As filed with the Securities and Exchange Commission on March 10, 2009.
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549
FORM 20-F
For the transition period from N/A to N/A
Commission file number: 1-14930
HSBC Holdings plc(Exact name of Registrant as specified in its charter)
8 Canada SquareLondon E14 5HQUnited Kingdom(Address of principal executive offices)
Russell C Picot8 Canada SquareLondon E14 5HQUnited KingdomTel +44 (0) 20 7991 8888Fax +44 (0) 20 7992 4880(Name, Telephone, Email and/or Facsimile number and Address of Company Contact Person)
Securities registered or to be registered pursuant to Section 12(b) of the Securities Exchange Act of 1934:
Securities registered or to be registered pursuant to Section 12(g) of the Securities Exchange Act of 1934: None
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Securities Exchange Act of 1934: None
Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the period covered by the annual report:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:
If “Other” has been checked in response to the previous question indicate by check mark which financial statement item the registrant has elected to follow.
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
* Not for trading, but only in connection with the registration of American Depositary Shares.
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Headquartered in London, HSBC is one of the largest banking and financial services organisations in the world. Its international network comprises some 10,000 properties in 86 countries and territories in Europe; Hong Kong; Rest of Asia-Pacific, including the Middle East and Africa; North America and Latin America.
With listings on the London, Hong Kong, New York, Paris and Bermuda stock exchanges, shares in HSBC Holdings plc are held by over 210,000 shareholders in 120 countries and territories. The shares are traded on the New York Stock Exchange in the form of American Depositary Shares.
HSBC provides a comprehensive range of financial services to more than 100 million customers through four customer groups and global businesses: Personal Financial Services (including consumer finance); Commercial Banking; Global Banking and Markets; and Private Banking.
Certain defined terms
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For footnotes, see page 5.
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The consolidated financial statements of HSBC and the separate financial statements of HSBC Holdings have been prepared in accordance with International Financial Reporting Standards (‘IFRSs’) as issued by the International Accounting Standards Board (‘IASB’) and as endorsed by the European Union (‘EU’). EU-endorsed IFRSs may differ from IFRSs as issued by the IASB if, at any point in time, new or amended IFRSs have not been endorsed by the EU. At 31 December 2008, there were no unendorsed standards effective for the year ended 31 December 2008 affecting these consolidated and separate financial statements, and there was no difference between IFRSs endorsed by the EU and IFRSs issued by the IASB in terms of their application to HSBC. Accordingly, HSBC’s financial statements for the year ended 31 December 2008 are prepared in accordance with IFRSs as issued by the IASB.
HSBC uses the US dollar as its presentation currency because the US dollar and currencies linked to it form the major currency bloc in which HSBC transacts its business. Unless otherwise stated, the information presented in this document has been prepared in accordance with IFRSs.
When reference to ‘underlying’ or ‘underlying basis’ is made in tables or commentaries, comparative information has been expressed at constant currency (see page 23) and adjusted for the effects of acquisitions and disposals. A reconciliation of reported and underlying profit before tax is presented on page 22.
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2008 was the most extraordinary year for the global economy and financial services in well over half a century. It marked the first crisis of the era of globalised securitisation. And it also marked the first crisis of the just-in-time global economy as the impact of the financial crisis fed rapidly straight into the performance of the real economy.
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HSBC strategy intact
We at HSBC were not immune from the crisis. But we have built our business on very strong foundations and are able to report results which demonstrate our ability to withstand the storm.
Our strategy has been tested and remains intact. We will continue to build our business by focusing on faster-growing markets around the world and on businesses where international connectivity is important – all from a position of financial strength. If anything, the current crisis validates our renewed focus over the last few years on fast-growing economies, since it will accelerate the shift in the world’s centre of economic gravity from west to east.
Our robust balance sheet and liquidity means that we have continued to lend. In 2008, we grew our lending to commercial customers by 10 per cent on an underlying basis. Lending to personal customers increased in all regions except North America. And our brand strength continues to underpin our performance. It was noticeable that, at times of stress in many markets, HSBC was a beneficiary of funds flowing in. Recently, the HSBC brand was recognised as the number one brand in banking by Brand Finance.
Profitable from a broad-based earnings platform
Excluding the goodwill impairment on our North America Personal Financial Services business, HSBC reported a pre-tax profit for 2008 of US$19.9 billion, a decline of 18 per cent. On a reported basis, pre-tax profit was US$9.3 billion, down 62 per cent. Within this were some strong regional and business line performances. However, there is one area on which I would like to comment.
For North America, we reported a loss of US$15.5 billion including the goodwill impairment charge of US$10.6 billion in Personal Financial Services. The significant deterioration in US employment and economic outlook in the fourth quarter of 2008 were the primary factors in causing us to write off all the remaining goodwill carried on our balance sheet in respect of our Personal Financial Services business in North America.
The management team has worked tirelessly to address this problem acquisition in the US and we have considered all viable options. We saw the disruption in sub-prime lending as early as 2006 and sharply scaled back in 2007 while others continued
to grow. We also devoted considerable resources to helping our customers. Virtually no one then foresaw the subsequent scale of the deterioration in the US economy and financial markets. It is now clear that models of direct personal lending that depend on wholesale markets for funding are no longer viable. In light of this, we have taken the difficult decision that, with the exception of credit cards, we will write no further consumer finance business through the HFC and Beneficial brands in the US and close the majority of the network. Thus, in terms of new business, we are drawing a line and we will run off our existing business, providing all necessary support to HSBC Finance to enable it to do so in a measured way and meet all its commitments.
HSBC has a reputation for telling it as it is. With the benefit of hindsight, this is an acquisition we wish we had not undertaken.
The US remains the world’s largest economy and HSBC remains committed to the US, which we see as a core market for HSBC. HSBC Bank in the US is not affected by the restructure. In the immediate future we will focus on those businesses and customers for whom our global connectivity gives us advantage – primarily in corporate and commercial business, and in Private and Premier banking.
Performance overview and strategic activity
In this difficult environment, we missed our profitability targets. We hit our capital target with our tier 1 ratio at 8.3 per cent. We maintained a very conservative advances-to-deposits ratio at 84 per cent. We grew lending in each region outside North America on an underlying basis. And we constrained costs, with the cost efficiency ratio improving to 47.2 per cent, excluding the goodwill impairment mentioned above. We also continued implementation of OneHSBC, our programme to enhance customer experience and improve cost efficiency through standardising products, processes and technology around the world.
We also acquired businesses in strategic areas – we acquired the assets, liabilities and operations of The Chinese Bank in Taiwan in March; IL&FS Investsmart, a retail brokerage in India in May; and, in October, the acquisition of Bank Ekonomi in Indonesia was announced. The first two are complete and being integrated, the last is expected to be completed in the second quarter. The most notable disposal was the sale of our regional bank network in France for a consideration of US$3.2 billion.
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Thank you to our people
This was an extraordinary year and made extraordinary demands on many of our people. I want to express my sincere thanks for all their efforts and achievements. Our industry has rightly been under considerable public scrutiny and banks have been indiscriminately bunched together. It is through our staff that HSBC’s distinctive character stands out for our customers and it is they who ensure that not all banks are the same.
Dividend declaration and progressive dividend policy
The Directors have declared a fourth interim dividend for 2008 of US$0.10 per ordinary share (in lieu of a final dividend) which, together with the first three interim dividends for 2008 of US$0.18 already paid, will make a total distribution in respect of the year of US$0.64 per ordinary share. The payments in total represent a decrease of 29 per cent in US dollar terms compared with 2007 and of 15 per cent in sterling terms. The dividend will be payable on 6 May 2009 to shareholders on the register at the close of business on 20 March 2009.
After 15 years of double-digit dividend growth, we did not make the decision to lower the dividend lightly. Very careful consideration was given to the current operating environment and the increased uncertainty over both the supply of capital required in an increasingly volatile financial world and a pro-cyclical regulatory capital framework.
For 2009, HSBC has rebased the envisaged dividend per share for the first three interim dividends to US$0.08 to reflect the impact of the enlarged ordinary share capital following the Rights Issue we are announcing today, prevailing business conditions and capital requirements. The dividend payments remain substantial and reflect management’s long-term confidence in the business. HSBC will continue to aim to pay progressive dividends in line with the long-term growth of the business.
Maintaining HSBC’s financial strength
The logic of maintaining HSBC’s distinctive financial strength which we have applied to our dividend also applies to our capital position. We have announced today a Rights Issue to strengthen further our capital ratios. We propose to raise, on a fully underwritten basis, approximately US$17.7 billion of equity which will increase our capital ratios by 150 basis points, strengthening the core equity tier 1 ratio to 8.5 per cent and the tier 1 ratio to 9.8 per cent, both on a pro forma basis as at
31 December 2008. I shall be writing to all shareholders with full details.
Over the past 12 months, many of our competitors have received significant government capital injections – something we said we could not envisage – or have raised capital from shareholders and other investors. Higher regulatory capital requirements, in part from the effect of the economic downturn on capital requirements under the Basel II regime, as well as changing market sentiment on appropriate levels of leverage, have also raised expectations regarding capital levels. We are determined that HSBC should maintain its signature financial strength and we are now raising the top of our target range for the tier 1 ratio so that the range will be from 7.5 per cent to 10 per cent.
Planned internal capital generation remains strong and this capital raising will enhance our ability to deal with the impact of an uncertain economic environment and to respond to unforeseen events. Importantly, it will also give us options with respect to opportunities which we believe will present themselves to those with superior financial strength. These may involve organic investment in the continued taking of market share from more capital constrained competitors. There may also be opportunities to grow through targeted acquisitions by taking advantage of attractive valuations where the opportunities in question align with our strategy and the risks are understood.
Culture and compensation
We believe in the profound importance of culture and ethics in business. HSBC’s longstanding traditions of financial strength, long-term customer relationships and conservative management are as important today as ever. They have not always been fashionable and we have not always been perfect. One of the consequences of the crisis – and rightly – is that we are going to see a fundamental re-evaluation of the rules and regulations that govern our business. But we should remember that no amount of rules and regulations will be sufficient if the culture does not encourage people to do the right thing. It is the responsibility of Boards to supervise and management to embed a sustainable culture into the very fibre of the organisation. For HSBC, there is nothing more important.
We also intend to play our part in rebuilding public trust in our industry. This means we must be willing to take part in and shape the debate on how our industry should evolve in the coming years, based on the lessons which must be learnt from this crisis. In particular, we strongly believe that the
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industry must respond to the requirement for a more sober and reasonable approach to compensation. At HSBC, we are committed to the principle of sensible market-related pay, structured to align executive actions with long-term shareholder interests. A small number of individuals in a market system will inevitably receive compensation that is high in absolute terms, but this must be genuinely linked to long-term shareholder interests. It is clear that the banking industry got it wrong in the go-go years: we will play our part in helping the industry respond appropriately to the new realities.
It is right therefore that in HSBC’s case, I outline our present position. As Chairman I elected in 2007 to no longer receive any cash bonus award; any variable compensation would be delivered through performance share awards – which would only vest if performance hurdles are met. And no performance share awards will be made in the Group in respect of 2008. Mike Geoghegan, Group Chief Executive, and Stuart Gulliver, Chief Executive Global Banking and Markets, and Douglas Flint, Group Finance Director, have asked the Remuneration Committee not to consider them for any bonus award for 2008. No cash bonus award will be made to any Executive Director for 2008. Full details on Directors’ remuneration can be found in the Annual Report.
Learning the lessons
We are living through a genuinely global crisis; it cannot be solved by one nation alone. Governments need to work together with our industry to tackle the root causes of the crisis, while maintaining the open, globalised markets that have helped spread prosperity in the last two decades. Protectionism, both in trade and in capital flows, is a threat and in all its forms must be resisted.
We must also urgently improve governance and regulation to create a more stable financial framework. The globalisation of financial markets contrasts sharply with the domestic agenda of the regulatory regimes that underpin it. We support intergovernmental efforts to enhance the coordination of regulatory oversight, since we believe that this is essential to the stable development of the international capital markets for the benefit of the common good.
Continued economic strain
The coming twelve months will be difficult. We expect parts of Asia, the Middle East and Latin America to continue to outperform Western economies, but to be constrained by the global downturn.
We see unemployment rising through 2009 into 2010 in both the US and the UK, together with continuing declines in housing markets. We should remember that the US is the driver of the global economy and global growth depends on the US recovery.
We remain confident that HSBC is well-placed in today’s environment and that our strength leads to opportunity. Our strategy has served HSBC well and positions it for long-term growth with attractive returns. HSBC continues to combine its position as the world’s leading emerging markets bank with an extensive international network across both developed and faster growing markets. At the same time, as the financial system exhibits stress, our competitive position is improving as the capacity and capabilities of financial institutions are constrained by lack of capital and funding; many of them are also focusing more on their domestic markets.
Further strengthening our capital base will enhance our ability to deal with the impact of an uncertain economic environment and to respond to unforeseen events, as well as giving us options regarding opportunities which will undoubtedly present themselves to those with superior financial strength.
S K Green, Group Chairman2 March 2009
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HSBC is one of the largest banking and financial services organisations in the world, with a market capitalisation of US$114 billion at 31 December 2008.
Through its subsidiaries and associates, HSBC provides a comprehensive range of banking and related financial services. Headquartered in London, HSBC operates through long-established businesses and has an international network of some 10,000 properties in 86 countries and territories in five geographical regions: Europe; Hong Kong; Rest of Asia-Pacific, including the Middle East and Africa; North America and Latin America. Within these regions, a comprehensive range of financial services is offered to personal, commercial, corporate, institutional, investment and private banking clients. Services are delivered primarily by domestic banks, typically with large retail deposit bases, and consumer finance operations. Taken together, the five largest customers of HSBC do not account for more than one per cent of HSBC’s income.
There were no significant acquisitions during the year (for details of acquisitions see page 418). HSBC disposed of its seven French regional banks for US$3.2 billion in July 2008 (see pages 418 and 458).
HSBC’s strategic direction reflects its position as ‘The world’s local bank’, combining the largest global emerging markets banking business and a uniquely cosmopolitan customer base with an extensive international network and substantial financial strength.
The Group’s strategy is aligned with key trends which are shaping the global economy. In particular, HSBC recognises that, over the long term, developing markets are growing faster than the mature economies, world trade is expanding at a greater rate than gross domestic product and life expectancy is lengthening virtually everywhere. Against this backdrop, HSBC’s strategy is focused on delivering superior growth and earnings over time by building on the Group’s heritage and skills. Its origins in trade in Asia have had a considerable influence over the development of the Group and, as a consequence, HSBC has an established and longstanding presence in many countries. The combination of local knowledge and international breadth is supported by a substantial financial capability founded on balance sheet strength, largely attributable to the scale of the Group’s retail deposit bases.
HSBC is, therefore, continuing to invest primarily in the faster growing markets and, in the more developed markets, by focusing on businesses which have international connectivity. Central to these reshaping activities is a policy of maintaining HSBC’s capital strength and strong liquidity position.
The Group has identified three main business models for its customer groups and global businesses that embody HSBC’s areas of natural advantage:
The means of executing the strategy, and further utilising the linkages within the Group, are clear:
Current economic and market conditions may adversely affect HSBC’s results.
The global economy has entered the most severe downturn for 80 years, with the financial services industry facing extraordinary turbulence. A shortage of liquidity, lack of funding, pressure on capital and extreme price volatility across a wide range of asset classes are putting financial institutions under considerable pressure. This is leading governments and central banks to undertake unprecedented intervention designed to stabilise the global and
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domestic financial systems, to stimulate new lending and to support systemically important institutions at risk of failing. Many developed economies have entered recession and growth has slowed in many emerging countries, with serious adverse consequences for asset values, employment, consumer confidence and levels of economic activity. Commodity prices have significantly retrenched, in many cases from recent historical highs, interest rate yield curves have flattened, interest rates have fallen in absolute terms and trade flows have contracted. Global equity markets have experienced severe declines and various currencies, including sterling, have depreciated significantly against the US dollar. Emerging markets have suffered as portfolio investments have been repatriated and cross-border inter-bank funding has been withdrawn. Numerous governments and central banks have responded by proposing programmes to make substantial funds and guarantees available to boost liquidity and confidence in their financial systems, as well as cutting taxes and lowering interest rates. It is not known whether these responses will be effective in addressing the severe economic and market conditions or whether recently proposed measures will be implemented as initially proposed.
HSBC’s earnings are affected by global and local economic and market conditions. Dramatic declines in 2007 and 2008 in the housing markets in the US, the UK and elsewhere have combined with increasing unemployment to affect negatively the credit performance of real estate-related exposures, resulting in significant write-downs of asset values by financial institutions, including HSBC. These write-downs, initially of asset-backed securities but spreading to other securities and loans, have caused many financial institutions to seek additional capital, to reduce or eliminate dividends, to merge with larger and stronger competitors or, in some cases, to fail.
A worsening of these conditions may exacerbate the impact of these difficult market conditions on HSBC and other financial institutions and could have an adverse effect on HSBC’s operating results. In particular, the Group may face the following challenges in connection with these events:
As a worldwide financial institution, HSBC is exposed to these developments across all its businesses, both directly and through their impact on its customers and clients. Local variations exist, however, reflecting regional circumstances and
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presenting challenges to HSBC which are specific to those areas.
Europe
In the UK, the economy has entered recession and the currency has fallen in value against the US dollar, the yen and the euro. Changes in the marketplace are emerging following the part-nationalisation of some major financial institutions, and political interaction with the regulatory environment is becoming more frequent as the government seeks to stimulate lending to preserve economic activity. A period of low interest rates will reduce deposit spreads and HSBC’s retail business model will be more dependent on transactional fees and lending margin. Pension funding requirements, in particular for UK defined benefit schemes, will place increased financing demands on corporates, which may lead to unfunded commitments being drawn down, adding to pressure on system liquidity. The recent deterioration in credit quality is expected to continue as the economy contracts, with loan impairment charges rising as a result. Market volatility is also expected to continue.
In France, changes in the marketplace are slowly emerging following government measures to stimulate lending and preserve economic activity. A period of low interest rates will not adversely impact spreads in the short-term but will have an adverse effect in later years. HSBC’s retail business model is dependent on banking fees to maintain profitability and a recovery in financial markets is necessary in order to enhance brokerage and management fees and stimulate fund management activities. Deterioration in credit quality is expected to continue as the economy contracts, with commercial loan impairment charges rising as a result. Personal loan impairment charges are expected to remain at around current levels unless there is a very deep recession.
Conditions are likely to remain difficult in a number of markets in which HSBC currently trades and volatility is expected to continue.
Hong Kong and Rest of Asia-Pacific
In Asia-Pacific, a prolonged period of low interest rates is expected which will put pressure on HSBC’s net interest income from its strong deposit base. With capital market and currency volatility endemic, customers are likely to seek capital protection and become increasingly rate and risk sensitive, seeking out products which offer deposit insurance and government guarantees. Regulatory reforms in the areas of wealth management product complexity,
sales requirements and liquidity and reserve ratios are likely, and these will lead to a higher cost of compliance, greater standardisation and slower product approvals. International trade is expected to continue to contract, affecting import and export volumes and reducing HSBC’s earnings from trade financing. The quality of the asset book will deteriorate if economic factors beyond HSBC’s control do not improve, reducing customer credit ratings and, as a consequence, increasing risk- weighted asset allocations and capital requirements. This could be exacerbated if capital continues to be repatriated from emerging markets to more developed economies to take advantage of lower asset prices, adversely affecting emerging markets’ balance of payments and foreign exchange reserves. However, Asia is expected to adapt quickly to secure recovery from the global recession, led by mainland China and India.
The fall in global demand for oil products and related prices, and the contraction in financial surpluses held by key oil-producing countries following the declines in capital markets, will reduce the ability of some countries in the Middle East to maintain spending, borrowing and investment domestically and internationally. This will result in the cancellation or postponement of infrastructure projects which, together with weakening property prices, is expected to reduce both credit cover and revenue streams for financial institutions. The availability of economically priced, long-term funding is likely to contract. Business activity and private investment will also slow as consumer confidence declines. These factors will combine to place pressure on net revenues and on capital requirements.
North America
In the US, the steep decline in the housing market, with falling home prices and increasing foreclosures, and rising unemployment have resulted in significant write-downs of loans and advances and mortgage-backed securities. The effect of these write-downs subsequently spread to other capital market activities, leading many financial institutions to seek additional capital, merge with larger and stronger institutions and, in some cases, fail. Many lenders reduced or stopped providing funding to borrowers, including to other financial institutions. This market turmoil and resultant tightening of credit have led to an increased level of delinquencies, a fall in consumer confidence, increased market volatility and a widespread reduction in business activity in general. To date, various government intervention measures designed to stabilise the markets, including
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the decision of the Federal Reserve to reduce interest rates to unprecedentedly low levels, appear to be having an impact on the trading of both guaranteed and non-guaranteed debt in early 2009. A prolonged period of low Federal funds rates will put pressure on deposit spreads earned on HSBC’s deposit base. It is likely that these conditions will continue to adversely affect the Group’s results into 2010, the degree to which remains uncertain.
Markets in Latin America are expected to be affected by recession in the developed world, particularly in the US. Output will fall as a decline in the demand for exports will adversely affect the export sector, and these factors are likely to combine with currency volatility to weaken the balance sheets of financial institutions. This may lead to a further contraction in the availability of credit, increasing the likelihood of bankruptcies and unemployment and reducing economic activity and consumption. Lower commodity prices and reduced remittance inflows are likely to affect economies in the region, particularly in Mexico and Central America. Exchange rates are likely to remain under pressure as growth stalls, and inflation may rise. The possibility of a combined credit crunch and stagflation in Latin America cannot be ruled out. The authorities may react with stricter prudential regulation and price controls. Public finances will come under strain if oil and other commodity prices remain low, restricting the authorities’ room for manoeuvre.
Risks associated with liquidity and funding, which are inherent in HSBC’s business, have been greatly increased by the current global market conditions
HSBC’s business model depends upon its ability to access financial resources whenever required to meet its obligations. To this end, HSBC seeks to maintain a diversified and stable funding base comprising core retail and corporate customer deposits and institutional balances and to augment this with wholesale funding and portfolios of highly liquid assets diversified by currency and maturity which are held to enable HSBC to respond to unforeseen liquidity requirements. HSBC’s earnings are affected by its ability to properly value financial instruments. In certain illiquid markets, determining the value at which financial instruments can be realised is highly subjective, and processes to ascertain value and estimates of value, both of which require substantial elements of judgement, assumptions and estimates (which may change over time), are required. Increased illiquidity adds to
uncertainty over the accessibility of financial resources and may reduce capital resources as valuations decline. Rating agencies, which determine HSBC’s own credit ratings and thereby influence the Group’s cost of funds, take into consideration management effectiveness and the success with which HSBC’s liquidity risk factors are managed. Actions by third parties and independent market participants, such as rating agency downgrades of instruments to which HSBC has exposure, can result in reduced liquidity and valuations of those instruments. HSBC’s liquidity could also be constrained by an inability to access the debt capital markets due to a variety of unforeseen market dislocations or interruptions.
The extreme market conditions facing the financial services industry have been reflected in shortages of liquidity, lack of funding, pressure on capital and extreme price volatility across a wide range of asset classes. Illiquidity of these assets has prevented the realisation of existing asset positions and has constrained risk distribution in ongoing banking activities. The extreme market conditions, which have highlighted the importance of a strong diversified core deposit base, have also lead to increased competition for such deposits and the risk of deposit migration. HSBC’s Global Banking and Markets business operates in the markets affected by illiquidity and extreme price volatility, either directly or indirectly, through exposures to securities, loans, derivatives and other commitments, and HSBC has made substantial write-downs and impairments on illiquid legacy credit and structured credit positions. While it is difficult to predict how long the conditions described above will exist and which of HSBC’s markets, products and other businesses will be affected, continuation of these factors could have an adverse effect on the Group’s results.
HSBC has significant exposure to counterparty risk
HSBC’s ability to engage in routine transactions to fund its operations and manage its risks could be adversely affected by the actions and commercial soundness of other financial services institutions. Financial institutions are extremely interdependent because of trading, clearing, counterparty or other relationships. As a consequence, a default by, or decline in market confidence in, individual institutions, or anxiety about the financial services industry generally, can lead to further individual and/or systemic difficulties, defaults and losses. HSBC has exposure to virtually all major industries and counterparties, and it routinely executes
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transactions with counterparties in financial services, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients. Many of these transactions expose HSBC to credit risk in the event of default by its counterparty or client. Where counterparty risk has been mitigated by taking collateral, HSBC’s credit risk may be exacerbated if the collateral it holds cannot be realised or has to be liquidated at prices which are insufficient to recover the full amount of its loan or derivative exposure. The failure of one of HSBC’s counterparties could have an adverse effect on its results.
HSBC operates in a highly competitive environment, and competition could intensify as a result of current global market conditions
Consolidation in the financial services industry is increasingly concentrating activity in companies that are capable of offering a wide array of financial products at competitive prices, with globalisation exposing HSBC to competition in capital markets and financial services at global and local levels alike. In addition, technological advances, the growth of e-commerce, regulatory developments and public sector participation or guarantees have made it possible for non-depository institutions to offer products and services that traditionally were the preserve of banks. The prominence in recent years of sovereign wealth funds, private equity and hedge funds as alternative sources of funding – which has increased competition for traditional financial institutions – may ease as investors seek safer, more traditional alternatives. Competition may further intensify or the competitive landscape may change as the consolidation of financial services companies continues and others are brought into part or full public ownership in response to the current market conditions. HSBC’s ability to grow its businesses, and therefore its earnings, is affected by these competitive pressures and is dependent on HSBC’s ability to attract and retain talented and dedicated employees.
HSBC is subject to political and economic risks in the countries in which it operates
HSBC operates through an international network of subsidiaries and affiliates in 86 countries and territories around the world. Its results are therefore subject to the risk of loss from unfavourable political developments, currency fluctuations, social instability and change in government policies on such matters as expropriation, authorisations, international ownership, interest-rate caps, limits
on dividend flows and tax in the jurisdictions in which it operates. These factors may also negatively affect revenues from the trading of securities and investment in securities, the effect being accentuated through certain international trading markets, particularly those in emerging market countries, being typically smaller, less liquid and more volatile than developed trading markets. HSBC’s subsidiaries’ and affiliates’ ability to pay dividends could be restricted by changes to official banking measures, exchange controls and other requirements. Because HSBC prepares its accounts in US dollars, while a substantial part of its assets, liabilities, assets under management, revenues and expenses are denominated in other currencies, changes in foreign exchange rates have an effect on its reported income and shareholders’ equity. For a detailed discussion of global and regional factors that impact the results of HSBC’s operations, see page 12.
Operational risks are inherent in HSBC’s business
HSBC is exposed to many types of operational risk, including fraudulent and other criminal activities (both internal and external), breakdowns in processes or procedures and systems failure or non-availability. HSBC is also subject to the risk of disruption of its business arising from events that are wholly or partially beyond its control (for example natural disasters, acts of terrorism, epidemics and transport or utility failures) which may give rise to losses in service to customers and/or economic loss to HSBC. All of these risks are also applicable where HSBC relies on outside suppliers or vendors to provide services to it and its customers.
HSBC is subject to legal risks, which have an adverse effect on the Group’s reputation
The risks to HSBC’s reputation arise from a variety of sources with the potential to cause harm to the Group and its ability to operate. These issues require the Group to deal appropriately with potential conflicts of interest; legal and regulatory requirements; ethical issues; anti-money laundering laws or regulations; privacy laws; information security policies; sales and trading practices; and the conduct of companies with which it is associated. Failure to address these issues appropriately may give rise to additional legal and compliance risk to HSBC, with an increase in the number of litigation claims and the amount of damages asserted against HSBC, or subject HSBC to regulatory enforcement actions, fines or penalties.
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Increased regulation of the financial services industry could have an adverse effect on HSBC’s operations
HSBC, its subsidiaries and its affiliates are subject to extensive and increasing regulation, accounting standards and interpretations thereof and legislation in the various countries in which the Group operates. From time to time, new laws are introduced, including tax, consumer protection, privacy and other legislation, which affect the operating environment in which the Group operates. As a result of the recent interventions by governments in response to global economic conditions, it is widely expected that there will be a substantial increase in government regulation and supervision of the financial services industry, including the imposition of higher capital requirements and restrictions on certain types of transaction structure. If enacted, such new regulations could require additional capital to be injected into HSBC’s subsidiaries and affiliates, require HSBC to enter into business transactions that are not otherwise part of its current Group strategy, prevent HSBC from continuing current lines of operations, restrict the type or volume of transactions HSBC may enter into, limit HSBC’s subsidiaries’ and affiliates’ ability to declare dividends to HSBC, or set limits on or require the modification of rates or fees that HSBC charges on certain loan or other products. HSBC may also face increased compliance costs and limitations on its ability to pursue business opportunities. Separately, the Basel II Accord’s requirement for financial institutions to increase their capital in response to deteriorating market conditions may have secondary effects on lending, which could exacerbate the current market downturn. These measures, alone or in combination, could have an adverse effect on HSBC’s operations.
In the UK for example, the Banking Act 2009 includes a ‘Special Resolutions Regime’ which gives wide powers in respect of UK banks and their parent companies to the UK Treasury, the FSA and the Bank of England in circumstances where any such UK bank has encountered, or is likely to encounter, financial difficulties.
HSBC is subject to tax-related risks in the countries in which it operates, which could have an adverse effect on its operating results
HSBC is subject to the substance and interpretation of tax laws in all countries in which it operates.
A number of double taxation agreements entered into between countries also affect the taxation of the Group. Tax risk is the risk associated with changes in tax law or in the interpretation of tax law. It also includes the risk of changes in tax rates and the risk of consequences arising from failure to comply with procedures required by tax authorities. Failure to manage tax risks could lead to increased tax charges, including financial or operating penalties, for not complying as required with tax laws.
The Board of Directors and the Group Management Board monitor HSBC’s progress against its strategic objectives. Progress is assessed by comparison with the Group’s strategy, its operating plan targets and its historical performance using both financial and non-financial measures.
As a prerequisite for the vesting of Performance Shares, the Remuneration Committee must satisfy itself that HSBC Holdings’ financial performance has shown a sustained improvement in the period since the award date. In determining this, the Remuneration Committee will take account of all relevant factors but in particular comparisons against the total shareholder return (‘TSR’) comparator group with regard to the financial key performance indicators (‘KPIs’) described below.
Financial KPIs
To support the Group’s strategy and ensure that HSBC’s performance can be monitored, management utilises a number of financial KPIs. The table below presents these KPIs for the period from 2004 to 2008. At a business level, the KPIs are complemented by a range of benchmarks which are relevant to the planning process and to reviewing business performance.
HSBC has published a number of key targets against which future performance can be measured. Financial targets have been set as follows: the return on average total shareholders’ equity over the medium term has been set at 15-19 per cent; the cost efficiency ratio has been set in the range of 48-52 per cent; and the TSR in the top half of that achieved by peers. The cost efficiency ratio has been set as a range within which the business is expected to remain in order to accommodate the need for continued investment in support of future business growth.
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Financial KPIs – trend analysis
Revenue growth provides an important guide to the Group’s success in generating business. In 2008, total revenue grew by 3.4 per cent to US$81.7 billion, 2.1 per cent on an underlying basis, reflecting the resilience of HSBC’s income generating capabilities in these exceptionally difficult economic circumstances.
Revenue mix represents the relative distribution of revenue streams between net interest income, net fee income and other revenue. It is used to understand how changing economic factors affect the Group, to highlight dependence on balance sheet utilisation for income generation and to indicate success in cross-selling fee-based services to customers with loan facilities. This understanding assists management in making business investment decisions. Comparison of the revenue mix between 2005 and 2007 shows a trend of net fee income increasing at a faster rate than net interest income. This trend has been reversed in 2008 as net fee income’s contribution fell by 3.4 percentage points mainly due to lower fees on cards and equity-related products.
Cost efficiency is a relative measure that indicates the consumption of resources in generating revenue. Management uses this to assess the success of technology utilisation and, more generally, the productivity of the Group’s distribution platforms and sales forces. The cost efficiency ratio for 2008 deteriorated by 10.7 percentage points to 60.1 per cent. This included writing off goodwill in the US.
Credit performance as measured by risk-adjusted margin is an important gauge for assessing whether credit is correctly priced so that the returns available after recognising impairment charges meet the Group’s required return parameters. The ratio for 2008 was 4.8 per cent, showing a decline of 1.2 percentage points over 2007, as loan impairment charges rose at a faster rate than income on higher average risk-weighted assets.
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Return on average invested capital measures the return on the capital investment made in the business, enabling management to benchmark HSBC against competitors. In 2008, the ratio of 4.0 per cent was 11.3 percentage points lower than that reported in 2007. This decrease reflected the decline in profit driven by goodwill impairment, the significant increase in loan impairment charges, write-downs in credit trading, leveraged and acquisition finance, and monoline exposures. The comparative period included dilution gains which were not repeated.
HSBC aims to deliver sustained dividend per share growth for its shareholders. The total dividend for 2008, based on the year to which the dividends relate (rather than when they were paid), amounts to US$0.64, a reduction of 28.9 per cent on 2007, reflecting the decline in profitability, prevailing business conditions and capital requirements. This basis differs from the disclosure in the five-year comparison on page 4.
Basic earnings per share (‘EPS’) is a ratio that shows the level of earnings generated per ordinary share. EPS is one of two KPIs used in rewarding employees and is discussed in more detail in the Director’s Remuneration Report on page 315. EPS for 2008 was US$0.47, a decline of 71.5 per cent on 2007. This, in part, reflected the effect of recognising goodwill impairment in North America as well as the broad based impact of the global economic crisis. In 2007, EPS grew by 17.9 per cent over that reported in 2006.
Return on average total shareholders’ equity measures the return on average shareholders’ investment in the business. This enables management to benchmark Group performance against competitors and its own targets. In 2008, the ratio was 4.7 per cent or 11.2 percentage points lower than in 2007 of which 8.6 percentage points related to the goodwill impairment recognised. This absolute performance is not regarded as satisfactory, being lower than management’s target range of between 15 and 19 per cent.
Total shareholder return (‘TSR’) is used as a method of assessing the overall return to shareholders on their investment in HSBC, and is defined as the growth in share value and declared dividend income during the relevant period. TSR is a key performance measure in rewarding employees. In calculating TSR, dividend income is assumed to be invested in the underlying shares. The TSR benchmark is an index set at 100 and measured over one, three and five years for the purpose of comparison with the performance of a group of competitor banks which reflect HSBC’s range and
breadth of activities. As the comparator group includes companies listed on overseas markets, a common currency is used to ensure that TSR is measured on a consistent basis. The TSR levels at the end of 2008 were 84.5, 84.5, and 98.5 over one, three and five years respectively. HSBC’s TSR over all periods, while disappointing in absolute terms, has significantly outperformed the peer group as the current financial crisis has had a significantly more adverse impact on their performance and rating.
Management believes that financial KPIs must remain relevant to the business so they may be changed over time to reflect changes in the Group’s composition and the strategies employed.
Non-financial KPIs
HSBC has chosen four non-financial KPIs which are important to the future success of the Group in delivering its strategic objectives. These non-financial KPIs are currently reported internally within HSBC on a local basis.
Employee engagement
Employee engagement is a measure of employees’ emotional and rational attachment to HSBC. It is critical to the long-term success of the Group and, as such, an employee engagement target was included in the 2008 objectives for Group Executives (see Directors’ Remuneration Report, page 315).
In 2008, HSBC conducted its second Global People Survey of HSBC’s permanent workforce worldwide. The 2008 participation rate of 93 per cent improved on the 2007 figure of 88 per cent, which was already around the highest in the industry.
The Group’s employee engagement score rose from 60 per cent in 2007 to 67 per cent in 2008. In achieving 67 per cent, HSBC exceeded its target for 2008 of 62 per cent, the external global norm and the sector norm. Its 2009 target is 69 per cent.
The 2008 survey covered 13 dimensions which included assessing for the first time whether action had been perceived to have been taken on the results of the 2007 survey. Employees rated HSBC above the external global norm across all dimensions. HSBC exceeded the external best-in-class norm for Corporate Sustainability, and the dimensions covering Strategy and Vision, Reputation, Direct Manager and Leadership were close to this norm.
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Brand perception
In order to manage the HSBC brand most effectively, the Group tracks brand health amongst Personal Financial Services and Commercial Banking customers in each of HSBC’s major markets. The survey is conducted on a consistent basis by accredited, independent, third-party organisations. A weighted scorecard of brand measures produces an overall score for each market on a 100-point scale, which is then benchmarked against HSBC’s main competitors. The scores from each market are then weighted according to the risk-adjusted revenues in that market to obtain the overall Group score.
In 2008, Personal Financial Services customers judged HSBC’s brand to be 9 points stronger than its competitors (+9), up from 6 points in 2007 and above the 8 point target. Commercial Banking customers judged the brand to be 6 points higher than HSBC’s competitors (+6), the same as in 2007.
For 2009, HSBC will track brand health in more countries. During 2008, competitors were acquired or withdrew from certain markets, so HSBC re-benchmarked its 2008 performance in respect of both brand and customer satisfaction for Personal Financial Services and Commercial Banking. For 2009, the benchmark is +4 with a target of +5 for the former and, for the latter, the equivalent numbers are +6 and +7, respectively.
Customer recommendation is an important driver of business growth for HSBC. HSBC uses a consistent measure of customer recommendation around the world to continue to improve the services provided by the Group to customers of Personal Financial Services and Commercial Banking. This measurement is carried out by accredited, independent, third-party organisations and the resulting recommendation scores are benchmarked against competitors.
The 2008 customer recommendation target for Personal Financial Services increased from +1 to +2, failing to meet the target of +3 by a small margin. Commercial Banking met the target of +7 over competitors, up from +6 in 2007.
In 2009, HSBC has adopted a new benchmark of +1 and a 2009 target of +3 for Personal Financial Services and a benchmark of +4 and a target of +4 for Commercial Banking.
IT performance and systems reliability
HSBC tracks two key measures as indicators of IT performance; namely, the number of customer transactions processed and the reliability and resilience of systems measured in terms of service availability targets.
Number of customer transactions processed
The number of customer transactions processed reflects the dependency on IT in the delivery channels that customers use to interact with HSBC. Monitoring the volumes by channel enables the Group to allocate resources appropriately. Overall, the results show the desired decrease in staff-assisted transactions. Self-service transactions increased as a result of the redesign of the Group’s distribution network and the continuing rollout of One HSBC Technologies, HSBC’s project to standardise its primary systems, products and processes. Internet transactions unexpectedly decreased as a direct result of lower online trading volumes in retail securities in 2008. To improve efficiency HSBC aims to manage the rate of increase in IT transaction processing costs to below the volume increase. The following chart shows the 2005 to 2008 volumes per delivery channel:
Number of customer transactions (millions)
Percentage of IT services meeting or exceeding targets
HSBC’s IT function establishes with its end-users service levels for systems performance, such as systems running 99.9 per cent of the time or credit card authorisations within two seconds, and monitors the achievement of each of these commitments. The following chart shows the percentage of IT services meeting or exceeding the agreed service targets by region. Overall, the results show a trend of improving service performance.
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HSBC measures its performance internally on a like-for-like basis by eliminating the effects of foreign currency translation differences, acquisitions, disposals and gains from the dilution of the Group’s interests in associates in 2007, which distort a year-on-year comparison. HSBC refers to this as its underlying performance.
The tables below compare HSBC’s underlying performance in 2008 with 2007, and 2007 with 2006. Equivalent tables are provided for each of HSBC’s customer groups and geographical segments in their respective sections below.
The foreign currency translation differences were mainly due to the strengthening of the US dollar against sterling in the second half of 2008 and its relative weakness against the euro and the Chinese renminbi in 2008 compared with 2007. The Group’s reported profit before tax in 2008 was 62 per cent lower than in 2007, with the effect of the change in foreign currency translation rates making a negligible difference. Comparing 2007 with 2006, the reported profit before tax growth was 10 per
cent, of which 4 per cent was explained by exchange rate movements.
The following acquisitions and disposals, which are listed in chronological order, affected both comparisons:
21
Reconciliation of reported and underlying profit before tax
For footnotes, see page 143.
22
Consolidated financial statements
HSBC uses the US dollar as its presentation currency because the US dollar and currencies linked to it form the major currency bloc in which HSBC transacts its business. Unless otherwise stated, the accounting information presented in this document has been prepared in accordance with IFRSs.
Constant currency
Constant currency comparatives for 2007 and 2006 used in the 2008 and 2007 commentaries, respectively, are computed by retranslating into US dollars, for non-US dollar branches, subsidiaries, joint ventures and associates:
No adjustment has been made to the exchange rates used to translate foreign currency denominated assets and liabilities into the functional currencies of any HSBC branches, subsidiaries, joint ventures or associates. When reference is made to ‘constant currency’ in tables or commentaries, comparative data reported in the functional currencies of HSBC’s operations have been translated at the appropriate exchange rates applied in the current period on the basis described above.
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2008 compared with 2007
Reported pre-tax profits in 2008 fell by 62 per cent to US$9.3 billion and earnings per share declined to US$0.47. In a year characterised by a significant deterioration in the credit markets and by unprecedented illiquidity in most asset classes, return on average total shareholders’ equity fell to 4.7 per cent.
The fall in profit before tax was exacerbated by recognition of a US$10.6 billion impairment
charge which wrote off in full the goodwill carried on the balance sheet in respect of the Group’s investment in its North America Personal Financial Services business. This non-cash charge arose substantially in the second half of 2008 as heightened risk premia in the market increased discount rates and cash flows estimated from ongoing activities fell as the US economy continued to decline and the outlook for the business deteriorated.
Asian performance was strong, generating profit
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before tax of US$11.9 billion, broadly in line with results excluding the dilution gains which arose in 2007 when HSBC did not participate in share offerings by its mainland Chinese associates. Within Asia, Global Banking and Markets’ results were strongly ahead, driven by foreign exchange, Rates and securities services. Balance Sheet Management revenues rose significantly from positioning ahead of interest rate cuts, and were especially strong in Europe despite losses from the defaults of certain financial sector companies.
With the exception of Personal Financial Services, which incurred significant losses in North America, all customer groups remained profitable. Commercial Banking and Private Banking delivered results broadly in line with 2007, while Global Banking and Markets’ profits declined.
Performance was overshadowed by a US$7.7 billion rise in loan impairment charges and other credit risk provisions, largely from the US consumer finance business, and a further US$5.4 billion in trading write-downs on illiquid legacy positions in credit trading, leveraged and acquisition finance and monoline credit exposure in Global Banking and Markets. Increases in loan impairment charges and other credit risk provisions in Personal Financial Services and Commercial Banking, the latter rising rapidly in the second half of 2008 from a low base, occurred as the global economy slowed. Global Banking and Markets also experienced a rise in loan impairment charges and other credit risk provisions as refinancing options dried up for a number of companies as the market for long-term asset financing became increasingly illiquid. The market turmoil also led to impairments on equity securities in the available-for-sale portfolio.
Investment Securities LLC (‘Madoff Securities’).
On an underlying basis, profit before tax declined by 73 per cent compared with 2007. The difference between the reported and underlying results is explained on page 21. Except where stated otherwise, the commentaries in the Financial Summary are on an underlying basis.
2007 compared with 2006
The strength of HSBC’s geographically diversified business model was demonstrated by profit growth in a year in which financial markets experienced significant dislocation and the credit environment, particularly in the US, deteriorated markedly. Pre-tax profits in 2007 increased by 10 per cent to US$24.2 billion and earnings per share rose by 18 per cent to US$1.65. Despite difficult market conditions, the return on shareholders’ equity exceeded 15 per cent, capital ratios remained strong, revenue growth was in double digits and the cost efficiency ratio improved. For the first time in recent years, pre-tax profits from the Group’s emerging markets operations exceeded 60 per cent of total profits.
On an underlying basis, profit before tax was broadly in line with 2006.
The Group had a notably strong year in most emerging markets. Vigorous economic activity, strong trade flows and buoyant equity markets helped drive broadly based profit growth, with profits in all customer groups ahead of 2006. A strong performance in Asia in all customer groups compensated for the effect of deteriorating conditions in the US and slower growth in other mature markets. Commercial Banking and Private Banking again delivered record results, as did many of the businesses within Global Banking and Markets, including foreign exchange, payments and cash management, equities, HSBC Global Asset Management and securities services.
The deterioration in credit quality which began in 2006 in a particular portfolio of purchased mortgages in the US consumer finance business widened in the second half of 2007, leading to significantly increased loan impairment charges in the US as economic conditions deteriorated and global market liquidity for asset-backed securities dried up. This lack of liquidity adversely affected credit trading and asset-backed securities businesses within Global Banking and Markets, where de-leveraging of traded markets contributed to volatility and lower valuations. The effect of these factors was partially offset by a gain on HSBC’s own debt designated at fair value.
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Group performance by income and expense item
Net interest income
Reported net interest income of US$42.6 billion rose by 13 per cent compared with 2007, 13 per cent on an underlying basis.
Growth in net interest income was driven by significantly higher revenues in Balance Sheet Management, in part reflecting favourable positioning to take advantage of falling interest rates. Lending and deposit balances also grew strongly, while progressive reductions in central bank reference rates led to a decline in both asset yields and the cost of funds. Overall, spreads narrowed on an underlying basis.
Average interest-earning assets increased to US$1,467 billion, led by growth in average loans and advances to customers. This was mainly due to an increase in average term lending balances in Europe and Asia.
An increase in average interest-bearing liabilities was driven by growth in average customer accounts, notably in Europe. HSBC attracted substantial deposits from customers who valued HSBC’s perceived strength at a time of global financial market turmoil and customers also expressed a preference for security and liquidity following declines in equity markets.
Interest rates were cut aggressively in many countries during 2008, as central banks reduced their reference rates as part of stimulus programmes introduced in response to deteriorating economic conditions. This contributed to a decline in asset yields. The cost of funds also fell, but this was less significant than the decline in yields as spreads narrowed overall on an underlying basis.
In North America, net interest income was also adversely affected by rises in loan modifications designed to reduce the payment burden on the Group’s customers, and impaired loans.
Reported net interest income increased by 10 per cent to US$37.8 billion, 4 per cent on an underlying basis. The increase was driven by an underlying 10 per cent rise in average interest earning assets to US$1,297 billion, partly offset by a decline in spreads as funding costs rose more than yields.
The growth in average interest earning assets was due to a 6 per cent rise in average loans and advances to customers. HSBC continued to focus on competitive liability products, with average deposits and current account balances rising by 16 per cent, driven by customer acquisition in Rest of Asia-Pacific and deposit balance growth in North America, Europe and Hong Kong.
Balance Sheet Management revenues increased compared with 2006, particularly in Hong Kong and Rest of Asia-Pacific as deposits grew strongly.
Lending spreads in 2007 reflected the continued benign corporate and commercial credit conditions that have existed in the last three or four years. However, some upward re-pricing occurred in personal lending as a result of growing delinquency and restricted credit appetite and, as market liquidity diminished in the last four months of 2007, the value and cost of funds, including the cost of funding HSBC’s trading activities, rose markedly.
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Net fee income
Reported net fee income declined by 9 per cent to US$20 billion, 7 per cent lower on an underlying basis.
Lower equity market-related revenues, notably in Hong Kong, were driven by weakened investor sentiment, and reflected in the fall of 17 per cent in the aggregate of broking income, global custody and unit trust income. Similarly, fund management fees declined as equity markets retreated and lower performance fees were earned.
HSBC announced revisions to its credit card fee charging policies in the US in 2007, and this fed through as expected in the form of a substantial decline in overlimit fees, further compounded by lower cash advance and interchange fee income as a result of reduced volumes. In the UK, the divestment in 2008 of the card acquiring business resulted in reduced card acquiring fees. Offsetting these factors were rises in card fees in Hong Kong, the Middle East, India and Turkey.
Fee income from credit facilities rose, notably in the Middle East, in line with customer volumes. Growth in fee income from trade and supply chain products reflected higher volumes and customer acquisition in India and, to a greater extent in the Middle East, increased activity driven by commodity price inflation.
Reported net fee income increased by 28 per cent to US$22 billion, 23 per cent on an underlying basis.
The rise in card fee income was mainly in the US and Mexico. Income growth in the US was driven by higher late and over-limit fees in addition to higher balances. Revenue from enhancement services on cards also increased. In Mexico, the credit card business continued to grow, both in balances and in transaction volumes.
Higher income from funds under management products, broking services, unit trusts and global custody was driven by buoyant stock markets in Hong Kong and throughout the Rest of Asia-Pacific region, enhanced by the launch of new investment schemes.
Increased account services income was due to higher levels of customer activity in Europe, North America and Latin America. In the US, growth in credit card balances triggered an increased use of the Intellicheck service. In the UK, growth in the sale of fee-based packaged accounts contributed to a rise in account services fees.
An increase in insurance fees was driven by higher life insurance commission income, boosted by new product offerings in Hong Kong.
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Reported net trading income fell by 33 per cent to US$6.6 billion, 32 per cent lower on an underlying basis.
Net income from trading activities declined by 81 per cent, driven by the continuing effect of the market turmoil which led to US$5.4 billion of write-downs on legacy monoline credit exposures, credit trading and leveraged and acquisition finance loans. More information about the losses, the associated assets and residual exposure is provided in ‘Impact of Market Turmoil’ on pages 144 to 162.
