Annual Financial Report - 29x of 48

RNS Number : 3843B

HSBC Holdings PLC

03 April 2013

 



Market risk

	Page		App1		Tables	Page
Market risk in 2012 ...................................	218
Overview of market risk in global businesses ..			265
Monitoring and limiting market risk exposures ...................................................................			265
Sensitivity analysis ....................................			266
Value at risk and stressed value at risk ............			266
Stress testing ..................................................			267
Trading and non-trading portfolios ..........	218				Types of risk by global business ....................................	218
					Overview of risk reporting ............................................	218
					Market risk linkages to the accounting balance sheet ...	219
Market risk reporting measures ......................	218
Value at risk of the trading and non-trading portfolios ...................................................	219				Trading and non-trading value at risk .........................	219
					Daily trading and non-trading VAR .............................	219
Trading portfolios .......................................	220		268
Value at risk of the trading portfolios .............	220				Trading value at risk ....................................................	220
					Daily VAR (trading portfolios) .....................................	220
					Daily revenue ..............................................................	220
					Daily distribution of Global Markets' trading and other trading revenues ......................................................	220
					VAR by risk type for trading activities ...........................	220
					Stressed value at risk (1-day equivalent) ......................	221
Stressed value at risk of the trading portfolio .	221
Gap risk .........................................................			268
ABS/MBS exposures .......................................			268
Non-trading portfolios ...............................	221		268
Value at risk of the non-trading portfolios .....	221				Non-trading value at risk .............................................	221
					Daily VAR (non-trading portfolios) ..............................	221
Credit spread risk for available-for-sale debt securities ....................................................	221		268
Equity securities classified as available for sale ...................................................................	222				Fair value of equity securities ......................................	222
Structural foreign exchange exposures ...	222		268
Non-trading interest rate risk ..................	222
Balance Sheet Management .....................	222				Analysis of third party assets in Balance Sheet Management ............................................................	223
Sensitivity of net interest income ............	223		269		Sensitivity of projected net interest income ...................	223
					Sensitivity of reported reserves to interest rate movements .................................................................................	224
Defined benefit pension schemes ............	224		269		HSBC's defined benefit pension schemes ......................	224
Additional market risk measures applicable only to the parent company	224		270
Foreign exchange risk ....................................	225				HSBC Holdings - foreign exchange VAR ......................	225
Sensitivity of net interest income ..................	225				Sensitivity of HSBC Holdings net interest income to interest rate movements ............................................	225
Interest rate repricing gap table .....................	226				Repricing gap analysis of HSBC Holdings ...................	226
1. Appendix to Risk - risk policies and practices.

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

There were no material changes to our policies and practices for the management of market risk in 2012.

A summary of our current policies and practices regarding market risk is provided in the Appendix to Risk on page 265.

Exposure to market risk

Exposure to market risk is separated into two portfolios:

·  Trading portfolios comprise positions arising from market-making and warehousing of customer-derived positions.

·  Non-trading portfolioscomprise positions that primarily arise from the interest rate management of our retail and commercial banking assets and liabilities, financial investments designated as available for sale and held to maturity, and exposures arising from our insurance operations (see page 239).

Monitoring and limiting market risk exposures

Our objective is to manage and control market risk exposures while maintaining a market profile consistent with our risk appetite.

We use a range of tools to monitor and limit market risk exposures, including:

·  sensitivity measures include sensitivity of net interest income and sensitivity for structural foreign exchange, which are used to monitor the market risk positions within each risk type;

·  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; and

·  in recognition of VAR's limitations we augment VAR with stress testing to evaluate the potential impact on portfolio values of more extreme, though plausible, events or movements in a set of financial variables. Examples of scenarios reflecting current market concerns are the slowdown of mainland China and the potential effects of a sovereign debt default, including its wider contagion effects.

Market risk in 2012

(Audited)

Some credit spread and interest rate exposures to sovereign borrowers were managed down during 2012 against the backdrop of continued concerns around eurozone sovereigns and financial institutions, the global economic slowdown and uncertainty about fiscal policy in the US. The second half of the year was characterised by

improved market sentiment, primarily because the ECB pledged to support the euro. This led to a more benign market environment and generally subdued volatilities of credit spreads and other market risk factors.

Trading and non-trading portfolios

(Audited)

The following tables provide an overview of the types of risks within the different global businesses.

Types of risk by global business

Risk types	Global businesses
Trading risk	GB&M including Balance
-  Foreign exchange	Sheet Management ('BSM')
and commodities
-  Interest rate
-  Equities
-  Credit spread
Non-trading risk	GB&M including BSM,
-  Foreign exchange (structural)	RBWM, CMB and GPB
-  Interest rate
-  Credit spread

The market risk for insurance operations is reported separately on page 239.

Market risk reporting measures

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

Overview of risk reporting

	Portfolio
	Trading		Non-trading
Risk type
Foreign exchange and commodity .....................	VAR		VAR
Interest rate ........................	VAR		VAR/   Sensitivity
Equity .................................	VAR		Sensitivity
Credit spread .......................	VAR		VAR
Structural foreign exchange .	n/a		Sensitivity

Structural foreign exchange risk is monitored using sensitivity analysis (see page 268). The reporting of commodity risk is consolidated with foreign exchange risk. There is no commodity risk in the non-trading portfolios. The interest rate risk on the fixed-rate securities issued by HSBC Holdings is not included in the Group VAR. The management of this risk is described on page 270.

