Interim Report - 19 of 26

RNS Number : 1283M

HSBC Holdings PLC

12 August 2011

 



Capital

Capital management

Our approach to capital management is driven by our strategic and organisational requirements, taking into account the regulatory, economic and commercial environment in which we operate.

It is our objective to maintain a strong capital base to support the development of our business and to meet regulatory capital requirements at all times. To achieve this, our policy is to hold capital in a range of different forms and from diverse sources. All capital raising is agreed with major subsidiaries as part of their individual and the Group's overall capital management processes.

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

Capital measures

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

·  invested capital is the equity capital invested in HSBC by our shareholders;

·  economic capital is the internally calculated capital requirement which we deem necessary to support the risks to which we are exposed at a confidence level consistent with a target credit rating of AA; and

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

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

We incorporate stress testing in the capital management framework, and it is important in understanding the sensitivities of the core assumptions in our capital plans to the adverse effect of extreme, but plausible, events. Stress testing allows us to formulate our response, including risk mitigation actions, in advance of conditions starting to exhibit the stress scenarios identified. The actual market stresses which occurred throughout the financial system during recent years have been used to inform our capital planning process and further develop the stress scenarios we employ.

In addition to our internal stress tests, others are carried out, both at the request of regulators and by the regulators themselves using their prescribed assumptions. We take into account the results of all such regulatory stress testing when undertaking our internal capital management assessment.

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

Our capital management process is articulated in the annual Group capital plan which is approved by the Board. The plan is drawn up with the objective of maintaining both an appropriate amount of capital and an optimal mix between the different components of capital. HSBC Holdings and its major subsidiaries raise non-equity tier 1 capital and subordinated debt in accordance with our guidelines on market and investor concentration, cost, market conditions, timing, capital composition and maturity profile. Application of the eligibility requirements for non-equity tier 1 and tier 2 instruments under Basel III has not been clearly defined in the UK. We have therefore not issued any non-equity capital securities in the first half of 2011. Each of our subsidiaries manages its own capital to support its planned business growth and meet its local regulatory requirements within the context of the approved annual Group capital plan. In accordance with our capital management framework, capital generated by subsidiaries in excess of planned requirements is returned to HSBC Holdings, normally by way of dividends.

HSBC Holdings is the primary provider of equity capital to its subsidiaries and also provides tier 2 capital to subsidiaries where necessary. These investments are substantially funded by HSBC Holdings' own capital issuance and profit retention. As part of its capital management process, HSBC Holdings seeks to maintain a prudent balance between the composition of its capital and that of its investment in subsidiaries.

Capital measurement and allocation

The FSA supervises HSBC on a consolidated basis and therefore receives information on the capital adequacy of, and sets capital requirements for, the Group as a whole. Individual banking subsidiaries are directly regulated by their local banking supervisors, who set and monitor their capital adequacy requirements.

Regulatory and accounting consolidations

The basis of consolidation for financial accounting purposes is described on page 251 of the Annual Report and Accounts 2010 and differs from that used for regulatory purposes. Investments in banking associates are equity accounted in the financial accounting consolidation, whereas their exposures are proportionally consolidated for regulatory purposes. Subsidiaries and associates engaged in insurance and non-financial activities are excluded from the regulatory consolidation and are deducted from regulatory capital. The regulatory consolidation does not include SPEs where significant risk has been transferred to third parties. Exposures to these SPEs are risk-weighted as securitisation positions for regulatory purposes.

We calculate capital at a Group level using the Basel II framework of the Basel Committee on Banking Supervision. However, local regulators are at different stages of implementation and local reporting may still be on a Basel I basis, notably in the US. In most jurisdictions, non-banking financial subsidiaries are also subject to the supervision and capital requirements of local regulatory authorities.

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

Regulatory capital

Our capital is divided into two tiers:

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

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

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

Pillar 1 capital requirements

Pillar 1 covers the capital resources requirements for credit risk, market risk and operational risk. Credit risk includes counterparty credit risk and securitisation requirements. These requirements are expressed in terms of risk-weighted assets ('RWA's).

Credit risk capital requirements

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

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

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

For consolidated Group reporting, the FSA's rules permit the use of other regulators' standardised approaches where they are considered equivalent. The use of other regulators' IRB approaches is subject to the agreement of the FSA. Under our Basel II rollout plans, a number of our Group companies and portfolios are in transition to advanced IRB approaches. At June 2011, portfolios in much of Europe, Hong Kong, Rest of Asia-Pacific

and North America were on advanced IRB approaches. Others remain on the standardised or foundation approaches under Basel II, pending definition of local regulations or model approval, or under exemptions from IRB treatment.

