Annual Financial Report - 27 of 44

RNS Number : 1493A

HSBC Holdings PLC

27 March 2012

 



Capital

Capital overview ......................................................	211
Movement in risk-weighted assets in 2011 ...............	211
Movement in tier 1 capital in 2011 .........................	212
Future developments ................................................	212
Appendix to Capital .................................................	215

Our objective in the management of Group capital is to maintain efficient levels of well diversified and varied forms of capital to support our business strategy and meet our regulatory requirements.

Capital management

(Unaudited)

Our approach to capital management is driven by our strategic and organisational requirements, taking into account the regulatory, economic and commercial environment in which we operate. It is our objective to maintain a strong capital base to support the development of our business and to meet regulatory capital requirements at all times. To achieve this, our policy is to hold capital in a range of different forms and from diverse sources.

Capital measurement and allocation

(Unaudited)

The FSA supervises HSBC on a consolidated basis and therefore receives information on the capital adequacy of, and sets capital requirements for, the Group as a whole. Individual banking subsidiaries are directly regulated by their local banking supervisors, who set and monitor their capital adequacy requirements. We calculate capital at a Group level using the Basel II framework of the Basel Committee on Banking Supervision as implemented by the FSA.

A summary of our policies and practices regarding capital management, measurement and allocation is provided in the Appendix to Capital on page 215.

Capital overview

In 2011, there were no material changes to our capital policies except to reflect the introduction of the Capital Requirement Directive ('CRD') III regulations in the EU, commonly known as Basel 2.5, which increased the capital requirements for market risk and re-securitisations, with effect from 31 December 2011.

Capital ratios

(Unaudited)

	2011		2010
	%		%
Core tier 1 ratio ........	10.1		10.5
Tier 1 ratio ...............	11.5		12.1
Total capital ratio ....	14.1		15.2
Core tier 1 target range ........................	9.5 - 10.5

Eligibility requirements for non-equity instruments under Basel III rules have not been clearly defined in the UK. We therefore chose not to issue any such capital securities during 2011.

Risk-weighted assets by risk type

(Unaudited)

	2011		2010
	US$m		US$m
Credit risk .......................	958,189		890,696
Counterparty credit risk ..	53,792		50,175
Market risk .....................	73,177		38,679
Operational risk ..............	124,356		123,563
Total ..............................	1,209,514		1,103,113

Movement in risk-weighted assets in 2011

(Unaudited)

RWAs increased by US$106bn or 10% in 2011. Exchange rate differences caused a net reduction in RWAs of around US$9bn in the year, reflecting the strengthening of the US dollar against a range of currencies, mainly in the faster-growing markets, partly offset by the effect of the strengthening of the renminbi against the US dollar. The remaining increase in RWAs of US$115bn arose mainly in credit risk and market risk.

RWAs increased by approximately US$50bn as a result of the introduction of Basel 2.5, net of mitigating actions undertaken by management. Of this increase, around US$40bn was in market risk of which the largest component was stressed VAR. Higher risk weights on re-securitisations increased credit risk RWAs by around US$10bn, primarily impacting the GB&M legacy portfolios.

The increase in credit risk RWAs reflected growth in our global businesses. In the Rest of Asia-Pacific, trade finance and lending balances in our CMB business grew as we captured inbound and outbound trade flows and as demand for credit increased. RWAs were also affected by increases in loan balances in our mainland China associates. In Latin America a favourable economic environment drove growth in trade-related lending, increasing RWAs in CMB and GB&M. In Europe, our CMB business experienced growth in corporate lending in the UK and Continental Europe. 

In our RBWM business, the increase in mortgage origination in Hong Kong and the UK had only a marginal impact on RWAs, due to the low risk weight applicable to the residential mortgages. In our North America legacy retail business, we continued to run-off the CML portfolio. This was partially offset by the slow pace of recovery of the US economy and deterioration in the US housing market, resulting in increased average risk weights applicable to those portfolios. Our strategy of running down legacy RWAs continued in 2011 as we announced the sale of the Card and Retail Services business, which is expected to be completed

in the first half of 2012 subject to regulatory approval.

