2008 Interim Report Section 1

RNS Number : 6172A

HSBC Holdings PLC

04 August 2008

 



Liquidity and funding 

The liquidity and funding risk framework is adapted in response to changes in the mix of business that HSBC undertakes, and to changes in the nature of the markets in which HSBC operates. There have been no material changes to HSBC's objectives, policies or procedures for the management of liquidity and funding risks as described in the Annual Report and Accounts 2007, the key features of which are repeated below. HSBC has continuously monitored the impact of recent market events on the Group's liquidity positions and introduced more conservative assumptions where justified. The impact of these recent market events is discussed more fully later in this section. The liquidity and funding risk framework will continue to adapt, particularly as the Group assimilates further knowledge from the recent dislocations in the market.

The management of liquidity and funding is primarily carried out locally in the operating entities of HSBC in accordance with practices and limits set by the Risk Management Meeting ('RMM'). These limits vary by entity to take into account the depth and liquidity of the market in which the entity operates. It is HSBC's general policy that each banking entity should be self-sufficient with regards to funding its own operations.

Current accounts and savings deposits payable on demand or at short notice form a significant part of HSBC's funding. HSBC places considerable importance on maintaining the stability of these deposits. Stability depends upon preserving depositor confidence in HSBC's capital strength 
and liquidity, and on competitive and transparent deposit-pricing strategies.

HSBC also accesses professional markets in order to provide funding for non-banking subsidiaries that do not accept deposits, to maintain a presence in local money markets and to optimise the funding of asset maturities not naturally matched by core deposit funding. In aggregate, HSBC's banking entities are liquidity providers to the interbank market, placing significantly more funds with other banks than they borrow.

The main operating subsidiary that does not accept deposits is HSBC Finance, which funds itself principally by taking term funding in the professional markets and by securitising assets. 
At 30 June 2008, US$132 billion (30 June 2007: US$144 billion; 31 December 2007: US$142 billion) of HSBC Finance's liabilities were drawn from professional markets, utilising a range of products, maturities and currencies to avoid undue reliance on any particular funding source.

Advances to deposits ratio

HSBC emphasises the importance of current accounts and savings accounts as a source of funds to finance lending to customers, and discourages reliance on short-term professional funding. To achieve this goal, limits are placed on Group banking entities which restrict their ability to grow loans to customers without corresponding growth in core current accounts and savings accounts. This measure is referred to as the 'advances to deposits' ratio.

Advances to deposits ratio limits are set by the RMM and monitored by Group Finance. The ratio compares loans and advances to customers as a percentage of core customer current and savings accounts together with term funding with a remaining term to maturity in excess of one year. Loans to customers which are part of reverse repurchase arrangements, and where the Group receives securities which are deemed to be liquid, are excluded from the advances to deposits ratio. Current accounts and savings accounts from customers deemed to be 'professional' are excluded. The definition of a professional customer takes account of the size of the customer's total deposit balances by applying a tiering classification. Generally, any customer with total funds deposited in excess of US$2 million is regarded as professional. Due to the distinction between core and professional depositors, the Group's measure of advances to deposits will be more restrictive than that which could be inferred from the published financial statements.

The three major Group banking entities shown separately in the table below represented 70 per cent of the Group's total core deposits at 30 June 2008 (30 June 2007: 72 per cent; 31 December 2007: 71 per cent). The table demonstrates that loans to customers in the Group's principal banking entities are broadly financed by reliable and stable sources of funding.

HSBC would meet any unexpected net cash outflows by selling securities and accessing additional funding sources such as interbank or collateralised lending markets. In addition to the advances to deposits ratio, the Group uses a range of other measures for managing liquidity risk. These other measures include the ratio of net liquid assets to customer liabilities and projected cash flow scenario analyses.

The advances to deposits ratios of the Group's principal banking entities 

	Half-year to
	30 June      2008		30 June     2007	31 December    2007
	%		%		%
HSBC Bank  (UK operations)
Period-end	100.9		96.6		97.5
Maximum	101.0		101.7		97.5
Minimum	97.5		95.5		92.6
Average	99.4		98.6		95.5
The Hongkong and  Shanghai Banking Corporation
Period-end	82.9		77.4		76.7
Maximum	82.9		78.2		82.2
Minimum	76.7		72.4		73.5
Average	80.5		75.3		77.6
HSBC Bank USA
Period-end	110.3		112.2		114.9
Maximum	115.9		116.8		116.0
Minimum	110.3		107.0		109.3
Average	113.1		111.5		113.7
Total of Group's other principal banking entities
Period-end	91.1		88.2		88.4
Maximum	92.3		88.2		89.3
Minimum	86.4		86.2		87.3
Average	89.4		87.1		88.4

Ratio of net liquid assets to customer liabilities

Net liquid assets are liquid assets less all funds maturing in the next 30 days from wholesale market sources and from customers who are deemed to be professional. The Group defines liquid assets for the purposes of the liquidity ratio as cash balances, short-term interbank deposits and highly rated debt securities available for immediate sale and for which a deep and liquid market exists. As noted above, the definition of a professional customer takes account of the size of the customer's total deposits. Contingent liquidity risk associated with committed loan facilities is not reflected in the ratios. The Group's framework for monitoring this risk is outlined below.

