Annual Financial Report - 19

RNS Number : 4088J

HSBC Holdings PLC

30 March 2010

Liquidity and funding

(Audited)

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

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

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

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

Policies and procedures

(Audited)

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

HSBC's liquidity and funding management process includes:

· projecting cash flows by major currency under various stress scenarios and considering the level of liquid assets necessary in relation thereto;

· monitoring balance sheet liquidity and advances to deposits ratios against internal and regulatory requirements;

· maintaining a diverse range of funding sources with back-up facilities;

· managing the concentration and profile of debt maturities;

· managing contingent liquidity commitment exposures within pre-determined caps;

· maintaining debt financing plans;

· monitoring depositor concentration in order to avoid undue reliance on large individual depositors and ensure a satisfactory overall funding mix; and

· maintaining liquidity and funding contingency plans. These plans identify early indicators of stress conditions and describe actions to be taken in the event of difficulties arising from systemic or other crises, while minimising adverse long-term implications for the business.

Primary sources of funding

(Audited)

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

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

The main operating subsidiary that does not accept deposits is HSBC Finance, which is funded principally by taking term funding in the professional markets and securitising assets. At 31 December 2009, US$82 billion (2008: US$111 billion) of HSBC Finance's liabilities were drawn from professional markets, utilising a range of products, maturities and currencies. As the loan portfolios within HSBC Finance are in run off it has not accessed the term debt markets for more than 2 years.

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

(Audited)

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

At 31 December 2009
Deposits by banks ................................................	39,484	85,922	18,925	6,180	1,359
Customer accounts ...............................................	800,199	277,071	71,243	45,561	7,911
Trading liabilities .................................................	268,130	-	-	-	-
Financial liabilities designated at fair value ...........	6,628	1,050	5,976	36,185	67,209
Derivatives ..........................................................	245,027	300	1,002	467	320
Debt securities in issue ..........................................	124	49,493	38,445	66,661	22,663
Subordinated liabilities ..........................................	43	481	3,020	8,660	52,304
Other financial liabilities ......................................	22,500	25,123	5,732	2,354	1,103

	1,382,135	439,440	144,343	166,068	152,869
Loan and other credit-related commitments .........	221,191	87,044	101,289	107,379	41,147
Financial guarantees and similar contracts ............	6,111	15,288	17,072	10,749	4,031

	1,609,437	541,772	262,704	284,196	198,047

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

	1,499,174	501,263	147,196	156,260	139,653
Loan and other credit-related commitments .........	239,753	105,952	153,774	72,111	32,432
Financial guarantees and similar contracts ............	5,749	13,429	17,756	9,807	5,577

	1,744,676	620,644	318,726	238,178	177,662

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

similar contracts are classified on the basis of the earliest date they can be called.

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

The management of liquidity risk

(Audited)

The Group uses three principal measures to manage liquidity risk, as described below.

Advances to deposits ratio

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

Advances to deposits ratio limits are set by the RMM and monitored by Group Finance. The ratio describes loans and advances to customers as a percentage of the total of core customer current and savings accounts and term funding with a remaining term to maturity in excess of one year. Loans and advances to customers which are part of reverse repurchase arrangements, and where HSBC receives securities which are deemed to be liquid, are excluded from the advances to deposits ratio. The classification of a deposit as 'core' includes consideration of the size of the customer's total deposit balances, the pricing and the deposit's behavioural characteristics.

The three principal banking entities listed in the table below represented 70 per cent of HSBC's total core deposits at 31 December 2009 (2008: 70 per cent). The table shows that loans and advances to customers in HSBC's principal banking entities are overwhelmingly financed by reliable and stable sources of funding. HSBC would meet any unexpected net cash outflows by selling securities and accessing additional funding sources such as interbank or collateralised lending markets. The distinction between core and non-core deposits generally means that the Group's measure of advances to deposits is more restrictive than that which could be inferred from the published financial statements. For example, HSBC's consolidated advances to deposits measure at 31 December 2009 based only on published balance sheet information was 77.3 per cent (2008: 83.6 per cent).

Ratio of net liquid assets to customer liabilities

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

Limits for the ratio of net liquid assets to customer liabilities are set for each bank operating entity, but not for HSBC Finance. As HSBC Finance does not accept customer deposits, it is not appropriate to manage its liquidity using standard liquidity ratios. See 'HSBC Finance' below.

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

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

(Audited)

	Advances to deposits ratios		Ratio of net liquid assets to customer liabilities		Net liquid assets
	2009	2008	2009	2008	2009	2008
	%	%	%	%	US$bn	US$bn
HSBC Bank (UK operations)
Year-end ........................	102.3	106.0	8.8	7.1	29.2	21.3
Maximum ......................	107.7	106.7	13.6	14.1	46.2	52.5
Minimum ......................	101.7	97.5	6.5	6.9	19.5	21.3
Average .........................	105.1	101.5	10.2	10.0	32.6	35.8

The Hongkong and Shanghai Banking Corporation
Year-end ........................	70.9	77.4	30.0	25.0	84.9	64.6
Maximum ......................	77.4	82.9	35.0	25.0	97.8	64.6
Minimum ......................	68.6	76.7	25.0	19.9	64.6	51.1
Average .........................	71.5	80.6	30.7	21.9	85.1	56.5

