Annual Report and Accounts -

RNS Number : 7271P

HSBC Holdings PLC

31 March 2009

Liquidity and funding

(Audited)

Liquidity risk is the risk that HSBC does not have sufficient financial resources to meet its obligations as they fall due, or will have to do so at an excessive cost. This risk arises from mismatches in the timing of cash flows. Funding risk (a form of liquidity risk) arises when the liquidity needed to fund illiquid asset positions cannot be obtained at the expected terms and when required.

The objective of HSBC's liquidity and funding management framework is to ensure that all foreseeable funding commitments can be met when due, and that access to the wholesale markets is coߛordinated and cost-effective. To this end, HSBC maintains a diversified funding base comprising core retail and corporate customer deposits and institutional balances. This is augmented with wholesale funding and portfolios of highly liquid assets diversified by currency and maturity which are held to enable HSBC to respond quickly and smoothly to unforeseen liquidity requirements.

HSBC requires its operating entities to maintain strong liquidity positions and to manage the liquidity profiles of their assets, liabilities and commitments with the objective of ensuring that their cash flows are balanced appropriately and that all their anticipated obligations can be met when due.

HSBC adapts its liquidity and funding risk management framework in response to changes in the mix of business that it undertakes, and to changes in the nature of the markets in which it operates. HSBC has continuously monitored the impact of recent market events on the Group's liquidity positions and has changed behavioural assumptions where justified. The impact of these recent market events is discussed more fully below. The liquidity and funding risk management framework will continue to evolve as the Group assimilates knowledge from the recent market events.

Policies and procedures

(Audited)

The management of liquidity and funding is primarily undertaken locally in HSBC's operating entities in compliance with practices and limits set by the Risk Management Meeting ('RMM'). These limits vary according to the depth and liquidity of the market in which the entities operate. It is HSBC's general policy that each banking entity should be self-sufficient when funding its own operations. Exceptions are permitted for certain short-term treasury requirements and start-up operations or branches which do not have access to local deposit markets. These entities are funded from HSBC's largest banking operations and within clearly defined internal and regulatory guidelines and limits. These limits place formal restrictions on the transfer of resources between HSBC entities and reflect the broad range of currencies, markets and time zones within which HSBC operates.

HSBC's liquidity and funding management process includes:

projecting cash flows by major currency under various stress scenarios and considering the level of liquid assets necessary in relation thereto;
monitoring balance sheet liquidity and advances to deposits ratios against internal and regulatory requirements;
maintaining a diverse range of funding sources with back-up facilities;
managing the concentration and profile of debt maturities;
managing contingent liquidity commitment exposures within pre-determined caps;
maintaining debt financing plans;
monitoring depositor concentration in order to avoid undue reliance on large individual depositors and ensure a satisfactory overall funding mix; and
maintaining liquidity and funding contingency plans. These plans identify early indicators of stress conditions and describe actions to be taken in the event of difficulties arising from systemic or other crises, while minimising adverse long-term implications for the business.

Primary sources of funding

(Audited)

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

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

The main operating subsidiary that does not accept deposits is HSBC Finance, which has historically funded itself principally by taking term funding in the professional markets and by securitising assets. At 31 December 2008, US$111 billion (2007: US$142 billion) of HSBC Finance's liabilities were drawn from professional markets, utilising a range of products, maturities and currencies.

Cash flows payable by HSBC under financial liabilities by remaining contractual maturities

(Audited)

	On demand US$m	Due within 3 months US$m	Due between 3 and 12 months US$m	Due between 1 and 5 years US$m	Due after 5 years US$m

At 31 December 2008
Deposits by banks	45,884	82,514	8,734	4,875	2,356
Customer accounts	698,187	332,207	69,721	34,537	5,798
Trading liabilities	247,652	-	-	-	-
Financial liabilities designated at fair value	5,365	2,713	6,969	34,855	64,853
Derivatives	482,039	373	1,479	2,634	1,003
Debt securities in issue	481	56,590	53,174	68,169	22,920
Subordinated liabilities	92	686	1,646	9,718	41,701
Other financial liabilities	19,474	26,180	5,473	1,472	1,022

	1,499,174	501,263	147,196	156,260	139,653
Loan commitments	239,753	105,952	153,774	72,111	32,432

	1,738,927	607,215	300,970	228,371	172,085

At 31 December 2007
Deposits by banks	42,793	78,429	11,445	4,208	5,199
Customer accounts	629,227	391,659	56,294	29,445	6,614
Trading liabilities	314,580	-	-	-	-
Financial liabilities designated at fair value	11,730	2,083	8,286	43,147	68,726
Derivatives	181,009	113	873	1,663	613
Debt securities in issue	635	90,718	59,626	109,054	38,782
Subordinated liabilities	3	277	1,951	10,181	34,841
Other financial liabilities	20,516	29,812	5,177	977	1,273

	1,200,493	593,091	143,652	198,675	156,048
Loan commitments	312,146	155,142	155,565	113,072	28,532

	1,512,639	748,233	299,217	311,747	184,580

The balances in the above table will not agree directly with the balances in the consolidated balance sheet as the table incorporates, on an undiscounted basis, all cash flows relating to principal and all future coupon payments (except for trading liabilities and trading derivatives). Also, loan commitments are generally not recognised on the balance sheet. Trading liabilities and trading derivatives have been included in the 'On demand' time bucket, and not by contractual maturity, because trading liabilities are typically held for short periods of time. The undiscounted cash flows payable under hedging derivative liabilities are classified according to their contractual maturity.

Cash flows payable in respect of customer accounts are primarily contractually repayable on demand or at short notice. However, in practice, short-term deposit balances remain stable as inflows and outflows broadly match and a significant portion of loan commitments expire without being drawn upon.

Advances to deposits ratio

(Audited)

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

Advances to deposits ratio limits are set by the RMM and monitored by Group Finance. The ratio describes loans and advances to customers as a percentage of the total of core customer current and savings accounts and term funding with a remaining term to maturity in excess of one year. Loans and advances to customers which are part of reverse repurchase arrangements, and where HSBC receives securities which are deemed to be liquid, are excluded from the advances to deposits ratio, as are current accounts and savings accounts from customers deemed to be 'non-core'. The definition of a non-core deposit includes a consideration of the size of the customer's total deposit balances. Due to the distinction between core and non-core depositors, the Group's measure of advances to deposits will be more restrictive than that which could be inferred from the published financial statements.

The three banking entities listed in the table below represented 70 per cent of HSBC's total core deposits at 31 December 2008 (2007: 71 per cent). The table demonstrates that loans and advances to customers in HSBC's principal banking entities are broadly financed by reliable and stable sources of funding. HSBC would meet any unexpected net cash outflows by selling securities and accessing additional funding sources such as interbank or collateralised lending markets. The Group also uses measures other than the advances to deposits ratio to manage liquidity risk, including the ratio of net liquid assets to customer liabilities and projected cash flow scenario analyses.

