Final Results-HSBC USA Inc.P2
HSBC Holdings PLC
1 March 2004
PART 2
RISK MANAGEMENT
Overview
Some degree of risk is inherent in virtually all of the Company's activities. For the principal activities
undertaken by the Company, the most important types of risks are considered to be credit, market, interest rate,
liquidity, operational, fiduciary and reputational. Market risk includes interest rate and trading risk, where
trading risk refers broadly to all price risk reflected in mark to market positions.
The objective of the Company's risk management system is to identify and measure risks so that:
- the potential costs can be weighed against the expected rewards from taking the risks
- unexpected losses can be minimized
- appropriate disclosures can be made to all concerned parties
- adequate protections, capital and other resources can be put in place to weather all significant risks
Historically, the Company's approach to risk management has emphasized a culture of business line responsibility
combined with central requirements for the diversification of customers and businesses. Extensive central
requirements for controls, limits, reporting and the escalation of issues have been detailed in Company policies
and procedures.
The Company recently embarked upon a multi-year program to upgrade its risk measurement methodologies and
systems. The new practices and techniques involve more data, modeling, simulation and analysis. A new senior
leadership structure has been introduced and includes independent risk specialists for operational and fiduciary
risk, in addition to the existing risk specialists for credit and market activities, and the appointment of a
Chief Risk Officer responsible for Company-wide risk management.
Risk management oversight begins with the Company's Board of Directors and its various committees, principally
the Audit and Examining Committee. Management oversight is provided by the Risk Management Committee which is
chaired by the Chief Risk Officer, and which leverages itself off four principal subcommittees:
- Credit Risk Committee
- Asset and Liability Policy Committee
- Operational Risk Management Committee
- Fiduciary Risk Management Committee
Day-to-day management of credit risk is centralized under the Chief Credit Officer, and market risk principally
under the Treasurer. Management of operational and fiduciary risk is decentralized and is the responsibility of
each business and support unit. However, all risk areas have independent risk specialists setting standards,
developing the new risk measurement methodologies, operating central risk databases, and conducting reviews and
analyses. The Chief Risk Officer provides day-to-day oversight of these activities and works closely with
Compliance and Audit.
Future Transactions With Household
Pending regulatory and other approvals, the Company is in the process of pursuing the transfer of certain assets
from Household, including additional residential mortgage assests and interest in credit card receivables. These
transactions potentially could have a significant impact on the economic and regulatory capital, credit risk,
interest rate management, and liquidity management practices of the Company.
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Economic and Regulatory Capital
A critical aspect of risk management is to define how much capital is needed to support losses that could
emanate from the risks that underlie the Company's businesses. This calculation is referred to as economic
capital. Economic capital is an estimate of how much capital is needed by the Company, as opposed to the amount
of capital actually held by the Company as a result of capital issuance, earnings retention and provisioning. In
early 2004, the Company will begin to calculate economic capital from statistical analyses of possible losses
related to credit, market, interest rate and operational risk. Confidence levels have been established: the
Company targets having economic capital sufficient to cover losses over a one year time horizon 99.95% of the
time. This is consistent with the maintenance of the Bank's "AA" rating, as "AA" rated credits have historically
defaulted at a rate of about .05% per year. The one year time horizon is also consistent with traditional
planning and budgeting time horizons. Quantification of possible losses related to other risks, such as
fiduciary and reputational risk, are broadly covered under the credit, market and operational risk
quantifications.
The new data collection and quantitative methodologies the Company is putting in place for calculating economic
capital are consistent with the requirements for the proposed advanced approaches for determining regulatory
capital under the New Basel Capital Accord, being developed by the Basel Committee on Banking Supervision (Basel
II). The advanced approaches include the Internal Ratings Based-Advanced approach for calculating credit risk
capital requirements and the Advanced Measurement Approaches for calculating operational risk capital
requirements. The Company is not required to adopt the advanced approaches by its primary regulator, the Federal
Reserve, but is intending to do so voluntarily. Implementation of the advanced approaches remains subject to the
finalization of the Accord by the Basel Committee, and its adoption by U.S. regulators.
Credit Risk Management
Credit risk is the potential that a borrower or counterparty will fail to perform an obligation. Potential loss
includes loss in the event of default, or the change in the value of a credit obligation because of changes in
the view of its possible default.
Credit risk exists widely in the Company: for example, in loan portfolios and investment portfolios; in unfunded
commitments such as lines of credit that customers can draw upon; in treasury instruments, such as interest rate
swaps which, if more valuable today than when originally contracted, may represent an exposure to the
counterparty to the contract. While credit risk exists widely within the Company, the fact of diversification,
particularly among various commercial and consumer portfolios, helps the Company to lessen risk exposure.
Credit risk exposure is controlled by the Company through various lending caps, prohibitions, and guidances. The
Company monitors and limits its exposure to individual counterparties and to the combined exposure of related
counterparties. In addition, selected industry portfolios, such as real estate, telecommunications, aviation,
and shipping, are subject to caps which are established by the Chief Credit Officer and reviewed where
appropriate by management and board committees. Counterparty credit exposure related to derivatives activities
is also managed under approved limits. Since the exposure related to derivatives is variable and uncertain, the
Company uses internal risk management methodologies to calculate the 95% worst case potential future exposure
for each customer. These methodologies take into consideration cross-product close-out netting, collateral
received from customers under Collateral Support Annexes (CSA), termination clauses, and off-setting positions
within the portfolio among other things.
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In addition to controlling credit risk exposure the credit approval, policy and monitoring functions are
centrally managed under the control of the Chief Credit Officer, and are subject to certain limits and approvals
by the Company's parent holding company, HSBC. While the Chief Credit Officer is responsible for the design and
management of the credit function, the Credit Risk Management Committee is responsible for strategic and
collection oversight of the scope of the risk being taken, the adequacy of the tools used to measure it, and the
adequacy of reporting.
Under the multi-year program to enhance risk management, the Company introduced late in 2003 a new 22 level
credit risk grading system to replace its previous 7 level system. The new system allows the Company to measure
customer risk on a more granular scale and with quantitative measures calibrated to the performance of Standard
and Poor's Long-Term Debt Ratings over a twenty year period.
The new system is two-dimensional with a customer rating measuring probability of default (frequency) and a
transaction rating measuring the probable loss in the event of default (severity). A suite of models, tools and
templates supports the estimation of the probability of default. This suite has been developed using a
combination of internal and external resources and data and closely follows what has been determined to be best
practice in the industry. To estimate the probable loss in the event of default, the Company is building a
significant database of historic credit losses, again, from both internal and external sources, and has
implemented other tools and models to support this effort.
Expected losses and hence desired credit reserves will be calculated based on probability of default (frequency)
and loss given default (severity) beginning in 2004. While this analysis will be done for individual corporate
and commercial transactions, for retail and small business portfolios it will be done using pools of similar
credits within various customer segments. Correlations among credits in the same portfolios will also be
calculated to indicate whether credit risks are more tied to a creditor's own fundamentals as opposed to
industry fundamentals.
Also in 2003, the Company started pilot calculations of economic capital related to credit risk. A simulation
model is used to determine the amount of possible losses, beyond expected losses, that the Company must be
prepared to support with capital. The Company intends to continue to refine its calculation of economic capital
related to credit risk and begin to integrate the new credit risk modeling tools into the credit decision making
process as appropriate.
The credit profile of the Company is subject to changes due to business strategies and conditions as well as
credit quality. The following table indicates certain sensitivities at December 31, 2003.
Impact
Element of Change Element Affected From To
--------- --------
in millions
25% of pass grade credits drop one grade: Criticized assets $ 1,428 $ 4,066
Allowance for credit losses 399 447
Reserve for off-balance sheet items 44 129
All pass grade credits drop
one grade: Criticized assets 1,428 11,980
Allowance for credit losses 399 591
Reserve for off-balance sheet items 44 384
10% lower unallocated reserve for credit
losses: Allowance for credit losses 399 392
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Asset/Liability Management
Asset and liability management includes management of liquidity and market risk. Liquidity risk is the potential
that an institution will be unable to meet its obligations as they become due or fund its customers because of
inadequate cash flow or the inability to liquidate assets or obtain funding itself. Market risk includes both
interest rate and trading risk. Interest rate risk is the potential impairment of net interest income due to
mismatched pricing between assets and liabilities and off-balance sheet instruments. Market risk is the
potential for losses in daily mark to market positions (mostly trading) due to adverse movements in money,
foreign exchange, equity or other markets. In managing these risks, the Company seeks to protect both its income
stream and the value of its assets.
The Company has substantial, but historically well controlled, interest rate risk in large part as a result of
its large portfolio of residential mortgages and mortgage backed securities, which consumers can prepay without
penalty, and to a lesser extent the result of its large base of demand and savings deposits. These deposits can
be withdrawn by consumers at will, but historically they have been a stable source of funds. Market risk exists
principally in treasury businesses and to a lesser extent in the residential mortgage business where mortgage
servicing rights and the pipeline of forward mortgage sales are hedged. The Company has little foreign exchange
exposure from investments in overseas operations, which are limited in scope, and total equity investments,
excluding stock owned in the Federal Reserve and New York Federal Home Loan Bank, which are less than 2% of
total available for sale securities.
The management of liquidity, interest rate and most market risk is centralized in treasury. Market risk related
to residential mortgages is primarily managed by the mortgage business. In all cases, the valuation of positions
and tracking of positions against limits is handled independently by the Company's finance units. Oversight of
all liquidity and market risks is provided by the Asset and Liability Policy Committee (ALCO), which indicates
the limits of acceptable risk, the adequacy of the tools used to measure it, and the adequacy of reporting. ALCO
also conducts contingency planning in regards to liquidity.
Liquidity Management
In providing liquidity, the Company focuses on five elements:
- customer generated deposits
- diverse sources of funds
- maximum collateral utilizing investment securities and residential mortgages, most of which are
pledgeable at the New York Federal Home Loan Bank or Federal Reserve
- strong credit ratings
- positive cash flow, even in a crisis
In carrying out this responsibility, ALCO projects cash flow requirements and determines the optimal level of
liquid assets and available funding sources to have at the Company's disposal, with consideration given to
anticipated deposit and balance sheet growth, contingent liabilities, and the ability to access short-term
wholesale funding markets. In addition, the Committee monitors deposit and funding concentrations in terms of
overall mix and to avoid undue reliance on individual funding sources and large deposit relationships. It also
maintains a liquidity management contingency plan, which identifies certain potential early indicators of
liquidity problems, and actions, which can be taken both initially and in the event of a liquidity crisis, to
minimize the long-term impact on the Company's business and customer relationships.
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Deposit accounts from a diverse mix of "core" retail, commercial and public sources represent a significant,
cost-effective source of liquidity under normal operating conditions. The Company's ability to regularly attract
wholesale funds at a competitive cost is enhanced by strong ratings from the major credit ratings agencies. At
December 31, 2003, the Company and its principal operating subsidiary, HSBC Bank USA, maintained the following
long and short-term debt ratings.
Short-Term Debt Long-Term Debt
Moody's S&P Fitch Moody's S&P Fitch
HSBC USA Inc. P-1 A-1 F1+ A1 A+ AA-
HSBC Bank USA P-1 A-1+ F1+ Aa3 AA- AA-
The Company's shelf registration statement filed with the United States Securities and Exchange Commission (SEC)
has $825 million available under which it may issue debt and equity securities and has ready access to the
capital markets for long-term funding through the issuance of registered debt. In addition, the Company has an
unused $500 million line of credit with HSBC Bank plc and, as a member of the New York Federal Home Loan Bank,
has a potential secured borrowing facility in excess of $5 billion. Off-balance sheet special purpose vehicles
or other off-balance sheet mechanisms are not utilized as a source of liquidity or funding.
Assets, principally consisting of a portfolio of highly rated investment securities in excess of $18 billion,
approximately $7 billion of which, based on anticipated cash flows, is scheduled to mature within the next
twelve months, a liquid trading portfolio of approximately $15 billion, and residential mortgages are a primary
source of liquidity to the extent that they can be sold or used as collateral for borrowing. The economics and
long-term business impact of obtaining liquidity from assets must be weighed against the economics of obtaining
liquidity from liabilities, along with consideration given to the associated capital ramifications of these two
alternatives. Currently, assets would be used to supplement liquidity derived from liabilities only in a crisis
scenario.
It is the policy of the Bank to maintain both primary and secondary collateral in order to ensure precautionary
borrowing availability from the Federal Reserve. Primary collateral is that which is physically maintained at
the Federal Reserve, and serves as a safety net against any unexpected funding shortfalls that may occur.
Secondary collateral is collateral that is acceptable to the Federal Reserve, but is not maintained there. If
unutilized borrowing capacity were to be low, secondary collateral would be identified and maintained as
necessary.
The Company projects, as part of normal ongoing contingency planning, that in the event of a severe liquidity
problem there would be sources of cash exceeding projected uses of cash by more than $9 billion, assuming that
the Company would not have access to the wholesale funds market. In addition, the Company maintains residential
mortgages and other eligible collateral at the Federal Reserve that could provide additional liquidity if
needed.
On December 31, 2003, approximately $2.8 billion of domestic residential mortgage loan assets were purchased
from Household. It is anticipated that an additional $1.0 billion of similar receivables will be purchased from
Household during the first quarter of 2004. During the remainder of 2004, the Company anticipates that
approximately $3.0 billion of additional new residential mortgage loans underwritten by Household will be
recorded by the Company. Subject to regulatory and other approvals, the Company anticipates the purchase of
approximately $14 billion of credit card receivables from Household during 2004. As part of the same purchase
transaction, residual interest in approximately $14 billion of securitized credit card receivable pools will
also be transferred from Household. Subsequent to the initial
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transfer, additional credit card receivables will be purchased from Household on a daily basis. Various methods
to fund these transactions are being explored, including the issuance of long-term registered debt, the filing
of an additional shelf registration statement with the SEC, and liquidation of certain investment securities. A
subordinated debt issuance is planned for the second quarter. The Company's objective is to maintain a strong
liquidity profile in 2004.
Interest Rate Risk Management
The Company is subject to interest rate risk associated with the repricing characteristics of its balance sheet
assets and liabilities and its derivative contracts. Specifically, as interest rates change, interest earning
assets reprice at intervals that do not correspond to the maturities or repricing patterns of interest bearing
liabilities. This mismatch between assets and liabilities in repricing sensitivity results in shifts in net
interest income as interest rates move. To help manage the risks associated with changes in interest rates, and
to optimize net interest income within ranges of interest rate risk that management considers acceptable, the
Company uses derivative instruments such as interest rate swaps, options, futures and forwards as hedges to
modify the repricing characteristics of specific assets, liabilities, forecasted transactions or firm
commitments.