Limits for the ratio of net liquid assets to customer liabilities are set for each bank operating entity. As HSBC Finance does not accept customer deposits, it is not appropriate to manage their liquidity using the standard liquidity ratios. The liquidity and funding risk framework of HSBC Finance is discussed below. Ratios of net liquid assets to customer liabilities are provided in the following table. For additional information, the US dollar equivalents of net liquid assets are also provided.

Net liquid assets and the ratio of net liquid assets to customer liabilities

	Half-year to
	30 June 2008				30 June 2007				31 December 2007
	Ratio		Net liquid     assets		Ratio		Net liquid     assets		Ratio		Net liquid     assets
	%		US$bn		%		US$bn		%		US$bn
HSBC Bank (UK operations)
Period-end	9.8		37.3		14.5		47.5		12.1		44.2
Maximum	14.1		52.5		16.3		48.7		21.5		80.6
Minimum	9.8		37.0		13.5		39.9		12.1		44.2
Average	11.5		42.2		14.5		44.8		16.6		59.3
The Hongkong and Shanghai Banking Corporation
Period-end	19.9		51.1		18.8		42.9		21.8		53.9
Maximum	22.7		57.7		22.9		52.6		24.1		56.9
Minimum	19.9		51.1		16.1		35.3		17.4		42.9
Average	21.5		54.9		20.2		44.9		21.2		50.7
HSBC Bank USA
Period-end	17.0		17.1		20.9		20.7		15.8		17.1
Maximum	20.4		21.7		25.7		26.1		23.0		23.4
Minimum	15.8		17.1		20.9		20.7		15.8		17.1
Average	18.6		19.6		23.4		23.8		19.2		20.0
Total of Group's other principal banking entities1
Period-end	19.4		68.3		25.3		68.3		21.0		66.1
Maximum	22.1		74.4		25.3		68.3		26.1		72.7
Minimum	19.4		66.1		23.7		58.8		21.0		64.5
Average	21.1		70.2		24.3		61.4		23.9		69.6

1    This reflects the other main banking subsidiaries and, as such, includes businesses spread across a range of locations, in many of which the Group may require a higher ratio of net liquid assets to customer liabilities to reflect local market conditions. 

Projected cash flow scenario analysis

The Group uses a number of standard projected cash flow scenarios which are designed to model both Group-specific and market-wide liquidity crises. The scenarios vary the rate and timing of deposit withdrawals and drawdowns on committed lending facilities, and restrict access to interbank funding, term debt markets and the ability to generate funds from asset portfolios. The scenarios are modelled by all Group banking entities and by HSBC Finance. The assumptions for each scenario are regularly reviewed for appropriateness. In addition to the Group's standard projected cash flow scenarios, individual entities are required to design their own scenarios tailored to reflect specific local market conditions, products and funding bases.

Limits for cumulative net cash flows under stress scenarios are set for each banking entity and for HSBC Finance.

Both ratio and cash flow limits reflect the local market place, the diversity of funding sources available and the concentration risk from large depositors. Compliance with entity level limits is monitored centrally by Group Finance and reported regularly to the RMM.

HSBC Finance

As HSBC Finance does not accept customer deposits, it takes funding from the professional markets. HSBC Finance uses a range of measures to monitor funding risk, including projected cash flow scenario analysis and placing caps on the amount of unsecured term funding that can mature in any rolling three-month and rolling 12-month periods. HSBC Finance also maintains access to committed sources of secured funding and has in place committed backstop lines for short-term refinancing CP programmes. At 30 June 2008, the maximum amounts of unsecured term funding maturing in any rolling three-month and rolling 12-month periods were US$6.2 billion and US$17.7 billion, respectively (30 June 2007: US$6.2 billion and US$16.2 billion; 31 December 2007: US$6.2 billion and US$17.7 billion). At 30 June 2008, HSBC Finance also had in place unused committed sources of secured funding, for which eligible assets were held, of US$2.9 billion (30 June 2007: US$9.1 billion; 31 December 2007: US$6.2 billion) and committed backstop lines from non-Group entities in support of CP programmes totalling US$6.3 billion (30 June 2007: US$9.3 billion; 31 December 2007: US$9.3 billion).

Contingent liquidity risk

In the normal course of its business, the Group provides committed facilities to customers; these facilities include committed backstop lines to conduit vehicles sponsored by the Group, as well as standby facilities to corporate customers. These facilities would increase the funding requirements of the Group should customers choose to raise drawdown levels over and above their normal utilisation rates. The liquidity risk consequences of drawdowns on these committed loan facilities provided by Group entities are reflected in projected cash flow scenario analyses, in which the level of drawdown is increased under different stress scenarios. The Group also sets total notional limits by Group entity for certain categories of non-cancellable contingent funding commitments. The limits are set by the RMM after due consideration of the entity's ability to fund the commitments. The limits are split according to the borrower, the liquidity of the underlying assets and the size of the committed line.