HSBC Bank USA
Year-end ........................	98.1	103.7	17.8	31.5	14.1	27.4
Maximum ......................	110.6	117.3	31.5	31.5	27.4	27.4
Minimum ......................	98.1	103.7	16.7	15.8	13.2	17.1
Average .........................	105.4	111.8	22.2	22.6	18.9	21.5

	Advances to deposits ratios		Ratio of net liquid assets to customer liabilities		Net liquid assets
	2009	2008	2009	2008	2009	2008
	%	%	%	%	US$bn	US$bn
Total of HSBC's other principal banking entities³⁷
Year-end ........................	80.8	85.2	29.4	26.5	94.7	83.5
Maximum ......................	85.2	92.3	29.4	26.5	94.7	83.5
Minimum ......................	80.8	82.7	24.7	19.4	73.2	66.1
Average .........................	82.2	88.1	27.3	22.5	84.8	73.9

For footnote, see page 291.

The reduction in the quantum of net liquid assets in HSBC Bank USA between 2008 and 2009 reflects the temporary high level of net liquid assets maintained at the end of 2008 in anticipation of funding requirements for the credit card portfolios transferred to HSBC Bank USA from HSBC Finance in early 2009.

Projected cash flow scenario analysis

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

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

HSBC Finance

As HSBC Finance is unable to accept standard retail customer deposits, it takes funding from the professional markets. HSBC Finance uses a range of measures to monitor funding risk, including projected cash flow scenario analysis and caps placed on the amount of unsecured term funding
that can mature in any rolling three-month and rolling 12‑month periods. HSBC Finance also maintains access to committed sources of secured funding and has in place committed backstop lines for short-term refinancing CP programmes.

HSBC Finance - funding

(Audited)

	At 31 December
	2009	2008
	US$bn	US$bn
Maximum amounts of unsecured term funding maturing in any rolling:
3 month period ...........................	5.2	6.0
12 month period .........................	12.3	17.4
Unused committed sources of secured funding³⁸ .....................................	0.4	2.4
Committed backstop lines from non-Group entities in support of CP programmes ..........................	5.3	7.3

For footnote, see page 291.

The need for HSBC Finance to refinance maturing term funding is mitigated by the continued run-down of its balance sheet.

Contingent liquidity risk

(Audited)

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

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

(Audited)

	HSBC Bank		HSBC Bank USA		HSBC Bank Canada		The Hongkong and Shanghai Banking Corporation
	2009	2008	2009	2008	2009	2008	2009	2008
	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn
Conduits
Client-originated assets³⁹ ........
- total lines ........................	7.4	5.6	6.4	11.2	0.3	0.3	0.3	-
- largest individual lines ......	0.8	1.0	0.4	0.4	0.1	0.2	0.3	-
HSBC-managed assets⁴⁰ ..........	29.1	34.8	-	-	-	-	-	-
Other conduits⁴¹ .....................	-	-	1.3	1.1	-	-	-	-

Single-issuer liquidity facilities
- five largest⁴² ....................	4.3	6.0	6.1	5.0	2.0	1.5	1.2	1.0
- largest market sector⁴³ ....	7.9	7.3	4.7	3.5	2.9	2.4	1.5	1.7

For footnotes, see page 291.

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

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

(Audited)

Market turmoil continued to have significant adverse effects on the liquidity and funding risk profile of the banking system in 2009, although the effects gradually moderated during the year:

· interbank funding costs remained above pre-market turmoil levels, although they declined significantly from the peaks observed in the latter part of 2008;

· many asset classes continued to suffer from reduced liquidity;

· the ability of many market participants to issue either unsecured or secured debt continued to be restricted, although the effect was mitigated in part by the support provided by some central bank and government programmes; and

· many special purpose entities with investments linked to US sub-prime mortgages, or to ABSs where the underlying credit exposures were not fully transparent, continued to experience difficulties in raising wholesale funding.

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

As a net provider of funds to the interbank market, HSBC has not been significantly affected by the scarcity of interbank funding.

HSBC's customer deposit base grew between 30 June 2007, the reporting date closest to the onset of the market turmoil, and 31 December 2009 by US$178 billion. This growth in US dollar equivalent terms was diluted by the strengthening of the US dollar against other major currencies between these two reporting dates, and therefore understates the growth in customer deposits on an underlying currency basis.

A number of central banks and governments have taken action to alleviate the effects of the market turmoil, including making available government guaranteed term funding facilities. In the US, bank issuance under such programmes became normal market practice during 2008, although many market participants successfully issued non-government guaranteed debt in the latter half of 2009. HSBC's US‑based operations participated modestly at the outset in the US government guaranteed term debt issuance scheme. At 31 December 2009, US$2.67 billion had been issued by HSBC USA, Inc. under the Federal Deposit Insurance Corporation Temporary Liquidity Guarantee Programme. This debt was issued in 2008.

The deterioration of the US sub-prime credit market reduced the availability of term financing to entities with exposures to the US sub-prime market. However, HSBC Finance, by virtue of its position within the Group, continued to enjoy committed financing facilities, albeit at a lower level, and access to CP markets at competitive interest rates. By reducing the size of its balance sheet, issuing cost-effective retail debt, receiving capital infusions from the HSBC Group and utilising alternative sources of funding, including from other members of the HSBC Group, HSBC Finance eliminated the need to issue institutional term debt in 2008 and 2009. Funding plans are in place which would enable HSBC Finance to deal with a recurrence of stress in the credit markets. As part of liquidity management, asset portfolios totalling US$15.3 billion were transferred from HSBC Finance to HSBC Bank USA in January 2009, resulting in US$8.0 billion of net funding benefit to HSBC Finance.

