2008 Interim Report Section 1

RNS Number : 6185A

HSBC Holdings PLC

04 August 2008

 



HSBC has codified its operational risk management framework in a high level standard, supplemented by more detailed formal policies. The detailed policies explain HSBC's approach to identifying, assessing, monitoring and controlling operational risk and give guidance on mitigating action to be taken when weaknesses are identified.

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

The control environment in each subsidiary is subject to an independent programme of periodic reviews undertaken by Internal Audit. This is supported by the monitoring of external operational risk events, which ensures that HSBC stays in line with industry best practice and takes account of lessons learned from publicised operational failures.

Legal risk 

Each operating company is required to implement policies, procedures and guidelines in respect of the management and control of legal risk which conform to HSBC standards. Legal risk falls within the definition of operational risk and includes contractual risk, legislative risk, intellectual property risk and litigation risk. Litigation risk is the risk of:

• failing to act appropriately in response to a claim made against any HSBC company; or

• being unable to defend successfully a claim brought against any HSBC company; or 

• HSBC being unable to take action to enforce its rights through the courts.

HSBC has a global legal function dedicated to managing legal risk in accordance with policies and procedures as described on page 261 in the Annual Report and Accounts 2007. 

Reputational risk

The safeguarding of HSBC's reputation is of paramount importance to its continued prosperity and is the responsibility of every member of staff. Reputational risks can arise from social, ethical or environmental issues, or as a consequence of operational risk events. As a banking group, HSBC's good reputation depends upon the way in which it conducts its business, but it can also be affected by the way in which its clients conduct themselves.

For this reason a Group Reputational Risk Committee ('GRRC') has been established, chaired by the Head of Group Compliance with membership drawn from senior Group business and functional heads. GRRC will meet as required, but at least quarterly, to consider issues and areas of policy relating to reputational risk, and where required make recommendations to senior Group management. A wider description of HSBC's management of reputational risk is described on page 263 in the Annual Report and Accounts 2007.

Risk management of insurance operations

HSBC operates a bancassurance model which provides insurance products for customers with whom the Group has a banking relationship. Many of these products are manufactured by HSBC subsidiaries but, where the Group considers it operationally more effective, third parties are engaged to manufacture and provide insurance products which HSBC sells through its banking network.

Life insurance contracts include participating business (with discretionary participation features) such as endowments and pensions, credit life business in respect of income and payment protection, annuities, term assurance and critical illness covers.

Non-life insurance contracts include motor, fire and other damage to property, accident and health, repayment protection and commercial insurances.

The principal insurance risk faced by HSBC is that, over time, the combined cost of claims, administration and acquisition of the contract may exceed the aggregate amount of premiums received and investment income. 

In respect of financial risks, subsidiaries manufacturing products with guarantees are usually exposed to falls in market interest rates and equity prices to the extent that the exposure cannot be managed through the discretionary bonus policy. 

HSBC manages its exposure to insurance risk by applying underwriting, reinsurance and claims-handling procedures designed to ensure compliance with regulations and insurance risk appetite, the latter proposed by local businesses and authorised centrally. This is supplemented by undertaking stress testing. The following tables provide an analysis of the insurance risk exposures by geography and by type of business. Life business tends to be longer term in nature than non-life business and frequently involves an element of savings and investment in the contract. Separate tables are therefore provided for life and non-life businesses, reflecting their distinctive risk characteristics. The life insurance risk table provides an analysis of insurance liabilities as the best available overall measure of insurance exposure, because provisions for life contracts are typically set by reference to expected future cash outflows relating to the underlying policies. The table for non-life business uses written premiums as the best available measure of risk exposure.

HSBC's management of insurance risk, including the risks relating to different life and non-life products, is described on page 264 in the Annual Report and Accounts 2007.

