Annual Financial Report - 26 of 56

RNS Number : 6288S

HSBC Holdings PLC

18 March 2016

 

Top and emerging risks

Our approach to identifying and monitoring top and emerging risks is described on page 103. Our current top and emerging risks are as follows:

Externally driven

·   Economic outlook and capital flows

·   Geopolitical risk

·   Turning of the credit cycle

·   Regulatory developments with adverse impact on business model and profitability

·   Regulatory focus on conduct of business and financial crime

·   Dispute risk

·   Regulatory commitments and consent orders

·   Cyber threat and unauthorised access to systems

Economic outlook and capital flows

Economic growth remained subdued in 2015, with a number of headwinds adversely affecting both developed and emerging market countries.

The slowdown of the mainland Chinese economy has dampened global trade flows and caused volatility in currency and global stock markets. Market concerns persist as to the scale of the slowdown and the potential for further depreciation of the renminbi and emerging market currencies.

Oil and gas prices fell further during 2015 and early 2016 as a result of continuing global supply and demand imbalances, raising the risk that any recovery in oil prices over the medium term will be even more gradual than currently expected. Although oil importers benefit from low prices, low oil prices increase fiscal and financing challenges for exporters and accentuate deflationary risks.

Emerging market economies have been affected by falling commodity prices, the economic slowdown in mainland China and a vulnerability to monetary policy normalisation in the US. This has led to steep depreciation in several key emerging market currencies against the US dollar and substantial capital outflows.

The economic recovery in the eurozone remains fragile, driven by a combination of low oil prices, a weak euro, slowing growth and loose monetary policy. Populist parties are in the ascendancy in several EU countries, helped by the subdued economic backdrop as well as other issues such as migration. A referendum on the UK's EU membership is expected to occur within the lifetime of the current Parliament, and may be held as early as mid-2016 (see 'Geopolitical risk' below). While the risk of Greece exiting the EU has faded, the implementation of required structural reforms could prove politically challenging.

Potential impact on HSBC

·   We earn a significant proportion of our profits from our operations in Asia. Our results could be adversely affected by a prolonged or severe slowdown in regional economic growth or contraction in global trade and capital flows as a consequence.

·   HSBC's results could be impacted by a prolonged period of low oil prices, particularly in conjunction with a low inflation environment and/or low or negative interest rates.

·   The intensification of fragmentation risks in the EU could have both political and economic consequences for Europe.

Mitigating actions

·   We closely monitor economic developments in key markets and sectors with the aim of ensuring trends are identified, the implications for specific customers, customer segments or portfolios are assessed, and appropriate mitigating action - which may include revising key risk appetite metrics or limits - is taken as circumstances evolve.

·   We use internal stress testing and scenario analysis as well as regulatory stress test programmes to evaluate the impact of macroeconomic shocks on our businesses and portfolios. Analyses undertaken on our oil and gas portfolio and mainland China exposures are discussed on page 117.

Geopolitical risk

Our operations and portfolios are exposed to risks arising from political instability, civil unrest and military conflict in many parts of the world.

In the Middle East, the intervention of Russia and the rise of the terrorist group, Daesh, have added to an already complex civil war in Syria and further destabilised Iraq. These are conflicts which show few signs of resolution. Daesh has proved capable of carrying out attacks in neighbouring countries and further afield. The lifting of sanctions following a deal between Iran and the five permanent members of the UN Security Council on the country's nuclear programme has done little to calm regional tensions.

Violence in Ukraine has abated but the conflict in the east of the country has not been resolved. Sanctions imposed by the US and EU against the Russian government, institutions and individuals have damaged the Russian economy.

European states are experiencing heightened political tension, reflecting concerns over migration, fears of terrorism and the possibility that the UK may vote to exit the EU following a referendum. An exit could have a significant impact on UK, European and global macroeconomic conditions, as well as substantial political ramifications.

In Asia, territorial disputes between Japan and China and other states have strained diplomatic relations and are testing the resolve of the US to defend freedom of navigation.

Potential impact on HSBC

·   Our results are subject to the risk of loss from physical conflicts or terrorist attacks, unfavourable political developments, currency fluctuations, social instability and changes in government policies in the jurisdictions in which we operate.