Record foreign exchange trading income was due to increased customer volumes and market volatility across all regions, as investors sought to reduce risk in the second half of 2008, driving growth in global foreign exchange trading as demand for assets denominated in US dollars and Japanese Yen increased.
Rates trading income rose substantially, with record revenues in the first half of 2008 due to favourable positioning against movements in interest rate yield curves as central banks responded to the market turmoil by lowering short-term interest rates. Revenues were also boosted by an increased number of deals, widening spreads and increased customer demand for trading and hedging products.
The decline in equities trading income reflected weaker equity markets, particularly in Hong Kong, where demand for structured equity products fell. In addition, following the alleged fraud at Madoff Securities, HSBC wrote off the value of units it held in funds that had invested with the company and took a US$984 million charge. The units had been acquired in connection with various financing transactions HSBC had entered into with institutional clients.
The decline in non-qualifying hedges related to mark-to-market losses on cross-currency swaps as the US dollar appreciated and on interest rate swaps as interest rates fell in late 2008.
Widening credit spreads led to further gains on credit default swap transactions in parts of the Global Banking portfolio.
Reported net trading income increased by 20 per cent to US$9.8 billion, 13 per cent on an underlying basis.
Net interest income on trading activities more than doubled, mainly due to increased holdings of shorter maturity assets in the UK.
Net trading income was significantly affected by a total of US$2.1 billion of write-downs on credit trading, leveraged and acquisition financing positions, and monoline credit exposures, resulting from deterioration in the credit market in the second half of 2007. The write-downs arose mainly in the US and, to a lesser extent, the UK.
Income from foreign exchange trading increased by 40 per cent to a record result. Revenues were driven by higher customer volumes, against the backdrop of a weakening US dollar and greater market volatility.
Trading income from structured derivatives fell by 26 per cent. The structured credit business incurred losses in the second half of the year in the difficult trading conditions. This was partly offset by higher trading income from other structured derivative products, following investment made in technical expertise and systems in previous years.
Record results were achieved in the equities business, reflecting strong growth across all regions, particularly Europe.
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Net income from financial instruments designated at fair value
HSBC designates certain financial instruments at fair value to remove or reduce accounting mismatches in measurement or recognition, or where financial instruments are managed and their performance is evaluated together on a fair value basis. All income and expense from financial instruments designated at fair value are included in this line except for interest arising from HSBC’s issued debt securities and related derivatives managed in conjunction with those debt securities, which is recognised in ‘Interest expense’.
HSBC principally uses the fair value designation in the following instances:
for certain fixed-rate long-term debt issues whose rate profile has been changed to floating through interest rate swaps as part of a documented interest rate management strategy.Approximately US$59 billion (2007:US$66 billion) of the Group’s debt issues have been accounted for using the fair value option.
The movement in fair value of these debt issues includes the effect of own credit spread changes and any ineffectiveness in the economic relationship between the related swaps andown debt. As credit spreads widen or narrow, accounting profits or losses are booked, respectively. The size and direction of the accounting consequences of changes in own credit spread and ineffectiveness can be volatile from year to year, but do not alter the cash flows envisaged as part of the documented interest rate management strategy; as a consequence of this, gains and losses arising from changes in own credit spread on long-term debt are not regarded internally as part of managerial performance. Similarly, such gains and losses are ignored in the calculation of regulatory capital.
Reported net income from financial instruments designated at fair value decreased by US$231 million to US$3.9 billion in 2008.
Credit spreads widened significantly during the year, leading to US$6.6 billion of positive fair value movements on certain long-term debt issued by the Group, compared with US$3.1 billion in 2007. These fair value movements will fully reverse over the life of the debt. The cumulative fair value adjustment at 31 December 2008 amounted to US$8.0 billion.
A negative movement of US$5.1 billion was recorded in the fair value of assets held to back insurance and investment contracts, compared with a positive movement of US$2.1 billion in 2007. This reflected investment losses driven by falling equity and bond markets, predominantly affecting the value of assets held in unit-linked and participating funds in Hong Kong, France and the UK. The negative movement in fair value is partially offset by a corresponding reduction in ‘Net insurance claims and movement in liabilities to policyholders’, where unit-linked policyholders in particular participate in the investment performance experienced on the investment portfolios held to support the liabilities.
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For assets held to meet liabilities under investment contracts the corresponding reduction in the liability to customers is also reported within net income from financial instruments designated at fair value. A reduction of US$1.8 billion in the movement in fair value of liabilities held under investment contracts compared with an increase in the fair value of liabilities of US$940 million in 2007.
Credit spreads widened significantly in the second half of 2007, leading to a substantial increase in net income from financial instruments designated at fair value compared with 2006. This was primarily driven by a widening in credit spreads on certain fixed-rate long-term debt issued by HSBC Holdings
and its subsidiaries. These cumulative gains will fully reverse over the life of the debt. The cumulative adjustments to reserves (when the policy is applied for the first time) and the income statement (subsequent applications of the policy), reflecting the change in own credit spread since the fair value option was available, was US$1.6 billion after taking into account the US$3.1 billion credit in 2007.
Income from assets held to meet liabilities under insurance and investment contracts also rose, by 32 per cent, reflecting primarily premium growth and higher investment returns on the portfolios held by the insurance businesses in the UK and Hong Kong. The change in fair value of liabilities under investment contracts declined by 7 per cent.
Gains less losses from financial investments
2008 compared 2007
Reported gains less losses of US$197 million from financial investments during 2008 were 90 per cent lower than in 2007, 93 per cent lower on an underlying basis. A reduction in net gains from disposals was compounded by significant impairments recognised on equity securities held in the available-for-sale portfolio as certain investments were marked down to reflect the prevailing market conditions.
The redemption of Visa Inc. (‘Visa’) shares following its IPO resulted in significant gains, and there were further gains from the sale of MasterCard Inc. (‘MasterCard’) shares. These were more than offset by losses in Principal Investments and the non-recurrence of various significant gains in 2007, mostly in respect of Euronext, the European stock exchange, and a credit bureau in Brazil.
Declining equity markets caused impairments to be recognised against a number of strategic investments in Asia, held in the available-for-sale portfolio and on private equity investments, mainly in Europe. The market turmoil in the US also led to impairments against investments in various US financial institutions.
Net gains of US$2.0 billion were reported by HSBC as a result of the disposal of financial investments during 2007, a two-fold increase over 2006 and 93 per cent higher on an underlying basis.
The increase was driven by the sale of shares and various equity investments in all regions, including holdings in Euronext (the European stock exchange), MasterCard in North America and a credit bureau in Brazil. In Private Banking, a gain of US$91 million arose from the sale of a further holding in the Hermitage Fund, compared with US$117 million in 2006. The gains in 2007 were marginally offset by the non-recurrence of a US$101 million gain on the sale of part of HSBC’s stake in UTI Bank Limited in 2006.
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Gains arising from dilution of interests in associates
In 2007, HSBC’s associates, Industrial Bank, Ping An Insurance and Bank of Communications in mainland China, Financiera Independencia in Mexico and Techcombank in Vietnam issued new shares for which HSBC did not subscribe. As a
Net earned insurance premiums
consequence of the new monies raised by the associates, HSBC’s share of their underlying assets increased by US$1.1 billion, notwithstanding the reduction in the Group’s interests. These gains were presented in the income statement as ‘Gains arising from dilution of interests in associates’, and should be regarded as exceptional.
Reported net earned insurance premiums amounted to US$10.9 billion, 20 per cent higher than in 2007. HSBC acquired the remaining interest in HSBC Assurances in France in March 2007 and, in October 2007, sold the Hamilton Insurance Company Limited and Hamilton Life Assurance Company Limited in the UK. On an underlying basis, net earned insurance premiums increased by 14 per cent.
Growth in net earned insurance premiums was driven by a continued strong performance from the UK life assurance business, mainly as a result of higher sales of the Guaranteed Income Bond, a non-linked product that was launched in June 2007. The introduction of enhanced life assurance benefits to certain pension products, which led to these products being reclassified as insurance contracts, also resulted in higher premiums.
The Hong Kong insurance business also performed well with respect to premium growth, due to stronger sales of products with discretionary participation features (‘DPF’) and an increase in regular premiums partly offset by a reduction in unit-linked premiums.
In France, HSBC Assurances performed well in a declining market, as three promotional campaigns during the year contributed to growth in sales of policies with DPF. However, a significant one-off reinsurance transaction undertaken during 2008 caused net earned insurance premiums to decrease compared with 2007.
Reported net earned insurance premiums of US$9.1 billion were 60 per cent higher than in 2006, boosted by HSBC’s acquisition in the first half of 2007 of the remaining shares in HSBC Assurances in France and the purchase of HSBC Bank Panama in Central America in late 2006. Underlying net insurance premiums grew by 21 per cent.
Growth in net earned insurance premiums was achieved in all regions except North America, primarily from new business growth in the life insurance business in Europe, Hong Kong and Latin America. An increase in net earned premiums was recorded in the UK due to higher sales of Guaranteed Income Bonds and the introduction of enhanced death benefits to pension contracts. New product launches also aided growth in Hong Kong. In Latin America, higher premiums in Brazil were driven by increased sales of pension products with linked-life policies.
In non-life insurance, the UK benefited from a decision to reduce the proportion of risk and corresponding premiums ceded to reinsurers compared with 2006. The Latin American business also performed well, led by growth in motor premiums in Argentina. However, results in North America declined, as a reduction in loan volumes led to a fall in credit insurance sales and HSBC stopped reinsuring credit insurance for other lenders.
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Other operating income
Reported other operating income of US$1.8 billion was 26 per cent higher than in 2007. This included gains of US$425 million on the sale of the card merchant acquiring business in the UK and US$71 million on the sale of HSBC’s entire stake in Financiera Independencia, a Mexican consumer lending company. On an underlying basis, other operating income fell by 23 per cent.
The difficult property market conditions in the UK led to a loss in value of a property fund, lower income from the sale of property fund assets and a reduction in Group real estate disposals in 2008. Similarly, in Hong Kong revaluation gains on investment properties did not recur.
Life assurance enhancements to pension products resulted in increased present value of in-force long-term insurance (‘PVIF’) business, which also benefited from the non-recurrence of regulatory changes in 2007 in the UK.
During 2008, HSBC recognised a gain of US$416 million in respect of the purchase of the subsidiary of Metrovacesa which owned the property and long leasehold comprising 8 Canada Square, London. See Note 23 on the Financial Statements.
Other operating income declined, driven by losses on sale of the Canadian vehicle finance business and other loan portfolios in 2008, in addition to the non-recurrence of gains on disposal of fixed assets and private equity investments in 2007.
Reported other operating income of US$1.4 billion was 43 per cent lower than in 2006, 51 per cent lower on an underlying basis.
Significant decreases in gain on disposal of property and other income were driven by lower proceeds from the sale of real estate in the declining US property market. This was compounded by the non-recurrence of income earned on asset disposals in 2006, including the sale of the former head office building of Hang Seng Bank in Hong Kong and properties in Japan and India, and the transfer of the credit card acquiring business into a joint venture with Global Payments Inc. A gain on the sale and leaseback of a London building in 2007 and the non-recurrence of a loss on sale on asset disposals in 2006 partially offset these factors.
Although HSBC sold its Canary Wharf headquarters building at 8 Canada Square in 2007, the gain remained unrecognised as the Group continued to provide bridge finance for the debt portion of the transaction.
PVIF business declined, primarily due to a change in the calculation methodology employed in the UK as HSBC implemented regulatory changes to the rules governing the calculation of insurance liabilities. This had a marginally positive effect on profit as there was a corresponding reduction in policyholder liabilities. Income rose in Mexico due to a refinement of the income recognition methodology in respect of long-term insurance contracts.
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Net insurance claims incurred and movement in liabilities to policyholders
Reported net insurance claims incurred and movement in liabilities to policyholders decreased by 20 per cent to US$6.9 billion. HSBC acquired the remaining interest in HSBC Assurances in France in March 2007 and, in October 2007, sold the Hamilton Insurance Company Limited and Hamilton Life Assurance Company Limited in the UK. On an underlying basis, net insurance claims incurred and movement in liabilities to policyholders fell by 22 per cent.
The reduction in net insurance claims incurred and movement in liabilities to policyholders primarily reflected the impact of markedly weaker investment markets worldwide. This led to a reduction in liabilities to policyholders on unit-linked and, to a certain extent, participating policies where policyholders participate in the investment performance of the assets supporting the liabilities. As noted above, the losses experienced on the assets held to support insurance contract liabilities are reported in ‘Net income from financial instruments designated at fair value’.
The decline arising from market value movements was partially offset by an increase in claims incurred and movement in liabilities to policyholders driven by new business growth, most significantly in France, the UK and Hong Kong. In addition, 2007 was affected by the implementation of an FSA regulatory change, which led to lower gross liability valuations in that year, along with a reduction in the corresponding reinsurers’ share.
A significant increase in the reinsurers’ share of claims incurred and movement in liabilities to policyholders was primarily driven by the above regulatory change plus an increase in a reserve provision on a unit-linked product in Hong Kong, which was fully reinsured. In addition, a significant one-off reinsurance transaction was undertaken in France during 2008.
Reported net insurance claims incurred and movement in liabilities to policyholders of US$8.6 billion were 83 per cent higher than in 2006 following the acquisition of the remaining shares in HSBC Assurances in France in March 2007 and HSBC Bank Panama in late 2006. The increase was 32 per cent on an underlying basis.
Growth in net insurance claims incurred and movement in liabilities to policyholders was largely driven by the life insurance business. This reflected a combination of business growth, and was in line with higher net earned insurance premiums and, where policyholders participate in the investment performance of the assets supporting the liabilities, higher investment returns on unit-linked and participating policies. This was most notable in Hong Kong, the UK and Brazil. There was an offsetting increase in ‘Net income from financial instruments designated at fair value’ which reflected these investment returns. In addition, FSA rule changes in the UK led to a lower valuation of the liabilities to policyholders on life policies.
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Loan impairment charges and other credit risk provisions
Reported loan impairment charges and other credit risk provisions were US$24.9 billion in 2008, an increase of 45 per cent over 2007, 46 per cent on an underlying basis.
A deterioration in credit quality was experienced across all customer groups and geographical regions as the global economy slowed. The rise in Group loan impairment charges and other credit risk provisions also reflected an underlying 8 per cent increase in lending to customers (excluding the financial sector and settlement accounts).
Loan impairment charges rose significantly in the US by 38 per cent to US$16.3 billion, due to credit quality deterioration across all US portfolios in Personal Financial Services.
In the US consumer lending portfolio, loan impairment charges rose as delinquency rates deteriorated sharply and the economy declined markedly in the second half of 2008, most notably in the first lien portfolio. This was particularly apparent in the geographical regions most affected by house price depreciation and rising unemployment rates. In mortgage services, loan impairment charges rose as 2005 and 2006 vintages matured and moved into the later stages of delinquency. This was partly offset by the benefit of lower balances as run-off continued, albeit at a slowing pace as house price depreciation restricted refinancing options for customers. In HSBC USA, loan impairment charges rose as credit quality worsened across the real estate secured portfolio and private label cards. Delinquencies rose
in the prime first lien residential mortgage portfolio, Home Equity Line of Credit and Home Equity Loan second lien portfolios. The higher delinquency rate for prime first lien mortgages was in part due to lower balances following US$7.0 billion of portfolio sales during the year.
Loan impairment charges in the US card and retail services portfolios rose, again driven by increasing unemployment, portfolio seasoning, higher levels of personal bankruptcy filings and continued weakness in the US economy which was most apparent in regions with the most significant declines in house prices and rising unemployment.
Loan impairment charges in Commercial Banking in North America more than doubled from a low base in 2007, due to deterioration across the commercial real estate, middle market and corporate banking portfolios in the US and, to a lesser extent, higher loan impairment charges against firms in the manufacturing, export and commercial real estate sectors in Canada.
In the UK, a modest decline in loan impairment charges in Personal Financial Services reflected the non-recurrence of a methodology change at HFC in 2007 which resulted in higher impairment charges. Credit quality in the Personal Financial Services portfolio remained broadly stable, reflecting early risk mitigation through the tightening of lending controls and the sale of non-core credit card portfolios during the year. Credit quality in the unsecured portfolios deteriorated slightly in 2008, particularly in the second half of the year, due to the weakening UK economy. Loan impairment charges in the commercial portfolio rose in 2008 as the
34
weakening property market led to higher impairment charges against construction companies and businesses dependent upon the real estate sector, particularly in the final quarter of the year. Impairment charges against banks rose due to some exposure to the Icelandic banks in 2008. In addition, rising levels of personal indebtedness resulted in lower releases and recoveries of charges than in 2007.
Higher loan impairment and other credit risk provisions within Global Banking and Markets in Europe reflected increased charges against certain corporate accounts and impairment recorded on available-for-sale debt securities.
In Mexico, loan impairment charges rose by US$513 million or 69 per cent, primarily in the credit card portfolio. This was due to a combination of higher lending volumes from organic expansion and higher delinquency rates which were driven by a deterioration in credit quality as the portfolio continued to season and move into the later stages of delinquency. Management took action to enhance collection activity and improve the quality of new business. Impairment charges in the commercial portfolio also rose due to credit quality deterioration among small and medium-sized enterprises as the economy weakened.
In Hong Kong, the rise in loan impairment charges was driven by weakness in parts of the export sector within the commercial portfolio in the second half of 2008. In Global Banking and Markets, credit impairment charges within Balance Sheet Management principally reflected losses on debt securities and paper issued by financial institutions previously rated at investment grade which failed in the year.
In Rest of Asia-Pacific, the growth in loan impairment charges reflected a combination of the expansion of consumer lending and credit quality deterioration in India and the Middle East. In addition, higher impairment charges in Commercial Banking were driven by a deterioration in credit quality in the second half of the year.
For the Group as a whole, the aggregate outstanding customer loan impairment allowances at 31 December 2008 of US$23.9 billion represented 2.6 per cent of gross customer advances (net of reverse repos and settlement accounts), compared with 2.0 per cent at the end of 2007.
Reported loan impairment charges and other credit risk provisions were US$17.2 billion, a 63 per cent increase over 2006.
Loan impairment charges increased by 58 per cent, reflecting substantially higher losses in the US consumer finance loan book, primarily in mortgage lending, but also in the credit cards portfolio in the final part of the year. US delinquency rates increased during 2007 as falling house prices constrained customers’ ability to refinance their loans.
The rise in Group charges also reflected an underlying 7 per cent increase in lending to customers (excluding lending to the financial sector and settlement accounts).
In North America, loan impairment charges increased by 79 per cent to US$12.2 billion. The main factor driving this deterioration was the impact of the weaker housing market on both economic activity and the ability of borrowers to extend or refinance debt. In addition, seasoning and mix change within the credit cards portfolio, and increases in bankruptcy filings after the exceptionally low levels seen in 2006 following changes in legislation, added to loan impairment charges.
The real estate secured portfolios experienced continuing deterioration in credit quality as a lack of demand for securitised sub-prime mortgages and falls in house prices severely restricted refinancing options for many customers. Loan impairment charges rose by 41 per cent to US$3.1 billion and by 139 per cent to US$4.1 billion in the mortgage services business and in consumer lending, respectively. Delinquency rates exceeded recent historical trends, particularly for those loans originated in 2005 and 2006. Performance was weakest in housing markets which had previously experienced the steepest home price appreciation, as well as in second lien products and stated income products.
US card services experienced an increase in loan impairment charges from a combination of growth in balances, higher losses in the final part of the year as the economy slowed, a rise in bankruptcy rates to near historical levels, and a shift in portfolio mix to higher levels of non-prime loans.
In the UK, loan impairment charges rose, primarily in the consumer finance business. Delinquency rates on mortgages in the UK offered through HSBC Finance remained stable throughout 2007, with delinquency rates for loans offered in 2006 and 2007 lower than in the preceding two
35
years. In the rest of the UK business, loan impairment charges in the second half of 2007 were lower than in the first half of the year, as overall credit quality improved following measures taken to tighten underwriting standards and improve the credit quality of new business. Although losses from mortgage lending remained low, maximum loan to value ratios were reduced during the year to mitigate the effects of a possible housing market downturn.
In Mexico, higher loan impairment charges were driven by strong growth in loan balances, a deterioration in credit quality and portfolio seasoning.
For the Group as a whole, the aggregate outstanding customer loan impairment allowances at 31 December 2007 of US$19.2 billion represented 2.0 per cent of gross customer advances (net of reverse repos and settlement accounts), compared with 1.6 per cent at the end of 2006.
Impaired loans to customers were US$18.3 billion at 31 December 2007 compared with US$13.8 billion at 31 December 2006. On a constant currency basis, impaired loans to customers were 28 per cent higher than in 2006 compared with customer lending growth (excluding loans to the financial sector and settlement accounts) of 7 per cent.
Operating expenses
Reported operating expenses increased by US$10.1 billion to US$49.1 billion, due to an impairment charge of US$10.6 billion to fully write off goodwill in Personal Financial Services in North America. Excluding this, operating expenses remained broadly in line on both reported and underlying bases.
Employee compensation and benefits fell marginally. Lower discretionary bonuses reflected weaker performance in the current economic conditions. A review of actuarial assumptions on employees’ defined benefit pensions resulted in lower service costs in the UK. The restructuring of the consumer finance business in North America led to reduced headcount and lower costs. This was partially offset by higher salaries and increased
headcount to support business expansion, mainly in Asia. Restructuring costs were incurred primarily in Latin America and Europe.
Premises and equipment costs increased primarily in the UK and the Rest of Asia-Pacific region, driven by investment in technology and extensions and improvements to the branch and ATM networks. As a consequence, repairs and maintenance costs rose. Commercial property rental costs also increased as a result of higher prices, new rentals and sale and leaseback deals.
General and administrative expenses decreased, primarily due to a one-off recovery of US$110 million of previous years’ transactional taxes in Brazil and the non-recurrence of a number of one-off items in 2007, most notably (i) ex-gratia payments made in the UK in respect of overdraft
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fees, (ii) the provision for reimbursement of certain charges on historic will trusts and other related services in the UK, (iii) the indemnification agreement with Visa ahead of Visa’s IPO, and (iv) restructuring charges in the US consumer finance business incurred in 2007. These were partly offset by an increase in the Financial Services compensation scheme levy in the UK and an increase in a litigation provision in Asia.
Goodwill impairment amounting to US$10.6 billion was booked following the continued deterioration in economic and credit conditions in North America. For further information see Note 22 on the Financial Statements.
Reported operating expenses increased by US$5.5 billion to US$39.0 billion. On an underlying basis, cost growth was 10 per cent.
Employee compensation and benefits rose due to increased headcount employed to support business expansion in Rest of Asia-Pacific and Europe and higher salaries and bonuses. Salary increases reflected inflationary pressures and performance as bonuses rose in response to revenue growth. A change in actuarial assumptions regarding the staff defined benefit pension scheme in the UK led to increased costs. Staff numbers in North America fell as the consumer finance business was restructured, resulting in the discontinuation of certain business channels in mortgage services and the closing of branch offices in consumer lending.
Premises and equipment costs increased on investments in technology, straight-through
processing and extending and improving the branch and ATM networks. In particular, there was investment in the distribution platform in Latin America, Middle East, India and mainland China. The retail bank branch network in North America was extended both within and beyond the Group’s traditional spheres of operation to support the expansion of retail and Commercial Banking businesses, increasing premises and equipment costs as a consequence. Commercial property rental costs rose in Hong Kong’s dynamic economy, the effect magnified by a sale and leaseback agreement on a headquarters building in 2006. In France, the IT systems inherited with the acquisition of HSBC France were replaced with HSBC’s universal banking platform.
General and administrative expenses rose in support of the business expansion and a number of one-off costs. Higher transaction volumes drove processing costs and transactional taxes while business expansion was supported by marketing expenditure. In the UK, ex-gratia payments of US$227 million were expensed in respect of overdraft fees applied in previous years and a provision of US$169 million was raised for reimbursement of certain charges on historic will trusts and other related services. In the US, the business incurred US$70 million of one-off costs arising from the indemnification agreement with Visa ahead of its planned IPO. The US consumer finance business incurred restructuring charges of US$103 million resulting from the discontinuation of the wholesale and correspondent channels in mortgage services and the closing of branch offices in consumer lending.
Cost efficiency ratios
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Share of profit in associates and joint ventures
Share of profit in associates and joint ventures was US$1.7 billion, an increase of 11 per cent compared with 2007, and 4 per cent on an underlying basis.
This increase was driven by higher contributions from Bank of Communications, Industrial Bank, and The Saudi British Bank, partly offset by lower profits from Ping An Insurance.
HSBC’s share of profits from the Bank of Communications rose by 52 per cent to US$741 million, primarily driven by increased margins, as yields rose following higher base rates in mainland China through most of 2008, and balance sheet growth. Growth in revenues from the asset custody business, financial advisory services and bank card transactions also drove higher profits.
HSBC’s share of profits from Ping An Insurance decreased by 43 per cent, primarily due to the impairment of Ping An Insurance’s investment in Fortis SA/NV and Fortis N.V. (‘Fortis Investments’), following significant declines in its market value.
Profits from the Saudi British Bank were higher by 16 per cent due to strong balance sheet growth, particularly in the lending portfolio, augmented by higher fees from cards, account services and trade.
Profits from Industrial Bank grew by 72 per cent, driven by increased investment income and balance sheet growth.
The share of profits from joint ventures rose due to growth in HSBC Saudi Arabia Ltd and the recognition of profits in HSBC Merchant Services UK Ltd, the new merchant acquiring venture with Global Payments Inc.
An adjustment to the embedded value of HSBC Assurances in 2007 did not recur.
Share of profit in associates and joint ventures of US$1.5 billion was 78 per cent higher than in 2006, on both reported and underlying bases.
Profit from associates and joint ventures rose due to increased contributions from HSBC’s strategic investments in mainland China. Profit from Bank of Communications, Ping An Insurance and Industrial Bank improved significantly, driven largely by the thriving local economy.
HSBC’s share of profit from Ping An Insurance rose by 101 per cent to US$518 million as a result of robust growth, notably from life insurance products, and the realisation of synergistic gains across Ping An Insurance’s other business offerings.
Profit from the Bank of Communications rose by 64 per cent to US$445 million as a result of improved performance across the associate’s various product offerings. Increased income from credit and treasury products and significant growth in fee income contributed to the increase in profits.
HSBC’s share of profits from the Saudi British Bank decreased by 22 per cent to US$216 million, driven by the effects of a significant correction to the local stock market in the second half of 2006.
A US$73 million adjustment to the embedded value of HSBC Assurances, an associate in France, resulted in an increase in profits from associates.
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Economic profit
HSBC’s internal performance measures include economic profit, a calculation which compares the return on financial capital invested in HSBC by its shareholders with the cost of that capital. HSBC prices its cost of capital internally and the difference between that cost and the post-tax profit attributable to ordinary shareholders (less goodwill previously amortised in respect of the French regional banks sold in 2008) represents the amount of economic profit generated. Economic profit generated is used by management as a means of deciding where to allocate resources so that they will be most productive.
In order to concentrate on external factors rather than measurement bases, HSBC emphasises the trend in economic profit ahead of absolute amounts within business units. In order to ensure consistency and comparability with the five-year strategic plan completed in 2008, the cost of capital on a consolidated basis remains at 10 per cent.
Economic profit decreased by US$14.8 billion to a loss of US$8.2 billion. Profit attributable fell, while average shareholders’ equity increased marginally. The decline in profit was predominately driven by the US$10.6 billion goodwill impairment charge relating to the North American Personal Financial Services business, alongside a significant increase in loan impairment charges and write-downs in credit trading, leveraged and acquisition finance, and monoline exposures. The comparative period included dilution gains of US$1.0 billion (excluding minority interests) which were not repeated. These effects were partially offset by fair value gains on own debt, driven by a widening of credit spreads, of US$6.6 billion compared with US$3.1 billion in 2007. The lower return on average invested capital led to a decrease in economic profit and an erosion in economic spread, which fell by 11.3 percentage points compared with 2007. Excluding the goodwill impairment charge, the economic profit spread decreased by 3.6 percentage points compared with 2007.
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Balance sheet
A more detailed consolidated balance sheet is contained in the Financial Statements on page 334.
Movement from 31 December 2007 to 31 December 2008
Total assets amounted to US$2.5 trillion, 7 per cent higher than at 31 December 2007. After excluding currency movements, the disposal of HSBC’s French regional subsidiaries and the acquisition of the assets, liabilities and operations of The Chinese Bank in 2008, underlying assets rose by 22 per cent, driven by growth in derivative assets.
The expansion in the Group’s balance sheet was largely attributable to increases in derivative assets and liabilities, and was due to growth in the fair value of these positions rather than a rise in their notional contract amounts. Excluding the growth in derivative liabilities, customer accounts formed an increasing share of the Group’s liabilities as depositors and savers responded to HSBC’s reputation for strength and security. As a result, a proportion of the Group’s funding repayable on demand or within one year rose. For information on the Group’s management of liquidity, see pages 235 to 240.
The Group’s tier 1 capital ratio declined from 9.3 per cent to 8.3 per cent. For detail on regulatory capital and risk weighted assets, see pages 274 to 280.
The following commentary is on an underlying basis.
Assets
The Group’s cash and balances at central banks rose substantially, particularly in Hong Kong as additional liquidity was injected into the banking system, and in the US where excess liquidity was required in the short-term as part of a planned transfer of assets between the Group’s subsidiaries.
Trading assets increased by 11 per cent. The majority of the rise occurred on 30 September 2008, following the Group’s consolidation of five Constant Net Asset Value (‘CNAV’) funds with assets of around US$40 billion. The decision to consolidate these funds was based on actions taken to support them. For further details of these actions, see page 180. The rise was partly offset by the reclassification of US$18 billion of trading assets
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partly to ‘Loans and Advances’ and partly to ‘Financial investments’ following the changes to International Accounting Standard 39 – ‘Financial Instruments – Recognition and Measurement’ (‘IAS39’) issued in October 2008 by the IASB.
Excluding these effects, trading assets remained broadly unchanged as rises in Europe and Asia, where the Group increased its holdings of government bonds, were offset by the run-off of the mortgage-backed securities portfolio in the US and a reduction in debt securities held for balance sheet management purposes due to changes in liquidity and risk preference.
An 18 per cent decline in financial assets designated at fair value was driven by falling equity markets, which reduced the value of assets held to meet life insurance liabilities, particularly in Hong Kong and France. To the extent that these liabilities related to unit-linked and participating insurance contracts, there was a corresponding decline inliabilities under insurance contracts. The underperformance of certain investment products also led clients to withdraw funds.
Derivative assets rose significantly, led by an increase in interest rate derivatives with further growth in credit and foreign exchange derivatives. The global falls in interest rates resulted in significant gaps between the fixed and floating legs of interest rate swaps, leading to substantial mark-to-market increases in the value of interest rate swap positions. Widening credit spreads and increasing market volatility caused mark-to-market increases in the value of credit derivatives held in the UK and the US. Foreign exchange derivative asset growth was driven by a combination of increased volumes and mark-to-market rises in existing positions in the UK. Under IFRS, only limited netting is allowed between derivative assets and liabilities with the same counterparty, and the balance sheet value is therefore significantly higher than the credit exposure. For information on maximum exposure to credit risk, see pages 197 to 200.
A 29 per cent decline in loans and advances to banks occurred mainly in Hong Kong and the UK where Balance Sheet Management invested a greater proportion of its assets in government and government-guaranteed debt.
HSBC also reduced counterparty credit risk in the UK by channelling an increasing proportion of lending to banks through the London Clearing House in the form of reverse repos. This is recorded within customer loans even when the end counterparty is a bank, which means the fall in loans and advances to banks and the rise in loans and advances to
customers are magnified. The rise in loans and advances to customers was also inflated by the reclassification of US$15 billion of assets following changes to IAS39 isused in October 2008.
Further increases in loans and advances to customers were due to growth in mortgage lending in Europe and Asia, as well as to a rise in overdraft balances to customers whose exposures are managed net but reported gross under IFRS. These rises were offset by a reduction in customer lending in the US due to the run-off of the mortgage services portfolio, the sale of certain loan portfolios at HSBC USA, tighter underwriting criteria which restricted originations in the consumer lending and credit card portfolios, and the cessation of most new originations in the US vehicle finance portfolio.
Financial investments grew by 15 per cent as Balance Sheet Management assets were increasingly classified as available-for-sale financial investments rather than trading assets. As noted above, there was also a rise in financial investments in the UK as the Group placed a greater proportion of surplus funds in government issued or guaranteed debt. The growth in the Group’s financial investments was partly offset by a reduction in holdings of asset-backed securities, including those held through special purpose entities, which decreased due to a combination of asset sales, amortisation and write-downs. For details of the Group’s asset-backed securities portfolios, see pages 145 to 158.
Liabilities
Deposits by banks rose by 14 per cent, driven, in particular, by increases in France, due to a rise in repo activity to finance increased trading activity, and in Hong Kong, where banks responded to HSBC’s reputation for strength and security and deposited their surplus liquidity with the Group.
Customer account balances grew by 16 per cent, driven by strong inflows from customers attracted by HSBC’s relative financial strength as they withdrew funds from more volatile investments.
Trading liabilities declined 9 per cent as a fall in third-party funding requirements allowed a reduction in liabilities in Hong Kong, and repo transactions were reduced in Europe to manage liquidity and counterparty credit risk.
A significant widening of credit spreads led to further falls in the fair value of the Group’s own debt which reduced financial liabilities designated at fair value. This was compounded by a decline in liabilities in the UK due to the underperformance of certain investment products.
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Derivative businesses are managed within market risk limits, and as a consequence the value of derivative liabilities broadly matched the value of derivative assets.
A decline of 22 per cent in debt securities in issue was driven by the US as maturing debt securities did not need replacing as the funding requirements of the consumer finance business declined as its balance sheet contracted. There was also a reduction in debt securities in issue in line with the decrease in holdings of asset-backed securities.
Liabilities under insurance contracts increased by 10 per cent, largely due to new business sales in Hong Kong, France and the UK, partly offset by reduced liabilities on unit-linked policies.
Other liabilities rose by 50 per cent due to the consolidation of the CNAV funds described above.
Equity
Total shareholders’ equity declined by 19 per cent, which mainly arose from a decline in the available-for-sale reserve. The continuing market turmoil led to falls in the market values of assets held in HSBC’s available-for-sale portfolio. These declines mainly represented market illiquidity rather than impairment of the assets concerned, but they nonetheless reduced the value of the available-for-sale reserve from a positive reserve of US$0.9 billion to a negative reserve of US$20.6 billion.
Average balance sheet and net interest income
Average balances and related interest are shown for the domestic operations of HSBC’s principal commercial banks by geographical region. ‘Other operations’ comprise the operations of the principal Commercial Banking and consumer finance entities outside their domestic markets and all other banking operations, including investment banking balances and transactions.
Average balances are based on daily averages for the principal areas of HSBC’s banking activities with monthly or less frequent averages used elsewhere.
Balances and transactions with fellow subsidiaries are reported gross in the principal Commercial Banking and consumer finance entities within ‘Other interest-earning assets’ and ‘Other interest-bearing liabilities’ as appropriate and the elimination entries are included within ‘Other operations’ in those two categories.
Net interest margin numbers are calculated by dividing net interest income as reported in the income statement by the average interest-earning assets from which interest income is reported within the ‘Net interest income’ line of the income statement. Interest income and interest expense arising from trading assets and liabilities and the funding thereof is included within ‘Net trading income’ in the income statement.
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43
Assets (continued)
44
45
Total equity and liabilities
46
47
Total equity and liabilities (continued)
48
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Analysis of changes in net interest income
The following table allocates changes in net interest income between volume and rate for 2008 compared with 2007, and for 2007 compared with 2006.
Interest income
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Interest expense (continued)
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Share capital and reserves
Authorised share capital
The authorised share capital of HSBC Holdings at 31 December 2008 was US$7,500,100,000 divided into 15,000 million ordinary shares of US$0.50 each and 10 million non-cumulative preference shares of US$0.01 each; £401,500 divided into 10 million non-cumulative preference shares of £0.01 each and 301,500 non-voting deferred shares of £1 each; and €100,000 divided into 10 million non-cumulative preference shares of €0.01 each.
The percentage of the total authorised share capital of HSBC Holdings at 31 December 2008 represented by the numbers of ordinary shares of US$0.50 each, non-cumulative preference shares of £0.01 each, non-cumulative preference shares of US$0.01 each, non-cumulative preference shares of €0.01 each and non-voting deferred shares of £1 each was approximately 99.9890, 0.0019, 0.0013, 0.0019 and 0.0059 per cent respectively.
Issued share capital
The issued share capital of HSBC Holdings at 31 December 2008 was US$6,052,647,041 divided into 12,105,265,082 ordinary shares of US$0.50 each and 1,450,000 non-cumulative preference shares of US$0.01 each; and £301,500 comprising 301,500 non-voting deferred shares of £1 each.
The percentage of the total issued share capital of HSBC Holdings at 31 December 2008 represented by the ordinary shares of US$0.50 each, non-cumulative preference shares of US$0.01 each and non-voting deferred shares of £1 each was approximately 99.9925, 0.0002, and 0.0073 per cent respectively.
Rights and obligations attaching to shares
The rights and obligations attaching to each class of share in the authorised share capital of HSBC Holdings are set out in the Articles of Association of HSBC Holdings. Set out below is a summary of the rights and obligations attaching to each class of shares with respect to voting, dividends, capital and, in the case of the preference shares, redemption.
To be registered, a transfer of shares must be in relation to a share which is fully paid up and on which the Company has no lien and to one class of shares denominated in the same currency. The transfer must be in favour of a single transferee or no more than four joint transferees and it must be duly stamped (if required). The transfer must be delivered to the registered office of the Company or to its
Registrars accompanied by the certificate to which it relates or such other evidence that proves the title of the transferor.
If a shareholder or any person appearing to be interested in the Company’s shares has been sent a notice under section 793 of the Companies Act 2006 (which confers upon public companies the power to require information from any person whom the Company knows or has reasonable cause to believe to be interested in the shares) and has failed in relation to any shares (the ‘default shares’) to supply the information requested within the period set out in the notice, then the member is not entitled to be present at or to vote the default shares at any general meeting or to exercise any other right conferred by being a shareholder. If the default shares represent at least 0.25 per cent in nominal value of the issued shares of that class any dividend shall be withheld by the Company, without interest and no election for the scrip dividend alternative may be made. No transfer of any shares held by the member will be registered, except in limited circumstances.
Ordinary shares
Subject to the Companies Act 2006 and the Articles of Association of HSBC Holdings, in a general meeting of HSBC Holdings, every holder of ordinary shares who is present in person or by proxy shall on a show of hands have one vote and every holder of ordinary shares present in person or by proxy shall on a poll have one vote for every share he or she holds. Where any shareholder is, under the rules governing the listing of securities on any stock exchange on which all or any shares of HSBC Holdings are for the time being listed or traded, required to abstain from voting on any particular resolution or restricted to voting only for or only against any particular resolution, any votes cast by or on behalf of such holder in contravention of such requirement or restriction will not be counted.
Subject to the Companies Act 2006 and the Articles of Association of HSBC Holdings, HSBC Holdings may, by ordinary resolution, declare dividends to be paid to the holders of ordinary shares, however, no dividend shall exceed the amount recommended by the Board. The Board may pay interim dividends as appears to the Board to be justified by the profits of HSBC Holdings available for distribution. All dividends shall be apportioned and paid proportionately to the percentage of the nominal amount paid up on the shares during any portion or portions of the period in respect of which the dividend is paid, but if any share is issued on terms providing that it shall rank for dividend as from a particular date, it shall rank for dividend
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accordingly. Subject to the Articles of Association of HSBC Holdings, the Board may, with the prior authority of an ordinary resolution of HSBC Holdings and subject to such terms and conditions as the Board may determine, offer to any holders of ordinary shares the right to elect to receive ordinary shares of the same or a different currency, credited as fully paid, instead of cash in any currency in respect of the whole (or some part, to be determined by the Board) of any dividend specified by the ordinary resolution. At the 2007 Annual General Meeting shareholders gave authority to the Directors to offer a scrip dividend alternative until the conclusion of the Annual General Meeting in 2012.
Subject to the relevant insolvency laws and the Articles of Association of HSBC Holdings, if HSBC Holdings is wound up, the assets available for distribution among the holders of ordinary shares will be distributed among such holders in proportion to the number of ordinary shares held by them respectively, such distribution to be adjusted to take account of any amount remaining unpaid on a holder’s share. On a winding up, the liquidator may, with the sanction of a special resolution of HSBC Holdings and any other sanction required by law, divide among the shareholders in specie the whole or any part of the assets of HSBC Holdings and may, for that purpose, value any assets and determine how the division shall be carried out as between the shareholders or different classes of shareholders.
Preference shares
The non-cumulative preference shares of £0.01 each, the non-cumulative preference shares of US$0.01 each (the ‘Dollar Preference Shares’) and the non-cumulative preference shares of €0.01 each carry the same rights and obligations under the Articles of Association save in respect of the timing of and payment of proceeds from the redemption of each class of share, to the extent issued, and certain rights and obligations that attach to each class of preference share as determined by the Board prior to allotment of the relevant preference shares. The Dollar Preference Shares are the only class of the preference shares which have been issued and allotted to date.
Holders of the preference shares will only be entitled to attend and vote at general meetings of HSBC Holdings if any dividend payable on the relevant preference shares in respect of such period as the Board shall determine prior to allotment thereof (which, in the case of the Dollar Preference Shares in issue at 2 March 2009, is four consecutive dividend payment dates) is not paid in full or in such other circumstances, and upon and subject to such
terms, as the Board may determine prior to allotment of the relevant preference shares. Whenever holders of the relevant preference shares are entitled to vote on a resolution at a general meeting, on a show of hands every such holder who is present in person or by proxy shall have one vote and on a poll every such holder who is present in person or by proxy shall have one vote per preference share held by him or her or such number of votes per share as the Board shall determine prior to allotment of such share.
Subject to the Articles of Association, holders of the relevant preference shares shall have the right to a non-cumulative preferential dividend at such rate, on such dates and on such other terms and conditions as may be determined by the Board prior to allotment thereof in priority to the payment of any dividend to the holders of ordinary shares and any other class of shares of HSBC Holdings in issue (other than (i) the other preference shares in issue and any other shares expressed to rank pari passu therewith as regards income; and (ii) any shares which by their terms rank in priority to the relevant preference shares as regards income). Dividends on the Dollar Preference Shares in issue at 2 March 2009 are paid quarterly at the sole and absolute discretion of the Board of Directors. The Board of Directors will not declare a dividend on the Dollar Preference Shares if payment of the dividend would cause HSBC Holdings not to meet the applicable capital adequacy requirements of the FSA or the profit of HSBC Holdings available for distribution as dividends is not sufficient to enable HSBC Holdings to pay in full both dividends on the relevant preference shares and dividends on any other shares that are scheduled to be paid on the same date and that have an equal right to dividends. HSBC Holdings may not declare or pay dividends on any class of its shares ranking lower in the right to dividends than the preference shares nor redeem nor purchase in any manner any of its other shares ranking equal with or lower than the preference shares unless it has paid in full, or set aside an amount to provide for payment in full, the dividends on the preference shares for the then-current dividend period.
The preference shares carry no rights to participate in the profits or assets of HSBC Holdings other than as set out in the Articles of Association and subject to the Companies Act 1985, do not confer any right to participate in any offer or invitation by way of rights or otherwise to subscribe for additional shares in HSBC Holdings, do no not confer any right of conversion and do not confer any right to participate in any issue or bonus shares or
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shares issued by way of capitalisation of reserves.
Subject to the relevant insolvency laws and the Articles of Association of HSBC Holdings, holders of the relevant preference shares have the right in a winding up of HSBC Holdings to receive out of the assets of HSBC Holdings available for distribution to its shareholders, in priority to any payment to the holders of the ordinary shares and any other class of shares of HSBC Holdings in issue (other than (i) the other relevant preference shares and any other shares expressed to rank pari passu therewith as regards repayment of capital; and (ii) any shares which by their terms rank in priority to the relevant preference shares as regards repayment of capital), a sum equal to any unpaid dividend on the relevant preference shares which is payable as a dividend in accordance with or pursuant to the Articles of Association and the amount paid up or credited as paid up on the relevant preference shares together with such premium (if any) as may be determined by the Board prior to allotment thereof.
HSBC Holdings may redeem the relevant preference shares in accordance with the Articles of Association and the terms on which the relevant preference shares were issued and allotted. In the case of the Dollar Preference Shares in issue at 2 March 2009, HSBC Holdings may redeem such shares in whole at any time on or after 16 December 2010, subject to prior notification to the FSA.
Non-voting deferred shares
The non-voting deferred shares are held by a subsidiary undertaking of HSBC Holdings. Holders of the non-voting deferred shares are not entitled to receive dividends on these shares. In addition, on winding up or other return of capital, holders are entitled to receive the amount paid up on their shares after distribution to ordinary shareholders of £10 million in respect of each ordinary share held by them. The holders of the non-voting deferred shares are not entitled to receive notice of or to attend (either personally or by proxy) any general meeting of HSBC Holdings or to vote (either personally or by proxy) on any resolution to be proposed thereat.
The following events occurred during the year in relation to the share capital of HSBC Holdings:
Other than as described in paragraphs 1 to 6 and 8 to 10 above, the Directors did not allot any shares during 2008.
Short-term borrowings
HSBC includes short-term borrowings within customer accounts, deposits by banks and debt securities in issue and does not show short-term borrowings separately on the balance sheet. Short- term borrowings are defined by the US Securities and Exchange Commission (‘SEC’) as Federal funds purchased and securities sold under agreements to repurchase, commercial paper and other short-term borrowings. HSBC’s only significant short-term borrowings are securities sold under agreements to repurchase and certain debt securities in issue. Additional information on these is provided in the tables below.
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Contractual obligations
The table below provides details of HSBC’s material contractual obligations as at 31 December 2008.
Ratios of earnings to combined fixed charges (and preference share dividends)
For the purpose of calculating the ratios, earnings consist of income from continuing operations before taxation and minority interests, plus fixed charges, and after deduction of the unremitted pre-tax income of associated undertakings. Fixed charges consist of total interest expense, including or excluding interest on deposits, as appropriate, dividends on preference shares and other equity instruments, as applicable, and the proportion of rental expense deemed representative of the interest factor.
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Loan maturity and interest sensitivity analysis
At 31 December 2008, the geographical analysis of loan maturity and interest sensitivity by loan type on a contractual repayment basis was as follows:
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Deposits
The following tables summarise the average amount of bank deposits, customer deposits and certificates of deposit (‘CDs’) and other money market instruments (which are included within ‘Debt securities in issue’ in the balance sheet), together
with the average interest rates paid thereon for each of the past three years. The geographical analysis of average deposits is based on the location of the office in which the deposits are recorded and excludes balances with HSBC companies. The ‘Other’ category includes securities sold under agreements to repurchase.
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Certificates of deposit and other time deposits
At 31 December 2008, the maturity analysis of CDs and other wholesale time deposits, by remaining maturity, was as follows:
The geographical analysis of deposits is based on the location of the office in which the deposits are recorded and excludes balances with HSBC companies. The majority of certificates of deposit and time deposits are in amounts of US$100,000 and over or the equivalent in other currencies.
Introduction
The results of HSBC are sensitive to the accounting policies, assumptions and estimates that underlie the preparation of its consolidated financial statements. The significant accounting policies used in the preparation of the consolidated financial statements are described in Note 2 on the Financial Statements.
When preparing the financial statements, it is the Directors’ responsibility under UK company law to select suitable accounting policies and to make judgements and estimates that are reasonable and prudent.
The accounting policies that are deemed critical to HSBC’s results and financial position, in terms of the materiality of the items to which the policy is applied, and which involve a high degree of judgement including the use of assumptions and estimation, are discussed below.
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Impairment of loans and advances
HSBC’s accounting policy for losses arising from the impairment of customer loans and advances is described in Note 2g on the Financial Statements. Loan impairment allowances represent management’s best estimate of losses incurred in the loan portfolios at the balance sheet date.
Management is required to exercise judgement in making assumptions and estimations when calculating loan impairment allowances on both individually and collectively assessed loans and advances. Of the Group’s total loans and advances to customers before impairment allowances of US$957 billion (2007: US$1,001 billion), US$6.9 billion or 1 per cent (2007: US$6.5 billion; 1 per cent) were individually assessed for impairment, and US$950 billion or 99 per cent (2007: US$994 billion; 99 per cent) were collectively assessed for impairment.
The most significant judgemental area is the calculation of collective impairment allowances. HSBC’s most significant geographical area of exposure to collectively assessed loans and advances is North America, which comprised US$271 billion or 29 per cent (2007: US$301 billion; 30 per cent) of HSBC’s total collectively assessed loans and advances. Collective impairment allowances in North America were US$15.9 billion, representing 77 per cent (2007: US$11.9 billion; 72 per cent) of the total collectively assessed loan impairment allowance.