Analysis of life insurance risk - liabilities to policyholders 

	Europe		Hong     Kong		Rest of     Asia-    Pacific		North     America		Latin     America		Total
	US$m		US$m		US$m		US$m		US$m		US$m
At 30 June 2008
Life (non-linked)
Insurance contracts with DPF1	1,094		9,744		238		-		-		11,076
Credit life	280		-		-		72		-		352
Annuities	484		-		29		826		1,697		3,036
Term assurance and other long-term  contracts	933		79		97		131		341		1,581
Total life (non-linked)	2,791		9,823		364		1,029		2,038		16,045
Life (linked)	2,289		2,263		429		-		2,751		7,732
Investment contracts with DPF1,2	20,218		-		45		-		-		20,263
Insurance liabilities to policyholders	25,298		12,086		838		1,029		4,789		44,040
At 30 June 2007
Life (non-linked)
Insurance contracts with DPF1	844		7,173		201		-		-		8,218
Credit life	234		-		-		201		-		435
Annuities	310		-		26		1,210		1,480		3,026
Term assurance and other long-term  contracts	94		76		93		-		291		554
Total life (non-linked)	1,482		7,249		320		1,411		1,771		12,233
Life (linked)	1,693		1,058		426		-		1,677		4,854
Investment contracts with DPF1,2	17,100		-		22		-		-		17,122
Insurance liabilities to policyholders	20,275		8,307		768		1,411		3,448		34,209
At 31 December 2007
Life (non-linked)
Insurance contracts with DPF1	940		8,489		231		-		-		9,660
Credit life	235		-		-		82		-		317
Annuities	413		-		28		1,154		1,532		3,127
Term assurance and other long-term  contracts	675		74		85		125		307		1,266
Total life (non-linked)	2,263		8,563		344		1,361		1,839		14,370
Life (linked)	1,720		2,019		467		-		2,193		6,399
Investment contracts with DPF1,2	18,954		-		29		-		-		18,983
Insurance liabilities to policyholders	22,937		10,582		840		1,361		4,032		39,752

1    Insurance contracts and investment contracts with discretionary participation features ('DPF') can give policyholders the contractual right to receive, as a supplement to their guaranteed benefits, additional benefits that may be a significant portion of the total contractual benefits, but whose amount and timing is determined by HSBC. These additional benefits are contractually based on the performance of a specified pool of contracts or assets, or the profit of the company issuing the contracts. 

2    Although investment contracts with DPF are financial instruments, HSBC continues to account for them as insurance contracts as permitted by IFRS 4.

Analysis of non-life insurance risk - net written insurance premiums1

	Europe		Hong     Kong		Rest of     Asia-    Pacific		North     America		Latin     America		Total
	US$m		US$m		US$m		US$m		US$m		US$m
Half-year to 30 June 2008
Accident and health	7		76		2		-		13		98
Motor	149		7		6		-		134		296
Fire and other damage	71		13		4		1		13		102
Liability	-		9		2		-		19		30
Credit (non-life)	43		-		-		75		-		118
Marine, aviation and transport	-		7		2		-		13		22
Other non-life insurance contracts	28		14		-		8		12		62
Total net written insurance premiums	298		126		16		84		204		728
Net insurance claims incurred and movement  in liabilities to policyholders	(268)		(50)		(5)		(41)		(82)		(446)
Half-year to 30 June 2007
Accident and health	18		68		2		-		8		96
Motor	172		8		5		-		96		281
Fire and other damage	99		11		2		1		6		119
Liability	-		9		2		8		15		34
Credit (non-life)	125		-		-		90		-		215
Marine, aviation and transport	-		6		2		-		8		16
Other non-life insurance contracts	24		11		-		6		8		49
Total net written insurance premiums	438		113		13		105		141		810
Net insurance claims incurred and movement  in liabilities to policyholders	(259)		(43)		(5)		(40)		(63)		(410)
Half-year to 31 December 2007
Accident and health	9		64		3		-		17		93
Motor	197		7		5		-		128		337
Fire and other damage	79		12		5		1		13		110
Liability	-		3		1		-		19		23
Credit (non-life)	(49)		-		-		67		-		18
Marine, aviation and transport	-		6		2		-		10		18
Other non-life insurance contracts	6		13		-		24		16		59
Total net written insurance premiums	242		105		16		92		203		658
Net insurance claims incurred and movement  in liabilities to policyholders	(339)		(47)		(5)		(39)		(88)		(518)

• Net written insurance premiums represent gross written premiums less gross written premiums ceded to reinsurers.

Balance sheet of insurance manufacturing operations by type of contract

A principal tool used to manage the Group's exposure to insurance risk, in particular for life insurance contracts, is asset and liability matching. Of particular importance is the need to match the expected pattern of cash inflows with the benefits payable on the underlying contracts which, in some cases, can extend for many years. The table below shows the composition of assets and liabilities and demonstrates that there was an appropriate level of matching at 30 June 2008. It may not always be possible to achieve a complete matching of asset and liability durations, partly because there is uncertainty over the receipt of all future premiums and partly because the duration of liabilities may exceed the duration of the longest available dated fixed interest investments.