Source and application of tier 1 capital

	2011              US$m		2010               US$m
Movement in tier 1 capital
(Audited)
Opening core tier 1 capital ......................................................................................................	116,116		106,260
Contribution to core tier 1 capital from profit for the year .................................................	14,011		13,218
Consolidated profits attributable to shareholders of the parent company .............................	16,797		13,159
Removal of own credit spread net of tax .............................................................................	(2,786)		59
Net dividends ..........................................................................................................................	(5,271)		(3,827)
Dividends ............................................................................................................................	(7,501)		(6,350)
Add back: shares issued in lieu of dividends ...........................................................................	2,230		2,523
Decrease in goodwill and intangible assets deducted ..................................................................	582		679
Ordinary shares issued .............................................................................................................	96		180
Foreign currency translation differences ..................................................................................	(2,705)		(526)
Other, including regulatory adjustments ...................................................................................	(333)		132
Closing core tier 1 capital .......................................................................................................	122,496		116,116
Opening other tier 1 capital ....................................................................................................	17,063		15,897
Hybrid capital securities issued net of redemptions ..................................................................	-		2,368
Other, including regulatory adjustments ...................................................................................	31		(1,202)
Closing tier 1 capital ...............................................................................................................	139,590		133,179

Movement in tier 1 capital in 2011

(Audited)

We complied with the FSA's capital adequacy requirements throughout 2011 and 2010. Internal capital generation contributed US$8.7bn to core tier 1 capital, being profits attributable to shareholders of the parent company after regulatory adjustment for own credit spread, and net dividends. Foreign currency translation differences decreased core tier 1 capital by US$2.7bn due to the strengthening of the US dollar.

Future developments

(Unaudited)

The regulation and supervision of financial institutions continues to undergo significant change in response to the global financial crisis. In December 2010, the Basel Committee issued two documents: A global regulatory framework for more resilient banks and banking systems and International framework for liquidity risk measurement, standards and monitoring, which together are commonly referred to as 'Basel III'. In June 2011, the Basel Committee issued a revision to the former document setting out the finalised capital treatment for counterparty credit risk in bilateral trades.

The Basel III rules set out the minimum common equity tier 1 requirement of 4.5% and additional capital conservation buffer requirement of 2.5%, to be phased in sequentially from 1 January 2013, becoming fully effective on 1 January 2019. Any additional countercyclical capital buffer requirements will also be phased in, starting in 2016 to a maximum level of 2.5% effective on 1 January 2019, although individual jurisdictions may choose to implement larger countercyclical capital buffers. The leverage ratio will be subject to a supervisory monitoring period, which commenced on 1 January 2011, and a parallel run period which will run from 1 January 2013 until 1 January 2017. Further calibration of the leverage ratio will be carried out in the first half of 2017 with a view to migrating to a pillar 1 requirement from 1 January 2018.

In addition to the criteria detailed in the Basel III proposals, the Basel Committee issued further minimum requirements in January 2011 to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss. Instruments issued on or after 1 January 2013 may only be included in regulatory capital if the new requirements are met. The capital treatment of securities issued prior to this date will be phased out over a 10-year period commencing on 1 January 2013.

In July 2011, the European Commission published proposals for a new Regulation and Directive, known collectively as CRD IV, to give effect to the Basel III framework in the EU. The majority of the Basel III proposals are in the Regulation, removing national discretion, with the exception of countercyclical and capital conservation buffers which are in the Directive.

The Regulation additionally sets out provisions to harmonise regulatory and financial reporting in the EU. In December 2011, the EBA published a consultative document proposing measures to specify uniform formats, frequencies and dates of prudential reporting to the regulator. The new requirements are due to take effect as of 1 January 2013.

The CRD IV measures are subject to agreement by the European Parliament, the Council and EU member states.

In parallel with the Basel III proposals, the Basel Committee issued a consultative document in July 2011, Global systemically important banks: assessment methodology and the additional loss absorbency requirement. In November 2011, they published their rules and the Financial Stability Board ('FSB') issued the initial list of global systematically important banks ('G-SIBs'). This list, which includes HSBC alongside twenty-eight other major banks globally, will be re-assessed periodically through annual re-scoring of the individual banks and triennial review of the methodology.