The scheme set up by the US Federal Reserve in 2008 to provide support to US issuers in the CP market was extended to 1 February 2010. Under this scheme, HSBC Finance was eligible to issue a maximum of US$12.0 billion. At 31 December 2009, HSBC Finance did not have any outstanding CP under this programme (31 December 2008: US$520 million).

The effect of the market turmoil on liquidity and funding elsewhere in HSBC was largely restricted to the Group's activities that historically depended upon the asset-backed CP markets for funding, specifically SIVs and conduits, and certain money market funds. This is discussed in detail on page 182.

HSBC Holdings

(Audited)

HSBC Holdings' primary sources of cash are the receipt of dividends from subsidiaries, interest on and repayment of, intra-group loans, and interest earned on its own liquid funds. HSBC Holdings also received cash from its rights issue in April 2009 and, on an ongoing basis, raises ancillary funds in the debt capital markets through subordinated and senior debt issuance. Primary uses of cash are investments in subsidiaries, interest payments to debt holders and dividend payments to shareholders.

HSBC Holdings is also subject to contingent liquidity risk by virtue of loan and other credit-related commitments and guarantees and similar contracts issued. Such commitments and guarantees are only issued after due consideration of HSBC Holdings' ability to finance the commitments and guarantees and the likelihood of the need arising.

HSBC Holdings actively manages the cash flows from its subsidiaries to optimise the amount of cash held at the holding company level. The ability of its subsidiaries to pay dividends or advance monies to HSBC Holdings depends on, among other things, their respective regulatory capital requirements, statutory reserves, and financial and operating performance. The wide range of HSBC's activities means that HSBC Holdings is not dependent on a single source of profits to fund its dividend payments to shareholders. During 2009 HSBC Holdings continued to have full access to debt capital markets at market rates and issued US$5.3 billion of capital instruments and senior debt (2008: US$8.8 billion).

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

(Audited)

	On demand	Due within 3 months	Due between 3 and 12 months	Due between 1 and 5 years	Due after 5 years
	US$m	US$m	US$m	US$m	US$m
At 31 December 2009
Amounts owed to HSBC undertakings ..............	-	292	25	3,477	-
Financial liabilities designated at fair value ......	-	229	687	6,205	26,152
Derivatives .....................................................	362	-	-	-	-
Debt securities in issue......................................	-	37	112	2,346	1,698
Subordinated liabilities .....................................	-	243	728	3,881	32,232
Other financial liabilities .................................	-	1,239	-	-	-

	362	2,040	1,552	15,909	60,082
Loan commitments .........................................	3,240	-	-	-	-
Financial guarantees and similar contracts .......	35,073	-	-	-	-

	38,675	2,040	1,552	15,909	60,082

At 31 December 2008
Amounts owed to HSBC undertakings ..............	-	133	539	3,590	-
Financial liabilities designated at fair value ......	-	587	1,762	5,977	25,571
Derivatives .....................................................	1,324	-	-	-	-
Subordinated liabilities .....................................	-	235	706	3,764	32,214
Other financial liabilities .................................	-	1,805	-	-	-

	1,324	2,760	3,007	13,331	57,785
Loan commitments .........................................	3,241	-	-	-	-
Financial guarantees and similar contracts .......	47,341	-	-	-	-

	51,906	2,760	3,007	13,331	57,785

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

In addition, loan and other credit-related commitments and financial guarantees and similar contracts are generally not recognised on the balance sheet. Trading derivatives are included in the 'On demand' time bucket, and not by contractual maturity, because trading derivatives are typically held for short periods of time. The undiscounted cash flows potentially payable under financial guarantees and similar contracts are classified on the basis of the earliest date they can be called.

Market risk

(Audited)

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

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

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

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

Market risk arising in HSBC's insurance businesses is discussed in 'Risk management of insurance operations' on pages 265 to 285.

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

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

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

Sensitivity analysis

(Unaudited)

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

Value at risk

(Audited)

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

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

exchange rates. The models also incorporate the effect of option features on the underlying exposures.

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

· potential market movements are calculated with reference to data from the past two years;

· historical market rates and prices are calculated with reference to foreign exchange rates and commodity prices, interest rates, equity prices and the associated volatilities; and

· VAR is calculated to a 99 per cent confidence level and for a one-day holding period.

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

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

· the use of historical data as a proxy for estimating future events may not encompass all potential events, particularly those which are extreme in nature;

· the use of a one-day holding period assumes that all positions can be liquidated or the risk offset in one day. This may not fully reflect the market risk arising at times of severe illiquidity, when a one‑day holding period may be insufficient to liquidate or hedge all positions fully;

· the use of a 99 per cent confidence level, by definition, does not take into account losses that might occur beyond this level of confidence;

· VAR is calculated on the basis of exposures outstanding at the close of business and therefore does not necessarily reflect intra-day exposures; and

· VAR is unlikely to reflect loss potential on exposures that only arise under significant market moves.