The Group's contractual exposures monitored under the contingent liquidity risk limit structure

	HSBC Bank						HSBC Bank USA						HSBC Bank Canada						The Hongkong and Shanghai Banking Corporation
	At     30 June     2008		At     30 June     2007		At     31 Dec     2007		At     30 June     2008		At     30 June     2007		At     31 Dec     2007		At     30 June     2008		At     30 June     2007		At     31 Dec     2007		At     30 June     2008		At     30 June     2007		At     31 Dec     2007
	US$bn		US$bn		US$bn		US$bn		US$bn		US$bn		US$bn		US$bn		US$bn		US$bn		US$bn		US$bn
Conduits
Client-originated assets1
- total lines	7.9		7.5		11.0		11.9		7.1		9.5		0.7		0.7		0.7		-		-		-
- largest individual lines	1.0		1.0		1.6		0.5		0.6		0.9		0.3		0.4		0.4		-		-		-
HSBC-managed  assets2	35.7		-		25.7		-		-		-		-		-		-		-		-		-
Other conduits3	0.2		-		-		1.4		2.7		2.6		-		1.3		1.8		-		-		-
Single-issuer  liquidity facilities
- five largest4	8.4		7.0		10.0		5.8		4.5		5.9		-		-		-		1.4		1.3		1.3
- largest market sector5	6.6		8.1		11.7		4.1		5.6		4.2		-		-		-		2.1		2.8		2.3

1    These exposures relate to consolidated multi-seller conduits (refer pages 148 to 149). These vehicles provide funding to Group customers by
      issuing debt secured by a diversified pool of customer-originated assets. 

2    These exposures relate to consolidated securities investment conduits, primarily Solitaire and Mazarin (refer pages 148 to 149). These
      vehicles issue debt secured by highly rated ABSs which are managed by HSBC. 

3    These exposures relate to third party sponsored conduits (refer page 151).

4    These figures represent the five largest committed liquidity facilities provided to customers other than those facilities to conduits.

5    These figures represent the total of all committed liquidity facilities provided to the largest market sector other than those facilities to
      conduits.

The Group recognises that, in times of market stress, it may also choose to provide non-contractual liquidity support to certain HSBC-sponsored vehicles or HSBC-promoted products. Such potential support would not be included in the Group's liquidity risk measures until such time as the support becomes legally binding, and would only be provided after careful consideration of the potential funding requirement and the impact on the entity's overall levels of liquidity. 

The impact of market turmoil on the Group's liquidity risk position 

The disruptions that have occurred in the financial markets since the onset of the market turmoil in August 2007 have been far reaching. A significant aspect of the credit crisis has been the adverse effect on the liquidity and funding risk profile of the banking system. 

At a systemic level, the effect of the credit crisis upon the liquidity and funding risk of the banking system can be characterised as follows:

• interbank funding costs increased as banks became reluctant to lend to each other beyond the very short-term;

• many asset classes previously considered as liquid became illiquid;

• the ability of many market participants to issue either unsecured or secured debt has been restricted; and

• special purpose entities with investments linked to US sub-prime mortgages, or to ABSs where the underlying credit exposures were not fully transparent, found it increasingly difficult to raise wholesale funding.

In response, a number of central banks have introduced measures to provide further liquidity into the market and to alleviate the strains being experienced.

In general terms, the strains due to the credit crisis have been concentrated in the wholesale market as opposed to the retail market (the latter being the market from which the Group sources its core current and savings accounts, the importance of which as a funding source for the Group is discussed under 'Advances to deposits ratio' above). Financial institutions such as HSBC, with less reliance on wholesale markets, were less affected by the recent conditions.

This distinction between the experience of financial institutions with greater or lesser dependence on the wholesale markets is critical to understanding the impact of the market turmoil upon the liquidity and funding of HSBC. The Group's limited dependence upon the wholesale or professional markets for funding has been a significant competitive advantage to HSBC through the recent period of dislocation in the financial markets.

The extent to which the liquidity and funding of HSBC has been affected by the market turmoil, has been largely limited to the Group's activities that had historically depended upon the asset-backed commercial paper markets for funding, specifically SIVs and conduits, and certain money market funds. This was discussed in detail on page 183 of the Annual Report and Accounts 2007 and updated for developments in the first six months of 2008 in this Interim Report. 

The deterioration of the US sub-prime credit market has reduced the availability of committed financing to entities with exposures to the US sub-prime market. However, HSBC Finance, by virtue of its position within the Group, continues to enjoy and renew, albeit at a lower level, committed financing facilities. HSBC Finance also continues to have access to term funding markets, although the price of this funding has increased to reflect the downturn in credit markets. Funding plans are in place to enable HSBC Finance to deal with continued stress in the credit markets.