The rules set out an indicator-based approach to G-SIBs assessment employing five broad categories: size, interconnectedness, lack of substitutability, cross-jurisdictional activity and complexity. The designated G-SIBs will be required to hold minimum additional common equity tier 1 capital of between 1% and 2.5%, depending on their relative systemic importance indicated by their assessed score. A further 1% charge may be applied to any bank which fails to make progress, or even regresses, in performance within the assessment categories. The requirements, initially for those banks identified in November 2014 as G‑SIBs, will be phased in from 1 January 2016, becoming fully effective on 1 January 2019. National regulators have discretion to introduce higher thresholds than these minima.

The above forms part of a broad mandate of the FSB to reduce the moral hazard of G-SIBs. A further exercise of this mandate was the FSB's own direct consultation of October 2011. This proposed introducing, over 2012-14, enhanced reporting by G‑SIBs to the Basel Committee centrally.

In September 2011, the ICB recommended measures on capital requirements for UK banking groups. For further details on these proposals see page 101. The requirements as set out above indicate the required regulatory common equity tier 1 ratio for a G-SIB may ultimately lie in the range of 8% to 12%.

Potential common equity tier 1 requirements from 1 January 2019

(Unaudited)

Minimum common equity tier 1                       4.5%

Capital conservation buffer                                              2.5%

Countercyclical capital buffer                           0 - 2.5%

G-SIB buffer                                                     1 - 2.5%

Against the backdrop of eurozone instability, on a temporary basis, the EBA recommends banks aim to reach a 9% core tier 1 ratio by the end of June 2012. We will continue to review our target core tier 1 ratio of 9.5% to 10.5% as the applicable regulatory capital requirements evolve over the period to 1 January 2019.

Impact of Basel III

(Unaudited)

In order to provide some insight into the possible effects of the Basel III rules on HSBC, we have estimated the Group's pro forma common equity tier 1 ratio on the basis of our interpretation of those rules applied to our position at 31 December 2011. 

The Basel III changes will be progressively phased in. The increased capital requirements which come into effect on 1 January 2013 are estimated to result in a common equity tier 1 ratio which is 100bps lower than the current core tier 1 ratio. Management actions, primarily the run-off of legacy positions including the US CML portfolio and the sale of the US Card and Retail Services portfolio, coupled with active management of the correlation trading portfolio, the market risk capital requirement and the counterparty capital risk requirement, will mitigate this by 110bps, more than offsetting the effect of these Basel III changes before taking account of any future retained earnings.

In addition to the impact on common equity tier 1 capital, tier 1 capital and tier 2 capital will also be affected by the derecognition of non-qualifying capital instruments. These changes will be phased in over 10 years from 1 January 2013, and will further reduce the tier 1 ratio by an estimated 10bps, and the total capital ratio by an estimated 50bps in 2013, excluding new issues of qualifying capital instruments.

The changes to capital deductions and regulatoryadjustments including deferred tax assets, material holdings, excess expected losses and unrealised losses on available-for-sale portfolios will be phased in over a five-year period starting on 1 January 2014.