HSBC uses two alternative methods to calculate collective impairment allowances on homogeneous groups of loans that are not considered individually significant:
Both methodologies are subject to estimation uncertainty, in part because it is not practicable to identify losses on an individual loan basis because of the large number of individually insignificant loans in the portfolio.
In addition, the use of statistically assessed historical information is supplemented with significant management judgement to assess whether current economic and credit conditions are such that the actual level of inherent losses is likely to be greater or less than that suggested by historical experience. In normal circumstances, historical experience provides the most objective and relevant information from which to assess inherent loss within each portfolio. In certain circumstances, historical loss experience provides less relevant information about the inherent loss in a given portfolio at the balance sheet date, for example, where there have been changes in economic, regulatory or behavioural conditions such that the most recent trends in the portfolio risk factors are not fully reflected in the statistical models. In these circumstances, such risk factors are taken into account when calculating the appropriate levels of impairment allowances, by adjusting the impairment allowances derived solely from historical loss experience.
This key area of judgement is subject to uncertainty and is highly sensitive to factors such as loan portfolio growth, product mix, unemployment rates, bankruptcy trends, geographic concentrations, loan product features, economic conditions such as national and local trends in housing markets, the level of interest rates, portfolio seasoning, account management policies and practices, changes in laws and regulations, and other factors that can affect customer payment patterns. Different factors are applied in different regions and countries to reflect different economic conditions and laws and regulations. The assumptions underlying this judgement are highly subjective. The methodology and the assumptions used in calculating impairment losses are reviewed regularly in the light of differences between loss estimates and actual loss experience. For example, roll rates, loss rates and the expected timing of future recoveries are regularly benchmarked against actual outcomes to ensure they remain appropriate.
The total amount of the Group’s impairment allowances on homogeneous groups of loans is inherently uncertain because it is highly sensitive to changes in economic and credit conditions across a
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large number of geographical areas. Economic and credit conditions within geographical areas are influenced by many factors with a high degree of interdependency so that there is no single factor to which the Group’s loan impairment allowances as a whole are sensitive. However, HSBC’s loan impairment allowances are particularly sensitive to general economic and credit conditions in North America. For example, a 10 per cent increase in impairment allowances on collectively assessed loans and advances in North America would increase loan impairment allowances by US$1.6 billion at 31 December 2008 (2007: US$1.2 billion). It is possible that the outcomes within the next financial year could be different from the assumptions built into the models, resulting in a material adjustment to the carrying amount of loans and advances.
HSBC’s accounting policy for goodwill is described in Note 2(p) on the Financial Statements. Note 22 on the Financial Statements lists the Group’s cash generating units (‘CGUs’) by geographical region and global business. Total goodwill for the Group amounted to US$22 billion as at 31 December 2008 (2007: US$34 billion).
The process of identifying and evaluating goodwill impairment is inherently uncertain because it requires significant management judgement in making a series of estimations, the results of which are highly sensitive to the assumptions used. The review of goodwill impairment represents management’s best estimate of the factors below:
When this exercise demonstrates that the expected cash flows of a CGU have declined and/or that its cost of capital has increased, the effect is to reduce the CGU’s estimated recoverable amount. If this results in an estimated recoverable amount that is lower than the carrying value of the CGU, a charge for impairment of goodwill will be recognised in HSBC’s income statement for the year.
The accuracy of forecast cash flows is subject to a high degree of uncertainty in volatile market conditions. In such market conditions, management retests goodwill for impairment more frequently than annually to ensure that the assumptions on which the cash flow forecasts are based continue to reflect current market conditions and management’s best estimate of future business prospects.
Given the extraordinary market events experienced globally during the second half of 2008, HSBC performed an additional impairment test on all the CGUs within the Group as at 31 December 2008. As a result, HSBC recognised an impairment charge of US$10.6 billion on Personal Financial Services – North America as at 31 December 2008 (2007: nil). Management concluded that the recoverable amount of the other CGUs to which goodwill has been allocated exceeded their carrying value. However, in the event of further significant deterioration in the economic and credit conditions beyond the levels already reflected by management in the cash flow forecasts for the CGUs, a material adjustment to a CGU’s recoverable amount may occur which may result in the recognition of an impairment charge in the income statement.
Note 22 on the Financial Statements includes details of the CGUs with significant balances of goodwill, states the key assumptions used to assess the goodwill in each of those CGUs for impairment, and provides a discussion of the sensitivity of the carrying value of goodwill to changes in key assumptions.
Valuation of financial instruments
HSBC’s accounting policy for determining the fair value of financial instruments is described in Note 2d on the Financial Statements.
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The best evidence of fair value is a quoted price in an actively traded market. In the event that the market for a financial instrument is not active, a valuation technique is used. The majority of valuation techniques employ only observable market data, and so the reliability of the fair value measurement is high. However, certain financial instruments are valued on the basis of valuation techniques that feature one or more significant market inputs that are unobservable. Valuation techniques that rely to a greater extent on unobservable inputs require a higher level of management judgement to calculate a fair value than those based wholly on observable inputs.
Valuation techniques used to calculate fair values include comparisons with similar financial instruments for which market observable prices exist, discounted cash flow analysis, option pricing models and other valuation techniques commonly used by market participants. Valuation techniques incorporate assumptions that other market participants would use in their valuations, including assumptions about interest rate yield curves, exchange rates, volatilities, and prepayment and default rates. When valuing instruments by reference to comparable instruments, management takes into account the maturity, structure and rating of the instrument with which the position held is being compared.
The main assumptions and estimates which management considers when applying a model with valuation techniques are:
When applying a model with unobservable inputs, estimates are made to reflect uncertainties in fair values resulting from a lack of market data inputs, for example, as a result of illiquidity in the market. For these instruments, the fair value measurement is less reliable. Inputs into valuations based on unobservable data are inherently uncertain because there are little or no current market data available from which to determine the level at which an arm’s length transaction would occur under normal business conditions. However, in most cases there are some market data available on which to base a determination of fair value, for example historical data, and the fair values of most financial instruments will be based on some market observable inputs even where the unobservable inputs are significant.
An analysis of the basis for valuation of financial instruments measured at fair value in the financial statements is provided on page 162. The value of financial assets and liabilities that use a valuation technique are US$876 billion (2007: US$626 billion) and US$671 billion (2007: US$401 billion) or 71 per cent (2007: 66 per cent) and 83 per cent (2007: 68 per cent) of total assets and total liabilities measured at fair value, respectively. A sensitivity analysis of fair values for financial instruments with significant unobservable inputs to reasonably possible alternative assumptions and a range of assumptions and inputs used in valuation models in respect of instruments of particular interest in the current market turmoil can be found on page 164. Given the uncertainty and subjective nature of valuing financial instruments at fair value, it is possible that the outcomes in the next financial year could differ from the assumptions used, and this could result in a material adjustment to the carrying amount of financial instruments measured at fair value.
Impairment of available-for-sale financial assets
HSBC’s accounting policy for impairment of available-for-sale financial assets is described in Note 2(j) on the Financial Statements.
Available-for-sale financial assets are measured at fair value, and changes in fair value are recognised in equity in the available-for-sale fair value reserve until the financial assets are either sold or become impaired. An impairment loss is recognised if there is objective evidence of impairment as a result of loss events which have an impact on the estimated future cash flows of the financial asset that can be reliably estimated. If an available-for-sale financial asset becomes impaired, the entire balance in equity
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relating to that asset is removed from equity and recognised in the income statement as an impairment loss. A further decline in the fair value of an available-for-sale debt security subsequent to the initial impairment is recognised in the income statement when there is further objective evidence of impairment.
At 31 December 2008 the Group’s total available-for-sale financial assets amounted to US$286 billion (2007: US$273 billion), of which US$279 billion or 98 per cent (2007: US$261 billion; 95 per cent) were debt securities. At 31 December 2008, the available-for-sale fair value reserve relating to debt securities amounted to a deficit of US$21.4 billion (2007: deficit of US$2.4 billion). A deficit in the available-for-sale fair value reserve occurs on an available-for-sale debt security when the fair value of the security is less than the security’s acquisition cost (net of any principal repayments and amortisation) less any previous impairment loss recognised in the income statement, but there is no evidence of any impairment or, if an impairment was previously recognised, any subsequent impairment.
Management is required to exercise judgement in determining whether there is objective evidence that an impairment loss has occurred. Once an impairment has been identified, the amount of impairment loss is measured in relation to the fair value of the asset. More information on assumptions and estimates requiring management judgement relating to the determination of fair values of financial instruments is provided above in ‘Valuation of financial instruments’.
The objective evidence required to determine whether an available-for-sale debt security is impaired comprises evidence of the occurrence of a loss event and evidence that the loss event results in a decrease in estimated future cash flows. Where cash flows are readily determinable, a low level of judgement may be involved. Where determination of estimated future cash flows requires consideration of a number of variables, some of which may be unobservable in current market conditions, more significant judgement is required.
The most significant judgements concern more complex instruments, such as asset-backed securities (‘ABS’s), where it is necessary to consider factors such as the estimated future cash flows on underlying pools of collateral, the extent and depth of market price declines and changes in credit ratings. The review of estimated future cash flows on underlying collateral is subject to estimation uncertainties where the assessment is based on historical information on pools of assets, and
judgement is required to determine whether historical performance is likely to be representative of current economic and credit conditions. A description of these securities is included in the ‘Impact of market turmoil’ section under ‘Nature and extent of HSBC’s exposures’ on page 150 and a more detailed description of the assumptions and estimates used in assessing these securities for impairment is disclosed in the section ‘Assessing available-for-sale assets for impairment’ on page 170.
There is no single factor to which the Group’s charge for impairment of available-for-sale debt securities is particularly sensitive, because of the range of different types of securities held, the range of geographical areas in which those securities are held, and the wide range of factors which can affect the occurrence of loss events and the cash flows of securities, including different types of collateral.
Management’s current assessment of the holdings of available-for-sale ABSs with the most sensitivity to possible future impairment is focused on sub-prime and Alt-A residential mortgage-backed securities (‘MBSs’). The Group’s principal exposure to these securities is in the Global Banking and Markets’ business. Excluding holdings in certain special purpose entities where significant first loss risks are borne by external investors, the available-for-sale holdings in these categories within Global Banking and Markets amounted to US$5.2 billion at 31 December 2008 (2007: US$11.8 billion). The deficit in the available-for-sale fair value reserve as at 31 December 2008 in relation to these securities was US$5.9 billion (2007: US$1.1 billion).
The main factors in the reduction in fair value of these securities over the period were the effects of reduced market liquidity and negative market sentiment. The level of actual credit losses experienced was low in 2008, notwithstanding the deterioration in the performance of the underlying mortgages in the period as US house prices fell and defaults increased. The absence of material credit losses is judged to be attributable to the seniority of the tranches held by HSBC as well as the priority for cash flow held by these tranches.
Further details of the nature and extent of HSBC’s exposures to asset backed securities classified as available-for-sale are provided in ‘Impact of market turmoil–nature and extent of HSBC’s exposures’ on page 150.
It is reasonably possible that outcomes in the next financial year could be different from the assumptions and estimates used in identifying
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impairment on available-for-sale debt securities, as a result of which, evidence of impairment may be identified in available-for-sale debt securities which had previously been determined not to be impaired. It is possible that this could result in the recognition of material impairment losses in the next financial year.
Deferred tax assets
HSBC’s accounting policy for the recognition of deferred tax assets is described in Note 2s on the Financial Statements. A deferred tax asset is recognised to the extent that it is probable that future taxable profits will be available against which deductible temporary differences can be utilised. The recognition of a deferred tax asset relies on management’s judgements surrounding the probability and sufficiency of future taxable profits, future reversals of existing taxable temporary differences and ongoing tax planning strategies.
HSBC’s most significant judgements are around the US deferred tax assets, where there has been a recent history of losses in HSBC’s US operations. Net US deferred tax assets amounted to US$5.0 billion or 71 per cent (2007: US$3.7 billion; 70 per cent) of total net deferred tax assets recognised on the Group’s balance sheet.
The amount of US deferred tax assets recognised is based on the evidence available about conditions at the balance sheet date, and requires significant judgements to be made by management, especially those based on management’s projections of credit losses and the timing of recovery in the US economy. Management’s judgement takes into consideration the impact of both positive and negative evidence, including historical financial performance, projections of future taxable income, future reversals of existing taxable temporary differences, and the availability of loss carrybacks. The recognition of the deferred tax asset is mainly dependent upon the projection of future taxable profits, future reversals of existing taxable temporary differences and the capacity to carry back net operating losses arising in 2009.
Tax losses were incurred in HSBC’s US operations in 2008. Management has evaluated the factors contributing to the losses to determine whether the factors leading to the losses are temporary or indicative of a permanent decline in earnings. Based on its analysis, management has
determined that the losses were primarily caused by increases in credit losses in the US due to the current housing and credit market conditions, as well as continued weakening in the general economy, which has led to higher unemployment levels and, consequently, higher credit losses.
In the US, management’s projections of future taxable income are based on business plans, future capital requirements and ongoing tax planning strategies. These projections include assumptions about the depth and severity of further house price depreciation, assumptions about the US recession, including unemployment levels and their related impact on credit losses, and assumptions about ongoing capital support from HSBC.
The assumptions surrounding future expected credit losses in the US represent the most subjective areas of judgement in management’s projections of future taxable income.
Management’s forecasts support the assumption that it is probable that the results of future operations will generate sufficient taxable income to utilise the deferred tax assets. In management’s judgement, the recent market conditions, which have resulted in losses being incurred in the US over the last two years, will create significant downward pressure and volatility on the profit or loss before tax in the next few years. To reflect this, the assessment of recoverability of the deferred tax asset in the US significantly discounts any future expected taxable income and relies to a greater extent on continued capital support to the US operations from HSBC, including tax planning strategies implemented in relation to such support. The most significant tax planning strategy is HSBC’s investment of capital into its US operations to ensure the utilisation of the net operating loss carry forwards. This strategy provides substantial support for the recoverability of the deferred tax assets. HSBC expects that its US operations will continue to be dependent upon its capital support, and will continue to execute their business strategies and plans until they return to profitability. Based on management’s forecasts, HSBC expects to provide capital support to its US operations in each of the next three years. If HSBC were to decide, however, not to provide this ongoing support, the full recovery of the deferred tax asset may no longer be probable and could result in a material adjustment to the deferred tax asset which would be recognised in the income statement.
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The Group Chairman and Group Finance Director, with the assistance of other members of management, carried out an evaluation of the effectiveness of the design and operation of HSBC Holdings’ disclosure controls and procedures as of 31 December 2008. Based upon that evaluation, the Group Chairman and Group Finance Director concluded that HSBC’s disclosure controls and procedures as of 31 December 2008 were effective to provide reasonable assurance that information required to be disclosed in the reports which the company files and submits under the US Securities Exchange Act of 1934, as amended, is recorded, processed, summarised and reported as and when required. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.
There has been no change in HSBC Holdings’ internal control over financial reporting during the year ended 31 December 2008 that has materially affected, or is reasonably likely to materially affect, HSBC Holdings’ internal control over financial reporting.
Management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and has completed an assessment of the effectiveness of the Group’s internal control over financial reporting as of 31 December 2008. In making the assessment, management used the framework for Director’s internal control evaluation contained within the Combined Code (‘The Revised Turnbull Guidance’), as well as the criteria established by the Committee of Sponsoring Organisations of the Treadway Commission (‘COSO’) in ‘Internal Control-Integrated Framework’.
Based on the assessment performed, management concluded that as at 31 December 2008, the Group’s internal control over financial reporting was effective.
KPMG Audit Plc, which has audited the consolidated financial statements of the Group for the year ended 31 December 2008, has also audited the effectiveness of the Group’s internal control over financial reporting under Auditing Standard No.5 of the Public Company Accounting Oversight Board (United States) as stated in their report on pages 330 and 331.
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Summary
HSBC manages its business through two customer groups, Personal Financial Services and Commercial Banking, and two global businesses, Global Banking and Markets (previously Corporate, Investment Banking and Markets), and Private Banking. Personal Financial Services incorporates the Group’s consumer finance businesses; the largest of these is HSBC Finance Corporation (‘HSBC Finance’).
All commentaries on the customer groups and global businesses are on an underlying basis unless stated otherwise.
Basis of preparation
The results are presented in accordance with the accounting policies used in the preparation of HSBC’s consolidated financial statements. HSBC’s operations are closely integrated and, accordingly, the presentation of customer group data includes internal allocations of certain items of income and expense. These allocations include the costs of certain support services and Group Management Office (‘GMO’) functions, to the extent that these
can be meaningfully attributed to operational business lines. While such allocations have been made on a systematic and consistent basis, they necessarily involve a degree of subjectivity.
Where relevant, income and expense amounts presented include the results of inter-segment funding as well as inter-company and inter-business line transactions. All such transactions are undertaken on arm’s length terms.
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Subsequent developments
The branch-based US consumer lending business of HSBC Finance has historically focused on sub-prime customers who rely on drawing cash against the equity in their homes to help meet their cash needs. Unsecured consumer lines of credit have served as a means of generating new customer accounts, with the potential to subsequently provide the customer with a mortgage product, typically a secured debt consolidation loan. As a result, the bulk of the mortgage lending products sold in the US consumer lending branch network have been for refinancing and debt consolidation rather than for house purchase.
The unprecedented deterioration in the US housing market over the last two years, including declining property values and lower secondary market demand for sub-prime mortgages, has undermined the ability of many real estate loan customers to make payments or refinance their loans. In many cases, there is no equity in their homes or, if there is, few institutions are willing to finance its withdrawal. As a result, loan originations in this business have fallen dramatically for both HSBC Finance and the industry as a whole. Management believes it will take years before property values return to the levels seen prior to the decline and, as such, has concluded that recovery in the sub-prime mortgage lending business is uncertain and the industry is unlikely to stabilise for a number of years. Management also expects that changes in regulation and practice will make it problematic to plan and execute a sub-prime lending business strategy with a reasonable degree of confidence.
Given the above, in 2008 HSBC began to reposition its US consumer lending business to reduce risk by tightening lending criteria and expanding its lending to include government sponsored entity and conforming loan products. As part of this repositioning, HSBC intended to place greater emphasis on unsecured loan products while decreasing secured loan production. To date, the results of this repositioning effort have not met expectations, in part due to the continued deterioration in the economy, leading management to re-evaluate whether, given the Group’s risk appetite, the initiative can produce the volume necessary to ensure that the consumer lending business will return to profitability in the foreseeable future.
As a consequence, at the end of February 2009, the Board of HSBC endorsed management’s recommendation to discontinue as soon as practicable originations of all products by the branch-based US consumer lending business of HSBC Finance. At 31 December 2008 this business had outstanding balances of US$62 billion comprising US$46 billion in real estate secured and US$16 billion in unsecured loan balances. HSBC will continue to service and collect the existing loan portfolio as it runs off, and will continue the Group’s efforts to help customers in need of loan modification and other account management programmes to maximise collection and preserve, as far as possible, home ownership. In the US, substantially all consumer lending branches branded HFC and Beneficial will cease taking loan applications and will be closed. HSBC Finance will also continue to run-off the loan portfolios of its mortgage services business and its vehicle finance business. HSBC will provide all necessary support to HSBC Finance to enable it to run off these businesses in a measured way and to meet all its commitments.
The operations of HSBC’s other US Personal Financial Services businesses, including its card business, and the retail bank branch business of HSBC USA are unaffected by this decision. HSBC USA will continue to service its customers with real estate secured and unsecured products.
HSBC expects as a result of this decision affecting the US consumer lending business of HSBC Finance that total revenue will fall by approximately US$50 million in 2009 and operating expenses by approximately US$700 million on an annualised basis. Closure costs of up to US$195 million will be incurred, predominantly related to one-off termination and other employee benefit costs, a substantial portion of which will be recorded in the first half of 2009.
In addition, a non-cash charge of approximately US$70 million is expected to be incurred in relation to the impairment of fixed assets associated with the consumer lending branch network, also to be recognised in the first half of 2009.
Employees supporting originations operations will be evaluated for service elsewhere in HSBC’s operations, but it is currently expected that approximately 6,100 employees will be displaced.
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71
Strategic direction
72
73
74
Global Banking and Markets
Profit before tax
75
Management view of total operating income
Comparative information has been adjusted to reflect the current management view.
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performance fees reflected a 20 per cent decrease in funds under management following recent equity market declines. Nevertheless, HSBC remained one of the leading emerging markets asset managers.
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Balance sheet data significant to Global Banking and Markets15
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Private Banking
79
Client assets
Client assets by investment class
Business highlights in 2008
80
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Other
Profit/(loss) before tax
Notes
82
Balance sheet data15
Reconciliation of reported and underlying profit/(loss) before tax
83
Customer groups > Profit/(loss) before tax
Analysis by customer group and global businessProfit/(loss) before tax
84
85
Customer groups > Profit/(loss) before tax // Geographical regions > Summary
Profit/(loss) before tax (continued)
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Additional information on results in 2008 may be found in the ‘Financial Summary’ on pages 23 to 38.
HSBC’s principal banking operations in Europe are HSBC Bank plc (‘HSBC Bank’) in the UK, HSBC France, HSBC Bank A.S. in Turkey, HSBC Bank Malta p.l.c., HSBC Private Bank (Suisse) S.A., HSBC Trinkaus & Burkhardt AG and HSBC Guyerzeller Bank AG. Through these operations HSBC provides a wide range of banking, treasury and financial services to personal, commercial and corporate customers across Europe.
Hong Kong
HSBC’s principal banking subsidiaries in Hong Kong are The Hongkong and Shanghai Banking Corporation Limited (‘The Hongkong and Shanghai Banking Corporation’) and Hang Seng Bank Limited (‘Hang Seng Bank’). The former is the largest bank incorporated in Hong Kong and is HSBC’s flagship bank in the Asia-Pacific region. It is one of Hong Kong’s three note-issuing banks, accounting for more than 65 per cent by value of banknotes in circulation in 2007.
Rest of Asia-Pacific (including the Middle East)
HSBC offers personal, commercial, global banking and markets services in mainland China, mainly through its local subsidiary, HSBC Bank (China) Company Limited (‘HSBC Bank China’). HSBC also participates indirectly in mainland China through its three associates, Bank of Communications (19.01 per cent owned), Ping An Insurance (16.78 per cent) and Industrial Bank (12.78 per cent), and has a further interest of 8 per cent in Bank of Shanghai.
Outside Hong Kong and mainland China, HSBC conducts business in 20 countries in the Asia-Pacific region, primarily through branches and subsidiaries of The Hongkong and Shanghai Banking Corporation, with particularly strong coverage in India, Indonesia, South Korea, Singapore and Taiwan. HSBC’s presence in the Middle East is led by HSBC Bank Middle East Limited (‘HSBC Bank Middle East’), whose network of branches, together with HSBC’s subsidiaries and associates, gives it the widest coverage in the region; in Australia by HSBC Bank Australia Limited; and in Malaysia by HSBC Bank Malaysia Berhad (‘HSBC Bank Malaysia’), which is the largest foreign-owned bank in the country by operating income and pre-tax profits. HSBC’s associate in Saudi Arabia, The Saudi British Bank (40 per cent owned), is the Kingdom’s fifth largest bank by total assets.
HSBC’s North American businesses are located in the US, Canada and Bermuda. Operations in the US are primarily conducted through HSBC Bank USA, N.A. (‘HSBC Bank USA’) which is concentrated in New York State, and HSBC Finance, a national consumer finance company based in the Chicago metropolitan area. HSBC Markets (USA) Inc. is the intermediate holding company of, inter alia, HSBC Securities (USA) Inc., a registered broker and dealer of securities and a registered futures commission merchant. HSBC Bank Canada and The Bank of Bermuda Limited (‘Bank of Bermuda’) operate in their respective countries.
Latin America
HSBC’s operations in Latin America principally comprise HSBC México, S.A. (‘HSBC Mexico’), HSBC Bank Brasil S.A.-Banco Múltiplo (‘HSBC Bank Brazil’), HSBC Bank Argentina S.A. (‘HSBC Bank Argentina’) and HSBC Bank (Panama) S.A. (‘HSBC Bank Panama’), which owns subsidiaries in Costa Rica, Honduras, Colombia, Nicaragua and El Salvador. HSBC is also represented by subsidiaries in Chile, the Bahamas, Peru, Paraguay and Uruguay and by a representative office in Venezuela. In addition to banking services, HSBC operates insurance businesses in Mexico, Argentina, Brazil, Panama, Honduras and El Salvador. In Brazil, HSBC offers consumer finance products through its subsidiary, Losango.
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Geographical regions > Summary / Europe
In the analysis of profit by geographical regions that follows, operating income and operating expenses
include intra-HSBC items of US$2,492 million (2007: US$1,985 million; 2006: US$1,494 million).
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Profit/(loss) before tax by country within customer groups and global businesses
Loans and advances to customers (net) by country
Customer accounts by country
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Economic briefing
In the UK, growth in gross domestic product (‘GDP’) decelerated markedly in 2008 to 0.7 per cent from 3.0 per cent in 2007, with a technical recession of two successive quarterly contractions in GDP confirmed during the second half of the year. Weakness proved widespread across most of the
economy, prompting a sharp deterioration in labour market conditions as unemployment hit a 9-year high of 6.1 per cent in November 2008. Consumer Price Index (‘CPI’) inflation reached a decade-long high of 5.2 per cent in September 2008 before falling back to 3.1 per cent by the year-end, still some way above the Bank of England’s 2 per cent target. House prices continued to fall throughout the year and housing activity decreased sharply. The Bank of
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England reduced interest rates by 350 basis points during 2008, to finish the year at 2 per cent, as policymakers sought to mitigate the worst effects of the economic slowdown.
The expansion of the eurozone economy slowed sharply in 2008, with GDP growth of 0.7 per cent following a 2.6 per cent expansion in 2007. As in the UK, conditions deteriorated markedly as the year progressed and three successive quarterly declines in GDP were recorded during 2008, confirming that the economy had entered a period
of recession. Consumer spending growth proved subdued following the sharp rise in oil prices during the first of half of 2008 and a progressive increase in the unemployment rate towards the year-end. Inflation remained a concern for much of 2008, hitting a peak of 4.0 per cent in July before falling rapidly to 1.6 per cent in December. The European Central Bank, having initially raised interest rates by 25 basis points in July, cut them by 175 basis points to finish the year at 2.5 per cent.
Review of business performance
HSBC’s European operations reported a pre-tax profit of US$10.9 billion, compared with US$8.6 billion in 2007, an increase of 26 per cent.
These results included gains of US$2.4 billion on the disposal of seven regional banks in France in July 2008, and of US$425 million on the sale of the card acquiring business in the UK to a joint venture with Global Payments, Inc. in June 2008. Excluding these disposals and, in 2007, the acquisition of HSBC Assurances and the disposal of Hamilton Insurance Company Limited and Hamilton Life Assurance Company Limited and substantial fair value gains on own debt, underlying pre-tax profits fell by 33 per cent. This primarily reflected a sharp decline in Global Banking and Markets’ revenues, which was mainly attributable to the deterioration in credit markets, the continuing illiquidity in asset-backed securities markets which led to further
write-downs, and a US$854 million charge within the equities business following the alleged fraud at Madoff Securities. Personal Financial Services and Private Banking delivered underlying growth.
Net interest income increased by 33 per cent. There was significant growth in Balance Sheet Management revenues, which reflected favourable interest rate risk positioning in expectation of interest rate cuts by central banks. Net interest income also benefited from necessarily selective incremental lending as credit availability generally contracted. In Global Banking, net interest income was boosted by improved spreads.
Falling confidence in the UK banking sector necessitated government intervention in a number of competitor banks. HSBC experienced a strong increase in customer numbers, with corresponding growth in liability balances as the market turmoil intensified. The volume benefit was partially offset
by narrowing deposit spreads, as base rates were cut in the UK, and increased funding costs, principally for trading activities, in France. Higher net interest income from the expansion of credit card lending and commercial loan portfolio growth in the small and mid-market customer segments in Turkey was partially offset by narrower spreads following credit card interest rate cap reductions by the central bank.
Net fee income fell by 7 per cent, with lower fees from mergers and acquisitions and equity capital markets due to origination and execution difficulties, coupled with a rise in brokerage expenses in line with increased trading activity in France. Lower performance and management fees in the UK and France as the value of funds under management reduced, reflected the decline in global equity markets. Increased customer acquisition partly offset this, with higher fees derived from growth in packaged accounts and transaction volumes in France and credit card fees in Turkey.
Trading incomewas 20 per cent lower than in 2007, falling significantly in Global Banking and Markets due to further write-downs on legacy exposures in credit, structured credit derivatives and leveraged and acquisition finance caused by the ongoing turmoil in the credit markets. In addition, a US$854 million charge was taken in equities in respect of the alleged fraud at Madoff Securities. US$11.4 billion and US$2.4 billion of held-for-trading financial assets were reclassified under revised IFRS rules as loans and receivables and available for sale, respectively, preventing any further mark-to-market trading losses on these assets. If these reclassifications had not been made, the profit before tax would have been US$2.6 billion lower.
Excluding the write-downs on legacy exposures and the charge relating to Madoff Securities, trading income grew by 11 per cent, driven by a significant increase in foreign exchange revenues against the backdrop of greater market volatility, and robust revenues in the Rates business, which was positioned to take advantage of falling interest rates. The widening of credit spreads, particularly in the second half of 2008, contributed to fair value gains on structured liabilities and on credit protection bought in the form of credit default swaps.
Net income from financial instruments designated at fair value increased by 36 per cent, primarily due to fair value gains from the effect of widening credit spreads on certain fixed-rate long-term debt issued by HSBC Holdings. This movement was partly offset by a reduction in the value of assets held to meet liabilities under insurance and
investment contracts. The reduction in fair value of assets held to meet liabilities under unit-linked insurance contracts is offset by a corresponding reduction in ‘Net insurance claims and liabilities to policyholders’. The fair value gains on HSBC’s own debt will fully reverse over the life of the debt.
Gains less losses from financial investments of US$418 million were US$915 million lower than in 2007 as there were fewer disposal opportunities in 2008 and the significant realisations from equity investments in the UK and France in 2007 did not recur. Gains largely reflected the sale of MasterCard shares in 2008.
Net earned insurance premiums increased by 22 per cent, largely due to growth in the Guaranteed Income Bond launched in June 2007 and the introduction of enhanced death benefits to certain pension products in the UK. In France, HSBC Assurances performed well in a declining market, as the launch of new guaranteed rate products contributed to 3 per cent growth in gross earned premiums. However, net earned insurance premiums fell following a significant re-insurance transaction undertaken in the first half of 2008.
Other operating income increased by 33 per cent. This was primarily due to recognition of the gain in respect of the purchase of the subsidiary of Metrovacesa which owned the property and long leasehold land comprising 8 Canada Square, London. See Note 23 on the Financial Statements for further details. The growth in revenue also reflected the non-recurrence of a decrease in the value of PVIF business in 2007 following regulatory changes to the rules governing the calculation of insurance liabilities. In addition, there was a favourable embedded value adjustment following HSBC’s introduction of enhanced benefits to existing commercial pension products in the first half of 2008. These benefits were partially offset by costs associated with the support of money market funds in the global asset management business.
Net insurance claims incurred and movement in liabilities to policyholders decreased by 5 per cent as a reduction in insurance liabilities reflected the fall in value of market-linked funds. This was partially offset by an increase in liabilities following increased sales of the Guaranteed Income Bond and the implementation of FSA rule changes in 2007 which lowered the liability valuation on life policies.
Loan impairment charges and credit risk provisions rose by 59 per cent to US$3.8 billion; in the UK, primarily in Global Banking and Markets. The deteriorating credit environment resulted in a rise in loan impairment charges, largely reflecting an
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exposure to a single European property company, and additional credit risk provisions on debt securities held within the Group’s available-for-sale portfolio, mainly in Solitaire Funding Limited (‘Solitaire’), a special purpose entity managed by HSBC. A modest improvement in the UK personal finance sector reflected the non-recurrence of a change in the methodology in the consumer finance business which resulted in a higher charge in 2007. Excluding this factor, delinquency rates in cards were marginally higher and there was a rise in impairments in the consumer finance business driven by worsening economic conditions and credit quality deterioration, partly offset by action taken to mitigate risk through the continued application of strict lending criteria and the sale of non-core credit card portfolios.
Credit conditions weakened in the commercial business and specific loan impairment charges increased in the UK and France due to the deteriorating credit environment in the second half of 2008. In Turkey, credit card and personal loan delinquency rates were significantly higher, resulting in the implementation of tighter underwriting criteria, reduced credit limits and revised account management policies throughout 2008.
Operating costs increased by 3 per cent to US$16.1 billion. Costs in the UK were in line with 2007, which included ex-gratia payments expensed in respect of overdraft fees applied in previous years and a provision for reimbursement of certain charges on historic will trusts and other related services. Excluding these items, costs rose as a result of an increase in the Financial Services Compensation Scheme levy, restructuring costs and increased rental charges following the sale and leaseback of branch properties, partially offset by lower performance-related pay and a reduction in defined benefit pension scheme costs due to a change in actuarial assumptions.
Operating costs in France decreased slightly with lower performance-related pay and a reduction in pension and retirement healthcare costs following the transfer of certain obligations to a third-party offsetting the higher costs of a voluntary retirement programme.
There was investment in premises and new staff to support business expansion in Turkey, Russia and central and eastern Europe. In 2008, 112 new branches opened and staff numbers increased by 30 per cent in these markets.
Share of profit in associates and joint ventures declined by 84 per cent to US$16 million with 2007
benefiting from an adjustment to the embedded value of HSBC Assurances. The absence of this gain was partially offset by increased joint venture profits following the sale of the card acquiring business in the UK.
In the UK, GDP growth accelerated in 2007 to 3.1 per cent from 2.9 per cent in 2006, mainly as a result of buoyant consumer and investment spending. Net trade depressed GDP growth through 2007, and the current account deficit reached a record 5.7 per cent of GDP in the third quarter of the year. Employment growth was fairly subdued, rising by approximately 0.7 per cent during the year. CPI inflation reached a decade-long high of 3.1 per cent in March but subsequently fell back to 2.1 per cent by the year-end, close to the Bank of England’s 2 per cent target. After a strong start to the year, nominal house prices declined and housing activity diminished in the final months of 2007. The Bank of England raised interest rates by 75 basis points during 2007 to a peak of 5.75 per cent, but subsequently reduced them to 5.5 per cent at the end of 2007.
The expansion of the eurozone economy continued steadily in 2007, with GDP growth of 2.7 per cent. As in the UK, much of the momentum came from strength in business investment and exports as global demand remained strong, particularly from emerging markets. Consumption was relatively subdued, despite declining unemployment, although fiscal reforms (particularly in Germany) are believed to have depressed household expenditure. Eurozone inflation increased steadily during the second half of the year to an annual rate of 3.1 per cent in December, driven largely by rises in food and energy prices. The European Central Bank (‘ECB’) raised interest rates by 50 basis points during 2007, to finish the year at 4 per cent.
European operations reported a pre-tax profit of US$8.6 billion, compared with US$7.0 billion in 2006, an increase of 23 per cent. On an underlying basis, pre-tax profits improved by 13 per cent.
In March 2007, HSBC acquired its partner’s shares in life, property and casualty insurer, HSBC Assurances. The results of HSBC Assurances are excluded from the commentary below, which is on an underlying basis.
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In Commercial Banking, growth in deposit and lending balances in the UK and ongoing business expansion in Turkey and Malta led to steady growth in revenues. This was partly offset by increased loan impairment charges and higher costs associated with business expansion. In Global Banking and Markets, higher income from most businesses was offset by trading losses in Credit and Rates and increased costs. Strong profit growth in Private Banking was driven by an increased client appetite for discretionary portfolios, a rise in lending volumes and further improvements in cross-referrals. In Personal Financial Services, a fall in pre-tax profits reflected ex gratia payments expensed in respect of overdraft fees applied in previous years and a provision for reimbursement of certain charges on historic will trusts and other related services. The ‘Other’ segment benefited from a US$1.3 billion fair value gain in HSBC’s own debt.
Net interest income declined by 18 per cent, mainly because the expansion of trading activities in both the UK and France resulted in higher funding costs, with the related revenues reported in the trading income line. This was partly offset by higher net interest income in the personal and commercial businesses.
In the UK, Personal Financial Services’ spreads widened in a rising interest rate environment and competitive pricing attracted higher balances. This was mitigated by lower spreads on mortgages as customers switched to fixed rate products. In
Commercial Banking, higher net interest income was largely driven by growth in the UK, Turkey, Germany and Malta. In the UK, a negotiated rate deposit product launched in previous years continued to be instrumental in driving higher deposit balances. Strong growth in corporate and structured banking for micro customers, together with expansion in lending to small and mid-market customers, contributed to higher lending balances although this benefit was partially constrained by spread compression in the competitive market.
Revenues from transactional balances held within the payments and cash management business increased by 13 per cent, as credit market dislocation in the second half of the year caused customers to hold higher cash balances. After several years of decline, balance sheet management revenues in Europe increased.
In Turkey, higher net interest income was driven by new customer acquisition. In Switzerland, the Private Banking business earned higher net interest income from lending to existing clients as they further leveraged their portfolios.
Net fee income rose by 11 per cent. Account services increased on higher customer balances and volumes of transactions in the UK and France, supported by sales of fee-earning packaged accounts. Card fees increased in the UK, mainly on interchange and acquiring fees, and in Turkey, on interchange and cash advance fees. This was partly offset by a reduction in credit card default fees in the
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UK following regulatory intervention by the OFT in 2006. Broking income increased in the UK, Germany and Switzerland, mainly driven by growth in client assets and transaction volumes. Funds under management fell on lower income from the Hermitage Fund following the part sale of HSBC’s investment in it.
Trading income rose by 41 per cent, driven by the equities business and foreign exchange trading, where income increased strongly, with volume and profitability reflecting market volatility. The increase was partly offset by write-downs in credit, structured derivatives and leveraged and acquisition finance. Net trading income increased following the strategic decision to expand the collateralised lending and structured derivatives businesses, the funding costs of which are reported in net interest income.
Credit spreads, primarily on certain fixed-rate long-term debt issued by HSBC Holdings and its subsidiaries, widened significantly in the second half of 2007, leading to a sevenfold increase innet income from financial instruments designated at fair value compared with 2006. These cumulative gains will fully reverse over the life of the debt.
The sale of shareholdings and various equity investments in the UK and France, including Euronext (the European stock exchange), contributed to gains from financial investments of US$1.3 billion, an increase of 101 per cent on 2006.
Net earned insurance premiums increased by 50 per cent to US$4.0 billion, including growth of the Guaranteed Income Bond and motor insurance, and the introduction of enhanced death benefits to pension contracts in the UK. Premiums also grew in the UK because of a higher retention of risk in the non-life business compared with 2006, when a greater proportion of risk and corresponding premiums were ceded to reinsurers. There were also significant contributions from the reinsurance business in Ireland and the life assurance business in Malta.
Other operating income declined by 25 per cent. This largely resulted from a fall in the value of in-force business in UK insurance, driven by a change in the calculation methodology of the PVIF business in the first half of 2007 when HSBC implemented regulatory changes to the rules governing the
calculation of insurance liabilities. This had a marginally positive effect on profit as there was a corresponding reduction in policyholder liabilities.
Net insurance claims incurred and movement in liabilities to policyholders grew by 121 per cent to US$3.5 billion. This growth, which paralleled the growth in net earned insurance premiums, included the effect of higher risk retention in the non-life business, although it was offset by FSA rule changes which led to lower claims valuations on life policies. There was also a rise in flood-related claims in the UK after record rainfalls during the summer.
Loan impairment charges rose by 10 per cent to US$2.5 billion. Overall credit quality remained broadly stable. In the UK, loan impairment charges rose, primarily in consumer finance lending outside HSBC Bank; within HSBC Bank, steps taken in 2006 to tighten underwriting standards led to an improvement in loan impairment trends. Corporate loan impairment charges remained low in absolute terms, although they were 23 per cent higher than in 2006, principally reflecting the effect of Individual Voluntary Arrangements on micro businesses and impairments on two large corporate accounts in the UK.
Operating costs increased by 10 per cent to US$16.5 billion, in line with the growth in net operating income before loan impairment charges. In the UK, a change in actuarial assumptions regarding the principal staff defined benefit pension scheme led to increased costs. Ex-gratia payments were expensed in respect of overdraft fees applied in previous years and a provision for reimbursement of certain charges on historic will trusts and other related services was raised which totalled US$396 million. Cost increases also reflected investments in technology, higher payments and cash management transaction volumes, investments in the French structured derivatives business to support revenue growth and, in Turkey, technical infrastructure and additional headcount in support of business expansion.
Share of profit in associates and joint ventures rose by US$167 million, largely as a result of a US$73 million adjustment to the embedded value of HSBC Assurances in France prior to the acquisition of its remaining share capital, following which it was accounted for as a subsidiary.
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Analysis by customer group and global business
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Analysis by customer group and global business (continued)
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Profit/(loss) before tax by customer group and global business
For footnote, see page 143.
All commentaries on Hong Kong are on an underlying basis unless stated otherwise.
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Hong Kong’sGDP growth slowed to 2.5 per cent in 2008 from 6.4 per cent in 2007. After performing strongly during the early months of the year, the economy slowed sharply and a technical recession was confirmed with the release of the third quarter GDP statistics. External demand proved especially weak during the second half of 2008 and the growth in private consumption also slowed sharply. The unemployment rate rose from a ten-year low of
3.2 per cent in August 2008 to 4.1 per cent by the year-end. Consumer price inflation proved volatile during the year, rising to a ten-year high of 6.3 per cent in July before slowing to 2.1 per cent by December 2008, although this movement largely reflected the trends in food and energy prices. In response to interest rate cuts in the US, Hong Kong cut its base interest rate on seven occasions during 2008, finishing the year at 0.5 per cent compared with 5.75 per cent at the end of 2007. The Hang Seng Index fell by 48 per cent during 2008.
Hong Kong reported pre-tax profits of US$5.5 billion, a 26 per cent decline compared with record profits of US$7.3 billion in 2007. Lower revenues largely reflected a decline in wealth management and insurance income as economic conditions deteriorated. Revenue decline was compounded by impairment charges recognised on certain investments, which arose as a consequence of significant falls in equity market prices. Offsetting this, in part, was considerably stronger balance sheet management income from treasury positions which correctly anticipated the decline in interest rates.
Net interest incomerose by 4 per cent, driven by the strong Balance Sheet Management performance in Global Banking and Markets mainly driven by liquidity generated by retail banking in the environment of falling short-term interest rates.
Savings and deposit balances grew strongly, particularly in Personal Financial Services, as customers revealed a preference for security and liquidity following declines in equity markets. Deposit growth was augmented by the launch of campaigns offering both preferential time deposit rates and an enhanced HSBC online platform. The significant decline in interest rates during 2008 led to a narrowing of deposit spreads.
Customer lending volumes were 11 per cent higher, due in part to an 11 per cent rise in mortgage balances. Lending margins narrowed, however, due to interest rate cuts, particularly affecting mortgage lending and other loans linked to HIBOR. Balances outstanding on credit cards rose, driven by increased cardholder spending, and spreads on this business increased due to lower funding costs. Nearly one million new cards were issued in the year, bringing the total cards in circulation to 5.3 million. Volumes
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of trade finance grew strongly, driven by demand from corporates with international trade requirements, and commercial lending balances rose, particularly during the first half of the year.
Fee income declined by 23 per cent, driven by lower equity market-related revenues. Weak market sentiment led to lower volumes of retail brokerage and a decrease in income from wealth management activity. This was partly offset by a rise in fees from cards following increases in both cards in circulation and cardholder spending. Fees from account services rose due to greater customer activity and there were higher fees generated from bundled products.
Trading incomewas 4 per cent lower, driven by further write-downs of US$0.2 billion in Global Banking and Markets on a legacy monoline exposure. Excluding these write-downs, trading income grew due to a rise in foreign exchange and rates income as continuing market volatility generated increased trading opportunities and demand for active hedging products.
The net loss of US$1.2 billion on financial instruments designated at fair value compared with income of US$676 million in 2007. The loss reflected a decline in the value of assets linked to the insurance business. To a large extent, these losses are attributable to policyholders, with an equivalent reduction in net insurance claims and movement in liabilities to policyholders. While the decline in the value of assets which relate to unit-linked products is allocated to policyholders in full, the portion of decline in the value passed on to clients who have products with discretionary participation features and guarantees may be restricted.
Losses from financial investments of US$309 million reflected impairments required on investments which have experienced significant falls in equity market prices. These equity investments are classified as available for sale, are not held for trading, and remain part of the strategic positioning of HSBC’s businesses in Asia. These losses were partly offset by an aggregate gain of US$203 million from the redemption of shares in the Visa initial public offering (‘IPO’) and the disposal of MasterCard shares.
Net earned insurance premiums increased by 16 per cent to US$3.2 billion, largely due to growth in the life insurance business, in particular for policies with discretionary participation features.
Net insurance claims and movement in liabilities to policyholders fell by 40 per cent, reflecting the decline in asset values noted above
partly offset by increases due to growth in premiums.
Loan impairment charges and other credit risk provisions rose markedly from the previously low level to US$765 million as economic conditions deteriorated. Within these charges were exposures to financial institutions held within Global Banking and Markets, which resulted in other credit risk provisions. In Commercial Banking, the combination of an absence of significant recoveries recorded in 2007 and weakness among certain exporters in Hong Kong, who were affected by reduced demand from the US and other developed countries, raised loan impairment charges. As local businesses responded to the economic environment, unemployment rose in the second half of 2008. Credit policies were consequently adjusted across certain products as delinquency and bankruptcy increased in Hong Kong. Although property market declines reduced equity levels for residential mortgage customers, the impact on loan impairment charges was limited as this lending was well-secured and regulatory restrictions constrained origination loan-to-value ratios to below 70 per cent.
Operating expensesrose by 4 per cent. Staff costs declined by 3 per cent despite wage increases and a rise in the number of customer-facing staff, largely due to lower performance-related costs in Global Banking and Markets. Staff numbers were higher than in 2007 notwithstanding reductions within the branch network for lower business volumes in the latter part of 2008. IT costs rose as investment in systems continued. Marketing costs were lower following active management of costs while property rental costs increased due to higher market rental rates. Overall, cost growth was curtailed in response to the more difficult economic climate.
Hong Kong’seconomy remained robust during 2007, with the annual rate of growth of 6.3 per cent. Domestic consumption was the major contributor to economic expansion, supported by the strong labour market. The unemployment rate fell to 3.4 per cent, a nine year low, as the supply of labour remained very tight. Global increases in food and oil prices affected Hong Kong, but the territory also experienced wage inflation, rising import prices and growth in property rental costs. Inflation increased as a result, exceeding 3 per cent in the final quarter of the year.
In response to interest rate cuts in the US and capital inflows into the local market, Hong Kong’s
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main interest rate was cut on three separate occasions during the final months of 2007, with the prime rate ending the year at 6.75 per cent, down by one per cent from its high for the year. Local asset markets benefited accordingly. The previously very strong levels of export growth slowed in the second half of 2007, as demand from the US moderated and
the reduction in mainland China’s export tax rebate in July temporarily affected Hong Kong’s re-exports. Despite relatively modest trade growth, external demand for Hong Kong’s services remained strong due to the buoyant tourism sector and increasing cross-border business activities, especially within the financial sector.
HSBC’s operations in Hong Kong reported a record pre-tax profit of US$7.3 billion, an increase of 42 per cent compared with US$5.2 billion in 2006. The underlying change was in line with the reported change. Net operating income increased by 32 per cent, double the rate of growth in operating expenses.
In Personal Financial Services, record results reflected increased fee income, particularly from retail brokerage and investment products, as well as growth in net interest income from higher deposit balances and lending. In Commercial Banking, results were driven by balance sheet growth from customer acquisition, increased trade flows and the expansion of supporting businesses into mainland China. In Global Banking and Markets, income growth reflected improved performance in balance sheet management and strong results from the trading businesses and securities services in the buoyant economic environment. Higher demand for structured products and mutual funds drove the increase in Private Banking profits. Cost efficiency ratios improved in all customer groups.
Net interest income rose by 17 per cent, driven by growth in asset and liability products in the personal, commercial and corporate businesses. Net interest income from Global Banking and Markets increased by 79 per cent as balance sheet management revenues recovered and deposits grew strongly with higher spreads. A rise in liabilities to fund trading activities reduced net interest income, with a corresponding rise in trading income. Personal Financial Services’ net interest income grew by 16 per cent as wider spreads were recorded on higher deposit balances, with the relaunch of HSBC Premier contributing to the growth in deposit balances. Card balances were also higher following a number of promotional programmes during the year. In Commercial Banking, strong economic growth helped generate demand for savings products and this, combined with strong customer acquisition, resulted in higher net interest from the investment of deposits.
Buoyant stock market activity drove an increase in fee income. Broking and global custody income rose as larger trading volumes were registered on higher stock exchange daily turnover. This was
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enhanced by the launch of new investment schemes, awareness campaigns and the adoption of a new portfolio wealth management sales tool in the branch network. An increase in IPO activity in Hong Kong, mainly derived from mainland China, had a positive effect on underwriting fees. Life insurance commission income increased, boosted by new product offerings. Credit card fee income also rose, driven by increased cards in circulation and a rise in cardholder balances.