Asset-backed securities and CDOs comprised US$249 million of the total US$69.3 billion of financial assets in Insurance; and in response to more difficult equity markets HSBC has reduced its exposure to equities by US$3.3 billion since 31 December 2007.

Models are used to assess the effect of a range of future scenarios on the values of financial assets and associated liabilities. The stresses applied include economic and non-economic factors. The economic stress tests include measuring the sensitivity of the asset and liability values to changes in equity prices and changes in interest rates. Nonߛeconomic stress tests include measuring the sensitivity of the liability values to mortality, lapse and expense rates. ALCOs consider the outcomes in determining the composition of assets supporting the customer liabilities.

Balance sheet of insurance operations by type of contract

	Insurance contracts										Investment contracts
	Contracts     with     DPF1		Unit-     linked		Annuities		Term     assurance2		Non-life		Contracts     with     DPF3		Unit-     linked		Other		Other      assets4		Total
	US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m
At 30 June 2008
Financial assets:
-     trading assets	-		-		30		-		33		-		-		-		4		67
-     financial assets designated at fair  value	2,328		7,136		523		485		237		5,604		11,725		1,617		2,787		32,442
-     derivatives	42		31		-		12		1		84		236		24		30		460
-     financial investments	6,448		-		1,434		410		1,058		13,559		-		1,554		2,753		27,216
-     other financial assets	2,208		475		766		924		1,174		9		607		599		2,369		9,131
Total financial assets	11,026		7,642		2,753		1,831		2,503		19,256		12,568		3,794		7,943		69,316
Reinsurance assets	4		101		396		317		530		515		-		-		67		1,930
PVIF5	-		-		-		-		-		-		-		-		2,344		2,344
Other assets and investment properties	107		5		35		105		298		493		55		43		734		1,875
Total assets	11,137		7,748		3,184		2,253		3,331		20,264		12,623		3,837		11,088		75,465
Liabilities under investment contracts designated at fair value	-		-		-		-		-		-		12,187		3,220		-		15,407
Liabilities under investment contracts  carried at amortised cost	-		-		-		-		-		-		-		376		-		376
Liabilities under insurance contracts	11,076		7,732		3,036		1,933		2,811		20,263		-		-		-		46,851
Deferred tax	1		6		3		28		5		-		-		1		632		676
Other liabilities	-		-		-		-		-		-		-		-		3,939		3,939
Total liabilities	11,077		7,738		3,039		1,961		2,816		20,263		12,187		3,597		4,571		67,249
Total equity	-		-		-		-		-		-		-		-		8,216		8,216
Total equity and liabilities6	11,077		7,738		3,039		1,961		2,816		20,263		12,187		3,597		12,787		75,465

For footnotes, see page 196.

	Insurance contracts										Investment contracts
	Contracts     with     DPF1		Unit-     linked		Annuities		Term     assurance2		Non-life		Contracts     with     DPF3		Unit-     linked		Other		Other      assets4		Total
	US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m
At 30 June 2007
Financial assets:
-     trading assets	-		-		46		-		41		-		-		-		33		120
-     financial assets designated at fair  value	1,851		4,138		559		693		44		6,792		11,094		1,610		2,686		29,467
-     derivatives	-		349		-		-		1		56		352		3		-		761
-     financial investments	4,949		-		1,253		388		1,294		10,076		-		1,412		2,712		22,084
-     other financial assets	1,504		304		419		197		704		616		409		633		1,236		6,022
Total financial assets	8,304		4,791		2,277		1,278		2,084		17,540		11,855		3,658		6,667		58,454
Reinsurance assets	1		62		314		260		628		-		-		-		54		1,319
PVIF5	-		-		-		-		-		-		-		-		1,909		1,909
Other assets and investment properties	37		6		574		124		174		97		68		-		1,357		2,437
Total assets	8,342		4,859		3,165		1,662		2,886		17,637		11,923		3,658		9,987		64,119
Liabilities under investment contracts designated at fair value	-		-		-		-		-		-		11,132		3,389		-		14,521
Liabilities under investment contracts  carried at amortised cost	-		-		-		-		-		-		-		268		-		268
Liabilities under insurance contracts	8,218		4,854		3,026		989		2,720		17,122		-		-		-		36,929
Deferred tax	-		-		-		-		-		-		-		-		603		603
Other liabilities	-		-		-		-		-		-		-		-		4,442		4,442
Total liabilities	8,218		4,854		3,026		989		2,720		17,122		11,132		3,657		5,045		56,763
Total equity	-		-		-		-		-		-		-		-		7,356		7,356
Total equity and liabilities6	8,218		4,854		3,026		989		2,720		17,122		11,132		3,657		12,401		64,119

For footnotes, see page 196. 