·   Physical conflicts or terrorist attacks could expose our staff to physical risk and/or result in physical damage to our assets and disruption to our operations.

·   The effect of a UK exit from the EU on HSBC would depend on the manner in which the exit occurs. A disorderly exit could force changes to HSBC's operating model, affect our ability to access ECB and high value euro payments, and affect our transaction volumes due to possible disruption to global trade flows.

Mitigating actions

·   We continuously monitor the geopolitical outlook, in particular in countries where we have material exposures and/or a physical presence.

·   Our internal credit risk ratings of sovereign counterparties take geopolitical factors into account and drive our appetite for conducting business in those countries. Where necessary, we adjust our country limits and exposures to reflect our risk appetite and mitigate risks as appropriate.

·   We run internal stress tests and scenario analyses, including reverse stress tests, on our portfolios that take into account geopolitical scenarios, such as conflicts in countries where we have a significant presence, or political developments that could disrupt our operations, including the potential effect of a UK exit on our business model.

Turning of the credit cycle

The long-anticipated move by the US Federal Reserve Board ('FRB') to raise interest rates and the slowdown in mainland China's economy, which is expected to continue, have increased risk aversion in global markets. This tendency has deepened since the turn of 2016, with market volatility increasing. In 2015, emerging markets experienced net capital outflows for the first time since 1988, with several major currencies at decade-plus lows against the US dollar and global corporate defaults rose to the highest since 2009. 2016 could see an intensification of these trends and the appearance of stress in a wide array of credit segments, particularly if monetary policy is tightened quickly, sentiment regarding China worsens and oil prices fail to recover. The combination of these factors with substantial amounts of external refinancing being due in emerging markets in 2016‑18 increases the risk of sharper and more protracted volatility.

Potential impact on HSBC

·   Impairment allowances or losses could begin to rise from their historical lows in 2014 and 2015 if the credit quality of our customers is affected by less favourable global economic conditions in some markets.

·   There may be impacts on the delinquency and losses in some portfolios which may be impacted by worsening macroeconomic conditions and their possible effects on particular geographies or industry sectors.

·   Particular portfolios such as oil and gas may come under particular strain which is partly cyclical and partly driven by geopolitical concerns.

Mitigating actions

·   We closely monitor economic developments in key markets and sectors, taking portfolio actions where necessary including enhanced monitoring or reducing limits and exposures.

·   We stress test those portfolios of particular concern to identify sensitivity to loss, with management actions taken to control appetite where necessary.

·   Where customers are either individually or collectively assessed, regular portfolio reviews are undertaken for sensitive portfolios to ensure that individual customer or portfolio risks are understood and that the level of facilities offered and our ability to manage through any downturn are appropriate.

Regulatory developments with adverse impact on business model and profitability 

Financial service providers continue to face stringent and costly regulatory and supervisory requirements, particularly in the areas of capital and liquidity management, conduct of business, financial crime, operational structures and the integrity of financial services delivery. Government intervention and control over financial institutions both on a sector-wide basis and individually, together with measures to reduce systemic risk, may significantly affect the competitive landscape locally, regionally and/or globally for some or all of the Group's businesses. These measures may be introduced with different, potentially conflicting requirements and to differing timetables by different regulatory regimes. Regulatory changes may affect our activities, both of the Group as a whole and of some or all of our principal subsidiaries. These changes include:

·   the UK's Financial Services (Banking Reform) Act 2013, which requires the ring-fencing of our UK retail banking activities from wholesale banking, together with the structural separation of other activities required by US legislation and rules (including the Volcker Rule implemented in December 2013 under the Dodd-Frank Act), and potential further changes under the European Commission's Banking Structural Reform Regulation which proposes similar structural reform for larger EU banks as well as structural changes in other jurisdictions;

·   revisions in the regime for the operation of capital markets, notably mandatory central clearing of over the counter ('OTC') derivatives and mandatory margin requirements for non-cleared derivatives under the Dodd-Frank Act, the EU's European Market Infrastructure Regulation ('EMIR') and similar local measures being progressed in Hong Kong, Singapore and Canada;