Ratio of net liquid assets to customer liabilities

(Audited)

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

Limits for the ratio of net liquid assets to customer liabilities are set for each bank operating entity, except for HSBC Finance. As HSBC Finance does not accept customer deposits, it is not appropriate to manage its liquidity using standard liquidity ratios. The liquidity and funding risk management framework of HSBC Finance is discussed below.

Ratios of net liquid assets to customer liabilities are provided in the following table, along with the US dollar equivalents of net liquid assets.

HSBC's principal banking entities - the management of liquidity risk

(Audited)

	Advances to deposits ratios		Ratio of net liquid assets to customer liabilities		Net liquid assets
	2008	2007	2008	2007	2008	2007
	%	%	%	%	US$bn	US$bn
HSBC Bank (UK operations)
Year-end	106.0	97.5	7.1	12.1	21.3	44.2
Maximum	106.7	101.7	14.1	21.5	52.5	80.6
Minimum	97.5	92.6	6.9	12.1	21.3	39.9
Average	101.5	97.1	10.0	15.6	35.8	52.4

The Hongkong and Shanghai Banking Corporation
Year-end	77.4	76.7	25.0	21.8	64.6	53.9
Maximum	82.9	82.2	25.0	24.1	64.6	56.9
Minimum	76.7	72.4	19.9	16.1	51.1	35.3
Average	80.6	76.4	21.9	20.8	56.5	48.2

HSBC Bank USA
Year-end	103.7	114.9	31.5	15.8	27.4	17.1
Maximum	117.3	116.8	31.5	25.7	27.4	26.1
Minimum	103.7	107.0	15.8	15.8	17.1	17.1
Average	111.8	112.7	22.6	21.3	21.5	22.0

Total of HSBC's other principal banking entities1
Year-end	85.2	88.4	26.5	21.0	83.5	66.1
Maximum	92.3	89.3	26.5	26.1	83.5	72.7
Minimum	82.7	86.2	19.4	21.0	66.1	58.8
Average	88.1	87.7	22.5	24.0	73.9	65.3

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

Projected cash flow scenario analysis

(Audited)

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

Limits for cumulative net cash flows under stress scenarios are set for each banking entity and for HSBC Finance. Both ratio and cash flow limits reflect the local market place, the diversity of funding sources available and the concentration risk from large depositors. Compliance with entity level limits is monitored centrally by Group Finance and reported regularly to the RMM.

HSBC Finance

As HSBC Finance does not accept customer deposits, it takes funding from the professional markets. HSBC Finance uses a range of measures to monitor funding risk, including projected cash flow scenario analysis and caps placed on the amount of unsecured term funding that can mature in any rolling three-month and rolling 12ߛmonth periods. HSBC Finance also maintains access to committed sources of secured funding and has in place committed backstop lines for short-term refinancing CP programmes. At 31 December 2008, the maximum amounts of unsecured term funding maturing in any rolling three-month and rolling 12ߛmonth periods were US$6.0 billion and US$17.4 billion, respectively (2007: US$6.2 billion and US$17.7 billion). At 31 December 2008, HSBC Finance also had in place unused committed sources of secured funding for which eligible assets were held, of US$2.4 billion (2007: US$6.2 billion) and committed backstop lines from non-Group entities in support of CP programmes totalling US$7.3 billion (2007: US$9.3 billion).

Contingent liquidity risk

(Audited)

In the normal course of business, Group entities provide customers with committed facilities, including committed backstop lines to conduit vehicles sponsored by the Group and standby facilities to corporate customers. These facilities increase the funding requirements of the Group when customers choose to raise drawdown levels over and above their normal utilisation rates. The liquidity risk consequences of increased levels of drawdown are analysed in the form of projected cash flows under different stress scenarios. The RMM also sets limits for non-cancellable contingent funding commitments by Group entity after due consideration of each entity's ability to fund them. The limits are split according to the borrower, the liquidity of the underlying assets and the size of the committed line.

The Group's contractual exposures at 31 December monitored under the contingent liquidity risk limit structure

(Audited)

	HSBC Bank		HSBC Bank USA		HSBC Bank Canada		The Hongkong and Shanghai Banking Corporation
	2008	2007	2008	2007	2008	2007	2008	2007
	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn
Conduits
Client-originated assets1
- total lines	5.6	11.0	11.2	9.5	0.3	0.7	-	-
- largest individual lines	1.0	1.6	0.4	0.9	0.2	0.4	-	-
HSBC-managed assets2	34.8	25.7	-	-	-	-	-	-
Other conduits3	-	-	1.1	2.6	-	1.8	-	-

Single-issuer liquidity facilities
- five largest4	6.0	10.0	5.0	5.9	1.5	1.1	1.0	1.3
- largest market sector5	7.3	11.7	3.5	4.2	2.4	1.5	1.7	2.3

1 These exposures relate to consolidated multi-seller conduits (see page 184). These vehicles provide funding to Group customers by issuing debt secured by a diversified pool of customer-originated assets.

2 These exposures relate to consolidated securities investment conduits, primarily Solitaire and Mazarin (see page 184). These vehicles issue debt secured by ABSs which are managed by HSBC. Of the total contingent liquidity risk under this category, US$25.3 billion was already funded on-balance sheet at 31 December 2008 leaving a net contingent exposure of US$9.5 billion.

3 These exposures relate to third-party sponsored conduits (see page 187).

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

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

In times of market stress, the Group may choose to provide non-contractual liquidity support to certain HSBC-sponsored vehicles or HSBC-promoted products. This support would only be provided after careful consideration of the potential funding requirement and the impact on the entity's overall liquidity.

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

(Audited)

A significant aspect of the market turmoil continues to be its adverse effects on the liquidity and funding risk profile of the banking system.

At a systemic level, these may be characterised as follows:

interbank funding costs increased as banks became reluctant to lend to each other beyond the very short-term;
many asset classes previously considered to be liquid became illiquid;
the ability of many market participants to issue either unsecured or secured debt has been restricted, although this has been partly mitigated following the introduction by some governments and central banks of term debt guarantee schemes; and
special purpose entities with investments linked to US sub-prime mortgages, or to ABSs where the underlying credit exposures were not fully transparent, found it increasingly difficult to raise wholesale funding.

In general terms, the strains arising from the credit crisis were concentrated in the wholesale market. The retail market, the market from which HSBC derives its core current and savings accounts, (the importance of which as a source of funding for the Group is discussed under 'Advances to deposits ratio' above) was relatively unaffected. The Group's limited dependence on wholesale markets for funding has been a significant competitive advantage to HSBC through the recent period of dislocation in the financial markets.

HSBC's customer deposit base has grown between 30 June 2007, the reporting date closest to the onset of the market turmoil, and 31 December 2008 by US$134 billion. This growth in US dollar equivalent terms has been diluted by the significant strengthening of US dollar against other major currencies between these two reporting dates, and therefore under represents the growth in customer deposits on an underlying currency basis. As a net provider of funds to the interbank market, the Group has not been significantly affected by the scarcity of interbank funding.