The following table shows the repricing structure of assets and liabilities as of December 31, 2003. For assets
and liabilities whose cash flows are subject to change due to movements in interest rates, such as the
sensitivity of mortgage loans to prepayments, data is reported based on the earlier of expected repricing or
maturity and reflects anticipated prepayments based on the current rate environment. The resulting "gaps" are
reviewed to assess the potential sensitivity to earnings with respect to the direction, magnitude and timing of
changes in market interest rates. Data shown is as of year end, and one-day figures can be distorted by
temporary swings in assets or liabilities.
December 31, 2003 Within After After After Total
One One But Five Ten
Year Within But Years
Five Within
Years Ten
Years
----------
in millions
Commercial loans (including
international) $ 15,260 $ 2,474 $ 1,016 $ 413 $ 19,163
Residential mortgages 12,253 11,637 1,742 663 26,295
Other loans 2,135 808 63 10 3,016
Total loans 29,648 14,919 2,821 1,086 48,474
Securities available for sale
and securities held to maturity 8,205 5,881 2,453 2,115 18,654
Other assets 23,395 2,157 2,882 - 28,434
Total assets 61,248 22,957 8,156 3,201 95,562
Domestic deposits (1) 21,200 19,765 36 - 41,001
Other liabilities/equity 46,553 330 6,107 1,571 54,561
Total liabilities 67,753 20,095 6,143 1,571 95,562
Total balance sheet gap (6,505 ) 2,862 2,013 1,630 -
Effect of derivative contracts (65 ) 50 15 - -
Total gap position $ (6,570 ) $ 2,912 $ 2,028 $ 1,630 $ -
(1) Includes demand, savings and certificates of deposits. Does not include purchased or wholesale treasury
deposits. The placement of administered deposits such as savings and demand for interest rate risk
purposes reflects behavioral expectations associated with these balances. Long term core balances are
differentiated from more fluid balances in an effort to reflect anticipated shifts of non-core balances
to other deposit products or equities over time.
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The Company does not use the static "gap" measurement of interest rate risk reflected in the table above as a
primary management tool. In the course of managing interest rate risk, a combination of risk assessment
techniques, including dynamic simulation modeling, gap analysis, Value at Risk (VAR) and capital at risk
analyses are employed. The combination of these tools enables management to identify and assess the potential
impact of interest rate movements and take appropriate action.
Certain limits and benchmarks that serve as guidelines in determining the appropriate levels of interest rate
risk for the institution have been established. One such limit is expressed in terms of the Present Value of a
Basis Point (PVBP), which reflects the change in value of the balance sheet for a one basis point upward
movement in all interest rates. The institutional PVBP limit as of December 31, 2003 was +/-$4.0 million, which
includes distinct limits associated with trading portfolio activities and financial instruments. Thus, for a one
basis point upward change in interest rates, the policy dictates that the value of the balance sheet shall not
change by more than +/- $4.0 million. As of December 31, 2003, the Company had a position of $(0.4) million PVBP
reflecting the impact of a one basis point increase in interest rates.
The Company also monitors changes in value of the balance sheet, or capital at risk, for large movements in
interest rates with an overall limit of +/- 10%, after tax, change from the base case valuation for either a 200
basis point gradual rate increase or a 100 basis point gradual rate decrease. As of December 31, 2003, for a
gradual 200 basis point increase in rates, the value was projected to drop by 7% and for a 100 basis point
gradual decrease in rates, value was projected to drop by 3%. The projected drop in value for a 100 basis point
gradual decrease in rates is primarily related to the anticipated acceleration of prepayments for the held
mortgage and mortgage backed securities portfolios in this lower rate environment. This assumes that no
management actions are taken to manage exposures to the changing interest rate environment.
In addition to the above mentioned limits, ALCO particularly monitors the simulated impact of a number of
interest rate scenarios, on net interest income. These scenarios include both rate shock scenarios which assume
immediate market rate movements of 200 basis points, as well as rate change scenarios in which rates rise or
fall by 200 basis points over a twelve month period. The individual limit for such gradual 200 basis point
movements is currently +/- 10%, pretax, of base case earnings over a twelve month period. Simulations are also
performed for other relevant interest rate scenarios including immediate rate movements and changes in shape of
the yield curve, or in competitive pricing policies. Net interest income under the various scenarios is reviewed
over a twelve month period, as well as over a three year period. The simulations capture the effects of the
timing of the repricing of all assets and liabilities, including derivative instruments such as interest rate
swaps, futures and option contracts. Additionally, the simulations incorporate any behavioral aspects such as
prepayment sensitivity under various scenarios.
For purposes of simulation modeling, base case earnings reflect the existing balance sheet composition, with
balances generally maintained at current levels by the anticipated reinvestment of expected runoff. These
balance sheet levels will, however, factor in specific known or likely changes, including material increases,
decreases or anticipated shifts in balances due to management actions. Current rates and spreads are then
applied to produce base case earnings estimates on both a twelve month and three year time horizon. Rate shocks
are then modeled and compared to base earnings (earnings at risk), and include behavioral assumptions as
dictated by specific scenarios relating to such factors as prepayment sensitivity and the tendency of balances
to shift among various products in different rate environments. This assumes that no management actions are
taken to manage exposures to the changing environment being simulated.
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Utilizing these modeling techniques, a gradual 200 basis point parallel rise or fall in the yield curve on
January 1, 2004 would cause projected net interest income for the next twelve months to decrease by $61 million
(-2%) and to increase by $134 million (+5%) respectively. These changes are well within the Company's +/- 10%
limit. An immediate 100 basis point parallel rise or fall in the yield curve on January 1, 2004, would cause
projected net interest income for the next twelve months to decrease by $92 million and $41 million
respectively. An immediate 200 basis point parallel rise or fall would decrease projected net interest income
for the next twelve months by $227 million and $205 million respectively. In addition, simulations are performed
to analyze the impact associated with various twists and shapes of the yield curve. If the yield curve were to
flatten significantly (i.e. long end of the yield curve down) over the next twelve months, the projected margin
could shrink by approximately 5% to 7%, assuming no management actions.
The projections do not take into consideration possible complicating factors such as the effect of changes in
interest rates on the credit quality, size and composition of the balance sheet. Therefore, although this
provides a reasonable estimate of interest rate sensitivity, actual results will vary from these estimates,
possibly by significant amounts.
Large movements of interest rates could directly affect some reported capital and capital ratios. The mark to
market valuation of available for sale securities is credited on a tax effective basis through other
comprehensive income in the statement of shareholders' equity. This valuation mark is excluded from the
Company's Tier 1 and Tier 2 capital ratios (see capital ratios table on page 5), but it would be included in two
important accounting based capital ratios: the tangible common equity to tangible assets and the tangible common
equity to risk weighted assets. As of December 31, 2003, the Company had a sizeable available for sale
securities portfolio of $14.1 billion with a mark to market of $74.2 million included in tangible common equity
of $4.0 billion. An increase of 25 basis points in interest rates of all maturities would lower the mark to
market by $93.0 million to a loss of $18.8 million with the following results on the tangible capital ratios.
December 31, 2003
----------
Actual Proforma-Reflecting
25 Basis
Points
Lower Rates
Tangible common equity to tangible assets 4.34 % 4.28 %
Tangible common equity to risk weighted assets 6.39 6.29
In addition to using the risk measures of PVBP, capital at risk analysis, and simulation, the Company also uses
Value at Risk (VAR) analysis to measure interest rate risk and to calculate the economic capital required to
cover potential losses due to interest risk. PVBP, capital at risk and net interest income simulation analyses
all look at what will happen as a result of change or stress. PVBP shows the current sensitivity of total
present value to a one basis point movement in rates. This sensitivity may change as interest rates diverge
further from current rate levels due to such factors as mortgage portfolio prepayment speeds. Capital at risk
also looks at the sensitivity of total present value in stress scenarios - for example, the amount of change in
value for a 100 basis point drop in term interest rates. Net interest income simulation looks at the projected
flow of net interest income over time, again in response to stress scenarios. VAR, related to net interest
income, on the other hand, looks at a historical observation period (here it is two years) and shows, based upon
that, the potential loss from unfavorable market conditions during a "given period" with a certain confidence
level (99%). The Company uses a one-day "given period" or "holding period" for setting limits and measuring
results. Thus, at a 99% confidence level for 500 business days (about two calendar years) the Company is setting
as its limit the fifth worse
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loss performance in the last 500 business days. For purposes of determining economic capital the Company uses a
six month "given period," a conservative time to allow for adjustments of the Company's interest rate risk
profile.
The predominant VAR methodology used by the Company, "historical simulation", has a number of limitations
including the use of historical data as a proxy for the future, the assumption that position adjustments can be
made within the holding period specified, and the use of a 99% confidence level, which does not take into
account potential losses that might occur beyond that level of confidence.
Trading Activities
The trading portfolios of the Company reside primarily in the Company's Treasury and mortgage banking areas and
include foreign exchange, derivatives, precious metals (gold, silver, platinum), commodities, equities, money
market instruments including "repos" and securities. Trading occurs as a result of customer facilitation,
proprietary position taking, and economic hedging. In this context, economic hedging may include, for example,
forward contracts to sell residential mortgages and derivative contracts which, while economically viable, may
not satisfy the hedge requirements of SFAS 133.
The trading portfolios of the Company have defined limits pertaining to items such as permissible investments,
risk exposures, loss review, balance sheet size and product concentrations. "Loss review" refers to the maximum
amount of loss that may be incurred before senior management intervention is required.
The Company relies upon VAR analysis as a basis for quantifying and managing risks associated with the Treasury
trading portfolios. Such analysis is based upon the following two general principles:
(i) VAR applies to all Treasury trading positions across all risk classes including interest rate, equity,
commodity, optionality and global/foreign exchange risks and
(ii) VAR is based on the concept of independent valuations, with all transactions being repriced by an
independent risk management function using separate models prior to being stressed against VAR parameters.
VAR attempts to capture the potential loss resulting from unfavorable market developments within a given time
horizon (typically ten days), given a certain confidence level (99%) and based on a two year observation period.
VAR calculations are performed for market risk-related activities associated with all material Treasury trading
portfolios. The VAR is calculated using the historical simulation or the variance/covariance (parametric)
method. Included in the trading VAR is a Monte Carlo based estimate of "issuer specific credit risk" for fixed
income securities, which captures residual risk beyond the credit spread curve by rating and the interest rate
curve.
A VAR report broken down by Treasury trading business and on a consolidated basis is distributed daily to
management. To measure the accuracy of the VAR model output, the daily VAR is compared to the actual result from
Treasury trading activities.
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The following table summarizes Treasury trading VAR of the Company.
Full Year 2003
December Minimum Maximum Average December
31, 31,
2003 2002
in millions
Total trading $ 23.1 $ 15.3 $ 35.6 $ 24.5 $ 11.4
Commodities .5 .4 5.9 2.3 2.6
Credit derivatives 3.8 .6 3.9 1.6 2.1
Equities .8 .8 5.2 1.3 1.0
Foreign exchange 11.5 1.0 14.2 5.0 3.1
Interest rate 15.7 13.4 37.7 21.7 8.6
The following table summarizes the frequency distribution of daily market risk-related revenues for Treasury
trading activities in 2003. Market risk-related Treasury trading revenues include realized and unrealized gains
(losses) related to Treasury trading activities, but excludes the related net interest income. Analysis of 2003
gain (loss) data shows that the largest daily gain was $17.0 million and the largest daily loss was $7.5
million.
Ranges of daily Treasury trading
revenue earned from
market risk-related activities
Below $(4) to $(2) to $0 to $2 to $4 to Over
in millions $(4 ) $(2 ) $ 0 $2 $4 $ 6 $ 6
------
Number of trading days
market risk-related
revenue was within the
stated range 3 10 49 87 62 29 10
During 2003, the Company experienced significant volatility in its trading positions relative to mortgage
banking activities, particularly derivative instruments used to protect the economic value of its MSRs
portfolio. The following table summarizes the frequency distribution of weekly market risk-related revenues
associated with mortgage trading positions.
Ranges of mortgage trading
revenue earned from
market risk-related activities
Below $(20) to $(10) to $0 to $10 to Over
in millions $(20 ) $(10 ) $0 $10 $20 $ 20
------
Number of trading weeks
market risk-related
revenue was within the
stated range 5 7 19 14 5 2
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Operational Risk
Operational risk is the risk of loss arising through fraud, unauthorized activities, errors, omissions,
inefficiency, systems failure or from external events. It is inherent in every business organization and covers
a wide spectrum of issues.
As part of its multi-year program to upgrade its risk management framework, the Company has developed an
independent Operational Risk Management discipline. Line management is responsible for managing and controlling
all risks and for communicating and implementing all control standards. A corporate Operational Risk Coordinator
maintains a network of business line Operational Risk Coordinators; develops quantitative tools and databases;
provides training and develops awareness; and independently reviews the assessments of Operational Risks. The
Operational Risk Management Committee is responsible for oversight of the risks being taken, the analytic tools
used, and reporting. Results from this Committee are communicated to the Risk Management Committee and
subsequently to the Audit and Examining Committee of the Board.
The management of operational risk comprises the identification, assessment, monitoring, control and mitigation
of the risk, rectification of the results of risk events and compliance with local regulatory requirements. Risk
assessments were completed by the majority of businesses in the Company in 2002. The balance were completed in
early 2003.
HSBC Group codified its Operational Risk Management process by issuing a high level standard in May 2002. Key
features within the standard have been addressed in the Company's Operational Risk Management program and
include:
- Each business and support department is responsible for the identification and management of their
operational risks.
- Each risk is evaluated and scored by its likelihood to occur; its potential impact on shareholder value;
and by exposure - based on the effectiveness of current controls to prevent or mitigate losses. An
Operational Risk automated database is used to record risk assessments and track risk mitigation action
plans. The risk assessments are reviewed as business conditions change or at least annually.
- Key risk indicators are established in the automated database where appropriate, and tracked monthly.
- The database is also used to track operational losses for analysis of root causes, comparison with risk
assessments and lessons learned.
Management practices include standard monthly reporting of high risks, risk mitigation action plan exceptions,
losses and key risk indicators to business line managers, executive management and the Operational Risk
Management Committee. Monthly certification of internal controls includes an Operational Risk attestation.
Operational Risk Management is an integral part of the new product development process and the management
performance measurement process.
Internal audits, including audits by specialist teams in information technology and treasury, provide an
important check on controls and test institutional compliance with the Operational Risk Management policy.
An annual review of internal controls is conducted by internal audit as part of the Company's compliance with
the Federal Deposit Insurance Corporation Improvement Act (FDICIA) and its comprehensive examination and
documentation of controls across the Company involving all business and support units.
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In the fall of 2003, the Company completed pilot calculations of economic capital related to operational risk
using all available internal data as well as external loss data.
Business Continuity Planning
The Company is committed to the protection of employees, customers and shareholders by a quick response to all
threats to the organization, whether they are of a physical or financial nature. For this purpose, the Company
has established a Business Continuity Event Management (EM) process. EM provides an enterprise-wide response and
communication framework for managing major business continuity events or incidents. It is designed to be
flexible and is scaled to the scope and magnitude of the event or incident.