·   those arising from the Markets in Financial Instruments Regulation/Directive ('MiFID II'), which includes mandatory trading of derivatives on organised venues, enhanced transparency and reporting requirements, controls on high frequency and algorithmic trading, changes to the use of dealing commissions and potential future restrictions on the ability of non-EU Group companies to provide certain services to EU based clients. Aspects of MiFID II also further enhance protections for investors in line with many regulators' focus on the wider conduct of business and delivery of fair outcomes for customers;

·   changes aimed at promoting effective competition in the interests of consumers, including investigations ordered by the UK Competition and Markets Authority and work to increase competition more generally;

·   the recommendations arising out of the Final Report on the Fair and Effective Financial Markets Review undertaken by the Bank of England, which include changes to market conduct rules and forward looking supervision in the operation of wholesale financial markets in the UK;

·   continued focus in the UK and elsewhere on matters relating to management accountability, institutional culture, employee conduct and increased obligations on market abuse and whistleblowing. In the UK, this includes implementing the individual accountability regime and wider recommendations made by the Parliamentary Commission on Banking Standards and the activities of the Banking Standards Board;

·   the Basel Committee on Banking Supervision ('Basel Committee') initiatives to enhance the risk sensitivity and robustness of the standardised approaches, to minimise reliance on internal models, and to incorporate capital floors in the Basel capital framework;

·   the implementation of the Capital Requirements Directive ('CRD IV'), notably the UK application of the capital framework and its interaction with Pillar 2;

·   proposals from the Financial Stability Board for global systemically important banks ('G-SIB's) to hold minimum levels of capital and debt as total loss absorbing capacity ('TLAC'), together with the Bank of England's consultation on UK implementation of MREL (for further details, see 'Capital' on page 239);

·   requirements flowing from arrangements for the resolution strategy of the Group and its individual operating entities, which may have different effects in different countries; and

·   the continued risk of further changes to regulation relating to taxes affecting financial service providers, including financial transaction taxes and ongoing implementation of initiatives to share tax information such as the Common Reporting Standard introduced by the Organisation for Economic Co-operation and Development ('OECD').

Potential impact on HSBC

·   Proposed changes in and/or the implementation of regulations including mandatory central clearing of OTC derivatives, EMIR, ring-fencing and similar requirements, MiFID II, the Volcker Rule, recovery and resolution plans, tax information sharing initiatives and findings from competition orientated enquiries and investigations may affect the manner in which we conduct our activities and how the Group is structured.

·   Requirements for higher levels of capital or TLAC may increase the funding costs for the Group and reduce our return on equity.

·   Mandatory central clearing of OTC derivatives also brings new risks to HSBC in its role as a clearing member, as we will be required to underwrite losses incurred by central clearing counterparties from the default of other clearing members and their clients. Hence central clearing brings with it a new element of interconnectedness between clearing members and clients which we believe may increase rather than reduce our exposure to systemic risk.

·   Increased regulatory scrutiny of conduct of business and management accountability may affect the industry in areas such as employee recruitment and retention, product pricing and profitability in both retail and wholesale markets. HSBC's businesses may be affected by these developments.

·   These measures have the potential to increase our cost of doing business and curtail the types of business we can carry out, which may adversely affect future profitability.

Mitigating actions

·   We are engaged closely with governments and regulators in the countries in which we operate to help ensure that the new requirements are considered properly and can be implemented in an effective manner.

·   We have enhanced our governance around central clearing counterparties and appointed specialists to manage the associated liquidity and collateral risks.

·   We continue to enhance and strengthen governance and resourcing more generally around regulatory change management and the implementation of required measures to actively address this ongoing and significant agenda of regulatory change.

Regulatory focus on conduct of business and financial crime

Financial service providers are at risk of regulatory sanctions or fines related to conduct of business and financial crime. The incidence of regulatory proceedings against financial service firms has become more common-place and may increase in frequency due to increased media attention and higher expectations from prosecutors and the public, with a consequent increase also in civil litigation arising from or relating to issues which are subject to regulatory investigation, sanction or fine.