Trading income growth was achieved throughout the Global Markets business and particularly in foreign exchange, assisted by investments made in recent years to extend the product range and customer base. Structured equity growth continued, driven by the bank’s product offering linked to the Hong Kong Stock Exchange, which rose significantly. HSBC had only very limited exposure to asset-based securities and structured credit products in Hong Kong.
Net earned insurance premiums increased by 7 per cent to US$2.8 billion, as the life assurance business expanded with the launch of new products.
Other operating income was largely in line with 2006, notwithstanding the non-recurrence of income on the sale of the former head office building of Hang Seng Bank and the transfer of the credit card
acquiring business into a joint venture with Global Payments Inc.
Net insurance claims incurred and movement in liabilities to policyholders increased by 19 per cent to US$3.2 billion. The increase was more significant than premium growth because many of the liabilities were related to life policies. Policyholders participate in the investment performance of assets supporting these liabilities and the investment return on these assets is shown in ‘Net income from financial instruments designated at fair value’.
Loan impairment charges continued at a low level and in line with 2006 at US$231 million, despite strong balance sheet growth. This reflected good credit quality and robust economic conditions.
Operating expensesincreased by 16 per cent. Staff costs rose by 23 per cent on wage inflation and the recruitment of additional staff, mainly in Commercial Banking and Global Banking and Markets. Performance-related bonuses grew in response to revenue growth. Higher marketing and IT costs reflected business growth and the launch of new initiatives. As commercial rents rose in Hong Kong’s dynamic economy, property rental costs increased, the effect magnified by the sale and leaseback agreement on Hang Seng Bank’s head office in 2006.
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Profit/(loss) before tax by country within customer groups and global businesses (continued)
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Growth in mainland China was steady during 2008, although lower than in previous years. Overall GDP growth totalled 9 per cent in 2008, down from 13 per cent in 2007, as weakness in key export markets led to a slowdown in industrial activity during the final months of the year. The tightening of monetary conditions in 2007 and early 2008 also contributed to the slowdown, although interest rates and reserve requirements were both reduced significantly during the final months of the year and a significant fiscal stimulus package was also announced. Consumer spending continued to advance at a strong pace with retail spending increasing by 21.6 per cent over the course of 2008. After accelerating to an eleven year high of 8.7 per cent in February 2008, consumer price inflation slowed to 1.2 per cent by the year-end, largely reflecting the movements in food and energy prices. The renminbi appreciated by more than 6 per cent against the US dollar during 2008, although the exchange rate was little changed during the second half of the year.
Japan’s economy slowed sharply during the course of 2008, with industrial activity declining rapidly during the final quarter of the year in response to much weaker external demand. Contractions were registered in both second and third quarter GDP data, confirming a technical recession, while the unemployment rate rose from 3.8 per cent in January 2008 to 4.4 per cent by the year-end. Inflationary pressures increased during the first half before subsiding during the final months of 2008, while measures of business confidence also fell sharply.
The economies of the Middle East performed strongly for much of 2008, although inflationary concerns were a feature for much of the year, driven by the surge in oil prices to record levels and private and public investment expenditure. High oil revenues continued to boost fiscal and current account surpluses throughout the region during 2008, although the impact of the decline in oil prices during the final months of the year, together with the OPEC-mandated production cuts, are expected to lead to slower growth in 2009.
Elsewhere in Asia, most economies followed an uneven pattern of growth during 2008. Policymakers focused on the rise in inflation during the first half of the year, but the sharp slowdown in growth during the final months of 2008 came to dominate, with a series of monetary and fiscal policy measures being introduced across the region to stimulate activity. The sustained rise in inflation prompted the Reserve Bank of India to tighten policy by raising both interest rates and reserve requirements during the first half of 2008, before then cutting the cash reserve ratio by 350 basis points and the repo rate by 250 basis points during the final quarter of the year. A recession was confirmed in Singapore after GDP contracted for three consecutive quarters in 2008, as an economic slowdown initially focused on specific industries turned more pervasive. After rising to a 26-year high of 7.5 per cent in June 2008, the annual rate of inflation slowed to 4.3 per cent by the year-end.
Inflation also proved the predominant concern in Vietnam during the first half of 2008 as the annual rate of consumer price inflation more than doubled to 28.3 per cent, prompting the State Bank of Vietnam to sanction substantial interest rate
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All commentaries on Rest of Asia-Pacific are on an underlying basis unless stated otherwise.
increases, before these measures were rapidly reversed during the final months of the year. Interest rate increases were also forthcoming in Indonesiabetween May and October 2008, although with growth levels maintaining a relatively robust level during much of the year, a tentative easing cycle was only initiated during the final weeks of 2008. Bank Negara Malaysia proved the exception by refraining
from interest rate increases during the year, even as consumer price inflation accelerated to 8.5 per cent in July 2008, before cutting the policy rate to 3.25 per cent in November. The outlook for the South Korean economy was affected by the open nature of the economy and the relatively high levels of household and corporate sector indebtedness. Full year GDP rose by 2.5 per cent in 2008, down from
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5.0 per cent in 2007 and the weakest performance for ten years, while fourth quarter GDP fell by 3.4 per cent on a year-on-year basis. Rising food prices proved particularly problematic for the Philippines during the first half of the year as inflation moved
well above the central bank’s targeted range, although the earlier tightening of monetary policy was partially reversed at the end of 2008. Growth slowed sharply in Taiwan during the course of the year, driven by deteriorating conditions overseas.
HSBC’s operations in Rest of Asia-Pacific performed strongly, reporting a pre-tax profit of US$6.5 billion compared with US$6.0 billion in 2007, an increase of 8 per cent. HSBC continued to increase its presence in key markets, augmenting organic growth with the integration of the operations of The Chinese Bank in Taiwan and the purchase of IL&FS Investsmart Ltd in India, which was completed in September. On an underlying basis, excluding the dilution gains on Chinese associates of US$1.1 billion recorded in 2007 and the acquisitions noted above, profit before tax increased by 27 per cent, with notable growth in the Middle East, South Korea, mainland China, India, and an increased contribution from associates in the region. Branches were added in mainland China, Indonesia, Japan, Malaysia and Bangladesh.
Net interest income increased by 30 per cent, with growth across most major countries and all customer groups. Deposit acquisition and related asset deployment across the region drove net interest income, though this volume growth was partly offset by deposit spread compression in the second half of the year due to declining interest rates, compounded by strong competition to acquire deposits.
In the Middle East, net interest income increased by 42 per cent, with deposit growth, notably in Personal Financial Services. This supported a strong rise in corporate lending balances aligned to trade and infrastructure investments, as well as increased personal lending, in particular credit cards. Asset spreads benefited from declines in local base rates following US dollar interest rate cuts, which resulted in a lower cost of funds.
In India, net interest income increased by 44 per cent as deposit balances in Personal Financial Services and Commercial Banking rose due to customer acquisition, notably among small businesses following the launch of the HSBC Direct for Business product. These deposits were deployed in increasing lending, where spreads improved on the corporate lending and credit card portfolios and mortgage spreads widened following a re-pricing in the second half of the year.
In mainland China, net interest income also rose due to deposit growth, as investors increasingly preferred deposits over market-led investments
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as market sentiment deteriorated. This facilitated an increase in personal lending balances following branch network expansion and successful re-pricing initiatives on corporate and commercial loans.
There was strong growth in net interest income from Balance Sheet Management within Global Banking and Markets, due to lower funding costs and steeper yield curves, notably in Singapore, mainland China, India, Japan and the Middle East.
Net fee income rose by 13 per cent, driven by a growth in fees from personal credit cards and trade and supply chain services. Credit card fees rose, particularly in the Middle East and India, driven by increases in interchange fees from higher cardholder spending and late payment and over-limit fees from higher delinquencies (see below). Trade and supply chain services contributed strongly to fee income growth with an increase of 34 per cent in the Middle East, in part reflecting the significant rise in commodity prices in the first half of the year, demonstrably in the construction and infrastructure industries in the UAE. There were lower fees from investment products and broking across the region, driven by a decline in equity markets and weakened investor sentiment.
Fee income from credit facilities rose, notably in the Middle East, India, Australia and Singapore, reflecting increases in the number of customers.
Net trading income rose by 51 per cent, predominantly due to strong Rates and foreign exchange trading across the region as volatile market conditions continued, encouraging increased corporate hedging activity.
Growth was particularly strong in South Korea, mainland China and Australia due to strategic positioning of HSBC’s balance sheet to benefit from the interest rate cuts and foreign exchange volatility in 2008, and increased activity in these local markets. In the Middle East, market uncertainty regarding possible currency revaluations drove volatility and, together with robust client demand, led to growth in foreign exchange income. In India, foreign exchange and, to a lesser extent, Rates revenues rose, driven mainly by increased customer activity and high levels of market volatility.
A net loss from financial instruments designated at fair value of US$171 million was recorded compared with income of US$111 million in 2007. Declines in equity markets affected unit-linked insurance products, particularly in Singapore. This was largely offset by a corresponding decrease in
liabilities to policyholders reflected in net insurance claims incurred and movement in liabilities to policyholders.
Net earned insurance premiums decreased by 17 per cent to US$197 million, mainly in Singapore and Malaysia due to lower sales of single premium unit-linked products. This was partly offset by an increase in the sale of general insurance products.
Loan impairment charges rose sharply, increasing by 88 per cent to US$1.1 billion, following a marked deterioration in credit quality across the region in the final quarter of the year. These charges rose most significantly in India, the Middle East and, to a lesser extent, in Australia.
In India, the rise was attributable to increased delinquency across personal lending portfolios, in response to which HSBC took action to restrict mortgage and personal lending. However, HSBC continued to extend credit to selected cards customers, which resulted in volume growth and also contributed to higher loan impairment charges.
In the Middle East, higher loan impairment charges were the result of volume growth and increased delinquency rates on personal lending. In Australia, higher delinquencies arose from the maturing of the cards portfolio and, to a lesser extent, volume growth, in addition to a credit risk provision related to an exposure to an Icelandic Bank. Partly offsetting this, loan impairment charges declined by 41 per cent in Taiwan due to an improvement in asset quality. Similarly, in Thailand, loan impairment charges were 69 per cent lower due to the non-recurrence of charges attributable to the down-grading of certain corporate customers.
Operating expenses increased by 16 per cent to US$5.7 billion. Significant investment in the region continued, notably in mainland China where 29 new outlets were opened and staff numbers increased. Related premises and equipment costs rose accordingly. Expansion was also pursued in Indonesia with the addition of new branches, and in Japan with the rollout of seven HSBC Premier centres. In the Middle East, operating expenses were 22 per cent higher in line with substantially increased levels of operating volumes and related headcount growth. In India, the rise in operating expenses was driven mainly by investment in IT, premises costs and an increase in collection activities as default rates rose. Business growth contributed to higher operating expenses in Australia. Litigation costs in the region rose.
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Growth in operating expenses at the Group Service and Software Development Centres was driven by increased volumes of activity as HSBC continued to implement a global resourcing strategy to minimise costs throughout the Group. All related costs are recharged to other Group entities and the income is reported within Other operating income.
Profit from associates and joint ventures in the region increased by 12 per cent, notwithstanding a significant impairment recorded in Ping An Insurance in respect of its stake in Fortis Bank. Growth was strong across HSBC’s other principal associates, the Bank of Communications, Industrial Bank, and the Saudi British Bank.
Mainland China’s economy continued to grow strongly, with GDP rising by 11.4 per cent in 2007, the fifth consecutive year of double-digit growth; this was despite a combination of measures aimed at curbing investment, such as increases in interest rates and reserve ratios required for banks. Economic performance remained primarily dependent on investment and exports. Bank loan growth also remained very strong. Export growth slowed from very high levels as the year progressed, reflecting the mild downturn in global trade. Consumer spending grew steadily in 2007, with retail sales rising by about 16 per cent. Inflationary pressures increased, with consumer price inflation exceeding 6 per cent towards the end of the year, mainly due to higher food prices. Mainland China’s foreign exchange reserves rose further, to more than US$1.5 trillion, while the renminbi appreciated by over 5 per cent against the US dollar in 2007.
Japan’s economy, the largest in the region, expanded modestly in 2007. Private capital investment decelerated after five years of firm growth but a rise in exports, especially to Asia, drove overall growth. Private consumption also made a positive contribution, helped by a gradual increase in employees’ income. Core consumer price inflation remained around zero throughout the course of the year.
In the Middle East, economies continued to grow, although growth rates slowed slightly on those recorded in 2006, largely as a result of OPEC-mandated cuts in oil production. Underlying
economic performance was robust, however, led by continued non-oil sector growth. The catalyst for expansion was a fifth consecutive year of rising oil prices, which facilitated continued growth in public and private investment. Consumption rose as employment levels increased and low interest rates supported an ongoing expansion in credit. Strong population growth, accelerated in parts of the region by high levels of immigration, also boosted demand for credit. High oil revenues resulted in a further year of fiscal and current account surpluses throughout the Middle East, boosting reserves and holdings of overseas assets. Rapid economic growth, low interest rates and currency weakness increased inflation, however, fuelling demands in some quarters for adjustments to the long-standing dollar pegs. Regional equity markets recovered from their 2005-06 downturns to perform strongly in 2007.
Elsewhere in the region, the Indian economy expanded by 8.7 per cent in 2007, although there was evidence that recent interest rate rises and the strength of the rupee were slowing some areas of the economy, and inflationary pressures eased in 2007. The economies of Vietnam and Singapore recorded strong performances too, expanding by 8.5 per cent and 7.7 per cent, respectively in 2007. Growth was approximately 6 per cent in Indonesia and Malaysia. Domestic demand in all these countries has become an increasingly important source of GDP growth with investment, particularly in the construction sector, expanding rapidly. Inflationary pressures intensified in 2007, largely as a result of higher oil and food prices, but remained under control. The South Korean economy accelerated in 2007 as exports continued to flourish and household spending recovered from levels recorded in 2006. Concerns over liquidity growth prompted the central bank to increase interest rates by 50 basis points to 5 per cent during the year. A gradual cooling of demand and concerns over rapid exchange rate appreciation are expected to limit the scope for further interest rate rises in 2008. Buoyant exports supported economic growth in Taiwan, while domestic demand remained lacklustre due to a lack of government initiatives which is expected to continue beyond the presidential and parliamentary elections scheduled for 2008. Generally robust economic performances in the Philippines, Thailand, and Pakistan in 2007 were overshadowed to varying degrees by political risks.
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HSBC’s operations in Rest of Asia-Pacific reported a pre-tax profit of US$6.0 billion compared with US$3.5 billion in 2006, an increase of 70 per cent. On an underlying basis, excluding dilution gains of US$1.1 billion, profit before tax increased by 34 per cent, bolstered by sustained growth and business expansion across the region.
In Global Banking and Markets, profit before tax increased significantly, driven by an enhanced product offering combined with buoyant local markets. Commercial Banking revenue benefited from increased customer volumes as a result of new and enhanced banking services. In Personal Financial Services, profit before tax rose as a result of strong balance sheet growth and increased contributions from associates. Private Banking delivered a solid performance, underpinned by robust stock markets and increasing wealth in the region.
HSBC’s three associates in mainland China, Ping An Insurance, Bank of Communications and Industrial Bank, all raised new capital in 2007 in the ‘A’ share market in Shanghai in which HSBC, as a foreign investor, was unable to participate. The dilution of the Group’s interests was considerably less than its share of the new monies, resulting in gains of US$1.1 billion which should be regarded as exceptional.
Net interest income rose by 30 per cent. Continued expansion of the branch network, particularly in the populous markets of mainland
China, Indonesia and India, together with increased marketing expenditure and greater brand awareness, accelerated customer acquisition and growth in loans and deposits.
In the Middle East, the significant increase in net interest income was driven by balance sheet growth across all customer groups and augmented by improved spreads. The growth was underpinned by strong local economies, higher oil prices and demand for credit for infrastructure investment and trade.
In Global Banking and Markets, the rise in net interest income was driven by the recovery in Balance Sheet Management revenues and, as trade and investment flows increased, by higher transactional balances in the payments and cash management businesses.
In Personal Financial Services, net interest income rose by 23 per cent, driven by higher personal lending, credit cards and deposit balances. Growth was broad-based across the region. Commercial Banking net interest income grew by 29 per cent due to volume growth in both loans and deposits following an increase in customer numbers.
Fee income increased by 34 per cent. Buoyant stock markets stimulated customer appetite for unit trusts and other investment products. Strong investment sales were recorded in India, Philippines, South Korea, Singapore and mainland China. Security services increased, driven by a sustained level of transaction volumes and investment flows. In the Middle East, increases were registered in cards,
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global custody, credit facilities and insurance. Increased trade services income in the region reflected higher intra-regional trade flows, which were driven by the favourable economic conditions.
Strong trading income growth was delivered, led by foreign exchange trading, where higher volumes were driven by increased volatility which, in turn, increased customer demand for risk management products.
Net earned insurance premiums rose by 24 per cent to US$226 million. This growth was mainly generated in Malaysia by the HSBC Amanah Takaful business which was launched in late 2006, offering shariah-compliant insurance products.
Other operating incomedecreased by 2 per cent, partly because gains on disposals of certain businesses in Australia were recorded in 2006. Similarly, profits from the disposal of assets held for sale decreased due to the non-recurrence of profits on sale of properties in Japan and India.
Net insurance claims incurred and movement in liabilities to policyholders rose by 25 per cent to US$253 million, in line with the increase in premiums, mainly in Malaysia.
Loan impairment charges rose by 17 per cent to US$616 million as corporate loan impairment charges increased in several countries. In addition, loan impairment charges in India rose due to balance sheet growth and higher loss rates on credit cards. Partly offsetting these factors, loan impairment charges were significantly lower in Taiwan due to the non-recurrence of impairment charges in 2006 which resulted from regulatory intervention in the card market and the imposition of a government debt negotiation scheme. In Indonesia, performance improved on 2006 when loan impairment charges
were affected by the introduction of minimum repayment terms.
Operating expenses increased by 28 per cent in line with the rise in net operating income before loan impairment charges. Business expansion continued throughout the region. Staff costs in India, mainland China and the Middle East rose on increases in volume-driven headcount and performance-related bonuses, the latter due to higher revenue generation. Business expansion initiatives were taken in mainland China, where an additional 27 new branches or sub-branches were opened. In India, the branch network and the consumer finance and credit card businesses were all expanded. Marketing, technology and infrastructure costs were incurred in support of business expansion.
Share of profit in associates and joint ventures in the region rose by 51 per cent, mainly due to increased contributions from HSBC’s strategic investments in mainland China, Bank of Communications, Ping An Insurance and Industrial Bank. HSBC’s share of profit from Ping An Insurance rose by 101 per cent to US$518 million as a result of robust growth, notably from life insurance products, and the realisation of synergistic gains across Ping An Insurance’s other business offerings. Profit from the Bank of Communications rose by 64 per cent to US$445 million as a result of improved performance across the associate’s various product offerings. Increased income from credit and treasury products and significant growth in fee income contributed to the rise in profits. HSBC’s share of profits from the Saudi British Bank decreased by 22 per cent to US$216 million. This was largely due to the effects of a significant correction to the local stock market in the second half of 2006.
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Economic conditions proved very difficult in the US during 2008 as the economy entered a period of recession. Overall GDP growth slowed to just 1.1 per cent for the year, down from 2 per cent in 2007. In common with many other economies, much of this weakness was concentrated in the final months of 2008 as fourth quarter GDP registered the largest quarterly decline for 26 years. Economic
weakness proved broad-based across most areas of the economy, with the notable exception of net exports. Housing sales and residential construction activity both declined from already depressed levels, with house prices continuing to fall in most regions and mortgage delinquencies continuing to rise. Labour market conditions weakened throughout the course of the year as the unemployment rate rose from 4.9 per cent in January to a 15-year high of 7.2 per cent in December 2008. The annual rate of
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consumer price inflation reached a 17-year high of 5.6 per cent in July 2008 before moderating sharply to stand at just 0.1 per cent by the year-end. A combination of falling asset values and weak employment conditions undermined consumer confidence and household spending growth turned negative during the second half of 2008. The Standard & Poor’s S&P 500 stock market index fell by 38 per cent during the year. Faced with this deterioration in economic activity and financial
conditions, the Federal Reserve lowered short-term interest rates by 425 basis points during the course of 2008, leaving the Funds’ target rate within a narrow range of between zero and 25 basis points, while a number of liquidity initiatives were also introduced.
Canadian GDP increased by 0.4 per cent during the first eleven months of 2008 compared with the equivalent period of 2007, with growth slowing markedly during the second half of the year, due predominantly to weaker external demand. Labour
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market conditions deteriorated as the unemployment rate rose from a historical low of 5.8 per cent in January 2008 to finish the year at 6.6 per cent. After rising to a level of 3.5 per cent in August 2008, the headline rate of consumer price inflation slowed to 1.2 per cent by the year-end. The core rate of
inflation remained below 2.0 per cent throughout the year. Responding to the deteriorating economic outlook, the Bank of Canada cut its overnight interest rate from 4.25 per cent at the end of 2007 to 1.5 per cent in December 2008.
HSBC’s operations in North America reported a pre-tax loss of US$15.5 billion in 2008, compared with a pre-tax profit of US$91 million in 2007.
Net interest income in North America increased by 2 per cent to US$15.2 billion, driven by Balance Sheet Management activities in Global Banking and Markets which more than offset the decline in Personal Financial Services as lending reduced.
The significant increase in net interest income in the Balance Sheet Management business resulted from correct positioning in anticipation of lower interest rates. Net interest income was also boosted by higher balances within certain loan portfolios in Global Banking and Markets.
Net interest income fell in Personal Financial Services as asset balances declined and deposit spreads narrowed. Deposit spread compression was driven by the competitive environment for retail deposits in which HSBC refrained from passing on the full effects of interest rate cuts to customers.
Asset spreads widened, particularly in vehicle finance and credit cards and, to a lesser extent, the real estate secured portfolios as yields declined by less than funding costs in the lower interest rate environment, and the credit card portfolio benefited from APR floors. This was partly offset by a rise in non-performing loans, lower loan prepayments, increased volumes of loan modifications, and lower fees from reduced loan origination volumes. Funding costs declined as a result of lower base rates during the year.
Lending balances declined as the mortgage services portfolio continued to run-off, originations ceased during the year within the dealer and direct-to-consumer channels in vehicle finance, and tighter underwriting criteria in consumer lending constrained customer eligibility for finance. In addition, US$8.2 billion of mortgages were sold from the US real estate secured portfolios during the year. These factors were partly offset by a change in mix towards higher-yielding credit card loans and reduced levels of prepayments that resulted in loans remaining on the balance sheet longer. At the end of
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February 2009, HSBC authorised the discontinuation as soon as practicable of all new receivable originations of all products by the branch-based consumer lending business of HSBC Finance in North America (see page 70).
Net fee income declined by 8 per cent, driven by reductions in US credit card fees following changes in fee practices implemented since the fourth quarter of 2007 and lower cash advance and interchange fees as a result of reduced volumes. Partly offsetting the decline were increased income from enhancement services due to higher customer acceptance rates of Account Secure Plus and Identity Protection Plan, a rise in syndication, credit and service fees in Commercial Banking and increased fees from asset management.
Trading losseswere dominated by write-downs in Global Banking and Markets on legacy exposures as continuing turmoil in credit markets adversely affected valuations of credit and structured credit trading positions, monoline exposures and leveraged and acquisition finance loans. Continued deterioration in the fair value of the run-off portfolio of sub-prime residential mortgage loans held for sale also contributed to the loss. US$3.6 billion in leveraged loans, high yield notes and securities held for balance sheet management were reclassified in 2008 under revised IFRS rules from trading assets to loans and receivables and available for sale, preventing any further mark-to-market trading losses on these assets. If these reclassifications had not been made, the loss before tax would have been US$0.9 billion higher.
The losses on legacy assets were partly offset by strong performances in other trading areas as foreign exchange trading benefited from pronounced market volatility, Rates trading correctly anticipated central bank rate cuts and gains were generated on credit default swaps in Global Banking. Revenues from emerging markets trading and precious metals trading also rose as a result of ongoing market volatility and increased transaction volumes as prices of gold and platinum rose during 2008. Losses on non-qualifying hedge positions in interest rate swaps generated further trading losses. In 2007, the Decision One business, which was closed that year, recorded trading losses of US$263 million.
Net income from financial instruments designated at fair value rose by US$2.0 billion to US$3.7 billion, primarily on HSBC’s fixed-rate long-term debt as credit spreads widened significantly in the second half of 2008 in the ongoing market turmoil. These gains, together with
those booked in previous years, will fully reverse over the life of the debt.
Gains less losses from financial investments declined, mainly due to losses on US government agency securities in 2008 and the non-recurrence of the sale of MasterCard shares, partly offset by gains from the Visa IPO in 2008.
Net earned insurance premiums decreased by 13 per cent to US$390 million, driven by lower credit related premiums in HSBC Finance due to declining loan volumes.
Other operating income declined due to losses on sale of the Canadian vehicle finance businesses and other loan portfolios in 2008, in addition to the non-recurrence of gains on disposal of fixed assets and a small portfolio of private equity investments in 2007.
Net insurance claims incurred and movement in liabilities to policyholders were broadly in line with 2007 at US$238 million.
Loan impairment charges and other credit risk provisions rose sharply, by 38 per cent to US$16.8 billion, reflecting substantially higher impairment charges in HSBC Finance across all portfolios and, in HSBC USA, the deterioration of credit quality in prime residential mortgages, second lien portfolios and private label cards. The main factors driving this deterioration were the continued weakening of the US economy, which led to rising levels of unemployment and personal bankruptcy filings: higher early-stage delinquency and increased roll rates in consumer lending: the ageing of portfolios: and further declines in house prices which increased loss severity and reduced customers’ ability to refinance and access equity in their homes. Partly offsetting these factors was a reduction in overall lending as HSBC continued to actively reduce its balance sheet and lower its risk profile in the US.
In the Mortgage Services business, loan impairment charges rose by 14 per cent to US$3.5 billion as the 2005 and 2006 vintages continued to season and experience rising delinquency. Run-off of the portfolio slowed in light of continued house price depreciation which, along with the constrained credit environment, restricted refinancing options for personal customers. In consumer lending, loan impairment charges rose by 39 per cent to US$5.7 billion. In the second half of 2008, delinquency rates began to accelerate particularly in the first lien portfolios in the parts of the country most affected by house price depreciation and rising unemployment rates. In
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HSBC USA, loan impairment charges rose by 76 per cent to US$2.6 billion driven by credit quality deterioration across the Home Equity line of credit, Home Equity loan, prime first lien residential mortgage and private label card portfolios.
Loan impairment charges in US card and retail services rose, driven by portfolio seasoning and rising unemployment, particularly in the second half of 2008, higher levels of personal bankruptcy filings and lower recovery rates. As with mortgages, this was most notable in parts of the country most affected by house price falls and unemployment. Vehicle finance loan impairment charges rose as delinquencies rose and lower prices resulted in lower recoveries when repossessed vehicles were sold at auction.
Loan impairment charges in Commercial Banking grew to US$449 million from a low base, primarily driven by higher impairment losses due to deterioration across the middle market, commercial real estate and corporate banking portfolios in the US and among firms in the manufacturing, export and commercial real estate sectors in Canada. Higher loan impairment charges and other credit risk provisions in Global Banking and Markets reflected weaker credit fundamentals in the US in 2008.
Operating expenses increased by 90 per cent, driven by US$10.6 billion of impairment charge recognised in respect of North America Personal Financial Services in 2008 to fully write off goodwill. Excluding the goodwill impairment charge, expenses were US$1.1 billion or 11 per cent lower. Staff costs declined, primarily in HSBC Finance, following decisions taken in 2007 to close the acquisition channels for new business in Mortgage Services and a number of consumer lending branches, and integrate the operations of the card businesses. HSBC USA made the decision to close its wholesale and third-party correspondent mortgage business in November 2008, while HSBC Finance took the decision to cease originations in the dealer and direct-to-consumer channels in the vehicle finance business in July 2008. Staff costs in Global Banking and Markets also fell as performance-related compensation and staff numbers both declined.
Other administrative costs decreased as origination activity declined, marketing costs in card and retail services reduced and branch costs in consumer lending fell as tightened underwriting criteria curtailed business and led to branch closures. This was partly offset by higher marketing and occupancy costs in the retail bank reflecting a continued expansion of the branch network,
increased community investment activities and higher deposit insurance, collection, payments and cash management and asset management costs in support of business growth.
In the US, GDP growth in 2007 was 2.2 per cent, 0.7 percentage points less than that recorded in 2006 as the housing-led downturn gathered pace. Consumer spending in 2007 grew by 2.9 per cent, the weakest annual expansion since 2003. Housing activity continued to weaken in 2007, with residential investment falling by 17 per cent during the year. Both new and existing home sales also declined to new lows in 2007. The unemployment rate averaged 4.6 per cent in 2007, with the average in the second half of the year slightly higher at 4.8 per cent. The trade deficit narrowed in 2007 as export growth strengthened. Consumer price inflation averaged around 4 per cent in the final quarter of 2007. This was largely due to higher energy prices; excluding food and energy, consumer price inflation averaged 2.3 per cent in the fourth quarter. The Federal Reserve lowered short-term interest rates by 100 basis points in the second half of 2007, from 5.25 per cent to 4.25 per cent, as policymakers attempted to mitigate the worst effects of the sub-prime related credit squeeze upon economic activity. 10-year note yields reached a high of 5.3 per cent in June 2007, before falling to 4 per cent by the year-end. Declines in the final months of 2007 left the S&P 500 stock market index practically unchanged compared with the end of 2006.
CanadianGDP increased by 2.4 per cent during the first eleven months of 2007 compared with the equivalent period of 2006. Domestic demand remained strong despite tighter credit conditions in the latter part of the year, supported by the robust labour market. The unemployment rate averaged 6 per cent for the year, reaching a historical low of 5.8 per cent in October. After hitting a high of 2.5 per cent in April, core consumer price inflation slowed to 1.5 per cent by the end of 2007. The Canadian dollar appreciated during the year, particularly in the second half. In July, the Bank of Canada raised its overnight interest rate from 4.25 per cent to 4.5 per cent before reversing this move in the final weeks of 2007.
HSBC’s operations in North America experienced a significant fall in pre-tax profits of 98 per cent in 2007, on both reported and underlying bases.
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The US economy began to slow in the fourth quarter of 2007 and, increasingly, evidence suggested that some parts of the country were already in recession. As the housing market slump affected the real economy, the deterioration in credit quality that began in the mortgage services business extended to include other consumer finance businesses in the US. In HSBC, this was reflected in a 79 per cent rise in loan impairment charges and a loss before tax of US$1.5 billion in Personal Financial Services. In response to this, management took actions to manage exposure and realign the business, including stopping new mortgage purchases in mortgage services, tightening underwriting criteria, restricting the product range in consumer lending, decreasing credit lines and reducing the volume of balance transfers in credit cards, and restructuring the consumer lending branch network by closing some 400 branches of HSBC Finance to reflect expected lower demand. A loss of US$965 million in Global Banking and Markets arose from credit-related and liquidity event write-downs as asset-backed securities markets became illiquid and credit spreads widened markedly.
Net interest income rose by 4 per cent, as higher revenues from payments and cash management, commercial lending and cards were offset by lower mortgage balances, spread compression and higher non-performing balances.
Overall, average lending balances were 5 per cent higher, as growth in credit and private label cards and vehicle finance offset lower mortgage
balances. The benefits of higher volumes were largely offset as asset spreads narrowed due to higher funding costs. Also, although deposit balances rose, spreads reduced as the product mix shifted to higher yielding products. Business expansion and higher customer volumes drove growth in loans and deposits in Commercial Banking. A 43 per cent increase in revenue from payments and cash management was due to higher customer balances.
Net fee income rose as a result of higher personal card balances attracting late and over-limit fees. Fees from card services also rose, due to enhancement services on cards such as debt protection and identity protection. The Intellicheck service, which allows customers to pay their credit card balances over the telephone for a fee, proved popular with customers. Payments and cash management fees also increased on higher volumes generated. In the fourth quarter of 2007, HSBC changed fee practices on credit cards to ensure they fully reflected HSBC’s brand principles. This reduced income by US$55 million in 2007.
HSBC incurred a trading loss following write-downs in credit and structured derivatives, including US$282 million relating to monoline exposures, and in leveraged and acquisition finance, driven by deterioration in the credit market in the second half of the year. The write-downs were compounded by trading losses on purchased loans in the mortgage services’ wholesale business, in response to which HSBC closed the Decision One business. By
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contrast, foreign exchange trading performance was strong, supported by activity generated by a weakening dollar and volatile markets.
Net income from financial instruments designated at fair value rose to US$1.8 billion, driven by significant fair value movements on HSBC’s own debt as a result of the widening of credit spreads and related derivatives in the second half of the year.
Gains less losses from financial investments of US$245 million were primarily attributable to the sale of shares in MasterCard.
Net earned insurance premiums decreased by 9 per cent to US$449 million, as the decline in loan volumes led to a fall in credit insurance sales and HSBC stopped reinsuring credit insurance for other lenders.
Other operating income decreased significantly, as higher losses were recorded on foreclosed properties due to the combined effect of an increase in the stock of such properties and a reduction in their value due to falling prices. In addition, there were lower gains on the sale of investments, mainly due to a significant one-off gain in the latter part of 2006.
Net insurance claims incurred and movement in liabilities to policyholders decreased by 7 per cent to US$241 million, in line with the change in net earned insurance premiums.
Loan impairment charges posted a steep rise, increasing by 79 per cent to US$12.2 billion, reflecting substantially higher charges in the US consumer finance loan book, primarily in mortgage lending but also in the credit cards portfolio in the final part of the year. The main factor driving this deterioration was the effect of the weaker housing market on both economic activity and the ability of borrowers to extend or refinance debt. In addition, seasoning and mix change within the credit cards portfolio and increases in bankruptcy filings after the exceptionally low levels seen in 2006, following changes in legislation, added to loan impairment charges.
The real estate secured portfolios experienced continuing deterioration in credit quality as a lack of demand for securitised sub-prime mortgages and falls in house prices severely restricted refinancing options for many customers. Loan impairment charges rose by 41 per cent to US$3.1 billion and by 139 per cent to US$4.1 billion in the mortgage services business and consumer lending,
respectively. Delinquency rates exceeded recent historical trends, particularly for those loans originated in 2005 and 2006. Performance was weakest in housing markets which had previously experienced the steepest home price appreciation, second lien products and stated income products.
US card services experienced a rise in loan impairment charges from a combination of factors, primarily a growth in balances, higher losses in the final part of the year as the economy slowed, a rise in bankruptcy rates to levels approaching those seen historically, and a shift in portfolio mix towards non-prime loans.
Loan impairment charges in Commercial Banking rose by 151 per cent to US$191 million, reflecting growth in the loan book, the increasing probability of default among commercial real estate loans in the US and a change in methodology for determining loan impairment allowances on a portfolio of revolving loans to small businesses. In addition, in Canada, loan impairment charges increased due to exposure to certain sectors affected by the strength of the Canadian dollar and an impairment charge for non-bank asset-backed commercial paper was also taken.
Operating expenses increased by 3 per cent, compared with growth in net operating income before loan impairment charges of 5 per cent. The retail bank branch network was extended both within and beyond the Group’s traditional spheres of operation to support the expansion of the Personal Financial Services and Commercial Banking businesses in the US and Canada. Premises and equipment expenses rose as a consequence. The consumer finance business incurred restructuring charges from the discontinuation of the wholesale and correspondent channels in mortgage services and the closing of branch offices in consumer lending. There were corresponding benefits in origination costs. The Canadian consumer finance business was also restructured in a similar fashion to the US. The business incurred US$70 million of one-off costs arising from the indemnification agreement with Visa ahead of Visa’s planned IPO. In the cards and consumer lending businesses, communication expenses increased due to higher mailing volumes on cards and consumer lending as credit collection policies were tightened. In the third quarter, however, expenditure on card marketing declined in line with a decision to slow lending growth.
Share of profit in associates and joint ventures declined to US$20 million.
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For footnote, see page 143.All commentaries on Latin America are on an underlying basis unless stated otherwise.
Inflationary pressures developed in Mexico during the course of 2008, mostly due to rising commodity prices, as consumer price inflation accelerated from 3.7 per cent in January to 6.5 per cent by the year-end. In response, the Bank of Mexico raised its overnight interest rate by 75 basis points to 8.25 per cent by the end of the year, although a variety of
economic indicators pointed to a sharp loss of momentum during the final quarter as global growth slowed.
The Brazilian economy performed strongly during the first half of 2008, driven by domestic demand, with the annual rate of consumer price inflation rising from 4.6 per cent in January to 6.4 per cent in July, towards the upper limit of the central banks’ tolerance range. Conditions within the labour market improved, with the rate of
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unemployment well below levels observed a year earlier. In line with many other economies within the region, however, conditions weakened markedly towards the end of 2008, with industrial production falling by close to 20 per cent during the fourth quarter.
In Argentina, economic activity held at a reasonably robust level for much of the year, although measures of industrial production growth slowed noticeably during the final months of 2008.
Declines in commodity prices during the second half of 2008 and the reduced value of exports raised concerns over the level of capital outflow from the country, while domestic currency interest rates increased sharply. The official headline rate of consumer price inflation rose during the first half of 2008, reaching 9.3 per cent in June 2008 before slowing to 7.2 per cent in December, although methodological changes make comparisons over year difficult.
In Latin America, HSBC reported a pre-tax profit of US$2.0 billion compared with US$2.2 billion in 2007, a decrease of 6 per cent. On an underlying basis, pre-tax profits decreased by 9 per cent as increased revenues were offset by higher loan impairment charges, largely in Mexico and Brazil, and increased operating costs across the region.
Net interest income increased by 13 per cent. Growth in average personal lending volumes was mainly driven by vehicle finance and payroll loans in Brazil, and credit cards and personal loans in Mexico. Average credit card balances increased as a result of significant organic growth in 2007 which was not repeated in 2008. Commercial loan volume growth was driven by increased lending for working capital and trade finance loans in Brazil, and medium-sized businesses and the real estate sector in Mexico. Increased income on customer liabilities, which was driven by volume growth, particularly in
time deposits, was largely offset by a contraction in deposit spreads, primarily on US dollar denominated accounts. Active repricing strategies were deployed to mitigate spread compression in the region and to better reflect the credit risk on the loan portfolio. Lower overall spreads on lending products were partly offset by increases in cards in the region, small business loans in Mexico and overdrafts in Brazil. In Argentina, spreads on most products widened.
Net fee incomedecreased by 2 per cent following a ruling by the Brazilian Central Bank reducing or eliminating certain fees such as charges on early loan repayments and returned cheques. Lower transaction volumes in Personal Financial Services in Brazil also reduced fee income. These were partly offset by product repricing, the introduction of new fees and volume growth, particularly in cards, personal loans, packaged deposit products and payments and cash management.
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Trading incomerose by 22 per cent largely reflecting favourable positioning against foreign exchange movements and increased foreign exchange sales volumes. Trading losses were registered on certain transactions where an offsetting benefit is reported in net income from financial instruments designated at fair value. Losses from defaults on derivative contracts were registered, primarily in Mexico.
Gains less losses from financial investments declined by 24 per cent as gains on the redemption of VISA shares, following its global IPO, and the sale of shares in both Brazil and Mexico were lower than the gains achieved on the sale of shares in a number of companies in Brazil in 2007.
Net earned insurance premiums rose, driven by higher prices and increased sales in the general insurance business, primarily in Argentina. Sales of life assurance products remained strong.
Increased net insurance claims incurred and movements in liabilities to policyholders in Argentina were more than offset by a decrease in liabilities to policyholders in Brazil following a decline in the equity market where the investment losses were passed on to unit-linked policyholders. This was compensated for by a similar decrease in net income from financial instruments designated at fair value.
Other operating income was broadly in line with 2007. A refinement of the income recognition methodology used in respect of long-term insurance contracts in Brazil in 2008 was offset by a similar adjustment in Mexico in 2007.
Loan impairment charges and other credit risk provisions rose by 42 per cent, mainly relating to credit cards, as organically grown portfolios in Mexico seasoned following market share growth and credit quality deteriorated in Mexico and Brazil. The personal unsecured, vehicle finance and small and medium-sized commercial loan portfolios in Brazil also experienced increased levels of loan impairment. Specific focus was placed on improving the quality of new business, based on underwriting experience and relationship management, and steps were taken to improve collection strategies.
Operating expenses increased by 7 per cent. An increase in staff costs was primarily driven by higher salaries following union-agreed pay rises and redundancy payments following reductions in staff numbers, partly offset by cost savings from the reduced headcount. Administrative expenses rose
following an increase in the use of a credit card cashback promotional facility in Mexico which was terminated at the end of 2008. Costs also grew in support of improved operational processes in the region. HSBC benefited in 2008 from the recognition of a tax credit following a court ruling in Brazil granting the right to recover excess taxes paid on insurance transactions and changes in transactional tax legislation. As economic conditions weakened towards the second half of 2008, strategic cost saving measures were implemented throughout the region.
In response to fluctuations in export demand from the US, economic growth in Mexico moderated during the course of 2007, with GDP rising an estimated 3.1 per cent during the year, compared with 4.8 per cent in 2006. Inflationary pressures remained significant throughout 2007, with consumer price inflation averaging 4 per cent, driven by increases in international prices of commodities, which affected domestic food prices in the core index. As a result, the Bank of Mexico raised its overnight interest rate by a total of 50 basis points, and has maintained its restrictive monetary policy despite reductions in interest rates by the US Federal Reserve.
The Brazilian economy expanded strongly in 2007, with GDP expected to have grown by 5.4 per cent compared with 3.7 per cent in 2006. As in 2006, growth was driven by domestic demand, with private consumption rising considerably. As a consequence, the average unemployment rate fell to 9.3 per cent in 2007 from 10 per cent in 2006. After declining to 3.1 per cent at the end of 2006, the annual rate of consumer price inflation climbed to 4.5 per cent by December 2007, mainly from higher food prices. The cycle of monetary easing which began in the third quarter of 2005 paused in October 2007 with the overnight rate at 11.25 per cent, the lowest level in several decades. After nine years of steady expansion, the trade balance surplus fell slightly in 2007, and is expected to decrease further in 2008. Balance of payments fundamentals, however, remained robust and, as a result, the Brazilian economy seemed less vulnerable to external shocks than in previous years.
The Argentine economy also performed strongly in 2007, with GDP expected to have risen by 8.7 per cent. This strength was a consequence of several factors such as a competitive exchange rate, spare capacity in the economy and a generally
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favourable external environment, which helped Argentina extend its fiscal and external surpluses into a fourth successive year. Less encouraging was the fact that inflation accelerated to about 13 per cent, up from 10 per cent in 2006. Although food inflation was part of the explanation, rapid demand growth was also a factor. 2007 was an election year, and as a result the rate of growth of fiscal spending doubled to 45 per cent on an annual basis. As a consequence, the primary surplus fell by around 1.2 per cent of GDP.
5.9 per cent in 2006 while, in South America, growth was an estimated 5.8 per cent, up from 5.3 per cent in 2006. The most dynamic economies in Central America were Panama (10.0 per cent growth in GDP) and the Dominican Republic (8.0 per cent), followed by Costa Rica (6.2 per cent) and Honduras (6.2 per cent). In South America, the fastest growing countries after Argentina were Peru (7.2 per cent growth in GDP), Venezuela (7.0 per cent) and Colombia (6.5 per cent). In general, inflation appears to be under control in Latin America, averaging around 5 per cent over the past three years. Only Venezuela and Argentina have experienced double-digit inflation, while the US dollar-based economies of Panama, Ecuador and El Salvador have better inflationary records.
HSBC’s operations in Latin America reported a pre-tax profit of US$2.2 billion compared with US$1.7 billion in 2006, representing an increase of 26 per cent. The Group’s acquisitions of HSBC Bank Panama and Banca Nazionale in 2006 strengthened the existing business platform and geographical representation. On an underlying basis, pre-tax profits rose by 14 per cent as increased revenues were partly offset by higher loan impairment charges, largely from Mexico, and a rise in operating costs.
Notable contributions to Commercial Banking’s pre-tax profits, which were 64 per cent higher than in 2006, arose in Brazil from small and mid-market
enterprises and in Mexico from larger corporates. In Personal Financial Services, profit before tax increased by 12 per cent as strong growth in revenues was partly offset by increased loan impairment charges in Mexico. Profit before tax in Global Banking and Markets increased as strong growth in net fee and net interest income was partly offset by a decrease in trading income and higher costs related to business expansion.
Notwithstanding continuing investment and integration costs throughout the region, the cost efficiency ratio improved by 2.7 percentage points to 58.3 per cent.
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Net interest income increased by 17 per cent. Growth was strong across the region, with net interest income rising by 22 per cent and 11 per cent in Mexico and Brazil, respectively.
In Mexico, net interest income rose despite a fall in balance sheet management revenues due to growth in both assets and liabilities. In particular, credit card balances increased, driven by marketing and portfolio management initiatives designed to improve customer retention and card usage. Volume growth was achieved in mortgages, commercial real estate lending, trade and factoring. Customer relationship management campaigns resulted in new customer acquisitions and increased cross-selling. Net interest income in Brazil increased as the sound economic outlook and falling interest rates resulted in strong demand for credit.
Fee income rose by 20 per cent, primarily driven by robust business growth across the region. In Mexico, the use of debit and credit cards grew, in part because of the growing ATM network and the number of cards in force, which drove commissions from ATM cash withdrawals and point of sale billing. Stricter guidelines on the imposition of late payment fees also led to higher income.
A strategy to migrate more transactions to internet-based services resulted in higher payment and cash management transactions as the number of active customers rose.
Current account income increased as a result of a re-pricing exercise and a rise in volumes. Fees from loans and funds under management also grew on higher volumes. Strong growth in customer accounts delivered higher transactional fees and the continuing success of the Tu Cuenta product in Mexico led to increased take-up with higher product fees charged to customers.
Net income from trading activities decreased by 4 per cent, mainly due to reduced trading opportunities in Credit and Rates. This was partly offset by income growth from foreign exchange trading, driven by continuing market volatility.
Net gains from financial investments rose significantly following a gain on sale of shares held
in a credit bureau, a stock exchange and a derivatives exchange in Brazil.
The continued growth of insurance operations in the region, achieved by increasing HSBC’s product offerings and expanding its distribution channels, along with targeted sales initiatives, led to higher net insurance claims incurred and movements in liabilities to policyholders.
A 97 per cent increase in other operating income reflected the recognition of the embedded value calculation on the PVIF life assurance business in Mexico. The improvement on 2006 was also aided by the non-recurrence of a loss on sale of a portfolio of assets during that year and sundry gains on foreclosed assets in 2007.
Loan impairment charges rose sharply, by 53 per cent to US$1.7 billion, mainly driven by portfolio growth, normal seasoning and higher delinquency rates on credit cards in Mexico, following a targeted expansion in market share. Loan impairment charges for small and medium-sized businesses lending and delinquencies on loans to the self-employed also increased in Mexico. Partly offsetting these developments was an improvement in personal and commercial delinquency rates in Brazil.
Continuing investment and business expansion resulted in an increase in operating expenses of 15 per cent. This compared favourably with growth in net operating income before loan impairment charges of 20 per cent. Staff costs rose, primarily on higher salaries and bonuses in the region, driven by the need to support business growth, union-agreed pay rises and one-off costs incurred in Brazil to improve operational efficiencies. These were partially offset by a curtailment and settlement gain in Mexico from staff transferring from the Group’s defined benefit healthcare scheme to a new defined contribution scheme.
Increases in non-staff costs included higher marketing expenditure in support of growth in credit card operations, continued investment in infrastructure to support business growth and a rise in telecommunication costs and transactional taxes. Four additional months of Banca Nazionale expenses also increased costs.
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Personal Financial Services provides over 105 million individual and self-employed customers with financial services in 62 countries. The selection of products and services offered in each case is determined by HSBC’s participation strategy in the respective markets.
In markets where HSBC already has scale or, in emerging markets where scale can be built over time, HSBC offers a full range of personal financial products and services. Typically, products provided include personal banking products (current and savings accounts, mortgages and personal loans, credit cards, and local and international payment services), together with consumer finance and wealth management services.
In other markets, HSBC participates more selectively, targeting only those customer segments which have strong international connectivity or where HSBC’s global scale is crucial.
HSBC Premier, the Group’s premium banking service, provides personalised relationship management, a single online view of all international accounts, free international funds transfer between HSBC accounts, 24-hour priority telephone access, global travel assistance and wealth management services. There are now over 2.6 million HSBC Premier customers, who can use more than 300 specially designated Premier branches and centres in 41 countries and territories.
Wealth management (insurance and investment products and financial planning services) plays an important part in meeting the needs of customers. Insurance products distributed by HSBC through its direct channels and branch networks include loan protection, life, property and health insurance and pensions. HSBC also makes available a wide range of investment products. A choice of third-party and proprietary funds provides customers with the ability to diversify their investments across a range of best-in-class fund managers chosen after a rigorous and objective selection process. Comprehensive financial planning services covering customers’ investment, retirement, personal and asset protection needs are offered through qualified financial planning managers.