The EM process works in tandem with the Company's business continuity policy, plans and key business continuity
committees to manage events. The Company's Crisis Management Committee, a 24/7 standing committee, is activated
to manage the EM process in concert with senior Company management. This committee provides critical strategic
and tactical management of business continuity crisis issues, risk management, communication, coordination and
recovery management. The Company also has designated an Institutional Manager for Business Continuity who plays
a key role on the Crisis Management Committee. All major business and support functions have a senior
representative assigned to the Company's Business Continuity Planning Committee chaired by the Institutional
Manager.
The Company has dedicated certain work areas as hot and warm backup sites, which serve as primary business
recovery locations. The Company also has concentrations of major operations in both upstate and downstate New
York. This geographic split of major operations is leveraged to provide secondary business recovery sites for
many critical business and support areas of the Company.
The Company has built its own tier-4 (highest level of resiliency) data center for disaster recovery purposes.
Data is mirrored synchronously to the disaster recovery site across duplicate dark fiber loops. A high level of
network backup resiliency has been established. In a disaster situation, the Company is positioned to bring main
systems and server applications online with predetermined timeframes.
The Company tests business continuity and disaster recovery resiliency and capability through routine
contingency tests and actual events. Business continuity and disaster recovery programs have been strengthened
in numerous areas as a result of these tests or actual events. There is a continuing effort to enhance the
program well beyond the traditional business resumption and disaster recovery model.
In 2003, the Company determined the applicability of the Interagency Paper on "Sound Practices to Strengthen the
Resiliency of the U.S. Financial System". The Company is committed to meeting or exceeding the requirements of
the paper for the businesses impacted by the compliance due date.
Business continuity is a critically and strategically important objective for the Company.
59
Fiduciary Risk
Fiduciary risk is the potential that we may fail to perform properly advisory services that have been agreed to
be performed for fees. These risks occur in several of the Company's businesses such as private banking,
investment management, investment advisory, or corporate trust. Frequently risks occur in areas regulated by
Federal securities laws. Almost always they occur in areas where the Company is entrusted to handle customer
business affairs with discretion or judgments. Many fiduciary risks are operational risks, such as settlement
fails on a trust customer's accounts, but others are not, such as inappropriate investment allocations.
Fiduciary risk management is overseen by the Fiduciary Risk Management Committee. Day-to-day oversight and
testing of controls, and the recommendation of appropriate tools, is done by an independent Fiduciary Risk
Officer appointed in July 2003.
As part of its multi-year program to enhance risk measurement and management, the Company is identifying and
scoring all fiduciary risk by likelihood, potential severity, and exposure; conducting self assessments of
controls; and tracking of key indicators of risk. Risk indicators are warning signals if they change too much
too fast (for example, levels of uninvested cash) or are too large or too high (for example, systems down time).
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Refer to the disclosure in Item 7 of the Management's Discussion and Analysis of Financial Condition and Results
of Operations under the captions "Interest Rate Risk Management" and "Trading Activities".
60
Item 8. Financial Statements and Supplementary Data
Page
Report of Independent Auditors 62
HSBC USA Inc.:
Consolidated Balance Sheet 63
Consolidated Statement of Income 64
Consolidated Statement of Changes in
Shareholders' Equity 65
Consolidated Statement of Cash Flows 66
HSBC Bank USA:
Consolidated Balance Sheet 67
Summary of Significant Accounting Policies 68
Notes to Financial Statements 75
61
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Shareholders of
HSBC USA Inc.
We have audited the accompanying consolidated balance sheets of HSBC USA Inc. and subsidiaries (the Company) as
of December 31, 2003 and 2002, and the related consolidated statements of income, changes in shareholders'
equity, and cash flows for each of the years in the three year period ended December 31, 2003, and the
accompanying consolidated balance sheets of HSBC Bank USA and subsidiaries (the Bank) as of December 31, 2003
and 2002. These consolidated financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of
America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing
the accounting principles used and significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material
respects, the financial position of the Company as of December 31, 2003 and 2002, and the results of their
operations and their cash flows for each of the years in the three year period ended December 31, 2003, and the
financial position of the Bank as of December 31, 2003 and 2002, in conformity with accounting principles
generally accepted in the United States of America.
As discussed in Note 7, the Company adopted prospectively the provisions of Statement of Financial Accounting
Standards No. 142, Goodwill and Other Intangible Assets, in 2002.
/s/ KPMG LLP
February 2, 2004
New York, New York
62
HSBC USA Inc. 2003
CONSOLIDATED BALANCE SHEET
December 31, 2003 2002
-------
Assets in thousands
Cash and due from banks $ 2,533,883 $ 2,081,279
Interest bearing deposits with banks 843,085 1,048,294
Federal funds sold and securities purchased under resale 2,445,511 2,742,943
agreements
Trading assets 14,646,222 13,408,215
Securities available for sale 14,142,723 14,694,115
Securities held to maturity (fair value $4,647,713 and 4,511,629 4,628,482
$4,905,162)
Loans 48,473,971 43,635,872
Less - allowance for credit losses 398,596 493,125
Loans, net 48,075,375 43,142,747
Premises and equipment 680,763 726,457
Accrued interest receivable 299,279 328,595
Equity investments 316,408 278,270
Goodwill 2,777,474 2,829,074
Other assets 4,289,366 3,517,730
Total assets $ 95,561,718 $ 89,426,201
Liabilities
Deposits in domestic offices
Noninterest bearing $ 6,092,560 $ 5,731,442
Interest bearing 38,995,090 34,902,431
Deposits in foreign offices
Noninterest bearing 453,332 397,743
Interest bearing 18,414,475 18,798,723
Total deposits 63,955,457 59,830,339
Trading account liabilities 10,460,112 7,710,010
Short-term borrowings 6,782,134 7,392,368
Interest, taxes and other liabilities 3,088,469 3,422,047
Long-term debt 3,814,010 3,674,844
Total liabilities 88,100,182 82,029,608
Shareholders' equity
Preferred stock 500,000 500,000
Common shareholder's equity
Common stock, $5 par; Authorized -150,000,000 shares
Issued - 704 shares 4 4
Capital surplus 6,027,001 6,056,307
Retained earnings 806,462 578,083
Accumulated other comprehensive income 128,069 262,199
Total common shareholder's equity 6,961,536 6,896,593
Total shareholders' equity 7,461,536 7,396,593
Total liabilities and shareholders' equity $ 95,561,718 $ 89,426,201
The accompanying notes are an integral part of the consolidated financial statements.
63
HSBC USA Inc. 2003
CONSOLIDATED STATEMENT OF INCOME
Year Ended December 31, 2003 2002 2001
-------------
in thousands
Interest income
Loans $ 2,349,681 $ 2,521,200 $ 2,937,052
Securities 886,706 951,542 1,260,439
Trading assets 136,577 161,262 217,007
Short-term investments 79,736 149,400 345,150
Other interest income 20,632 23,366 27,853
Total interest income 3,473,332 3,806,770 4,787,501
Interest expense
Deposits 666,336 973,575 1,904,386
Short-term borrowings 91,277 231,567 337,205
Long-term debt 205,478 225,352 280,618
Total interest expense 963,091 1,430,494 2,522,209
Net interest income 2,510,241 2,376,276 2,265,292
Provision for credit losses 112,929 195,000 238,400
Net interest income, after provision for credit losses 2,397,312 2,181,276 2,026,892
Other operating income
Trust income 93,768 94,419 87,600
Service charges 211,733 206,423 189,025
Other fees and commissions 446,297 398,139 324,804
Other income 165,582 88,804 56,960
Mortgage banking revenue (expense) (102,606 ) 23,752 33,214
Trading revenues 290,632 130,079 254,812
Security gains, net 48,302 117,648 149,267
Total other operating income 1,153,708 1,059,264 1,095,682
3,551,020 3,240,540 3,122,574
Operating expenses
Salaries and employee benefits 1,131,063 1,029,254 1,000,409
Occupancy expense, net 156,347 155,655 155,436
Goodwill amortization - - 176,482
Princeton Note Matter - - 575,000
Other expenses 752,465 690,558 635,658
Total operating expenses 2,039,875 1,875,467 2,542,985
Income before taxes and cumulative effect of accounting 1,511,145 1,365,073 579,589
change
Applicable income tax expense 570,400 509,629 226,000
Income before cumulative effect of accounting change 940,745 855,444 353,589
Cumulative effect of accounting change - implementation
of SFAS 133, net of tax - - (451 )
Net income $ 940,745 $ 855,444 $ 353,138
The accompanying notes are an integral part of the consolidated financial statements.
64
HSBC USA Inc. 2003
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
2003 2002 2001
in thousands
Preferred stock
Balance, January 1, $ 500,000 $ 500,000 $ 500,000
Balance, December 31, 500,000 500,000 500,000
Common stock
Balance, January 1, 4 4 4
Balance, December 31, 4 4 4
Capital surplus
Balance, January 1, 6,056,307 6,034,598 6,104,264
Return of capital (43,905 ) - (84,939 )
Other 14,599 21,709 15,273
Balance, December 31, 6,027,001 6,056,307 6,034,598
Retained earnings
Balance, January 1, 578,083 415,821 612,798
Net income 940,745 855,444 353,138
Cash dividends declared:
Preferred stock (22,366 ) (23,182 ) (25,115 )
Common stock (690,000 ) (670,000 ) (525,000 )
Balance, December 31, 806,462 578,083 415,821
Accumulated other comprehensive income (loss)
Balance, January 1, 262,199 98,607 116,851
Net change in unrealized gains on securities (174,629 ) 80,508 31,100
Net change in unrealized gain (loss) on
derivatives
classified as cash flow hedges 11,197 78,968 (37,503 )
Foreign currency translation adjustment 29,302 4,116 (11,841 )
Other comprehensive income (loss), net of tax (134,130 ) 163,592 (18,244 )
Balance, December 31, 128,069 262,199 98,607
Total shareholders' equity, December 31, $ 7,461,536 $ 7,396,593 $ 7,049,030
Comprehensive income
Net income $ 940,745 $ 855,444 $ 353,138
Other comprehensive income (loss) (134,130 ) 163,592 (18,244 )
Comprehensive income $ 806,615 $ 1,019,036 $ 334,894
The accompanying notes are an integral part of the consolidated financial statements.
65
HSBC USA Inc. 2003
CONSOLIDATED STATEMENT OF CASH FLOWS
Year Ended December 31, 2003 2002 2001
-------------
in thousands
Cash flows from operating activities
Net income $ 940,745 $ 855,444 $ 353,138
Adjustments to reconcile net income to net cash
provided (used) by operating activities
Depreciation, amortization and deferred taxes 398,821 810,810 119,831
Provision for credit losses 112,929 195,000 238,400
Net change in other accrual accounts (959,656 ) (693,559 ) 897,893
Net change in loans originated for sale 1,032,677 (775,464 ) (665,273 )
Net change in trading assets and liabilities 448,255 (408,543 ) (1,752,622 )
Other, net (484,907 ) (585,592 ) (348,128 )
Net cash provided (used) by operating 1,488,864 (601,904 ) (1,156,761 )
activities
Cash flows from investing activities
Net change in interest bearing deposits with banks (396,319 ) 2,512,580 1,389,943
Net change in short-term investments 493,637 (95,601 ) (751,850 )
Purchases of securities held to maturity (2,677,475 ) (1,556,240 ) (545,874 )
Proceeds from maturities of securities held to 3,003,556 1,595,747 1,175,902
maturity
Purchases of securities available for sale (13,827,092 ) (13,109,951 ) (15,585,510 )
Proceeds from sales of securities available for sale 3,636,698 7,032,407 12,395,526
Proceeds from maturities of securities available for 10,752,357 5,305,988 4,820,044
sale
Net change in credit card receivables (85,601 ) (15,316 ) (11,937 )
Net change in other short-term loans 245,261 (374,180 ) 616,194
Net originations and maturities of long-term loans (3,130,777 ) (1,561,311 ) (551,253 )
Loans purchased (2,846,997 ) - -
Sales of loans 668,548 189,905 79,666
Expenditures for premises and equipment (65,208 ) (82,821 ) (76,810 )
Net cash provided (used) in acquisitions, net of cash 403,263 23,221 (21,547 )
acquired
Other, net (351,120 ) 25,126 92,975
Net cash provided (used) by investing (4,177,269 ) (110,446 ) 3,025,469
activities
Cash flows from financing activities
Net change in deposits 4,405,072 2,399,319 (79,387 )
Net change in short-term borrowings (660,356 ) (978,648 ) (339,348 )
Issuance of long-term debt 270,588 978,765 23,262
Repayment of long-term debt (117,869 ) (1,021,996 ) (595,397 )
Contribution (return) of capital (43,905 ) 6,500 (84,939 )
Dividends paid (712,521 ) (693,067 ) (550,856 )
Net cash provided (used) by financing 3,141,009 690,873 (1,626,665 )
activities
Net change in cash and due from banks 452,604 (21,477 ) 242,043
Cash and due from banks at beginning of year 2,081,279 2,102,756 1,860,713
Cash and due from banks at end of year $ 2,533,883 $ 2,081,279 $ 2,102,756
Cash paid for: Interest $ 990,172 $ 1,484,348 $ 2,721,880
Income taxes 330,746 210,610 259,387
The accompanying notes are an integral part of the consolidated financial statements.
Pending settlement receivable/payables related to securities and trading assets and liabilities are treated as
non cash items for cash flows reporting.
66
HSBC Bank USA 2003
CONSOLIDATED BALANCE SHEET
December 31, 2003 2002
-------
in thousands
Assets
Cash and due from banks $ 2,531,805 $ 2,079,940
Interest bearing deposits with banks 554,627 707,840
Federal funds sold and securities purchased under resale agreements 2,445,511 2,742,943
Trading assets 14,487,418 13,243,465
Securities available for sale 13,525,458 13,701,218
Securities held to maturity (fair value $4,453,356 and $4,639,939) 4,331,174 4,372,512
Loans 48,389,821 43,528,280
Less - allowance for credit losses 397,898 491,801
Loans, net 47,991,923 43,036,479
Premises and equipment 676,445 723,647
Accrued interest receivable 295,360 322,297
Equity investments 247,811 245,614
Goodwill 2,172,973 2,224,573
Other assets 3,697,618 3,015,241
Total assets $ 92,958,123 $ 86,415,769
Liabilities
Deposits in domestic offices
Noninterest bearing $ 6,064,846 $ 5,682,618
Interest bearing 38,995,090 34,902,431
Deposits in foreign offices
Noninterest bearing 453,332 397,743
Interest bearing 19,033,289 19,731,918
Total deposits 64,546,557 60,714,710
Trading account liabilities 10,442,571 7,696,329
Short-term borrowings 5,516,678 5,907,951
Interest, taxes and other liabilities 2,718,768 3,147,260
Long-term debt 1,812,203 1,660,912
Total liabilities 85,036,777 79,127,162
Shareholder's equity
Common shareholder's equity
Common stock, $100 par; Authorized - 2,250,000 shares
Issued - 2,050,002 shares 205,000 205,000
Capital surplus 6,925,306 6,454,612
Retained earnings 695,161 384,408
Accumulated other comprehensive income 95,879 244,587
Total shareholder's equity 7,921,346 7,288,607
Total liabilities and shareholder's equity $ 92,958,123 $ 86,415,769
The accompanying notes are an integral part of the consolidated financial statements.