Market risk linkages to the accounting balance sheet

Trading assets and liabilities The Group's trading assets and liabilities are in substantially all cases originated by GB&M. As described on page 393, the assets and liabilities are classified as held for trading if they have been acquired or incurred principally for the purpose of selling or repurchasing in the near term, or form part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent pattern of short-term profit-taking. These assets and liabilities are treated as traded risk for the purposes of market risk management, other than a limited number of exceptions, primarily in Global Banking where the short-term acquisition and disposal of the assets are linked to other non-trading related activities such as loan origination. Financial assets designated at fair value Financial assets designated at fair value within HSBC are predominantly held within the Insurance entities. The majority of these assets are linked to policyholder liabilities for either unit-linked or insurance and investment contracts with DPF. Further information in respect of these assets is given on page 393. The risks of these assets largely offset the market risk on the liabilities under the policyholder contracts, and are risk managed on a non-trading basis. Market risk for insurance operations is covered on page 239. Financial liabilities designated at fair value Financial liabilities designated at fair value within HSBC are primarily fixed-rate securities issued by HSBC entities for funding purposes. As described on page 393, an accounting mismatch would arise if the debt securities were accounted for at amortised cost because the derivatives which economically hedge market risks on the securities would be accounted for at fair value with changes recognised in the income statement. The market risks of these liabilities are treated as non-traded risk, the principal risks being interest rate and/or foreign exchange risks. We also incur liabilities to customers under investment contracts, where the liabilities on unit-linked contracts are based on the fair value of assets within the unit-linked funds. The exposures on these funds are treated as non-traded risk and the principal risks are those of the underlying assets in the funds. Derivative assets and liabilities As described in Note 19 on the Financial Statements HSBC undertakes derivative activity for three primary purposes; to

create risk management solutions for clients, to manage the portfolio risks arising from client business and to manage and hedge HSBC's own risks.  Most of HSBC's derivative exposures arise from sales and trading activities within GB&M and are treated as traded risk for market risk management purposes. Within derivative assets and liabilities there are portfolios of derivatives which are not risk managed on a trading intent basis and are treated as non-traded risk for VAR measurement purposes.  These arise when the derivative was entered into in order to manage risk arising from non-traded exposures. These include non-qualifying hedging derivatives, and derivatives qualifying for fair value and cash flow hedge accounting. The use of non-qualifying hedges whose primary risks relate to interest rate and foreign exchange exposure is described on page 397. Details of derivatives in fair value and cash flow hedge accounting relationships are given in Note 19 on the Financial Statements. HSBC's primary risks in respect of these instruments relate to interest rate and foreign exchange risks. Loans and advances to customers The primary risk on assets within loans and advances to customers is the credit risk of the borrower. The risk of these assets is treated as non-trading risk for market risk management purposes. Financial investments Financial investments include assets held on an available-for-sale and held-to-maturity basis. An analysis of the Group's holdings of these securities by accounting classification and issuer type is shown on page 457 and by business activity on page 20. The majority of these securities are mainly held within Balance Sheet Management in GB&M. The positions which are originated in order to manage structural interest rate and liquidity risk are treated as non-trading risk for the purposes of market risk management. Available-for-sale security holdings within insurance entities are treated as non-trading risk and are largely held to back non-linked insurance policyholder liabilities. Market risk for insurance operations is covered on page 239. The other main holdings of available-for-sale assets are the ABSs within GB&M's legacy credit business, which are treated as non-trading risk for market risk management purposes, the principal risk being the credit risk of the obligor. The Group's held-to-maturity securities are principally held within the Insurance business. Risks of held-to-maturity assets are treated as non-trading for risk management purposes.

Value at risk of the trading and non-trading portfolios

Our Group VAR, both trading and non-trading, was as tabulated below. For a description of HSBC's fair value and price verification controls, see page 438.

Trading and non-trading value at risk

(Audited)

	2012		2011
	US$m		US$m
At 31 December ..................	181.3		367.0
Average ...............................	244.4		301.6
Minimum ............................	163.8		231.5
Maximum ............................	383.9		404.3

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

(Unaudited)

The decrease of Group trading and non-trading VAR during 2012 was driven primarily by the reduced effect of credit spreads, as a result of subdued volatilities and lower credit spread baselines utilised in the VAR calculations.

For a description of the parameters used in calculating VAR, see the 'Appendix to Risk' on page 266.

Trading portfolios

(Audited)

Value at risk of the trading portfolios

Our Group trading VAR was as shown below:

Trading value at risk

	2012		2011
	US$m		US$m
At 31 December ..................	78.8		118.3
Average ...............................	74.2		101.8
Minimum ............................	47.3		62.2
Maximum ............................	130.9		143.9

Almost all trading VAR resides within Global Markets. The VAR for trading activity at 31 December 2012 was lower than at 31 December 2011 due primarily to the reduced contribution of credit spread exposures to sovereigns. This reduction was driven by positions being managed down, together with the lower credit spread volatilities and baselines in the VAR calculations.