HSBC Holdings has continued to have access to debt capital markets at normal market pricing levels.

The customer deposit base of the Group has grown since August 2007. During this period, the Group has not increased deposit pricing to attract additional deposits. As a net provider of funds to the interbank market, the Group has not been significantly affected by the scarcity of interbank funding.

The Group has regularly reviewed the quality of assets to ensure that only those assets for which a deep and liquid market exists are classified as liquid within liquidity and funding risk measures.

Market risk 

There have been no material changes to HSBC's objectives for the management of market risk as described in the Annual Report and Accounts 2007. The key features are reported below.

Market risk is the risk that movements in market risk factors, including foreign exchange rates and commodity prices, interest rates, credit spreads and equity prices will reduce HSBC's income or the value of its portfolios.

HSBC separates exposures to market risk into trading and non-trading portfolios. Trading portfolios include those positions arising from market-making, proprietary position-taking and other marked-to-market positions so designated. 

Non-trading portfolios primarily arise from the interest rate management of HSBC's retail and commercial banking assets and liabilities, financial investments classified as available for sale and held to maturity, and exposure arising from HSBC's insurance operations.

HSBC uses a range of tools to monitor and limit market risk exposures. These include sensitivity analysis, value at risk ('VAR') and stress testing. 

Sensitivity analysis

Sensitivity measures are used to monitor the market risk positions within each risk type, for example, present value of a basis point movement in interest rates, for interest rate risk. Sensitivity limits are set for portfolios, products and risk types, with the depth of the market being one of the principal factors in determining the level of limits set.

Value at risk 

VAR is a technique that estimates the potential losses that could occur on risk positions as a result of movements in market rates and prices over a specified time horizon and to a given level of confidence. 

The VAR models used by HSBC are based predominantly on historical simulation. These models derive plausible future scenarios from past series of recorded market rates and prices, taking into account inter-relationships between different markets and rates such as interest rates and foreign exchange rates. The models also incorporate the effect of option features on the underlying exposures.

The historical simulation models used by HSBC incorporate the following features:

• potential market movements are calculated with reference to data from the past two years;

• historical market rates and prices are calculated with reference to foreign exchange rates and commodity prices, interest rates, equity prices and the associated volatilities; and

• VAR is calculated to a 99 per cent confidence level and for a one-day holding period.

HSBC routinely validates the accuracy of its VAR models by back-testing the actual daily profit and loss results, adjusted to remove non-modelled items such as fees and commissions, against the corresponding VAR numbers. Statistically, HSBC would expect to see losses in excess of VAR only one per cent of the time over a one-year period. The actual number of excesses over this period can therefore be used to gauge how well the models are performing.

Although a valuable guide to risk, VAR should always be viewed in the context of its limitations. For example: 

• the use of historical data as a proxy for estimating future events may not encompass all potential events, particularly those which are extreme in nature;

• the use of a one-day holding period assumes that all positions can be liquidated or the risks offset in one day. This may not fully reflect the market risk arising at times of severe illiquidity, when a one-day holding period may be insufficient to liquidate or hedge all positions fully;

• the use of a 99 per cent confidence level, by definition, does not take into account losses that might occur beyond this level of confidence;

• VAR is calculated on the basis of exposures outstanding at the close of business and therefore does not necessarily reflect intra-day exposures; and

• VAR is unlikely to reflect loss potential on exposures that only arise under significant market moves.

Stress testing 

In recognition of the limitations of VAR, HSBC augments VAR with stress testing to evaluate the potential impact on portfolio values of more extreme, although plausible, events or movements in a set of financial variables.

Stress testing is performed at a portfolio level, as well as on the consolidated positions of the Group, and covers the following scenarios:

• Sensitivity scenarios, which consider the impact of market moves to any single risk factor or a set of factors. For example the impact resulting from a break of a currency peg that is unlikely to be captured within the VAR models;

• Technical scenarios, which consider the largest move in each risk factor, without consideration of any underlying market correlation;

• Hypothetical scenarios, which consider potential macro economic events; and

• Historical scenarios, which incorporate historical observations of market moves during previous periods of stress which would not be captured within VAR.

Stress testing is governed by the 'Stress Testing Review Group' forum that coordinates the Group stress testing scenarios in conjunction with the regional risk managers. Consideration is given to the actual market risk exposures, along with market events in determining the stress scenarios.

Stress testing results are reported to senior management and provide them with an assessment of the financial impact such events would have on the profit of HSBC. The daily losses experienced in the first half of 2008 were within the stress loss scenarios reported to senior management.

The impact of market turmoil on market risk

The years preceding the current market turmoil were characterised by historically low levels of volatility, with ample market liquidity. This period was associated with falling levels of VAR as the level of observed market volatility is a key determinant in the VAR calculation. As a consequence HSBC reduced the overall VAR limit to reflect the lower level of volatility, and associated VAR.