A number of central banks and governments have taken action to alleviate the effects of the market turmoil, these actions have included making available government guaranteed term funding facilities. In the US, bank issuance under such programmes became normal market practice during 2008. To date, only HSBC's US based operations have participated in government guaranteed term debt issuance schemes. At 31 December 2008, US$2.65 billion had been issued by HSBC USA, Inc. under the Federal Deposit Insurance Corporation Temporary Liquidity Guarantee Programme.

The deterioration of the US sub-prime credit market has reduced the availability of term financing to entities with exposures to the US sub-prime market. However, HSBC Finance, by virtue of its position within the Group, continued to enjoy committed financing facilities, albeit at a lower level, and access to commercial paper markets at interest rates below interbank rates. Through planned balance sheet reductions, the issuance of cost effective retail debt, capital infusions from the HSBC Group, and the utilisation of alternative sources of funding, including funding from other members of the HSBC Group, HSBC Finance was able to eliminate the need to issue institutional term debt in 2008. Funding plans are in place to enable HSBC Finance to deal with continued stress in the credit markets. As part of these plans, asset portfolios totalling US$15.3 billion were transferred from HSBC Finance to HSBC Bank USA in January 2009, resulting in US$8.0 billion of net funding benefit to HSBC Finance.

HSBC Finance is eligible to participate in the US Federal Reserve's Commercial Paper Funding Facility (CPFF), a new scheme aimed at providing support to US issuers in the commercial paper market. At 31 December 2008, HSBC Finance had issued US$520 million under the CPFF and is eligible to issue a maximum of US$12.0 billion prior to 30 October 2009, the current expiry date for the scheme.

The effect of the market turmoil on liquidity and funding elsewhere in HSBC was largely restricted to the Group's activities that historically depended upon the asset-backed commercial paper markets for funding, specifically SIVs and conduits, and certain money market funds. This is discussed in detail on page 174.

HSBC Holdings

(Audited)

HSBC Holdings' primary sources of cash are interest and capital receipts from its subsidiaries, which it deploys in short-term bank deposits. HSBC Holdings' primary uses of cash are investments in subsidiaries, interest payments to debt holders and dividend payments to shareholders. On an ongoing basis, HSBC Holdings replenishes its liquid resources through the receipt of interest on, and repayment of, intra-group loans, from dividends paid by subsidiaries and from interest earned on its own liquid funds.

HSBC Holdings is also subject to contingent liquidity risk by virtue of loan commitments and guarantees given. Such commitments are only provided after due consideration of HSBC Holdings' ability to finance these commitments and the likelihood of the need arising.

HSBC Holdings actively manages the cash flows from its subsidiaries to optimise the amount of cash held at the holding company level, and expects to continue doing so in the future. The ability of its subsidiaries to pay dividends or advance monies to HSBC Holdings depends on, among other things, their respective regulatory capital requirements, statutory reserves, and financial and operating performance. The wide range of HSBC's activities means that HSBC Holdings is not dependent on a single source of profits to fund its dividend payments to shareholders. HSBC Holdings believes that, with its accumulated liquid assets, planned dividends and interest from subsidiaries it will be able to meet anticipated cash obligations. Also, during 2008 HSBC Holdings continued to have full access to capital markets at market rates and issued US$8.8 billion of capital instruments (2007: US$4.4 billion).

Cash flows payable by HSBC Holdings under financial liabilities by remaining contractual maturities

(Audited)

	On demand	Due within 3 months	Due between 3 and 12 months	Due between 1 and 5 years	Due after 5 years
	US$m	US$m	US$m	US$m	US$m
At 31 December 2008
Amounts owed to HSBC undertakings	-	133	539	3,590	-
Financial liabilities designated at fair value	-	587	1,762	5,977	25,571
Derivatives	1,324	-	-	-	-
Subordinated liabilities	-	235	706	3,764	32,214
Other financial liabilities	-	1,805	-	-	-

	1,324	2,760	3,007	13,331	57,785
Loan commitments	3,241	-	-	-	-

	4,565	2,760	3,007	13,331	57,785


At 31 December 2007
Amounts owed to HSBC undertakings	-	109	1,801	1,192	-
Financial liabilities designated at fair value	-	258	776	8,152	28,639
Derivatives	44	-	-	-	-
Subordinated liabilities	-	160	482	2,568	23,069
Other financial liabilities	-	1,398	-	-	-

	44	1,925	3,059	11,912	51,708
Loan commitments	3,638	-	-	-	-

	3,682	1,925	3,059	11,912	51,708

The balances in the above table will not agree directly with the balances in the balance sheet of HSBC Holdings as the table incorporates, on an undiscounted basis, all cash flows relating to principal and all future coupon payments (except for trading derivatives).

Also, loan commitments are generally not recognised on the balance sheet. Trading derivatives

are included in the 'On demand' time bucket, and not by contractual maturity, because trading derivatives are typically held for short periods of time. The undiscounted cash flows on hedging derivative liabilities are classified according to their contractual maturity.

Market risk

(Audited)

The objective of HSBC's market risk management is to manage and control market risk exposures in order to optimise return on risk while maintaining a market profile consistent with the Group's status as one of the world's largest banking and financial services organisations.

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

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

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

Market risk arising in HSBC's insurance businesses is discussed in 'Risk management of insurance operations' on pages 255 to 274.

The management of market risk is principally undertaken in Global Markets using risk limits approved by the GMB. Limits are set for portfolios, products and risk types, with market liquidity being a principal factor in determining the level of limits set. Traded Credit and Market Risk, an independent unit within Group Management Office, develops the Group's market risk management policies and measurement techniques. Each major operating entity has an independent market risk management and control function which is responsible for measuring market risk exposures in accordance with the policies defined by Traded Credit and Market Risk, and monitoring and reporting these exposures against the prescribed limits on a daily basis.

Each operating entity is required to assess the market risks which arise on each product in its business and to transfer these risks to either its local Global Markets unit for management, or to separate books managed under the supervision of the local Asset and Liability Management Committee ('ALCO'). The aim is to ensure that all market risks are consolidated within operations which have the necessary skills, tools, management and governance to manage such risks professionally. In certain cases where the market risks cannot be adequately captured by the transfer process, simulation modelling is used to identify the impact of varying scenarios on valuations and net interest income.

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

Sensitivity analysis

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

Value at risk

(Audited)

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

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

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

potential market movements are calculated with reference to data from the past two years;
historical market rates and prices are calculated with reference to foreign exchange rates and commodity prices, interest rates, equity prices and the associated volatilities; and
VAR is calculated to a 99 per cent confidence level and for a one-day holding period.

HSBC routinely validates the accuracy of its VAR models by back-testing the actual daily profit and loss results, adjusted to remove non-modelled items such as fees and commissions, against the corresponding VAR numbers. Statistically, HSBC would expect to see losses in excess of VAR only 1 per cent of the time over a one-year period. The actual number of excesses over this period can therefore be used to gauge how well the models are performing.