Regulators in the UK and other countries have continued to increase their focus on conduct matters relating to fair outcomes for customers and orderly and transparent operations in financial markets. For further details, see 'Compliance risk' on page 178.

Potential impact on HSBC

·   HSBC may face regulatory censure or sanctions including fines and/or be exposed to legal proceedings and litigation.

·   Regulators in the UK and other countries may identify future industry-wide mis-selling, market conduct or other issues that could affect the Group. This may lead from time to time to significant direct costs or liabilities and/or changes in the practices of such businesses. Also, decisions taken by the Financial Ombudsman Service in the UK (or similar overseas bodies) could, if applied to a wider class or grouping of customers, have a material adverse effect on the operating results, financial condition and prospects of the Group.

Mitigating actions

·   We have taken a number of steps including introduction of new global policies, enhancement to the product governance processes, establishment of a global conduct programme and review of sale processes and incentive schemes (see 'Compliance risk' on page 178).

US deferred prosecution agreement and related agreements and consent orders

An independent compliance monitor ('the Monitor') was appointed in 2013 under the 2012 agreements entered into with the US Department of Justice ('DoJ') and the UK Financial Conduct Authority ('FCA') to produce annual assessments of the effectiveness of our AML and sanctions compliance programme. Additionally, the Monitor is serving as HSBC's independent consultant under the consent order of the FRB. HSBC Bank USA is also subject to an agreement entered into with the Office of the Comptroller of the Currency ('OCC') in December 2012, the Gramm-Leach-Bliley Act Agreement and other consent orders. In January 2016, the Monitor delivered his second annual follow-up review report as required by the US DPA. The Monitor's report is discussed on page 116.

Potential impact on HSBC

·   The design and execution of AML and sanctions remediation plans are complex and require major investments in people, systems and other infrastructure. This complexity creates significant execution risk, which could affect our ability to effectively identify and manage financial crime risk and remedy AML and sanctions compliance deficiencies in a timely manner. This could, in turn, impact our ability to satisfy the Monitor or comply with the terms of the US DPA and related agreements and consent orders, and may require us to take additional remedial measures in the future.

·  
Under the terms of the US DPA, upon notice and an opportunity to be heard, the DoJ has sole discretion to determine whether HSBC has breached the US DPA. Potential consequences of breaching the US DPA could include the imposition of additional terms and conditions on HSBC, an extension of the agreement, including its monitorship, or the criminal prosecution of HSBC, which could, in turn, entail further financial penalties and collateral consequences.

·   Breach of the US DPA or related agreements and consent orders could have a material adverse effect on our business, financial condition and results of operations, including loss of business and withdrawal of funding, restrictions on performing dollar-clearing functions through HSBC Bank USA or revocation of bank licences. Even if we are not determined to have breached these agreements, but the agreements are amended or their terms extended, our business, reputation and brand could suffer materially.

Mitigating actions

·   We are continuing to take concerted action to remedy AML and sanctions compliance deficiencies and to implement Global Standards. We are also working to implement the agreed recommendations flowing from the Monitor's 2013 and 2014 reviews, and will implement the agreed recommendations from the 2015 review.

·   During 2015, we continued to make progress toward putting in place a robust and sustainable AML and sanctions compliance programme, including continuing to build a strong Financial Crime Compliance sub-function, rolling out improved systems and infrastructure to manage financial crime risk and improve transaction monitoring and enhancing internal audits.

Dispute risk 

HSBC is party to legal proceedings and regulatory matters in a number of jurisdictions arising out of its normal business operations. Further details are provided in Note 40 on the Financial Statements.

Potential impact on HSBC

·   Dispute risk may give rise to potential financial loss as well as significant reputational damage. This in turn could adversely affect customer, investor and other stakeholder confidence.

Mitigating actions

·   We continue to focus on identifying emerging regulatory and judicial trends, and sharing globally lessons learned in an effort to avoid or limit future litigation exposure and regulatory enforcement action.

·   We continue to review and enhance our financial crime and regulatory compliance controls and resources.