The increase in market volatility experienced during the last six months of 2007 was most noticeable in the credit spreads of financial institutions and ABSs/MBSs. The increase in the volatility of credit spreads reflected the market's uncertainty of financial institutions exposure to the US sub-prime market, either directly or through structured products. This is discussed further in 'Credit spread risk' on page 186.

The tightening of both credit and liquidity within the wholesale markets prompted remedial action from the central banks, which included injecting liquidity into the wholesale markets and cutting rates. 

Credit spread volatility has continued to increase during 2008, and as the effect of the market turmoil on the wider economy has become more apparent, there has been a larger increase in the volatility of other risk types, such as interest rates.

Positions taken in anticipation of rate reductions led to an increase in the total VAR in early 2008. VAR continued to increase during the period as a result of higher volatility; however, the impact on VAR was limited as a result of a reduction in positions towards the end of the period (see 'Value at risk of the trading and non-trading portfolios' below).

The overall VAR limit for the Group remained unchanged from the level prior to the market turmoil, despite the increase in volatility. 

The following table provides an overview of the reporting of risks within this section:

	Portfolio
	Trading	Non-trading
	Portfolio
	Trading	Non-trading
Risk type
Foreign exchange	VAR	VAR1
Interest rate	VAR	VAR2
Commodity	VAR	N/A
Equity	VAR	Sensitivity
Credit spread	Sensitivity	Sensitivity3

1    The structural foreign exchange risk is monitored using sensitivity analysis.

2    The VAR for the fixed-rate securities issued by HSBC Holdings is not included within the Group VAR. See page 187. In addition, see Sensitivity of net interest income on page 188.

3    Credit spread VAR is reported for the credit derivatives transacted by Global Banking. See page 186.

Value at risk of the trading and non-trading portfolios

The VAR, both trading and non-trading, for the Group was as follows: 

Value at risk

	Half-year to
	30 June      2008		30 June     2007	31 December    2007
	US$m		US$m		US$m
At period end	144.2		84.2		70.1
Average	135.5		62.5		67.9
Minimum	59.8		43.8		57.3
Maximum	230.5		98.1		85.9

As a result of improvements in the Group VAR data collection process during 2008, all entities within the Group are now aggregated on a historical simulation basis, reflecting the full diversification effects across the Group's VAR. The 2007 VAR has been adjusted, reducing the total VAR by US$18.9 million as at 30 June 2007 and by US$25.2 million as at 31 December 2007. The maximum, minimum and average VARs have also been adjusted on a comparable basis in order to fairly present the trend.

The daily VAR, both trading and non-trading, for the Group was as follows:

Daily VAR (trading and non-trading) (US$m) 

The major contributor to the trading and non-trading VAR for the Group was Global Markets.

The histogram below illustrates the frequency of daily revenue arising from Global Markets' trading, balance sheet management and other trading activities.

The average daily revenue earned therefrom in the first half of 2008 was US$21.7 million, compared with US$26.3 million in the first half of 2007. The standard deviation of these daily revenues was US$48.3 million compared with US$17.8 million in the first half of 2007. The standard deviation measures the variation of daily revenues about the mean value of those revenues. 

An analysis of the frequency distribution of daily revenue shows that there were 33 days with negative revenue during the first half of 2008 compared with one day in the first half of 2007. The most frequent result was a daily revenue of between US$46 million and US$50 million with 8 occurrences. 

Daily distribution of Global Markets' trading, balance sheet management and other trading revenues1

Half-year to 30 June 2008

Number of days

Revenues (US$m)

 Profit and loss frequency

Half-year to 30 June 2007

Number of days

Revenues (US$m)

 Profit and loss frequency

Half-year to 31 December 2007

Number of days

Revenues (US$m)

 Profit and loss frequency

1    The effect of any month-end adjustments not attributable to a specific daily market move is spread evenly over the days in the month in question.

For a description of HSBC's fair value and price verification controls, see pages 129 to 137.

Trading portfolios

HSBC's control of market risk is based on a policy of restricting individual operations to trading within a list of permissible instruments authorised for each site by Traded Credit and Market Risk, of enforcing rigorous new product approval procedures, and of restricting trading in the more complex derivative products to offices with appropriate levels of product expertise and robust control systems.

Market making and proprietary position-taking is undertaken within Global Markets. The VAR 
for such trading activity at 30 June 2008 was US$37.0 million (30 June 2007: US$22.4 million; 31 December 2007: US$30.2 million). This is analysed below by risk type. 