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

the use of historical data as a proxy for estimating future events may not encompass all potential events, particularly those which are extreme in nature;
the use of a one-day holding period assumes that all positions can be liquidated or the risk offset in one day. This may not fully reflect the market risk arising at times of severe illiquidity, when a oneߛday holding period may be insufficient to liquidate or hedge all positions fully;
the use of a 99 per cent confidence level, by definition, does not take into account losses that might occur beyond this level of confidence;
VAR is calculated on the basis of exposures outstanding at the close of business and therefore does not necessarily reflect intra-day exposures; and
VAR is unlikely to reflect loss potential on exposures that only arise under significant market moves.

Stress testing

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

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

sensitivity scenarios, which consider the impact of market moves to any single risk factor or a set of factors. For example the impact resulting from a break of a currency peg that is unlikely to be captured within the VAR models;
technical scenarios, which consider the largest move in each risk factor, without consideration of any underlying market correlation;
hypothetical scenarios, which consider potential macro economic events; and
historical scenarios, which incorporate historical observations of market moves during previous periods of stress which would not be captured within VAR.

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

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

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


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

1 The structural foreign exchange risk is monitored using sensitivity analysis. See page 429.

2 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 249.

3 Credit spread VAR is reported for the credit derivatives transacted by Global Banking. See page 244.

The impact of market turmoil on market risk

(Audited)

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

The tightening of both credit and liquidity within the wholesale markets observed during the latter half of 2007 led to an increase in market volatility, most noticeably in the credit spreads of financial institutions and ABSs/MBSs.

Credit spread volatility continued to increase during the first half of 2008, and as the effect of the market turmoil on the wider economy became more apparent, there was a larger increase in the volatility in other risk types, such as interest rates. Coupled with positions taken in anticipation of rate reductions, the increase in volatility led to an increase in the total VAR in early 2008.

Volatility across all asset classes continued to increase in the second half of 2008, as central banks coordinated a series of rate cuts, in an attempt to stimulate demand within the global economy. Although the increase in volatility led to a further increase in total VAR during the second half of 2008, the overall impact was limited as a result of managing down the market risk exposures during this period (see 'Value at risk of the trading and nonߛtrading portfolios' below).

Although the overall VAR limit for the Group was increased towards the end of 2008, as a result of the increased market volatility, the limit remained within the level set in early 2007.

Value at risk of the trading and non-trading portfolios

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

Value at risk

(Audited)

	2008	2007
	US$m	US$m

At 31 December	191.2	70.1
Average	158.9	65.3
Minimum	59.8	43.8
Maximum	287.1	98.1

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

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

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

(Unaudited)

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

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

The average daily revenue earned in 2008 was US$21.7 million, compared with US$18.7 million in 2007. The standard deviation of these daily revenues was US$53.4 million compared with US$25.3 million in 2007. The standard deviation measures the variation of daily revenues about the mean value of those revenues.

An analysis of the frequency distribution of daily revenue shows that there were 66 days with negative revenue during 2008 compared with 35 days in 2007. The most frequent result was a daily revenue of between US$40 million and US$50 million with 28 occurrences, compared with between US$20 million and US$30 million with 71 occurrences in 2007.

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

(Unaudited)

2008

Number of days

Profit and loss frequency

2007

Number of days

Profit and loss frequency

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

For a description of HSBC's fair value and price verification controls, see page 163.

Trading portfolios

(Audited)

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

Market making and proprietary position taking is undertaken within Global Markets. The VAR for such trading activity at 31 December 2008 was US$72.5 million (2007: US$30.2 million). This is analysed below by risk type:

VAR by risk type for the trading activities (excluding Credit Spread VAR)

(Audited)

	Foreign exchange and commodity	Interest rate	Equity	Total1
	US$m	US$m	US$m	US$m

At 31 December 2008	29.8	63.4	13.9	72.5
At 31 December 20072	10.7	25.4	10.2	30.2

Average
2008	19.0	50.7	15.2	53.1
20072	9.5	22.9	7.9	23.7
Minimum
2008	8.7	21.4	8.2	22.6
20072	4.0	14.9	3.4	14.3
Maximum
2008	54.9	147.4	39.0	104.4
20072	23.0	36.1	15.1	38.8

1 The total VAR is non-additive across risk types due to diversification effects.

2 The VAR for 2007 has been adjusted on the same basis as Group VAR on page 243.

Credit spread risk

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

The Group is introducing credit spread as a separate risk type within the VAR models. At 31 December 2008, credit spread VAR was calculated for the London trading and New York credit derivatives portfolios. At that date, the total VAR for the trading activities, including credit spread VAR for the above portfolios, was US$106.4 million (2007: US$43.8 million) compared with a total VAR of US$72.5 million reported within the 'VAR by risk type for the trading activities' (see above), which excludes the credit spread VAR for these two portfolios.

The sensitivity of trading income to the effect of movements in credit spreads on the total trading activities of the Group was US$590.9 million at 31 December 2008 (2007: US$95.4 million). This sensitivity captures the credit spread exposure arising from positions taken throughout the Group, in addition to the London trading and New York credit derivative portfolios captured within credit spread VAR (see above). The sensitivity was calculated using simplified assumptions based on one-day movements in average market credit spreads over a two-year period at a confidence level of 99 per cent, and assumes a simultaneous movement in credit spreads across issuers. It should be noted that diversification effects within the portfolio and with other risk types is likely to lead to a reduced impact on trading income.

The significant increase in the sensitivity at 31 December 2008, compared with 31 December 2007, was due to the effect of much higher volatility in credit spreads observed during 2008. The actual positions within the trading portfolios exposed to credit spread risk were lower on 31 December 2008 than on 31 December 2007.

In addition to the above measure certain portfolios are also managed using default risk measures where appropriate.

The measurement of the credit spread impact on trading income as at 31 December 2008 excludes those positions that were reclassified as non-trading during the second half of 2008 following the amendment to IFRS. These positions are included within the 31 December 2007 comparative, as the reclassification took effect from 1 July 2008.

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

At 31 December 2008, the credit spread VAR on the credit derivatives transactions entered into by Global Banking was US$23.0 million (2007: US$19.7 million). The VAR shows the effect on trading income from a one-day movement in credit spreads over a two-year period, calculated to a 99 per cent confidence level.

Gap risk

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

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

ABSs/MBSs positions

The ABSs/MBSs exposures within the trading portfolios are managed within sensitivity and VAR limits, as described on page 241, and are included within the stress testing scenarios as described on page 242.

Non-trading portfolios

(Audited)

The principal objective of market risk management of non-trading portfolios is to optimise net interest income.

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

The transfer of market risk to books managed by Global Markets or supervised by ALCO is usually achieved by a series of internal deals between the business units and these books. When the behavioural characteristics of a product differ from its contractual characteristics, the behavioural characteristics are assessed to determine the true underlying interest rate risk. Local ALCOs are required to regularly monitor all such behavioural assumptions and interest rate risk positions to ensure they comply with interest rate risk limits established by GMB.