Stress testing

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

The process is governed by the Stress Testing Review Group forum. This coordinates the Group's stress testing scenarios in conjunction with regional risk managers, considering actual market risk exposures and market events in determining the scenarios to be applied at portfolio and consolidated levels, as follows:

· sensitivity scenarios, which consider the impact of any single risk factor or set of factors that are unlikely to be captured within the VAR models, such as the break of a currency peg;

· technical scenarios, which consider the largest move in each risk factor, without consideration of any underlying market correlation;

· hypothetical scenarios, which consider potential macro economic events, for example, a global flu pandemic; and

· historical scenarios, which incorporate historical observations of market movements during previous periods of stress which would not be captured within VAR.

Stress testing results provide senior management with an assessment of the financial impact such events would have on HSBC's profit. The daily losses experienced during 2009 were within the stress loss scenarios reported to senior management.

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

	Portfolio
	Trading	Non-trading
Risk type
Foreign exchange and commodity ....................	VAR	VAR⁴⁴
Interest rate ......................	VAR	VAR⁴⁵
Equity ...............................	VAR	Sensitivity
Credit spread .....................	VAR	VAR⁴⁶

For footnotes, see page 291.

The impact of market turmoil on market risk

(Audited)

The market turmoil that began in 2007 and accelerated through 2008 was characterised by extreme market volatility and, as a consequence, increased levels of VAR notwithstanding reduced underlying risk positions. High levels of market volatility across all asset classes continued into early 2009. However, the overall impact was limited as a result of further managing down the market risk exposures in all asset classes during this period.

Continued high levels of volatility in interest rates in 2009 caused a small increase in VAR.

Central banks' monetary easing has led to the progressive stabilisation of financial markets during the second half of 2009. Credit spreads and volatility levels have generally continued to decrease as liquidity improved throughout the period. Additionally, this period was characterised by high levels of government borrowing, uncertainty around the robustness of economic recovery in major economies and concerns over the effect of any developing inflationary pressures. As a result, this led to the continuation of high levels of volatility in interest rates which, together with the extension of the asset profile in the non-trading books, caused a small increase in the total VAR.

Value at risk of the trading and non-trading portfolios

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

Value at risk

(Audited)

	2009	2008
	US$m	US$m

At 31 December .............	204.5	191.2
Average ..........................	156.1	158.9
Minimum .......................	105.7	59.8
Maximum .......................	204.5	287.1

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

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

(Unaudited)

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

The histogram on page 253 illustrates the frequency of daily revenue arising from Global Markets' trading, balance sheet management and other trading activities.

The average daily revenue earned from Global Markets' trading, balance sheet management and other trading activities in 2009 was US$59.9 million, compared with US$21.7 million in the same period ended 31 December 2008. The standard deviation of these daily revenues was US$38.4 million compared with US$53.4 million in 2008. The standard deviation measures the variation of daily revenues about the mean value of those revenues.

An analysis of the frequency distribution of daily revenue shows that there were 11 days with negative revenue during 2009 compared with 66 days in 2008. The most frequent result was daily revenue of between US$30 million and US$40 million and US$40 million and US$50 million with 29 occurrences each, compared with between US$40 million and US$50 million with 28 occurrences in 2008.

11 days of negative revenue compared with 66 in 2008.

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

Trading revenues generated by Global Markets and Balance Sheet Management improved considerably in 2009 compared with 2008 due to strong client business and favourable positioning against the backdrop of a low interest rate environment. The histogram of daily revenues for 2009 below therefore shows the majority of trading days closely concentrated around the average daily revenues of US$59.9 million, with relatively few loss days recorded during the year.

By contrast, in 2008, trading revenues were more volatile, particularly across the Credit businesses, which experienced significant losses on legacy Credit Trading positions and monoline exposures. The graph of daily revenues for 2008 shows a flatter profile and greater distribution of revenues around the average daily revenue of US$21.7 million, as the turmoil in the credit markets caused volatile trading days where large daily profits and losses were reported.

Daily distribution of Global Markets' trading, balance sheet management and other trading revenues⁴⁷

(Unaudited)

2009

Number of days

US$m

< Profit and loss frequency

2008

Number of days

US$m

< Profit and loss frequency

For footnote, see page 291.

For a description of HSBC's fair value and price verification controls, see page 166.

Trading portfolios

(Audited)

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

Market making and position taking is undertaken within Global Markets. The VAR for such trading activity at 31 December 2009 was US$45.3 million (2008: US$72.5 million). This is analysed below by risk type:

VAR by risk type for the trading activities (excluding credit spread VAR)

(Audited)

	Foreign exchange and commodity	Interest rate	Equity	Total⁴⁸
	US$m	US$m	US$m	US$m

At 31 December 2009 ........................................	19.5	42.6	17.5	45.3
At 31 December 2008 ..........................................	29.8	63.4	13.9	72.5

Average
2009 ................................................................	20.6	51.3	11.3	53.8
2008 ................................................................	19.0	50.7	15.2	53.1
Minimum
2009 ................................................................	11.1	35.6	4.9	35.6
2008 ................................................................	8.7	21.4	8.2	22.6
Maximum
2009 ................................................................	46.7	78.0	21.2	86.6
2008 ................................................................	54.9	147.4	39.0	104.4

For footnote, see page 291.