We routinely validate the accuracy of our 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. We expect on average to see losses in excess of VAR 1% of the time over a one-year period. The actual number of losses in excess of VAR over this period can therefore be used to gauge how well the models are performing. In 2012, there were no exceptions at the Group level.

Daily VAR (trading portfolios) (US$m)		Daily revenue
(Unaudited)		(Unaudited)
		2012 2011 US$m US$m Average daily revenue ..............               31.8               27.3 Standard deviation48 .................               22.8               32.3 Ranges of most frequent -  daily revenues ...................        20 to 30        20 to 30              days               days -  daily occurrences ..............                  60                  41 Days of negative revenue .........                    8                  40
Daily distribution of Global Markets' trading and other trading revenues49 (Unaudited)
2012		2011
Number of days		Number of days
Revenues (US$m)		Revenues (US$m)
< Profit and loss frequency		< Profit and loss frequency

For footnotes, see page 249.

VAR by risk type for trading activities⁵⁰

(Audited)

	Foreign exchange and     commodity		Interest                 rate		Equity		Credit             spread		Portfolio diversification51		Total52
	US$m		US$m		US$m		US$m		US$m		US$m
At 31 December 2012 .	20.5		37.5		17.7		16.1		(12.9)		78.8
Average ........................	23.5		42.7		9.3		26.8		(28.1)		74.2
Minimum ......................	6.9		29.5		2.7		12.2		-		47.3
Maximum .....................	46.0		60.0		24.9		77.9		-		130.9

	Foreign    exchange and       commodity		Interest                  rate		Equity		Credit               spread		Portfolio diversification51		Total52
	US$m		US$m		US$m		US$m		US$m		US$m
At 31 December 2011 ...	18.6		49.4		7.4		75.2		(32.3)		118.3
Average ........................	16.8		54.2		8.0		57.3		(34.4)		101.8
Minimum ......................	7.6		30.1		2.5		34.7		-		62.2
Maximum .....................	31.9		80.2		17.2		103.2		-		143.9

For footnotes, see page 249.

Stressed value at risk of the trading portfolios

(Unaudited)

Stressed VAR is primarily used for regulatory capital purposes but is integrated into the risk management process to facilitate efficient capital management and to highlight potentially risky positions based on previous market volatility.

Our Group stressed VAR for trading portfolios was as follows:

Stressed value at risk (1-day equivalent)

(Unaudited)

	2012		2011
	US$m		US$m
At 31 December ..................	172.4		293.6

Stressed VAR for trading portfolios reduced primarily as a result of the de-risking of exposures to eurozone sovereigns and managing down of interest rate risks, together with the impact of lower credit spread levels on the VAR calculation.

Non-trading portfolios

(Audited)

Value at risk of the non-trading portfolios

Non-trading value at risk

	2012		2011
	US$m		US$m
At 31 December ..................	119.2		310.9
Average ...............................	197.9		244.2
Minimum ............................	118.1		182.2
Maximum ............................	322.5		354.8

The daily levels of non-trading VAR over the course of 2012 are set out in the graph below.

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

(Unaudited)

Most of the Group non-trading VAR relates to Balance Sheet Management ('BSM') or local treasury management functions. Contributions to Group non-trading VAR are driven by interest rates and credit spread risks arising from all global businesses as illustrated on page 265). The decrease of non-trading VAR during 2012 was due primarily to the reduced contribution of credit spread risks as a result of lower volatilities and credit spread baselines utilised in the VAR calculations. This movement includes the reduction in credit spread risks relating to the Group's holdings of available for sale debt securities (excluding those held in insurance operations), which is discussed further in the following section.

Non-trading VAR also includes the interest rate risk of non-trading financial instruments held by the global businesses and transferred into portfolios managed by Global Markets or local treasury functions. In measuring, monitoring and managing risk in our non-trading portfolios, VAR is just one of the tools used. The management of interest rate risk in the banking book is described further in 'Non-trading interest rate risk' below, including the role of Balance Sheet Management.

Non-trading VAR excludes equity risk on available for sale securities, structural foreign exchange risk, and interest rate risk on fixed rate securities issued by HSBC Holdings, the management of which is described in the relevant sections below. These sections together describe the scope of HSBC's management of market risks in non-trading books.

Credit spread risk for available-for-sale debt securities

Credit spread VAR for available-for-sale debt securities, excluding those held in insurance operations, is included in the Group non‑trading VAR.

At 31 December 2012, the sensitivity of equity capital to the effect of movements in credit spreads on our available-for-sale debt securities, including the gross exposure for the SICs consolidated within our balance sheet, based on credit spread VAR, was US$150m (2011: US$389m). This sensitivity was calculated before taking into account losses which would have been absorbed by the capital note holders. Excluding the gross exposure for SICs consolidated in our balance sheet, this exposure reduced to US$119m (2011: US$325m).

The decrease in this sensitivity at 31 December 2012 compared with 31 December 2011 was due mainly to the effect of the lower volatility in credit spreads observed during 2012.

At 31 December 2012, the capital note holders would absorb the first US$2.3bn (2011: US$2.3bn) of any losses incurred by the SICs before we incur any equity losses.