Cyber threat and unauthorised access to systems

Like other public and private organisations, we continue to be a target of cyber attacks which, in some cases, disrupt services including the availability of our external facing websites, compromise organisational and customer information or expose security weaknesses. Management of cyber risks is coming under increased regulatory scrutiny.

Potential impact on HSBC

·   A major cyber attack, which could result from unauthorised access to our systems, may result in financial loss as well as significant reputational damage which could adversely affect customer and investor confidence in HSBC. Any loss of customer data would also trigger regulatory breaches which could result in fines and penalties being incurred.

Mitigating actions

·   The security of our information and technology infrastructure is crucial for maintaining our banking applications and processes and protecting our customers and the HSBC brand. We continue to strengthen our ability to prevent, detect and respond to the ever-increasing and sophisticated threat of cyber attacks by enhancing our governance and controls framework and technology infrastructure, processes and controls.

·   We took part in the PRA's Cyber Vulnerability Testing exercise during 2015 and are making further enhancements to improve our resilience to, and ability to recover from, cyber attacks.

·   We have realigned the responsibilities and accountabilities for cyber and information risk management to align with the operational risk lines of defence operational model and instigated a number of security improvement programmes within IT.

Internally driven

·   People risk

·   Execution risk

·   Third-party risk management

·   Model risk

·   Data management

People risk

Significant demands continue to be placed on our staff. The cumulative workload arising from regulatory reform and remediation programmes together with those related to the delivery of our strategy is hugely consumptive of human resources, placing increasingly complex and conflicting demands on a workforce in a world where expertise is often in short supply and globally mobile.

Potential impact on HSBC

·   Changes in remuneration policy and practice resulting from CRD IV regulations, European Banking Authority ('EBA') Guidelines and PRA remuneration rules apply on a Group-wide basis for any material risk takers. This presents significant challenges for HSBC because a significant number of our material risk takers are based outside the EU.

·   The Senior Managers and Certification regimes and the related Rules of Conduct, which come into force in 2017 for other employees, set clear expectations of the accountabilities and behaviour of both senior and more junior employees.

·   Organisational changes to support the Group's strategy and/or implement regulatory reform programmes have the potential to lead to increased staff turnover.

Mitigating actions

·   The changes in remuneration under the CRD IV regulations, EBA guidelines and PRA remuneration rules have necessitated a review of our remuneration policy, especially the balance between fixed and variable pay, to ensure we can remain globally competitive on a total compensation basis and retain our key talent.

·   We continue to increase the level of specialist resource in key areas, and to engage with our regulators as they finalise new regulations.

·   Risks related to organisational change and disposals are subject to close management oversight, especially in those countries where staff turnover is particularly high.

Execution risk

Execution risk heightened during 2015 due to a number of factors. Significant programmes are under way to deliver nine business actions to capture value from our global presence, announced at the Investor Update in June 2015. These, along with the regulatory reform agenda and our commitments under the US DPA require the management of complex projects that are resource demanding and time sensitive. In addition, the risks arising from the disposal of our business in Brazil require careful management.

Potential impact on HSBC

·   Risks arising from the number, magnitude and complexity of projects underway to meet these demands may include financial losses, reputational damage or regulatory censure.

·   The potential risks of disposals include regulatory breaches, industrial action, loss of key personnel and interruption to systems and processes during business transformation. They can have both financial and reputational implications.

Mitigating actions

·   We have strengthened our prioritisation and governance processes for significant projects, which are monitored by the GMB.

·   We have invested in our project implementation and IT capabilities and increased our focus on resource management.

·   Risks relating to disposals are carefully assessed and monitored and are subject to close management oversight.

Third-party risk management

HSBC, in common with peers in the financial services industry, utilises third parties for the provision of a range of goods and services. Global regulators have raised concerns regarding the dependency on third parties, and expect firms to be able to demonstrate adequate control over the selection, governance and oversight of their third parties (including affiliates). Risks arising from the use of third-party service providers may be less transparent and therefore more challenging to manage or influence.

Potential impact on HSBC

·   Any deficiency in the management of third-party risk could affect our ability to meet strategic, regulatory and client expectations. This may lead to a range of consequences including regulatory censure, civil penalties or reputational damage.