VAR by risk type for the trading activities

	Foreign     exchange and     commodity		Interest     rate		Equity		Total
	US$m		US$m		US$m		US$m
At 30 June 2008	16.6		34.5		9.6		37.0
At 30 June 2007	9.7		20.5		7.6		22.4
At 31 December 2007	10.7		25.4		10.2		30.2
Average
First half of 2008	14.2		39.6		16.8		44.2
First half of 2007	9.8		20.3		7.3		21.4
Second half of 2007	9.2		25.4		8.5		25.9
Minimum
First half of 2008	8.7		21.4		9.2		23.7
First half of 2007	4.0		14.9		3.9		14.3
Second half of 2007	5.1		17.6		3.4		18.1
Maximum
First half of 2008	21.9		67.9		37.9		87.2
First half of 2007	23.0		26.8		12.4		31.7
Second half of 2007	13.6		36.1		15.1		38.8

The VAR for 2007 has been restated on the same basis as the Group VAR on page 185.

Credit spread risk

The risk associated with movements in credit spreads is primarily managed through sensitivity limits, stress testing and VAR on those portfolios where it is calculated.

The Group is introducing credit spread as a separate risk type within its VAR models and, at 30 June 2008, credit spread VAR was calculated for the London trading and New York credit derivatives portfolios. At 30 June 2008, the total VAR for the trading activities, including credit spread VAR for the above portfolios, was US$46.8 million (31 December 2007: US$39.8 million).

The sensitivity of trading income to the effect of movements in credit spreads on the total trading activities of the Group was US$188.1 million at 30 June 2008 (30 June 2007: US$18.5 million; 31 December 2007: US$95.4 million). This sensitivity was calculated using simplified assumptions based on one-day movements in average market credit spreads over a two-year period at a confidence level of 99 per cent. It should be noted that diversification effects with other risk types is likely to lead to a reduced impact on trading income.  

The increase in the sensitivity at 30 June 2008, compared with 30 June 2007 was mainly due to the effect of higher volatility in credit spreads.

Credit spread risk also arises on credit derivative transactions entered into by Global Banking in order to manage the risk concentrations within the corporate loan portfolio and so enhance capital efficiency. The mark-to-market of these transactions is taken through the income statement.

At 30 June 2008, the credit spread VAR on the credit derivatives transactions entered into by Global Banking was US$33.7 million (30 June 2007: US$4.8 million; 31 December 2007: US$19.7 million). The VAR shows the effect on trading income from a one-day movement in credit spreads over a two-year period, calculated to a 99 per cent confidence level.

Gap risk

Certain transactions are structured such that the risk to HSBC is negligible under a wide range of market conditions or events, but in which there exists a remote probability that a significant gap event could lead to loss. A gap event could be seen as a change in market price from one level to another with no trading opportunity in between, and where the price change breaches the threshold beyond which the risk profile changes from having no open risk to having full exposure to the underlying structure. Such movements may occur, for example, when there are adverse news announcements and the market for a specific investment becomes illiquid, making hedging impossible.

Given the characteristics of these transactions, they will make little or no contribution to VAR or to traditional market risk sensitivity measures. HSBC captures the risks for such transactions within its stress testing scenarios. Gap risk arising is monitored on an ongoing basis, and HSBC incurred no gap losses on such transactions in the first half of 2008.

ABSs/MBSs positions

The ABSs/MBSs exposures within the trading portfolios are managed within sensitivity and VAR limits, as described on page 249 in the Annual Report and Accounts 2007, and are included within the stress testing scenarios as described on page 184.

Non-trading portfolios

Interest rate risk in non-trading portfolios arises principally from mismatches between the future yield on assets and their funding cost, as a result of interest rate changes. Analysis of this risk is complicated by having to make assumptions on embedded optionality within certain product areas such as the incidence of mortgage prepayments, and from behavioural assumptions regarding the economic duration of liabilities which are contractually repayable on demand such as current accounts. The prospective change in future net interest income from non-trading portfolios will be reflected in the current realisable value of these positions, should they be sold or closed prior to maturity. In order to manage this risk optimally, market risk in non-trading portfolios is transferred to Global Markets or to separate books managed under the supervision of the local Asset and Liability Committee ('ALCO').

Once market risk has been consolidated in Global Markets or ALCO-managed books, the net exposure is typically managed through the use of interest rate swaps within agreed limits. The VAR for these portfolios is included within the Group VAR (see 'Value at risk of the trading and non-trading portfolios' above).

Credit spread risk

At 30 June 2008, the sensitivity of equity to the effect of movements in credit spreads on the Group's available-for-sale debt securities was US$345.1 million (30 June 2007: US$45.0 million; 31 December 2007: US$206.5 million). The sensitivity was calculated on the same basis as that applied to the trading portfolio. Including the gross exposure to the SIVs consolidated within HSBC's balance sheet the sensitivity increased to US$393.1 million (31 December 2007: US$279.8 million). This sensitivity was calculated, however, before taking account of any losses which would have been absorbed by the income note holders. At 30 June 2008, the income note holders would have absorbed the first US$1.2 billion of any losses incurred by the SIVs prior to HSBC incurring any.

The increase in this sensitivity at 30 June 2008, compared with 30 June 2007, was due to the effect of higher volatility in credit spreads.