67
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
HSBC USA Inc. (the Company), is a New York State based bank holding company, and is an indirect wholly owned
subsidiary of HSBC Holdings plc (HSBC).
The accounting and reporting policies of the Company and its subsidiaries, including its principal subsidiary,
HSBC Bank USA (the Bank), conform to accounting principles generally accepted in the United States of America
and to predominant practice within the banking industry. The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America requires the use of estimates and
assumptions that affect reported amounts and disclosures. Actual results could differ from those estimates.
Certain reclassifications have been made to prior year amounts to conform with current year presentations.
The following is a description of the significant policies and practices.
Principles of Consolidation
The financial statements of the Company and the Bank are consolidated with those of their respective wholly
owned subsidiaries. All material intercompany transactions and balances have been eliminated. Investments in
companies in which the percentage of ownership is at least 20%, but not more than 50%, are generally accounted
for under the equity method and reported as equity investments.
Foreign Currency Translation
The accounts of the Company's foreign operations are measured using local currency as the functional currency.
Assets and liabilities are translated into United States dollars at period end exchange rates. Income and
expense accounts are translated at average monthly exchange rates. Net exchange gains or losses resulting from
such translation are included in accumulated other comprehensive income and reported as a separate component of
shareholders' equity. Foreign currency denominated transactions in other than the local functional currency are
translated using the period end exchange rate with any foreign currency transaction gain or loss recognized
currently in income.
Statement of Cash Flows
For the Company's consolidated statement of cash flows, cash and cash equivalents is defined as those amounts
included in cash and due from banks.
Resale and Repurchase Agreements
The Company enters into purchases of securities under agreements to resell ("resale agreements") and sales of
securities under agreements to repurchase ("repurchase agreements") of substantially identical securities.
Resale agreements and repurchase agreements are generally accounted for as secured lending and secured borrowing
transactions respectively.
The amounts advanced under resale agreements and the amounts borrowed under repurchase agreements are carried on
the consolidated balance sheet at the amount advanced or borrowed. Interest earned on resale agreements and
interest paid on repurchase agreements are reported as interest income and
68
interest expense respectively. The Company offsets resale and repurchase agreements executed with the same
counterparty under legally enforceable netting agreements that meet the applicable netting criteria. The
Company's policy is to take possession of securities purchased under resale agreements. The market value of the
securities subject to the resale and repurchase agreements is regularly monitored to ensure appropriate
collateral coverage of these secured financing transactions.
Securities
Debt securities that the Company has the ability and intent to hold to maturity are reported at cost, adjusted
for amortization of premiums and accretion of discounts. Securities acquired principally for the purpose of
selling them in the near term are classified as trading assets and reported at fair value, with unrealized gains
and losses included in earnings. All other securities are classified as available for sale and carried at fair
value, with unrealized gains and losses, net of related income taxes, included in accumulated other
comprehensive income and reported as a separate component of shareholders' equity.
The fair value of securities and derivative contracts is based on current market quotations, where available or
internal valuation models that approximate market pricing. The validity of internal pricing models is regularly
substantiated by reference to actual market prices realized upon sale or liquidation of these instruments. If
quoted market prices are not available, fair value is estimated based on the quoted price of similar
instruments.
Realized gains and losses on sales of securities are computed on a specific identified cost basis and are
reported within other operating income in the consolidated statement of income. Adjustments of trading assets to
fair value and gains and losses on the sale of such securities are recorded in trading revenues.
The Company regularly evaluates its securities portfolios to identify losses in value that are deemed other than
temporary. To the extent such losses are identified, a loss is recognized in current other operating income.
Loans
Loans are stated at their principal amount outstanding, net of unearned income, purchase premium or discount,
unamortized nonrefundable fees and related direct loan origination costs. Loans held for sale are carried at the
lower of aggregate cost or market value and remain presented as loans in the consolidated balance sheet.
Interest income is recorded based on methods that result in level rates of return over the terms of the loans.
Commercial loans are categorized as nonaccruing when, in the opinion of management, reasonable doubt exists with
respect to the ultimate collectibility of interest or principal based on certain factors including period of
time past due (principally ninety days) and adequacy of collateral. At the time a loan is classified as
nonaccruing, any accrued interest recorded on the loan is generally reversed and charged against income.
Interest income on these loans is recognized only to the extent of cash received. In those instances where there
is doubt as to collectibility of principal, any interest payments received are applied to principal. Loans are
not reclassified as accruing until interest and principal payments are brought current and future payments are
reasonably assured.
69
Residential mortgages are generally designated as nonaccruing when delinquent for more than ninety days. Loans
to credit card customers that are past due more than ninety days are designated as nonaccruing if the customer
has agreed to credit counseling; otherwise they are charged off in accordance with a predetermined schedule.
Other consumer loans are generally not designated as nonaccruing and are charged off against the allowance for
credit losses according to an established delinquency schedule.
Loans, other than those included in large groups of smaller balance homogenous loans, are considered impaired
when, based on current information, it is probable that the Company will be unable to collect all amounts due
according to the contractual terms of the loan agreement. Impaired loans are valued at the present value of
expected future cash flows, discounted at the loan's original effective interest rate or, as a practical
expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral
dependent.
Restructured loans are loans for which the original contractual terms have been modified to provide for terms
that are less than the Company would be willing to accept for new loans with comparable risk because of a
deterioration in the borrowers' financial condition. Interest on these loans is accrued at the renegotiated
rates.
Loan Fees
Nonrefundable fees and related direct costs associated with the origination or purchase of loans are deferred
and netted against outstanding loan balances. The amortization of net deferred fees and costs are recognized in
interest income, generally by the interest method, based on the estimated lives of the loans. Nonrefundable fees
related to lending activities other than direct loan origination are recognized as other operating income over
the period the related service is provided. This includes fees associated with the issuance of loan commitments
where the likelihood of the commitment being exercised is considered remote. In the event of the exercise of the
commitment, the remaining unamortized fee is recognized in interest income over the loan term using the interest
method. Other credit-related fees, such as standby letter of credit fees, loan syndication and agency fees and
annual credit card fees are recognized as other operating income over the period the related service is
performed.
Allowance for Credit Losses
The Company maintains an allowance for credit losses that is, in the judgment of management, adequate to absorb
estimated losses inherent in its commercial and consumer loan portfolios. A separate reserve for credit losses
associated with certain off-balance sheet exposures including letters of credit, guarantees to extend credit and
financial guarantees is also maintained and included in other liabilities. The adequacy of the allowance and
this reserve is assessed within the context of both Statement of Financial Accounting Standards No. 114,
Accounting by Creditors for Impairment of a Loan (SFAS 114), and Statement of Financial Accounting Standards No.
5, Accounting for Contingencies (SFAS 5), and is based upon an evaluation of various factors including an
analysis of individual exposures, current and historical loss experience, changes in the overall size and
composition of the portfolio, specific adverse situations, and general economic conditions. Provisions for all
credit losses are recorded to earnings based upon the Company's periodic review of these and other pertinent
factors. Actual loan losses are charged and recoveries are credited to the allowance.
70
For commercial and select consumer loan assets, the Company conducts a periodic assessment of losses it believes
to be inherent in the loan portfolio. When it is deemed probable, based upon known facts and circumstances, that
full contractual interest and principal on an individual loan will not be collected, the asset is considered
impaired. In accordance with SFAS 114, a "specific loss" impairment reserve is established based upon the
present value of expected future cash flows, discounted at the loan's original effective interest rate, or as a
practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is
collateral dependent.
Formula-based reserves are also established against commercial loans and off balance sheet credit exposures in
accordance with SFAS 5, when based upon an analysis of relevant data, it is probable that a loss has been
incurred and will be realized and the amount of that loss can be reasonably estimated, even though it has yet to
manifest itself in a specifically identifiable loan asset. These reserves are determined by reference to
continuously monitored and updated historical loss rates or factors, derived from a migration analysis which
considers net charge off experience by loan and industry type, in relation to internal credit grading.
Homogeneous pools of loans including consumer installment, residential mortgage and credit cards are not
assigned specific loan grades. Formula based reserves are generally determined based upon historical loss
experience by loan type or in certain instances, by reference to specific collateral values.
Although the calculation of required formula reserves is a mechanical process incorporating historical data, the
ultimate selection of reserve factors and the assessment of the overall adequacy of the allowance to provide for
credit losses inherent in the loan portfolio involves a high degree of subjective management judgment. With
recognition to the imprecision in estimating credit losses, and with consideration given to probable losses
associated with factors including the impact of the national economic cycle, migration trends within
non-criticized portfolios of loans, as well as portfolio concentration, the Company therefore also maintains an
"unallocated reserve".
The Company gathers and analyzes historical data, updates assumptions relative to expected loss experience and
reviews individual and portfolio loan assets on a quarterly basis. There have been no material changes in
estimation techniques or loss reserve methodology during the year.
Mortgage Servicing Rights
The Company recognizes the right to service mortgages as a separate and distinct asset at the time the loans are
sold. Servicing rights are then amortized in proportion to net servicing income and carried on the balance sheet
in other assets at the lower of their initial carrying value, adjusted for amortization, or fair value.
As interest rates decline, prepayments generally accelerate, thereby reducing future net servicing cash flows
from the mortgage portfolio. The carrying value of the mortgage servicing rights (MSRs) is periodically
evaluated for impairment based on the difference between the carrying value of such rights and their current
fair value. For purposes of measuring impairment which, if temporary is recorded through the use of a valuation
reserve or, if permanent as a direct write-down, MSRs are stratified based upon interest rates and whether such
rates are fixed or variable and other loan characteristics. Fair value is determined based upon the application
of pricing valuation models incorporating portfolio specific prepayment assumptions. The reasonableness of these
pricing models is periodically substantiated by reference to independent broker price quotations and actual
market sales.
71
If the carrying value of the servicing rights exceeds fair value, the asset is deemed impaired and impairment is
recognized by recording a balance sheet valuation reserve with a corresponding charge to income.
The Company uses certain derivative financial instruments including constant maturity U.S. Treasury floors and
interest rate swaps, to protect against the decline in economic value of servicing rights. These instruments
have not been designated as qualifying hedges under SFAS 133 and are therefore recorded as trading instruments
that are marked to market through earnings.
Goodwill and Other Acquisition Intangibles
On January 1, 2002, the Company adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets (SFAS 142). SFAS 142 requires that goodwill, including previously existing goodwill, and
intangible assets with indefinite useful lives, not be amortized but rather tested for impairment at least
annually. Under SFAS 142, all recorded goodwill must be assigned to one or more reporting units of the entity
and evaluated for impairment at that level. Impairment testing requires that the fair value of each reporting
unit be compared to its carrying amount, including the goodwill.
Goodwill, representing the excess of purchase price over the fair value of net assets acquired, results from
purchase acquisitions made by the Company. Prior to the adoption of SFAS 142, goodwill and other acquisition
intangibles were amortized over the estimated periods to be benefited, under the straight-line method, not
exceeding 20 years.
Income Taxes
The Company and its subsidiaries are members of a larger group which files a consolidated federal income tax
return.
Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to
differences between the financial statement carrying amounts of existing assets and liabilities and their
respective tax bases, as well as the estimated future tax consequences attributable to net operating loss and
tax credit carryforwards. A valuation allowance is established if, based on available evidence, it is more
likely than not that some portion or all of the deferred tax asset will not be realized. Foreign taxes paid are
applied as credits to reduce federal income taxes payable.
Derivative Financial Instruments
On January 1, 2001, the Company adopted Statement of Financial Accounting Standards No. 133, Accounting for
Derivative Instruments and Hedging Activities (SFAS 133). All derivatives are now recognized on the balance
sheet at their fair value. On the date the derivative contract is entered into (January 1, 2001 for all
derivatives in place at that date) the Company designates it as (1) a qualifying SFAS 133 hedge of the fair
value of a recognized asset or liability or of an unrecognized firm commitment ("fair value" hedge); or (2) a
qualifying SFAS 133 hedge of a forecasted transaction of the variability of cash flows to be received or paid
related to a recognized asset or liability ("cash flow" hedge); or (3) as a trading position.
Changes in the fair value of a derivative that has been designated and qualifies as a fair value hedge, along
with the changes in the fair value of the hedged asset or liability that is attributable to the hedged risk
(including losses or gains on firm commitments), are recorded in current.
72
period earnings. Changes in the fair value of a derivative that has been designated and qualifies as a cash flow
hedge are recorded in other comprehensive income to the extent of its effectiveness, until earnings are impacted
by the variability of cash flows from the hedged item. Changes in the fair value of derivatives held for trading
purposes are reported in current period earnings.
At the inception of each hedge (January 1, 2001 for all derivatives in place at that date), the Company formally
documents all relationships between hedging instruments and hedged items, as well as its risk management
objective and strategy for undertaking various hedge transactions. This process includes linking all derivatives
that are designated as fair value or cash flow hedges to specific assets and liabilities on the balance sheet or
to specific firm commitments or forecasted transactions.
Increased earnings volatility may result from the on-going mark to market of certain economically viable
derivative contracts that do not satisfy the hedging requirements of SFAS 133, as well as from the hedge
ineffectiveness associated with the qualifying contracts. The Company expects however that it will be able to
continue to pursue its overall asset and liability risk management objectives using a combination of derivatives
and cash instruments.
Embedded Derivatives
The Company may acquire or originate a financial instrument that contains a derivative instrument "embedded"
within it. Upon origination or acquisition of any such instrument, the Company assesses whether the economic
characteristics of the embedded derivative are clearly and closely related to the economic characteristics of
the principal component of the financial instrument (i.e., the "host contract") and whether a separate
instrument with the same terms as the embedded instrument would meet the definition of a derivative instrument.
When it is determined that (1) the embedded derivative possesses economic characteristics that are not clearly
and closely related to the economic characteristics of the host contract; and (2) a separate instrument with the
same terms would qualify as a derivative instrument, the embedded derivative is separated from the host
contract, carried at fair value, and designated a trading instrument.
Hedge Discontinuation
The Company formally assesses, both at the hedge's inception and on an on-going basis, whether the derivatives
that are used in hedging transactions are highly effective in offsetting changes in fair values or cash flows of
hedged items and whether they are expected to continue to be highly effective in future periods. If it is
determined that a derivative is not highly effective as a hedge, or that in the future it ceases to be a highly
effective hedge, the Company discontinues hedge accounting prospectively, as discussed below.