In certain cases, the non-linear characteristics of products cannot be adequately captured by the risk transfer process. For example, both the flow from customer deposit accounts to alternative investment products and the precise prepayment speeds of mortgages will vary at different interest rate levels, and where expectations about future moves in interest rates change. In such circumstances, simulation modelling is used to identify the impact of varying scenarios on valuations and net interest income.

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

Credit spread risk

At 31 December 2008, the sensitivity of equity to the effect of movements in credit spreads on the Group's available-for-sale debt securities was US$1,092 million (2007: US$206 million). The sensitivity was calculated on the same basis as applied to the trading portfolio. Including the gross exposure for the SICs consolidated within HSBC's balance sheet at 31 December 2008, the sensitivity increased to US$1,145 million. This sensitivity is struck, however, before taking account of any losses which would be absorbed by the capital note holders. At 31 December 2008, the capital note holders would have absorbed the first US$2.2 billion (2007: US$2.3 billion) of any losses incurred by the SICs prior to HSBC incurring any equity losses.

The notable increase in this sensitivity at 31 December 2008, compared with 31 December 2007, was again due to the effect of higher volatility in credit spreads observed during 2008. The overall credit spread positions within the available-for-sale portfolios were lower on 31 December 2008 compared with 31 December 2007.

Equity securities classified as available for sale

(Audited)

Market risk arises on equity securities held as available for sale. The fair value of these securities at 31 December 2008 was US$6.8 billion (2007: US$12.6 billion) and included private equity holdings of US$2.5 billion (2007: US$3.2 billion). Investments in private equity are primarily made through managed funds that are subject to limits on the amount of investment. Potential new commitments are subject to risk appraisal to ensure that industry and geographical concentrations remain within acceptable levels for the portfolio as a whole. Regular reviews are performed to substantiate the valuation of the investments within the portfolio. Funds typically invested for short-term cash management represented US$0.9 billion (2007: US$3.1 billion). Investments held to facilitate ongoing business, such as holdings in government-sponsored enterprises and local stock exchanges, represented US$1.0 billion (2007: US$1.7 billion). Other strategic investments represented US$2.4 billion (2007: US$4.6 billion). The fair value of the constituents of equity securities classified as available for sale can fluctuate considerably. A 10 per cent reduction in the value of the available-for-sale equities at 31 December 2008 would have reduced equity by US$0.7 billion (2007: US$1.3 billion). For details of the impairment incurred on available-for-sale equity securities see 'Accounting policies' on page 350.

US$1.0 billion of the reduction in the AFS Equities relates to funds that were consolidated within the Group's balance sheet as at 31 December 2008.

Defined benefit pension schemes

(Audited)

Market risk also arises within HSBC's defined benefit pension schemes to the extent that the obligations of the schemes are not fully matched by assets with determinable cash flows. Pension scheme obligations fluctuate with changes in long-term interest rates, inflation, salary increases and the longevity of scheme members. Pension scheme assets will include equities and debt securities, the cash flows of which change as equity prices and interest rates vary. There are risks that market movements in equity prices and interest rates could result in asset valuations which, taken together with regular ongoing contributions, are insufficient over time to cover the level of projected obligations and these, in turn, could increase with a rise in inflation and members living longer. Management, together with the trustees who act on behalf of the pension scheme beneficiaries, assess these risks using reports prepared by independent external actuaries and take action and, where appropriate, adjust investment strategies and contribution levels accordingly. For example, in order to mitigate the risk of adverse movements in investments, interest rates and inflation, the Trustee of the HSBC Bank (UK) Pension Scheme has continued to implement a programme of initiatives proposed by HSBC, including reducing the equity content of the investment strategy, increasing the diversification of the scheme's assets, and entering into long-term interest rate and inflation swaps.

The present value of HSBC's defined benefit pension plans' obligations was US$24.0 billion at 31 December 2008, compared with US$32.4 billion at 31 December 2007. Assets of the defined benefit schemes at 31 December 2008 comprised equity investments, 20 per cent (2007: 26 per cent); debt securities, 68 per cent (2007: 62 per cent); and other (including property), 12 per cent (2007: 12 per cent) (see Note 8 on the Financial Statements).

Increased corporate bond yields in the UK in 2008 have resulted in an increase of 110 basis points in the real discount rate (net of the increase in expected inflation) used to value the accrued benefits payable under the HSBC Bank (UK) Pension Scheme, the Group's largest plan. The resulting decrease in the liabilities of the scheme has been largely offset by a reduction in the fair values of the plan assets of the scheme. As a consequence, the deficit on the HSBC Bank (UK) Pension Scheme has decreased to US$392 million from US$808 million.

Sensitivity of net interest income

(Unaudited)

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

For simulation modelling, businesses use a combination of scenarios relevant to local businesses and local markets and standard scenarios which are required throughout HSBC. The standard scenarios are consolidated to illustrate the combined pro forma effect on HSBC's consolidated portfolio valuations and net interest income.

The table below sets out the effect on future net interest income of an incremental 25 basis points parallel fall or rise in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 January 2009. Assuming no management actions, a series of such rises would decrease planned net interest income for 2009 by US$463 million (2008: US$503 million), while a series of such falls would decrease planned net interest income by US$284 million (2008: increase US$525 million). These figures incorporate the effect of any option features in the underlying exposures.

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

Sensitivity of projected net interest income

(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 2009 projected net interest income arising from a shift in yield curves of:

+25 basis points at the beginning of each quarter	(243)	42	(45)	100	28	(345)	(463)
-25 basis points at the beginning of each quarter	41	(42)	(285)	(114)	(235)	351	(284)

Change in 2008 projected net interest income arising from a shift in yield curves of:

+25 basis points at the beginning of each quarter	(275)	96	9	77	(140)	(270)	(503)
-25 basis points at the beginning of each quarter	272	(95)	11	(65)	142	260	525

The interest rate sensitivities set out in the table above are illustrative only and are based on simplified scenarios.

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

HSBC's exposure to the effect of movements in interest rates on its net interest income arises in two main areas: core deposit franchises and Global Markets.

Core deposit franchises: these are exposed to changes in the cost of deposits raised and spreads on wholesale funds. In a low interest rate environment, the net interest income benefit of core deposits increases as interest rates rise and decreases as interest rates fall. This risk is asymmetrical in a very low interest rate environment, however, as there is limited room

to lower deposit pricing in the event of interest rate reductions.

Residual interest rate risk is managed within Global Markets, under the Group's policy of transferring interest rate risk to Global Markets to be managed within defined limits and with flexibility as to the instruments used.

The main drivers of the year on year movements in the sensitivity of the Group's net interest income to the changes in interest rates tabulated above were:

decreases in interest rates, particularly in US dollar, Hong Kong dollar and Sterling which have restricted the Group's ability to pass on to depositors further rate reductions thereby increasing exposures to further rate falls; and
Global Markets increased net trading asset positions, particularly in euro. The funding of net trading assets is generally sourced from floating rate retail deposits and recorded in 'Net interest income' whereas the income from such assets is recorded in 'Net trading income'.