Fixed-rate securities

Market risk also arises on fixed-rate securities issued by HSBC Holdings. These securities are issued to support long-term capital investments in subsidiaries and include non-cumulative preference shares, non-cumulative perpetual preferred securities and fixed-rate subordinated debt. The interest rate VAR for these capital instruments, which is not included within the Group VAR, was as follows:

Capital instruments VAR

	VAR
	US$m
At 30 June 2008	223.3
At 30 June 2007	61.8
At 31 December 2007	104.7
Average
First half of 2008	148.0
First half of 2007	67.8
Second half of 2007	83.7
Minimum
First half of 2008	101.8
First half of 2007	61.8
Second half of 2007	63.3
Maximum
First half of 2008	223.3
First half of 2007	72.0
Second half of 2007	105.4

The increase in the VAR is due to the issuance of fixed rate securities during the first half of 2008, coupled with an increase in market volatility.

Equity securities classified as available for sale

Market risk arises on equity securities held as available for sale. The fair value of these securities at 30 June 2008 was US$9.5 billion (30 June 2007: US$9.3 billion; 31 December 2007: US$12.6 billion), including private equity holdings of US$3.4 billion (30 June 2007: US$2.7 billion; 31 December 2007: US$3.2 billion). Investments in private equity are primarily made through managed funds that are subject to limits on the amount invested. Potential new commitments are subject to risk appraisal to ensure that industry and geographical concentrations remain within acceptable levels for the portfolio as a whole. Regular reviews are performed to substantiate the value of the investments within the portfolio. At 30 June 2008, funds typically invested for short-term cash management represented US$1.8 billion (30 June 2007: US$2.2 billion; 31 December 2007: US$3.1 billion), and investments held to facilitate ongoing business, such as holdings in government-sponsored enterprises and local stock exchanges, represented US$1.4 billion (30 June 2007: US$1.3 billion; 31 December 2007: US$1.7 billion). Other strategic investments represented US$2.9 billion at 30 June 2008 (30 June 2007: US$3.1 billion; 31 December 2007: US$4.6 billion). The fair value of the constituents of equity securities classified as available for sale can fluctuate considerably. A 10 per cent reduction in the value of the available-for-sale equities at 30 June 2008 would have reduced equity by US$0.9 billion (30 June 2007: US$0.9 billion; 31 December 2007: US$1.3 billion). For details of the impairment incurred on available-for-sale equity securities see 'Accounting policies' on page 116.

Defined benefit pension scheme

Market risk also arises within HSBC's defined benefit pension schemes to the extent that the obligations of the schemes are not fully matched by assets with determinable cash flows. Pension scheme obligations fluctuate with changes in long-term interest rates, inflation, salary levels and the longevity of scheme members. Pension scheme assets include equities and debt securities, the cash flows from which change as equity prices and interest rates vary. There are risks that market movements in equity prices and interest rates could result in asset values which are insufficient over time to cover the level of projected obligations and these, in turn, could increase with a rise in inflation and members living longer. Management, together with the trustees who act on behalf of the pension scheme beneficiaries, assess these risks using reports prepared by independent external actuaries and, where appropriate, adjust investment strategies and contribution levels accordingly. 

The present value of HSBC's defined benefit pension schemes' liabilities was US$32.3 billion at 30 June 2008, compared with US$31.0 billion at 30 June 2007 and US$32.4 billion at 31 December 2007. Assets of the defined benefit pension schemes at 30 June 2008 comprised 21 per cent equity investments (30 June 2007: 26 per cent; 31 December 2007: 26 per cent); 64 per cent debt securities (30 June 2007: 62 per cent; 31 December 2007: 62 per cent) and 15 per cent other (including property) (30 June 2007: 12 per cent; 31 December 2007: 12 per cent).

Sensitivity of net interest income

There have been no material changes since 31 December 2007 to HSBC's measurement and management of the sensitivity of net interest income to movements in interest rates.

A principal part of HSBC's management of market risk in non-trading portfolios is to monitor the sensitivity of projected net interest income under varying interest rate scenarios (simulation modelling). HSBC aims, through its management of market risk in non-trading portfolios, to mitigate the effect of prospective interest rate movements which could reduce future net interest income, while balancing the cost of such hedging activities on the current net revenue stream.

The table below sets out the effect on future net interest income of an incremental 25 basis points parallel rise or fall in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 July 2008. Assuming no management actions, a series of such rises would decrease planned net interest income for the 12 months to 30 June 2009 by US$610 million (to 31 December 2008: US$503 million), while a series of such falls would increase planned net interest income by US$430 million (to 31 December 2008: US$525 million). These figures incorporate the effect of any option features in the underlying exposures.