The Company discontinues hedge accounting prospectively when (1) the derivative is no longer effective in
offsetting changes in the fair value or cash flows of a hedged item (including firm commitments or forecasted
transactions); (2) the derivative expires or is sold, terminated, or exercised; (3) it is unlikely that a
forecasted transaction will occur; (4) the hedged firm commitment no longer meets the definition of a firm
commitment; or (5) the designation of the derivative as a hedging instrument is no longer appropriate.
73
When hedge accounting is discontinued because it is determined that the derivative no longer qualifies as an
effective fair value or cash flow hedge, the derivative will continue to be carried on the balance sheet at its
fair value, and the hedged item will no longer be adjusted for changes in fair value or changes in the fair
value of the derivative reclassified to other comprehensive income. If the hedged item was a firm commitment or
forecasted transaction that is not expected to occur, any amounts recorded on the balance sheet related to the
hedged item, including any amounts recorded in other comprehensive income, are reclassified to current period
earnings. In all other situations in which hedge accounting is discontinued, the derivative will be carried at
its fair value on the balance sheet, with changes in its fair value recognized in current period earnings unless
redesignated as a qualifying SFAS 133 hedge.
Regulation
A description of bank regulatory matters affecting the Company is included in the Description of Business
section under "Regulation, Supervision and Capital" on page 5 until the second table on page 6.
74
NOTES TO FINANCIAL STATEMENTS
Note 1. Acquisitions/Divestitures
2003
On December 31, 2003 approximately $2.8 billion of residential mortgage loan assets were purchased from
Household International, Inc. (Household).
On December 31, 2003 the Company sold its domestic factoring business to CIT Group Inc. Approximately $1 billion
of gross loan assets and over $700 million of liabilities were sold for $325 million in cash. The transaction
did not have a material effect on the 2003 results of the Company.
2001
On April 1, 2001, the Bank acquired approximately a 5 percent interest in the voting shares of HSBC Republic
Bank (Suisse) S.A. (Swiss Bank), an affiliate wholly owned by the HSBC Group, in exchange for the contribution
to the Swiss Bank of private banking businesses conducted by the Bank's Singapore and Hong Kong branches
acquired as part of the Republic acquisition. The 5 percent interest represented the fair value estimate of the
businesses transferred to the Swiss Bank and is being accounted for using the equity method of accounting due to
the common control relationship of the entities. The Bank retained its banknotes activities in Singapore and its
banknotes and foreign currency businesses in Hong Kong, and maintained its branch licenses in both locations.
The transaction was another step in an internal reorganization of the HSBC Group's global private banking
operations, which began late in 2000. The Swiss Bank, a Switzerland based banking affiliate, manages much of the
HSBC Group's worldwide private banking business. Swiss Bank is a foreign bank chartered and regulated under the
banking laws of Switzerland.
On January 1, 2001, the Bank acquired the Panama branches of HSBC Bank plc for approximately $22 million in
cash. The purchase included two branches in Panama City, one in the Colon Free Trade Zone, one in Colon and one
in Aguadulce. The Bank acquired approximately $500 million in assets and assumed $450 million in customer and
bank deposits. The acquisition was accounted for as a transfer of assets between companies under common control
at HSBC Bank plc's historical cost.
Note 2. Trading Assets and Liabilities
An analysis of trading assets and liabilities follows.
December 31, 2003 2002
-------
in thousands
Trading assets:
U.S. Treasury $ 114,804 $ 523,908
U.S. Government agency 875,450 711,000
Asset backed securities 1,504,782 1,870,750
Corporate bonds 847,911 1,236,953
Other securities 1,344,506 693,986
Fair value of derivatives 7,652,596 5,418,705
Precious metals 2,306,173 2,952,913
$ 14,646,222 $ 13,408,215
Trading account liabilities:
Securities sold, not yet purchased $ 913,958 $ 1,481,788
Payables for precious metals 1,181,237 1,183,243
Fair value of derivatives 8,364,917 5,044,979
$ 10,460,112 $ 7,710,010
75
Note 3. Securities
At December 31, 2003 and 2002, the Company held no securities of any single issuer (excluding the U.S. Treasury
and federal agencies) with a book value that exceeded 10% of shareholders' equity.
The amortized cost and fair value of the securities available for sale and securities held to maturity
portfolios follow.
December 31, 2003 Amortized Gross Gross Fair
Cost Unrealized Unrealized Value
Gains Losses
----------
in thousands
U.S. Treasury $ 213 $ 8 $ - $ 221
U.S. Government agency 10,778,055 154,921 141,012 10,791,964
Asset backed securities 1,784,272 7,427 5,818 1,785,881
Other domestic debt securities 414,924 1,057 35 415,946
Foreign debt securities 903,869 12,601 312 916,158
Equity securities 187,176 49,547 4,170 232,553
Securities available for sale $ 14,068,509 $ 225,561 $ 151,347 $ 14,142,723
U.S. Treasury $ 124,361 $ 88 $ - $ 124,449
U.S. Government agency 3,513,099 123,186 40,111 3,596,174
Obligations of U.S. states and
political subdivisions 572,356 47,145 17 619,484
Other domestic debt securities 294,123 7,703 1,911 299,915
Foreign debt securities 7,690 1 - 7,691
Securities held to maturity $ 4,511,629 $ 178,123 $ 42,039 $ 4,647,713
December 31, 2002 Amortized Gross Gross Fair
Cost Unrealized Unrealized Value
Gains Losses
----------
in thousands
U.S. Treasury $ 263,765 $ 2,001 $ - $ 265,766
U.S. Government agency 9,293,270 306,772 2,873 9,597,169
Asset backed securities 2,924,183 15,454 4,750 2,934,887
Other domestic debt securities 703,062 2,571 20 705,613
Foreign debt securities 869,076 20,798 2,909 886,965
Equity securities 289,485 27,293 13,063 303,715
Securities available for sale $ 14,342,841 $ 374,889 $ 23,615 $ 14,694,115
U.S. Treasury $ 14,444 $ 6 $ - $ 14,450
U.S. Government agency 3,903,397 233,942 1,319 4,136,020
Obligations of U.S. states and political 672,787 44,452 746 716,493
subdivisions
Other domestic debt securities 31,379 525 180 31,724
Foreign debt securities 6,475 - - 6,475
Securities held to maturity $ 4,628,482 $ 278,925 $ 2,245 $ 4,905,162
76
A summary of gross unrealized losses and related fair values, classified as to the length of time the losses
have existed, follows. The unrealized losses that have existed for more than one year related to asset backed
securities are due to interest rate market conditions. The securities in question are high credit grade (i.e.
AAA or AA) and no permanent impairment is expected to be realized. The unrealized losses that have existed for
more than one year on equity securities are primarily related to seed money investments in mutual funds managed
by an HSBC Group entity.
Less Than One Year Greater Than One Year
December 31, 2003 Gross Aggregate Gross Aggregate
Unrealized Fair Value Unrealized Fair Value
Losses of Losses of
Investment Investment
----------
in thousands
U.S. Government agency $ 140,814 $ 4,753,228 $ 198 $ 66,535
Asset backed securities 4,422 280,077 1,396 233,673
Other domestic debt securities 35 35,221 - -
Foreign debt securities 136 60,854 176 12,598
Equity securities 1,099 11,488 3,071 10,129
Securities available for sale $ 146,506 $ 5,140,868 $ 4,841 $ 322,935
U.S. Government agency $ 40,111 $ 904,851 $ - $ -
Obligations of U.S. states and
political subdivisions - - 17 446
Other domestic debt securities 1,399 11,508 512 5,419
Securities held to maturity $ 41,510 $ 916,359 $ 529 $ 5,865
The following table presents realized gains and losses on investment securities transactions attributable to
securities available for sale and securities held to maturity. Net realized gains of $22.4 million and $.5
million related to the securities available for sale portfolio are included in mortgage banking revenue in the
consolidated statement of income for 2003 and 2002 respectively.
Year Ended December 31, Gross Gross Net
Realized Realized Realized
Gains (Losses) Gains
(Losses)
-------------
in thousands
2003
Securities available for sale $ 81,137 $ (10,734 ) $ 70,403
Securities held to maturity:
Maturities, calls and mandatory
redemptions 301 (11 ) 290
$ 81,438 $ (10,745 ) $ 70,693
2002
Securities available for sale $ 187,021 $ (69,903 ) $ 117,118
Securities held to maturity:
Maturities, calls and mandatory
redemptions 3,412 (2,361 ) 1,051
$ 190,433 $ (72,264 ) $ 118,169
2001
Securities available for sale $ 250,381 $ (102,671 ) $ 147,710
Securities held to maturity:
Maturities, calls and mandatory
redemptions 1,578 (21 ) 1,557
$ 251,959 $ (102,692 ) $ 149,267
77
The amortized cost and fair values of securities available for sale and securities held to maturity at December
31, 2003, by contractual maturity are shown in the following table. Expected maturities differ from contractual
maturities because borrowers have the right to prepay obligations without prepayment penalties in certain cases.
The amounts exclude $187 million cost ($233 million fair value) of equity securities that do not have
maturities.
December 31, 2003 Amortized Fair
Cost Value
----------
in thousands
Within one year $ 362,058 $ 362,407
After one but within five years 2,330,552 2,339,589
After five but within ten years 1,424,687 1,432,069
After ten years 9,764,036 9,776,105
Securities available for sale $ 13,881,333 $ 13,910,170
Within one year $ 149,079 $ 149,614
After one but within five years 171,996 182,397
After five but within ten years 226,962 243,592
After ten years 3,963,592 4,072,110
Securities held to maturity $ 4,511,629 $ 4,647,713
Note 4. Loans
A distribution of the loan portfolio follows.
December 31, 2003 2002
-------
in thousands
Domestic:
Commercial:
Construction and mortgage loans $ 7,075,046 $ 6,350,036
Other business and financial 8,657,860 11,024,378
Consumer:
Residential mortgages 26,294,464 20,437,891
Credit card receivables 1,111,763 1,101,067
Other consumer loans 1,904,484 1,693,224
International 3,430,354 3,029,276
$ 48,473,971 $ 43,635,872
Included in commercial loans for 2002 were $249.5 million of commercial mortgages and other commercial loans
held for sale. Residential mortgages include $941.3 million and $1,838.1 million of mortgages held for sale at
December 31, 2003 and 2002 respectively. Other consumer loans include $385.0 million and $372.8 million of
higher education loans also held for sale at December 31, 2003 and 2002 respectively.
International loans include certain bonds issued by the government of Venezuela as part of debt renegotiations
(Brady bonds). These bonds had an aggregate carrying value of $165.9 million (face value $177.5 million) at year
end 2003 and 2002, and an aggregate fair value of $164.4 million and $141.9 million at year end 2003 and 2002
respectively. The Company's intent is to hold these instruments until maturity. The bonds are fully secured as
to principal by zero-coupon U.S. Treasury securities with face value equal to that of the underlying bonds.
At December 31, 2003 and 2002, the Company's nonaccruing loans were $365.7 million and $387.4 million
respectively. At December 31, 2003 and 2002, the Company had commitments to lend additional funds of $3.6
million and $12.3 million respectively, to borrowers whose loans are classified as nonaccruing. A significant
portion of these commitments includes clauses that provide for cancellation in the event of a material adverse
change in the financial position of the borrower.
78
Year Ended December 31, 2003 2002 2001
-------------
in thousands
Interest income on nonaccruing loans which
would have been recorded had they been
current in accordance with their original terms $ 27,696 $ 36,826 $ 30,565
Interest income recorded on nonaccruing loans 11,509 9,354 18,677
Other real estate and owned assets included in other assets amounted to $17.4 million and $16.6 million at
December 31, 2003 and 2002 respectively.
The Company identified impaired loans totaling $266.8 million at December 31, 2003, of which $179.2 million had
a related impairment reserve of $86.5 million. At December 31, 2002, the Company had identified impaired loans
of $288.1 million of which $170.3 million had a related impairment reserve of $88.9 million. The average
recorded investment in such impaired loans was $274.3 million, $288.2 million and $215.5 million in 2003, 2002
and 2001 respectively.
The Company has loans outstanding to certain executive officers and directors. The loans were made on
substantially the same terms, including interest rates and collateral, as those prevailing at the same time for
comparable transactions with other persons and do not involve more than normal risk of collectibility. The
aggregate amount of such loans did not exceed 5% of shareholders' equity at December 31, 2003 and 2002.
Note 5. Allowance for Credit Losses
An analysis of the allowance for credit losses follows.
2003 2002 2001
in thousands
Balance at beginning of year $ 493,125 $ 506,366 $ 524,984
Allowance related to acquisitions and
(dispositions), net (15,567 ) (2,249 ) (18,987 )
Provision charged to income 112,929 195,000 238,400
Recoveries on loans charged off 50,964 35,301 42,821
Loans charged off (242,822 ) (240,926 ) (280,500 )
Translation adjustment (33 ) (367 ) (352 )
Balance at end of year $ 398,596 $ 493,125 $ 506,366
Note 4 provides information on impaired loans and the related impairment reserve.
Included in the December 31, 2003 and December 31, 2002 allowance for credit losses are $33.2 million and $40.8
million respectively, of non-United States transfer risk reserves.
Note 6. Mortgage Servicing Rights
Residential mortgage loans serviced for others are not included in the accompanying consolidated balance sheets.
The outstanding principal balances of these loans were $34.1 billion and $25.9 billion at December 31, 2003 and
2002 respectively. Custodial balances maintained in connection with the foregoing loan servicing, and included
in noninterest bearing deposits in domestic offices, were $643.3 million and $841.0 million at December 31, 2003
and 2002 respectively.
79
An analysis of residential MSRs, reported in other assets, follows.
2003 2002 2001
in thousands
Balance at beginning of year $ 352,367 $ 314,272 $ 265,752
Additions 331,517 171,424 106,560
Amortizations (158,213 ) (76,989 ) (58,040 )
Provision for impairment * (26,550 ) (56,340 ) -
Balance at end of year $ 499,121 $ 352,367 $ 314,272
* Temporary impairment was recorded in a valuation reserve which has a balance of $23.0 million and $40.6
million at December 31, 2003 and 2002 respectively. See the following table.
The fair value of residential MSRs as of December 31, 2003, 2002 and 2001 was approximately $499.1 million,
$352.4 million and $362.0 million respectively.
The following table summarizes the changes in the valuation reserve for residential MSRs.
2003 2002
in thousands
Balance at beginning of year $ 40,591 $ -
Temporary impairment 26,550 56,340
Write-down of MSRs (44,096 ) (15,749 )
Balance at end of year $ 23,045 $ 40,591
In 2003, 2002 and 2001, the Company realized net gains from the sale of residential mortgages in
securitizations, including those through agencies such as FHLMC, of $117.4 million, $163.7 million and $66.6
million respectively.
At December 31, 2003, the carrying value of residential MSRs was written down to their fair value of $499.1
million. That fair value was based on the present value of future cash flows, using a constant prepayment rate
(CPR) of 17.4% annualized, a constant discount rate of 9.3% and a weighted average life of 5.0 years.