Mitigating actions

·   HSBC is undertaking a multi-year strategic plan to enhance its third-party risk management capability. We are implementing a programme that will provide a holistic view of third-party risks. This will enable the consistent risk assessment of any third-party service against key criteria, along with the associated control monitoring, testing and assurance throughout the third-party lifecycle.

·   The Group's most critical third parties were identified and subjected to enhanced risk assessment, with remediation plans agreed where necessary. Plans are in place to extend the assessment to a broader group of third parties.

·   In addition, the highest priority third-party vendors in the US went through enhanced risk assessment with findings remediated in 2015. A risk monitoring solution was implemented for all vendors and a due diligence solution is in the process of being implemented.

Model risk

We use models for a range of purposes in managing our business, including regulatory and economic capital calculations, stress testing, credit approvals, pricing, financial crime and fraud risk management and financial reporting. Model risk is the potential for adverse consequences as a result of decisions based on incorrect model outputs and reports or the use of such information for purposes for which it was not designed. This risk can arise from models that are poorly developed, implemented or used, or from the modelled outcome being misunderstood and acted upon inappropriately by management. The regulatory environment and supervisory concerns over banks' use of internal models to determine regulatory capital is also considerable, and further contributes to model risk.

Potential impact on HSBC

·   HSBC could incur losses, be required to hold additional capital, fail to meet regulatory standards or incur higher operating expenses due to the use of inappropriate models or poor model risk management.

·   Supervisory concerns over the internal models and assumptions used by banks in the calculation of regulatory capital have led to the imposition of floors in risk weight and model parameters such as the loss given default. Such changes have the potential to increase our capital requirement and/or make it more volatile.

·   Our reputation may be questioned due to our inability to comply with specific modelling and model risk management requirements.

Mitigating actions

·   We have strengthened our model risk governance framework by establishing global model oversight committees and implementing policies and standards in accordance with key regulatory requirements.

·   We have strengthened our governance over the development, usage and validation of models including the creation of centralised global analytical functions with necessary subject-matter expertise.

·   We have hired additional subject matter experts as part of our independent model review function and empowered the function to ensure appropriate challenge and feedback are given to models prior to and as part of their ongoing use.

Data management

Regulators require more frequent and granular data submissions, which must be produced on a consistent, accurate and timely basis. As a G-SIB, HSBC must comply with the principles for effective risk data aggregation and risk reporting set out by the Basel Committee.

Potential impact on HSBC

·   Ineffective data management capabilities could impact our ability to aggregate and report complete, accurate and consistent data to regulators, investors and senior management on a timely basis.

·   Financial institutions that fail to meet their Basel Committee data obligations by the required deadline may face supervisory measures.

Mitigating actions

·   We have set a data strategy for the Group and defined Group-level principles, standards and policies to enable consistent data aggregation, reporting and management. We continue to focus on enhancing data governance, quality and architecture to support our objectives of ensuring reliability of information used in support of internal controls and external financial reporting.

·   A number of key initiatives and projects to implement our data strategy and work towards meeting our Basel Committee data obligations are in progress.

Areas of special interest

During 2015, we considered a number of particular areas because of the effect they may have on the Group. Whilst these areas may already have been identified in top and emerging risks, further details of the actions taken during the year are provided below.

Financial crime compliance and regulatory compliance

We continued to experience increased levels of compliance risk as regulators and other agencies pursued investigations into historical activities. Examples include continued engagement with respect to compliance with AML and sanctions law (historical investigations gave rise to the US DPA and related FCA Direction), on-going interaction with regulators relating to mis-selling of the PPI policies and allegations of pressure selling in the UK, investigations in relation to conduct in the foreign exchange market, and benchmark interest rate and commodity price setting. Details of these investigations and legal proceedings may be found in Note 40 on the Financial Statements. The work of the Monitor, who was appointed to assess the effectiveness of our AML and sanctions compliance programme, is discussed below.

The level of inherent compliance risk remained high in 2015 as the industry continued to experience greater regulatory scrutiny and heightened levels of regulatory oversight and supervision.

For further information about the Group's compliance risk management, see page 178.