Counterparty credit risk

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

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

Securitisation

Securitisation positions in the trading book are treated in the same way as other market risk positions.

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

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

Market risk capital requirement

The market risk capital requirement is measured, with the FSA's permission, using VAR models, or the standard rules prescribed by the FSA.

We use both VAR and standard rules approaches for market risk. Our aim is to migrate more positions from standard rules to VAR.

Operational risk capital requirement

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

We have adopted the standardised approach in determining our operational risk capital requirements.

Pillar 2 capital requirements

The second pillar of Basel II (Supervisory Review and Evaluation Process) involves both firms and regulators taking a view on whether a firm should hold additional capital against risks not covered in pillar 1. Part of the pillar 2 process is the Internal Capital Adequacy Assessment Process which is the firm's self assessment of the levels of capital that it needs to hold. The pillar 2 process culminates in the FSA providing firms with Individual Capital Guidance ('ICG'). The ICG is set as a capital resources requirement higher than that required under pillar 1. In 2011, this is expected to be supplemented by an additional Capital Planning Buffer, set by the FSA, to cover capital demand should economic conditions worsen considerably against the current outlook.

Pillar 3 disclosure requirements

Pillar 3 of Basel II is related to market discipline and aims to make firms more transparent by requiring them to publish specific, prescribed details of their risks, capital and risk management under the Basel II framework. Our pillar 3 disclosures for the year ended 31 December 2010 were published as a separate document on the Group Investor Relations website.

Capital structure

	At           30 June		At             30 June		At    31 December
	2011		2010		2010
	US$m		US$m		US$m
Composition of regulatory capital
Tier 1 capital
Shareholders' equity ...................................................................................	154,652		136,719		142,746
Shareholders' equity per balance sheet1 ...................................................	160,250		135,943		147,667
Preference share premium ......................................................................	(1,405)		(1,405)		(1,405)
Other equity instruments ........................................................................	(5,851)		(5,851)		(5,851)
Deconsolidation of special purpose entities2 ...........................................	1,658		8,032		2,335
Non-controlling interests ...........................................................................	3,871		3,949		3,917
Non-controlling interests per balance sheet ............................................	7,287		7,380		7,248
Preference share non-controlling interests .............................................	(2,445)		(2,391)		(2,426)
Non-controlling interest transferred to tier 2 capital ..............................	(507)		(676)		(501)
Non-controlling interest in deconsolidated subsidiaries ............................	(464)		(364)		(404)
Regulatory adjustments to the accounting basis ..........................................	888		(3,079)		1,794
Unrealised (gains)/losses on available-for-sale debt securities3 ..................	3,290		(797)		3,843
Own credit spread ...................................................................................	(773)		(1,779)		(889)
Defined benefit pension fund adjustment4 ...............................................	1,211		1,940		1,676
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities ....................................................................	(3,085)		(2,500)		(3,121)
Cash flow hedging reserve .......................................................................	245		57		285
Deductions .................................................................................................	(33,649)		(30,753)		(32,341)
Goodwill capitalised and intangible assets ................................................	(29,375)		(26,398)		(28,001)
50% of securitisation positions................................................................	(1,274)		(1,754)		(1,467)
50% of tax credit adjustment for expected losses.....................................	126		269		241
50% of excess of expected losses over impairment allowances ...............	(3,126)		(2,870)		(3,114)
Core tier 1 capital ..................................................................................	125,762		106,836		116,116
Other tier 1 capital before deductions .........................................................	18,339		17,577		17,926
Preference share premium ......................................................................	1,405		1,405		1,405
Preference share non-controlling interests .............................................	2,445		2,391		2,426
Hybrid capital securities ..........................................................................	14,489		13,781		14,095
Deductions .................................................................................................	(988)		(345)		(863)
Unconsolidated investments5 ..................................................................	(1,114)		(614)		(1,104)
50% of tax credit adjustment for expected losses ....................................	126		269		241
Tier 1 capital ...........................................................................................	143,113		124,068		133,179
Tier 2 capital
Total qualifying tier 2 capital before deductions .........................................	50,544		48,170		52,713
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities ....................................................................	3,085		2,500		3,121
Collective impairment allowances6 .........................................................	2,772		3,526		3,109
Perpetual subordinated debt ....................................................................	2,782		2,982		2,781
Term subordinated debt ..........................................................................	41,605		38,862		43,402
Non-controlling interest in tier 2 capital ................................................	300		300		300
Total deductions other than from tier 1 capital ..........................................	(19,873)		(17,352)		(18,337)
Unconsolidated investments5 ..................................................................	(15,471)		(12,727)		(13,744)
50% of securitisation positions ...............................................................	(1,274)		(1,754)		(1,467)
50% of excess of expected losses over impairment allowances ...............	(3,126)		(2,870)		(3,114)
Other deductions ....................................................................................	(2)		(1)		(12)
Total regulatory capital .........................................................................	173,784		154,886		167,555
Risk-weighted assets
Credit risk ..................................................................................................	947,525		839,079		890,696
Counterparty credit risk .............................................................................	52,985		57,323		50,175
Market risk ................................................................................................	44,456		52,964		38,679
Operational risk .........................................................................................	123,563		125,898		123,563
Total .........................................................................................................	1,168,529		1,075,264		1,103,113