The VAR for overall trading activity as at 31 December 2009 was lower than in 2008 and remained within a narrower band. The decrease was driven primarily by the interest rate component due to reduced levels of underlying exposure in the trading book.

Credit spread risk

The risk associated with movements in credit spreads is primarily managed through sensitivity limits, stress testing, and VAR for those portfolios where VAR is calculated. The Group has introduced credit spread as a separate risk type within its VAR models on a global basis. The VAR shows the effect on trading income from a one-day movement in credit spreads over a two-year period, calculated to a 99 per cent confidence level.

Increased market liquidity helped dampen volatility of credit spreads and decrease credit VAR in 2009.

At 31 December 2009, the credit VAR for trading activities was US$72.7 million (2008: US$218.4 million, calculated on a comparable basis). The decrease in the credit VAR in 2009 was due to the effect of a reduction in the volatility of credit spreads observed during the year, in part reflecting increased market liquidity. Also, the actual positions within the trading portfolios exposed to credit spread risk were lower on 31 December 2009 than on 31 December 2008. In addition to the above measure, certain portfolios are also managed using default risk measures where appropriate.

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

At 31 December 2009, the credit VAR on the credit derivatives transactions entered into by Global Banking was US$13.8 million (2008: US$23.0 million).

Gap risk

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

Given the characteristics of these transactions, they will make little or no contribution to VAR or to traditional market risk sensitivity measures. HSBC captures the risks of such transactions within its stress testing scenarios and monitors gap risk arising on an ongoing basis. HSBC regularly considers the probability of gap loss and fair value adjustments are booked against this risk. HSBC has not incurred any material gap loss in respect of such transactions in the 12 months ended 31 December 2009.

ABSs/MBSs positions

The ABSs/MBSs exposures within the trading portfolios are managed within sensitivity and VAR limits, as described on page 251, and are included within the stress testing scenarios as described on page 252.

Non-trading portfolios

(Audited)

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

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

In order to manage this risk optimally, market risk in non-trading portfolios is transferred to Global Markets or to separate books managed under the supervision of the local ALCO. This transfer is usually achieved by a series of internal deals between the business units and these books. When the behavioural characteristics of a product differ from its contractual characteristics, the former are assessed to determine the true underlying interest rate risk. Local ALCOs are required to regularly monitor all such behavioural assumptions and interest rate risk positions to ensure they comply with interest rate risk limits established by GMB.

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

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

Credit spread risk

At 31 December 2009, the sensitivity of equity to the effect of movements in credit spreads, based on credit spread VAR, on the Group's available-for-sale debt securities was US$535 million (2008: US$1,013 million). The sensitivity was calculated on the same basis as applied to the trading portfolio. Including the gross exposure for the SICs consolidated within HSBC's balance sheet at 31 December 2009, the sensitivity increased to US$549 million. This sensitivity is struck, however, before taking account of any losses which would be absorbed by the capital note holders. At 31 December 2009, the capital note holders would have absorbed the first US$2.2 billion (2008: US$2.2 billion) of any losses incurred by the SICs prior to HSBC incurring any equity losses.

The notable decrease in this sensitivity at 31 December 2009, compared with 31 December 2008, was due to the effect of lower volatility in credit spreads observed during 2009. The overall credit spread positions within the available-for-sale portfolios were lower on 31 December 2009 compared with 31 December 2008.

Equity securities classified as available for sale

Market risk arises on equity securities classified as available for sale. The fair value of these securities at 31 December 2009 was US$9.1 billion (2008: US$7.3 billion) and included private equity holdings of US$4.0 billion (2008: US$2.5 billion). Investments in private equity are primarily made through managed funds that are subject to limits on the amount of investment. Potential new commitments are subject to risk appraisal to ensure that industry and geographical concentrations remain within acceptable levels for the portfolio as a whole. Regular reviews are performed to substantiate the valuation of the investments within the portfolio. Funds typically invested for short-term cash management represented US$0.8 billion (2008: US$0.9 billion). Investments held to facilitate ongoing business, such as holdings in government-sponsored enterprises and local stock exchanges, represented US$1.2 billion (2008: US$1.0 billion). Other strategic investments represented US$3.1 billion (2008: US$2.4 billion). The fair value of the constituents of equity securities classified as available for sale can fluctuate considerably. A 10 per cent reduction in the value of the available-for-sale equities at 31 December 2009 would have reduced equity by US$0.9 billion (2008: US$0.7 billion). For details of the impairment incurred on available-for-sale equity securities, see 'Summary of significant accounting policies' on page 369.

Sensitivity of net interest income

(Unaudited)

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

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

The table below sets out the effect on future net interest income of an incremental 25 basis points parallel fall or rise in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 January 2010. Assuming no management actions, a sequence of such rises would increase planned net interest income for 2010 by US$695 million (2009: US$463 million decrease), while a sequence of such falls would decrease planned net interest income by US$1,563 million (2009: US$284 million decrease). These figures incorporate the effect of any option features in the underlying exposures.