Equity securities classified as available for sale

Fair value of equity securities

(Audited)

	2012		2011
	US$bn		US$bn
Private equity holdings53 ........	2.9		3.0
Funds invested for short-term cash management ...............	0.2		0.2
Investment to facilitate ongoing business54 ..............	1.1		1.1
Other strategic investments ...	1.6		2.9
	5.8		7.2

For footnotes, see page 249.

The fair value of the constituents of equity securities classified as available for sale can fluctuate considerably. The table above sets out maximum possible loss on shareholder's equity from available-for-sale equity securities.

For details of the impairment incurred on available-for-sale equity securities, see 'Securitisation exposures and other structured products' on page 184.

Structural foreign exchange exposures

(Unaudited)

Our policies and procedures for managing structural foreign exchange exposures are described on page 268. For details of structural foreign exchange exposures see Note 35 on the Financial Statements.

Non-trading interest rate risk

(Unaudited)

Asset, Liability and Capital Management ('ALCM') is responsible for measuring and controlling non-trading interest rate risk under the supervision of the Risk Management Meeting ('RMM'). Its primary responsibilities are:

·     to define the rules governing the transfer of interest rate risk from the global businesses to BSM;

·     to ensure that all market interest rate risk that can be hedged is transferred from the global businesses to BSM; and

·     to define the rules and metrics for monitoring the residual interest rate risk in the global businesses.

The different types of non-trading interest rate risk and the controls which we use to quantify and limit exposure to these risks can be categorised as follows:

·     risk which is transferred to BSM and managed by BSM within a defined risk mandate (see below);

·     risk which remains outside BSM because it cannot be hedged or which arises due to our behaviouralised transfer pricing assumptions. This risk is captured by our net interest income or Economic Value of Equity ('EVE') sensitivity and corresponding limits are part of our global and regional risk appetite statements for non-trading interest rate risk. A typical example would be margin compression created by unusually low rates in key currencies;

·     basis risk which is transferred to BSM when it can be hedged. Any residual basis risk remaining in the global businesses is reported to ALCO. A typical example would be a managed rate savings product transfer-priced using a Libor-based interest rate curve; and

·     model risks which cannot be captured by net interest income or EVE sensitivity, but are controlled by our stress testing framework. A typical example would be prepayment risk on residential mortgages or pipeline risk.

Balance Sheet Management

(Unaudited)

Effective governance across BSM is supported by the dual reporting lines it has to the CEO of GB&M and to the Group Treasurer. In each operating entity, BSM is responsible for managing liquidity and funding under the supervision of the local ALCO. It also manages the non-trading interest rate positions transferred to it within a Global Markets limit structure.

BSM reinvests excess liquidity into highly-rated liquid assets. The majority of the liquidity is invested in central bank deposits and government, supranational and agency securities with most of

the remainder held in short-term interbank and central bank loans.

Analysis of third party assets in Balance Sheet Management

(Unaudited)

	At 31 December 2012
	US$m
Cash and balances at central banks ........	93,946
Trading assets .......................................	8,724
Financial assets designated at fair value .	74
Loans and advances:
- to banks .............................................	72,771
- to customers ......................................	22,052
Financial investments ...........................	293,421
Other ....................................................	2,948
	493,936

Central bank deposits are accounted for as cash balances. Interbank loans and loans to central banks are accounted for as loans and advances to banks. BSM's holdings of securities are accounted for as available-for-sale or to a lesser extent, held to maturity assets.

BSM is permitted to use derivatives as part of its mandate to manage interest rate risk. Derivative activity is predominantly through the use of vanilla interest rate swaps which are part of cash flow hedging and fair value hedging relationships.

Credit risk in BSM is predominantly limited to short-term bank exposure created by interbank lending and exposure to central banks as well as high quality sovereigns, supranationals or agencies which constitute the majority of BSM's liquidity portfolio. BSM does not manage the structural credit risk of any Group entity balance sheets.

BSM is permitted to enter into single name and index credit derivatives activity, but it does so to manage credit risk on the exposure specific to its securities portfolio in limited circumstances only. The risk limits are extremely limited and closely monitored. At 31 December 2012 and 31 December 2011 BSM had no open credit derivative index risk.

VAR is calculated on both trading and non-trading positions held in BSM. It is calculated by applying the same methodology used for the Global Markets business and utilised as a tool for market risk control purposes.

BSM holds trading portfolio instruments in only very limited circumstances. Positions and the associated VAR were not significant during 2012 and 2011.

Sensitivity of net interest income

(Unaudited)

The table below sets out the effect on our 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 January 2013. Assuming no management actions, a sequence of such rises would increase planned net interest income for 2013 by US$1,391m (2012: US$1,571m), while a sequence of such falls would decrease planned net interest income by US$1,471m (2012: US$1,909m). These figures incorporate the effect of any option features in the underlying exposures.

Sensitivity of projected net interest income⁵⁵

(Unaudited)

	US dollar            bloc         US$m		Rest of   Americas            bloc         US$m		Hong Kong         dollar            bloc         US$m		Rest of            Asia            bloc         US$m		Sterling            bloc         US$m		Euro            bloc         US$m		Total         US$m
Change in 2013 projected net interest income arising from a shift in yield curves of:
+25 basis points at the beginning of each quarter ..	133		64		246		237		679		44		1,403
-25 basis points at the beginning of each quarter ..	(366)		(52)		(305)		(168)		(602)		(57)		(1,550)
Change in 2012 projected net interest income arising from a shift in yield curves of:
+25 basis points at the beginning of each quarter ..	209		62		263		232		729		76		1,571
-25 basis points at the beginning of each quarter ..	(465)		(59)		(443)		(166)		(708)		(68)		(1,909)

For footnote, see page 249.