The Monitor

Under the agreements entered into with the DoJ and the FCA in 2012, including the five-year US DPA, the Monitor was appointed to produce annual assessments of the effectiveness of the Group's AML and sanctions compliance programme.

In January 2016, the Monitor delivered his second annual follow-up review report based on various thematic and country reviews he had conducted over the course of 2015. In his report, the Monitor concluded that, in 2015, HSBC made progress in developing an effective and sustainable financial crime compliance programme. However, he expressed significant concerns about the pace of that progress, instances of potential financial crime and systems and controls deficiencies, whether HSBC is on track to meet its goal to the Monitor's satisfaction within the five-year period of the US DPA and, pending further review and discussion with HSBC, did not certify as to HSBC's implementation of and adherence to remedial measures specified in the US DPA. The 'US deferred prosecution agreement and related agreements and consent orders' are discussed in top and emerging risks on page 113.

Regulatory stress tests

Stress testing is an important tool for regulators to assess vulnerabilities in the banking sector and in individual banks, the results of which could have a significant effect on minimum capital requirements, risk and capital management practices and planned capital actions, including the payment of dividends, going forward.

We are subject to regulatory stress testing in many jurisdictions. These have increased both in frequency and in the granularity of information required by supervisors. They include the programmes of the Bank of England ('BoE'), the FRB, the OCC, the EBA and the Hong Kong Monetary Authority and other regulators. Assessment by regulators is on both quantitative and qualitative bases, the latter focusing on portfolio quality, data provision, stress testing capability, forward-looking capital management processes and internal management processes.

In 2015, the Group took part in the BoE's concurrent stress test exercise involving major UK banks. The 2015 stress scenario incorporates a global recession in which disinflationary pressures and weakening expectations of growth lead to diminished risk appetite, falling commodity prices and lower market liquidity. Several emerging economies are adversely affected, as is the eurozone, where the rate of deflation increases. The UK experiences a downturn as the global recession affects exports and as financial linkages and weaker confidence affects other parts of the economy.

Selected key economic variables for the BoE 2015 concurrent stress test, as specified by the BoE

		GDP             growth1	Unemploy-                 ment2	House    Price Index	Equity               prices3
		%	%	%	%
Hong Kong		(5.6)	5.8	40	65
China		1.7	-	35	-
UK		(3.1)	9.2	20	36

1   Worst quarter (percentage quarter on quarter - year earlier).

2   Peak percentage.

3   Price fall percentage (start to trough).

The results were published by the BoE alongside the Financial Stability Report on 1 December 2015. The stressed CET1 capital ratio of HSBC was deemed by the BoE to fall to a minimum of 7.7%, taking into account management mitigating actions accepted by the BoE for this exercise. This was above the hurdle ratio of 4.5% set for this exercise. The leverage ratio fell to a minimum of 3.7% after management actions, also above the minimum hurdle ratio of 3%.

HSBC North America Holdings Inc. ('HNAH') participated in the 2015 Comprehensive Capital Analysis and Review ('CCAR') and the annual Dodd-Frank Act Stress Test ('DFAST') programmes as required by the FRB. In addition, HSBC Bank USA N.A. ('HSBC Bank USA') participated in the OCC's 2015 DFAST programme. The CCAR and DFAST submissions were made on 5 January 2015 and their results publically disclosed on 5 March 2015. On 11 March 2015, HNAH received notice that the FRB did not object to its 2015 Capital Plan - a key component of the CCAR submission. Under DFAST, HNAH is also required to conduct a company-run mid-cycle stress test, the results of which were disclosed on 16 July 2015. Under this test HNAH maintained capital levels in excess of regulatory minimums; specifically, the stressed common equity tier 1 ratio fell to a minimum of 7.5% compared with a required level of 4.5%.

Other entities in the Group, including The Hongkong and Shanghai Banking Corporation Limited and HSBC Bank plc, continue to participate in regulatory stress tests conducted at a subsidiary level by local regulators.

In October 2015, the BoE published details of its medium-term approach to stress testing the UK banking system. Key features of the approach include an annual cyclical stress test and a biennial exploratory stress test, starting in 2017.