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

Sensitivity of projected net interest income

(Unaudited)

	US dollar bloc US$m	Rest of Americas bloc US$m	Hong Kong dollar bloc US$m	Rest of Asia bloc US$m	Sterling bloc US$m	Euro bloc US$m	Total US$m
Change in 2010 projected net interest income arising from a shift in yield curves of:

+25 basis points at the beginning of each quarter ..	13	92	416	112	363	(301)	695
-25 basis points at the beginning of each quarter ..	(382)	(46)	(507)	(133)	(689)	194	(1,563)

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

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

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

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

Projecting the movement in net interest income from prospective changes in interest rates is a complex interaction of structural and managed exposures. HSBC's exposure to the effect of

movements in interest rates on its net interest income arises in two main areas, core deposit franchises and Global Markets:

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

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

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

· decreases in interest rates, particularly in US dollar, Hong Kong dollar and sterling which have restricted the Group's ability to pass on to depositors further rate reductions, thereby increasing exposures to further rate falls; and

· Global Markets' decreased net trading asset positions, particularly in euros and US dollars. The funding of net trading assets is recorded in 'Net interest income' whereas the income from such assets is recorded in 'Net trading income'.

HSBC monitors the sensitivity of reported reserves to interest rate movements on a monthly basis by assessing the expected reduction in valuation of available-for-sale portfolios and cash flow hedges due to parallel movements of plus or minus 100 basis points in all yield curves. The table below describes the sensitivity of HSBC's reported reserves to these movements at the end of 2009 and 2008 and the maximum and minimum month-end figures during these years:

Sensitivity of reported reserves to interest rate movements

(Unaudited)

	US$m	Maximum impact US$m	Minimum impact US$m
At 31 December 2009

+ 100 basis point parallel move in all yield curves ..................................	(3,096)	(3,438)	(2,715)
As a percentage of total shareholders' equity ......................................	(2.4%)	(2.7%)	(2.1%)

- 100 basis point parallel move in all yield curves ..............................	3,108	3,380	2,477
As a percentage of total shareholders' equity ......................................	2.4%	2.6%	1.9%

At 31 December 2008

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

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

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

Structural foreign exchange exposures

(Unaudited)

Structural foreign exchange exposures represent net investments in subsidiaries, branches and associates, the functional currencies of which are currencies other than the US dollar. An entity's functional currency is the currency of the primary economic environment in which the entity operates.

Exchange differences on structural exposures are recognised in other comprehensive income. The main functional currencies in which HSBC's operations transact business are the US dollar, the Hong Kong dollar, pound sterling, the euro, the Mexican peso, the Brazilian real and the Chinese renminbi. HSBC Holdings' functional currency is the US dollar because the US dollar and currencies linked to it are the most significant currencies relevant to the operations of its subsidiaries, as well as representing a significant proportion of its funds generated from financing activities. HSBC uses the US dollar as its presentation currency in its consolidated financial statements because the US dollar and currencies linked to it form the major currency bloc in which HSBC transacts and funds its business. HSBC's consolidated balance sheet is, therefore, affected by exchange differences between the US dollar and all the non-US dollar functional currencies of underlying subsidiaries.

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

HSBC may also transact hedges where a currency in which it has structural exposures is considered to be significantly overvalued and it is possible in practice to transact a hedge. Any hedging is undertaken using forward foreign exchange contracts which are accounted for under IFRSs as hedges of a net investment in a foreign operation, or by financing with borrowings in the same currencies as the functional currencies involved. No forward foreign exchange hedges were in place during 2009 or at the end of 2008.

Defined benefit pension schemes

(Audited)

Market risk arises within HSBC's defined benefit pension schemes to the extent that the obligations of the schemes are not fully matched by assets with determinable cash flows. Pension scheme obligations fluctuate with changes in long-term interest rates, inflation, salary levels and the longevity of scheme members. Pension scheme assets include equities and debt securities, the cash flows of which change as equity prices and interest rates vary. There is a risk that market movements in equity prices and interest rates could result in asset values which, taken together with regular ongoing contributions, are insufficient over time to cover the level of projected obligations and these, in turn, could increase with a rise in inflation and members living longer. Management, together with the trustees who act on behalf of the pension scheme beneficiaries, assess these risks using reports prepared by independent external actuaries, take action and, where appropriate, adjust investment strategies and contribution levels accordingly.

HSBC's defined benefit pension schemes

(Audited)

	2009	2008
	US$bn	US$bn

Liabilities (present value) ...	30.6	24.0

	%	%
Assets:
Equity investments ............	21	20
Debt securities ....................	67	68
Other (including property) .	12	12

	100	100

Lower corporate bond yields in the UK in 2009 resulted in a decrease of 160 basis points in the real discount rate (net of the increase in expected inflation) used to value the accrued benefits payable under the HSBC Bank (UK) Pension Scheme, the Group's largest plan. There was an increase in the liabilities of the scheme which was partially offset by an increase in the fair values of the scheme's plan assets. As a consequence, the deficit on the HSBC Bank (UK) Pension Scheme increased to US$3,822 million from US$392 million. For details of the latest actuarial valuation of the HSBC Bank (UK) pension scheme, see Note 8 on the Financial Statements.

HSBC Holdings

(Audited)

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

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

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

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

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

Net interest income sensitivity

HSBC Holdings monitors net interest income sensitivity over a 5-year time horizon reflecting the longer-term perspective on interest rate risk management appropriate to a financial services holding company. The table below sets out the effect on HSBC Holdings' future net interest income over a 5-year time horizon of an incremental 25 basis point parallel fall or rise in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 January 2010.