The interest rate sensitivities set out above are illustrative only and are based on simplified scenarios. The limitations of this analysis are discussed in the Appendix to Risk on page 269.

The year-on-year change in the sensitivity of the Group's net interest income to the change in rates shown in the table above is largely driven by lower implied yield curves, reducing the capacity to shock interest rates down. Net interest income and its associated sensitivity as reflected in the table above include the expense of internally funding trading

assets, while related revenue is reported in 'Net trading income'.

We monitor the sensitivity of reported reserves to interest rate movements on a monthly basis by assessing the expected reduction in valuation of available-for-sale portfolios and cash flow hedges due to parallel movements of plus or minus 100bps in all yield curves. The table below describes the sensitivity of our reported reserves to these movements and the maximum and minimum month‑end figures during the year:

Sensitivity of reported reserves to interest rate movements

(Unaudited)

	US$m		Maximum impact US$m		Minimum impact US$m
At 31 December 2012
+ 100 basis point parallel move in all yield curves ........................................	(5,602)		(5,748)		(5,166)
As a percentage of total shareholders' equity ................................................	(3.2%)		(3.3%)		(2.9%)
- 100 basis point parallel move in all yield curves ........................................	4,996		5,418		4,734
As a percentage of total shareholders' equity ................................................	2.9%		3.1%		2.7%
At 31 December 2011
+ 100 basis point parallel move in all yield curves ........................................	(5,594)		(6,178)		(5,594)
As a percentage of total shareholders' equity ................................................	(3.5%)		(3.9%)		(3.5%)
- 100 basis point parallel move in all yield curves ........................................	5,397		6,411		5,397
As a percentage of total shareholders' equity ................................................	3.4%		4.0%		3.4%

The sensitivities above are illustrative only and are based on simplified scenarios. The table shows the potential sensitivity of reported reserves to valuation changes in available-for-sale portfolios and from cash flow hedges following the specified shifts in yield curves. These particular exposures form only a part of our overall interest rate exposures. The accounting treatment of our remaining interest rate exposures, while economically largely offsetting the exposures shown in the above table, does not require revaluation movements to go to reserves.

Defined benefit pension schemes

(Audited)

Market risk arises within our defined benefit pension schemes to the extent that the obligations of the schemes are not fully matched by assets with determinable cash flows.

HSBC's defined benefit pension schemes

(Audited)

	2012		2011
	US$bn		US$bn
Liabilities (present value) ....	38.1		35.0
	%		%
Assets:
Equities ...............................	18		15
Debt securities .....................	71		73
Other (including property) ..	11		12
	100		100

For details of our defined benefit schemes, see Note 7 on the Financial Statements, and for pension risk management, see page 269.

Additional market risk measures applicable only to the parent company

(Audited)

The principal tools used in the management of market risk are VAR for foreign exchange rate risk, and the projected sensitivity of HSBC Holdings' net interest income to future changes in yield curves and interest rate gap re-pricing tables for interest rate risk.

Foreign exchange risk

Total foreign exchange VAR arising within HSBC Holdings in 2012 was as follows:

HSBC Holdings - foreign exchange VAR

(Audited)

	2012      US$m		2011       US$m
At 31 December ........................	69.9		47.7
Average .....................................	51.4		43.3
Minimum ...................................	39.2		38.2
Maximum ..................................	69.9		48.3

The foreign exchange risk largely arises from loans to subsidiaries of a capital nature that are not denominated in the functional currency of either the provider or the recipient and which are accounted for as financial assets. Changes in the carrying amount of these loans due to foreign exchange rate differences are taken directly to HSBC Holdings' income statement. These loans, and most of the associated foreign exchange exposures, are eliminated on a Group consolidated basis.

Sensitivity of net interest income

(Audited)

HSBC Holdings monitors net interest income sensitivity over a 5-year time horizon reflecting the longer-term perspective on interest rate risk management appropriate to a financial services holding company. The table below sets out the effect on HSBC Holdings' future net interest income over a 5-year time horizon of incremental 25 basis point parallel falls or rises in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 January 2013.

Assuming no management actions, a sequence of such rises would increase planned net interest income for the next five years by US$532m (2011: decrease of US$269m), while a sequence of such falls would decrease planned net interest income by US$329m (2011: increase of US$248m). These figures incorporate the effect of any option features in the underlying exposures.