Note 7. Goodwill and Intangible Assets
The Company adopted the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other
Intangible Assets (SFAS 142), on January 1, 2002. Under SFAS 142, goodwill is no longer amortized, but is
reviewed for impairment at least annually at the reporting unit level. Identifiable intangible assets acquired
in a business combination are amortized over their useful lives unless their useful lives are indefinite, in
which case those intangible assets are tested for impairment annually. During the second quarter of 2003, the
Company completed its annual impairment test of goodwill and determined that the fair value of each of the
reporting units exceeded its carrying value. As a result, no impairment loss was required to be recognized.
In October 2002, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards
No. 147, Acquisitions of Certain Financial Institutions (SFAS 147), an amendment of FASB Statements No. 72 and
144 and FASB Interpretation No. 9. This statement removes acquisitions of financial institutions from the
scope of both Statement No. 72 and Interpretation No. 9 and requires that those transactions, which constitute
a business, be accounted for in accordance with SFAS No. 141 and SFAS No. 142. Thus, the requirement in
paragraph 5 of Statement No. 72 to recognize (and subsequently amortize) any excess of the fair value of
liabilities assumed over the fair value of tangible and identifiable intangible assets acquired as an
unidentifiable intangible asset no longer applies to acquisitions within the scope of SFAS 147.
80
SFAS 147 is effective for acquisitions on or after October 1, 2002 with mandatory implementation effective
January 1, 2002 for existing intangibles. The Company concluded that its acquisition of East River Savings Bank
was within the scope of SFAS 147. As of December 31, 2001, the unamortized amount of unidentifiable intangible
assets (i.e. excess premium SFAS 72) was $64.6 million. During the fourth quarter of 2002, this intangible asset
was reclassified retroactively to January 1, 2002 to goodwill and no longer amortized but subject to annual
impairment testing. The amortization previously recorded for the first three quarters of 2002 was reversed in
accordance with SFAS 147.
The following table presents the consolidated results of operations adjusted as though the adoption of SFAS 142
occurred as of January 1, 2001.
2003 2002 2001
in thousands
Reported net income $ 940,745 $ 855,444 $ 353,138
Goodwill amortization add-back - - 176,482
Adjusted net income $ 940,745 $ 855,444 $ 529,620
The following table presents all intangible assets of the Company that are being amortized. Given current market
conditions relative to interest rates and prepayments, normally scheduled annual MSRs' amortization for the next
five years would be approximately $90 million for the year ended 2004 declining gradually to approximately $40
million for the year ended 2008. Actual annual levels of MSRs' amortization could either increase or decrease
dependent upon changes in interest rates, prepayment activity, new production and changes in strategy relative
to sales of servicing rights. At December 31, 2003 intangible assets are as follows.
Intangible Assets
Gross Accumulated Amortization
Carrying Amortization Expense
Amount 2003
in thousands
Mortgage servicing rights $ 875,137 $ 372,412 * $ 185,488 **
Favorable lease arrangements 66,768 18,625 5,021
Total $ 941,905 $ 391,037 $ 190,509
* Includes a $23.0 million impairment valuation reserve.
** Includes $184.7 million of amortization and impairment charges related to residential mortgage activity and
$.8 million related to commercial mortgage activity.
81
Note 8. Deposits
The aggregate amount of time deposit accounts (primarily certificates of deposits) each with a minimum of
$100,000 included in domestic office deposits were $6.98 billion and $5.60 billion at December 31, 2003 and 2002
respectively. The scheduled maturities of all domestic time deposits at December 31, 2003 follows.
in thousands
2004 $ 10,031,689
2005 983,601
2006 594,947
2007 133,519
2008 58,208
Later years 409,777
$ 12,211,741
Note 9. Short-Term Borrowings
The following table shows detail relating to short-term borrowings in 2003, 2002 and 2001. Average interest
rates during each year are computed by dividing total interest expense by the average amount borrowed.
2003 2002 2001
Amount Rate Amount Rate Amount Rate
in thousands
Federal funds purchased
(day to day):
At December 31 $ 1,718,097 .95 % $ 656,181 1.29 % $ 133,640 1.18 %
Average during year 915,236 1.11 1,401,672 1.62 1,436,449 3.78
Maximum month-end balance 2,563,087 2,788,010 2,919,576
Securities sold under
repurchase agreements:
At December 31 357,223 1.45 552,583 1.52 377,059 1.25
Average during year 638,431 1.97 834,477 3.64 1,116,433 2.94
Maximum month-end balance 1,475,415 1,053,540 2,280,180
Commercial paper:
At December 31 1,730,356 1.08 1,484,417 1.53 1,634,559 2.05
Average during year 1,405,508 1.21 1,496,367 1.79 1,218,242 3.77
Maximum month-end balance 1,730,356 1,787,276 1,642,520
Precious metals:
At December 31 2,807,970 .78 3,083,397 .42 2,300,704 1.37
Average during year 3,436,540 .33 3,274,783 .51 2,200,346 1.13
Maximum month-end balance 3,734,699 3,865,153 2,544,318
All other short-term
borrowings:
At December 31 168,488 .97 1,615,790 1.46 4,756,124 2.32
Average during year 1,044,394 1.80 2,780,541 2.76 3,145,211 4.97
Maximum month-end balance 2,103,380 6,669,263 5,817,136
At December 31, 2003, the Company had unused lines of credit with HSBC Bank plc aggregating $500 million. These
lines of credit do not require compensating balance arrangements and commitment fees are not significant. In
addition, the Company, as a member of the New York Federal Home Loan Bank, has a secured borrowing facility in
excess of $5 billion collateralized by residential mortgage loan assets.
82
Note 10. Income Taxes
Total income taxes were allocated as follows.
Year Ended December 31, 2003 2002 2001
-------------
in thousands
To income before income taxes $ 570,400 $ 509,629 $ 226,000
To shareholders' equity as tax charge (benefit):
Net unrealized gains (losses) on securities
available for sale (99,236 ) 41,407 20,638
Unrealized gain (loss) on derivatives
classified as cash flow hedges 6,029 42,521 (20,194 )
Foreign currency translation, net 15,778 2,216 (6,383 )
$ 492,971 $ 595,773 $ 220,061
The components of income tax expense follow.
Year Ended December 31, 2003 2002 2001
-------------
in thousands
Current:
Federal $ 364,781 $ (31,657 ) $ 384,849
State and local 47,829 10,393 60,987
Foreign 24,357 19,218 24,127
Total current 436,967 (2,046 ) 469,963
Deferred, primarily federal 133,433 511,675 (243,963 )
Total income taxes $ 570,400 $ 509,629 $ 226,000
The following table is an analysis of the difference between effective rates based on the total income tax
provision attributable to pretax income and the statutory U.S. Federal income tax rate.
Year Ended December 31, 2003 2002 2001
-------------
Statutory rate 35.0 % 35.0 % 35.0 %
Increase (decrease) due to:
State and local income taxes 3.1 4.2 1.8
Goodwill .9 - 9.8
Change in valuation allowance
for deferred tax assets - - (4.9 )
Tax exempt interest income (.8 ) (1.0 ) (2.6 )
Other items (.5 ) (.9 ) (.1 )
Effective income tax rate 37.7 % 37.3 % 39.0 %
The components of the net deferred tax position are summarized below.
December 31, 2003 2002
-------
in thousands
Deferred tax assets:
Allowance for credit losses $ 175,562 $ 177,680
Benefit accruals 93,326 128,620
Accrued expenses not currently deductible 41,473 88,785
Investment securities (38,446 ) 49,256
Net purchase discount on acquired companies 58,069 68,245
Other (26,929 ) 35,590
Total deferred tax assets 303,055 548,176
Less deferred tax liabilities:
Unrealized gains on securities available for sale 30,515 129,751
Lease financing income accrued 35,825 62,405
Accrued pension cost 212,049 133,766
Accrued income on foreign bonds 10,787 16,161
Deferred net operating loss recognition - 113,468
Depreciation and amortization 49,786 118,484
Interest and discount income 47,120 42,901
Mortgage servicing rights 184,828 140,492
Total deferred tax liabilities 570,910 757,428
Net deferred tax asset (liability) $ (267,855 ) $ (209,252 )
83
Realization of deferred tax assets is contingent upon the generation of future taxable income or the existence
of sufficient taxable income within the carryback period. Based upon the level of historical taxable income and
the scheduled reversal of the deferred tax liabilities over the periods which the deferred tax assets are
deductible, management believes that it is more likely than not the Company would realize the benefits of these
deductible differences.
84
Note 11. Long-Term Debt
Face Value Book Value
December 31, 2003 2002 2003 2002
-------
in thousands
Issued or acquired by the Company or
subsidiaries other than the Bank
Non-subordinated debt:
Floating Rate Senior Notes due 2004
(1.32%) $ 300,000 $ 300,000 $ 300,000 $ 300,000
8.375% Debentures due 2007 100,000 100,000 102,160 102,861
400,000 400,000 402,160 402,861
Subordinated debt:
7% Subordinated notes due 2006 300,000 300,000 299,286 299,034
5.875% Subordinated notes due 2008 250,000 250,000 233,308 229,794
6.625-9.70% Subordinated notes
due 2009 550,000 550,000 599,940 619,594
Floating Rate Subordinated Notes
due 2009 (5.25%) 124,320 124,320 124,320 124,320
7% Subordinated notes due 2011 100,000 100,000 116,508 116,279
9.50% Subordinated debentures
due 2014 150,000 150,000 162,890 164,148
9.125-9.30% Subordinated notes
due 2021 200,000 200,000 215,772 216,680
7.20% Subordinated debentures
due 2097 250,000 250,000 215,549 215,181
Perpetual Capital Notes (1.438%) 129,000 129,000 124,674 124,133
7.53% Junior Subordinated Debentures
due 2026 206,186 - 216,313 -
7.75% Junior Subordinated Debentures
due 2026 154,640 - 142,025 -
7.808% Junior Subordinated Debentures
due 2026 206,186 - 206,186 -
8.38% Junior Subordinated Debentures
due 2027 206,186 - 206,186 -
7.85% Junior Subordinated Debentures
due 2032 309,279 - 285,976 -
3,135,797 2,053,320 3,148,933 2,109,163
Guaranteed mandatorily redeemable
securities:
7.53% Capital Securities due 2026 - 200,000 - 214,110
7.75% Capital Securities due 2026 - 150,000 - 136,832
7.808% Capital Securities due 2026 - 200,000 - 200,000
8.38% Capital Securities due 2027 - 200,000 - 200,000
7.85% Capital Securities due 2032 - 300,000 - 300,000
- 1,050,000 - 1,050,942
Issued or acquired by the Bank or its
subsidiaries
Non-subordinated debt:
Medium-Term Floating Rate Notes
due 2004-2010 (1.12% to 1.17%) 149,555 - 149,555 -
Medium-Term Floating Rate Note
due 2040 (0.99%) 24,999 24,999 24,999 24,999
Fixed rate Federal Home Loan Bank of
New York advances 17,253 14,128 17,253 14,128
Collateralized repurchase agreements 18,817 18,777 18,817 18,777
Other 52,374 54,000 52,293 53,974
262,998 111,904 262,917 111,878
Total long-term debt $ 3,798,795 $ 3,615,224 $ 3,814,010 $ 3,674,844
The above table excludes $1,550 million of debt issued by the Bank or its subsidiaries payable to the Company.
Of this amount, the earliest note to mature is in 2006 and the latest note to mature is in 2097.
85
Interest rates on floating rate notes are determined periodically by formulas based on certain money market
rates or, in certain instances, by minimum interest rates as specified in the agreements governing the issues.
Interest rates on the floating rate notes in effect at December 31, 2003 are shown in parentheses.
The Floating Rate Senior Notes due 2004 represent unsecured obligations of the Company bearing interest at the
3-month U.S. Dollar London Interbank offered rate plus 15 basis points. The notes are not redeemable prior to
maturity in September 2004.
The 8.375% Debentures are direct unsecured general obligations of the Company and are not subordinated in right
of payment to any other unsecured indebtedness of the Company. The Debentures are not redeemable prior to
maturity in February 2007.
The Perpetual Capital Notes (PCNs) are a component of total qualifying capital under applicable risk-based
capital rules. The PCNs may be exchanged for securities that constitute permanent primary capital securities for
regulatory purposes. The principal amount of each PCN will be payable as follows: (1) at the option of the
holder on the put date in each year commencing in 2012, (2) at the option of the Company on 90 days prior
notice, the PCNs may be either (i) redeemed on the specified redemption date, in whole, for cash and at par, but
only with the proceeds of a substantially concurrent sale of capital securities issued for the purpose of such
redemption or (ii) exchanged, in whole, for capital securities having a market value equal to the principal
amount of the PCNs, and, in each case, the payment of accrued interest in cash or (3) in the event that the sum
of the Company's retained earnings and surplus accounts becomes less than zero, the PCNs will automatically be
exchanged, in whole, for capital securities having a market value equal to the principal amount of the PCNs and
the payment of accrued interest in cash.
Prior to the Company's adoption of FIN 46 at December 31, 2003, the statutory business trusts (issuer trusts)
that issued guaranteed mandatorily redeemable securities (Capital Securities) were considered consolidated
subsidiaries of the Company. The $1,050 million of Capital Securities issued by these trusts to third party
investors, along with $32 million of common securities of the trusts (Common Securities) issued to the Company,
were invested in Junior Subordinated Debentures of the Company. The Capital Securities were included in
long-term debt on the Company's consolidated balance sheet and the Common Securities and Junior Subordinated
Debentures were eliminated in consolidation. Upon adoption of FIN 46 the Company deconsolidated the issuer
trusts. As a result, the Junior Subordinated Debentures issued by the Company to the trusts are now reflected in
total long-term debt on the Company's consolidated balance sheet at December 31, 2003. The Junior Subordinated
Debentures, excluding the portion representing the Common Securities of the trusts, continue to qualify as Tier
I capital under interim guidance issued by the Board of Governors of the Federal Reserve System ("Federal
Reserve Board"), effective through the March 31, 2004 reporting period.
The Medium-Term Floating Rate Notes due 2004-2010 represent equity linked notes issued under the Bank's Global
Medium-Term Note Program, which provides for the issuance of up to $4 billion of notes having maturities of 7
days or more from the date of issuance. The Medium-Term Floating Rate Note due 2040 was also issued under this
Program.
The fixed rate Federal Home Loan Bank of New York advances have interest rates ranging from 2.01% to 7.24%.
The collateralized repurchase agreements consist of securities repurchase agreements with initial maturities
exceeding one year. The repurchase agreements have fixed rates ranging from 4.97% to 7.16%.
86
Contractual scheduled maturities for total long-term debt over the next five years are as follows: 2004, $390
million; 2005, $28 million; 2006, $306 million; 2007, $119 million and $280 million in 2008.
Note 12. Preferred Stock
The following table presents information related to the issues of preferred stock outstanding.