The EBA plan to conduct stress tests in 2016. Details of their proposed approach were published by them in November 2015.

Oil and gas prices

Oil and commodity prices have remained low since the middle of 2014 as a result of existing global supply and demand imbalances, with significant price declines in late 2015 and early 2016. Continued lower oil prices cause increased credit risks within oil-related industries together with fiscal and financing challenges for energy exporters.

The overall portfolio of exposures directly exposed to oil and gas companies had drawn risk exposures amounting to about $29bn (2014: $34bn) with sub-sectoral distributions as follows: integrated producers 48%, service companies 28%, pure producers 17% and infrastructure companies 7%.

The credit quality distribution of the oil and gas portfolio was as follows: 'strong' and 'good' categories made up 56% of the portfolio, 'satisfactory' 35%, 'sub-standard' 7% and 'impaired' 2%. The majority of the exposures were located in North America, Asia and Europe.

Oil and gas related counterparties have responded rapidly to the changing economic outlook, cutting back on capital expenditure as well as reducing operating expenses in order to manage cash flows and sustain profitability.

Large integrated producers remained resilient. Within the pure producers sector, the higher cost entities such as shale and oil sands producers showed more evidence of stress, resulting in credit grade deterioration. Similarly, service companies continued to be more vulnerable as producers curtailed capital expenditures.

Individually assessed loan impairment charges in 2015 remained contained at approximately $0.3bn. Oil prices are now predicted to remain lower for longer and the oil price recovery is dependent on the removal of the excess supply that currently exists in the market. In view of these factors collective allowances for exposures related to oil and gas were increased by $0.2bn at the end of the year. Total allowances in respect of the oil and gas portfolio were $0.6bn.

The sector remains under enhanced monitoring with risk appetite and new lending has been significantly curtailed.

Metals and mining

Metals prices declined during 2015 although the pace and extent of the price decline was more gradual than for oil and gas.

Precious metals, copper, nickel and zinc prices are generally forecast to improve slightly in 2016. The outlook for steel, aluminium and bulk metals is more negative due to a combination of oversupply and reduction in demand. The low oil and gas prices benefit most metals and mining customers given that they are large consumers of energy.

Our total drawn risk exposure to metals and mining was $18bn (steel and aluminium $9bn, copper, nickel and zinc $4bn, iron ore and metallurgical coal $3bn, precious metals $2bn). Individually assessed loan impairments were $0.1bn.

Given the pressures in metals prices the metals and mining sector is under heightened management review.

Mainland China exposures

Mainland China's economic growth rate slowed in 2014 and 2015 with a gross domestic product of 6.9% in 2015 compared with 7.3% in 2014 (2013: 7.7%). China's economic growth rate remains very strong when compared with developed western economies. Although the largest foreign bank in China, HSBC's overall lending market share is very small at about 0.2%. This allows us to be selective in our lending to mainland China-related exposures, targeting high quality lending centred around specific priority sectors. The portfolio has continued to perform well with loan impairment charges remaining at their existing low levels.

The total mainland China portfolio had drawn risk exposures of $143bn, of which $77bn was booked onshore, with the remainder mainly booked in Hong Kong. Retail lending amounted to $8bn, focused primarily on residential mortgages in selected geographical areas. Wholesale lending amounted to $135bn. 51% of the wholesale portfolio was corporate lending with 26% to banks and the remainder to China sovereign. The lending to banks was 99% investment grade. The corporate portfolio was also of high quality with 62% of the portfolio of investment grade. Only 2% of the corporate portfolio was rated substandard which compares favourably with the Group as a whole. The corporate portfolio was well diversified with less than 40% of lending to state owned enterprises. The corporate real estate portfolio amounted to about $15bn. This portfolio which is primarily focused on tier 1 and tier 2 cities and the Pearl River Delta, was managed carefully under a series of caps ensuring that the lending to this sector remained within our risk appetite.

Our resultant ability to be selective in our lending and apply our traditionally strong underwriting standards means we have a high quality portfolio which we would expect to be resilient even in a situation where mainland China's growth rate slows further.

 

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