Balance sheet of insurance operations by type of contract (continued)

	Insurance contracts										Investment contracts
	Contracts     with     DPF1		Unit-     linked		Annuities		Term     assurance2		Non-life		Contracts     with     DPF3		Unit-     linked		Other		Other      assets4		Total
	US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m		US$m
At 31 December 2007
Financial assets:
-     trading assets	-		-		37		-		22		-		-		-		35		94
-     financial assets designated at fair  value	3,424		5,799		610		559		130		6,210		12,379		1,610		2,992		33,713
-     derivatives	2		52		-		-		1		78		250		3		30		416
-     financial investments	4,518		-		1,265		328		1,071		12,305		-		1,526		2,939		23,952
-     other financial assets	1,896		520		1,047		716		1,175		3		762		714		1,483		8,316
Total financial assets	9,840		6,371		2,959		1,603		2,399		18,596		13,391		3,853		7,479		66,491
Reinsurance assets	4		57		337		264		653		-		-		-		54		1,369
PVIF5	-		-		-		-		-		-		-		-		1,965		1,965
Other assets and investment properties	65		2		30		104		193		399		46		52		1,196		2,087
Total assets	9,909		6,430		3,326		1,971		3,245		18,995		13,437		3,905		10,694		71,912
Liabilities under investment contracts designated at fair value	-		-		-		-		-		-		12,725		3,328		-		16,053
Liabilities under investment contracts  carried at amortised cost	-		-		-		-		-		-		-		312		-		312
Liabilities under insurance contracts	9,660		6,399		3,127		1,583		2,854		18,983		-		-		-		42,606
Deferred tax	-		7		3		22		3		-		6		-		582		623
Other liabilities	-		-		-		-		-		-		-		-		3,888		3,888
Total liabilities	9,660		6,406		3,130		1,605		2,857		18,983		12,731		3,640		4,470		63,482
Total equity	-		-		-		-		-		-		-		-		8,430		8,430
Total equity and liabilities6	9,660		6,406		3,130		1,605		2,857		18,983		12,731		3,640		12,900		71,912

1    Discretionary participation features ('DPF').

2    Term assurance includes credit life insurance.

3    Although investment contracts with DPF are financial instruments, HSBC continues to account for them as insurance contracts as permitted by IFRS 4.

4    Other assets comprise shareholder assets.

5    Present value of in-force long-term insurance contracts and investment contracts with DPF.

6    Excludes assets, liabilities and shareholders' funds of associate insurance company, Ping An Insurance.

Capital management and allocation

Capital management

HSBC's capital management approach is driven by its strategy and organisational requirements, taking into account the regulatory and commercial environment in which it operates. The Group's strategy underpins HSBC's Capital Management Framework which has been approved by the Group Management Board. It is HSBC's policy to maintain a strong capital base to support the development of its business and to meet regulatory capital requirements at all times. HSBC also maintains a strong discipline over its investment decisions and where it allocates its capital, seeking to ensure that returns on investment are appropriate after taking account of capital costs. In addition, the level of capital held by HSBC Holdings and certain subsidiaries, particularly HSBC Finance, is determined by rating targets. 

HSBC's strategy is to allocate capital to businesses based on their economic profit generation and, within this process, regulatory and economic capital requirements and the cost of capital are key factors. The responsibility for global capital allocation principles and decisions rests with the Group Management Board. Stress testing is used as an important mechanism in understanding the sensitivities of the core assumptions in the capital plans to the adverse impact of extreme, but plausible, events. Stress testing allows senior management to formulate management action in advance of conditions starting to reflect the stress scenarios identified. The Group has identified the following as being the material risks faced and managed through the Capital Management Framework; credit, market, operational, asset and liability management, pension, and insurance risks.