Personal customers prefer to conduct their financial business at times convenient to them, using the sales and service channels of their choice. This demand for flexibility is met through the increased provision of direct channels such as the internet and self-service terminals, in addition to traditional and
automated branches and service centres accessed by telephone.
HSBC is a major global credit card issuer with over 100 million credit cards in force in 49 countries. In addition to HSBC branded cards, HSBC Finance in the US offers Household Bank and Orchard Bank branded cards and affiliation programmes such as the GM card and the AFL-CIO Union Plus card. HSBC is also a provider of third-party private label credit cards (or store cards) through merchant relationships.
HSBC Finance’s operations in the US, the UK and Canada also make credit available to customers not well catered for by traditional banking operations and facilitate point-of-sale credit in support of retail purchases. At the end of February 2009, HSBC authorised the discontinuation as soon as practicable of all new receivable originations of all products by the branch-based consumer lending business of HSBC Finance in North America (see page 70).
High net worth individuals and their families who choose the differentiated services offered within Private Banking are not included in this customer group.
HSBC is one of the world’s leading and most international banks, with over 2.9 million Commercial Banking customers in 63 countries, including sole proprietors, partnerships, clubs and associations, incorporated businesses and publicly quoted companies. At 31 December 2008, HSBC had total commercial customer account balances of US$236 billion and total commercial customer loans and advances, net of loan impairment allowances, of US$204 billion.
HSBC segments its Commercial Banking business into corporate, mid-market, small and micro businesses, allowing the development of tailored customer propositions while adopting a broader view of the entire Commercial Banking sector, from sole traders to top-end mid-market corporations. This allows HSBC to provide continuous support to companies as they grow in size both domestically and internationally, and ensures a clear focus on the small and micro business sectors, which are typically the key to innovation and growth in market economies.
HSBC places particular emphasis on geographical collaboration to meet its business customers’ needs and aims to be recognised as the leading international business bank and the best bank
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for small business in target markets. The range of products and services includes:
Financing: HSBC provides a range of short and longer-term financing options for Commercial Banking customers, both domestically and cross-border, including overdrafts, receivables finance, term loans and property finance. The Group offers forms of asset finance in selected sites and has established specialised divisions providing leasing and instalment finance for vehicles, plant and equipment.
Payments and cash management: HSBC is a leading provider of domestic and cross-border payments, collections, liquidity management and account services worldwide. The Group’s extensive network of offices and direct access to numerous local clearing systems enhances its customers’ ability to manage their cash efficiently on a global basis. Deposits are attracted through both current accounts and savings products, in local and foreign currencies.
International trade: HSBC finances and facilitates significant volumes of international trade, under both open account terms and traditional trade finance instruments. HSBC also provides international factoring, commodity and insured export finance, and forfaiting services. The Group utilises its extensive international network to build customer relationships at both ends of trade flows, and maximises efficiency through expertise in documentary checking and processing, and highly automated systems.
Treasury and capital markets: Commercial Banking customers are volume users of the Group’s foreign exchange capabilities, including sophisticated currency and interest rate options.
Commercial cards: HSBC offers commercial card services covering both issuing and acquiring. Commercial card issuing provides its customers with services which enhance cash management, improve cost control and streamline purchasing processes. HSBC offers card acquiring services, either directly or as part of a joint venture, enabling merchants to accept credit and debit card payments either in person/on the premises or when the cardholder is not present (eg over the internet or on the telephone).
Insurance: HSBC offers insurance services covering a full range of commercial insurance products designed to meet the needs of businesses and their employees, including employee benefit, pension and healthcare programmes, and a variety of commercial risks such as buildings, marine, cargo, keyman and credit protection. These products are provided by HSBC either as an intermediary (broker,
agent or consultant) or as a supplier of in-house or third-party offerings. HSBC also provides insurance due diligence reviews, and actuarial and employee benefit consultancy services.
Wealth management services: These include advice and products related to savings and investments provided to Commercial Banking customers and their employees through HSBC’s worldwide network, with clients being referred to Private Banking where appropriate.
Investment banking: A small number of Commercial Banking customers need corporate finance and advisory support. These requirements are serviced by the Group on a client-specific basis.
Delivery channels: HSBC deploys a full range of delivery channels, including specific online and direct banking offerings such as HSBCnet and Business Internet Banking.
Global Banking and Markets provides tailored financial solutions to major government, corporate and institutional clients worldwide. Managed as a global business, Global Banking and Markets operates a long-term relationship management approach to build a full understanding of clients’ financial requirements. Sectoral client service teams comprising relationship managers and product specialists develop financial solutions to meet individual client needs. With dedicated offices in over 66 countries and access to HSBC’s worldwide presence and capabilities, this business serves subsidiaries and offices of its clients on a global basis.
Global Banking and Markets is managed as four principal business lines: Global Markets, Global Banking, Principal Investments and Global Asset Management. This structure allows HSBC to focus on relationships and sectors that best fit the Group’s footprint and facilitates seamless delivery of HSBC’s products and services to clients.
HSBC’s operations in Global Markets consist of treasury and capital markets services for supranationals, central banks, corporations, institutional and private investors, financial institutions and other market participants. Products include:
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HSBC’s operations in Global Banking consist of financing, advisory and transaction services for corporations, institutional and private investors, financial institutions, and governments and their agencies. Products include:
HSBC’s operations in asset management consist of products and services for institutional investors, intermediaries and individual investors and their advisers.
This includes private equity, which comprises HSBC’s captive private equity funds, strategic relationships with third-party private equity managers and other investments.
HSBC’s presence in all the major wealth-creating regions has enabled it to build one of the world’s leading private banking groups, providing private banking and trustee services to high net worth individuals and their families from over 90 locations
in 43 countries and territories, with client assets of US$352 billion at 31 December 2008.
HSBC Private Bank is the principal marketing name of the HSBC Group’s international private banking business and utilising the most suitable products from the marketplace, HSBC Private Bank works with its clients to offer both traditional and innovative ways to manage and preserve wealth while optimising returns. Products and services offered include:
Private Banking Services: These comprise multi-currency deposit accounts and fiduciary deposits, credit and specialist lending, treasury trading services, cash management, securities custody and clearing. In addition, HSBC Private Bank works to ensure its clients have full access to other products and services available throughout HSBC, such as credit cards, internet banking, corporate banking, and investment banking.
Private Wealth Management: These comprise both advisory and discretionary investment services. A wide range of investment vehicles is covered, including bonds, equities, derivatives, options, futures, structured products, mutual funds and alternatives (hedge funds, private equity and real estate). By accessing regional expertise located within six major advisory centres in Hong Kong, Singapore, Geneva, New York, Paris and London, Private Banking seeks to find the most suitable investments for clients’ needs and investment strategies. Corporate Finance Solutions helps provide clients with cross-border solutions for their companies working with Global Banking & Markets.
Private Wealth Solutions: These comprise inheritance planning, trustee and other fiduciary services designed to protect existing wealth and create tailored structures to preserve wealth for future generations. Areas of expertise include trusts, foundation and company administration, charitable trusts and foundations, insurance, family office advisory and philanthropy. These are tailored to meet the individual needs of each family.
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Funds under management at 31 December 2008 were US$735 billion, a decrease of 13 per cent compared with 31 December 2007. Both Global Asset Management and Private Banking funds decreased due to the fall in equity markets.
Global Asset Management funds under management amounted to US$370 billion, a decrease of 3 per cent compared with 31 December 2007. Excluding an internal transfer of US$67 billion, Global Asset Management funds decreased by 20 per cent to US$303 billion.
Net outflows were predominantly driven by clients redeeming long-term funds as a consequence of the downturn in the global economic environment, although this was reduced by net new money into money market funds as clients sought to reduce risk. Additionally, the total value of funds under management was affected by a weaker investment performance resulting from turbulent markets and by foreign exchange movements.
Notwithstanding a decrease in emerging markets funds during the year, Global Asset Management remained one of the world’s largest emerging market asset managers, with US$52 billion of funds under management.
Private Banking’s funds under management decreased by 20 per cent to US$219 billion, driven by equity market performance. Net new money, while positive, amounted to only US$2 billion as positive flows in Europe, were offset by outflows of funds in other regions as clients reduced risk by transferring funds to cash deposits, many with HSBC in response to its perceived strength.
Other funds under management, of which the main element is a corporate trust business in Asia, decreased to US$144 billion.
Assets held in custody and under administration
Custody is the safekeeping and servicing of securities and other financial assets on behalf of clients. At 31 December 2008, assets held by HSBC as custodian amounted to US$3.6 trillion, 33 per cent lower than the US$5.4 trillion held at 31 December 2007. This was mainly driven by
adverse market movements affecting the value of assets held.
HSBC’s assets under administration business, which includes the provision of various support function activities including the valuation of portfolios of securities and other financial assets on behalf of clients, complements the custody business. At 31 December 2008, the value of assets held under administration by the Group amounted to US$3.3 trillion, in line with 31 December 2007.
Property
During 2008, HSBC recognised a gain of US$416 million in other operating income in respect of the purchase of the subsidiary of Metrovacesa which owned the property and long leasehold land comprising 8 Canada Square, London. See Note 23 on the Financial Statements for further details.
At 31 December 2008, HSBC operated from some 9,870 operational properties worldwide, of which approximately 2,770 were located in Europe, 1,090 in Hong Kong and Rest of Asia-Pacific, 1,640 in North America, 4,200 in Latin America and 170 in the Middle East. These properties had an area of approximately 73.6 million square feet (2007: 69.8 million square feet).
Freehold, long leasehold and short leasehold land and buildings carried on the balance sheet represented 35 per cent of HSBC’s operational space. Of the total net book value of HSBC properties, more than 72 per cent was for owned properties or properties under long-term leases. In addition, properties with a net book value of US$971 million were held for investment purposes.
HSBC’s operational properties are stated at cost, being historical cost or fair value at the date of transition to IFRSs (their deemed cost) less any impairment losses, and are depreciated on a basis calculated to write off the assets over their estimated useful lives. Properties owned as a consequence of an acquisition are recognised initially at fair value.
Valuation of freehold and leasehold land and buildings
HSBC’s freehold and long leasehold properties, together with all leasehold properties in Hong Kong, were valued in 2008. The value of these properties was US$3.3 billion (2007: US$2.2 billion) in excess of their carrying amount in the consolidated balance sheet.
Further details are included in Note 23 on the Financial Statements.
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Legal proceedings
On 27 July 2007, the UK Office of Fair Trading (‘OFT’) issued High Court legal proceedings against a number of UK financial institutions, including HSBC Bank, to determine the legal status and enforceability of certain of the charges applied to their personal customers in relation to unauthorised overdrafts (the ‘charges’). Pending the resolution of the proceedings, the Financial Services Authority (‘FSA’) has granted firms (including HSBC Bank) a waiver enabling them to place relevant complaints about the charges on hold and the County Courts have stayed all individual customer claims.
Certain preliminary issues in these proceedings have been heard in the Commercial Division of the High Court. This has confirmed that HSBC Bank’s current and historic charges are capable of being tested for fairness but are not capable of being penalties. HSBC Bank (and all the other financial institutions involved in the legal proceedings) appealed the finding that the current charges are capable of being tested for fairness. The Court of Appeal delivered its judgement on 26 February 2009, confirming the decision of the High Court that the charges of HSBC Bank (and all of the other financial institutions involved in the legal proceedings) are capable of being tested for fairness. HSBC Bank is considering applying for leave to appeal to the House of Lords.
The proceedings remain at an early stage and may, allowing for appeals on the issues, take some time to conclude. A wide range of outcomes is possible, depending upon the outcome of any appeal to the House of Lords and, to the extent applicable, upon the Court’s assessment of the fairness of each charge across the period under review. Since July 2001, there have been a variety of charges applied by HSBC Bank across different charging periods under the then existing contractual arrangements. HSBC Bank considers the charges to be and to have been valid and enforceable, and intends strongly to defend its position.
If, contrary to HSBC Bank’s current assessment, the Court should ultimately (after appeals) reach an adverse decision that results in a liability, a large number of different outcomes is possible, each of which would have a different financial impact. Given that there is limited authority on how an assessment of fairness should be conducted, HSBC Bank’s estimate of the potential financial impact is that it could be in the order of approximately £350 million (US$510 million), as published in the Interim Report 2008. To make an estimate of the potential financial impact at this stage with any
precision is extremely difficult, owing to (among other things) the complexity of the issues, the number of permutations of possible outcomes, and the early stage of the proceedings. In addition, the assumptions made by HSBC Bank may prove to be incorrect.
On 11 December 2008 Bernard L Madoff (‘Madoff’) was arrested and charged in the United States District Court for the Southern District of New York with one count of securities fraud. That same day, the US Securities and Exchange Commission (‘SEC’) filed securities fraud charges against Madoff and his firm Bernard L Madoff Investment Securities LLC (‘Madoff Securities’), a broker dealer and investment advisor registered with the SEC. The criminal complaint and SEC complaint each alleged that Madoff had informed senior Madoff Securities employees, in substance, that his investment advisory business was a fraud. On 15 December 2008, on the application of the Securities Investor Protection Corporation, the United States District Court for the Southern District of New York appointed a trustee for the liquidation of the business of Madoff Securities, and removed the liquidation proceeding to the United States Bankruptcy Court for the Southern District of New York. On 9 February 2009, on Madoff’s consent, the United States District Court for the Southern District of New York entered a partial judgement in the SEC action, permanently enjoining Madoff from violating certain antifraud provisions of the US securities laws, ordering Madoff to pay disgorgement, prejudgement interest and a civil penalty in amounts to be determined at a later time, and continuing certain other relief previously imposed, including a freeze on Madoff’s assets. The relevant US authorities are continuing their investigations into the alleged fraud. There remains significant uncertainty as to the facts of the alleged fraud and the extent of any assets of, and remaining within, Madoff Securities.
Various non-US HSBC group companies provide custodial, administration and similar services to a number of funds incorporated outside the United States of America whose assets were invested with Madoff Securities. Based on information provided by Madoff Securities, as at 30 November 2008, the aggregate net asset value of these funds (which would include principal amounts invested and unrealised gains) was US$8.4 billion.
Proceedings concerning Madoff and Madoff Securities have already been issued in various jurisdictions against numerous defendants and HSBC expects further proceedings to be brought, including by the Madoff Securities trustee. Various
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HSBC group companies have been named as defendants in suits in the United States anticipated to seek class action status and cases in the Commercial List of the Irish courts. All of the cases where HSBC group companies are named as a defendant are at a very early stage. HSBC considers that it has good defences to these claims and will continue to defend them vigorously. HSBC is unable reliably to estimate the liability, if any, that might arise as a result of such claims.
Various HSBC group companies have also received requests for information from various regulatory authorities in connection with the alleged fraud by Madoff. HSBC group companies are co-
operating with these requests for information.
These actions apart HSBC is party to legal actions in a number of jurisdictions including the UK, Hong Kong and the US arising out of its normal business operation. HSBC considers that none of the actions is material, and none is expected to result in a significant adverse effect on the financial position of HSBC, either individually or in the aggregate. Management believes that adequate provisions have been made in respect of the litigation arising out of its normal business operations. HSBC has not disclosed any contingent liability associated with these legal actions because it is not practical to do so.
Operating and Financial Review footnotes (see pages 12 to 143)
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As a result of the widespread deterioration in the markets for securitised and structured financial assets, and consequent disruption to the global financial system since mid-2007, it has become increasingly difficult to observe prices for structured credit risk, including prime tranches of such risk as the markets for these assets became illiquid. The resulting constraint on the ability of financial institutions to access wholesale markets to fund such assets added additional downward pressure on all asset prices. As a consequence, many financial institutions have recorded considerable reductions in the fair values of their asset-backed securities (‘ABS’s) and leveraged structured transactions, most significantly in sub-prime mortgages but in other asset classes too.
In light of increasing illiquidity and the risk to capital from further write-downs, many financial institutions took steps during 2008 to reduce leveraged exposures, build liquidity and raise additional capital. However, credit conditions suffered additional deterioration in the second half of the year, as the economic outlook worsened and unemployment rose, intensifying the pressure on the global financial system. Volatility in money markets also increased during the second half of 2008, resulting in wider interest spreads, and markets for securitised and structured financial assets continued to be thoroughly constrained. This instability triggered a series of significant events including the default of a number of major financial institutions, and the taking into public ownership of banks in a number of countries.
Deterioration in the measured fair value of assets supported by sub-prime mortgages continued in 2008 with the primary market for all but US government-sponsored issues remaining weak. Spreads widened due to credit and liquidity concerns as delinquencies on the underlying mortgages continued to increase beyond the levels priced into securitisations issued in recent years. The impact widened beyond sub-prime related assets, with the measured fair value of securities backed by Alt-A collateral, in particular, suffering significant deterioration.
During 2008, governments and central banks worldwide took unprecedented measures designed to stabilise and increase confidence in financial markets. These measures included providing vast amounts of liquidity via emergency funding, extending guarantees of financial assets, and launching various forms of rescue plans.
This section contains disclosures about the effect of the recent market turmoil on HSBC’s securitisation activities and other structured products. HSBC’s principal exposures to the US and the UK mortgage markets primarily take the form of credit risk from direct loans and advances to customers which were originated to be held to maturity or refinancing, details of which are provided on page 208.
Financial instruments which were most affected by the market turmoil include exposures to direct lending held at fair value through profit or loss and ABSs, including mortgage-backed securities (‘MBS’s) and collateralised debt obligations (‘CDO’s), and exposures to and contingent claims on monoline insurers in respect of structured credit activities and leveraged finance transactions which were originated to be distributed.
In accordance with HSBC’s policy to provide meaningful disclosures that help investors and other stakeholders understand the financial position, performance and changes in the financial position of the Group, the information provided in this section goes beyond the minimum levels required by accounting standards, statutory and regulatory requirements and listing rules. In the specific context of facilitating an understanding of the recent market turmoil in markets for securitised and structured assets, HSBC has considered the recommendations relating to disclosure contained within the reports issued by the Financial Stability Forum on ‘Enhancing Market and Institutional Resilience’ (April and October 2008), the Committee of European Banking Supervisors on ‘Banks’ Transparency on Activities and Products Affected by the Recent Market Turmoil’ (June and October 2008) and the International Accounting Standards Board Expert Advisory Panel on ‘Measuring and disclosing the fair value of financial instruments in markets that are no longer active’ (October 2008). In addition, HSBC has considered feedback from investors, regulators and other stakeholders on the disclosures that investors would find most useful.
The specific topics covered in respect of HSBC’s securitisation activities and exposure to structured products are as follows:
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At 31 December 2008, the aggregate carrying amount of HSBC’s exposure to ABSs, trading loans
held for securitisation and exposure to leveraged finance transactions was US$91 billion (2007:US$131 billion), summarised as follows:
The majority of these exposures arise in the Global Banking and Markets business segment.
Within the total carrying amount of ABSs on the balance sheet, ABS holdings of US$14.6 billion (2007: US$32.1 billion) are held through vehicles discussed on page 148, where significant first loss protection is provided by external investors on a fully collateralised basis.
A reconciliation of the movement in the carrying amount of ABSs on the balance sheet of US$34.5 billion is set out below:
Due to the market dislocation in respect of these securities, the impact of purchases and sales on the total carrying amount of ABSs was not significant in 2008.
At 31 December 2008, of the total carrying amount of ABSs and trading loans held for securitisation in respect of sub-prime and Alt-A residential mortgage exposure, US$3.5 billion (2007: US$11.7 billion) was held through special purpose entities (‘SPE’s).
Reclassification of financial assets
In October 2008, the IASB issued amendments to IAS 39 ‘Financial Instruments: Recognition and Measurement’ and IFRS 7 ‘Financial Instruments: Disclosures’ which permitted an entity to reclassify non-derivative financial assets out of the held-for-trading category as described in the accounting policies on Note 2 (e) on the Financial Statements. This was done to better align IFRSs with US GAAP and was restricted to situations where the transferring entity had the intention and ability to hold the transferred position for the foreseeable future or until maturity.
During the second half of 2008, HSBC reclassified financial assets from the held-for-trading category as tabulated below. The amount reclassified was the fair value of the financial assets at the date of reclassification, subject to the transition rules noted below. In October 2008, HSBC reclassified US$12.5 billion and US$0.4 billion of held-for-trading financial assets as loans and receivables and available for sale, respectively. During November and December 2008, HSBC reclassified a further US$2.8 billion and US$2.2 billion of held-for-trading financial assets as loans and receivables and available for sale, respectively. The financial consequence of the reclassification is that the reclassified assets are no longer marked-to-market through the income statement. Amounts reclassified as loans and receivables are accounted as such from the date of reclassification and tested thereafter for
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impairment. Amounts reclassified as available for sale are held at fair value with changes in the fair value recognised in equity, and tested for impairment. In line with the transition rules, for reclassifications made during October 2008, the reclassified financial assets were treated as having been so reclassified as at 1 July 2008. The impact of back-dating these retrospective reclassifications was that fair value movements between 1 July 2008 and October 2008 of US$835 million were not recorded in the income statement.
The reclassifications resulted from significant reductions in market liquidity for these assets and a change in HSBC’s intention to hold them for the foreseeable future or to maturity. These circumstances arose in the wider context of market turmoil. As a result, the Group decided to reclassify financial assets that would have met the definition of loans and receivables at initial recognition, as permitted by the IAS 39 amendments. In addition, as permitted by the IAS 39 amendments in rare
circumstances, the Group reclassified securities, that did not meet the definition of loans and receivables on initial recognition, as the conditions of market turmoil prevailing in the second half of 2008 were considered rare.
If these reclassifications had not been made, the Group’s pre-tax profit would have been reduced by US$3.5 billion from US$9.3 billion to US$5.8 billion. The reduction would have been US$0.9 billion in the North America and US$2.6 billion in the Europe segments. There was no significant impairment identified on the loans transferred even though the fair value continued to fall as a consequence of illiquidity and market sentiment.
The following table shows the fair value gains and losses, income and expense recognised in the income statement both before and after the date of reclassification:
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Financial effect of market turmoil
As described in the background to market turmoil on page 144, the dislocation of financial markets which developed in the second half of 2007 continued throughout 2008. For the three half-year periods
affected to date, the write-downs incurred by the Group on ABSs, trading loans held for securitisation, leveraged finance transactions and the movement in fair values on available-for-sale ABSs taken to equity, plus impairment losses on specific exposures to banks, are summarised in the following table:
Virtually all of these effects were recorded in Global Banking and Markets. Included in write-downs taken to the income statement is US$209 million in respect of impairment losses on the collapse of financial institutions, of which US$126 million was incurred on the collapse of Icelandic banks. The group took no material write-
downs to the income statement in respect of exposures to Lehman Brothers.
Further analysis of the write-downs taken to the income statement by Global Banking and Markets, and the net carrying amounts of the positions that have generated these write-downs, are shown in the following table:
Global Banking and Markets write-downs taken to the income statement and carrying amounts
Global Banking and Markets asset-backed securities classified as available for sale
HSBC’s principal holdings of ABSs are in the Global Banking and Markets’ business through special purpose entities (‘SPE’s) which have the benefit of external investor first loss protection
support, positions held directly and by Solitaire Funding Limited (‘Solitaire’) where HSBC has first loss risk.
The table below summarises these Global Banking and Markets’ exposures to ABSs which are held on an available-for-sale basis.
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Structured investment vehicles and securities investment conduits (special purpose entities)
In the table above, the total carrying amount of ABSs on the balance sheet in respect of SPEs represent holdings in which significant first loss protection is provided through the capital notes issued by the structured investment conduits (‘SIC’s), excluding Solitaire. The economic first loss protection remaining at 31 December 2008 amounted to US$2.2 billion (2007: US$2.3 billion). As set out on page 174, on an IFRS accounting basis the impairment charge of US$293 million was allocated to the capital note holders at 31 December 2008 (2007: n/a).
At each balance sheet date, an assessment is made as to whether there is any objective evidence of impairment in the value of available-for-sale ABSs. Impairment charges incurred on assets held by these SPEs are offset by a credit to the impairment line for the amount of the loss allocated to capital note holders.
Impairments recognised at 31 December 2008 from assets held directly or within Solitaire in recognition of the first loss protection of US$1.2 billion provided by HSBC through credit enhancement were US$279 million (2007: nil), based on a notional principal value of securities which were impaired of US$570 million (2007: nil). The low level of impairment recognised in comparison with the deficit in the available-for-sale reserve is a reflection of the credit quality and seniority of the assets held.
Sub-prime and Alt-A residential mortgage-backed securities
Management’s current assessment of the holdings of available-for-sale ABSs with the most sensitivity to possible future impairment is focused on sub-prime and Alt-A residential mortgage-backed securities (‘MBS’s).
Excluding holdings in the SPEs discussed above, available-for-sale holdings in these categories within Global Banking and Markets amounted to US$5.2 billion at 31 December 2008 (2007: US$11.8 billion). During the year ended 31 December 2008, the movement in fair values of these securities taken to equity was a reduction of US$4.8 billion. The deficit in the available-for-sale fair value reserve as at 31 December 2008 in relation to these securities was US$5.9 billion (2007: US$1.1 billion). The main factors in the reduction in fair value of these securities over the period were the effects of reduced market liquidity and negative market sentiment. The level of actual credit losses experienced was low in 2008, notwithstanding the deterioration in the performance of the underlying mortgages in the period as US house prices fell and defaults increased. The absence of material credit losses is judged to be attributable to the seniority of the tranches held by HSBC as well as the priority for cash flow held by these tranches.
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During February 2009, the credit ratings on a proportion of ABSs held directly by HSBC, Solitaire and the SICs were downgraded. In particular, Moody’s Investor Services downgraded the ratings on substantially all the Group’s holdings of US Alt-A residential MBSs issued during 2006 and 2007.
As discussed on page 170, when assessing available-for-sale ABSs for objective evidence of impairment at the balance sheet date HSBC considers all available evidence including the performance of the underlying collateral. A downgrade of a security’s credit rating is not, of itself, evidence of impairment. Consequently, Moody’s action has no direct impact on the measurement of impairment losses. The impairment losses recognised on these securities at 31 December 2008 is set out on page 148.
Stress analysis(Unaudited)
HSBC’s regular impairment assessment uses an industry standard model with inputs which are corroborated using observable market data where available. At 31 December 2008, management performed a stress test on the available-for-sale ABS positions, based on the fair value of the positions at that date. The outcome of the stress test was particularly sensitive to expected loss and prepayment rates for Alt-A securities and the loss of credit protection from certain monoline insurers on US Home Equity Lines of Credit (‘HELoC’s). The results of the stress test showed that, by applying different inputs to those currently observed, a further potential impairment charge to the income statement of some US$2 billion to US$2.5 billion could arise over the next three years. These different inputs were calculated by increasing the net impact of expected loss and prepayment rates for Alt-A securities by between a third and a half depending on loan vintage and by removing all credit protection from monoline insurers rated below AAA by S&P on the HELoC positions. However, management believes that the loss which would be realised in cash terms would be considerably lower than the impairment charge above and potentially cost some US$0.6 billion to US$0.8 billion over the next four years.
Asset-backed securities and leveraged finance
HSBC is or has been involved in the following activities in these areas:
Historically, these activities have not been a significant part of Global Banking and Markets’ business, and Global Banking and Markets is not reliant on them for any material aspect of its business operations or profitability.
The purchase and securitisation of US mortgage loans and the secondary trading of US MBSs was conducted in HSBC’s US MBSs business. This business was discontinued in 2007.
Special purpose entities
HSBC enters into certain transactions with customers in the ordinary course of business which involve the establishment of SPEs to facilitate customer transactions. SPEs are used in HSBC’s business in order to provide structured investment opportunities for customers, facilitate the raising of funding for customers’ business activities, or diversify HSBC’s sources of funding and/or improve capital efficiency.
The use of SPEs is not a significant part of HSBC’s activities and HSBC is not reliant on the use of SPEs for any material part of its business operations or profitability. Detailed disclosures of HSBC’s sponsored SPEs are provided on page 173.
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The effect of the recent market turmoil on HSBC’s risk exposures, the way in which HSBC has managed risk exposures in this context, and any changes made in HSBC’s risk management polices and procedures in response to the market conditions are set out in the following sections:
HSBC’s accounting policies regarding the classification and valuation of financial instruments are in accordance with the requirements of IAS 32 ‘Financial Instruments: Presentation’ and IAS 39 ‘Financial Instruments: Recognition and Measurement’, as described in Note 2 on the Financial Statements, and the use of assumptions and estimation in respect of valuation of financial instruments as described on page 63.
This section contains information on HSBC’s exposures to the following:
MBSs are securities that represent interests in a group of mortgages. Investors in these securities have the right to cash received from future mortgage payments (interest and/or principal). Where an MBS references mortgages with different risk profiles, the MBS is classified according to the highest risk class. Consequently, an MBS with both sub-prime and Alt-A exposures is classified as sub-prime.
CDOs are securities in which ABSs and/or certain other related assets have been purchased and securitised by a third-party, or securities which pay a
return which is referenced to those assets. CDOs may feature exposure to sub-prime mortgage assets through the underlying assets. As there is often uncertainty surrounding the nature of the underlying collateral supporting CDOs, all CDOs supported by residential mortgage-related assets, irrespective of the level of sub-prime assets, are classified as sub-prime.
HSBC’s holdings of ABSs and CDOs, and its direct lending positions, include the following categories of collateral and lending activity:
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residential mortgage-related assets are included in this category.
HSBC’s exposure to non-residential mortgage-related ABSs and direct lending includes:
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Carrying amount of HSBC’s consolidated holdings of ABSs, and direct lending held at fair value through profit or loss (continued)
Included in the above table are ABSs which are held through SPEs that are consolidated by HSBC. Although HSBC includes these assets in full on its balance sheet, the risks arising from the assets are mitigated to the extent of third-party investment in notes issued by those SPEs. For a description of HSBC’s holdings of and arrangements with SPEs, see page 173.
The exposure detailed above includes long positions where risk is mitigated by specific credit derivatives with monoline insurers (‘monolines’) and other financial institutions. These positions comprise:
US government-sponsored enterprises mortgage-related assets shown in the table above include holdings of securities issued by Freddie Mac of US$8.0 billion (2007: US$6.8 billion) and by Fannie Mae of US$6.6 billion (2007: US$8.5 billion).
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HSBC’s consolidated holdings of US ABSs, and direct lending held at fair value through profit or loss
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HSBC’s consolidated holdings of US ABSs, and direct lending held at fair value through profit or loss (continued)
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HSBC’s consolidated holdings of UK ABSs, and direct lending held at fair value through profit or loss
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HSBC’s consolidated holdings of UK ABSs, and direct lending held at fair value through profit or loss (continued)
For footnotes, see page 162.
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HSBC’s consolidated holdings of ABSs, and direct lending held at fair value through profit or loss, other than those supported by US and UK-originated assets
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HSBC’s consolidated holdings of ABSs, and direct lending held at fair value through profit or loss, other than those supported by US and UK-originated assets (continued)
Vintages of US sub-prime and Alt-A mortgage-backed securities
Transactions with monoline insurers
HSBC’s exposure to derivative transactions entered into directly with monoline insurers
HSBC’s principal exposure to monolines is through a number of over-the-counter (‘OTC’) derivative transactions, mainly credit default swaps (‘CDS’s). HSBC entered into these CDSs primarily to purchase credit protection against securities held within the trading portfolio.
During 2008, the notional value of contracts with monolines decreased as certain transactions were commuted and others matured. Nevertheless, HSBC’s overall credit exposure to monolines increased as the fair value of the underlying securities declined, causing the value of the CDS protection purchased to increase. The table below sets out the fair value, essentially the replacement cost, of the derivative transactions at 31 December 2008, and hence the amount at risk if the CDS
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protection purchased were to be wholly ineffective because, for example, the monoline insurer was subdivided between those monolines that were rated by S&P at ‘BBB or above’ at 31 December 2008, and those that were ‘below BBB’ (‘BBB’ is the S&P cut-off for an investment grade classification). As certain monolines were downgraded during 2008, exposure to monolines rated ‘below BBB’ at 31 December 2008 increased from the position as at 31 December 2007. The ‘Credit risk adjustment’
unable to meet its obligations. In order to illustrate that risk, the value of protection purchased is shown column indicates the valuation adjustment (the provision) taken against the net exposures, and reflects the assessed loss of value on purchased protection arising from the deterioration in creditworthiness of the monolines. These valuation adjustments, which reflect a measure of the irrecoverability of the protection purchased, have been charged to the income statement.
The above table can be analysed as follows. HSBC has derivative transactions referenced to underlying securities with a nominal value of US$12.4 billion, whose value at 31 December 2008 indicated a potential claim against the protection purchased from the monolines of some US$3.9 billion. On the basis of a credit assessment of the standing of the monolines, a provision of US$1.5 billion has been taken, leaving US$2.4 billion exposed, of which US$2.1 billion is recoverable from monolines rated investment grade at 31 December 2008. The provisions taken imply in aggregate that 74 cents in the dollar will be recoverable from investment grade monolines and 32 cents in the dollar from non-investment grade monolines.
HSBC’s exposure to direct lending and irrevocable commitments to lend to monoline insurers
HSBC has outstanding liquidity facilities totalling US$47 million to monoline insurers, of which US$2 million was drawn at 31 December 2008 (2007: US$158 million, none drawn).
HSBC’s exposure to debt securities which benefit from guarantees provided by monoline insurers
Within both the trading and available-for-sale portfolios, HSBC holds bonds that are ‘wrapped’ with a credit enhancement from a monoline insurer. As the bonds are traded explicitly with the benefit of this enhancement, any deterioration in the credit profile of the monoline insurer is reflected in market prices and, therefore, in the carrying amount of these securities on HSBC’s balance sheet at 31 December2008. For wrapped bonds held in the trading portfolio, the mark-to-market movement has been reflected through the income statement. For wrapped bonds held in the available-for-sale portfolio, the mark-to-market movement is reflected in equity unless there is objective evidence of impairment, in which case the impairment loss is reflected in the income statement. No wrapped bonds were included in the reclassification of financial assets described on page 145.
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HSBC’s exposure to Credit Derivative Product Companies
CDPCs are independent companies that specialise in selling credit default protection on corporate exposures. As corporate credit spreads widened during the second half of 2008, increasing the potential value of claims against the CDPCs, the creditworthiness of CDPCs became a focus. At 31 December 2008, HSBC had purchased credit protection from CDPCs with a notional value of US$6.4 billion (2007: US$5.7 billion) which had a fair value (essentially, replacement cost) of US$1.2 billion (2007: US$218 million), against which a credit risk adjustment (a provision) of US$228 million (2007: nil) was held. All of the fair value exposures at 31 December 2008 and 2007 represented exposure to CDPCs with investment grade ratings.
Leveraged finance transactions
Leveraged finance transactions include sub-investment grade acquisition or event-driven financing. During the second half of 2008, HSBC reclassified US$6.5 billion of leveraged finance loans from the held-for-trading category to loans and receivables as detailed on page 146 as its intention now is to hold these assets for the foreseeable future or until maturity. Impairment on these reclassified assets is now recognised on an incurred loss basis. The following tables show HSBC’s gross commitments and exposure to leveraged finance transactions arising from primary transactions and the movement in that leveraged finance exposure in the year. HSBC’s additional exposure to leveraged finance loans through holdings of ABSs from its trading and investment activities is shown in the tables on pages 151 and 152.
HSBC’s gross commitments to leveraged finance transactions by geographical segment
HSBC’s exposure to leveraged finance transactions
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The fall in unfunded exposures during 2008 primarily relates to the depreciation in sterling against the US dollar.
As described in the background to market turmoil on page 144, the dislocation of financial
markets developed in the second half of 2007 and continued throughout 2008. Consequently, income statement write-downs on leveraged finance transactions are presented for the three half-year periods affected to date.
As a result of the reclassification of certain leveraged finance loans from held-for-trading to loans and receivables, write-downs of US$1.2 billion were not taken to the income statement for the half year to 31 December 2008.
At 31 December 2008, HSBC’s principal exposures were to companies in two sectors:
US$3.6 billion to data processing (2007: US$3.8 billion) and US$1.7 billion to communications and infrastructure (2007: US$2.7 billion). During the year, 99 per cent of the total write-downs were against exposures in these two sectors.
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Footnotes to ‘Nature and extent of HSBC’s exposures’
The classification of financial instruments is determined in accordance with the accounting policies set out in Note 2 on the Financial Statements, and the use of assumptions and estimation in respect of valuation of financial instruments as described on page 63. The following is a description of HSBC’s methods of determining fair value and its related control framework, and a quantification of its exposure to financial instruments measured at fair value.
Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.
Financial instruments measured at fair value on an ongoing basis include trading assets and liabilities, instruments designated at fair value, derivatives and financial investments classified as available for sale (including treasury and other eligible bills, debt securities, and equity securities).
Fair values of financial instruments carried at fair value
Control framework
Fair values are subject to a control framework designed to ensure that they are either determined or validated by a function independent of the risk-taker.
To this end, ultimate responsibility for the determination of fair values lies with Finance, which reports functionally to the Group Finance Director. Finance establishes the accounting policies and procedures governing valuation, and is responsible for ensuring that they comply with all relevant accounting standards.
For all financial instruments where fair values are determined by reference to externally quoted prices or observable pricing inputs to models, independent price determination or validation is utilised. In inactive markets, direct observation of a traded price may not be possible. In these circumstances, HSBC will source alternative market information to validate the financial instrument’s fair value, with greater weight given to information that is considered to be more relevant and reliable. The factors that are considered in this regard are, inter alia:
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Models provide a logical framework for the capture and processing of necessary valuation inputs. For fair values determined using a valuation model, the control framework may include, as applicable, independent development or validation of (i) the logic within valuation models; (ii) the inputs to those models; (iii) any adjustments required outside the valuation models; and, (iv) where possible, model outputs. Valuation models are subject to a process of due diligence and calibration before becoming operational and are calibrated against external market data on an ongoing basis.
The results of the independent validation process are reported to, and considered by, Valuation Committees. Valuation Committees are composed of valuation experts from several independent support functions (Product Control, Market Risk Management, Derivative Model Review Group and Finance) in addition to senior management. The members of each Valuation Committee consider the appropriateness and adequacy of the fair value adjustments and the effectiveness of valuation models. If necessary, they may require changes to model calibration or calibration procedures. The Valuation Committees are overseen by the Valuation Committee Review Group, which consists of Heads of Global Banking and Markets’ Finance and Risk Functions. All subjective valuation items with a potential impact in excess of US$5 million are reported to the Valuation Committee Review Group.
Determination of fair value
Fair values are determined according to the following hierarchy:
The best evidence of fair value is a quoted price in an actively traded market. In the event that the market for a financial instrument is not active, a valuation technique is used.
The judgement as to whether a market is active may include, but is not restricted to, the consideration of factors such as the magnitude and frequency of trading activity, the availability of prices and the size of bid/offer spreads. In inactive markets, obtaining assurance that the transaction price provides evidence of fair value or determining the adjustments to transaction prices that are necessary to measure the fair value of the instrument requires additional work during the valuation process.
The majority of valuation techniques employ only observable market data, and so the reliability of the fair value measurement is high. However, certain financial instruments are valued on the basis of valuation techniques that feature one or more significant market inputs that are unobservable, and for them, the derivation of fair value is more judgemental. An instrument in its entirety is classified as valued using significant unobservable inputs if, in the opinion of management, a significant proportion of the instrument’s balance sheet value and/or inception profit (‘day 1 gain or loss’) is driven by unobservable inputs. ‘Unobservable’ in this context means that there is little or no current market data available from which to determine the price at which an arm’s length transaction would be likely to occur. It generally does not mean that there is no market data available at all upon which to base a determination of fair value (consensus pricing data may, for example, be used). Furthermore, in some cases the majority of the fair value derived from a valuation technique with significant unobservable inputs may be attributable to observable inputs. Consequently, the effect of uncertainty in determining unobservable inputs will generally be restricted to uncertainty about the overall fair value of the financial instrument being measured. To help in understanding the extent and the range of this uncertainty, additional information is provided in the section headed ‘Effect of changes in significant unobservable assumptions to reasonably possible alternatives’ below.
In certain circumstances, primarily where debt is hedged with interest rate derivatives or structured notes issued, HSBC records its own debt in issue at fair value, based on quoted prices in an active market for the specific instrument concerned, if available. When quoted market prices are unavailable, the own debt in issue is valued using valuation techniques, the inputs for which are either based upon quoted
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prices in an inactive market for the instrument, or are estimated by comparison with quoted prices in an active market for similar instruments. In both cases, the fair value includes the effect of applying the credit spread which is appropriate to HSBC’s liabilities. For all issued debt securities, discounted cash flow modelling is used to separate the change in fair value that may be attributed to HSBC’s credit spread movements from movements in other market factors such as benchmark interest rates or foreign exchange rates. Specifically, the change in fair value of issued debt securities attributable to the Group’s own credit spread is computed as follows: for each security at each reporting date, an externally verifiable price is obtained or a price is derived using credit spreads for similar securities for the same issuer. Then, using discounted cash flow, each security is valued using a risk-free discount curve. The difference in the valuations is attributable to the Group’s own credit spread. This methodology is applied consistently across all securities.
Structured notes issued and certain other hybrid instrument liabilities are included within trading liabilities and are measured at fair value. The credit spread applied to these instruments is derived from the spreads at which HSBC issues structured notes. These market spreads are significantly smaller than credit spreads observed for plain vanilla debt or in the credit default swap markets.
Gains and losses arising from changes in the credit spread of liabilities issued by HSBC reverse over the contractual life of the debt, provided that the debt is not repaid early.
All net positions in non-derivative financial instruments, and all derivative portfolios, are valued at bid or offer prices as appropriate. Long positions are marked at bid prices; short positions are marked at offer prices.
The fair value of a portfolio of financial instruments quoted in an active market is calculated as the product of the number of units and its quoted price and no block discounts are made.
The valuation techniques used when quoted market prices are not available incorporate certain assumptions that HSBC believes would be made by a market participant to establish fair value. When HSBC considers that there are additional considerations not included within the valuation model, appropriate adjustments may be made. Examples of such adjustments are:
Transaction costs are not included in the fair value calculation, nor are the future costs of administering the OTC derivative portfolio. These, along with trade origination costs such as brokerage fees and post-trade costs, are included either in fee expense or in operating expenses.
A detailed description of the valuation techniques applied to instruments of particular interest follows:
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Bases of valuing financial assets and liabilities measured at fair value
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Bases of valuing financial assets and liabilities measured at fair value (continued)
The main drivers of the movement in the balances of assets and liabilities measured at fair value with significant unobservable inputs were an increase in the fair value of derivative assets and liabilities due to market conditions, and a reduction in the level of ABSs and loans held at fair value due
either to disposal, repayment or reclassification. At 31 December 2008, financial instruments measured at fair value using a valuation technique with significant unobservable inputs represented 2 per cent of total assets and liabilities measured at fair value (31 December 2007: 2 per cent).
Financial instruments measured at fair value using a valuation technique with significant unobservable inputs
At 31 December 2008, available-for-sale assets valued using a valuation technique with significant unobservable inputs principally comprised various ABSs, private equity investments and other portfolios, similar to the position at 31 December 2007.
Trading assets valued using a valuation technique with significant unobservable inputs
principally comprised loans held for securitisation and other portfolios. Other portfolios included holdings in various bonds, preference shares and corporate and mortgage loans. The decrease during the year largely reflected leveraged finance and ABS positions no longer held on a fair value basis following their reclassification to loans and receivables as a result of the amendment to IAS 39
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and a reduction in the level of loans held for securitisation.
Derivative products valued using valuation techniques with significant unobservable inputs included certain types of correlation products, such as foreign exchange basket options, foreign exchange-interest rate hybrid transactions and long-dated option transactions. Examples of the latter are equity options, interest rate and foreign exchange options and certain credit derivatives. Credit derivatives included tranched CDS transactions. The increase in derivative assets during the year was mainly due to (i) the transfer of certain leveraged credit derivative transactions into this category because widening credit spreads increased the significance of unobservable credit spread volatilities, and (ii) a general increase in the fair value of derivative assets during 2008.
Trading liabilities valued using a valuation technique with significant unobservable inputs principally comprised equity-linked structured note
transactions. These notes, which HSBC issues to investors, provide the counterparty with a return that is linked to the performance of certain equity securities.
The increase in derivative liabilities valued using a valuation technique with significant unobservable inputs was due to the general increase in the fair value of derivative liabilities during 2008.
Effect of changes in significant unobservable assumptions to reasonably possible alternatives
As discussed above, the fair value of financial instruments are, in certain circumstances, measured using valuation techniques that incorporate assumptions that are not evidenced by prices from observable current market transactions in the same instrument and are not based on observable market data. The following table shows the sensitivity of these fair values to reasonably possible alternative assumptions:
The increase in the effect of changes in significant unobservable inputs in relation to derivatives, trading assets and trading liabilities
during the year primarily reflected increased sensitivity of instruments to unobservable parameters across asset and liability classes.
Principal assumptions used in the valuation of financial instruments with significant unobservable inputs
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Principal assumptions used in the valuation of financial instruments with significant unobservable inputs (continued)
Favourable and unfavourable changes are determined on the basis of changes in the value of the instrument as a result of varying the levels of the unobservable parameter using statistical techniques. When parameters are not amenable to statistical analysis, quantification of uncertainty is judgemental.
When the fair value of a financial instrument is affected by more than one unobservable assumption, the above table reflects the most favourable or most unfavourable change from varying the assumptions individually.
In respect of private equity investments, the valuations are assessed on an asset by asset basis using a valuation methodology appropriate to the specific investment, in line with industry guidelines. In many of the methodologies, the principal assumption is the valuation multiple to be applied to the main financial indicators including, for example, multiples for comparable listed companies and discounts for marketability.
For ABSs whose prices are unobservable, models are used to generate the expected value of the asset, incorporating benchmark information on factors such as prepayment speeds, default rates, loss severities and the historical performance of the underlying assets. The models used are calibrated by using securities for which external market information is available.
For leveraged finance, loans held for securitisation and derivatives with monolines the principal assumption concerns the appropriate value to be attributed to the counterparty credit risk. This requires exposure at default, probability of default and recovery in the event of default to be estimated. For loan transactions, assessment of exposure at default is straight-forward. For derivative transactions, a future exposure profile is generated based on current market data. Probabilities of default and recovery levels are estimated using market evidence, which may include financial information,
historical experience, CDS spreads and consensus recovery levels.
In the absence of such evidence, management’s best estimate is used.
For structured notes and other derivatives, principal assumptions concern the future volatility of asset values and the future correlation between asset values. For such unobservable assumptions, estimates are based on available market data, which may include the use of a proxy method to derive a volatility or a correlation from comparable assets for which market data is more readily available, and/or an examination of historical levels.
Changes in fair value recorded in the income statement
The following table quantifies the changes in fair values recognised in profit or loss during the year in respect of exposures whose fair values are estimated using valuation techniques that incorporate significant assumptions that are not evidenced by prices from observable current market transactions in the same instrument, and are not based on observable market data:
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The profit during the year primarily reflects changes in the fair value of credit derivatives which were transferred from using a valuation technique with significant observable inputs to a valuation technique with significant unobservable inputs. The change in valuation technique was due to widening
credit spreads which have increased the significance of unobservable credit spread volatilities. These movements are offset by reductions occurring due to write-downs of MBSs, mortgage loans acquired for the purpose of securitisation and credit derivative transactions executed against monoline insurers.
HSBC Holdings
The following table provides an analysis of the basis for valuing financial assets and financial liabilities measured at fair value in the financial statements:
Financial investments measured using a valuation technique with significant unobservable inputs comprise fixed-rate trust-preferred securities and senior notes purchased from HSBC undertakings. The unobservable elements of the valuation technique include the use of implied credit spreads and simplified bond pricing assumptions.
As discussed above, the fair value of financial instruments are in certain circumstances measured using valuation models that incorporate assumptions that are not supported by prices from observable current market transactions in the same instrument and are not based on observable market data. The following table shows the sensitivity of non-derivative financial instruments to reasonably possible alternative assumptions.
Assessing available-for-sale assets for impairment
HSBC’s policy on impairment of available-for-sale assets is described on page 350. The following is a description of HSBC’s application of that policy.
A systematic impairment review is carried out periodically of all available-for-sale assets, and all available indicators are considered to determine whether there is any objective evidence that an impairment may have occurred, whether as the result of a single loss event or as the combined effect of several events.
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Debt securities
When assessing available-for-sale debt securities for objective evidence of impairment at the balance sheet date, HSBC considers all available evidence, including observable data or information about events specifically relating to the securities which may result in a shortfall in recovery of future cash flows. These events may include a significant financial difficulty of the issuer, a breach of contract such as a default, bankruptcy or other financial reorganisation, or the disappearance of an active market for the debt security because of financial difficulties relating to the issuer.
These types of specific event and other factors such as information about the issuers’ liquidity, business and financial risk exposures, levels of and trends in default for similar financial assets, national and local economic trends and conditions, and the fair value of collateral and guarantees may be considered individually, or in combination, to determine if there is objective evidence of impairment of a debt security.
In addition, when assessing available-for-sale ABSs for objective evidence of impairment, HSBC considers the performance of underlying collateral, the extent and depth of market price declines and changes in credit ratings. The primary indicators of potential impairment are considered to be adverse fair value movements, and the disappearance of an active market for the securities.