Capital structure at 31 December

	2011		2010
	US$m		US$m
Composition of regulatory capital
(Audited)
Tier 1 capital
Shareholders' equity ................................................................................................................	154,148		142,746
Shareholders' equity per balance sheet1 ................................................................................	158,725		147,667
Preference share premium ...................................................................................................	(1,405)		(1,405)
Other equity instruments .....................................................................................................	(5,851)		(5,851)
Deconsolidation of special purpose entities2 ........................................................................	2,679		2,335
Non-controlling interests ........................................................................................................	3,963		3,917
Non-controlling interests per balance sheet .........................................................................	7,368		7,248
Preference share non-controlling interests ..........................................................................	(2,412)		(2,426)
Non-controlling interests transferred to tier 2 capital ..........................................................	(496)		(501)
Non-controlling interests in deconsolidated subsidiaries .......................................................	(497)		(404)
Regulatory adjustments to the accounting basis .......................................................................	(4,331)		1,794
Unrealised losses on available-for-sale debt securities3 ..........................................................	2,228		3,843
Own credit spread ................................................................................................................	(3,608)		(889)
Defined benefit pension fund adjustment4 ............................................................................	(368)		1,676
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities .................................................................................................	(2,678)		(3,121)
Cash flow hedging reserve ....................................................................................................	95		285
Deductions ..............................................................................................................................	(31,284)		(32,341)
Goodwill capitalised and intangible assets .............................................................................	(27,419)		(28,001)
50% of securitisation positions ............................................................................................	(1,207)		(1,467)
50% of tax credit adjustment for expected losses .................................................................	188		241
50% of excess of expected losses over impairment allowances ............................................	(2,846)		(3,114)
Core tier 1 capital ...............................................................................................................	122,496		116,116
Other tier 1 capital before deductions ......................................................................................	17,939		17,926
Preference share premium ...................................................................................................	1,405		1,405
Preference share non-controlling interests ..........................................................................	2,412		2,426
Hybrid capital securities .......................................................................................................	14,122		14,095
Deductions ..............................................................................................................................	(845)		(863)
Unconsolidated investments5 ...............................................................................................	(1,033)		(1,104)
50% of tax credit adjustment for expected losses .................................................................	188		241
Tier 1 capital ........................................................................................................................	139,590		133,179
Tier 2 capital
Total qualifying tier 2 capital before deductions ......................................................................	48,676		52,713
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities .................................................................................................	2,678		3,121
Collective impairment allowances6 ......................................................................................	2,660		3,109
Perpetual subordinated debt .................................................................................................	2,780		2,781
Term subordinated debt .......................................................................................................	40,258		43,402
Non-controlling interests in tier 2 capital ............................................................................	300		300
Total deductions other than from tier 1 capital .......................................................................	(17,932)		(18,337)
Unconsolidated investments5 ...............................................................................................	(13,868)		(13,744)
50% of securitisation positions ............................................................................................	(1,207)		(1,467)
50% of excess of expected losses over impairment allowances ............................................	(2,846)		(3,114)
Other deductions .................................................................................................................	(11)		(12)
Total regulatory capital ......................................................................................................	170,334		167,555

1  Includes externally verified profits for the year ended 31 December 2011.

2  Mainly comprises unrealised losses on available-for-sale debt securities within special purpose entities which are excluded from the regulatory consolidation.

3  Under FSA rules, unrealised gains/losses on debt securities net of tax must be excluded from capital resources.

4  Under FSA rules, any defined benefit asset is derecognised and a defined benefit liability may be substituted with the additional funding that will be paid into the relevant schemes over the following five-year period.

5  Mainly comprise investments in insurance entities.

6  Under FSA rules, collective impairment allowances on loan portfolios on the standardised approach are included in tier 2 capital.

Appendix to Capital Capital management and capital measurement and allocation

Capital management

(Audited)

Our policy on capital management is underpinned by a capital management framework, which enables us to manage our capital in a consistent manner. The framework, which is approved by the GMB annually, incorporates a number of different capital measures including market capitalisation, invested capital, economic capital and regulatory capital.

Capital measures

·  market capitalisation is the stock market value of the company;

·  invested capital is the equity capital invested in HSBC by our shareholders, adjusted for certain reserves and goodwill previously amortised or written off;

·  economic capital is the internally calculated capital requirement which we deem necessary to support the risks to which we are exposed; and

·  regulatory capital is the capital which we are required to hold in accordance with the rules established by the FSA for the consolidated Group and by our local regulators for individual Group companies.

The following risks managed through the capital management framework have been identified as material: credit, market, operational, interest rate risk in the banking book, pension fund, insurance and residual risks.

We incorporate stress testing in the capital management framework, because it is important in understanding the sensitivities of the core assumptions in our capital plans to the adverse effect of extreme but plausible events. Stress testing allows us to formulate our response, including risk mitigation actions, in advance of conditions starting to exhibit the stress scenarios identified. The actual market stresses which occurred throughout the financial system during recent years have been used to inform our capital planning process and further develop the stress scenarios we employ. In addition to our internal stress tests, others are carried out, both at the request of regulators and by the regulators themselves using their prescribed assumptions. We take into account the results of all such regulatory stress testing when undertaking our internal capital management assessment.