Projecting the movement in net interest income from prospective changes in interest rates is a complex interaction of structural and managed exposures.

HSBC monitors 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 100 basis points in all yield curves. The table below describes the sensitivity of HSBC's reported reserves to these movements at the end of 2008 and 2007 and the maximum and minimum month-end figures during these years:

Sensitivity of reported reserves to interest rate movements

(Unaudited)

	US$m	Maximum impact US$m	Minimum impact US$m
At 31 December 2008

+ 100 basis point parallel move in all yield curves	(2,740)	(2,740)	(1,737)
As a percentage of total shareholders' equity	(2.9%)	(2.9%)	(1.9%)

- 100 basis point parallel move in all yield curves	2,477	2,609	1,944
As a percentage of total shareholders' equity	2.6%	2.8%	2.1%

At 31 December 2007

+ 100 basis point parallel move in all yield curves	(1,737)	(1,738)	(1,519)
As a percentage of total shareholders' equity	(1.4%)	(1.4%)	(1.2%)

- 100 basis point parallel move in all yield curves	1,977	2,048	1,430
As a percentage of total shareholders' equity	1.5%	1.6%	1.1%

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

Structural foreign exchange exposures

(Unaudited)

Structural foreign exchange exposures represent net investments in subsidiaries, branches or associates, the functional currencies of which are currencies other than the US dollar.

Exchange differences on structural exposures are recorded in the consolidated statement of recognised income and expense. The main operating (or functional) currencies in which HSBC's business is transacted are the US dollar, the Hong Kong dollar, pound sterling, the euro, the Mexican peso, the Brazilian real and the Chinese renminbi. As the US dollar and currencies linked to it form the dominant currency bloc in which HSBC's operations transact business, HSBC Holdings prepares its consolidated financial statements in US dollars. HSBC's consolidated balance sheet is, therefore, affected by exchange differences between the US dollar and all the non-US dollar functional currencies of underlying subsidiaries.

HSBC hedges structural foreign exchange exposures only in limited circumstances. HSBC's structural foreign exchange exposures are managed

with the primary objective of ensuring, where practical, that HSBC's consolidated capital ratios and the capital ratios of individual banking subsidiaries are largely protected from the effect of changes in exchange rates. This is usually achieved by ensuring that, for each subsidiary bank, the ratio of structural exposures in a given currency to risk-weighted assets denominated in that currency is broadly equal to the capital ratio of the subsidiary in question.

The Group's capital ratios were affected by the strengthening US dollar in the latter part of 2008. The effect on the Group's consolidated tier 1 and total ratios is estimated to have been a reduction of approximately 40 basis points and approximately 50 basis points respectively. These movements were within approved tolerance levels.

HSBC may also transact hedges where a currency in which it has structural exposures is considered to be significantly overvalued and it is possible in practice to transact a hedge. Selective hedges were in place during 2007 and 2008. Hedging is undertaken using forward foreign exchange contracts which are accounted for under IFRSs as hedges of a net investment in a foreign operation, or by financing with borrowings in the same currencies as the functional currencies involved. There was no ineffectiveness arising from these hedges in the year ended 31 December 2008.

HSBC Holdings

(Audited)

As a financial services holding company, HSBC Holdings has limited market risk activity. Its activities predominantly involve maintaining sufficient capital resources to support the Group's diverse activities; allocating these capital resources across the Group's businesses; earning dividend and interest income on its investments in the Group's businesses; providing dividend payments to HSBC Holding's equity shareholders and interest payments to providers of debt capital; and maintaining a supply of short-term cash resources. It does not take proprietary trading positions.

The main market risks to which HSBC Holdings is exposed are interest rate risk and foreign currency risk. Exposure to these risks arises from short-term cash balances, funding positions held, loans to subsidiaries, investments in long-term financial assets and financial liabilities including debt capital issued. The objective of HSBC Holding's market risk management strategy is to reduce exposure to these risks and minimise volatility in reported income, cash flows and distributable reserves. Market risk for HSBC Holdings is monitored by its Structural Positions Review Group.

A number of cross currency interest rate swaps entered into as part of HSBC Holdings' management of interest rate risk arising on certain long-term debt capital issues do not qualify for hedge accounting treatment. Changes in the market values of these swaps are taken directly to the income statement. HSBC Holdings expects that these swaps will be held to final maturity with the accumulated changes in market value consequently trending to zero.

Certain loans to subsidiaries of a capital nature that are not denominated in the functional currency of either the provider or the recipient are accounted for as financial assets. Changes in the carrying amount of these assets due to exchange differences are taken directly to the income statement. These loans, and the associated foreign exchange exposures, are eliminated on a Group consolidated basis.

The principal tools used in the management of market risk are 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, and VAR for foreign exchange rate risk.

Net interest income sensitivity

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 an incremental 25 basis point parallel fall or rise in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 January 2009.

Assuming no management action, a series of such rises would decrease HSBC Holdings' planned net interest income for 2009 by US$60 million (2008: decrease of US$23 million) and decrease cumulative net interest income by US$554 million over a 5-year period from 1 January 2009 (2008: decrease of US$104 million), while a series of such falls would increase planned net interest income by US$60 million (2008: increase of US$23 million) and increase cumulative net interest income by US$554 million over a 5ߛyear period from 1 January 2009 (2008: increase of US$104 million). These figures incorporate the impact of any option features in the underlying exposures.

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


Sensitivity of HSBC Holdings' net interest income to interest rate movements (Unaudited)
	US dollar bloc	Sterling bloc	Euro bloc	Total
	US$m	US$m	US$m	US$m

Change in 2009 projected net interest income arising from a shift in yield curves of:

+ 25 basis points at the beginning of each quarter in 2009
0-1 year	(81)	10	11	(60)
2-3 years	(351)	20	77	(254)
4-5 years	(358)	54	64	(240)
- 25 basis points at the beginning of each quarter in 2009
0-1 year	81	(10)	(11)	60
2-3 years	351	(20)	(77)	254
4-5 years	358	(54)	(64)	240

Change in 2008 projected net interest income arising from a shift in yield curves of:

+ 25 basis points at the beginning of each quarter in 2008
0-1 year	(51)	16	12	(23)
2-3 years	(180)	69	83	(28)
4-5 years	(200)	69	78	(53)
- 25 basis points at the beginning of each quarter in 2008
0-1 year	51	(16)	(12)	23
2-3 years	180	(69)	(83)	28
4-5 years	200	(69)	(78)	53

HSBC Holdings' principal exposure to changes in its net interest income from movements in interest rates arises on short-term cash balances, floating rate loans advanced to subsidiaries and fixed rate debt capital securities in issue which have been swapped to floating rate.

The interest rate sensitivities tabulated above are illustrative only and are based on simplified scenarios. The figures represent the effect of pro forma movements in net interest income based on the projected yield curve scenarios, HSBC Holdings' current interest rate risk profile and assumed changes to that profile during the next five years. 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. The figures do not take into account the effect of actions that could be taken to mitigate this interest rate risk, however.