At 31 December 2008, the population of available-for-sale ABSs identified as being most at risk of impairment included residential MBSs backed by sub-prime and Alt-A mortgages originated in the US, and CDOs with significant exposure to this sector. The estimated future cash flows of these securities are assessed to determine whether any of their cash flows are unlikely to be recovered as a result of events occurring on or before the balance sheet date.
In particular, for residential MBSs the estimated future cash flows are assessed by determining the future projected cash flows arising on the underlying collateral taking into consideration the delinquency status of underlying loans, the probability of delinquent loans progressing to default and the proportion of the advances subsequently recoverable. HSBC uses a modelling approach which incorporates historically observed progression rates to default, to determine if the decline in aggregate projected cash flows from the underlying collateral will lead to a shortfall in contractual cash flows. In such cases the security is considered to be impaired.
In respect of CDOs, in order to determine whether impairment has occurred, the expected future cash flows of the CDOs are compared with the total of the underlying collateral on the non-defaulted assets and the recovery value of the defaulted assets. In the event of a shortfall, the CDO is considered to be impaired.
When a security benefits from a contract provided by a monoline insurer that insures payments of principal and interest, the expected recovery on the contract is assessed in determining the total expected credit support available to the ABS.
Objective evidence of impairment for available-for-sale equity securities may include specific information about the issuer as detailed above, but may also include information about significant changes in technology, markets, economics or the law that provides evidence that the cost of the equity securities may not be recovered.
A significant or prolonged decline in the fair value of the asset below its cost is also objective evidence of impairment. In assessing whether it is significant, the decline in fair value is evaluated against the original cost of the asset at initial recognition. In assessing whether it is prolonged, the decline is evaluated against the period in which the fair value of the asset has been below its original cost at initial recognition.
For impairment losses on available-for-sale debt and equity securities, see pages 34 and 30, respectively. Any impairment losses recognised in the income statement relating to ABSs are recorded in the ‘Loan impairment charges and other credit risk provisions’ line. Impairment losses incurred on assets held by consolidated securities investment conduits (excluding Solitaire) are offset by a credit to the impairment line for the amount of the loss borne by capital note holders.
Fair values of financial instruments not carried at fair value
Financial instruments that are not measured at fair value on the balance sheet include loans and advances to banks and customers, deposits by banks, customer accounts, debt securities in issue and subordinated liabilities. Their fair values are, however, provided for information by way of note disclosure and are calculated as described below.
The calculation of fair value incorporates HSBC’s estimate of the amount at which financial
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assets could be exchanged, or financial liabilities settled, between knowledgeable, willing parties in an arm’s length transaction. It does not reflect the economic benefits and costs that HSBC expects to flow from the instruments’ cash flows over their expected future lives. Other reporting entities may use different valuation methodologies and assumptions in determining fair values for which no observable market prices are available, so comparisons of fair values between entities may not be meaningful and users are advised to exercise caution when using this data.
Since August 2007, the unstable market conditions in the US mortgage lending industry have resulted in a significant reduction in the secondary market demand for US consumer lending assets. Uncertainty over the extent and timing of future credit losses, together with an absence of liquidity for non-prime ABSs, continued to be reflected in a lack of bid prices at 31 December 2008. It is not possible to distinguish from the indicative market prices that are available, between the relative discount to nominal value within the fair value measurement that reflects cash flow impairment due to expected losses to maturity, and the discount that the market is demanding for holding an illiquid and out of favour asset. Under impairment accounting for loans and advances, there is no need nor requirement to adjust carrying amounts to reflect illiquidity as HSBC’s intention is to fund assets until the earlier of prepayment, charge-off or repayment on maturity. Market fair values, on the other hand, reflect both incurred loss and loss expected through the life of the asset, a discount for illiquidity and a credit spread which reflects the market’s current risk preferences. This usually differs from the credit spread applicable in the market at the time the loan was underwritten and funded.
The estimated fair values at 31 December 2008 and 31 December 2007 of loans and advances to customers in North America reflect the combined effect of these conditions. As a result, the fair values are substantially lower than the carrying amount of customer loans held on-balance sheet and lower than would otherwise be reported under more normal market conditions. Accordingly, the fair values reported do not reflect HSBC’s estimate of the underlying long-term value of the assets.
Fair values at the balance sheet date of the assets and liabilities set out below are estimated for the purpose of disclosure as follows:
The fair values in this note are stated at a specific date and may be significantly different from the amounts which will actually be paid on the maturity or settlement dates of the instruments. In many cases, it would not be possible to realise immediately the estimated fair values given the size
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of the portfolios measured. Accordingly, these fair values do not represent the value of these financial instruments to HSBC as a going concern.
For all classes of financial instruments, fair value represents the product of the value of a single instrument, multiplied by the number of instruments held. No block discount or premium adjustments are made. The fair values of intangible assets related to the businesses which originate and hold the financial instruments subject to fair value measurement, such as values placed on portfolios of core deposits, credit card and customer relationships, are not included above because they are not classified as financial instruments. Accordingly, an aggregation of fair value measurements does not approximate to the value of the organisation as a going concern.
The following table lists financial instruments whose carrying amount is a reasonable approximation of fair value because, for example, they are short-term in nature or reprice to current market rates frequently:
Cash and balances at central banksItems in the course of collection from other banksHong Kong Government certificates of indebtednessEndorsements and acceptancesShort-term receivables within ‘Other assets’Accrued income
Hong Kong currency notes in circulationItems in the course of transmission to other banksInvestment contracts with discretionary participation features within ‘Liabilities under insurance contracts’Endorsements and acceptancesShort-term payables within ‘Other liabilities’Accruals
Fair values of financial instruments which are not carried at fair value on the balance sheet
Fair values of financial investments classified as held for sale which are not carried at fair value on the balance sheet
Analysis of loans and advances to customers by geographical segment
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The methods used by HSBC Holdings to determine fair values of financial instruments for the purpose of measurement and disclosure are described above.
The following table provides an analysis of the fair value of financial instruments not carried at fair value on the balance sheet:
Fair values of HSBC Holdings’ financial instruments not carried at fair value on the balance sheet
This section contains disclosures about HSBC-sponsored SPEs that are included in HSBC’s consolidated balance sheet, with a particular focus on SPEs containing exposures affected by recent turmoil in credit markets, and those that are not consolidated by HSBC under IFRSs. In addition to the disclosures about SPEs, information on other off-balance sheet arrangements has been included in this section.
HSBC enters into certain transactions with customers in the ordinary course of business which involve the establishment of SPEs to facilitate or secure customer transactions.
HSBC structures that utilise SPEs are authorised centrally when they are established to ensure appropriate purpose and governance. The activities of SPEs administered by HSBC are closely monitored by senior management. HSBC’s involvement with SPE transactions is described below.
HSBC-sponsored SPEs
HSBC sponsors the formation of entities which are designed to accomplish certain narrow and well-defined objectives, such as securitising financial assets or affecting a lease, and this requires a form of legal structure that restricts the assets and liabilities within the structure to the single purpose for which it was established. HSBC consolidates these SPEs when the substance of the relationship indicates that HSBC controls them. In assessing control, all relevant factors are considered, including qualitative and quantitative aspects. For example:
Qualitative factors – in substance:
Quantitative factors – hereinafter referred to as ‘the majority of risks and rewards of ownership’. In substance:
In a number of cases, these SPEs are accounted for off-balance sheet under IFRSs where HSBC does not have the majority of the risks and rewards of ownership of the SPE. However in certain circumstances, after careful consideration of the facts, HSBC consolidates an SPE when, although it does not obtain the majority of risks and rewards of ownership, the qualitative features of HSBC’s involvement indicate that, in substance, the activities of the SPE are being conducted on behalf of HSBC.
HSBC reassesses the required consolidation accounting tests whenever there is a change in the substance of the relationship between HSBC and an SPE, for example, when the nature of HSBC’s involvement or the governing rules, contractual
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arrangements or capital structure of the SPE change. The most significant categories of SPEs are discussed in more detail below.
Structured investment vehicles and conduits
Structured investment vehicles
Structured investment vehicles (‘SIV’s) are SPEs which invest in diversified portfolios of interest-earning assets, generally funded through issues of commercial paper (‘CP’), medium-term notes (‘MTN’s) and other senior debt to take advantage of the spread differentials between the assets in the SIV and the funding cost. Prior to the implementation of Basel II, it was capital efficient to many bank investors to invest in highly-rated investment securities in this way. HSBC sponsored the establishment of two SIVs, Cullinan Finance Limited (‘Cullinan’) and Asscher Finance Limited (‘Asscher’) in 2005 and 2007, respectively, and in November 2007 HSBC consolidated Cullinan and Asscher.
As market illiquidity intensified, there were two main challenges for the SIV sector which could force asset sales: an inability to fund in the CP markets and the sensitivity of the continuing operation of SIVs to changes in the market value of their underlying assets.
In order to remove the risk of having to make forced asset sales, HSBC established three new securities investment conduits (defined below) to take on the assets held in Cullinan and Asscher. Mazarin Funding Limited (‘Mazarin’), an asset backed CP conduit, and Barion Funding Limited (‘Barion’), a term-funding vehicle, were set up in respect of Cullinan; and Malachite Funding Limited (‘Malachite’), a term-funding vehicle, was set up in respect of Asscher. During 2008, the investors in the capital notes issued by Cullinan and Asscher had the option of exchanging their existing capital notes for the capital notes of the respective new conduits. In addition, the new conduits agreed to purchase the assets in Cullinan and Asscher. As a result of this agreement the legal title of all Cullinan and Asscher’s assets were transferred to the new conduits. By 31 December 2008, all the original assets in Cullinan and Asscher were transferred to the new conduits.
During 2008, 91.3 per cent of the remaining capital note holders in Asscher and all of the capital note holders in Cullinan elected to exchange their existing holdings for capital notes in the new conduits. In January 2009, the remaining 8.7 per cent of Asscher’s capital notes were redeemed. At
31December 2007, the holders of the capital notes bore the risk of any actual losses arising in the new conduits up to US$2.3 billion, being the par value of their respective holdings. Prior to the exchanges of assets against capital note extinguishments, the par value of the capital notes was US$2.6 billion. At 31 December 2008, the economic first loss protection from capital note holders amounted to US$2.2 billion (2007: US$2.3 billion). The reduction in economic first loss protection is attributable to the recognition of a US$92 million realised loss at 31 December 2008 (2007: n/a). On an IFRS accounting basis, the capital notes were initially recognised at fair value on consolidation, which amounted to US$1.3 billion at 31 December 2007. At 31 December 2008, on an IFRS accounting basis, an impairment charge of US$293 million (2007: n/a) was recognised in addition to the realised loss of US$92 million, therefore reducing the carrying amount of these capital notes to US$0.9 billion.
HSBC sponsors and manages two types of conduits which issue CP; multi-seller securities and securities investment conduits (‘SIC’s). HSBC has consolidated these conduits from inception because it is exposed to the majority of risks and rewards of ownership.
Securities investment conduits
Solitaire, HSBC’s principal securities investment conduit, purchases highly rated ABSs to facilitate tailored investment opportunities. HSBC’s other SICs, Mazarin, Barion and Malachite, evolved from the restructuring of HSBC’s sponsored SIVs as discussed above.
These vehicles were established for the purpose of providing access to flexible market-based sources of finance for HSBC’s clients, for example, to finance discrete pools of third-party originated trade and vehicle finance loan receivables. HSBC’s principal multi-seller conduits are Regency Assets Limited (‘Regency’), Bryant Park Funding Limited LLC (‘Bryant Park’), Abington Square Funding LLC (‘Abington Square’) and Performance Trust.
The multi-seller conduits purchase or fund interests in diversified pools of third-party assets financed by issuing CP or drawing advances from HSBC. The cash flows received by the conduits from the third-party assets are used to service the funding and provide a commercial rate of return for
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HSBC for structuring, for various other administrative services, and for the liquidity and credit support it gives to the conduits. The asset pools acquired by the conduits are structured so that the credit enhancement the conduits receive, which equates to senior investment grade ratings, and the benefit of liquidity facilities typically provided by HSBC mean that the CP issued by the multi-seller conduits is itself highly rated.
During 2008, the finance provided by HSBC to Abington Square Funding LLC at the end of 2007 was repaid using the proceeds received from refinancing the assets within the conduit. The conduit did not enter into any new securitisation transactions during the period.
An analysis of the assets held by HSBC’s SIVs and conduits is set out below:
Ratings analysis of assets
Composition of asset portfolio
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Composition of asset portfolio (continued)
During 2008, the credit ratings of various securities held by the SICs, many with exposures to US sub-prime and Alt-A mortgages, were downgraded by rating agencies. At 31 December 2008, 44.7 per cent of the SICs’ exposures to US sub-prime and Alt-A mortgages remained AAA rated (2007: 100 per cent), while 81.4 per cent remained investment grade.
It should be noted that securities purchased by SICs typically benefit from substantial transaction- specific credit enhancements such as subordinated tranches and/or excess spread, which absorb any
credit losses before they would fall on the tranche held by the SPE.
As noted above, by 31 December 2008, all the original assets held by the SIVs were transferred to the new SICs. However, during the second half of 2008, the SIVs purchased CP issued by certain SICs set up by HSBC and, at 31 December 2008, the SIVs’ holdings amounted to US$0.3 billion. The cash flows of the CP issued by the new SICs are referenced to bonds which include those backed by US sub-prime and US Alt-A MBSs. In early 2009, the CP matured, and the cash received by the SIVs has been transferred to the respective SICs.
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The revolving credit facilities of multi-seller conduits will predominantly have expected average
lives with maturities of less than 12 months, but typically have a range of 1 to 60 months.
The majority CP and MTN funding issued by the SIVs was repaid in full during 2008 using the proceeds from the asset sales to the new SICs. The MTNs matured in early 2009.
HSBC’s maximum exposure
have a par value of US$17million (2007: n/a), and a carrying amount of US$0.6 million (2007: n/a).
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Money market funds
HSBC has established and manages a number of money market funds which provide customers with tailored investment opportunities with a set of narrow and well-defined objectives. In most cases, they are not consolidated in HSBC because the Group’s holdings in them are not of sufficient size to represent the majority of the risks and rewards of ownership.
Investors in money market funds generally have no recourse other than to the assets in the funds, so asset holdings are designed to meet expected fund liabilities. Usually, money market funds are constrained in their operations should the value of their assets and their ratings fall below predetermined thresholds. The risks to HSBC are, therefore, contingent, arising from the reputational damage which could occur if an HSBC-sponsored money market fund was thought to be unable to meet withdrawal requests on a timely basis or in full.
In aggregate, HSBC has established money market funds with total assets of US$102.7 billion at 31 December 2008 (2007: US$91.3 billion).
The main sub-categories of money market funds are:
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These money market funds invest in diverse portfolios of highly-rated debt instruments, including limited holdings in instruments issued by SIVs. At 31 December 2008, the exposure of these funds to SIVs was US$0.5 billion (2007: US$3.9 billion).
Constant Net Asset Value funds
CNAV funds price their assets on an amortised cost basis, subject to the amortised book value of the portfolio remaining within 50 basis points of its market value. This feature enables CNAV funds to create and liquidate shares in the funds at a constant price. If the amortised value of an asset portfolio were to vary by more than 50 basis points from its market value, the CNAV fund would be required to price its assets at market value, and consequently would no longer be able to create or liquidate shares at a constant price. This is commonly known as ‘breaking the buck’.
Investments made by the CNAV funds in senior notes issued by SIVs continued to deteriorate in valuation terms during 2008. The market values of the underlying assets of those SIVs were affected by market nervousness over possible default levels, exacerbated by severe illiquidity. This reduced the ability of SIVs to sell assets in order to fund maturing liabilities, or issue new senior notes in order to raise cash. As a consequence, the CNAV funds recorded unrealised losses on their SIV holdings.
During 2008, the following actions were taken by HSBC in respect of the CNAV funds to maintain their AAA rating and mitigate any forced sale of liquid assets to meet potential redemptions:
The following table provides a breakdown of the losses incurred and capital contributions made as a result of the actions taken by HSBC.
As stated on page 173, a reassessment of the required consolidation accounting tests is performed whenever there is a change in the substance of the relationship between HSBC and an SPE. As a result of the events described above, a reassessment of the consolidation tests was, therefore, performed.
When considered together, the actions taken by HSBC demonstrated the Group’s support, within limited parameters, of the CNAV funds in the prevailing market conditions. This support was based on a commercial decision to support the funds at that time, but did not constitute any commitment to undertake further action and the future operations of the funds in question continue to be governed by their respective prospectuses. HSBC concluded that this substantively changed the relationship HSBC had with these CNAV funds, and therefore HSBC consolidated them from 30 September 2008. Although the actions taken by HSBC described above occurred in early October 2008, management’s intention had been agreed prior to this date.
The effect of consolidating the CNAV funds on HSBC’s balance sheet was to include US$43.8 billion of assets and US$43.1 billion of liabilities. HSBC’s exposure to the funds is described below.
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Composition of CNAV asset portfolio
HSBC’s maximum exposure to consolidated and unconsolidated CNAV funds is represented by HSBC’s investment in the units of each CNAV fund, and by the maximum limit of the letters of limited indemnity provided to the CNAV funds. HSBC’s exposure at 31 December 2008 amounted to US$0.7 billion (2007: US$1.3 billion) and US$58 million (2007: US$41 million) for investment in units within the CNAV funds and letters of limited indemnity, respectively.
Enhanced Variable Net Asset Value funds
Enhanced VNAV funds price their assets on a fair value basis and, consequently, prices may change from one day to the next. These funds pursue an ‘enhanced’ investment strategy, as part of which investors accept greater credit and duration risk in the expectation of higher returns.
As part of action taken in respect of these funds in the second half of 2007, HSBC acquired some of the underlying assets and shares in two of its French dynamic money market funds. HSBC’s aggregate holding in these funds at 31 December 2008 amounted to €0.5 billion (US$0.6 billion) (2007: €0.9 billion; US$1.4 billion). As a result of continued redemptions by unitholders during 2008, HSBC’s holding in the two funds increased to a level at which it obtained the majority of the risks and rewards of ownership, and it therefore consolidated these funds.
HSBC’s maximum exposure to consolidated and unconsolidated Enhanced VNAV and consolidated and unconsolidated VNAV funds is represented by HSBC’s investment in the units of each fund. HSBC’s maximum exposure at 31 December 2008 amounted to US$0.6 billion (2007:
US$5.9 billion) and US$1.6 billion (2007: US$0.3 billion), for Enhanced VNAV and VNAV funds, respectively.
Total assets of HSBC’s money market funds which are on-balance sheet by balance sheet classification
Non-money market investment funds
HSBC, through its fund management business, has established a large number of non-money market funds to enable customers to invest in a range of assets, typically equities and debt securities. At the launch of a fund HSBC, as fund manager, usually provides a limited amount of initial capital known as ‘seed capital’ to enable the fund to start purchasing assets. These holdings are normally redeemed over time. The majority of these funds are off-balance sheet for HSBC because the Group’s limited economic interest means it does not have the majority of the risks and rewards of ownership. As the non-money market funds explicitly provide investors with tailored risk, the risk to HSBC is restricted to HSBC’s own investments in the funds.
In aggregate, HSBC has established non-money market funds with total assets of US$200.3 billion at 31 December 2008 (2007: US$288.8 billion).
The main sub-categories of non-money market funds are:
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Total assets of HSBC’s non-money market funds which are on-balance sheet by balance sheet classification
HSBC’s maximum exposure to consolidated and unconsolidated non-money market funds is represented by HSBC’s investment in the units of each respective fund. HSBC’s exposure at 31 December 2008 amounted to US$4.4 billion (2007: US$6.0 billion).
Securitisations
HSBC uses SPEs to securitise customer loans and advances that it has originated, mainly in order to diversify its sources of funding for asset origination and for capital efficiency purposes. In such cases, the loans and advances are transferred by HSBC to the SPEs for cash, and the SPEs issue debt securities to investors to fund the cash purchases. Credit enhancements to the underlying assets may be used to obtain investment grade ratings on the senior debt issued by the SPEs. Except in one instance, these securitisations are all consolidated by HSBC. HSBC has also established securitisation programmes in the US and Germany where loans originated by third parties are securitised. Most of these vehicles are not consolidated by HSBC as it is not exposed to the majority of risks and rewards of ownership in the SPEs. In 2008, demand for the securitised products remained low.
In addition, HSBC uses SPEs to mitigate the capital absorbed by some of the customer loans and advances it has originated. Credit derivatives are used to transfer the credit risk associated with such customer loans and advances to an SPE, using securitisations commonly known as synthetic securitisations. These SPEs are consolidated when HSBC is exposed to the majority of risks and rewards of ownership.
Total assets of HSBC’s securitisations which are on-balance sheet, by balance sheet classification
These assets include US$1.3 billion (2007: US$3.6 billion) of exposure to US sub-prime mortgages.
Total assets of HSBC’s securitisations which are off-balance sheet
HSBC’s financial investments in off-balance sheet securitisations at 31 December 2008 amounted to US$0.2 billion (2007: US$0.4 billion). These assets include assets which are classified as available-for-sale securities and measured at fair value, and have been securitised by HSBC under arrangements by which HSBC retains a continuing involvement in them. Further details are provided in Note 20 on the Financial Statements.
The maximum exposure is the aggregate of any holdings of notes issued by these vehicles and the reserve account positions intended to provide credit support under certain pre-defined circumstances to senior note holders. HSBC is not obligated to provide further funding. At 31 December 2008, HSBC’s maximum exposure to consolidated and unconsolidated securitisations amounted to US$27.2 billion (2007: US$31 billion).
HSBC also establishes SPEs in the normal course of business for a number of purposes, for example, structured credit transactions for customers to provide finance to public and private sector infrastructure projects, and for asset and structured finance (‘ASF’) transactions.
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Structured credit transactions
HSBC provides structured credit transactions to third-party professional and institutional investors who wish to obtain exposure, sometimes on a leveraged basis, to a reference portfolio of debt instruments. In such structures, the investor receives returns referenced to the underlying portfolio by purchasing notes issued by the SPEs. HSBC enters into contracts with the SPEs, generally in the form of derivatives, in order to pass the required risks and rewards of the reference portfolios to the SPEs. HSBC’s risk in relation to the derivative contracts with the SPEs is managed within HSBC’s trading market risk framework (see Market Risk on page 241). In certain transactions HSBC is exposed to risk often referred to as gap risk. Gap risk typically arises in transactions where the aggregate potential claims against the SPE by HSBC pursuant to one or more derivatives could be greater than the value of the collateral held by the SPE and securing such derivatives. HSBC often mitigates such gap risk by incorporating in the SPE transaction features which allow for deleveraging, a managed liquidation of the portfolio, or other mechanisms. Following the inclusion of such risk reduction mechanisms, HSBC has, in certain circumstances, retained all or a portion of the underlying exposure in the transaction. When this retained exposure represents ABSs, it has been included in ‘Nature and extent of HSBC’s exposures’ on page 150.
Often, transactions are facilitated through SPEs to enable the notes issued to the investors to be rated. The SPEs are not consolidated by HSBC because the investors bear substantially all the risks and rewards of ownership through the notes.
The total fair value of liabilities (notes issued and derivatives) in structured credit transaction SPEs was US$21.2 billion at 31 December 2008 (2007: US$23.6 billion). These amounts included US$0.3 billion (2007: US$0.1 billion) in SPEs that were consolidated by HSBC.
Other uses of SPEs
HSBC participates in Public-Private Partnerships to provide financial support for infrastructure projects initiated by government authorities. The funding structure is commonly achieved through the use of SPEs. HSBC consolidates these SPEs when it is exposed to the majority of risks and rewards of the vehicles.
HSBC’s ASF business specialises in leasing and arranging finance for aircraft and other physical assets, which it is customary to ring-fence through the use of SPEs, and in structured loans and deposits, where SPEs introduce cost efficiencies. HSBC consolidates these SPEs when the substance of the relationship indicates that HSBC controls the SPE.
HSBC’s risks and rewards of ownership in these SPEs are in respect of its on-balance sheet assets and liabilities.
HSBC’s maximum exposures to SPEs
The following tables show the total assets of the various types of SPEs, and the amount and types of funding provided by HSBC to these SPEs. The tables also show HSBC’s maximum exposure to the SPEs and, within that exposure, the types of liquidity and credit enhancements provided by HSBC. The maximum exposures to SPEs represent HSBC’s maximum possible risk exposure that could occur as a result of the Group’s arrangements and commitments to SPEs. The maximum amounts are contingent in nature, and may arise as a result of drawdowns under liquidity facilities, where these have been provided, and any other funding commitments, or as a result of any loss protection provided by HSBC to the SPEs. The conditions under which such exposure might arise differ depending on the nature of each SPE and HSBC’s involvement with it. The aggregation of such maximum exposures across the different forms of SPEs results in a theoretical total maximum exposure number. The elements of the maximum exposure to an SPE are not necessarily additive and a detailed explanation of how maximum exposures are determined is provided under each category of SPE.
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HSBC’s maximum exposure to consolidated SPEs affected by the recent market turmoil
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HSBC’s maximum exposure to unconsolidated SPEs
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Third-party sponsored SPEs
Through standby liquidity facility commitments, HSBC has exposure to third-party sponsored SIVs, conduits and securitisations under normal banking arrangements on standard market terms. These exposures are quantified below.
HSBC’s commitments under liquidity facilities to third-party SIVs, conduits and securitisations
Other exposures to third-party SIVs, conduits and securitisations where a liquidity facility has been provided
Financial guarantees, letters of credit and similar undertakings
Note 40 on the Financial Statements describes various types of guarantees and discloses the maximum potential future payments under such arrangements. Credit risk associated with all forms of guarantees is assessed in the same manner as for on-balance sheet credit advances and, where necessary, provisions for assessed impairment are included in ‘Other provisions’.
Commitments to lend
Undrawn credit lines are disclosed in Note 40 on the Financial Statements. The majority by value of undrawn credit lines arise from ‘open to buy’ lines on personal credit cards, advised overdraft limits and other pre-approved loan products, and mortgage offers awaiting customer acceptance. HSBC generally has the right to change or terminate any conditions of a personal customer’s overdraft, credit card or other credit line upon notification to the customer. In respect of corporate commitments to lend, in most cases HSBC’s position will be protected through restrictions on access to funding in the event of material adverse change.
Loan commitments in respect of leveraged finance transactions are accounted for as derivatives where it is HSBC’s intention to sell the loan after origination. Further information is provided on page 160.
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With listings of its ordinary shares in London, Hong Kong, New York, Paris and Bermuda, HSBC Holdings complies with the relevant requirements for listing and trading on each of these exchanges. In the UK, these are the Listing Rules of the Financial Services Authority (‘FSA’); in Hong Kong, The Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (‘HKSE’); in the US, where the shares are traded in the form of ADSs, HSBC Holdings’ shares are registered with the US Securities and Exchange Commission (‘SEC’). As a consequence of its US listing, HSBC Holdings is also subject to the reporting and other requirements of the US Securities Act of 1933, as amended, the Securities Exchange Act of 1934, as amended, and the New York Stock Exchange’s (‘NYSE’) Listed Company Manual, in each case as applied to foreign private issuers. In France and Bermuda, HSBC Holdings is subject to the listing rules of Euronext, Paris and the Bermuda Stock Exchange respectively, applicable to companies with secondary listings.
A statement of HSBC’s compliance with the code provisions of the Combined Code on Corporate Governance issued by the Financial Reporting Council and with the Code on Corporate Governance Practices in Appendix 14 to the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited is set out in the ‘Report of the Directors: Governance’ on page 281.
HSBC’s operations throughout the world are regulated and supervised by approximately 540 different central banks and regulatory authorities in those jurisdictions in which HSBC has offices, branches or subsidiaries. These authorities impose a variety of requirements and controls designed to improve financial stability and the transparency of financial markets and their contribution to economic growth. These regulations and controls cover, inter alia, capital adequacy, depositor protection, market liquidity, governance standards, customer protection (for example, fair lending practices, product design, and marketing and documentation standards), and social responsibility obligations (for example, anti-money laundering and anti-terrorist financing measures). In addition, a number of countries in which HSBC operates impose rules that affect, or place limitations on, foreign or foreign-owned or controlled banks and financial institutions. The rules include restrictions on the opening of local offices, branches or subsidiaries and the types of banking and non-banking activities that may be conducted by those local offices, branches or subsidiaries;
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restrictions on the acquisition of local banks or regulations requiring a specified percentage of local ownership; and restrictions on investment and other financial flows entering or leaving the country. The supervisory and regulatory regimes of the countries where HSBC operates will determine to some degree HSBC’s ability to expand into new markets, the services and products that HSBC will be able to offer in those markets and how HSBC structures specific operations. As a result of the recent government interventions in response to recent global economic conditions – it is widely anticipated that there will be a substantial increase in government regulation and supervision of the financial services industry, including the imposition of higher capital requirements, heightened disclosure standards and restrictions on certain types of transaction structures.
In June 2006, the Basel Committee on Banking Supervision introduced a new capital adequacy framework to replace the 1988 Basel Capital Accord in the form of a new Accord (commonly known as ‘Basel II’). Details of the way in which Basel II has been implemented by the FSA, the timing of the change and the impact on HSBC are set out on page 275.
The FSA supervises HSBC on a consolidated basis. In addition, each operating bank, finance company or insurance operation within HSBC is regulated by local supervisors. The primary regulatory authorities are those in the UK, Hong Kong and the US, the Group’s principal areas of operation.
UK regulation and supervision
UK banking and financial services institutions are subject to multiple regulations. The primary UK statute is the Financial Services and Markets Act 2000 (‘FSMA’). Additionally, data privacy is regulated by the Data Protection Act 1998. Other UK financial services legislation is derived from EU directives relating to banking, securities, insurance, investments and sales of personal financial services.
In addition to its role as HSBC’s lead regulator, the FSA is responsible for authorising and supervising all HSBC’s businesses in the UK which require authorisation under FSMA. These include deposit-taking, retail banking, life and general insurance, pensions, investments, mortgages, custody and share dealing businesses, and treasury and capital markets activity. HSBC Bank plc is HSBC’s principal authorised institution in the UK.
FSA rules establish the minimum criteria for authorisation for banks and financial services
businesses in the UK. They also set out reporting (and, as applicable, consent) requirements with regard to large individual exposures and large exposures to related borrowers. In its capacity as supervisor of HSBC on a consolidated basis, the FSA receives information on the capital adequacy of, and sets requirements for, HSBC as a whole. Further details on capital measurement are included in ‘Capital management and allocation’ on pages 274 to 280. The FSA’s approach to capital requirements for UK insurers is to require minimum capital to be calculated on two bases. First, firms must calculate their liabilities on a prudent basis and add a statutory solvency margin (‘pillar 1’). Secondly, firms must calculate their liabilities on a realistic basis then add to this their own calculation of risk-based capital. The sum of realistic reserves and risk-based capital (‘pillar 2’) is agreed with the FSA. Insurers are required to maintain capital equal to the higher of pillars 1 and 2. The FSA has the right to object, on prudential grounds, to persons who hold, or intend to hold, 10 per cent or more of the voting power of a financial institution.
The regulatory framework of the UK financial services system has traditionally been based on co-operation between the FSA and authorised institutions. The FSA monitors authorised institutions through ongoing supervision and the review of routine and ad hoc reports relating to financial and prudential matters. The FSA may periodically obtain independent reports, usually from the auditors of the authorised institution, as to the adequacy of internal control procedures and systems as well as procedures and systems governing records and accounting. The FSA meets regularly with HSBC’s senior executives to discuss HSBC’s adherence to the FSA’s prudential guidelines. They also regularly discuss fundamental matters relating to HSBC’s business in the UK and internationally, including areas such as strategic and operating plans, risk control, loan portfolio composition and organisational changes, including succession planning. In light of current conditions, HSBC has experienced an increased level of ongoing interaction with the FSA.
Hong Kong regulation and supervision
Banking in Hong Kong is subject to the provisions of the Banking Ordinance and to the powers, functions and duties ascribed by the Banking Ordinance to the Hong Kong Monetary Authority (the ‘HKMA’). The principal function of the HKMA is to promote the general stability and effective working of the banking system in Hong Kong. The HKMA is responsible for supervising compliance
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with the provisions of the Banking Ordinance. The Banking Ordinance gives power to the Chief Executive of Hong Kong to give directions to the HKMA and the Financial Secretary with respect to the exercise of their respective functions under the Banking Ordinance.
The HKMA has responsibility for authorising banks, and has discretion to attach conditions to its authorisation. The HKMA requires that banks or their holding companies file regular prudential returns, and holds regular discussions with the management of the banks to review their operations. The HKMA may also conduct ‘on-site’ examinations of banks and, in the case of banks incorporated in Hong Kong, of any local and overseas branches and subsidiaries. The HKMA requires all authorised institutions to have adequate systems of internal control and requires the institutions’ external auditors, upon request, to report on those systems and other matters such as the accuracy of information provided to the HKMA. In addition, the HKMA may from time to time conduct tripartite discussions with banks and their external auditors.
The HKMA has the power to divest controlling interests in a bank from persons if they are no longer deemed to be fit and proper, if they may otherwise threaten the interests of depositors or potential depositors, or if they have contravened any conditions specified by the HKMA. The HKMA may revoke authorisation in the event of an institution’s non-compliance with the provisions of the Banking Ordinance. These provisions require, among other things, the furnishing of accurate reports.
The HKMA implemented Basel II with effect from 1 January 2007 for all Authorised Institutions incorporated in Hong Kong.
The marketing of, dealing in and provision of advice and asset management services in relation to securities in Hong Kong are subject to the provisions of the Securities and Futures Ordinance of Hong Kong (‘Securities and Futures Ordinance’). Entities engaging in activities regulated by the Securities and Futures Ordinance are required to be licensed. The HKMA is the primary regulator for banks involved in the securities business, while the Securities and Futures Commission is the regulator for non-banking entities.
US regulation and supervision
HSBC is subject to extensive federal and state supervision and regulation in the US. Banking laws and regulations of the Board of Governors of the Federal Reserve System (the ‘Federal Reserve Board’), the Office of the Comptroller of the
Currency (the ‘OCC’) and the Federal Deposit Insurance Corporation (the ‘FDIC’) govern many aspects of HSBC’s US business.
HSBC and its US operations are subject to supervision, regulation and examination by the Federal Reserve Board because HSBC is a ‘bank holding company’ under the US Bank Holding Company Act of 1956 (‘BHCA’), as a result of its control of HSBC Bank USA, N.A., Mclean, Virginia (‘HBUS’); HSBC Trust Company (Delaware), N.A., Wilmington, Delaware (‘HTCD’); and Wells Fargo Trade Bank, N.A., San Francisco, California (‘WFTB’). HSBC North America Holdings Inc. (‘HNAH’), formed to hold HSBC’s US and Canadian operations is also a ‘bank holding company’. Both HSBC and HNAH are registered as financial holding companies (‘FHC’s) under the BHCA, and, accordingly, may affiliate with securities firms and insurance companies and engage in other activities that are financial in nature or incidental or complementary to activities that are financial in nature. The ability of HSBC and HNAH to engage in expanded financial activities as FHCs depends upon HSBC and HNAH continuing to meet certain criteria set forth in the BHCA, including requirements that their US depository institution subsidiaries be ‘well capitalised’ and ‘well managed’, and that such institutions have achieved at least a satisfactory record in meeting community credit needs during their most recent examinations pursuant to the Community Reinvestment Act.
In general, under the BHCA, an FHC would be required, upon notice by the Federal Reserve Board, to enter into an agreement with the Federal Reserve Board to correct any failure to comply with the requirements to maintain FHC status. Until such deficiencies are corrected, the Federal Reserve Board may impose limitations on the US activities of an FHC and depository institutions under its control. If such deficiencies are not corrected, the Federal Reserve Board may require an FHC to divest its control of any subsidiary depository institution or to desist from certain financial activities in the US.
The three US banks, HBUS, HTCD, and WFTB are subject to regulation and examination primarily by the OCC, secondarily by the FDIC, and by the Federal Reserve Board. Banking laws and regulations restrict many aspects of their operations and administration, including the establishment and maintenance of branch offices, capital and reserve requirements, deposits and borrowings, investment and lending activities, payment of dividends and numerous other matters.
In December 2007, US regulators published a
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final rule regarding Risk-Based Capital Standards: Advanced Capital Adequacy Framework – Basel II. This final rule represents the US adoption of the Basel II International Capital Accord (‘Basel II’). The final rule became effective on 1 April 2008, and requires large bank holding companies, including HNAH, to adopt its provisions no later than 1 April 2011. HNAH has established comprehensive Basel II implementation project teams comprised of risk management specialists representing all risk disciplines. In addition, US banking authorities have adopted ‘leverage’ capital requirements that generally require US banks and bank holding companies to maintain a minimum amount of capital in relation to their balance sheet assets (measured on a non-risk-weighted basis).
HBUS and HTCD are subject to risk-based assessments from the FDIC, which insures deposits generally to a maximum of US$100,000 per domestic depositor. In October 2008, the FDIC raised the maximum amount of insured deposits to US$250,000 per domestic depositor until 31 December 2009, after which the limit will return to US$100,000. The FDIC bases assessments on supervisory ratings, financial ratios and long-term debt issuer ratings, with those banks in the highest rated categories paying lower assessments.
In October 2008, the FDIC announced its Temporary Liquidity Guarantee Programme (‘TLGP’), under which the FDIC will guarantee (i) newly-issued senior unsecured debt issued by eligible, participating institutions, and (ii) certain non-interest bearing transaction accounts. HNAH and its subsidiary banks and bank holding companies elected to participate in both components of the TLGP, as applicable.
HSBC’s US consumer finance operations are subject to extensive state-by-state regulation in the US, and to laws relating to consumer protection (both in general, and in respect of sub-prime lending operations, which have been subject to enhanced regulatory scrutiny); discrimination in extending credit; use of credit reports; privacy matters; disclosure of credit terms; and correction of billing errors. They also are subject to regulations and legislation that limit operations in certain jurisdictions.
All HSBC’s activities involve, to varying degrees, the analysis, evaluation, acceptance and management of risks or combinations of risks. The most important
categories of risk that the Group is exposed to are credit risk (including cross-border country risk), market risk, operational risks in various forms, liquidity risk, insurance risk, pension risk, residual value risk, reputational risk and sustainability (environmental and social) risks. Market risk includes foreign exchange, interest rate and equity price risks.
The management of these various risk categories is discussed below. Insurance risk is managed by the Group’s insurance businesses together with their own credit, liquidity and market risk functions, distinct from those covering the rest of HSBC due to the different nature of their activities. They remain under risk oversight at Group level.
The risk profiles of HSBC Group and of individual operating entities change constantly under the influence of a wide range of factors. The risk management framework established by the Group fosters the continuous monitoring of the risk environment and an integrated evaluation of risks and their interdependencies.
Risk governance and ownership
A well-established risk governance and ownership structure ensures oversight of, and accountability for, the effective management of risk at Group, regional, customer group and operating entity levels.
The Board approves the Group’s risk appetite framework, plans and performance targets for the Group and its principal operating subsidiaries, the appointment of senior officers, the delegation of authorities for credit and other risks and the establishment of effective control procedures. Under authority delegated by the Board, the Group Management Board (‘GMB’) through its separately convened Risk Management Meeting (‘RMM’) formulates high-level Group risk management policy, exercises delegated risk authorities and oversees the implementation of risk appetite and controls. It monitors all categories of risk, receives reports on actual performance and emerging issues, determines action to be taken and reviews the efficacy of HSBC’s risk management framework.
Primary responsibility for managing risk at operating entity level lies with the respective boards and Chief Executive Officers, as custodians of their balance sheets. In their oversight and stewardship of risk management at Group level, GMB and RMM are supported by a dedicated Global Risk function headed by the Group Chief Risk Officer (‘GCRO’), who is a member of both bodies and reports to the Group Finance Director within the integrated Finance and
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Risk function, which the Group Finance Director represents on the Board.
Global Risk has functional responsibility for the principal financial risk types, namely retail and wholesale credit, market, operational, security and fraud risks. For these it establishes Group policy, exercises Group-wide oversight and provides reporting and analysis of portfolio composition on a global and a regional basis to senior management. Accountability and consistent control across the Global Risk function is provided through the Global Risk Management Board, chaired by the GCRO, the membership of which includes the Chief Risk Officers of HSBC’s regions and the heads of risk disciplines within GMO. Global Risk also co-ordinates the continued development of the Group’s risk appetite, economic capital and stress testing frameworks. In addition, the GCRO is a member of the Group Portfolio Oversight Committee, chaired by the Group Treasurer, which governs the Group’s portfolio management activities for the wholesale business sector.
Risk appetite
HSBC’s risk appetite framework describes the quantum and types of risk that HSBC is prepared to take in executing its strategy. It is central to an integrated approach to risk, capital and business management and supports the Group in achieving its return on equity objectives, as well as being a key element in meeting the Group’s obligations under pillar 2 of Basel II.
The formulation of risk appetite considers HSBC’s risk capacity, its financial position, the strength of its core earnings and the resilience of its reputation and brand. It is expressed both qualitatively, describing which risks are taken and why, and quantitatively. HSBC senior management attaches quantitative metrics to individual risk types to ensure that:
The risk appetite framework, governed by the Board and overseen in its implementation on an ongoing basis by GMB and RMM, is also
maintained at regional and customer group levels. It operates through two key mechanisms:
The risk appetite framework covers both the beneficial and adverse aspects of risk. Within it, economic capital is the common currency through which risk is measured and used as the basis for risk evaluation, capital allocation and performance measurement across regions and customer groups. Risk appetite is executed through the operational limits that control the levels of risk run by the Group, regions and customer groups and is measured using risk-adjusted performance metrics.
Risk control culture
HSBC’s risk management policies are encapsulated in the Group Standards Manual and cascaded in a hierarchy of policy manuals throughout the Group and communicate standards, instructions and guidance to employees. They support the formulation of risk appetite and establish procedures for monitoring and controlling risks, with timely and reliable reporting to management. HSBC regularly reviews and updates its risk management policies, systems and methodologies to reflect changes in law, regulation, markets, products and emerging best practice.
It is the responsibility of all Group officers to identify, assess and manage risk within the scope of their assigned responsibilities. Personal accountability, reinforced by the Group’s governance structure and instilled by training and experience, helps to foster throughout the Group a disciplined and constructive culture of risk management and control.
Credit risk is the risk of financial loss if a customer or counterparty fails to meet an obligation under a contract. It arises principally from direct lending, trade finance and leasing business, but also from certain off-balance sheet products such as guarantees and credit derivatives, and from the Group’s holdings of assets in the form of debt securities. HSBC has standards, policies and procedures
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dedicated to monitoring and managing risk from such activities.
The credit risk governance structures and control frameworks implemented by the Group are designed for all stages of economic and financial cycles, including the current economic environment. No material changes were initiated to HSBC’s risk management objectives, policies or procedures as a direct result of market turmoil. Certain measures already undertaken, however, are helping the Group to manage the effects of that turmoil. Such measures, for example the reinforcement of central credit risk oversight and independent review activities, continue to be implemented within a common operating model for the responsibilities and interaction of GMO Risk, regionally integrated risk functions and country-based management. In addition, certain operational processes have been invoked and applied in order to manage risks more intensively.
Credit Risk is part of the Global Risk function, and the heads of its Retail and Wholesale risk disciplines within GMO, as well as regional Chief Risk Officers, certain country Chief Credit Officers and the Head of Risk Strategy, report to the GCRO. The regional governance bodies for key risk matters reflect those in place at the centre. Functional units at the entity and regional levels report to GMO Risk. GMO helps build the Group’s credit risk management capacity through staff selection, training, development, performance assessment and remuneration – the GCRO is jointly responsible with business heads for setting the performance goals of senior Global Risk officers.
Across the Group, Credit Risk fulfils the role of an independent credit control unit, while engaging in dialogue with business teams to set priorities, refine risk appetite, and monitor and report higher-risk exposures. Credit risk and risk capital management policies and methodologies, including analytical model development/review and management information, are enhanced in the light of experience gained, for instance through the roll-out of the Group’s advanced internal ratings-based (‘IRB’) approach to Basel II. See also ‘Capital Management’ on page 274.
The Credit Risk function within GMO provides high-level oversight and management of credit risk for HSBC worldwide. Its responsibilities include:
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Each HSBC operating company is required to implement credit policies, procedures and lending guidelines that meet local requirements while conforming to Group standards. Credit approval authorities are delegated by the Board of Directors of HSBC Holdings to the most senior Chief Executive Officers, who receive commensurate delegations from their own boards. In each major subsidiary, a Chief Risk Officer or Chief Credit Officer reports to the local Chief Executive Officer or Chief Operating Officer on credit-related issues, while maintaining a direct functional reporting line to the GCRO.
Each operating company is responsible for the quality and performance of its credit portfolios and for monitoring and controlling all credit risks in them, including those subject to central approval by Group Risk. This includes managing its own risk concentrations by market sector, geography and product. Local systems are in place throughout the Group to enable operating companies to control and monitor exposures by customer and retail product segments.
Special attention is paid to problem exposures, which are subject to more frequent and intensive review and reporting, in order to accelerate remedial action. Where appropriate, HSBC’s local operating companies maintain or establish specialist units to provide customers with support in order to help them avoid default wherever possible.
Periodic risk-based audits of operating companies’ credit processes and portfolios are
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undertaken by HSBC’s Internal Audit function. Audits include consideration of the adequacy and clarity of credit policy/procedure manuals; an in-depth analysis of a representative sample of accounts; an overview of homogeneous portfolios of similar assets to assess the quality of the loan book and other exposures; consideration of any oversight or review work performed by credit risk management functions and the adequacy of impairment calculations; a review of analytical model governance and implementation; a review of management objectives and a check that Group and local standards and policies are adhered to in the approval and management of credit facilities.
Individually significant accounts are reviewed on a sample basis to ensure that risk ratings are appropriate, that credit and collection procedures have been properly followed and that, when an account or portfolio evidences deterioration, impairment allowances are raised in accordance with the Group’s established procedures. Internal Audit discusses with management any risk ratings it considers to be inappropriate; after discussion, its final recommendations for revised ratings must then be adopted.
Credit quality(Audited)
HSBC’s credit risk rating systems and processes differentiate exposures in order to highlight those with greater risk factors and higher potential severity of loss. In the case of individually significant accounts, risk ratings are reviewed regularly and any amendments are implemented promptly. Within the Group’s retail businesses, risk is assessed and managed using a wide range of risk and pricing models to generate portfolio data.
HSBC’s historical, seven-grade risk rating system based on a judgemental assessment of the likelihood and impact of delinquency was superseded in 2008 for financial reporting purposes, as for those of all significant risk management decisions employing credit risk ratings, by a more risk-sensitive and granular methodology. This facilitates the IRB approach under Basel II adopted by the Group to support calculation of its minimum credit regulatory capital requirement.
The integration of this methodology into HSBC’s risk processes and structures is well advanced and supports reporting on the new basis to senior management in line with the Group’s IRB obligations. For further details, please see ‘Credit quality of financial instruments’ on page 217.
Impairment assessment(Audited)
When impairment losses occur, HSBC reduces the carrying amount of loans and advances through the use of an allowance account. When impairment of available-for-sale financial assets and held-to-maturity financial investments occurs, the carrying amount of the asset is reduced directly. For further details on the accounting policy for impairment of available-for-sale debt and equity securities, see ‘Accounting policies’ on page 350.
Impairment allowances may be assessed and created either for individually significant accounts or, on a collective basis, for groups of individually significant accounts for which no evidence of impairment has been individually identified or for high-volume groups of homogeneous loans that are not considered individually significant.
It is HSBC’s policy that each operating company creates allowances for impaired loans promptly and consistently.
Management regularly evaluates the adequacy of the established allowances for impaired loans by conducting a detailed review of the loan portfolio, comparing performance and delinquency statistics with historical trends and assessing the impact of current economic conditions.
Individually assessed impairment allowances
These are determined by evaluating exposure to loss, case by case, on all individually significant accounts and all other accounts that do not qualify for the collective assessment approach outlined below. Loans are treated as impaired as soon as there is objective evidence that an impairment loss has been incurred. The criteria used by HSBC to determine that there is such objective evidence include:
In determining the level of allowances on such accounts, the following factors are typically considered:
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The level of impairment allowances on individually significant accounts that are above defined materiality thresholds is reviewed at least semi-annually, and more regularly when circumstances require. This normally encompasses re-assessment of the enforceability of any collateral held and of actual and anticipated receipts. For significant commercial and corporate debts, specialised loan ‘work-out’ teams with experience in insolvency and specific market sectors are used to manage the lending and assess likely losses.
Individually assessed impairment allowances are only released when there is reasonable and objective evidence of a reduction in the established loss estimate.
Collectively assessed impairment allowances
Impairment is assessed on a collective basis in two circumstances:
Incurred but not yet identified impairment
Individually assessed loans for which no evidence of impairment has been specifically identified on an individual basis are grouped together according to their credit risk characteristics. A collective impairment allowance is calculated to reflect impairment losses incurred at the balance sheet date which will only be individually identified in the future.