For footnotes, see page 164.

Capital structure (continued)

	At 30 June		At 30 June		At 31 December
	2011		2010		2010
	%		%		%
Capital ratios
Core tier 1 ratio .........................................................................................	10.8		9.9		10.5
Tier 1 ratio ................................................................................................	12.2		11.5		12.1
Total capital ratio ......................................................................................	14.9		14.4		15.2

Source and application of tier 1 capital

	Half-year to
	30 June		30 June		31 December
	2011		2010		2010
	US$m		US$m		US$m
Movement in tier 1 capital
Opening tier 1 capital ................................................................................	133,179		122,157		124,068
Contribution to tier 1 capital from profit for the period .........................	9,315		6,030		7,188
Consolidated profits attributable to shareholders of the parent company	9,215		6,763		6,396
Removal of own credit spread net of tax ................................................	100		(733)		792
Net dividends .............................................................................................	(2,672)		(1,678)		(2,149)
Dividends ...............................................................................................	(4,006)		(3,261)		(3,089)
Add back: shares issued in lieu of dividends ..............................................	1,334		1,583		940
Decrease/(increase) in goodwill and intangible assets deducted .....................	(1,374)		2,282		(1,603)
Ordinary shares issued ................................................................................	13		61		119
Hybrid capital securities issued net of redemptions .....................................	-		2,368		-
Foreign currency translation differences .....................................................	4,471		(6,002)		5,476
Other .........................................................................................................	181		(1,150)		80
Closing tier 1 capital ..................................................................................	143,113		124,068		133,179
Movement in risk-weighted assets
At beginning of period ...............................................................................	1,103,113		1,133,168		1,075,264
Movements ................................................................................................	65,416		(57,904)		27,849
At end of period .........................................................................................	1,168,529		1,075,264		1,103,113

Movement in tier 1 capital

We complied with the FSA's capital adequacy requirements through 2010 and the first half of 2011. Internal capital generation contributed US$6.6bn to tier 1 capital, being profits attributable to shareholders of the parent company after taking account of own credit spread and net dividends. Tier 1 capital was further strengthened by foreign currency translation differences of US$4.5bn, partly offset by an increase in goodwill of US$1.4bn also due to exchange movements.

Movement in risk-weighted assets

RWAs increased by US$65.4bn or 6% in the first half of 2011. Foreign currency translation effects are estimated to have increased RWAs by US$16.2bn, mainly as a result of the weakening of the US dollar, particularly against sterling and the euro. Of the underlying rise of US$49.2bn, US$40.6bn was due to credit risk, predominantly reflecting the growth in lending in Hong Kong, Rest of Asia‑Pacific and Latin America. Market risk RWAs rose by US$5.8bn and counterparty credit risk RWAs by US$2.8bn, largely as a result of increased trading volumes.

Future developments

The regulation and supervision of financial institutions continues to undergo significant change in response to the global financial crisis. In December 2010, the Basel Committee issued final rules in two documents: A global regulatory framework for more resilient banks and banking systems and International framework for liquidity risk measurement, standards and monitoring, which together are commonly referred to as 'Basel III'.

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

On 1 June 2011, the Basel Committee issued a revised version of A global regulatory framework for more resilient banks and banking systems that set out the finalised capital treatment for counterparty credit risk in bilateral trades.