Assuming no management action, a sequence of such rises would increase HSBC Holdings' planned net interest income for 2010 by US$16 million (2009: decrease of US$60 million) and decrease cumulative net interest income by US$116 million over a 5-year period from 1 January 2010 (2009: decrease of US$554 million), while a sequence of such falls would decrease planned net interest income for 2010 by US$17 million (2009: increase of US$60 million) and increase cumulative net interest income by US$115 million over a 5-year period from 1 January 2010 (2009: increase of US$554 million). These figures incorporate the effect of any option features in the underlying exposures.

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

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

(Unaudited)

	US dollar bloc	Sterling bloc	Euro bloc	Total
	US$m	US$m	US$m	US$m
Change in projected net interest income as at 31 December 2009 arising from a shift in yield curves of:

+ 25 basis points at the beginning of each quarter
0-1 year .............................................................	(13)	18	11	16
2-3 years ...........................................................	(172)	75	19	(78)
4-5 years ...........................................................	(165)	105	6	(54)

- 25 basis points at the beginning of each quarter
0-1 year .............................................................	12	(18)	(11)	(17)
2-3 years ...........................................................	172	(75)	(19)	78
4-5 years ...........................................................	165	(105)	(6)	54

Change in projected net interest income as at 31 December 2008 arising from a shift in yield curves of:

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

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

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

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

The projected decrease in HSBC Holdings' sensitivity to moves in interest rates is mainly due to the placing of funds received as a result of the rights issue at short tenors.

Interest repricing gap table

The interest rate risk on the fixed-rate securities issued by HSBC Holdings is not included within the Group VAR but is managed on a repricing gap basis. The interest rate repricing gap table below analyses the full term structure of interest rate mismatches within HSBC Holdings' balance sheet. The year on year decrease in the negative net interest rate gap in the up to 1 year time bucket is due to funds received as a result of the rights issue being invested in short-term liquid assets.

Repricing gap analysis of HSBC Holdings

(Audited)

	Total	Up to 1 year	1-5 years	5-10 years	More than 10 years	Non- interest bearing
	US$m	US$m	US$m	US$m	US$m	US$m
At 31 December 2009
Cash at bank and in hand:
-. balances with HSBC undertakings .........	224	224	-	-	-	-
Derivatives ..................................................	2,981	-	-	-	-	2,981
Loans and advances to HSBC undertakings ..	23,212	16,980	3,084	-	1,896	1,252
Financial investments ..................................	2,455	-	-	300	1,610	545
Investments in subsidiaries ...........................	86,247	1,866	1,217	-	875	82,289
Other assets .................................................	674	-	-	-	-	674

Total assets .................................................	115,793	19,070	4,301	300	4,381	87,741

Amounts owed to HSBC undertakings ..........	(3,711)	(2,898)	-	-	-	(813)
Financial liabilities designated at fair values .	(16,909)	-	(6,108)	(5,017)	(5,015)	(769)
Derivatives ..................................................	(362)	-	-	-	-	(362)
Debt securities in issue .................................	(2,839)	-	(1,784)	-	(1,055)	-
Other liabilities ............................................	(1,257)	-	-	-	-	(1,257)
Subordinated liabilities .................................	(14,406)	(2,850)	(865)	(3,117)	(7,382)	(192)
Total equity .................................................	(75,876)	-	-	-	(3,650)	(72,226)
Other non-interest bearing liabilities ............	(433)	-	-	-	-	(433)

Total liabilities and equity ............................	(115,793)	(5,748)	(8,757)	(8,134)	(17,102)	(76,052)

Off-balance sheet items attracting interest rate sensitivity .........................................	-	(15,302)	6,275	6,306	4,051	(1,330)
Net interest rate risk gap .............................	-	(1,980)	1,819	(1,528)	(8,670)	10,359

Cumulative interest rate gap ........................	-	(1,980)	(161)	(1,689)	(10,359)	-

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

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

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

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

Off-balance sheet items attracting interest rate sensitivity .............................	-	(12,353)	4,410	5,046	3,760	(863)
Net interest rate risk gap ..........	-	(10,555)	(582)	(2,906)	(6,508)	20,551

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

Value at risk

Total foreign exchange VAR arising within HSBC Holdings in 2009 and 2008 was as follows:

HSBC Holdings - value at risk

(Audited)

	Foreign exchange
	2009 US$m	2008 US$m

At 31 December .......................	83.2	55.2
Average ....................................	76.6	40.3
Minimum .................................	55.2	29.2
Maximum .................................	190.8	56.1

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

The increased maximum VAR in 2009 related to a portion of the proceeds of the Group's rights issue that was held in sterling.

Residualvalue risk

(Unaudited)

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

The net carrying amount of equipment leased to customers on operating leases by the Group takes into account projected residual values at the end of current lease terms, to be recovered through re‑letting or disposal in the following periods:

Residual values (Unaudited)
	2009	2008
	US$m	US$m

Within 1 year ......................	21	108
Between 1-2 years ...............	233	59
Between 2-5 years ...............	1,347	530
More than 5 years ...............	792	1,549

Total exposure ....................	2,393	2,246

Operational risk

(Unaudited)

Operational risk is relevant to every aspect of the Group's business and covers a wide spectrum of issues. Losses arising through fraud, unauthorised activities, errors, omission, inefficiency, systems failure or from external events all fall within the definition of operational risk.