Shares Dividend Amount
Outstanding Rate Outstanding
2003 2003
December 31, 2003 2002
-------
in thousands
$1.8125 Cumulative Preferred Stock
($25 stated value) 3,000,000 7.25 % $ 75,000 $ 75,000
6,000,000 Depositary shares each
representing a one-fourth interest in
a share of Adjustable Rate Cumulative
Preferred Stock, Series D ($100 stated
value) 1,500,000 4.50 150,000 150,000
Dutch Auction Rate Transferable Securities (TM)
Preferred Stock (DARTS)
Series A ($100,000 stated value) 625 1.286 62,500 62,500
Series B ($100,000 stated value) 625 1.283 62,500 62,500
$2.8575 Cumulative Preferred Stock
($50 stated value) 3,000,000 5.715 150,000 150,000
CTUS Inc. Preferred Stock 100 - - -
$ 500,000 $ 500,000
The $1.8125 Cumulative Preferred Stock may be redeemed, as a whole or in part, at the option of the Company at
$25 per share plus dividends accrued and unpaid to the redemption date.
The dividend rate on the Adjustable Rate Cumulative Preferred Stock, Series D (Series D Stock) is determined
quarterly, by reference to a formula based on certain benchmark market interest rates, but will not be less than
41/2% or more than 101/2% per annum for any applicable dividend period. The Series D Stock is redeemable, as a
whole or in part, at the option of the Company at $100 per share (or $25 per depositary share), plus accrued and
unpaid dividends to the redemption date.
DARTS of each series are redeemable at the option of the Company, as a whole or in part on any dividend payment
date, at $100,000 per share, plus accrued and unpaid dividends to the redemption date. Dividend rates for each
dividend period are set pursuant to an auction procedure. The maximum applicable dividend rates on the shares of
DARTS range from 110% to 150% of the 60 day "AA" composite commercial paper rate. DARTS are also redeemable at
the option of the Company, as a whole but not in part, on any dividend payment date at a redemption price of
$100,000 per share plus the payment of accrued and unpaid dividends, if the applicable rate for such series
fixed with respect to the dividend period for such series ending on such dividend payment date equals or exceeds
the 60 day "AA" composite commercial paper rate in effect on the date of determination of such rate.
The outstanding shares of $2.8575 Cumulative Preferred Stock have an aggregate stated value of $150 million. The
Cumulative Preferred Stock may be redeemed at the option of the Company, as a whole or in part, on or after
October 1, 2007 at $50 per share, plus dividends accrued and unpaid to the redemption date.
The Company acquired CTUS Inc., a unitary thrift holding company in 1997 from CT Financial Services Inc. (the
Seller). CTUS owned First Federal Savings and Loan Association of Rochester (First Federal). The acquisition
agreement
87
provided that the Company issue preferred shares to the Seller. The preferred shares provide for, and only for,
a contingent dividend or redemption equal to the amount of recovery, net of taxes and costs, if any, by First
Federal resulting from the pending action against the United States government alleging breaches by the
government of contractual obligations to First Federal following passage of the Financial Institutions Reform,
Recovery and Enforcement Act of 1989. The Company issued 100 preferred shares at a par value of $1.00 per share
in connection with the acquisition.
Note 13. Retained Earnings
Bank dividends are a major source of funds for payment by the Company of shareholder dividends and along with
interest earned on investments, cover the Company's operating expenses which consist primarily of interest on
outstanding debt. The approval of the Federal Reserve Board is required if the total of all dividends declared
by the Bank in any year exceeds the net profits for that year, combined with the retained profits for the two
preceding years. Under a separate restriction, payment of dividends is prohibited in amounts greater than
undivided profits then on hand, after deducting actual losses and bad debts. Bad debts are debts due and unpaid
for a period of six months unless well secured, as defined, and in the process of collection.
Under the more restrictive of the above rules the Bank can pay dividends to the Company as of December 31, 2003
of approximately $568 million, adjusted by the effect of its net income (loss) for 2004 up to the date of such
dividend declaration.
88
Note 14. Accumulated Other Comprehensive Income
Accumulated other comprehensive income includes net income as well as certain items that are reported directly
within a separate component of shareholders' equity. The following table presents changes in accumulated other
comprehensive income balances.
2003 2002 2001
in thousands
Unrealized gains on securities
Balance, January 1, $ 235,948 $ 155,440 $ 124,340
Increase (decrease) in fair value, net of
taxes of $(74,595), $82,398, and $72,307
in 2003, 2002 and 2001 respectively (128,867 ) 156,635 127,141
Reclassification adjustment for (gains)
losses included in net income, net of
taxes of $24,641, $40,991 and $51,669
in 2003, 2002 and 2001 respectively (45,762 ) (76,127 ) (96,041 )
Net change (174,629 ) 80,508 31,100
Balance, December 31, 61,319 235,948 155,440
Unrealized gain (loss) on derivatives classified
as cash flow hedges
Balance, January 1, 41,465 (37,503 ) -
Change in unrealized gain (loss) on
derivatives classified as cash flow hedges,
net of taxes of $6,029, $42,521 and $(20,194)
in 2003, 2002 and 2001 respectively 11,197 78,968 (37,503 )
Unrealized net transitional gain related
to initial adoption of SFAS 133 - - 2,853
Amortization of unrealized transitional
SFAS 133 gains credited to current income - - (2,853 )
Net change 11,197 78,968 (37,503 )
Balance, December 31, 52,662 41,465 (37,503 )
Foreign currency translation adjustment
Balance, January 1, (15,214 ) (19,330 ) (7,489 )
Translation gains (losses) net of taxes
of $15,778, $2,216 and $(6,383) in
2003, 2002 and 2001 respectively 29,302 4,116 (11,841 )
Net change 29,302 4,116 (11,841 )
Balance, December 31, 14,088 (15,214 ) (19,330 )
Total accumulated other comprehensive
income at December 31, $ 128,069 $ 262,199 $ 98,607
89
Note 15. Related Party Transactions
In the normal course of business, the Company conducts transactions with HSBC, including its 25% or more owned
subsidiaries (HSBC Group). These transactions occur at prevailing market rates and terms. The following table
presents related party transaction balances at year end and the total income and expense generated by those
transactions.
December 31, 2003 2002 2001
-------
in millions
Assets:
Interest bearing deposits with banks $ 139 $ 130 $ 564
Loans 330 338 142
Other 34 38 33
Total assets $ 503 $ 506 $ 739
Liabilities:
Deposits $ 7,512 $ 6,140 $ 4,686
Short-term borrowings 735 267 114
Other 79 349 34
Total liabilities $ 8,326 $ 6,756 $ 4,834
Interest income $ 17 $ 28 $ 46
Interest expense 91 87 160
HSBC charges (1) 102 81 72
(1) Various members of the HSBC Group provide operational, information technology related and administrative
support to the Company. The majority of these charges relate to support provided to the Company's
treasury and traded markets businesses.
At December 31, 2003 and 2002, the aggregate notional amounts of all derivative contracts with other HSBC
affiliates were $168 billion and $88 billion respectively.
Extensions of credit by the Company to other HSBC affiliates are legally required to be secured by eligible
collateral.
Pursuant to various service agreements, the Company will pay fees for sourcing, underwriting, pricing and
on-going servicing functions related to residential mortgage loans recorded as a result of the relationship with
Household.
Refer to Note 1 for discussions of the Company's acquisition and divestiture transactions with other HSBC Group
members.
90
Note 16. Stock Option Plans and Restricted Share Plans
Options have been granted to employees of the Company under the HSBC Holdings Group Share Option Plan (the Group
Share Option Plan), the HSBC Holdings Executive Share Option Scheme (the Executive Share Option Plan) and under
the HSBC Holdings Savings-Related Share Option Plan: Overseas Section (the Sharesave Plans). Since the shares
and contribution commitment have been granted directly by HSBC, the offset to compensation expense was a credit
to capital surplus, representing a contribution of capital from HSBC.
Group Share Option Plan
The Group Share Option Plan is a discretionary long-term incentive compensation plan available to certain
Company employees, based on performance criteria and potential, with grants usually made each year. Options are
granted at market value and are normally exercisable between the third and tenth anniversaries of the date of
grant, subject to vesting conditions. This plan was adopted by the Company during 2001.
Total options granted were 4,076,000 in 2003, 4,615,000 in 2002 and 4,084,000 in 2001. The fair value of options
granted was $3.01 per option in 2003, $2.33 per option in 2002 and $3.38 per option in 2001. Compensation
expense recognized amounted to $11.2 million, $6.6 million and $3.0 million in 2003, 2002 and 2001 respectively.
Executive Share Option Plan
The Executive Share Option Plan is a discretionary long-term incentive compensation plan available to certain
Company employees, based on performance criteria and potential, with grants usually made each year. Options are
granted at market value and are normally exercisable between the third and tenth anniversaries of the date of
grant, subject to vesting conditions. No further grants have been made under this plan since the adoption of the
Group Share Option Plan.
Compensation expense recognized related to this plan amounted to $1.0 million, $3.6 million and $4.9 million in
2003, 2002 and 2001 respectively. Since all remaining options granted under the Executive Share Option Plan are
now fully vested, no further expense is expected to be recognized for this plan.
Sharesave Plans
The Sharesave Plans invite eligible employees to enter into savings contracts to save up to $400 per month, with
the option to use the savings to acquire shares. There are currently two types of plans offered which allow the
participant to select savings contracts of either a 5 year or 3 year length. The options are exercisable within
six months following the third or fifth year respectively of the commencement of the related savings contract,
at a 20 percent discount for options granted in 2003, 2002 and 2001.
Total options granted under the 5 year vesting period were 737,000 in 2003, 524,000 in 2002 and 495,000 in 2001.
The fair value of options granted was $3.29 per option in 2003, $3.53 per option in 2002, and $3.84 per option
in 2001. Compensation expense recognized amounted to $.7 million, $2.6 million and $2.7 million in 2003, 2002
and 2001 respectively.
Total options granted under the 3 year vesting period were 910,000 in 2003, 691,000 in 2002 and 803,000 in 2001.
The fair value of options granted was $3.20 per option in 2003, $3.63 per option in 2002 and $3.60 per option in
2001. Compensation expense recognized amounted to $1.4 million in 2003, $1.2 million in 2002 and $.5 million in
2001.
91
Prior to the Sharesave Plans being offered to employees in its present form, eligible employees could elect to
participate through the Company's 401(k) plan and acquire contributions based on HSBC stock at 85% of market
value on the date of grant. An employee's agreement to participate was a five year commitment. At the end of
each five year period employees receive the appreciation of the HSBC stock over the initial exercise price
credited to their 401(k) account. Eligibility for this plan was discontinued after 1999 with the adoption of the
Sharesave Plans. Compensation expense related to this plan amounted to $.3 million in 2003, $2.1 million in 2002
and $2.4 million in 2001.
Fair values of share options, measured at the date of grant of the option, are calculated using a model that is
based on the underlying assumptions of the Black-Scholes model. The fair values calculated are inherently
subjective and uncertain due to the assumptions made and the limitations of the model used. The significant
assumptions used to estimate the fair value of options granted are as follows.
2003 Group Share Sharesave Sharesave
Option Plan Plan Plan
5 Year 3 Year
---
Risk free interest rate 4.68 % 4.24 % 4.01 %
Expected life (years) 5 5 3
Expected volatility 30 % 30 % 30 %
2002 Group Share Sharesave Sharesave
Option Plan Plan Plan
5 Year 3 Year
---
Risk free interest rate 5.57 % 5.57 % 5.46 %
Expected life (years) 5.25 5.25 3.25
Expected volatility 25 % 30 % 30 %
2001 Group Share Sharesave Sharesave
Option Plan Plan Plan
5 Year 3 Year
---
Risk free interest rate 5.65 % 5.50 % 5.40 %
Expected life (years) 10 5.5 3.5
Expected volatility 30 % 30 % 30 %
Restricted Share Plans
HSBC and the Company grant awards to key individuals in the form of performance and non-performance restricted
shares. The awards are based on an individual's demonstrated performance and future potential. Performance
related restricted shares generally vest after three years from date of grant, based on HSBC's Total Shareholder
Return (TSR) relative to the TSR of the benchmark during the performance period. TSR is defined as the growth in
share value and declared dividend income during the period and the benchmark is composed of HSBC's peer group of
financial institutions. If the performance conditions are met, the shares vest and are released to the
recipients two years later. Non-performance restricted shares are released to the recipients based on continued
service, typically at the end of a three year vesting period. Total expense recognized for the plan for 2003,
2002 and 2001 was $40.3 million, $28.2 million and $23.7 million respectively.
92
Note 17. Postretirement Benefits
The Company, the Bank and certain other subsidiaries maintain noncontributory defined benefit pension plans
covering substantially all of their employees hired prior to January 1, 1997 and those employees who joined the
Company through acquisitions and were participating in a defined benefit plan at the time of acquisition.
Certain other HSBC subsidiaries participate in these plans.
The Company also maintains unfunded noncontributory health and life insurance coverage for all employees who
retired from the Company and were eligible for immediate pension benefits from the Company's retirement plan.
Employees retiring after 1992 will absorb a portion of the cost of these benefits. Employees hired after that
same date are not eligible for these benefits. A premium cap has been established for the Company's share of
retiree medical cost.
On December 8, 2003, the President signed into law the Medicare Prescription Drug, Improvement and Modernization
Act of 2003 (the Act). The accumulated postretirement benefit obligation and net periodic benefit cost listed
below do not reflect the effects of the Act on the plan. As authoritative guidance to implement the Act has not
been issued, the Company is unable to assess the impact on the accumulated postretirement obligation and the net
periodic benefit cost. The issued guidance could require the Company to change previously reported information.
The measurement date for all plans described above is December 31. The following table provides data concerning
the Company's benefit plans.
Pension Benefits Other
Postretirement Benefits
2003 2002 2003 2002
in thousands
Change in benefit obligation
Benefit obligation, January 1 $ 952,437 $ 824,582 $ 126,652 $ 100,603
Service cost 28,917 25,826 2,265 2,274
Interest cost 63,756 59,862 7,073 7,388
Participant contributions - - 325 349
Plan amendment - 639 (2,043 ) -
Actuarial (gain) loss 91,210 70,973 (1,647 ) 24,629
Benefits paid (33,996 ) (29,445 ) (9,065 ) (8,591 )
Benefit obligation, December 31 $ 1,102,324 $ 952,437 $ 123,560 $ 126,652
Change in plan assets
Fair value of plan assets, January 1 $ 877,622 $ 774,127 $ - $ -
Actual return on plan assets 203,081 (132,060 ) - -
Company contribution 175,000 265,000 8,740 8,242
Participant contributions - - 325 349
Benefits paid (33,996 ) (29,445 ) (9,065 ) (8,591 )
Fair value of plan assets, December 31 $ 1,221,707 $ 877,622 $ - $ -
Funded status of plan
Funded status, December 31 $ 119,383 $ (74,815 ) $ (123,560 ) $ (126,652 )
Unrecognized actuarial (gain) loss 389,482 446,855 11,685 13,332
Unrecognized prior service cost 4,470 5,613 - -
Unrecognized net transition obligation - - 27,181 32,471
Recognized amount $ 513,335 $ 377,653 $ (84,694 ) $ (80,849 )
Amount recognized in the consolidated
balance sheet
Prepaid benefit cost $ 513,335 $ 377,653 $ - $ -
Accrued benefit liability - - (84,694 ) (80,849 )
Recognized amount $ 513,335 $ 377,653 $ (84,694 ) $ (80,849 )
93
The accumulated benefit obligation for the defined benefit pension plan was $942,823 and $820,577 at December
31, 2003 and 2002 respectively.