The responsibility for global capital allocation principles and decisions rests with the GMB. Through our structured internal governance processes, we maintain discipline over our investment and capital allocation decisions and seek to ensure that returns on investment are adequate after taking account of capital costs. Our strategy is to allocate capital to businesses on the basis of their economic profit generation, regulatory and economic capital requirements.

Our capital management process is articulated in the annual Group capital plan which is approved by the Board. The plan is drawn up with the objective of maintaining both an appropriate amount of capital and an optimal mix between the different components of capital. HSBC Holdings and its major subsidiaries raise non-equity tier 1 capital and subordinated debt in accordance with our guidelines on market and investor concentration, cost, market conditions, timing, capital composition and maturity profile. Each of our subsidiaries manages its own capital to support its planned business growth and meet its local regulatory requirements within the context of the approved annual Group capital plan. In accordance with our capital management framework, capital generated by subsidiaries in excess of planned requirements is returned to HSBC Holdings, normally by way of dividends.

HSBC Holdings is the primary provider of equity capital to its subsidiaries and also provides non-equity capital to subsidiaries where necessary. These investments are substantially funded by HSBC Holdings' own capital issuance and profit retention. As part of its capital management process, HSBC Holdings seeks to maintain a prudent balance between the composition of its capital and that of its investment in subsidiaries.

Capital measurement and allocation

(Unaudited)

Our policy and practice in capital measurement and allocation at Group level is underpinned by the Basel II framework. However, local regulators are at different stages of implementation and local reporting may still be on a Basel I basis, notably in the US. In most jurisdictions, non-banking financial subsidiaries are also subject to the supervision and capital requirements of local regulatory authorities.

Regulatory and accounting consolidations

The basis of consolidation for financial accounting purposes is described on page 292 and differs from that used for regulatory purposes. Investments in banking associates are equity accounted in the financial accounting consolidation, whereas their exposures are proportionally consolidated for regulatory purposes. Subsidiaries and associates engaged in insurance and non-financial activities are excluded from the regulatory consolidation and are deducted from regulatory capital. The regulatory consolidation does not include SPEs where significant risk has been transferred to third parties. Exposures to these SPEs are risk-weighted as securitisation positions for regulatory purposes.

Basel II is structured around three 'pillars': minimum capital requirements, supervisory review process and market discipline. The CRD implemented Basel II in the EU and the FSA then gave effect to the CRD by including the latter's requirements in its own rulebooks.

Regulatory capital

Our capital is divided into two tiers:

·     tier 1 capital is divided into core tier 1 and other tier 1 capital. Core tier 1 capital comprises shareholders' equity and related non-controlling interests. The book values of goodwill and intangible assets are deducted from core tier 1 capital and other regulatory adjustments are made for items reflected in shareholders' equity which are treated differently for the purposes of capital adequacy. Qualifying capital instruments such as non-cumulative perpetual preference shares and hybrid capital securities are included in other tier 1 capital; and

·     tier 2 capital comprises qualifying subordinated loan capital, related non-controlling interests, allowable collective impairment allowances and unrealised gains arising on the fair valuation of equity instruments held as available for sale. Tier 2 capital also includes reserves arising from the revaluation of properties.

To ensure the overall quality of the capital base, the FSA's rules set limits on the amount of hybrid capital instruments that can be included in tier 1 capital relative to core tier 1 capital, and also limits overall tier 2 capital to no more than tier 1 capital.

Pillar 1 capital requirements

Pillar 1 covers the capital resources requirements for credit risk, market risk and operational risk. Credit risk includes counterparty credit risk and securitisation requirements. These requirements are expressed in terms of RWAs.

Credit risk capital requirements

Basel II applies three approaches of increasing sophistication to the calculation of pillar 1 credit risk capital requirements. The most basic level, the standardised approach, requires banks to use external credit ratings to determine the risk weightings applied to rated counterparties and group other counterparties into broad categories and apply standardised risk weightings to these categories. The next level, the internal ratings-based ('IRB') foundation approach, allows banks to calculate their credit risk capital requirements on the basis of their internal assessment of the probability that a counterparty will default ('PD'), but subjects their quantified estimates of exposure at default ('EAD') and loss given default ('LGD') to standard supervisory parameters. Finally, the IRB advanced approach allows banks to use their own internal assessment in determining PD and quantifying EAD and LGD.