In June 2006, the Basel Committee on Banking Supervision ('the Basel Committee') published the final comprehensive version of 'International Convergence of Capital Measurement and Capital Standards' ('Basel II') which replaced Basel I. In 2008, as the Group operates under Basel II, it targets a tier 1 capital ratio within the range 7.5 to 9.0 per cent for the purposes of its long-term capital planning. In 2007, under the Basel I approach, HSBC managed its capital against a tier 1 ratio of 8.25 per cent.

HSBC recognises the effect on shareholder returns of the level of equity capital employed within the Group and seeks to maintain a prudent balance between the advantages and flexibility afforded by a strong capital position and the higher returns on equity that are possible with greater leverage. 

The Capital Management Framework covers the different capital measures within which HSBC manages its capital in a consistent and aligned manner. These include the market capitalisation, invested capital, economic capital and regulatory capital. HSBC defines invested capital as the equity capital invested in HSBC by its shareholders. Economic capital is the capital requirement calculated internally by HSBC to support the risks to which it is exposed and is set at a confidence level consistent with a target credit rating of AA. Regulatory capital is the capital which HSBC is required to hold as determined by the rules established by the FSA for the consolidated Group and by HSBC's local regulators for individual Group companies.

An annual Group capital plan is prepared and approved by the Board with the objective of maintaining both the optimal amount of capital and the mix between the different components of capital. The Group's policy is to hold capital in a range of different forms and from diverse sources and all capital raising is agreed with major subsidiaries as part of their individual and the Group's capital management processes. HSBC Holdings and its major subsidiaries raise non-equity tier 1 capital and subordinated debt in accordance with the Group's guidelines on market and investor concentration, cost, market conditions, timing, effect on composition and maturity profile. During the recent market turmoil, HSBC's access to the debt markets for such capital issuance has continued. The subordinated debt requirements of other HSBC companies are met internally.

Each subsidiary manages its own capital required to support planned business growth and meet local regulatory requirements within the context of the approved annual Group capital plan. As part of HSBC's Capital Management Framework, capital generated in excess of planned requirements is returned to HSBC Holdings, normally by way of dividends.

HSBC Holdings is primarily a provider of equity capital to its subsidiaries. These investments are substantially funded by HSBC Holdings' own capital issuance and profit retentions. 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, as such, receives information on the capital adequacy of, and sets capital requirements for, HSBC as a whole. Individual banking subsidiaries are directly regulated by their local banking supervisors, who set and monitor their capital adequacy requirements. Although HSBC calculates capital at a Group level using the Basel II framework, local regulators are at different stages 
of implementation and local rules 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. 

Further details regarding the calculation of capital adequacy under Basel I, including the constituent components of HSBC's capital base, the various regulatory limits which apply to them and the categorisation of banking operations as trading or banking book for determining risk-weighted assets, are detailed in the Annual Report and Accounts 2007. 

Basel II

The supervisory objectives of Basel II are to promote safety and soundness in the financial system and maintain at least the current overall level of capital in the system, enhance competitive equality, constitute a more comprehensive approach to addressing risks, and focus on internationally active banks. Basel II is structured around three 'pillars': minimum capital requirements, supervisory review process and market discipline. The Capital Requirements Directive ('CRD') implements Basel II in the EU and the FSA then gives effect to the CRD by including the requirements of the CRD in its own rulebooks.

Basel II provides three approaches of increasing sophistication to the calculation of pillar 1 credit risk capital requirements. The most basic, the standardised approach, requires banks to use external credit ratings to determine the risk weightings applied to rated counterparties, and groups other counterparties into broad categories and applies 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 with quantification of exposure at default ('EAD') and loss given default estimates ('LGD') being subject to standard supervisory parameters. Finally, the IRB advanced approach allows banks to use their own internal assessment of not only PD but also the quantification of EAD and LGD. Expected losses are calculated by multiplying EAD by PD and LGD. The capital resources requirement under the IRB approaches is intended to cover unexpected losses and is derived from a formula specified in the regulatory rules, which incorporates these factors and other variables such as maturity and correlation.

For credit risk, with FSA approval, HSBC has adopted the IRB advanced approach to Basel II for the majority of its business with effect from 1 January 2008, with the remainder on either IRB foundation or standardised approaches. A rollout plan is in place to extend coverage of the advanced approach over the next three years, leaving a small residue of exposures on the standardised approach. 