On 20 July 2011, the European Commission published proposals for a new Regulation and Directive, which collectively are known as CRD IV, to give effect to the Basel III framework in the EU. The measures are subject to agreement by the European Parliament, the Council and EU member states. We will continue to assess the impact of these new proposals on HSBC's capital position.

The Basel Committee has increased the capital requirements for the trading book and complex securitisation exposures, under what is commonly known as Basel 2.5, which are due to take effect from 31 December 2011.

On 13 January 2011, the Basel Committee issued further minimum requirements to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss. Instruments issued on or after 1 January 2013 may only be included in regulatory capital if the new requirements are met. The capital treatment of securities issued prior to this date will be phased out over a 10-year period commencing on 1 January 2013.

The Basel Committee issued a consultative document on 19 July 2011, Global systemically important banks: Assessment methodology and the additional loss absorbency requirement. It sets out the assessment methodology for global systematically important banks ('G-SIBs') which is based on an indicator-based approach and comprises five broad categories: size, interconnectedness, lack of substitutability, global (cross-jurisdictional) activity and complexity. Those banks designated as G-SIBs will be required to hold a minimum amount of loss absorbency capital depending on their relative systemic importance. This requirement ranges from 1% to 2.5% and will be met with common equity tier 1 capital. An additional 1% surcharge will be applied to banks, if any, exceeding a certain level of systemic importance relative to their peers, as a disincentive to materially grow their operations further. These requirements will be phased-in in parallel with the capital conservation and countercyclical capital buffers between 1 January 2016 and 31 December 2018, becoming fully effective on 1 January 2019.

Impact of Basel 2.5 and Basel III

In order to provide some insight into the possible effects of the new Basel 2.5 and Basel III rules on HSBC, we have estimated the pro forma common equity tier 1 ratio of the Group on the basis of our interpretation of those rules, as they would apply at 1 January 2019, but based on the position at 30 June 2011.

Our estimate includes mitigating actions planned by management, but does not take account of any future retained earnings. On this basis, the resulting common equity tier 1 ratio would be lower than the Basel II core tier 1 ratio by some 170 basis points, comprising 270bps gross impact less 100bps from mitigating action planned by management. The estimated impact is subject to change as further clarification emerges around the practical application and interpretation of the requirements.

The Basel 2.5 changes, which are due to take effect from 31 December 2011, primarily relate to market risk amendments. These changes are estimated to reduce the common equity tier 1 capital ratio by 50bps. We expect to be able to reduce this impact by 20bps by running off non-core and legacy positions and actively managing the correlation trading portfolio and the market risk capital requirement.

The Basel III changes, which will be progressively phased in, relate to increased capital deductions, new regulatory adjustments and increases in RWAs. We estimate that the initial introduction of these rules on 1 January 2013, on a pro forma basis, will result in a reduction in the common equity tier 1 capital ratio of 90bps. We plan to mitigate this impact by 40bps, over the period between 1 January 2012 and 31 December 2013, by continuing the actions mentioned above, and by active management of the counterparty credit risk capital requirement. The remainder of the Basel III changes, mainly relating to regulatory adjustments, will be phased in over the period from 1 January 2014 up to 31 December 2018 with a further reduction in the common equity tier 1 capital ratio of 130bps, partly off-set by an estimated 40bps through the continued run-off of non-core portfolios and legacy positions. This phase includes the majority of the unconsolidated investments that we previously deducted from capital, together with changes to the treatment of deferred tax assets and the 50% of excess of expected loss over impairment allowances previously deducted from total capital.

Further uncertainty remains regarding any capital requirements which may be imposed on the Group over the period to 1 January 2019 in respect of the countercyclical capital buffer and any additional regulatory requirements for G‑SIBs. Under the Basel III rules as they will apply from 1 January 2019, we believe that ultimately the level for the common equity tier 1 ratio of the Group may lie in the range 9.5% to 10.5%. This exceeds the minimum requirement for common equity tier 1 capital plus the capital conservation buffer. HSBC has a strong track record of capital generation and actively manages its RWAs.

Footnotes to Capital

1   Includes externally verified profits for the half-year to 30 June 2011.

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

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

4   Under FSA rules, the defined benefit liability may be substituted with the additional funding that will be paid into the relevant schemes over the following five year period.

5   Mainly comprise investments in insurance entities.

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

 

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