Sensitivity of HSBC Holdings' net interest income to interest rate movements⁵⁵

(Audited)

	US dollar                 bloc		Sterling                 bloc		Euro                 bloc		Total
	US$m		US$m		US$m		US$m
Change in projected net interest income as at 31 December  arising from a shift in yield curves
2012
of + 25 basis points at the beginning of each quarter
0-1 year .....................................................................	83		(23)		4		64
2-3 years ....................................................................	303		(108)		37		232
4-5 years ....................................................................	319		(120)		37		236
of - 25 basis points at the beginning of each quarter
0-1 year .....................................................................	(34)		21		(2)		(15)
2-3 years ....................................................................	(139)		65		(17)		(91)
4-5 years ....................................................................	(306)		118		(35)		(223)
Change in projected net interest income as at 31 December  arising from a shift in yield curves
2011
of + 25 basis points at the beginning of each quarter
0-1 year .....................................................................	(13)		11		4		2
2-3 years ....................................................................	(161)		33		33		(95)
4-5 years ....................................................................	(244)		21		47		(176)
of - 25 basis points at the beginning of each quarter
0-1 year .....................................................................	14		(11)		(4)		(1)
2-3 years ....................................................................	127		(27)		(27)		73
4-5 years ....................................................................	244		(21)		(47)		176

For footnote, see page 249.

The interest rate sensitivities tabulated above are illustrative only and are based on simplified scenarios. The figures represent hypothetical movements in net interest income based on our projected yield curve scenarios, HSBC Holdings' current interest rate risk profile and assumed changes to that profile during the next five years. The main driver of the change in the US dollar projected net interest income sensitivity was a change in the assumptions for projected capital funding. The change to the GBP projected net interest income sensitivity was caused by changes in the composition of HSBC Holdings' investments. Changes to assumptions concerning the risk profile over the next five years

can have a significant impact on the net interest income sensitivity for that period. However, the figures do not take into account the effect of actions that could be taken to mitigate this interest rate risk.

Interest rate repricing gap table

The interest rate risk on the fixed-rate securities issued by HSBC Holdings is not included within the Group VAR but is managed on a repricing gap basis. The interest rate repricing gap table below analyses the full-term structure of interest rate mismatches within HSBC Holdings' balance sheet.

Repricing gap analysis of HSBC Holdings

(Audited)

	Total		Up to         1 year		Between       1 and 5          years		Between     5 and 10          years		More than     10 years	Non-interest       bearing
	US$m		US$m		US$m		US$m		US$m		US$m
At 31 December 2012
Cash at bank and in hand:
- balances with HSBC undertakings ..........	353		312		-		-		-		41
Derivatives ..................................................	3,768		-		-		-		-		3,768
Loans and advances to HSBC undertakings ..	41,675		38,473		-		1,477		630		1,095
Financial investments ..................................	1,208		-		300		731		-		177
Investments in subsidiaries ...........................	92,234		-		-		-		-		92,234
Other assets .................................................	246		-		-		-		-		246
Total assets .................................................	139,484		38,785		300		2,208		630		97,561
Amounts owed to HSBC undertakings ..........	(12,856)		(12,259)		-		-		-		(597)
Financial liabilities designated at fair values .	(23,195)		(1,654)		(6,334)		(7,708)		(4,301)		(3,198)
Derivatives ..................................................	(760)		-		-		-		-		(760)
Debt securities in issue .................................	(2,691)		-		(1,648)		-		(1,051)		8
Other liabilities ............................................	(1,048)		-		-		-		-		(1,048)
Subordinated liabilities .................................	(11,907)		-		(808)		(2,110)		(8,828)		(161)
Total equity .................................................	(87,027)		-		-		-		-		(87,027)
Total liabilities and equity ............................	(139,484)		(13,913)		(8,790)		(9,818)		(14,180)		(92,783)
Off-balance sheet items attracting interest rate sensitivity .........................................	-		(18,583)		6,348		7,341		4,325		569
Net interest rate risk gap .............................	-		6,289		(2,142)		(269)		(9,225)		5,347
Cumulative interest rate gap ........................	-		6,289		4,147		3,878		(5,347)		-
At 31 December 2011
Cash at bank and in hand:
- balances with HSBC undertakings ..........	316		280		-		-		-		36
Derivatives ..................................................	3,568		-		-		-		-		3,568
Loans and advances to HSBC undertakings ..	28,048		25,373		1,175		279		603		618
Financial investments ..................................	1,078		-		300		731		-		47
Investments in subsidiaries ...........................	90,621		-		-		-		-		90,621
Other assets .................................................	231		-		-		-		-		231
Total assets .................................................	123,862		25,653		1,475		1,010		603		95,121
Amounts owed to HSBC undertakings ..........	(2,479)		(2,260)		-		-		-		(219)
Financial liabilities designated at fair values .	(21,151)		(2,694)		(6,423)		(6,157)		(5,156)		(721)
Derivatives ..................................................	(1,067)		-		-		-		-		(1,067)
Debt securities in issue .................................	(2,613)		-		(1,617)		-		(1,006)		10
Other liabilities ............................................	(1,919)		-		-		-		-		(1,919)
Subordinated liabilities .................................	(12,450)		(776)		(774)		(2,070)		(8,671)		(159)
Total equity .................................................	(82,183)		-		-		-		-		(82,183)
Total liabilities and equity ............................	(123,862)		(5,730)		(8,814)		(8,227)		(14,833)		(86,258)
Off-balance sheet items attracting interest rate sensitivity .........................................	-		(17,945)		6,405		5,749		5,048		743
	-
Net interest rate risk gap .............................	-		1,978		(934)		(1,468)		(9,182)		(9,606)
	-
Cumulative interest rate gap ........................	-		1,978		1,044		(424)		(9,606)		-

Operational risk

(Unaudited)

	Page		App1		Tables	Page
Operational risk ..........................................			270
Operational risk management framework	227				Three lines of defence ..................................................	227
					Operational risk management framework ....................	228
Operational risk in 2012 ............................	228
Frequency and amount of operational risk losses	229				Frequency of operational risk incidents by risk category .....................................................................................	229
					Distribution of operational risk losses in US dollars by risk category ................................................................	230
Compliance risk ..........................................	230		271
Legal risk .....................................................			271
Global security and fraud risk ...................			271
Systems risk .................................................			272
Vendor risk management ...........................			272
Fiduciary risk ...............................................	231		273
1      Appendix to Risk - risk policies and practices.