The collective impairment allowance is determined having taken into account:
The period between a loss occurring and its identification is estimated by local management for each relevant portfolio. In general, the periods used vary between four and twelve months although, in exceptional cases, longer periods are warranted.
The basis on which impairment allowances for incurred but not yet identified losses is established in each reporting entity is documented and reviewed by senior Finance and Credit Risk management to ensure conformity with Group policy.
Homogeneous groups of loans
Two methodologies are used to calculate impairment allowances where large numbers of relatively low-value assets are managed using a portfolio approach, typically:
When appropriate empirical information is available, the Group uses roll rate methodology. This employs a statistical analysis of historical trends of
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default and the amount of consequential loss, based on the delinquency of accounts within a portfolio of homogeneous accounts. Other historical data and current economic conditions are also evaluated when calculating the appropriate level of impairment allowance required to cover inherent loss. In certain highly developed markets, models also take into account behavioural and account management trends revealed in, for example, bankruptcy and rescheduling statistics.
When the portfolio size is small, or when information is insufficient or not reliable enough to adopt a roll rate methodology, a formulaic approach is used that allocates progressively higher percentage loss rates the longer a customer’s loan is overdue. Loss rates reflect the discounted expected future cash flows for a portfolio.
Generally, historical experience is the most objective and relevant information from which to begin to assess inherent loss within each portfolio. In circumstances where historical loss experience provides less relevant information about the inherent loss in a given portfolio at the balance sheet date – for example, where there have been changes in economic conditions or regulations – management considers the more recent trends in the portfolio risk factors which may not be adequately reflected in its statistical models and, subject to guidance from Group Finance and GMO Risk, adjusts impairment allowances accordingly.
Roll rates, loss rates and the expected timing of future recoveries are regularly benchmarked against actual outcomes to ensure they remain appropriate.
Write-off of loans and advances
Loans are normally written off, either partially or in full, when there is no realistic prospect of further recovery. Where loans are secured, this is generally after receipt of any proceeds from the realisation of security. In the case of residential mortgages and second lien loans in HSBC Finance, loan carrying amounts in excess of net realisable value are written off at or before the time foreclosure is completed or when settlement is reached with the borrower. If there is no reasonable expectation of recovery, and foreclosure is pursued, unconstrained by delays required by law or regulation, the loan is normally written off no later than the end of the month in which the loan becomes 240 days contractually past due.
Unsecured personal facilities, including credit cards, are generally written off at between 150 and 210 days past due, the standard period being the end of the month in which the account becomes 180 days
contractually delinquent. This period may be extended, generally to 300 days past due but in no event exceeding 360 days past due, in the case of HSBC Finance’s unsecured personal facilities other than credit cards.
Cases of write-off periods exceeding 360 days past due are few but arise, for example, in a few countries where local regulation or legislation constrain earlier write-off, or where the realisation of collateral for secured real estate lending extends beyond this time.
In the event of bankruptcy or analogous proceedings, write-off may occur earlier than at the periods stated above. Collections procedures may continue after write-off.
Cross-border exposures
Management assesses the vulnerability of countries to foreign currency payment restrictions when considering impairment allowances on cross-border exposures. This assessment includes an analysis of the economic and political factors existing at the time. Economic factors include the level of external indebtedness, the debt service burden and access to external sources of funds to meet the debtor country’s financing requirements. Political factors taken into account include the stability of the country and its government, threats to security, and the quality and independence of the legal system.
Impairment allowances are assessed in respect of all qualifying exposures within these countries unless these exposures and the inherent risks are:
Credit exposure
Maximum exposure to credit risk(Audited)
HSBC’s exposure to credit risk is spread over several asset classes, including derivatives, trading
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assets, loans and advances to customers, loans and advances to banks, and financial investments. The balance of exposure at 31 December 2008 represented a change in risk profile compared with a year ago as HSBC repositioned its balance sheet in the face of unprecedented turmoil in financial markets. The following commentary is on a constant currency basis.
Derivative asset balances rose significantly as the financial turmoil of 2008 led to heightened levels of volatility in the underlying markets to which the derivatives are referenced. The rise in asset balances was primarily driven by interest rate derivatives as the global fall in interest reference rates created significant gaps between the fixed and floating components of interest rate swaps, which in turn led to substantial mark-to-market increases in the value of interest rate swap positions. The widening credit spreads and significant volatility in credit and foreign exchange markets created the environment in which credit derivative positions and foreign exchange derivative assets increased.
HSBC reduced exposure to banks as it tightened lending limits in response to declining credit quality. Much of this lending was instead placed into government issued or guaranteed debt, which contributed to an increase in financial investments.
Loans and advances to customers in the commercial sector grew while personal lending declined, primarily due to the continued run-off of parts of the portfolio in North America. Amounts due from non-bank financial institutions increased due to the expansion of reverse repo lending with the London Clearing House in the UK and a reclassification of cash collateral in the US.
Within trading assets, debt securities and treasury and other bills increased, primarily due to the consolidation on 30 September 2008 of five Constant Net Asset Value funds containing assets upon consolidation of around US$40 billion held for trading. For further details see pages 180 to 181.
As a consequence of the significant increase in derivative balances, there was a decline in the proportion of total assets represented by most other asset classes. On a reported basis, the proportion of total assets represented by derivative assets increased by 12 percentage points while that deployed in loans and advances to customers declined by 5 percentage points and the proportion of trading assets declined by 2 percentage points. Loans and advances to banks as a proportion of total assets declined by 4 percentage points.
The most significant factor affecting HSBC’s exposure to credit risk during 2008 was the continuing deterioration in credit conditions in the US mortgage market. HSBC also experienced deterioration in credit quality in the commercial real estate sector. Loss experience remained concentrated in the personal lending portfolios, primarily in the US with 85 per cent of loan impairment charges and other credit risk provisions arising in Personal Financial Services in 2008 compared with 94 per cent in 2007. In 2008, 9 per cent of loan impairment charges and other credit risk provisions arose in Commercial Banking, compared with 6 per cent in 2007. In the UK, despite significant declines in house prices and activity in the housing market as a whole, the credit quality of HSBC’s mortgage business remained materially stable in 2008.
The following table presents the maximum exposure to credit risk from balance sheet and off-balance sheet financial instruments, before taking account of any collateral held or other credit enhancements (unless such credit enhancements meet offsetting requirements). For financial assets recognised on the balance sheet, the maximum exposure to credit risk equals their carrying amount; for financial guarantees granted, it is the maximum amount that HSBC would have to pay if the guarantees were called upon. For loan commitments and other credit-related commitments that are irrevocable over the life of the respective facilities, it is the full amount of the committed facilities.
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Collateral and other credit enhancements(Audited)
Collateral held against financial instruments presented in the ‘Maximum exposure to credit risk’ table above is described in more detail below.
Items in the course of collection from other banks
Settlement risk arises in any situation where a payment in cash, securities or equities is made in the expectation of a corresponding receipt of cash, securities or equities. Daily settlement limits are established for counterparties to cover the aggregate of HSBC’s transactions with each one on any single day. Settlement risk on many transactions, particularly those involving securities and equities, is substantially mitigated by settling through assured
payment systems or on a delivery-versus-payment basis.
Treasury, other eligible bills and debt securities
Collateral held as security for financial assets other than loans and advances is determined by the nature of the instrument. Debt securities, treasury and other eligible bills are generally unsecured, except for ABSs and similar instruments, which are secured by pools of financial assets.
Derivatives
The ISDA Master Agreement is HSBC’s preferred agreement for documenting derivatives activity. It provides the contractual framework within which dealing activity across a full range of over-the-
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counter products is conducted, and contractually binds both parties to apply close-out netting across all outstanding transactions covered by an agreement if either party defaults or other pre-agreed termination events occur. It is common, and HSBC’s preferred practice, for the parties to execute a Credit Support Annex (‘CSA’) in conjunction with the ISDA Master Agreement. Under a CSA, collateral is passed between the parties to mitigate the market-contingent counterparty risk inherent in the outstanding positions.
Loans and advances
It is HSBC’s policy, when lending, to do so on the basis of the customer’s capacity to repay, rather than rely primarily on the value of security offered. Depending on the customer’s standing and the type of product, facilities may be provided unsecured. Whenever available, collateral can be an important mitigant of credit risk.
The guidelines applied by operating companies in respect of the acceptability of specific classes of collateral or credit risk mitigation, and the determination of valuation parameters are subject to regular review to ensure that they are supported by empirical evidence and continue to fulfil their intended purpose. The principal collateral types employed by HSBC are as follows:
In addition, credit derivatives, including credit default swaps and structured credit notes, and securitisation structures are used to manage credit risk in the Group’s loan portfolio.
HSBC does not disclose the fair value of collateral held as security or other credit enhancements on loans and advances past due but not impaired, or on individually assessed impaired loans and advances, as it is not practicable to do so.
Concentration of exposure (Audited)
Concentrations of credit risk arise when a number of counterparties or exposures have comparable
economic characteristics, or such counterparties are engaged in similar activities or operate in the same geographical areas or industry sectors, so that their collective ability to meet contractual obligations is uniformly affected by changes in economic, political or other conditions.
Securities held for trading (Unaudited)
Total securities held for trading within trading assets were US$254 billion at 31 December 2008 (2007: US$247 billion). The largest concentration of these assets was government and government agency securities, which amounted to US$143 billion, or 56 per cent of overall trading securities (2007: US$115 billion, 46 per cent). This included US$32 billion (2007: US$16 billion) of treasury and other eligible bills. Corporate debt and other securities were US$82 billion or 32 per cent of overall trading securities, 8 percentage points higher than 2007’s level of 24 per cent at US$60 billion. Included within total securities held for trading were US$50 billion (2007: US$70 billion) of debt securities issued by banks and other financial institutions.
A more detailed analysis of securities held for trading is set out in Note 16 on the Financial Statements and an analysis of credit quality is provided on page 218.
Debt securities, treasury and other eligible bills (Unaudited)
At US$293 billion, total financial investments excluding equity securities were 8 per cent higher at 31 December 2008 than at the end of 2007. Debt securities, at US$252 billion, represented the largest concentration of financial investments at 86 per cent of the total, compared with US$240 billion (89 per cent) at 31 December 2007. HSBC’s holdings of corporate debt, ABSs and other securities were spread across a wide range of issuers and geographical regions, with 48 per cent invested in securities issued by banks and other financial institutions. In total, holdings in ABSs decreased by US$24 billion due to a combination of movements in fair values, principal amortisations and write-downs.
Investments in securities of governments and government agencies of US$114 billion were 38 per cent of overall financial investments, 5 percentage points higher than in 2007. US$41 billion of these investments comprised treasury and other eligible bills.
A more detailed analysis of financial investments is set out in Note 19 on the Financial
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Statements and an analysis by credit quality is provided on page 218.
The insurance businesses held diversified portfolios of debt and equity securities designated at fair value (2008: US$20 billion; 2007: US$34 billion) and debt securities classified as financial investments (2008: US$28 billion; 2007: US$23 billion). A more detailed analysis of securities held by the insurance businesses is set out on page 262.
Derivatives(Unaudited)
Derivative assets at 31 December 2008 were US$495 billion, a rise of 163 per cent from 31 December 2007, primarily foreign exchange, interest rate and credit derivatives. The main drivers of growth were mark-to-market movements across the entire portfolio arising from volatility and movements in interest rates and credit spreads.
Loans and advances(Unaudited)
Loans and advances were well diversified across industry sectors and jurisdictions.
At constant exchange rates, gross loans and advances to customers (excluding the financial sector settlement accounts and reclassified ABSs) at 31 December 2008 rose by US$54 billion or 7 per cent from 31 December 2007.
Personal lending represented 46 per cent of total loans and advances to customers including the financial sector settlement accounts and reclassified ABSs. Residential mortgages of US$243 billion represented 25 per cent of total advances to customers, the Group’s largest concentration in a single exposure type.
Corporate, commercial and financial lending, including settlement accounts, amounted to 53 per cent of total loans and advances to customers at 31 December 2008. The largest industry concentrations were in non-bank financial institutions and commercial real estate lending at 10 per cent and 7 per cent, respectively, of total gross lending to customers.
Exposure to non-bank financial institutions principally comprised secured lending on trading accounts, primarily through repo facilities. During 2008, HSBC reduced unsecured exposure to hedge
fund trading accounts. HSBC had no material exposure to hedge funds affected by the administration of Lehman Brothers International (Europe).
HSBC managed its exposure to insurance institutions closely within existing limits and experienced no material loss during 2008.
Commercial, industrial and international trade lending rose strongly during 2008, increasing its proportion of total lending by 2 percentage points to 22 per cent of total gross loans and advances to customers on a reported basis. Within this category, the largest concentration of lending was to the service sector, which amounted to 6 per cent of total gross lending to customers.
Loans and advances to banks were widely distributed across major institutions.
Lending to banks was managed downwards through 2008. HSBC reduced limits to this sector in response to a deterioration in credit quality which was most visible in the collapse of a number of US and Icelandic banks to which the Group had advanced funds. The expansion of sovereign guarantees for some bank issuance increased appetite for these counterparties.
2008 compared with 2007(Unaudited)
The commentary below analyses, on a constant currency basis, the changes in lending noted in the table below, compared with the position at 31 December 2007. On this basis, loans and advances to personal, corporate and commercial customers increased by 7 per cent, and total gross loans and advances rose by 1 per cent.
Total lending to personal customers was concentrated in North America (US$196 billion), the UK (US$108 billion) and Hong Kong (US$46 billion). Collectively, these regions accounted for 79 per cent of total personal lending, a decline of 1 percentage point from the level reported at 31 December 2007. Total lending to personal customers declined by 3 per cent to US$440 billion at 31 December 2008.
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Gross loans and advances by industry sector(Unaudited)
Residential mortgages rose slightly to US$243 billion at 31 December 2008, comprising 25 per cent of total loans and advances to customers (including the financial sector and settlement accounts). A significant increase in mortgage lending in the UK, combined with more modest increases in Hong Kong, Rest of Asia-Pacific and Latin America, more than offset a 15 per cent decrease in the value of mortgage lending in North America.
In Europe, residential mortgage lending rose by 22 per cent to US$87 billion. Mortgage lending rose by 26 per cent in the UK, driven by the successful launch of the RateMatcher campaign in April 2008, and a similarly successful campaign in First Direct. This was partly offset by a decline in France due to the sale of the regional banks in July 2008.
In Hong Kong, residential mortgage lending rose by 11 per cent due to successful repricing initiatives which allowed HSBC to become the market leader for new mortgage lending during the year. In response to the weakening local economy and declining house prices in the second half of 2008, HSBC tightened lending criteria and increased pricing on new loans.
In Rest of Asia-Pacific, mortgage lending rose by 11 per cent, driven by continued business
expansion in the Middle East. Balances in mainland China grew strongly as the branch network expanded.
In North America, mortgage lending declined by 15 per cent. In the US, total mortgage lending amounted to US$81 billion at 31 December 2008, a decline of 18 per cent since 31 December 2007. In the mortgage services business, balances declined by 21 per cent as there were no new originations and the portfolio continued to run-off. In consumer lending, balances declined by 7 per cent as a result of management actions taken to reduce risk in the portfolio, including further tightening underwriting criteria and increasing collateral requirements for new originations. In HSBC USA, balances declined by 32 per cent, primarily due to the sale of US$7.0 billion of mortgage portfolios during 2008 and the fact that the majority of loan originations continued to be sold in the secondary markets. In line with HSBC’s reduced risk appetite, the wholesale and third-party correspondent prime mortgage business of HSBC USA was closed in November 2008.
In Latin America, residential mortgage lending increased, driven by continued growth in fixed rate mortgage lending in Mexico.
Other personal lending declined by 8 per cent to US$197 billion at 31 December 2008, representing
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21 per cent of total loans and advances to customers (including the financial sector and settlement accounts).
In Europe, other personal lending declined by 11 per cent from the end of 2007 to US$54 billion. The decrease was primarily attributable to the UK as a stronger focus on secured lending restricted originations in the unsecured portfolio. The sale of certain non-core credit card portfolios in the first half of 2008 also contributed to the decrease in the UK. In France, balances declined due to the sale of the regional banks in the second half of 2008. In Turkey, continued expansion of the branch network during 2008 resulted in higher balances, particularly in credit cards and overdrafts.
In Hong Kong, other personal lending declined by 2 per cent to US$13 billion. HSBC remained the market leader for credit cards in Hong Kong based on cards in circulation, cardholder spending and balances.
In Rest of Asia-Pacific, other personal lending rose by 12 per cent, primarily due to strong growth in the Middle East. Elsewhere in the region, balances rose in Malaysia and Indonesia.
In North America, other personal lending balances declined by 12 per cent to US$97 billion. In the US, consumer finance business and credit card lending fell due to the combined effect of tighter underwriting criteria and lower marketing expenditure. A reduction in non-credit card personal lending reflected the decision to cease new business in guaranteed direct mail loans and personal homeowner loans in the second half of 2007, and tighter underwriting criteria applied to originations in the remainder of the portfolio. In the mortgage services business, second lien balances declined due to the continued run-off of the portfolio following the cessation of originations in 2007. Lower vehicle finance lending at HSBC Finance reflected the discontinuation of certain product offerings and the cessation of new vehicle loan originations from the dealer and direct-to-consumer channels in July 2008. HSBC USA also discontinued originations of indirect vehicle finance loans, but second lien loans increased following a promotional campaign channelled through the branch network in the first half of 2008. In Canada, lower balances were attributable to the disposal of the vehicle finance businesses during the year.
In Latin America, other personal lending rose by 9 per cent to US$15 billion. Lending growth was primarily concentrated in Brazil and reflected strong demand for payroll loans and vehicle lending. In Mexico, balances were broadly in line with
31 December 2007 and the mix was adjusted towards customers of higher credit quality. Further growth was restricted as risk appetite was adjusted by closing certain products to new originations and tightening underwriting criteria on cards, leading to a sharp reduction in the number of cards issued in 2008.
Loans and advances to corporate and commercial customers rose by 19 per cent to US$407 billion, with strong growth across all regions. Lending was primarily concentrated in Europe, where it accounted for 54 per cent of advances to this sector, of which more than 40 per cent were in the UK.
In Europe, corporate and commercial advances rose by 24 per cent. In the UK, lending rose by 35 per cent, driven by growth in lending to large corporates. Balances declined in France due to the sale of the regional banks in July 2008.
In Hong Kong, corporate and commercial lending rose by 19 per cent, driven by higher lending in commercial, industrial and international trade, commercial real estate and other property-related sectors.
In Rest of Asia-Pacific, strong corporate and commercial lending growth was experienced in the Middle East and Singapore, which rose by 26 per cent and 50 per cent respectively and, to a lesser extent, in Malaysia, India and Taiwan, the latter due to the acquisition of the assets and liabilities of The Chinese Bank in March 2008. In the Middle East, the corporate and commercial loan book continued to grow, owing to an expansion of lending in UAE, particularly for trade and investment projects, in addition to general business growth. In Singapore, higher lending was driven by strong demand from the international trade sector. Lending in Japan declined due to the closure of inactive and unprofitable accounts, and lending in mainland China fell as a result of tightened government regulations and tighter lending criteria in response to the weakening local economy. This partly offset the strong growth elsewhere in the region.
In North America, corporate and commercial lending increased by 7 per cent, driven by growth in HSBC USA and, to a lesser extent, in Canada. In HSBC USA, higher lending to corporate and commercial clients reflected the targeted expansion of middle market activities and the drawdown of existing credit facilities, partly offset by a decline in commercial real estate activity as the bank managed down its lending exposures in light of lower risk appetite and a deterioration in market conditions. In Canada, corporate and commercial lending rose by
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9 per cent, particularly in Western Canada, as demand remained strong for commercial loans.
In Latin America, corporate and commercial lending rose by 20 per cent, driven by higher lending in Brazil as a result of strong growth in the trade loans portfolio and working capital products.
Loans and advances to the financial sector rose by 15 per cent with strong growth in the UK and North America, largely in collateralised lending. Lending balance were 46 per cent higher in the UK due to the increased use of secured funding facilities through the London Clearing House in the form of repos. In North America, higher lending was driven by HSBC USA due to the reclassification from ‘Other assets’ of cash collateral held with other institutions.
Loans and advances to banks fell by 29 per cent to US$154 billion due to a significant decline in placement activity in Hong Kong and Europe. This was driven by a reduction in money market and inter-bank placements in favour of treasury bills and bank securities. In the UK, a higher proportion of assets were invested in government and government-guaranteed debt. Elsewhere, growth in Latin America was primarily in Brazil, due to higher reverse repo balances.
The following tables analyse loans by industry sector and by the location of the principal operations of the lending subsidiary or, in the case of the operations of The Hongkong and Shanghai Banking Corporation Limited, HSBC Bank plc, HSBC Bank Middle East Limited and HSBC Bank USA N.A., by the location of the lending branch.
Gross loans and advances to customers by industry sector(Audited: 2008 to 2005; Unaudited: 2004)
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Loans and advances to customers by industry sector and by geographical region(Audited)
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Additional disclosure on gross loans and advances to customers by principal country within Rest of Asia-Pacific and Latin America(Audited)
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Loans and advances to banks by geographical region(Audited: 2008 to 2005; Unaudited: 2004)
Country distribution of outstandings and cross-border exposures(Unaudited)
HSBC controls the risk associated with cross-border lending, essentially that foreign currency will not be made available to local residents to make payments, through a centralised structure of internal country limits which are determined by taking into account relevant economic and political factors. Exposures to individual countries and cross-border exposure in aggregate are kept under continual review.
The following table summarises the aggregate of in-country foreign currency and cross-border outstandings by type of borrower to countries which
individually represent in excess of 1 per cent of HSBC’s total assets. The classification is based on the country of residence of the borrower but also recognises the transfer of country risk in respect of third-party guarantees, eligible collateral held and residence of the head office when the borrower is a branch. In accordance with the Bank of England Country Exposure Report (Form CE) guidelines, outstandings comprise loans and advances (excluding settlement accounts), amounts receivable under finance leases, acceptances, commercial bills, CDs and debt and equity securities (net of short positions), and exclude accrued interest and intra-HSBC exposures.
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At 31 December 2008, HSBC had in-country foreign currency and cross-border amounts outstanding to counterparties in Japan of between 0.75 per cent and 1.0 per cent of total assets; in aggregate, US$24.4 billion.
At 31 December 2007, HSBC had in-country foreign currency and cross-border amounts outstanding to counterparties in Hong Kong, Belgium and Ireland of between 0.75 per cent and 1.0 per cent of total assets. The aggregate in-country foreign currency and cross-border amounts outstanding were Hong Kong, US$19.7 billion, Belgium, US$19.3 billion and Ireland, US$19.3 billion.
At 31 December 2006, HSBC had in-country foreign currency and cross-border amounts outstanding to counterparties in Australia and Hong Kong of between 0.75 per cent and 1 per cent of total assets. The aggregate in-country foreign currency and cross-border amounts outstanding were Australia, US$17.1 billion, Hong Kong, US$13.9 billion.
Areas of special interest
Personal lending(Unaudited)
HSBC provides a broad range of secured and unsecured personal lending products to meet customer needs. Given the diverse nature of the markets in which HSBC operates, the range is not standardised across all countries but is tailored to meet the demands of individual markets while using appropriate distribution channels and, wherever possible, common global IT platforms.
Personal lending includes advances to customers for asset purchase, such as residential property and motor vehicles, where the loans are typically secured on the assets being acquired. HSBC also offers loans secured on existing assets, such as first and second liens on residential property; unsecured lending products such as overdrafts, credit cards and payroll loans; and debt consolidation loans which may be secured or unsecured. At the end of February 2009, HSBC authorised the discontinuation as soon as
practicable of all new receivable originations of all products by the branch-based consumer lending business of HSBC Finance in North America (see page 70).
Various underwriting controls are applied before a loan is issued, and delinquency is managed through collection and customer management procedures. The expected occurrence and degree of delinquency varies according to the type of loan and the customer segment. Delinquency levels tend to increase in the normal course of portfolio ageing. As a result, loan impairment charges usually relate to lending originated in earlier accounting periods.
As discussed in ‘Challenges and uncertainties’ on page 12, rising unemployment has been the major factor in the deterioration in credit quality of personal lending portfolios in 2008. Further weakening in consumers’ confidence and capacity to service financial commitments may result in deteriorating payment patterns and increased delinquencies and default rates and, as a consequence, higher loan impairment allowances and write-offs. HSBC monitors the effect of these factors on its personal lending portfolios and keeps under review a range of measures designed to limit the Group’s exposure and mitigate the effect on customers.
Loan impairment allowances are sensitive to changes in the level of unemployment, particularly at the current time in North America, which affects customers’ future ability to repay their loans. For example, had there been an additional 1 per cent increase in unemployment in North America, loan impairment allowances could have been higher by between US$0.7 billion and US$1.5 billion as at 31 December 2008. The relationship between changes in unemployment and loan impairment charges cannot be predicted with any degree of certainty. For example, sharp increases in unemployment may not have a linear impact on the level of increase in loan impairment charges.
Please refer to page 205 for further analysis of gross loans and advances by region and pages 34 and 229 for discussion of loan impairment charges and other credit risk provisions.
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Total personal lending(Unaudited)
The commentary that follows is on a constant currency basis.
At 31 December 2008, total personal lending was US$440 billion, a decline of 3 per cent from the balance at 31 December 2007. In 2008, personal lending accounted for 85 per cent of the Group’s loan impairment charges and other credit risk provisions. Within personal lending, total loan impairment charges and other credit risk provisions of US$21.2 billion were concentrated in North America (US$16.1 billion) and, to a lesser extent, in Latin America (US$2.1 billion) and Europe (US$2.0 billion). These loan impairment charges represented, respectively, 39 per cent, 5 per cent and 5 per cent of each region’s total Personal Financial Services’ net operating income before loan impairment charges and other credit risk provisions.
Total US personal lending at 31 December 2008 was 15 per cent less than at the end of 2007, at US$171 billion, as HSBC’s strategy to run off its existing portfolio and improve credit quality on new originations took effect. Residential mortgage balances fell by 18 per cent to US$81 billion, driven by decisions taken in 2007 to end new correspondent channel originations in Mortgage Services and limit new originations in the consumer lending business through tighter underwriting standards. Portfolio run-off, charge-off of impaired loans and the sale of
US$8.2 billion of loans during 2008 from the US real estate secured portfolios contributed to these lower balances.
Other personal lending in the US fell by 11 per cent to US$90 billion as a result of actions taken by HSBC since 2007 to reduce risk in the portfolio, including the elimination of guaranteed direct mail loans to new customers, the discontinuance of personal homeowner loans and a general tightening of underwriting criteria. Card balances declined by 5 per cent to US$47 billion as HSBC reduced credit lines, closed dormant accounts and curtailed marketing expenditure, which together lowered originations in line with HSBC’s reduced appetite for risk in this segment at this time.
Motor vehicle finance loans in the US fell by 18 per cent to US$11 billion, again reflecting reduced risk appetite and lower origination. In July, the decision was taken to discontinue all new motor vehicle loan originations from the dealer and direct-to-consumer channels within the North America vehicle finance business of HSBC Finance as management determined that the business was sub-scale and did not have sufficient market strength to provide an acceptable level of risk-adjusted returns.
In the UK, gross loans and advances to personal customers rose by 14 per cent to US$108 billion, due to strong growth in residential mortgage lending following successful campaigns during 2008 at HSBC Bank and First Direct. Other personal lending
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declined by 11 per cent to US$29 billion, driven by lower originations, reduced marketing activities and lower customer appetite for unsecured borrowing. Credit quality in the unsecured portfolios of M&S Money, HSBC Bank and Partnership Cards in the UK showed a slight deterioration in 2008, particularly in the second half of the year, due to the weakening UK economy.
In Latin America, in response to rising impairment charges and the weaker economic conditions, HSBC moderated loan growth from that achieved in the previous year, with gross loans and advances to personal customers rising by 11 per cent to US$20 billion compared with 31 per cent in 2007. Loan impairment charges were 20 per cent higher in Brazil but 57 per cent higher in Mexico following strong growth in recent years in lending portfolio seasoning and credit deterioration. As a consequence of this experience, in Mexico, HSBC’s other personal lending balances at 31 December 2008 were US$3.7 billion, 1 per cent lower than at 31 December 2007 as management realigned the business towards customers of higher credit quality.
Mortgage lending products (Unaudited)
The Group offers a wide range of mortgage products designed to meet customer needs, including capital repayment mortgages subject to fixed or variable interest rates and products designed to meet demand for housing loans with more flexible payment structures. HSBC underwrites both first lien residential mortgages and loans secured by second lien mortgages.
Interest-only mortgages are those for which customers make regular payments of interest during the life of the loan and repay the principal from the sale of their home or alternative sources of funds. Introductory interest-only mortgages are typically where the interest-only element is for a fixed term at the start of the loan, after which principal repayments commence.
Affordability mortgages include all products where the customer’s monthly payments are set at a low initial rate, either variable or fixed, before resetting to a higher rate once the introductory period is over. These include adjustable-rate mortgages (‘ARM’s), loans on which the interest rate is periodically changed based on a reference price. HSBC Finance no longer originates or acquires interest-only loans or ARMs.
Affordability mortgages are primarily offered in the US and the UK. Under the HFC and Beneficial brands, HSBC Finance and HFC Bank Ltd (‘HFC UK’) offer a range of products predominantly designed for the needs of customers with nonstandard or less favourable credit profiles. Offset mortgages are products linked to a current or savings account, where the interest earned is used to repay mortgage debt.
US mortgage lending
US mortgage lending, comprising residential mortgage and second lien lending, made up 22 per cent of the Group’s gross loans and advances to personal customers at 31 December 2008.
Balances declined by 18 per cent from 31 December 2007, as the Mortgage Services portfolio continued to run-off and tighter underwriting standards were applied to originations for the consumer lending portfolio. As the bulk of the mortgage lending products sold in the US consumer lending branch network are for refinancing and debt consolidation, rather than for house purchase, the limited availability of home equity severely restricts the number of eligible customers. As a consequence, HSBC began the process of repositioning its consumer lending business in 2008, reducing exposure to lower tiers of sub-prime credit and expanding its range of lending for real estate loans to include both government-sponsored entity and conforming loan products. At the end of February 2009, HSBC authorised the discontinuation as soon as practicable of all new receivable originations of all products by the branch-based consumer lending business of HSBC Finance in North America (see page 70).
Mortgage lending in HSBC USA also declined, following a series of management actions to reduce risk in the portfolio. These included closing the prime wholesale and third-party correspondent mortgage business in November 2008, selling US$7.0 billion in loans during 2008, and continuing to sell newly originated residential mortgages to the US government-sponsored mortgage agencies.
Affordability mortgage balances in HSBC Finance declined from US$19 billion at 31 December 2007 to US$14 billion at 31 December 2008. These mortgages continued to experience the heightened levels of delinquency that began to emerge in late 2006. They are no longer originated through the consumer lending branch network. In aggregate, HSBC Finance’s mortgage balances declined to US$74 billion at 31 December 2008 (31 December 2007: US$87 billion) as set out in the table on page 211. Within this, the portfolio of real estate secured business originated through the branch network was US$46 billion at 31 December
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2008, of which approximately 95 per cent were fixed rate loans and 87 per cent were first lien. At 31 December 2008, the mortgage services business had approximately 250,000 accounts and
US$28 billion in balances outstanding. Approximately 59 per cent were fixed rate loans and 84 per cent were first lien.
Further discussion of credit trends in the US mortgage lending portfolio and management actions taken to mitigate risk is provided in ‘US personal lending – credit quality’ on page 212.
HSBC Finance US mortgage lending1 (Unaudited)
UK mortgage lending
Mortgage lending in the UK rose significantly in 2008 and overall credit quality was maintained despite a significant deterioration in the housing market. The withdrawal of many competitors from the market and the consequent repricing of mortgage products allowed HSBC Bank to expand its share of the new lending market while staying within its targeted customer segments. In December 2008, HSBC announced that it will make available up to US$22 billion of new UK residential mortgages in 2009.
Total mortgage lending in the UK rose from US$64 billion at 31 December 2007 to US$80 billion at 31 December 2008. This was driven by the success of the RateMatcher mortgage campaign in the first half of 2008 in generating new business, and an increase at First Direct due to growth in offset mortgage lending following a similarly successful campaign.
The maintenance of good credit quality in difficult market conditions is attributable to the business model pursued by HSBC in the UK. HSBC Bank originates virtually all new business through its own salesforce and does not rely on business introduced through third parties. Also, HSBC does
not allow customer self-certification of income. The majority of lending is to existing customers holding a current or savings account relationship with the bank. At 31 December 2008, less than 2 per cent of the bank’s book consisted of lending to purchase property for rent to third parties, for which the bank applies higher collateral requirements.
In the UK, affordability mortgages have experienced relatively low levels of delinquency, reflecting the different credit profiles of the customers, compared with those in the US, and the tighter underwriting criteria.
Interest-only mortgage balances rose from US$22 billion at 31 December 2007 to US$32 billion at 31 December 2008, driven by an increase in balances at First Direct. The majority of these mortgages were offset mortgages linked to a current account and are classified as interest-only.
Second lien balances, which were all held by HFC UK, declined by US$770 million to US$1.2 billion at 31 December 2008 due to run-off and severely tighter underwriting criteria. In the first half of 2008, HFC UK ceased originating loans through brokers.
The credit quality of the UK mortgage portfolio remained broadly stable as a consequence of the business model and underwriting criteria described
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above. Additionally, HSBC Bank is now benefiting from having intentionally reduced its market share in 2006 and 2007 as property prices continued to rise. The portion of mortgages with a loan to value ratio greater than 90 per cent declined as virtually no new loans were originated at this level. The average loan to value ratio for new business in 2008 was 58.7 per cent, the lowest for 5 years.
At HSBC Bank, 30 days or more delinquency rates were unchanged from 31 December 2007 to 31 December 2008 at 1.8 per cent.
The following table shows the levels of mortgage lending products in the various portfolios in the US and the UK, together with the rest of the HSBC Group.
US personal lending – credit quality (Unaudited)
The deterioration in credit quality which began in the sub-prime mortgage portfolio in 2006 accelerated in
2008 and spread across the remainder of the US personal lending portfolio as the economy weakened, levels of unemployment and personal bankruptcy filings rose, and house price depreciation became more pronounced (the S&P/Case-Shiller 10-City Composite Index of house prices showed a
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decline of 19 per cent in 2008). These factors restricted the ability of many customers to refinance and access equity retained in their homes.
Two months or more delinquencies in mortgages originated through the HSBC Finance
branch network rose most rapidly in those states most severely affected by continued house price depreciation and rising unemployment, particularly in California, Florida, New York, Virginia, Maryland, New Jersey, Illinois, Pennsylvania, Massachusetts and Ohio.
HSBC Finance: geographical concentration of US lending1, 2 (Unaudited)
In the US real estate secured portfolios, two months and over contractual delinquency ratios at the end of 2008 were higher across the portfolio than during 2007 and the first half of 2008, for the reasons described above. There was also a significant effect on delinquency ratios from declining balances. As the portfolios aged, outstanding balances fell as new lending in certain portfolios ceased, risk mitigation efforts and changes to product offerings which began in 2007 and continued in 2008 resulted in lower originations and US$8.2 billion in mortgage portfolios were sold during the year.
Both dollar and percentage two months and over contractual delinquency in the real estate secured portfolios of HSBC Finance and HSBC USA increased following a voluntary one month suspension of final court proceedings in foreclosure cases relating to owner-occupied properties, implemented in December 2008, which was in addition to actions taken by a number of states to slow foreclosure proceedings. Within these portfolios, dollar delinquencies rose sharply in 2008 as credit quality in the consumer lending portfolio, most notably for first lien products, and in mortgage services, continued to deteriorate, particularly in the second half of the year. In mortgage services, the rise in the fourth quarter of 2008 was despite lower balances following portfolio run-off and the sale of portfolios during the year, and was partly caused by the above-mentioned action on foreclosure.
Residential mortgages
The unprecedented turmoil in the mortgage lending market continued in 2008. Investors remained unwilling to purchase securitised credit, and this resulted in a sharp contraction in the supply of liquidity to the mortgage market. Progressively fewer refinancing options were available for customers as house prices fell and housing equity declined, a number of market participants exited the sub-prime mortgage industry, and the remaining providers tightened their underwriting criteria.
Equity withdrawal had been the principal source of credit available to sub-prime borrowers dealing with unforeseen financial needs. With this source of funds heavily restricted, consumers faced increasing difficulty in maintaining their contractual payment schedules as they confronted the challenges of rising unemployment and increases in the costs of living, particularly in the first half of the year. Compounding the situation, mortgage interest rates remained high for much of 2008 as credit spreads on interbank lending widened due to the turmoil in the global financial system.
The increase in delinquency rates was accompanied by a rise in loss severities as falling house prices led to a reduction in the amounts recoverable from foreclosure and repossession. These factors were partly offset by a decline in lending balances as HSBC continued to manage down exposure in the US.
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Second lien loans have a risk profile characterised by higher loan-to-value ratios because, in many cases, the second lien loan was taken out to complete the refinancing or purchase of the property. For HSBC Finance second lien mortgages, the proportion of customers two months or more behind on contractual payments rose from 11.2 per cent at 31 December 2007 to 15.9 per cent at 31 December 2008. Loss on default of second lien loans typically approaches 100 per cent of the amount owed as any equity in the property is applied initially to the first lien loan, particularly during periods of house price depreciation when its value is eroded to the point where there is no surplus available to support the repayment of second liens.
Stated-income mortgages, which represented a small part of the HSBC Finance loan book, also continued to decline. These mortgages are of higher than average risk as they are underwritten on the basis of borrowers’ representations of annual income and are not verified by receipt of supporting documentation. These loan balances declined from US$8.3 billion at 31 December 2007 to US$5.7 billion at 31 December 2008. Two months or more delinquency rates on stated-income loans rose from 19.0 per cent at 31 December 2007 to 27.7 per cent at 31 December 2008. The percentage rise was primarily attributable to lower balances and portfolio ageing as the portfolio continued to run off.
In the mortgage services business, credit quality continued to deteriorate as 2005 and 2006 vintages continued to season and move into later stages of delinquency as economic conditions worsened. Amounts of two months or more delinquency in mortgage services rose by 9 per cent during the year to US$4.7 billion at 31 December 2008. These represented an increased proportion of a reducing portfolio, rising from 11.9 per cent to 17.0 per cent. An increase in foreclosures in process during the fourth quarter, arising from a voluntary one month suspension of final court proceedings in foreclosure cases relating to owner occupied properties, implemented in December 2008 and the actions taken by a number of states to slow foreclosure proceedings, affected total lending in mortgage services at 31 December 2008.
HSBC undertook several actions during 2008 to reposition HSBC Finance, including closure of more than 200 consumer lending branches, reducing the network to approximately 800 branches, and tightening credit criteria for originations. These actions followed the decisions taken in 2007 to cease purchasing mortgages from third-party correspondents and to close the wholesale business, Decision One, in September 2007, thereby ending new originations for the mortgage services business.
The branch-based consumer lending business continued to experience rising delinquency levels, particularly on first lien loans in the states most exposed to falling house prices and rising unemployment; 63 per cent of the increase in amounts of two months or more contractual delinquency was concentrated in the ten states noted above. Delinquencies rose across all vintages, with the most pronounced increase for first lien loans extended in 2006 and 2007. This trend was experienced across the rest of the industry in the US. Two months or more delinquencies rose from 4.2 per cent of loans and advances at 31 December 2007 to 12.1 per cent at 31 December 2008 and delinquent balances increased to US$5.6 billion. In this environment, HSBC took additional measures to tighten underwriting standards, including reducing the loan to value ratio for residential mortgages, ceasing to underwrite certain products and raising the credit requirements for certain risk factors. As a result, originations declined to 38 per cent of the levels recorded in 2007.
At HSBC USA, delinquencies rose as credit quality deterioration was experienced across the real estate secured portfolio, driven by house price depreciation and the US economic weakness. Delinquency rates of prime first lien mortgages were also affected by the sale of US$7.0 billion of mortgage portfolios during the year. Originations declined as HSBC’s risk appetite in the US reduced. Two months or more delinquencies in prime first lien mortgages rose from 1.1 per cent at 31 December 2007 to 3.4 per cent at 31 December 2008, and in second lien mortgages from 1.8 per cent to 3.5 per cent over the same period, on a management basis. The rise in delinquency was appreciably worse in third-party originations and, in response, HSBC USA closed its wholesale and third-party correspondent mortgage business in November 2008, curtailed certain stated-income mortgage products, tightened underwriting criteria and sold US$7.0 billion of mortgage portfolios during 2008. As a result, stated-income mortgage balances declined from US$2.4 billion at 31 December 2007 to US$2.2 billion at 31 December 2008.
HSBC has been proactive in approaching customers to provide financial assistance in restructuring their debts to avoid foreclosure and, as a result, HSBC has restructured and modified loans that it believes could be serviced on revised terms. For further details, see ‘US loan modifications’ on page 216.
The aggregate balances of loans which reached their first interest rate reset continued to decline in 2008. As interest rates fall, the effect of the reset on affordability becomes less pronounced.
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Credit cards
US credit card portfolio two or more months delinquencies rose from 5.7 per cent at 31 December 2007 to 6.6 per cent at 31 December 2008. In the private label cards portfolio, two or more months delinquencies rose from 3.4 per cent at 31 December 2007 to 4.3 per cent at 31 December 2008. Higher delinquency rates in both portfolios were driven by continued deterioration in the US economy, significantly higher unemployment rates, portfolio seasoning and higher levels of personal bankruptcy filings.
Motor vehicle finance
Two months or more delinquencies in vehicle finance rose from 3.7 per cent at 31 December 2007 to 5.0 per cent at 31 December 2008, in part due to portfolio ageing following the decision in July 2008 to cease new originations in HSBC Finance
from the dealer and direct-to-consumer channels, having earlier terminated a number of dealer relationships, particularly in the Northeast of the US.
Other personal lending
Higher delinquency rates were experienced in the HSBC Finance unsecured lending portfolio, excluding credit cards. The increase was driven by a deterioration in credit quality due to the weakness in the US economy, combined with portfolio seasoning as the lending book aged. Balances declined due to tightened credit criteria which resulted in lower originations. Management actions were taken in 2007 and continued in 2008 to reduce risk in the portfolio including the tightening of underwriting criteria.
The following tables provide a detailed analysis of loan delinquency in the US.
Two months and over contractual delinquency1 (Unaudited)
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Two months and over contractual delinquency1 (continued)(Unaudited)
Renegotiated loans(Audited)
Restructuring activity is designed to manage customer relationships, maximise collection opportunities and, if possible, avoid foreclosure or repossession. Such activities include extended payment arrangements, approved external debt management plans, deferring foreclosure, modification, loan rewrites and/or deferral of payments pending a change in circumstances. Following restructuring, an overdue consumer account is normally reset from delinquent to current status. Restructuring policies and practices are based on indicators or criteria which, in the judgement of local management, indicate that repayment will probably continue. These policies are required to be kept under continual review and their application varies according to the nature of the market, the product, and the availability of empirical data. Criteria vary between products, but typically include receipt of one or more or, in the case of HSBC Finance, two or more, qualifying payments within a certain period, a minimum lapse of time from origination before restructuring may occur, and restrictions on the number and/or frequency of
successive restructurings. When empirical evidence indicates an increased propensity to default on restructured accounts, the use of roll rate methodology ensures this factor is taken into account when calculating impairment allowances.
Renegotiated loans that would otherwise be past due or impaired totalled US$35 billion at 31 December 2008 (2007: US$28 billion). Restructuring is most commonly applied to consumer finance portfolios. The largest concentration was in the US and amounted to US$31 billion (2007: US$24 billion) or 89 per cent (2007: 86 per cent) of the Group’s total renegotiated loans. The increase was due to a significant deterioration in credit quality in the US, where most restructurings related to loans secured on real estate.
US loan modifications (Unaudited)
In 2008, HSBC Finance continued to refine and expand its customer account management policies and practices. Through its ARM Reset Modification Programme, established in October 2006, HSBC Finance proactively contacts customers who have
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ARM loans nearing their first reset that HSBC Finance expects will be the most affected by a rate adjustment. By a variety of means, HSBC Finance assesses the customer’s ability to make the adjusted payment and, as appropriate and in accordance with defined policies, HSBC Finance modifies the loans, allowing time for the customer to seek alternative financing or improve their individual situation. These loan modifications primarily provide for temporary interest rate relief for up to 12 months by either maintaining the current interest rate for that period or resetting the interest rate to one lower than that originally required at the reset date. At the end of the relief period, the interest rate on the loan will reset in accordance with the original loan terms, unless the borrower qualifies for, and is granted, a further modification. These loans are not included in the renegotiated loans figures quoted above, because they were not contractually delinquent at the time of the modification.
HSBC Finance also significantly expanded its Foreclosure Avoidance and Account Modification Programmes designed to provide relief to qualifying home owners by either loan restructuring or modification. Following a strategic review, in the first quarter of 2008 these programmes were expanded in the consumer lending business, to help those customers who did not qualify for assistance under previous programmes, and to help customers who required greater assistance than that available
under previous programmes. Innovations included lowering the interest rate for qualifying customers on fixed rate loans as well as ARMs, and implementing longer term modifications, providing assistance generally for two to five years. Under these expanded programmes, HSBC Finance modified over 92,000 loans in 2008 with an aggregate balance of US$13.5 billion. The ARM Reset Modification Programme covered some 13,000 loans, with an aggregate value of US$2.1 billion.
HSBC Finance also supports a variety of national and local efforts in home ownership preservation and foreclosure avoidance.
Credit quality of financial instruments(Audited)
The four credit quality classifications set out and defined below describe the credit quality of HSBC’s lending, debt securities portfolios and derivatives. These classifications each encompass a range of more granular, internal credit rating grades assigned to wholesale and retail lending business, as well as the external ratings attributed by external agencies to debt securities.
There is no direct correlation between the internal and external ratings at granular level, except to the extent each falls within a single quality classification.
Quality classification definitions
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Risk rating scales
Compared with previous years, the basis of reporting has been changed to replace the former uniform seven-grade portfolio quality scale, in order both to extend the range of financial instruments covered in the presentation of portfolio quality and to reflect the more risk-sensitive rating systems introduced under the Group’s Basel II programme.
The Customer Risk Rating (‘CRR’) 10-grade scale above summarises a more granular underlying 22-grade scale of obligor probability of default (‘PD’). All distinct customers Group-wide are rated using one of these two PD scales, depending on the degree of sophistication of the Basel II approach adopted for the exposure.
The Expected Loss (‘EL’) 10-grade scale for retail business summarises a more granular underlying EL scale for these customer segments; this combines obligor and facility/product risk factors in a composite measure.
For debt securities and certain other financial instruments, external ratings have been aligned to the four quality classifications. The ratings of Standard and Poor’s are cited, with those of other agencies being treated equivalently. Debt securities with short-term issue ratings are reported against the long-term rating of the issuer of those securities. If major rating agencies have different ratings for the same debt securities, a prudent rating selection is made in line with regulatory requirements.
Additional credit quality information in respect of HSBC’s consolidated holdings of ABSs and assets held in consolidated SIVs and conduits is provided on pages 153 to 158 and 175 to 176, respectively.
For the purpose of the following disclosure, retail loans which are past due up to 89 days and are not otherwise classified as EL9 or EL10, are separately classified as past due but not impaired.
The following tables set out the Group’s distribution of financial instruments by measures of credit quality:
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Past due but not impaired gross financial instruments(Audited)
Examples of exposures past due but not impaired include overdue loans fully secured by cash collateral; mortgages that are individually assessed for impairment, and that are in arrears more than 90
days, but where the value of collateral is sufficient to repay both the principal debt and all potential interest for at least one year; and short-term trade facilities past due more than 90 days for technical reasons such as delays in documentation, but where there is no concern over the creditworthiness of the counterparty.
Past due but not impaired loans and advances to customers and banks by geographical region
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Past due but not impaired loans and advances to customers and banks by industry sector
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2008 compared with 2007 (Unaudited)
Total impaired loans to customers were US$25.4 billion at 31 December 2008, an increase of 29 per cent since the end of 2007 (42 per cent at constant currency). Impaired loans were 3 per cent of gross customer loans and advances, a rise from 2 per cent at 31 December 2007.
The commentary that follows compares balances at 31 December 2008 with those at 31 December 2007, at constant exchange rates.
In Europe, impaired loans at US$6.8 billion were 32 per cent higher than at the end of 2007. The increase was driven by the UK where credit quality in the UK commercial portfolio deteriorated sharply in the final quarter of the year. A small number of exposures in the commercial real estate sector were particularly affected by a sharp deterioration in market conditions in the fourth quarter. UK mortgage impairments remained broadly stable despite the substantial increase in balances in the second half of the year and delinquency levels increased modestly from a low base. Unsecured personal lending in the UK also saw a slight increase in the levels of impaired loans, particularly in the second half of the year, as the economy weakened. A single financial sector loan in Europe also affected results. Impairment levels in France remained low in the personal sector. However, Commercial Banking experienced a rising number of small impairments during the second half of the year and a small number of larger impairments in the last quarter. In Turkey, impaired loans rose by 81 per cent due to increased delinquency in the personal lending portfolio and, particularly, in credit cards.