The capital resources requirement, which is intended to cover unexpected losses, is derived from a formula specified in the regulatory rules, which incorporates PD, LGD, EAD and other variables such as maturity and correlation. Expected losses under the IRB approaches are calculated by multiplying PD by EAD and LGD. Expected losses are deducted from capital to the extent that they exceed total accounting impairment allowances.

For credit risk we have adopted the IRB advanced approach for the majority of our business, with the remainder on either IRB foundation or standardised approaches.

Under our Basel II rollout plans, a number of our Group companies and portfolios are in transition to advanced IRB approaches. At end of 2011, portfolios in much of Europe, Hong Kong, Rest of Asia-Pacific and North America were on advanced IRB approaches. Others remain on the standardised or foundation approaches under Basel II, pending definition of local regulations or model approval, or under exemptions from IRB treatment.

·     Counterparty credit risk

Counterparty credit risk arises for OTC derivatives and securities financing transactions. It is calculated in both the trading and non-trading books and is the risk that the counterparty to a transaction may default before completing the satisfactory settlement of the transaction. Three approaches to calculating counterparty credit risk and determining exposure values are defined by Basel II: standardised, mark-to-market and internal model method. These exposure values are used to determine capital requirements under one of the credit risk approaches: standardised, IRB foundation and IRB advanced.

We use the mark-to-market and internal model method approaches for counterparty credit risk. Our longer-term aim is to migrate more positions from the mark-to-market to the internal model method approach.

·     Securitisation

Securitisation positions are held in both the trading and non-trading book. For non-trading book securitisation positions, Basel II specifies two methods for calculating credit risk requirements, these being the standardised and IRB approaches. Both approaches rely on the mapping of rating agency credit ratings to risk weights, which range between 7% and 1,250%. Positions that would otherwise be weighted at 1,250% are deducted from capital.

Within the IRB approach, we use the Ratings Based Method for the majority of our non-trading book securitisation positions, and the Internal Assessment Approach for unrated liquidity facilities and programme-wide enhancements for asset-backed securitisations.

Following the implementation of Basel 2.5, the majority of securitisation positions in the trading book are treated for capital purposes as if they are held in the non-trading book under the standardised or IRB approaches. Other traded securitisation positions, known as correlation trading, are treated under an internal model approach approved by the FSA.

Market risk capital requirement

The market risk capital requirement is measured using internal market risk models where approved by the FSA, or the FSA's standard rules. Following the implementation of Basel 2.5, our internal market risk models comprise VAR, stressed VAR, incremental risk charge and correlation trading under the comprehensive risk measure.

Operational risk capital requirement

Basel II includes a capital requirement for operational risk, again utilising three levels of sophistication. The capital required under the basic indicator approach is a simple percentage of gross revenues, whereas under the standardised approach it is one of three different percentages of gross revenues allocated to each of eight defined business lines. Both these approaches use an average of the last three financial years' revenues. Finally, the advanced measurement approach uses banks' own statistical analysis and modelling of operational risk data to determine capital requirements. We have adopted the standardised approach in determining our operational risk capital requirements.

Pillar 2 capital requirements

We conduct an Internal Capital Adequacy Assessment Process ('ICAAP') to determine a forward looking assessment of HSBC's capital requirements given its business strategy, risk profile, risk appetite and capital plan. This process incorporates the risk management processes and governance of the firm. A range of stress tests are applied to our base capital plan. These coupled with our economic capital framework and other risk management practices are used to assess HSBC's internal capital adequacy requirements.

The ICAAP is examined by the FSA as part of the FSA's Supervisory Review and Evaluation Process, which occurs periodically to enable the FSA to define the Individual Capital Guidance or minimum capital requirements for HSBC.

Pillar 3 disclosure requirements

Pillar 3 of Basel II is related to market discipline and aims to make firms more transparent by requiring them to publish specific, prescribed details of their risks, capital and risk management under the Basel II framework. Our Pillar 3 disclosures for the year ended 31 December 2011 are published as a separate document on the Group Investor Relations website.

 

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