Instead of assuming that all interest rates move together, HSBC groups its interest rate exposures into blocs of currencies whose rates are considered likely to move together. The sensitivity of projected net interest income, on this basis, is as follows:

Sensitivity of projected net interest income

	US dollar     bloc		Rest of     Americas     bloc		Hong Kong     dollar     bloc		Rest of     Asia     bloc		Sterling     bloc		Euro     bloc		Total
	US$m		US$m		US$m		US$m		US$m		US$m		US$m
Change in July 2008 to June 2009 projected net interest income
+ 25 basis points shift in yield curves at the beginning of each quarter	(258)		82		(29)		128		(164)		(369)		(610)
- 25 basis points shift in yield curves at the beginning of each quarter	271		(95)		(155)		(113)		165		357		430
Change in January 2008 to December 2008 projected net interest income
+ 25 basis points shift in yield curves at the beginning of each quarter	(275)		96		9		77		(140)		(270)		(503)
- 25 basis points shift in yield curves at the beginning of each quarter	272		(95)		11		(65)		142		260		525

The interest rate sensitivities set out in the table above are illustrative only and are based on simplified scenarios. The figures represent the effect on projected net interest income of the pro forma movements of the yield curve based on the Group's current interest rate risk profile. This effect, however, does not incorporate actions that would be taken by Global Markets or in the business units to mitigate the effect of this interest rate risk. In reality, Global Markets proactively seeks to change the interest rate risk profile to minimise losses and optimise net revenues. The projections above also assume that interest rates of all maturities move by the same amount and, therefore, do not reflect the potential effect on net interest income of some rates changing while others remain unchanged. The projections take account of the effect on net interest income of anticipated differences in changes between interbank interest rates and interest rates linked to other bases (such as Central Bank rates or product rates for which the entity has discretion over the timing and extent of rate changes). The projections make other simplifying assumptions too, including that all positions run to maturity.

HSBC's core exposure to the effect of movements in interest rates on its net interest income arise from three areas: core deposit franchises, HSBC Finance and Global Markets. This is described more fully in the Annual Report and Accounts 2007.

The major driver of the changes in the sensitivity of projected net interest income from January 2008 to December 2008 and from July 2008 to June 2009 is growth in net trading assets, the funding for which is generally sourced from floating rate retail deposits and recorded in net interest income, but the income from which is recorded in net trading income, and an increased reduction in the net interest margin on the Group's core deposit base should interest rates fall, this is most significant in the Hong Kong dollar bloc. 

Projecting the movement in net interest income from prospective changes in interest rates entails a complex interaction of structural and managed exposures. In a rising rate environment, the most critical exposures are those managed within Global Markets.

Sensitivity of reported reserves to interest rate movements

			Impact in the preceding 6 months
	US$m		Maximum     US$m		Minimum     US$m
At 30 June 2008
+ 100 basis point parallel move in all yield curves	(2,179)		(2,519)		(1,737)
As a percentage of total shareholders' equity	(1.7%)		(2.0%)		(1.4%)
- 100 basis point parallel move in all yield curves	2,494		2,609		1,947
As a percentage of total shareholders' equity	2.0%		2.1%		1.5%
At 30 June 2007
+ 100 basis point parallel move in all yield curves	(1,713)		(1,713)		(1,519)
As a percentage of total shareholders' equity	(1.4%)		(1.4%)		(1.3%)
- 100 basis point parallel move in all yield curves	1,668		1,668		1,430
As a percentage of total shareholders' equity	1.4%		1.4%		1.2%
At 31 December 2007
+ 100 basis point parallel move in all yield curves	(1,737)		(1,738)		(1,565)
As a percentage of total shareholders' equity	(1.4%)		(1.4%)		(1.2%)
- 100 basis point parallel move in all yield curves	1,977		2,048		1,498
As a percentage of total shareholders' equity	1.5%		1.6%		1.2%

The sensitivities are illustrative only and are based on simplified scenarios. The table shows the potential sensitivity of reserves to valuation changes in available-for-sale portfolios and cash flow hedges following the pro forma movements in interest rates. These particular exposures form only a part of the Group's overall interest rate exposures. The accounting treatment under IFRSs of the Group's remaining interest rate exposures, while economically largely offsetting the exposures shown in the above table, does not require revaluation movements to go to reserves.

Structural foreign exchange exposures

Structural foreign exchange exposures represent net investments in subsidiaries, branches or associates, the functional currencies of which are currencies other than the US dollar. HSBC's policies and procedures for managing these exposures are described on page 256 in the Annual Report and Accounts 2007.

Operational risk

Operational risk is the risk of loss arising from fraud, unauthorised activities, error, omission, inefficiency, systems failure or external events. It is inherent in every business organisation and covers a wide spectrum of issues.

The Group's approach to the management of operational risk is described on page 260 in the Annual Report and Accounts 2007, and is summarised below: 

Operational risk is managed as an independent risk discipline within Group Risk. A Group Operational Risk function is responsible for establishing and maintaining the operational risk management framework and for monitoring the Group's operational risk profile. A Global Operational Risk and Controls Committee has been established, which reports to the Risk Management Meeting and meets quarterly to discuss key risk issues and review the effective implementation of the Group's operational risk management framework.

 

END

 

 

MSCQZLFBVVBEBBB