The projected increase in HSBC Holdings' sensitivity to moves in interest rates is mainly due to new interest-bearing capital issues, the funds from which have been largely invested in non-interest bearing equity investments in subsidiaries.

Interest repricing gap table

The interest rate repricing gap table below analyses the full term structure of interest rate mismatches within HSBC Holdings' balance sheet. The year on year increase in the negative net interest rate gap in the up to 1 year time bucket is due to an increase in non-interest bearing equity investments in subsidiaries which has been funded by new issues of interest bearing liabilities and by the capitalisation of interest bearing loans to subsidiaries.


Repricing gap analysis of HSBC Holdings (Audited)
	Total	Up to 1 year	1-5 years	5-10 years	More than 10 years	Non- interest bearing
	US$m	US$m	US$m	US$m	US$m	US$m
At 31 December 2008
Cash at bank and in hand:
- balances with HSBC undertakings	443	443	-	-	-	-
Derivatives	3,682	-	-	-	-	3,682
Loans and advances to HSBC undertakings	11,804	8,995	511	-	1,222	1,076
Financial investments	2,629	-	-	300	1,885	444
Investments in subsidiaries	81,993	1,459	1,094	-	875	78,565
Other assets	131	-	-	-	-	131

Total assets	100,682	10,897	1,605	300	3,982	83,898

Amounts owed to HSBC undertakings	(4,042)	(3,389)	-	-	-	(653)
Financial liabilities designated at fair values	(16,389)	(4,210)	(4,410)	(5,290)	(3,448)	969
Derivatives	(1,324)	-	-	-	-	(1,324)
Other liabilities	(1,816)	-	-	-	-	(1,816)
Subordinated liabilities	(14,017)	(1,500)	(2,187)	(2,962)	(7,152)	(216)
Total equity	(62,587)	-	-	-	(3,650)	(58,937)
Other non-interest bearing liabilities	(507)	-	-	-	-	(507)

Total liabilities and equity	(100,682)	(9,099)	(6,597)	(8,252)	(14,250)	(62,484)

Off-balance sheet items attracting interest rate sensitivity	-	(12,353)	4,410	5,046	3,760	(863)

Net interest rate risk gap	-	(10,555)	(582)	(2,906)	(6,508)	20,551

Cumulative interest rate gap	-	(10,555)	(11,137)	(14,043)	(20,551)	-

At 31 December 2007
Total assets	92,948	19,136	-	-	2,774	71,038
Total liabilities	(92,948)	(6,597)	(6,546)	(8,755)	(8,864)	(62,186)

Off-balance sheet items attracting interest rate sensitivity	-	(13,619)	4,313	7,752	3,804	(2,250)

Net interest rate risk gap	-	(1,080)	(2,233)	(1,003)	(2,286)	6,602

Cumulative interest rate gap	-	(1,080)	(3,313)	(4,316)	(6,602)	-

As part of the continuous enhancement and development of HSBC's management tools, the net interest income sensitivity projection over a 5-year horizon and the interest rate repricing table shown above have replaced the VAR analysis disclosed in the Annual Report and Accounts 2007 as the principal measures used to monitor interest rate risk for HSBC Holdings. These enhanced reports are considered to be more suitable risk management measures for the longer term profile of a bank holding company balance sheet.

Value at risk

Total foreign exchange VAR arising within HSBC Holdings in 2008 and 2007 was as follows:

HSBC Holdings - value at risk

(Audited)

	Foreign exchange
	2008 US$m	2007 US$m

At 31 December	55.2	29.1
Average	40.3	29.4
Minimum	29.2	27.6
Maximum	56.1	30.9

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 the income statement. These loans, and the associated foreign exchange exposures, are eliminated on a Group consolidated basis.

Residual value risk

(Unaudited)

A significant part of a lessor's return from operating leases is dependent upon its management of residual value risk. This arises from operating lease transactions to the extent that the values recovered from disposing of leased assets or re-letting them at the end of the lease terms (the 'residual values') differ from those projected at the inception of the leases. The business regularly monitors residual value exposure by reviewing the recoverability of the residual value projected at lease inception. This entails considering the potential of re-letting of operating lease assets and their projected disposal proceeds at the end of their lease terms. Provision is made to the extent that the carrying values of leased assets are impaired through residual values not being fully recoverable.

The net book value of equipment leased to customers on operating leases by the Group includes projected residual values at the end of current lease terms, to be recovered through reߛletting or disposal in the following periods:

Residual values (Unaudited)
	2008	2007
	US$m	US$m

Within 1 year	108	155
Between 1-2 years	59	243
Between 2-5 years	530	713
More than 5 years	1,549	1,892

Total exposure	2,246	3,003

Operational risk

(Unaudited)

Operational risk is the risk of loss arising through fraud, unauthorised activities, error, omission, inefficiency, systems failure or from external events. It is inherent to every business organisation and covers a wide spectrum of issues. The terms 'error', 'omission' and 'inefficiency' include process failures, systems/machine failures and human error.

The objective of HSBC's operational risk management is to manage and control operational risk in a cost effective manner within targeted levels of operational risk consistent with the Group's risk appetite, as defined by the Group Management Board.

A formal governance structure provides oversight over the management of operational risk. A Global Operational Risk and Control Committee, which reports to the Risk Management Meeting, meets quarterly to discuss key risk issues and review the effective implementation of the Group's operational risk management framework.

In each of HSBC's subsidiaries, business managers are responsible for maintaining an acceptable level of internal control, commensurate with the scale and nature of operations. They are responsible for identifying and assessing risks, designing controls and monitoring the effectiveness of these controls. The operational risk management framework helps managers to fulfil these responsibilities by defining a standard risk assessment methodology and providing a tool for the systematic reporting of operational loss data.

A centralised database is used to record the results of the operational risk management process. Operational risk self-assessments are input and maintained by the business unit. To ensure that operational risk losses are consistently reported and monitored at Group level, all Group companies are required to report individual losses when the net loss is expected to exceed US$10,000.

Further details of the HSBC approach to Operational Risk Management can be found in the Capital and Risk Management Interim Pillar 3 Disclosures 2008.

Legal risk

(Unaudited)

Each operating company is required to implement procedures to manage legal risk that conform to HSBC standards. Legal risk falls within the definition of operational risk and includes contractual risk, dispute risk, legislative risk and non-contractual rights risk.

Contractual risk is the risk that the rights and/or obligations of an HSBC company within a contractual relationship are defective.
Dispute risk is the risk that an HSBC company is subject to when it is involved in or managing a potential or actual dispute.
Legislative risk is the risk that an HSBC company fails to adhere to the laws of the jurisdictions in which it operates.
Non-contractual rights risk is the risk that an HSBC company's assets are not properly owned or are infringed by others, or an HSBC company infringes another party's rights.

HSBC has a global legal function to assist management in controlling legal risk. The function provides legal advice and support in managing claims against HSBC companies, as well as in respect of non-routine debt recoveries or other litigation against third parties.