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

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

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

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

Further details of the HSBC approach to Operational Risk Management can be found in the Group pillar 3 disclosures.

Legal risk

(Unaudited)

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

· Contractual risk is the risk that the rights and/or obligations of an HSBC company within a contractual relationship are defective.

· Dispute risk is made up of the risks that an HSBC company is subject to when it is involved in or managing a potential or actual dispute.

· Legislative risk is the risk that an HSBC company fails to adhere to the laws of the jurisdictions in which it operates.

· Non-contractual rights risk is the risk that an HSBC company's assets are not properly owned or are infringed by others, or an HSBC company infringes another party's rights.

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

The GMO Legal department oversees the global legal function and is headed by a Group General Manager. There are legal departments in 58 of the countries in which HSBC operates. There are also regional legal functions in each of Europe, North America, Latin America, the Middle East, and
Asia-Pacific.

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

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

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

Group security and fraud risk

(Unaudited)

Security and fraud risk issues are managed at Group level by Group Security and Fraud Risk. This unit, which has responsibility for physical risk, fraud, information and contingency risk, and security and business intelligence, is fully integrated within the central GMO Risk function. This enables the Group to identify and mitigate the permutations of these and other non-financial risks to its business lines across the jurisdictions in which it operates.

Pension risk

(Unaudited)

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

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

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

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

· investments delivering a return below that required to provide the projected plan benefits. This could arise, for example, when there is a fall in the market value of equities, or when increases in long-term interest rates cause a fall in the value of fixed income securities held;

· the prevailing economic environment leading to corporate failures, thus triggering write-downs in asset values (both equity and debt);

· a change in either interest rates or inflation which causes an increase in the value of the scheme liabilities; and

· scheme members living longer than expected (known as longevity risk).

The plan's investment strategy is determined after taking into consideration the market risk inherent in the investments and its consequential impact on potential future contributions.

Ultimate responsibility for investment strategy rests with either the trustees or, in certain circumstances, a Management Committee. The degree of independence of the trustees from HSBC varies in different jurisdictions. For example, the HSBC Bank (UK) Pension Scheme, which accounts for approximately 70 per cent of the obligations of the Group's defined benefit pension plans, is overseen by a corporate trustee who regularly monitors the market risks inherent in the scheme.

Reputational risk

(Unaudited)

The safeguarding of HSBC's reputation is of paramount importance to its continued prosperity and is the responsibility of every member of staff.

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

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

A Group Reputational Risk Committee ('GRRC') was established in 2008 at which Group functions with responsibility for activities that attract reputational risk are represented. The primary role of the GRRC is to consider areas and activities presenting significant reputational risk and, where appropriate, to make recommendations to the Risk Management Meeting and GMB for policy or procedural changes to mitigate such risk. With effect from 2010, Reputational Risk Committees have been established in each of the Group's regions. These committees will ensure that reputational risks are considered at a regional as well as Group level. Minutes from the regional committees will be tabled at GRRC.

Standards on all major aspects of business are set for HSBC and for individual subsidiaries, businesses and functions. Reputational risks, including ESG matters, are considered and assessed by the Board, GMB, the Risk Management Meeting, subsidiary company boards, board committees and senior management during the formulation of policy and the establishment of HSBC standards. These policies, which form an integral part of the internal control system (see page 313), are communicated through manuals and statements of policy and are promulgated through internal communications and training. The policies cover ESG issues and set out operational procedures in all areas of reputational risk, including money laundering deterrence, counter-terrorist financing, environmental impact, anti-corruption measures and employee relations. The policy manuals address risk issues in detail and co-operation between GMO departments and businesses is required to ensure a strong adherence to HSBC's risk management system and its sustainability practices.

Sustainability risk

(Unaudited)

Assessing the environmental and social impacts of providing finance to the Group's customers has been firmly embedded into HSBC's overall risk management processes. Sustainability risks arise from the provision of financial services to companies or projects which run counter to the needs of sustainable development; in effect this risk arises when the environmental and social effects outweigh economic benefits. Within GMO, a separate function, Group Corporate Sustainability, is mandated to manage these risks globally working through local offices as appropriate. Sustainability Risk Managers have regional or national responsibilities for advising on and managing environmental and social risks.

Group Corporate Sustainability's risk management responsibilities include:

· formulating sustainability risk policies. This includes oversight of HSBC's sustainability risk standards, management of the Equator Principles for project finance lending, and sector‑based sustainability policies covering those sectors with high environmental or social impacts (forestry, freshwater infrastructure, chemicals, energy, mining and metals, and defence-related lending); undertaking an independent review of transactions where sustainability risks are assessed to be high, and supporting HSBC's operating companies to assess similar risks of a lower magnitude;

· building and implementing systems-based processes to ensure consistent application of policies, reduce the costs of sustainability risk reviews and capture management information to measure and report on the effect of HSBC's lending and investment activities on sustainable development; and

· providing training and capacity building within HSBC's operating companies to ensure sustainability risks are identified and mitigated consistently to either HSBC's own standards, international standards or local regulations, whichever is the higher.

This information is provided by RNS

The company news service from the London Stock Exchange

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