Operational risk is relevant to every aspect of our business, and covers a wide spectrum of issues, in particular legal, compliance, security and fraud. Losses arising from breaches of regulation and law, unauthorised activities, error, omission, inefficiency, fraud, systems failure or external events all fall within the definition of operational risk.

We continued to enhance our operational risk management framework ('ORMF') policies and procedures in 2012, including the implementation of a top risk analysis process to improve the quantification and management of material risks through scenario analysis. This provides a top down, forward-looking view of risks to help determine whether they are being effectively managed within our risk appetite or whether further management action is required.

Responsibility for minimising operational risk management lies with HSBC's management and staff. Each regional, global business, country, business unit and functional head is required to maintain oversight over operational risk and internal control covering all business and operational activities for which they are responsible.

A summary of our current policies and practices regarding operational risk is provided in the Appendix to Risk on page 270.

Operational risk management framework

The Group Operational Risk function and the ORMF assist business management in discharging their responsibilities.

The ORMF defines minimum standards and processes, and the governance structure for operational risk and internal control across the Group. Inherent to the ORMF is a 'three lines of defence' model for the management of risk, as described below:

Three lines of defence

A diagrammatic representation of the ORMF is presented below:

Operational risk management framework

·   RCAs are used to inform the evaluation of the effectiveness of controls over top risks.

·   KIs are linked to TRAs to help monitor the risks and controls in the operational risk system.

·   Internal incidents are used to forecast typical losses.

·   External sources (e.g. Fitch and ORX databases) are used to inform the assessment of extreme TRAs.

·  

Operational risk in 2012

During 2012, our top and emerging risk profile was dominated by compliance and legal risks as referred to in the 'Top and emerging risks' section and Note 43 on the Financial Statements. A number of other material losses were realised in 2012, which related largely to events that occurred in previous years. These events included the possible historical mis-selling of PPI and interest rate protection products in the UK (see Note 32 on the Financial Statements). A number of mitigating actions continue to be taken to prevent future mis-selling incidents including enhanced new product approval processes.

The incidence of regulatory proceedings and other adversarial proceedings against financial service firms is increasing. Proposed changes relating to capital and liquidity requirements, remuneration and/or taxes could increase our cost of doing business, reducing future profitability. Various regulators and competition authorities around the world are also investigating and reviewing certain past submissions made by panel banks and the process for making submissions in connection with the setting of Libor, Euribor and other benchmark interest and foreign exchange rates. In response, we have undertaken a number of initiatives which seek to address the issues identified, including creating a new global management structure, enhancing our governance and oversight, increasing our compliance function resource, emphasising HSBC Values and designing and implementing new global standards as

described on page 6. For further information, see Note 43 on the Financial Statements.

Other significant operational risks included:

·     challenges to achieving our strategy in a downturn: businesses and geographical regions have prioritised strategy and annual operating plans to reflect current economic conditions. Performance against plan is monitored through a number of means including the use of balanced scorecards and performance reporting at all relevant management committees;

·     internet crime and fraud: the threat of external fraud, especially in retail and commercial banking, may increase during adverse economic conditions. We have increased our defences through enhanced monitoring and have implemented additional controls, such as two-factor authentication, to mitigate the possibility of losses from fraud risks. We continually assess these threats as they evolve and adapt our controls to mitigate these risks;

·     level of change creating operational complexity: the Risk function is engaged with business management in business transformation initiatives to ensure robust internal controls are maintained, including through participation in all relevant management committees. For example, we undertake rigorous testing and review of all planned updates to our systems environment. All changes are risk assessed and appropriate mitigating controls are required for any planned high risk changes;

·     information security: the security of our information and technology infrastructure is crucial for maintaining our banking applications and processes while protecting our customers and the HSBC brand. In common with other banks and multinational organisations, we face a growing threat of cyber attacks. A failure of our defences against such attacks could result in financial loss, loss of customer data and other sensitive information which could undermine both our reputation and our ability to retain the trust of our customers. We experienced a number of cyber attacks in 2012, none of which resulted in financial loss or the loss of customer data. Significant investment has already been made in enhancing controls, including increased training to raise staff awareness of the requirements, improved controls around data access and heightened monitoring of information flows. The threat from cyber attacks is a concern for our organisation and failure to protect our operations from internet crime or cyber attacks may result in financial loss, loss of customer data or other sensitive information which could undermine our reputation and our ability to attract and keep customers. This area will continue to be a focus of ongoing initiatives to strengthen the control environment;

·     vendor risk management: this continues to evolve, with a project underway to accelerate the review of existing contracts, including those that support key economic functions, and a global project to manage the performance of critical outsourced vendors; and

·     compliance with regulatory agreements and orders: in relation to the Deferred Prosecution Agreements ('DPA's), the Group has committed to take or continue to adhere to a number of remedial measures. Breach of the DPAs at any time during its term may allow the DoJ or the New York County District Attorney's Office to prosecute HSBC in relation to the matters which are the subject of the DPAs. For further detail please see 'Top and emerging risks'.