Operating expenses for 2003, 2002 and 2001 included the following components.
Pension Benefits Other
Postretirement Benefits
2003 2002 2001 2003 2002 2001
in thousands
Net periodic benefit cost
Service cost $ 28,917 $ 25,826 $ 25,232 $ 2,265 $ 2,274 $ 2,228
Interest cost 63,756 59,862 55,523 7,073 7,388 6,579
Expected return on
plan assets (87,005 ) (83,974 ) (79,689 ) - - -
Prior service cost
amortization 1,143 1,187 944 - - -
Actuarial (gain)/loss 32,507 9,159 - - - (527 )
Transition amount
amortization - - - 3,247 3,247 3,247
Net periodic benefit cost $ 39,318 $ 12,060 $ 2,010 $ 12,585 $ 12,909 $ 11,527
Weighted-average assumptions
to determine benefit
obligations at December 31
Discount rate 6.25 % 6.75 % 7.25 % 5.75 % 6.25 % 6.75 %
Rate of compensation
increase 3.75 3.75 4.00 3.75 (1) 3.75 (1) 4.00 (1)
Weighted-average assumptions
to determine net cost for
years ended December 31
Discount rate 6.75 % 7.25 % 7.75 % 6.25 % 6.75 % 7.25 %
Expected return on
plan assets 8.75 9.50 9.50 - - -
Rate of compensation
increase 3.75 4.00 4.50 3.75 4.00 4.50
(1) Applicable to life insurance only.
The Company determines its expected long-term rate of return based upon historical market returns of equities
and fixed income investments adjusted for the mix between these instruments. Additional factors are considered
such as the rate of inflation and interest rates. The expected long-term rate of return is validated by
comparison to independent sources, which include actuarial consultants and investment advisors.
Net periodic pension cost includes $2.4 million, $1.6 million and $1.1 million for 2003, 2002 and 2001
respectively recognized in the financial statements of other HSBC subsidiaries participating in the Company's
pension plan.
Assumed Health Care Cost Trend Rates
December 31 2003 2002
-------
Health care cost trend rate assumed for next year 7 % 7 %
Rate that the cost trend rate gradually declines to 7 % 7 %
Year that the rate reaches the ultimate rate 2003 2002
94
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care
plans. A one percentage point change in assumed health care cost trend rates would have the following effects.
One One
Percentage Percentage
Point Point
Increase Decrease
in thousands
Effect on total service and interest cost $ 275 $ (262 )
Effect on postretirement benefits obligation 3,170 (2,982 )
Plan Assets
The Company's pension plan weighted-average asset allocation at December 31, 2003 and 2002 by asset category are
as follows.
Percentage of Plan
Assets
December 31 2003 2002
-------
Equity securities 62 % 61 %
Debt securities 38 28
Cash and cash equivalents - 11
Total 100 % 100 %
The Company's Investment Committee has developed an asset allocation policy based on the plan's objectives,
characteristics of the pension liabilities, and asset projections. In addition, the Committee considered
industry practices, the current market environment, and practical investment issues. The Company is cognizant of
the fact that diversification is necessary to reduce unnecessary risk. Therefore the pension fund is diversified
across several asset classes and securities. The Committee discussed "traditional" asset classes (i.e., publicly
traded securities) as well as "alternative" asset classes (e.g., private equity, hedge funds, real estate,
etc.), but decided it was not comfortable with alternative asset classes at this time. The current policy is
described below.
Asset Class Target Allocation
Percentage
--------
Equity securities 60 %
Debt securities 40
Total 100 %
The Company strives to maximize the possibility of having sufficient funds to meet the long-term liabilities of
the pension fund. To do so, the Company must achieve a fine balance between the goals of growing the assets of
the plan and keeping risk at an acceptable level. A key factor in shaping the Company's attitude towards risk is
the long-term investment horizon of the pension fund. The long-term horizon enables the plan to tolerate the
risk of somewhat volatile investment returns in the short run with the expectation of higher returns in the long
run.
The Committee has examined the plan's risk tolerance from the perspective of participant demographic
characteristics, funding characteristics and business/financial characteristics. Based on its assessment of
these characteristics and risk preference, the Company believes that its overall risk posture is average
relative to the typical pension plan. Consequently, the Company believes an average equity exposure is
appropriate for its pension fund.
Cash Flows
The Company expects to contribute nothing for pension benefits and approximately $9 million for other
postretirement benefits during fiscal year 2004.
95
Defined Contribution Plans
Employees hired after December 31, 1996 become participants in a defined contribution plan after one year of
service. Contributions to the plan are based on a percentage of employees' compensation. Total expense
recognized for the plan was $7.8 million in 2003, $3.0 million in 2002 and $3.0 million in 2001.
The Company maintains a 401(k) plan covering substantially all employees. Contributions to the plan by the
Company are based on employee contributions. Total expense recognized for the plan was $18.0 million in 2003,
$16.3 million in 2002 and $15.1 million in 2001.
Note 18. Business Segments
The Company reports and manages its business segments consistently with the line of business groupings used by
HSBC. As a result of HSBC line of business changes, the Company altered the business segments that it used in
2002 to reflect the movement of certain domestic private banking activities from the Personal Financial Services
Segment to the Private Banking Segment. Also activity related to selected commercial customers was moved from
the Commercial Banking Segment to the Corporate, Investment Banking and Markets Segment. Prior year disclosures
have been conformed herein to the presentation of current segments.
The Company has four distinct segments that it utilizes for management reporting and analysis purposes. These
segments are based upon products and services offered and are identified in a manner consistent with the
requirements outlined in Statement of Financial Accounting Standards No. 131, Disclosures about Segments of an
Enterprise and Related Information (SFAS 131). See the Business Segments sections for additional disclosure
regarding the Company's operating segments: Business Segments on page 30 and segment results table on page 31.
Note 19. Collateral, Commitments and Contingent Liabilities
The following table presents pledged assets included in the consolidated balance sheet.
December 31, 2003 2002
-------
in millions
Interest bearing deposits with banks $ 140 $ 65
Trading assets 647 1,770
Securities available for sale 4,171 6,083
Securities held to maturity 956 1,607
Loans 360 343
Total $ 6,274 $ 9,868
In accordance with the Statement of Financial Accounting Standards No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities (SFAS 140), debt securities pledged as
collateral that can be sold or repledged by the secured party continue to be reported on the consolidated
balance sheet. The fair value of securities available for sale that can be sold or repledged at December 31,
2003 and 2002 was $349 million and $1,936 million respectively.
The fair value of collateral accepted by the Company not reported on the consolidated balance sheet that can be
sold or repledged at December 31, 2003 and 2002 was $1,655 million and $3,011 million respectively. This
collateral was obtained under security resale agreements. Of this collateral, $1,138 million at December 31,
2003 has been sold or repledged as collateral under
96
repurchase agreements or to cover short sales compared with $2,428 million at December 31, 2002.
The Company and its subsidiaries are obligated under a number of noncancellable leases for premises and
equipment. Certain leases contain renewal options and escalation clauses. Rental expense under all operating
leases, net of sublease rentals, was $63.2 million, $58.1 million and $60.1 million in 2003, 2002 and 2001
respectively. Minimum future rental commitments on operating leases in effect at December 31, 2003 were as
follows: 2004, $68 million; 2005, $59 million; 2006, $46 million; 2007, $39 million; 2008, $29 million; and $86
million thereafter.
Note 20. Litigation
The Company is named in and is defending legal actions in various jurisdictions arising from its normal
business. None of these proceedings is regarded as material litigation. In addition, there are certain
proceedings related to the "Princeton Note Matter" that are described below.
In relation to the Princeton Note Matter, as disclosed in the Company's 2002 Annual Report on Form 10-K, two of
the noteholders were not included in the settlement and their civil suits are continuing. The U.S. Government
excluded one of them from the restitution order (Yakult Honsha Co., Ltd.) because a senior officer of the
noteholder was being criminally prosecuted in Japan for his conduct relating to its Princeton Notes. The senior
officer in question was convicted during September 2002 of various criminal charges related to the sale of the
Princeton Notes. The U.S. Government excluded the other noteholder (Maruzen Company, Limited) because the sum it
is likely to recover from the Princeton Receiver exceeds its losses attributable to its funds transfers with
Republic New York Securities Corporation as calculated by the U.S. Government. Both of these civil suits seek
compensatory, punitive, and treble damages pursuant to RICO and assorted fraud and breach of duty claims arising
from unpaid Princeton Notes with face amounts totaling approximately $125 million. No amount of compensatory
damages is specified in either complaint. These two complaints name the Company, the Bank, and Republic New York
Securities Corporation as defendants. The Company and the Bank have moved to dismiss both complaints. The motion
is fully briefed and sub judice. Mutual production of documents took place in 2001, but additional discovery
proceedings have been suspended pending the Court's resolution of the motions to dismiss.
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Note 21. Derivative Instruments and Hedging Activities
The Company is party to various derivative financial instruments as an end user (1) for asset and liability
management purposes; (2) in order to offset the risk associated with changes in the value of various assets and
liabilities accounted for in the trading account; (3) to protect against changes in value of its mortgage
servicing rights portfolio; and (4) for trading in its own account.
The Company is also an international dealer in derivative instruments denominated in U.S. dollars and other
currencies which include futures, forwards, swaps and options related to interest rates, foreign exchange rates,
equity indices, commodity prices and credit, focusing on structuring of transactions to meet clients' needs.
Fair Value Hedges
Specifically, interest rate swaps that call for the receipt of a variable market rate and the payment of a fixed
rate are utilized under fair value strategies to hedge the risk associated with changes in the risk free rate
component of the value of certain fixed rate investment securities. Interest rate swaps that call for the
receipt of a fixed rate and payment of a variable market rate are utilized to hedge the risk associated with
changes in the risk free rate component of certain fixed rate debt obligations. Additionally, beginning in
December 2002, the Company established a qualifying hedge strategy using forward sales contracts to offset the
fair value changes of certain conventional closed mortgage loans originated for sale.
Where the critical terms of the hedge instrument are identical at hedge inception, the short-cut method of
accounting is utilized. As a result, no retrospective or prospective assessment of effectiveness is required and
no hedge ineffectiveness is recognized. However, in instances where the short-cut method of accounting cannot be
applied, the cumulative dollar offset method is utilized in order to satisfy the retrospective and prospective
assessment of hedge effectiveness for SFAS 133.
For the year ended December 31, 2003, the Company recognized a net gain of $.2 million compared with a net gain
of $7.5 million for the year ended December 31, 2002 and a net loss of $.6 million for the year ended December
31, 2001 (reported as mortgage banking revenue and/or other income in the consolidated statement of income),
which represented the ineffective portion of all fair value hedges. Only the time value component of these
derivative contracts has been excluded from the assessment of hedge effectiveness.
Cash Flow Hedges
Similarly, interest rate swaps and futures contracts that call for the payment of a fixed rate are utilized
under the cash flow strategy to hedge the forecasted repricing of certain deposit liabilities and commercial
loan assets. In order to initially qualify for hedge accounting, assessment of hedge effectiveness is
demonstrated on a prospective basis utilizing both regression analysis and the cumulative dollar offset method.
In order to satisfy the retrospective assessment of hedge effectiveness, the cumulative dollar offset method is
utilized and ineffectiveness is recorded to the income statement on a monthly basis.
For the year ended December 31, 2003, the Company recognized a net gain of $3.4 million compared with a net gain
of $12.7 million for the year ended December 31, 2002 and a net gain of $8.5 million for the year ended December
31, 2001 (reported as a component of other income in the consolidated
98
statement of income), which represented the total ineffectiveness of all cash flow hedges. Only the time value
component of these derivative contracts has been excluded from the assessment of hedge effectiveness.
Gains or losses on derivative contracts that are reclassified from accumulated other comprehensive income to
current period earnings pursuant to this strategy, are included in interest expense on deposit liabilities
during the periods that net income is impacted by the repricing. As of December 31, 2003, $10.0 million of
deferred net losses on derivative instruments accumulated in other comprehensive income are expected to be
charged to earnings during 2004.
Trading and Other Activities
The Company enters into certain derivative contracts for purely trading purposes in order to realize profits
from short-term movements in interest rates, commodity prices, foreign exchange rates and credit spreads. In
addition, certain derivative contracts are accounted for on a full mark to market basis through current earnings
even though they were acquired for the purpose of protecting the economic value of certain assets and
liabilities.
Credit and Market Risks
By using derivative instruments, the Company is exposed to credit and market risks. If the counterparty fails to
perform, credit risk is equal to the fair value gain in a derivative. When the fair value of a derivative
contract is positive, this generally indicates that the counterparty owes the Company, and, therefore, creates a
repayment risk for the Company. When the fair value of a derivative contract is negative, the Company owes the
counterparty and, therefore, it has no repayment risk.
The Company minimizes the credit (or repayment) risk in derivative instruments by entering into transactions
with quality counterparties including other members of the HSBC Group. Counterparties include financial
institutions, government agencies, both foreign and domestic, corporations, funds (mutual funds, hedge funds,
etc.), insurance companies and private clients. These counterparties are subject to regular credit review by the
Company's credit risk management department. The Company generally requires that derivative contracts be
governed by an International Swaps and Derivatives Association Master Agreement. Depending on the type of
counterparty and the level of expected activity, bilateral collateral arrangements may be required as well. When
the Company has more than one transaction with a counterparty and has a legally enforceable master netting
agreement in place with that counterparty, the net positive mark to market value, less the amount of collateral,
if any, should represent the measure of current credit exposure with that counterparty as of the reporting date.
Market risk is the adverse effect that a change in interest rates, currency, or implied volatility rates has on
the value of a financial instrument. The Company manages the market risk associated with interest rate and
foreign exchange contracts by establishing and monitoring limits as to the types and degree of risk that may be
undertaken. The Company also manages the market risk associated with the trading derivatives through hedging
strategies that correlate the rates, price and spread movements. The Company measures this risk daily by using
Value at Risk (VAR) and other methodologies.
The Company's Asset and Liability Policy Committee is responsible for monitoring and defining the scope and
nature of various strategies utilized to manage interest rate risk that are developed through its analysis of
data from financial simulation models and other internal and industry sources. The resulting hedge strategies
are then incorporated into the Company's overall interest rate risk management and trading strategies.
99
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