Basel II also introduces capital requirements for operational risk and, again, contains 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. Finally, the advanced measurement approach uses banks' own statistical analysis and modelling of operational risk data to determine capital requirements. HSBC has adopted the standardised approach to the determination of Group operational risk capital requirements.

The basis of calculating capital changed with effect from 1 January 2008 and the effect on both tier 1 capital and total capital is shown in the table below, 'Capital Structure'. The Group's capital base is reduced compared with Basel I by the extent to which expected losses exceed the total of individual and collective impairment allowances on IRB portfolios. These collective impairment allowances are no longer eligible for inclusion in tier 2 capital. 

For disclosure purposes, this excess of expected losses over total impairment allowances in IRB portfolios is deducted 50 per cent from tier 1 and 50 per cent from tier 2 capital. In addition, a tax credit adjustment is made to tier 1 capital to reflect the tax consequences insofar as they affect the availability of tier 1 capital to cover risks or losses. 

Expected losses derived under Basel II rules, represent losses that would be expected in the scenario of a severe downturn over a 12-month period. This definition differs from loan impairment allowances, which only address losses incurred within lending portfolios at the balance sheet date and are not permitted to recognise the additional level of conservatism that the regulatory measure requires through reflecting a downturn scenario. For rapidly revolving consumer credit portfolios such as credit cards, therefore, impairment allowances only capture some of the expected losses predicted over the next 12 months. These portfolios turn over three to four times per year, and therefore a large proportion of expected losses relate to credit advances not made at the measurement date. 

The effect of deducting the difference between expected losses and total impairment allowances 
is to equate the total effect on capital with the regulatory definition of expected losses. Because expected losses are based on long-term estimates and incorporate through-the-cycle considerations, it is not anticipated that they will be very volatile. The impact of this deduction, however, may vary 
from time to time as the accounting measure of impairment moves closer to or further away from 
the regulatory measure of expected losses. 

The FSA's rules permit the inclusion of profits in tier 1 capital to the extent that they have been verified in accordance with the FSA's General Prudential Sourcebook by the external auditors. Verification procedures covering interim profits for the half year to 30 June 2008 were completed by the external auditor on 4 August 2008 and therefore these interim profits have been included in the Group's 30 June 2008 tier 1 capital. Technically, from 1 January 2008, the FSA's regulatory reporting forms defer the recognition of these profits in tier 1 capital until the conclusion of the external auditor's procedures.

The second pillar of Basel II (Supervisory Review and Evaluation Process - 'SREP') 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 ('ICAAP') which is the firm's self assessment of risks not captured by pillar 1. The pillar 2 process culminates with the FSA providing firms with Individual Capital Guidance ('ICG'). The ICG replaces the trigger ratio and is set as a capital resources requirement higher than that required under pillar 1, generally by a specified percentage.

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. HSBC will publish qualitative pillar 3 disclosures on its investor relations internet site later in 2008, with the first full set of pillar 3 disclosures, including quantitative tables, being made for 31 December 2008 during the first half of 2009. 

For individual banking subsidiaries, the timing and manner of implementing Basel II varies by jurisdiction according to requirements set by local banking supervisors. Applying Basel II across HSBC's geographically diverse businesses, which operate in a large number of different regulatory environments, presents a significant logistical and technological challenge, involving an extensive programme of implementation. Basel II allows local regulators to exercise discretion in a number of areas. The extent to which their requirements diverge, coupled with how the FSA and the local regulators in the other countries in which HSBC operates interact, are key factors in completing implementation of Basel II locally.

Source and application of tier 1 capital 

	Half-year to
	30 June     2008		31 December     2007		30 June     2007
	Basel II		Basel I		Basel I
	Actual		Actual		Actual
	US$m		US$m		US$m
Movement in tier 1 capital
Opening tier 1 capital	104,967		97,344		87,842
Changes to tier 1 capital arising from transition to pro-forma Basel II basis	(3,282)
Opening pro-forma tier 1 capital under Basel II rules	101,685
Consolidated profits attributable to shareholders of the parent company	7,722		8,238		10,895
Dividends	(6,823)		(4,049)		(6,192)
Shares issued in lieu of dividends	2,488		1,525		2,826
Ordinary shares issued	52		359		118
Innovative tier 1 securities issued	2,134		-		-
Increase in goodwill and intangible assets deducted	(1,505)		(1,308)		(1,058)
Other (including exchange differences)	2,098		2,858		2,913
Closing tier 1 capital	107,851		104,967		97,344
Movement in risk-weighted assets
Opening risk-weighted assets	1,123,782		1,041,540		938,678
Movements on Basel I basis	-		82,242		102,862
Changes to risk-weighted assets arising from transition to pro-forma  Basel II basis1	40,867
Opening Basel II pro-forma risk-weighted assets	1,164,649		-		-
Movements on Basel II basis	66,832		-		-
Closing risk-weighted assets	1,231,481		1,123,782		1,041,540