Other operational risks are also monitored and managed through the use of the ORMF, including investments made to further improve the resilience of our payments infrastructure.

Further information on the nature of these risks is provided in 'Top and emerging risks' on page 130.

Frequency and amount of operational risk losses

The profile of operational risk incidents and associated losses is summarised below, showing the distribution of operational risk incidents in terms of their frequency of occurrence and total loss amount in US dollars.

The operational risk incident profile in 2012 comprised both high frequency, low impact events and high impact events that occurred much less frequently. For example, losses due to external fraud incidents such a credit card fraud occurred more often than other types of event, but the amounts involved were often small in value. Fraud incidents continued to account for over 50% of the total number of incidents but only 4% of operational risk losses.

By contrast, operational risk incidents in the compliance category remained relatively low frequency events, but the total cost was significant. Compliance-related losses increased in 2012 to 79% of total operational risk losses due to significant historical events including the possible mis-selling of PPI and interest rate protection products in the UK and the incidence of regulatory matters described in Note 43 on the Financial Statements.

Frequency of operational risk incidents by risk category

Distribution of operational risk losses in US dollars by risk category

Compliance risk

(Unaudited)

Compliance risk is the risk that we fail to observe the letter and spirit of all relevant laws, codes, rules, regulations and standards of good market practice, and incur fines and penalties and suffer damage to our business as a consequence.

All Group companies are required to observe the letter and spirit of all relevant laws, codes, rules, regulations and standards of good market practice. In 2012, we experienced increasing levels of compliance risk as regulators and other agencies pursued investigations into historical activities and as we continued to work with them in relation to already identified issues. These included:

·     an appearance before the US Senate Permanent Subcommittee on Investigations and the DPAs reached with US authorities in relation to investigations regarding inadequate compliance with anti-money laundering, the US Bank Secrecy Act and sanctions laws, plus a related undertaking with the FSA;

·     investigations into the possible mis-selling of interest rate derivative products to SMEs in the UK; and

·     investigations and reviews related to certain past submissions made by panel banks and the process for making submissions in connection with the setting of Libor, Euribor and other benchmark interest and foreign exchange rates. As some HSBC entities are members of such panels, HSBC Holdings and certain of its subsidiaries have been the subject of regulatory demands for information.

With a new senior leadership team and strategy in place since 2011, we have already taken steps to address these issues including making significant changes to strengthen compliance, risk management and culture. These steps, which will also enhance our compliance risk management capabilities, including the following:

·     the creation of a new global structure, which will make HSBC easier to manage and control;

·     simplifying our business through the ongoing implementation of our organisational effectiveness programme and our five economic filters strategy;

·     introducing a sixth global risk filter which will standardise the way we do business in high risk countries;

·     substantially increasing resources, doubling global expenditure and significantly strengthening Compliance as a control (rather than as an advisory) function;

·     continuing to roll out an HSBC Values programme that defines the way everyone in the Group should act; and

·     adopting and enforcing the most effective standards globally, including a globally consistent approach to knowing and retaining our customers.

Additionally, we have substantially revised our governance framework in this area, appointing a new Chief Legal Officer with particular expertise and experience in US law and regulation, and creating and appointing experienced individuals to the new roles of Head of Group Financial Crime Compliance and Global Head of Regulatory Compliance.

It is clear from both our own and wider industry experience that there is a significantly increased level of activity from regulators and law enforcement agencies in pursuing investigations in relation to possible breaches of regulation and that the direct and indirect costs of such breaches can be significant. Coupled with a substantial increase in the volume of new regulation, much of which has some level of extra-territorial effect, and the geographical spread of our businesses, we believe that the level of inherent compliance risk that we face will continue to remain high for the foreseeable future.

Fiduciary risk

(Unaudited)

Fiduciary risk is the risk to the Group of breaching our fiduciary duties when we act in a fiduciary capacity as trustee or investment manager or as mandated by law or regulation.

A fiduciary duty is one where HSBC holds, manages, oversees or has responsibility for assets for a third party that involves a legal and/or regulatory duty to act with the highest standard of care and with utmost good faith. A fiduciary must make decisions and act in the best interests of the third party and must place the wants and needs of the client first, above the needs of the Group.

We may be held liable for damages or other penalties caused by failure to act in accordance with those duties. Fiduciary duties may also arise in other circumstances, such as when we act as an agent for a principal, unless the fiduciary duties are specifically excluded (e.g. under the agency appointment contract).

During 2012, our principal fiduciary businesses (the 'designated businesses') developed fiduciary risk appetite statements for their various fiduciary roles and a joint review was commissioned by Global Operational Risk and RBWM to identify businesses other than designated businesses conducting fiduciary activities to ensure that they were subject to adequate review and oversight.

 

END

 

 

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