The GMO legal department oversees the global legal function and is headed by a Group General Manager who reports to the Group Chairman. There are legal departments in 54 of the countries in which HSBC operates. There are also regional legal functions in each of Europe, North America, Latin America, the Middle East, and Asia-Pacific.

Operating companies must notify the appropriate legal department immediately any litigation is either threatened or commenced against HSBC or an employee. The appropriate regional legal department must be immediately advised (and must in turn immediately advise the GMO legal department) of any action by a regulatory authority, where the proceedings are criminal, or where the claim might materially affect the Group's reputation. Further, any claims which exceed US$1.5 million or equivalent must also be advised to the appropriate regional legal department and the regional legal department must immediately advise the GMO legal department if any such claim exceeds US$5 million. All such matters are then reported to the Risk Management Meeting of the Group Management Board in a monthly paper.

An exception report must be made to the local compliance function and escalated to the Head of Group Compliance in respect of any breach which has given rise to a fine and/or costs levied by a court of law or regulatory body where the amount is US$1,500 or more, and material or significant issues are reported to the Risk Management Meeting of GMB and/or the Group Audit Committee.

In addition, operating companies are required to submit quarterly returns detailing outstanding claims where the claim (or group of similar claims) exceeds US$10 million, where the action is by a regulatory authority, where the proceedings are criminal, where the claim might materially affect the Group's reputation, or, where the GMO legal department has requested returns be completed for a particular claim. These returns are used for reporting to the Group Audit Committee and the Board of HSBC Holdings, and disclosure in the Interim Report and Annual Report and Accounts, if appropriate.

Global security and fraud risk

(Unaudited)

Security and fraud risk issues are managed at Group level by Global Security and Fraud Risk. This unit, which has responsibility for physical, fraud, information and contingency risk, and security and business intelligence, is fully integrated within the central GMO Risk function. This facilitates synergies between it and other risk functions, such as with Global Retail Risk Management in the selection, design and implementation of systems and processes to protect the Group against fraud by deterring fraudulent activity, detecting it where it does occur and mitigating its effects.

Pension risk

(Unaudited)

HSBC operates a number of pension plans throughout the world, as described in Note 8 on the Financial Statements. Some of these pension plans are defined benefit plans, of which the largest is the HSBC Bank (UK) Pension Scheme.

In order to fund these benefits, sponsoring group companies (and in some instances, employees) make regular contributions in accordance with advice from actuaries and in consultation with the scheme's Trustees (where relevant). The defined benefit plans invest these contributions in a range of investments designed to meet their long-term liabilities.

The level of these contributions has a direct impact on the cash flow of the Group and would normally be set to ensure that there are sufficient funds to meet the cost of the accruing benefits for the future service of active members. However, higher contributions will be required when plan assets are considered insufficient to cover the existing pension liabilities as a deficit exists. Contribution rates are typically revised annually or triennially, depending on the plan. The agreed contributions to the HSBC Bank (UK) Pension Scheme are revised triennially.

A deficit in a defined benefit plan may arise from a number of factors, including:

investments delivering a return below that required to provide the projected plan benefits. This could arise, for example, when there is a fall in the market value of equities, or when increases in long-term interest rates cause a fall in the value of fixed income securities held;
the prevailing economic environment leading to corporate failures, thus triggering write-downs in asset (both equity and debt) values;
a change in either interest rates or inflation which causes an increase in the value of the scheme liabilities; and
scheme members living longer than expected (known as longevity risk).

The plan's investment strategy is determined in the light of the market risk inherent in the investments and the consequential impact on potential future contributions.

Ultimate responsibility for investment strategy rests with either the Trustees or, in certain circumstances, a Management Committee. The degree of independence of the Trustees from HSBC differs in different jurisdictions. For example, the HSBC Bank (UK) Pension Scheme, which accounts for approximately 63 per cent of the obligations of the Group's defined benefit pension plans, is overseen by a corporate Trustee. This scheme's Trustee regularly monitors the market risks inherent in the scheme.

Reputational risk

(Unaudited)

The safeguarding of HSBC's reputation is of paramount importance to its continued prosperity and is the responsibility of every member of staff. HSBC regularly reviews its policies and procedures for safeguarding against reputational and operational risks. This is an evolutionary process which takes account of relevant developments and industry guidance such as The Association of British Insurers' guidance on best practice when responding to environmental, social and governance ('ESG') risks.

HSBC has always aspired to the highest standards of conduct and, as a matter of routine, takes account of reputational risks to its business. Reputational risks can arise from a wide variety of causes, including ESG issues and operational risk events. As a banking group, HSBC's good reputation depends upon the way in which it conducts its business, but it can also be affected by the way in which clients, to whom it provides financial services, conduct themselves. The training of Directors on appointment includes reputational matters.

A Group Reputational Risk Committee ('GRRC') has been established at which relevant Group functions with responsibility for activities and functions which attract reputational risk are represented. The primary role of the GRRC is to consider areas and activities presenting significant reputational risk and, where appropriate, to make recommendations to the Risk Management Meeting and GMB for policy or procedural changes to mitigate such risk.

Standards on all major aspects of business are set for HSBC and for individual subsidiaries, businesses and functions. Reputational risks, including ESG matters, are considered and assessed by the Board, GMB, the Risk Management Meeting, subsidiary company boards, board committees and senior management during the formulation of policy and the establishment of HSBC standards. These policies, which form an integral part of the internal control system (see page 299), are communicated through manuals and statements of policy and are promulgated through internal communications and training. The policies cover ESG issues and set out operational procedures in all areas of reputational risk, including money laundering deterrence, counter-terrorist financing environmental impact, anti-corruption measures and employee relations. The policy manuals address risk issues in detail and co-operation between GMO departments and businesses is required to ensure a strong adherence to HSBC's risk management system and its sustainability practices.

Sustainability risk

(Unaudited)

Sustainability risks arise from the provision of financial services to companies or projects which run counter to the needs of sustainable development; in effect this risk arises when the environmental and social effects outweigh economic benefits. Within Group Management Office, a separate function, Group Corporate Sustainability, is mandated to manage these risks globally working through local offices as appropriate. Its risk management responsibilities include:

formulating sustainability risk policies. This includes oversight of HSBC's sustainability risk standards, management of the Equator Principles for project finance lending, and sectorߛbased sustainability policies covering those sectors with high environmental, ethical or social impacts (forestry, freshwater infrastructure, chemicals, energy, mining and metals, and defence-related lending); undertaking an independent review of transactions where sustainability risks are assessed to be high, and supporting HSBC's operating companies to assess similar risks of a lower magnitude;
building and implementing systems-based processes to ensure consistent application of policies, reduce the costs of sustainability risk reviews and capture management information to measure and report on the effect of HSBC's lending and investment activities on sustainable development; and
providing training and capacity building within HSBC's operating companies to ensure sustainability risks are identified and mitigated on a consistent basis and to either HSBC's own standards, or international standards or local regulations, whichever is the higher.

This information is provided by RNS

The company news service from the London Stock Exchange

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