1    As Basel II rules were implemented across the Group, adjustments to the previously published 31 December 2007 pro-forma risk-weighted assets were identified, amounting to US$35,198 million. The pro-forma position at 31 December 2007 has been adjusted accordingly.

HSBC complied with the FSA's capital adequacy requirements throughout 2007 and the first half of 2008. Comparisons discussed below are with the 31 December 2007 pro-forma Basel II position.

Tier 1 capital increased by US$6.2 billion. Retained profits contributed US$0.9 billion, shares issued, including shares issued in lieu of dividends, contributed US$2.5 billion, innovative tier 1 securities issued contributed US$2.1 billion and exchange differences added a further US$3.1 billion. These increases were partly offset by an increase in goodwill and intangible assets, which are deducted from capital, of US$1.5 billion.

Total risk-weighted assets on a Basel II basis increased by US$66.8 billion, or 6 per cent. After taking account of US$9.5 billion of exchange differences, US$51.0 billion of the underlying movement occurred from credit risk and counterparty credit risk, reflecting balance sheet growth in Hong Kong, the rest of Asia-Pacific and Europe, mainly in lending products. This was partly offset by a contraction of the business in North America. There was an underlying increase of US$6.3 billion in market risk, largely as a result of volatile market conditions.

Capital structure

Composition of regulatory capital
Tier 1 capital
Shareholders' equity2	126,785		128,160		128,160		119,780
Minority interests	4,076		4,059		4,059		3,542
Preference shares	2,170		2,181		2,181		2,126
Adjustment for:
Goodwill capitalised and intangible assets	(40,360)		(38,855)		(38,855)		(37,547)
Unrealised losses on available-for-sale debt  securities3	9,075		2,445		2,445		265
Other regulatory adjustments4,5	(3,086)		(2,309)		(3,535)		(696)
Excess of expected losses over impairment  allowances	(3,490)		(4,508)		-		-
Core tier 1 capital	95,170		91,173		94,455		87,470
Innovative tier 1 securities	12,681		10,512		10,512		9,874
Total tier 1 capital	107,851		101,685		104,967		97,344
Tier 2 capital
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities	2,768		4,393		4,393		3,653
Collective impairment allowances6	3,564		2,176		14,047		11,735
Perpetual subordinated debt	3,113		3,114		3,114		3,387
Term subordinated debt	44,036		37,658		37,658		30,901
Minority and other interests in tier 2 capital	300		300		300		425
Total qualifying tier 2 capital before deductions	53,781		47,641		59,512		50,101
Unconsolidated investments7	(11,183)		(11,092)		(11,092)		(9,883)
Excess of expected losses over impairment  allowances	(3,490)		(4,508)		-		-
Other deductions	(9)		(747)		(747)		(520)
Total deductions other than from tier 1 capital	(14,682)		(16,347)		(11,839)		(10,403)
Total regulatory capital	146,950		132,979		152,640		137,042
Risk-weighted assets
Credit and counterparty risk	1,071,482		1,011,343		-		-
Market risk	52,533		45,840		-		-
Operational risk	107,466		107,466		-		-
Banking book	-		-		1,020,747		949,958
Trading book	-		-		103,035		91,582
Total	1,231,481		1,164,649		1,123,782		1,041,540
	%		%		%		%
Capital ratios
Core tier 1 ratio	7.7		7.8		8.4		8.4
Tier 1 ratio	8.8		8.7		9.3		9.3
Total capital ratio	11.9		11.4		13.6		13.2
	30 June     2008		31 December     2007		31 December     2007		30 June     2007
	Basel II		Basel II		Basel I		Basel I
	Actual		Pro-forma1		Actual		Actual
	US$m		US$m		US$m		US$m
Composition of regulatory capital
Tier 1 capital
Shareholders' equity2	126,785		128,160		128,160		119,780
Minority interests	4,076		4,059		4,059		3,542
Preference shares	2,170		2,181		2,181		2,126
Adjustment for:
Goodwill capitalised and intangible assets	(40,360)		(38,855)		(38,855)		(37,547)
Unrealised losses on available-for-sale debt  securities3	9,075		2,445		2,445		265
Other regulatory adjustments4,5	(3,086)		(2,309)		(3,535)		(696)
Excess of expected losses over impairment  allowances	(3,490)		(4,508)		-		-
Core tier 1 capital	95,170		91,173		94,455		87,470
Innovative tier 1 securities	12,681		10,512		10,512		9,874
Total tier 1 capital	107,851		101,685		104,967		97,344
Tier 2 capital
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities	2,768		4,393		4,393		3,653
Collective impairment allowances6	3,564		2,176		14,047		11,735
Perpetual subordinated debt	3,113		3,114		3,114		3,387
Term subordinated debt	44,036		37,658		37,658		30,901
Minority and other interests in tier 2 capital	300		300		300		425
Total qualifying tier 2 capital before deductions	53,781		47,641		59,512		50,101
Unconsolidated investments7	(11,183)		(11,092)		(11,092)		(9,883)
Excess of expected losses over impairment  allowances	(3,490)		(4,508)		-		-
Other deductions	(9)		(747)		(747)		(520)
Total deductions other than from tier 1 capital	(14,682)		(16,347)		(11,839)		(10,403)
Total regulatory capital	146,950		132,979		152,640		137,042
Risk-weighted assets
Credit and counterparty risk	1,071,482		1,011,343		-		-
Market risk	52,533		45,840		-		-
Operational risk	107,466		107,466		-		-
Banking book	-		-		1,020,747		949,958
Trading book	-		-		103,035		91,582
Total	1,231,481		1,164,649		1,123,782		1,041,540
	%		%		%		%
Capital ratios
Core tier 1 ratio	7.7		7.8		8.4		8.4
Tier 1 ratio	8.8		8.7		9.3		9.3
Total capital ratio	11.9		11.4		13.6		13.2

