks between amount at risk and using our behavioural score.

We make early contact - this is key here! - through outbound power dialling, and we do that at times we are likely to get customers in, which generally is early evening when they have come back from work or Saturday mornings before they are heading out for the day.

Late stage is where they have missed three consecutive payments. At this stage we are focusing on recovering the debt, we pass the amount to a debt collection agency initially in-house, it is still in Southend, and then further down the track to an external agency. We close the account at that stage and clearly try to recover the debt, but again I would like to stress here we do it in a way which is very cognisant of the individual’s circumstances and it is not heavy-handed.

Looking at our strategies, we have over a hundred strategies covering collections, re-issue, amount of credit limit and so on. As shown on this slide, this is just an example of one in the collection site. I am not going to run through it but its really to get across that we have a very defined process here, our operations centres are working to these processes, and we are continually refining these and feeding them back in from our learning’s and we have champion/challenger approaches in all these areas.

Looking at our delinquency experience, a fairly standard measure, and you could get this data in the market place. It is looking at how much of your customers have missed repayments, that is three payments delinquent as we call it. You can see that the cards business in RBS is significantly lower than the industry as a whole and that is due to what I have been talking about in terms of how we select customers, what we do when they are on board and the collections process.

If you look at the percentage of our portfolio balances greater than three payments delinquent, you cannot compare this with the market because it is not available on a like for like basis, but you can see from this slide again that is coming down, and that is indicative again of the strength of our processes over the last few years.

Looking at provisions, they are automated. We based them on the amount of delinquent balances and the expected loss rate depending on the number of missed payments you have. You have seen from the graphs I have given you, the loss rates will be relatively stable over time; we provide for expected loss at all stages of delinquency and we feed the trends back into the scorecards again, so it is a cycle that continues.

Looking at our balance sheet provisions as a percentage of delinquent balances greater than 90 days, there was a blip in 2001 as we changed systems and also we wrote off accounts one month earlier which just reduced the coverage there. Generally it is falling a little bit and that again is just coming back to the strength of our processes. The quality of our delinquent balances has improved, there is more of them in the early stages of delinquency as opposed to previously because we are catching them earlier.

Turning now to the last area I want to talk about, which is fraud. It is an industry problem, quite a significant problem on credit cards. Traditionally fraudsters would steal a credit card or they have applied fraudulently for a credit card, but in the last couple of years we have seen a big increase in organised crime getting involved in credit cards, much more sophisticated doing things like actually getting the information off the magnetic stripe and copying it, counterfeiting the card and also stealing people’s identity. You have probably seen this in the media in the last couple of years and it seems to be growing.

How do we tackle it? There are four main areas of fraud. The first one, counterfeit loss and stolen cards. We have an automated system again, real time profiling of every transaction on a credit card. We monitor them for any exceptional transactions. A couple of examples of those could be all of a sudden we start seeing mobile phone top-ups, we can see from experience that is indicative of potential fraud; also unusual international payments. What we do in that situation is fire a message back to the retailer, this all happens in just a couple of seconds, and the retailer would be asked to call us so we could talk to the customer to verify their identity. There is a big balance here we have got to get right between not doing that too often and inconveniencing customers and not doing it enough and we see high fraud, so we are continually refining that balance.

Three other types of fraud, the primary ones: card not present - this is where you pay for things over the Internet, over the phone or by post - in that instance the retailer is liable for the fraud. We help the retailers to minimise this again through our monitoring systems and also the retailer can use the three digit security code on the back of the card because that is difficult for fraudsters to get hold of.

Card not received - someone has intercepted your card in the mail. We have secure mail, we put it out in disguised fashions, we know where the high risk post code areas are, and you have to activate your card before it is live, so if someone intercepts our card they cannot just go and use it.

Lastly identity theft, which I have already talked about. We use the credit bureaux information here to pick up inconsistencies in the information that a fraudster would attempt to use.

The last one, Chip & PIN: that is coming along. Everyone is aware of Chip and PIN. It is an industry initiative, it is going to reduce fraud hopefully in various areas - counterfeit loss and stolen card not received. We are an industry leader in this, we are right at the forefront, and by the end of this year 85 per cent of our bank-owned terminals will be Chip & PIN enabled and we will have over 7 million of our cards with a chip embedded in it. We have a lot of retailers already live on this, and these are retailers that are customers of our Merchant Acquiring business, and we have a major customer education programme underway.

With that, I will now pass over to Tony Surridge to talk to you about the Acquiring business.