1    As Basel II rules were implemented across the Group, adjustments to the previously published 31 December 2007 pro-forma risk-weighted assets were identified, amounting to US$35,198 million. The pro-forma position at 31 December 2007 has been adjusted accordingly.

2    Includes externally verified profits for the half year to 30 June 2008.

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

4    Includes removal of the fair value gains and losses, net of deferred tax, arising from the credit spreads on debt issued by HSBC Holdings and its subsidiaries and designated at fair value.

5    Includes a tax credit adjustment in respect of the excess of expected losses over impairment allowances.

6    Under Basel II, only collective impairment allowances on loan portfolios on the standardised approach are included in tier 2 capital.

7    Mainly comprise investments in insurance entities.

Risk-weighted assets by principal subsidiary

The table below shows the contribution to Group total risk-weighted assets arising from each principal subsidiary on an FSA basis and excluding intra-HSBC items. 

Risk-weighted assets by principal subsidiary

	30 June     2008		31 December     2007		30 June     2007
	Basel II		Basel I		Basel I
	Actual		Actual		Actual
	US$m		US$m		US$m
Risk-weighted assets
The Hongkong and Shanghai Banking Corporation	263,127		256,761		249,394
Hang Seng Bank	48,199		55,043		60,263
The Hongkong and Shanghai Banking Corporation and other subsidiaries	214,928		201,718		189,131
HSBC Bank	441,186		423,941		380,870
HSBC Private Banking Holdings (Suisse)	25,501		32,942		30,616
HSBC France	80,571		76,188		65,054
HSBC Bank and other subsidiaries	335,114		314,811		285,200
HSBC North America	374,017		336,998		326,248
HSBC Finance	187,762		135,757		140,859
HSBC Bank Canada	34,950		50,659		43,617
HSBC Bank USA and other subsidiaries	151,305		150,582		141,772
HSBC Mexico	22,615		18,513		16,770
HSBC Bank Middle East	34,681		25,226		21,097
HSBC Bank Malaysia	11,745		8,601		7,764
HSBC Brazil	35,301		27,365		22,009
HSBC Bank Panama	10,178		7,824		6,696
Bank of Bermuda	4,230		4,133		4,611
Other	34,401		14,420		6,081
	1,231,481		1,123,782		1,041,540

 

END

 

 

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