In Hong Kong, impaired loans increased from a previously low level to US$852 million. The deterioration was concentrated in the commercial lending portfolio and was attributable to a number of factors including exporters in Hong Kong being affected by reduced demand from the US and other developed countries. The sharp fall in the value of currencies and commodities left some customers’ balance sheets weakened, coupled with rising fraud encountered with certain counterparties.
In the Rest of Asia-Pacific impaired loans increased by 8 per cent to US$1.1 billion, primarily due to the deterioration in the commercial lending portfolio. In the last quarter of 2008 the number of export orders suffered a sharp fall and, together with a deterioration in credit quality around the region, caused a rise in impaired loans. Noticeable increases were recognised in Taiwan, Indonesia and India. In Taiwan the commercial loan portfolio started to deteriorate in the second half of the year as the fall in exports started to affect local businesses. In Indonesia and India, the increase in impaired loans was a result of the downgrade of a few individual customers as economic conditions worsened. Impaired personal loans rose as increased unemployment and bankruptcy rates affected the ability of customers to repay. India continued to show significant impaired loans as the economic conditions deteriorated and credit quality weakened. Active measures are being taken to reduce exposure in India and manage the personal lending portfolio.
In North America, impaired loans rose significantly, increasing by 49 per cent to US$14.3 billion at 31 December 2008. The US consumer finance business experienced a broad based deterioration in credit quality due to higher unemployment as the economy slowed. A full discussion of these developments and their effect on credit quality is provided in the ‘Areas of special interest’ commentary on page 208. In Canada, impaired loans rose from a low base as credit conditions weakened, with the loss concentrated in a single exposure in the commercial real estate portfolio. In the US, commercial and corporate credit quality declined due to downgrades as the economic environment deteriorated.
In Latin America, impaired loans increased by 37 per cent to US$2.3 billion. Impaired loans in Mexico rose by 32 per cent, largely in credit cards driven by portfolio growth in personal lending, seasoning and higher delinquency rates. In Brazil, impaired loans rose by 34 per cent due to growth in personal lending due to deterioration in payroll and vehicle finance loan portfolios, and weakness in a number of real estate portfolios and corporates exposed to the sharp rise in the value of the US dollar in the second half of the year.
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Collateral and other credit enhancements obtained(Audited)
HSBC obtained assets by taking possession of collateral held as security, or calling upon other credit enhancements, as follows:
Repossessed properties are made available for sale in an orderly fashion, with the proceeds used to reduce or repay the outstanding indebtedness. If excess funds arise after the debt has been repaid, they are made available either to repay other secured lenders with lower priority or are returned to the customer. HSBC does not generally occupy
repossessed properties for its business use. The majority of repossessed properties arose in HSBC Finance in the US, which, compared with 2007 experienced higher levels of foreclosure and higher losses on sale due to declining house prices. The average time taken to sell a repossessed property during 2008 was 177 days and the average loss upon sale of foreclosed properties was 13 per cent. The December 2008 balance of repossessed property was lower than otherwise would have been the case due to several factors that occurred during the month: HSBC Finance implemented a voluntary one month suspension of final court proceedings in foreclosure cases relating to owner occupied properties in December 2008, some states suspended foreclosure activity, and there was a backlog in moving foreclosure proceedings through the courts. HSBC expects, subject to further state actions, that repossessed property levels will increase in the first quarter of 2009 as foreclosure proceedings normalise. A quarterly breakdown of foreclosure data is provided below:
HSBC Finance foreclosed properties in the US(Unaudited)
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Impairment allowances and charges on loans and advances to customers and banks (Audited)
The tables below analyse by geographical region the impairment allowances recognised for impaired
loans and advances that are either individually assessed or collectively assessed, and collective impairment allowances on loans and advances classified as not impaired.
Impairment allowances on loans and advances to customers by geographical region(Audited)
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Impairment allowances on loans and advances to customers and banks by industry sector (Audited)
Impairment allowances as a percentage of loans and advances1(Unaudited)
Movement in impairment allowances
The tables below describe details of the movements in HSBC’s loan impairment allowances (i) for loans
and advances, (ii) by industry segment for each of the past 5 years and (iii) by industry segment and geographical region for 2008 and 2007.
Movement in impairment allowances on loans and advances (Audited)
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Movement in impairment allowances by industry sector and by geographical region (Audited)
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Individually and collectively assessed charge to impairment allowances by industry segment(Unaudited)
Charge for impairment losses
The following tables analysing the net loan impairment charge to the income statement are
followed by a discussion of the material movements in loan impairment charges by region.
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Loan impairment charges increased by 40 per cent to US$24.1 billion from US$17.2 billion in 2007. The commentary that follows is on a constant currency basis.
New allowances for loan impairment charges rose by 37 per cent compared with 2007. Releases
and recoveries of allowances declined by 10 per cent to US$1.4 billion.
In Europe, new loan impairment charges were US$4.0 billion, a rise of 24 per cent compared with 2007. This primarily reflected higher impairment charges in Global Banking and Markets following a significant charge against a single European commercial real estate corporate customer.
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Impairment charges against banks rose in the UK due to exposures to the Icelandic banks in 2008. New loan impairment charges rose in Turkey as delinquency rates rose across credit cards, personal loans and corporate lending in light of the deteriorating economic environment. Elsewhere, impairment charges on the commercial portfolio rose in the UK, particularly in the final quarter of 2008 as the weakening property market led to higher impairment charges against construction companies and businesses dependent upon the real estate sector. In France, the impact of declining commercial credit quality more than offset lower balances. Impairment allowances against firms in the financial sector rose due to exposure to a single asset management firm in the UK. Credit quality in the UK personal lending portfolio remained broadly stable, reflecting the strength of HSBC’s loan book in a period of significant economic uncertainty. Mortgage lending in the UK remained well secured as risk mitigation actions taken since 2006 reduced risk exposure to some of the problems now being uncovered in the UK residential property market. Credit quality in the unsecured portfolios of M&S Money, HSBC Bank and Partnership Cards deteriorated slightly in 2008, particularly in the second half of the year, due to the weakening UK economy.
Releases and recoveries in Europe declined by 27 per cent, driven by the deterioration in economic conditions.
In Hong Kong, new loan impairment charges more than doubled from a low base, driven by deterioration in credit quality in the commercial portfolio in the second half of the year as the economy and trade flows weakened. Residential mortgage lending continued to be well-secured, as regulatory restrictions constrained origination loan-to-value ratios to below 70 per cent.
In Rest of Asia-Pacific, new loan impairment charges rose by 59 per cent to US$1.3 billion, primarily in India and the Middle East. Higher impairment charges in India were driven by a combination of rising delinquency rates in consumer lending, as credit conditions deteriorated, and increased lending. Increased charges in the Middle East were due to rising delinquencies as growth rates declined and the property market retreated as economic conditions deteriorated on the back of lower oil and gas prices.
New loan impairment charges in North America rose by 37 per cent to US$16.8 billion, driven by the continued deterioration in credit quality in the HSBC Finance loan portfolio and, to a lesser extent, in HSBC USA.
US credit quality showed significant deterioration across the portfolio, driven by the continued weakness of the US economy. The reasons behind the deterioration in US credit quality, the effects on the US personal lending portfolio and actions taken as a result are discussed in more detail on page 210. Partly offsetting the effect of the deterioration was a reduction in overall lending as HSBC continued to reduce its exposure in the US.
In US card and retail services, impairment charges rose, driven by portfolio seasoning, higher levels of personal bankruptcy filings and continued weakness in the US economy. Delinquency increased in the geographical regions most affected by house price falls and rising unemployment.
In Commercial Banking, impairment charges rose from a low base driven by deterioration in the commercial real estate loan book in the US, and higher impairment charges against firms in the manufacturing, export and commercial real estate sectors in Canada. Higher impairment charges in Global Banking and Markets reflected weaker credit fundamentals in the US in 2008. Impairment allowances against firms in the financial sector rose due to rising delinquencies, despite government intervention.
Releases and recoveries in North America rose by 55 per cent to US$180 million.
In Latin America, new loan impairment charges rose by 37 per cent to US$2.8 billion. The most significant increase was in Mexico, reflecting higher impairment charges in the credit card portfolio due to a combination of higher average balances from organic expansion and growing delinquency rates driven by a deterioration in credit quality as the 2006 and 2007 vintages continued to season and move into later stages of delinquency. Management action to improve the quality of new business included tightened underwriting, enhanced collection strategies and better managed customer acquisition channels. The commercial portfolio in Mexico also experienced higher impairment charges due to credit quality deterioration among small and medium sized enterprises as the economy weakened. In Brazil, higher impairment charges were driven by a combination of balance growth and credit quality deterioration in the vehicle finance and payroll loan portfolios.
2007 compared with 2006 (Unaudited)
Loan impairment charges rose by 63 per cent to US$17.2 billion from US$10.5 billion in 2006. The
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commentary that follows is on a constant currency basis:
New allowances for loan impairment charges rose by 52 per cent, compared with 2006. Releases and recoveries of allowances increased by 1 per cent to US$1.6 billion.
In Europe, new loan impairment charges were US$3.5 billion, a rise of 8 per cent compared with 2006. This partly reflected growth in commercial lending, where charges remained low compared with historical amounts but rose from the exceptionally low levels experienced in 2005 and 2006. Increased charges also reflected growth in credit card lending in Turkey. In the UK, refinements to the methodology used to calculate roll rate percentages resulted in a higher charge in the consumer finance operations in the first half of the year. Excluding this, loan impairment charges were marginally lower than in 2006.
Releases and recoveries in Europe were broadly in line with 2006.
In Hong Kong, new loan impairment charges of US$287 million were recorded, an increase of 19 per cent, due to the growth in credit card balances and new corporate loan charges.
Releases and recoveries in Hong Kong decreased to US$75 million, primarily in the corporate sector. This reflected the low level of allowances added in recent years.
In Rest of Asia-Pacific, new loan impairment charges rose by 10 per cent to US$834 million, with higher loan impairment charges arising in the commercial loan books in Thailand and Malaysia. This was offset by a decline in loan impairment charges for personal lending, particularly in Taiwan and Indonesia, where charges returned to more regular levels after an upsurge in 2006 due to regulatory changes which affected collection activity and minimum payments.
With corporate and commercial loan impairment charges low in recent years, releases and recoveries decreased by 6 per cent to US$220 million.
New loan impairment charges in North America rose by 76 per cent to US$12.2 billion, driven by the continued deterioration in credit quality in the US consumer finance loan portfolio.
US credit quality deteriorated as mortgage delinquencies rose, house prices declined, refinancing credit became less available in the market and the macroeconomic outlook worsened.
Other factors affecting the rise in US loan impairment charges included normal seasoning of the portfolio, a higher proportion of unsecured personal lending and a return to historical norms from the unusually low levels of bankruptcy filings experienced in 2006, following changes enacted to US bankruptcy law in 2005.
Delinquency rates rose across all parts of the HSBC Finance personal lending portfolio, with mortgage services and consumer lending experiencing significant rises in delinquency which flowed through subsequent stages through to foreclosure. As the housing downturn began to have more effect on the broader economy, delinquency rates in credit cards and vehicle finance rose in the final quarter of 2007. A change in product mix in the cards portfolio towards higher yielding products also contributed to higher impairment charges as this segment of the portfolio seasoned.
Releases and recoveries in North America decreased to US$116 million. In the US consumer finance business, collection staff increased in all lending portfolios as part of the response to the deteriorating credit environment.
In Latin America, new loan impairment charges rose by 63 per cent to US$2.0 billion. The most significant increase was registered in Mexico, reflecting strong growth in balances, normal portfolio seasoning and a rise in delinquency rates in credit cards. Charges for commercial lending in Mexico fell as increased delinquency rates in the small and medium-sized business portfolios were offset by impairment allowance releases. Products with high credit losses were discontinued or restructured. Loan impairment charges in Brazil rose marginally, due to growth in store loans and credit cards.
Releases and recoveries in Latin America increased to US$272 million. In Brazil, credit models were changed during 2007 to align with credit behaviour in underlying portfolios.
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Charge for impairment losses as a percentage of average gross loans and advances to customers (Unaudited)
Charge for impairment losses as a percentage of average gross loans and advances to customers by geographical region (Unaudited)
HSBC Holdings (Audited)
Credit risk arises in HSBC Holdings primarily from transactions with Group subsidiaries and from guarantees issued in support of obligations assumed by certain Group operations in the normal conduct of their business.
These risks are reviewed and managed within regulatory and internal limits for exposures by the HSBC Global Risk function, which provides high-
level, centralised oversight and management of HSBC’s credit risks world-wide.
No collateral or other credit enhancements were held by HSBC Holdings in respect of its transactions with subsidiary undertakings.
HSBC Holdings’ maximum exposure to credit risk at 31 December 2008 is shown below. HSBC Holdings’ financial assets principally represent claims on Group subsidiaries in Europe and North America.
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All of the derivative transactions are with HSBC undertakings which are banking counterparties (2007: 100 per cent).
The credit quality of loans and advances to HSBC undertakings is assessed as satisfactory risk, with 100 per cent of the exposure being neither past due nor impaired (2007: 100 per cent).
The long-term debt ratings of HSBC Group issuers of financial investments are within the Standard & Poor’s ratings range of AA– to AA+ (2007: AA– to AA+).
Risk elements in the loan portfolio (Unaudited)
The disclosure of credit risk elements under the following headings reflects US accounting practice and classifications for publicly traded bank holding companies:
Interest forgone on impaired loans (Audited)
Interest income that would have been recognised under the original terms of impaired and restructured loans amounted to approximately US$1.9 billion in 2008 (2007: US$1.1 billion). Interest income from such loans of approximately US$702 million (2007: US$374 million) was recorded in 2008.
Troubled debt restructurings
The SEC requires separate disclosure of any loans whose terms have been modified because of problems with the borrower to grant concessions other than are warranted by market conditions. These are classified as ‘troubled debt restructurings’ (TDRs). The definition of TDRs differs from the ‘Renegotiated loans that would otherwise be past due or impaired’ quantified on page 216 insofar as for TDRs the delinquency status of the loan following restructuring may continue to be past due not impaired or, where appropriate, impaired. In addition, the classification of a loan as a TDR may be discontinued after the first year if the debt performs in accordance with the new terms.
Troubled debt restructurings increased by 47 per cent in 2008, reflecting measures taken to mitigate risk in the US consumer finance business in response to the deterioration in mortgage loans.
Unimpaired loans past due 90 days or more
Unimpaired loans contractually past due 90 days or more increased. Figures for 2004 to 2007 have been restated due to the reclassification of an element of the North America credit card portfolio as impaired. There has been no effect on impairment allowances.
Impaired loans
In accordance with IFRSs, HSBC recognises interest income on assets after they have been written down as a result of an impairment loss. In the following tables, HSBC represents information on its impaired loans and advances in accordance with the disclosure convention described on page 217.
Potential problem loans
Credit risk elements also cover potential problem loans. These are loans where information on possible credit problems among borrowers causes management to seriously doubt their ability to comply with the loan repayment terms. There are no potential problem loans other than those identified in the table of risk elements set out below, and as discussed in ‘Areas of special interest’ on page 210. ‘Areas of special interest’ includes further disclosure about certain homogeneous groups of loans which are collectively assessed for impairment, and represent the Group’s most significant exposures to potential problem loans, including ARMs and stated-income products. Collectively assessed loans and advances, as set out on page 223, although not classified as impaired until more than 90 days, are assessed collectively for losses that have been incurred but have not yet been individually identified. This policy is further described on page 196.
Risk elements
The following table provides an analysis of risk elements in the loan portfolios at 31 December for the past five years.
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Analysis of risk elements(Unaudited)
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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. HSBC has continuously monitored the impact of recent market events on the Group’s liquidity positions and has changed behavioural assumptions where justified. The impact of these recent market events is discussed more fully below. The liquidity and funding risk management framework will continue to evolve as the Group assimilates knowledge from the recent market events.
Policies and procedures (Audited)
The management of liquidity and funding is primarily undertaken locally in HSBC’s operating entities in compliance with practices and limits set by the Risk Management Meeting (‘RMM’). These limits vary according to the depth and liquidity of the market in which the entities operate. It is HSBC’s general policy that each banking entity should be self-sufficient when funding its own operations. Exceptions are permitted for certain short-term treasury requirements and start-up operations or branches which do not have access to local deposit
markets. These entities are funded from HSBC’s largest banking operations and within clearly defined internal and regulatory guidelines and limits. These limits place formal restrictions on the transfer of resources between HSBC entities and reflect the broad range of currencies, markets and time zones within which HSBC operates.
HSBC’s liquidity and funding management process includes:
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.
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The main operating subsidiary that does not accept deposits is HSBC Finance, which has historically funded itself principally by taking term funding in the professional markets and by securitising assets. At 31 December 2008,
US$111 billion (2007: US$142 billion) of HSBC Finance’s liabilities were drawn from professional markets, utilising a range of products, maturities and currencies.
Cash flows payable by HSBC under financial liabilities by remaining contractual maturities(Audited)
The balances in the above table will not agree directly with the balances in the consolidated balance sheet as the table incorporates, on an undiscounted basis, all cash flows relating to principal and all future coupon payments (except for trading liabilities and trading derivatives). Also, loan commitments are generally not recognised on the balance sheet. Trading liabilities and trading derivatives have been included in the ‘On demand’ time bucket, and not by contractual maturity, because trading liabilities are typically held for short periods of time. The undiscounted cash flows payable under hedging derivative liabilities are classified according to their contractual maturity.
Cash flows payable in respect of customer accounts are primarily contractually repayable on demand or at short notice. However, in practice, short-term deposit balances remain stable as inflows and outflows broadly match and a significant portion of loan commitments expire without being drawn upon.
Advances to deposits ratio(Audited)
HSBC emphasises the importance of core current accounts and savings accounts as a source of funds to finance lending to customers, and discourages reliance on short-term professional funding. This is achieved by placing limits on Group banking entities which restrict their ability to increase loans and advances to customers without corresponding growth in current accounts and savings accounts. This measure is referred to as the ‘advances to deposits’ ratio.
Advances to deposits ratio limits are set by the RMM and monitored by Group Finance. The ratio describes loans and advances to customers as a percentage of the total of core customer current and savings accounts and term funding with a remaining term to maturity in excess of one year. Loans and advances to customers which are part of reverse repurchase arrangements, and where HSBC receives
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securities which are deemed to be liquid, are excluded from the advances to deposits ratio, as are current accounts and savings accounts from customers deemed to be ‘non-core’. The definition of a non-core deposit includes a consideration of the size of the customer’s total deposit balances. Due to the distinction between core and non-core depositors, the Group’s measure of advances to deposits will be more restrictive than that which could be inferred from the published financial statements.
The three banking entities listed in the table below represented 70 per cent of HSBC’s total core deposits at 31 December 2008 (2007: 71 per cent). The table demonstrates that loans and advances to customers in HSBC’s principal banking entities are broadly financed by reliable and stable sources of funding. HSBC would meet any unexpected net cash outflows by selling securities and accessing additional funding sources such as interbank or collateralised lending markets. The Group also uses measures other than the advances to deposits ratio to manage liquidity risk, including the ratio of net liquid assets to customer liabilities and projected cash flow scenario analyses.
Ratio of net liquid assets to customer liabilities(Audited)
Net liquid assets are liquid assets less all funds maturing in the next 30 days from wholesale market sources and from customers who are deemed to be professional. For this purpose, HSBC defines liquid assets as cash balances, short-term interbank deposits and highly-rated debt securities available for immediate sale and for which a deep and liquid market exists. Contingent liquidity risk associated with committed loan facilities is not reflected in the ratios. The Group’s framework for monitoring this risk is outlined under ‘Contingent liquidity risk’ below.
Limits for the ratio of net liquid assets to customer liabilities are set for each bank operating entity, except for HSBC Finance. As HSBC Finance does not accept customer deposits, it is not appropriate to manage its liquidity using standard liquidity ratios. The liquidity and funding risk management framework of HSBC Finance is discussed below.
Ratios of net liquid assets to customer liabilities are provided in the following table, along with the US dollar equivalents of net liquid assets.
HSBC’s principal banking entities – the management of liquidity risk(Audited)
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Projected cash flow scenario analysis (Audited)
The Group uses a number of standard projected cash flow scenarios designed to model both Group-specific and market-wide liquidity crises, in which the rate and timing of deposit withdrawals and drawdowns on committed lending facilities are varied, and the ability to access interbank funding and term debt markets and to generate funds from asset portfolios is restricted. The scenarios are modelled by all Group banking entities and by HSBC Finance. The appropriateness of the assumptions under each scenario is regularly reviewed. In addition to the Group’s standard projected cash flow scenarios, individual entities are required to design their own scenarios tailored to reflect specific local market conditions, products and funding bases.
Limits for cumulative net cash flows under stress scenarios are set for each banking entity and for HSBC Finance. Both ratio and cash flow limits reflect the local market place, the diversity of funding sources available and the concentration risk from large depositors. Compliance with entity level limits is monitored centrally by Group Finance and reported regularly to the RMM.
HSBC Finance
As HSBC Finance does not accept customer deposits, it takes funding from the professional markets. HSBC Finance uses a range of measures to monitor funding risk, including projected cash flow scenario analysis and caps placed on the amount of unsecured term funding that can mature in any rolling three-month and rolling 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. At 31 December 2008, the maximum amounts of unsecured term funding maturing in any rolling three-month and rolling 12-month periods were US$6.0 billion and US$17.4 billion, respectively (2007: US$6.2 billion and US$17.7 billion). At 31 December 2008, HSBC Finance also had in place unused committed sources of secured funding for which eligible assets were held, of US$2.4 billion (2007: US$6.2 billion) and committed backstop lines from non-Group entities in support of CP programmes totalling US$7.3 billion (2007: US$9.3 billion).
Contingent liquidity risk (Audited)
In the normal course of business, Group entities provide customers with committed facilities, including committed backstop lines to conduit vehicles sponsored by the Group and standby facilities to corporate customers. These facilities increase the funding requirements of the Group when customers choose to raise drawdown levels over and above their normal utilisation rates. The liquidity risk consequences of increased levels of drawdown are analysed in the form of projected cash flows under different stress scenarios. The RMM also sets limits for non-cancellable contingent funding commitments by Group entity after due consideration of each entity’s ability to fund them. The limits are split according to the borrower, the liquidity of the underlying assets and the size of the committed line.
The Group’s contractual exposures at 31 December monitored under the contingent liquidity risk limit structure(Audited)
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In times of market stress, the Group may choose to provide non-contractual liquidity support to certain HSBC-sponsored vehicles or HSBC-promoted products. This support would only be provided after careful consideration of the potential funding requirement and the impact on the entity’s overall liquidity.
The impact of market turmoil on the Group’s liquidity risk position (Audited)
A significant aspect of the market turmoil continues to be its adverse effects on the liquidity and funding risk profile of the banking system.
At a systemic level, these may be characterised as follows:
In general terms, the strains arising from the credit crisis were concentrated in the wholesale market. The retail market, the market from which HSBC derives its core current and savings accounts, (the importance of which as a source of funding for the Group is discussed under ‘Advances to deposits ratio’ above) was relatively unaffected. The Group’s limited dependence on wholesale markets for funding has been a significant competitive advantage to HSBC through the recent period of dislocation in the financial markets.
HSBC’s customer deposit base has grown between 30 June 2007, the reporting date closest to the onset of the market turmoil, and 31 December 2008 by US$134 billion. This growth in US dollar equivalent terms has been diluted by the significant strengthening of US dollar against other major currencies between these two reporting dates, and therefore under represents the growth in customer deposits on an underlying currency basis. As a net provider of funds to the interbank market, the Group
has not been significantly affected by the scarcity of interbank funding.
A number of central banks and governments have taken action to alleviate the effects of the market turmoil, these actions have included making available government guaranteed term funding facilities. In the US, bank issuance under such programmes became normal market practice during 2008. To date, only HSBC’s US based operations have participated in government guaranteed term debt issuance schemes. At 31 December 2008, US$2.65 billion had been issued by HSBC USA, Inc. under the Federal Deposit Insurance Corporation Temporary Liquidity Guarantee Programme.
The deterioration of the US sub-prime credit market has reduced the availability of term financing to entities with exposures to the US sub-prime market. However, HSBC Finance, by virtue of its position within the Group, continued to enjoy committed financing facilities, albeit at a lower level, and access to commercial paper markets at interest rates below interbank rates. Through planned balance sheet reductions, the issuance of cost effective retail debt, capital infusions from the HSBC Group, and the utilisation of alternative sources of funding, including funding from other members of the HSBC Group, HSBC Finance was able to eliminate the need to issue institutional term debt in 2008. Funding plans are in place to enable HSBC Finance to deal with continued stress in the credit markets. As part of these plans, asset portfolios totalling US$15.3 billion were transferred from HSBC Finance to HSBC Bank USA in January 2009, resulting in US$8.0 billion of net funding benefit to HSBC Finance.
HSBC Finance is eligible to participate in the US Federal Reserve’s Commercial Paper Funding Facility (CPFF), a new scheme aimed at providing support to US issuers in the commercial paper market. At 31 December 2008, HSBC Finance had issued US$520 million under the CPFF and is eligible to issue a maximum of US$12.0 billion prior to 30 October 2009, the current expiry date for the scheme.
The effect of the market turmoil on liquidity and funding elsewhere in HSBC was largely restricted to the Group’s activities that historically depended upon the asset-backed commercial paper markets for funding, specifically SIVs and conduits, and certain money market funds. This is discussed in detail on page 174.
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HSBC Holdings’ primary sources of cash are interest and capital receipts from its subsidiaries, which it deploys in short-term bank deposits. HSBC Holdings’ primary uses of cash are investments in subsidiaries, interest payments to debt holders and dividend payments to shareholders. On an ongoing basis, HSBC Holdings replenishes its liquid resources through the receipt of interest on, and repayment of, intra-group loans, from dividends paid by subsidiaries and from interest earned on its own liquid funds.
HSBC Holdings is also subject to contingent liquidity risk by virtue of loan commitments and guarantees given. Such commitments are only provided after due consideration of HSBC Holdings’ ability to finance these commitments and the likelihood of the need arising.
HSBC Holdings actively manages the cash flows from its subsidiaries to optimise the amount of cash held at the holding company level, and expects to continue doing so in the future. The ability of its subsidiaries to pay dividends or advance monies to HSBC Holdings depends on, among other things, their respective regulatory capital requirements, statutory reserves, and financial and operating performance. The wide range of HSBC’s activities means that HSBC Holdings is not dependent on a single source of profits to fund its dividend payments to shareholders. HSBC Holdings believes that, with its accumulated liquid assets, planned dividends and interest from subsidiaries it will be able to meet anticipated cash obligations. Also, during 2008 HSBC Holdings continued to have full access to capital markets at market rates and issued US$8.8 billion of capital instruments (2007: US$4.4 billion).
Cash flows payable by HSBC Holdings under financial liabilities by remaining contractual maturities(Audited)
The balances in the above table will not agree directly with the balances in the balance sheet of HSBC Holdings as the table incorporates, on an undiscounted basis, all cash flows relating to principal and all future coupon payments (except for trading derivatives).
Also, loan commitments are generally not recognised on the balance sheet. Trading derivatives
are included in the ‘On demand’ time bucket, and not by contractual maturity, because trading derivatives are typically held for short periods of time. The undiscounted cash flows on hedging derivative liabilities are classified according to their contractual maturity.
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The objective of HSBC’s market risk management is to manage and control market risk exposures in order to optimise return on risk while maintaining a market profile consistent with the Group’s status as one of the world’s largest banking and financial services organisations.
Market risk is the risk that movements in market risk factors, including foreign exchange rates and commodity prices, interest rates, credit spreads and equity prices will reduce HSBC’s income or the value of its portfolios.
HSBC separates exposures to market risk into trading and non-trading portfolios. Trading portfolios include those positions arising from market-making, proprietary position-taking and other marked-to-market positions so designated.
Non-trading portfolios include positions that arise from the interest rate management of HSBC’s retail and commercial banking assets and liabilities, financial investments designated as available for sale and held to maturity, and exposures arising from HSBC’s insurance operations.
Market risk arising in HSBC’s insurance businesses is discussed in ‘Risk management of insurance operations’ on pages 255 to 274.
The management of market risk is principally undertaken in Global Markets using risk limits approved by the GMB. Limits are set for portfolios, products and risk types, with market liquidity being a principal factor in determining the level of limits set. Traded Credit and Market Risk, an independent unit within Group Management Office, develops the Group’s market risk management policies and measurement techniques. Each major operating entity has an independent market risk management and control function which is responsible for measuring market risk exposures in accordance with the policies defined by Traded Credit and Market Risk, and monitoring and reporting these exposures against the prescribed limits on a daily basis.
Each operating entity is required to assess the market risks which arise on each product in its business and to transfer these risks to either its local Global Markets unit for management, or to separate books managed under the supervision of the local Asset and Liability Management Committee (‘ALCO’). The aim is to ensure that all market risks are consolidated within operations which have the necessary skills, tools, management and governance to manage such risks professionally. In certain cases where the market risks cannot be adequately
captured by the transfer process, simulation modelling is used to identify the impact of varying scenarios on valuations and net interest income.
HSBC uses a range of tools to monitor and limit market risk exposures. These include sensitivity analysis, value at risk (‘VAR’) and stress testing.
Sensitivity analysis
Sensitivity measures are used to monitor the market risk positions within each risk type, for example, present value of a basis point movement in interest rates, for interest rate risk. Sensitivity limits are set for portfolios, products and risk types, with the depth of the market being one of the principal factors in determining the level of limits set.
Value at risk(Audited)
VAR is a technique that estimates the potential losses that could occur on risk positions as a result of movements in market rates and prices over a specified time horizon and to a given level of confidence.
The VAR models used by HSBC are based predominantly on historical simulation. These models derive plausible future scenarios from past series of recorded market rates and prices, taking account of inter-relationships between different markets and rates such as interest rates and foreign exchange rates. The models also incorporate the effect of option features on the underlying exposures.
The historical simulation models used by HSBC incorporate the following features:
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.
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Although a valuable guide to risk, VAR should always be viewed in the context of its limitations. For example:
Stress testing
In recognition of the limitations of VAR, HSBC augments it with stress testing to evaluate the potential impact on portfolio values of more extreme, although plausible, events or movements in a set of financial variables.
Stress testing is performed at a portfolio level, as well as on the consolidated positions of the Group, and covers the following scenarios:
Stress testing is governed by the ‘Stress Testing Review Group’ forum that coordinates the Group stress testing scenarios in conjunction with the
regional risk managers. Consideration is given to the actual market risk exposures, along with market events in determining the stress scenarios.
Stress testing results are reported to senior management and provide them with an assessment of the financial impact such events would have on the profit of HSBC. The daily losses experienced during 2008 were within the stress loss scenarios reported to senior management.
The following table provides an overview of the reporting of risks within this section:
The impact of market turmoil on market risk(Audited)
The years preceding the current market turmoil were characterised by historically low levels of volatility, with ample market liquidity. This period was associated with falling levels of VAR as the level of observed market volatility is a key determinant in the VAR calculation. As a consequence HSBC reduced the overall VAR limit to reflect the lower level of volatility, and associated VAR.
The tightening of both credit and liquidity within the wholesale markets observed during the latter half of 2007 led to an increase in market volatility, most noticeably in the credit spreads of financial institutions and ABSs/MBSs.
Credit spread volatility continued to increase during the first half of 2008, and as the effect of the market turmoil on the wider economy became more apparent, there was a larger increase in the volatility in other risk types, such as interest rates. Coupled with positions taken in anticipation of rate reductions, the increase in volatility led to an increase in the total VAR in early 2008.
Volatility across all asset classes continued to increase in the second half of 2008, as central banks coordinated a series of rate cuts, in an attempt to stimulate demand within the global economy. Although the increase in volatility led to a further
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increase in total VAR during the second half of 2008, the overall impact was limited as a result of managing down the market risk exposures during this period (see ‘Value at risk of the trading and non-trading portfolios’ below).
Although the overall VAR limit for the Group was increased towards the end of 2008, as a result of the increased market volatility, the limit remained within the level set in early 2007.
Value at risk of the trading and non-trading portfolios
The VAR, both trading and non-trading, for the Group was as follows:
As a result of improvements in the Group VAR data collection process during 2008, all entities within the Group are now aggregated on a historical simulation basis, reflecting the full diversification effects across the Group’s VAR. The 2007 VAR has been adjusted, reducing the total VAR by US$25.2 million as at 31 December 2007. The maximum, minimum and average VARs have also been adjusted on a comparable basis in order to fairly present the trend.
The daily VAR, both trading and non-trading, for the Group was as follows:
The major contributor to the trading and non-trading VAR for the Group was Global Markets.
The histogram to the right illustrates the frequency of daily revenue arising from Global Markets’ trading, balance sheet management and other trading activities.
The average daily revenue earned in 2008 was US$21.7 million, compared with US$18.7 million in 2007. The standard deviation of these daily revenues was US$53.4 million compared with US$25.3 million in 2007. The standard deviation measures the variation of daily revenues about the mean value of those revenues.
An analysis of the frequency distribution of daily revenue shows that there were 66 days with negative revenue during 2008 compared with 35 days in 2007. The most frequent result was a daily revenue of between US$40 million and US$50 million with 28 occurrences, compared with between US$20 million and US$30 million with 71 occurrences in 2007.
For a description of HSBC’s fair value and price verification controls, see page 163.
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Trading portfolios(Audited)
HSBC’s control of market risk is based on a policy of restricting individual operations to trading within a list of permissible instruments authorised for each site by Traded Credit and Market Risk, of enforcing rigorous new product approval procedures, and of restricting trading in the more complex derivative
products only to offices with appropriate levels of product expertise and robust control systems.
Market making and proprietary position taking is undertaken within Global Markets. The VAR for such trading activity at 31 December 2008 was US$72.5 million (2007: US$30.2 million). This is analysed below by risk type:
Credit spread risk
The risk associated with movements in credit spreads is primarily managed through sensitivity limits, stress testing, and VAR for those portfolios where VAR is calculated.
The Group is introducing credit spread as a separate risk type within the VAR models. At 31 December 2008, credit spread VAR was calculated for the London trading and New York credit derivatives portfolios. At that date, the total VAR for the trading activities, including credit spread VAR for the above portfolios, was US$106.4 million (2007: US$43.8 million) compared with a total VAR of US$72.5 million reported within the ‘VAR by risk type for the trading activities’ (see above), which excludes the credit spread VAR for these two portfolios.
The sensitivity of trading income to the effect of movements in credit spreads on the total trading activities of the Group was US$590.9 million at 31 December 2008 (2007: US$95.4 million). This sensitivity captures the credit spread exposure arising from positions taken throughout the Group, in addition to the London trading and New York credit derivative portfolios captured within credit spread VAR (see above). The sensitivity was calculated using simplified assumptions based on one-day movements in average market credit spreads
over a two-year period at a confidence level of 99 per cent, and assumes a simultaneous movement in credit spreads across issuers. It should be noted that diversification effects within the portfolio and with other risk types is likely to lead to a reduced impact on trading income.
The significant increase in the sensitivity at 31 December 2008, compared with 31 December 2007, was due to the effect of much higher volatility in credit spreads observed during 2008. The actual positions within the trading portfolios exposed to credit spread risk were lower on 31 December 2008 than on 31 December 2007.
In addition to the above measure certain portfolios are also managed using default risk measures where appropriate.
The measurement of the credit spread impact on trading income as at 31 December 2008 excludes those positions that were reclassified as non-trading during the second half of 2008 following the amendment to IFRS. These positions are included within the 31 December 2007 comparative, as the reclassification took effect from 1 July 2008.
Credit spread risk also arises on credit derivative transactions entered into by Global Banking in order to manage the risk concentrations within the corporate loan portfolio and so enhance capital
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efficiency. The mark-to-market of these transactions is taken through the income statement.
At 31 December 2008, the credit spread VAR on the credit derivatives transactions entered into by Global Banking was US$23.0 million (2007: US$19.7 million). The VAR shows the effect on trading income from a one-day movement in credit spreads over a two-year period, calculated to a 99 per cent confidence level.
Gap risk
Certain transactions are structured such that the risk to HSBC is negligible under a wide range of market conditions or events, but in which there exists a remote probability that a significant gap event could lead to loss. A gap event could be seen as a change in market price from one level to another with no trading opportunity in between, and where the price change breaches the threshold beyond which the risk profile changes from having no open risk to having full exposure to the underlying structure. Such movements may occur, for example, when there are adverse news announcements and the market for a specific investment becomes illiquid, making hedging impossible.
Given the characteristics of these transactions, they will make little or no contribution to VAR or to traditional market risk sensitivity measures. HSBC captures the risks for such transactions within its stress testing scenarios. Gap risk arising is monitored on an ongoing basis, and HSBC incurred no gap losses arising from movements in the underlying market price on such transactions in 2008.
ABSs/MBSs positions
The ABSs/MBSs exposures within the trading portfolios are managed within sensitivity and VAR limits, as described on page 241, and are included within the stress testing scenarios as described on page 242.
Non-trading portfolios (Audited)
The principal objective of market risk management of non-trading portfolios is to optimise net interest income.
Interest rate risk in non-trading portfolios arises principally from mismatches between the future yield on assets and their funding cost, as a result of interest rate changes. Analysis of this risk is complicated by having to make assumptions on embedded optionality within certain product areas such as the incidence of mortgage prepayments, and from behavioural assumptions regarding the
economic duration of liabilities which are contractually repayable on demand such as current accounts. The prospective change in future net interest income from non-trading portfolios will be reflected in the current realisable value of these positions, should they be sold or closed prior to maturity. In order to manage this risk optimally, market risk in non-trading portfolios is transferred to Global Markets or to separate books managed under the supervision of the local ALCO.
The transfer of market risk to books managed by Global Markets or supervised by ALCO is usually achieved by a series of internal deals between the business units and these books. When the behavioural characteristics of a product differ from its contractual characteristics, the behavioural characteristics are assessed to determine the true underlying interest rate risk. Local ALCOs are required to regularly monitor all such behavioural assumptions and interest rate risk positions to ensure they comply with interest rate risk limits established by GMB.
In certain cases, the non-linear characteristics of products cannot be adequately captured by the risk transfer process. For example, both the flow from customer deposit accounts to alternative investment products and the precise prepayment speeds of mortgages will vary at different interest rate levels, and where expectations about future moves in interest rates change. In such circumstances, simulation modelling is used to identify the impact of varying scenarios on valuations and net interest income.
Once market risk has been consolidated in Global Markets or ALCO-managed books, the net exposure is typically managed through the use of interest rate swaps within agreed limits. The VAR for these portfolios is included within the Group VAR (see ‘Value at risk of the trading and non-trading portfolios’ above).
At 31 December 2008, the sensitivity of equity to the effect of movements in credit spreads on the Group’s available-for-sale debt securities was US$1,092 million (2007: US$206 million). The sensitivity was calculated on the same basis as applied to the trading portfolio. Including the gross exposure for the SICs consolidated within HSBC’s balance sheet at 31 December 2008, the sensitivity increased to US$1,145 million. This sensitivity is struck, however, before taking account of any losses which would be absorbed by the capital note holders. At 31 December 2008, the capital note holders
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would have absorbed the first US$2.2 billion (2007: US$2.3 billion) of any losses incurred by the SICs prior to HSBC incurring any equity losses.
The notable increase in this sensitivity at 31 December 2008, compared with 31 December 2007, was again due to the effect of higher volatility in credit spreads observed during 2008. The overall credit spread positions within the available-for-sale portfolios were lower on 31 December 2008 compared with 31 December 2007.
Equity securities classified as available for sale (Audited)
Market risk arises on equity securities held as available for sale. The fair value of these securities at 31 December 2008 was US$6.8 billion (2007: US$12.6 billion) and included private equity holdings of US$2.5 billion (2007: US$3.2 billion). Investments in private equity are primarily made through managed funds that are subject to limits on the amount of investment. Potential new commitments are subject to risk appraisal to ensure that industry and geographical concentrations remain within acceptable levels for the portfolio as a whole. Regular reviews are performed to substantiate the valuation of the investments within the portfolio. Funds typically invested for short-term cash management represented US$0.9 billion (2007: US$3.1 billion). Investments held to facilitate ongoing business, such as holdings in government-sponsored enterprises and local stock exchanges, represented US$1.0 billion (2007: US$1.7 billion). Other strategic investments represented US$2.4 billion (2007: US$4.6 billion). The fair value of the constituents of equity securities classified as available for sale can fluctuate considerably. A 10 per cent reduction in the value of the available-for-sale equities at 31 December 2008 would have reduced equity by US$0.7 billion (2007: US$1.3 billion). For details of the impairment incurred on available-for-sale equity securities see ‘Accounting policies’ on page 350.
US$1.0 billion of the reduction in the AFS Equities relates to funds that were consolidated within the Groups balance sheet as at 31 December 2008.
Defined benefit pension schemes (Audited)
Market risk also arises within HSBC’s defined benefit pension schemes to the extent that the obligations of the schemes are not fully matched by assets with determinable cash flows. Pension scheme obligations fluctuate with changes in long-term interest rates, inflation, salary increases and the
longevity of scheme members. Pension scheme assets will include equities and debt securities, the cash flows of which change as equity prices and interest rates vary. There are risks that market movements in equity prices and interest rates could result in asset valuations which, taken together with regular ongoing contributions, are insufficient over time to cover the level of projected obligations and these, in turn, could increase with a rise in inflation and members living longer. Management, together with the trustees who act on behalf of the pension scheme beneficiaries, assess these risks using reports prepared by independent external actuaries and take action and, where appropriate, adjust investment strategies and contribution levels accordingly. For example, in order to mitigate the risk of adverse movements in investments, interest rates and inflation, the Trustee of the HSBC Bank (UK) Pension Scheme has continued to implement a programme of initiatives proposed by HSBC, including reducing the equity content of the investment strategy, increasing the diversification of the scheme’s assets, and entering into long-term interest rate and inflation swaps.
The present value of HSBC’s defined benefit pension plans’ obligations was US$24.0 billion at 31 December 2008, compared with US$32.4 billion at 31 December 2007. Assets of the defined benefit schemes at 31 December 2008 comprised equity investments, 20 per cent (2007: 26 per cent); debt securities, 68 per cent (2007: 62 per cent); and other (including property), 12 per cent (2007: 12 per cent) (see Note 8 on the Financial Statements).
Increased corporate bond yields in the UK in 2008 have resulted in an increase of 110 basis points in the real discount rate (net of the increase in expected inflation) used to value the accrued benefits payable under the HSBC Bank (UK) Pension Scheme, the Group’s largest plan. The resulting decrease in the liabilities of the scheme has been largely offset by a reduction in the fair values of the plan assets of the scheme. As a consequence, the deficit on the HSBC Bank (UK) Pension Scheme has decreased to US$392 million from US$808 million.
Sensitivity of net interest income (Unaudited)
A principal part of HSBC’s management of market risk in non-trading portfolios is to monitor the sensitivity of projected net interest income under varying interest rate scenarios (simulation modelling). HSBC aims, through its management of market risk in non-trading portfolios, to mitigate the
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effect of prospective interest rate movements which could reduce future net interest income, while balancing the cost of such hedging activities on the current net revenue stream.
For simulation modelling, businesses use a combination of scenarios relevant to local businesses and local markets and standard scenarios which are required throughout HSBC. The standard scenarios are consolidated to illustrate the combined pro forma effect on HSBC’s consolidated portfolio valuations and net interest income.
The table below sets out the effect on future net interest income of an incremental 25 basis points parallel fall or rise in all yield curves worldwide at the beginning of each quarter during the 12 months
from 1 January 2009. Assuming no management actions, a series of such rises would decrease planned net interest income for 2009 by US$463 million (2008: US$503 million), while a series of such falls would decrease planned net interest income by US$284 million (2008: increase US$525 million). These figures incorporate the effect of any option features in the underlying exposures.
Instead of assuming that all interest rates move together, HSBC groups its interest rate exposures into currency blocs whose rates are considered likely to move together. The sensitivity of projected net interest income, on this basis, is as follows:
The interest rate sensitivities set out in the table above are illustrative only and are based on simplified scenarios.
The figures represent the effect of the pro forma movements in net interest income based on the projected yield curve scenarios and the Group’s current interest rate risk profile. This effect, however, does not incorporate actions that would be taken by Global Markets or in the business units to mitigate the impact of this interest rate risk. In reality, Global Markets seeks proactively to change the interest rate risk profile to minimise losses and optimise net revenues. The projections above also assume that interest rates of all maturities move by the same amount and, therefore, do not reflect the potential impact on net interest income of some rates changing while others remain unchanged. The projections take account of the effect on net interest income of anticipated differences in changes
between interbank interest rates and interest rates linked to other bases (such as Central Bank rates or product rates over which the entity has discretion in terms of the timing and extent of rate changes). The projections make other simplifying assumptions too, including that all positions run to maturity.
HSBC’s exposure to the effect of movements in interest rates on its net interest income arises in two main areas: core deposit franchises and Global Markets.
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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:
interest income’ whereas the income from such assets is recorded in ‘Net trading income’.
Projecting the movement in net interest income from prospective changes in interest rates is a complex interaction of structural and managed exposures.
HSBC monitors the sensitivity of reported reserves to interest rate movements on a monthly basis by assessing the expected reduction in valuation of available-for-sale portfolios and cash flow hedges due to parallel movements of plus or minus 100 basis points in all yield curves. The table below describes the sensitivity of HSBC’s reported reserves to these movements at the end of 2008 and 2007 and the maximum and minimum month-end figures during these years:
Sensitivity of reported reserves to interest rate movements (Unaudited)
The sensitivities are illustrative only and are based on simplified scenarios. The table shows the potential sensitivity of reserves to valuation changes in available-for-sale portfolios and from cash flow hedges following the pro forma movements in interest rates. These particular exposures form only a part of the Group’s overall interest rate exposures. The accounting treatment under IFRSs of the Group’s remaining interest rate exposures, while economically largely offsetting the exposures shown in the above table, does not require revaluation movements to go to reserves.
Structural foreign exchange exposures(Unaudited)
Structural foreign exchange exposures represent net investments in subsidiaries, branches or associates, the functional currencies of which are currencies other than the US dollar.
Exchange differences on structural exposures
are recorded in the consolidated statement of recognised income and expense. The main operating (or functional) currencies in which HSBC’s business is transacted are the US dollar, the Hong Kong dollar, pound sterling, the euro, the Mexican peso, the Brazilian real and the Chinese renminbi. As the US dollar and currencies linked to it form the dominant currency bloc in which HSBC’s operations transact business, HSBC Holdings prepares its consolidated financial statements in US dollars. HSBC’s consolidated balance sheet is, therefore, affected by exchange differences between the US dollar and all the non-US dollar functional currencies of underlying subsidiaries.
HSBC hedges structural foreign exchange exposures only in limited circumstances. HSBC’s structural foreign exchange exposures are managed
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with the primary objective of ensuring, where practical, that HSBC’s consolidated capital ratios and the capital ratios of individual banking subsidiaries are largely protected from the effect of changes in exchange rates. This is usually achieved by ensuring that, for each subsidiary bank, the ratio of structural exposures in a given currency to risk-weighted assets denominated in that currency is broadly equal to the capital ratio of the subsidiary in question.
The Group’s capital ratios were affected by the strengthening US dollar in the latter part of 2008. The effect on the Group’s consolidated tier 1 and total ratios is estimated to have been a reduction of approximately 40 basis points and approximately 50 basis points respectively. These movements were within approved tolerance levels.
HSBC may also transact hedges where a currency in which it has structural exposures is considered to be significantly overvalued and it is possible in practice to transact a hedge. Selective hedges were in place during 2007 and 2008. Hedging is undertaken using forward foreign exchange contracts which are accounted for under IFRSs as hedges of a net investment in a foreign operation, or by financing with borrowings in the same currencies as the functional currencies involved. There was no ineffectiveness arising from these hedges in the year ended 31 December 2008.
HSBC Holdings(Audited)
As a financial services holding company, HSBC Holdings has limited market risk activity. Its activities predominantly involve maintaining sufficient capital resources to support the Group’s diverse activities; allocating these capital resources across the Group’s businesses; earning dividend and interest income on its investments in the Group’s businesses; providing dividend payments to HSBC Holding’s equity shareholders and interest payments to providers of debt capital; and maintaining a supply of short-term cash resources. It does not take proprietary trading positions.
The main market risks to which HSBC Holdings is exposed are interest rate risk and foreign currency risk. Exposure to these risks arises from short-term cash balances, funding positions held, loans to subsidiaries, investments in long-term financial assets and financial liabilities including debt capital issued. The objective of HSBC Holding’s market risk management strategy is to reduce exposure to these risks and minimise volatility in reported income, cash flows and distributable reserves. Market risk for HSBC
Holdings is monitored by its Structural Positions Review Group.
A number of cross currency interest rate swaps entered into as part of HSBC Holdings’ management of interest rate risk arising on certain long-term debt capital issues do not qualify for hedge accounting treatment. Changes in the market values of these swaps are taken directly to the income statement. HSBC Holdings expects that these swaps will be held to final maturity with the accumulated changes in market value consequently trending to zero.
Certain loans to subsidiaries of a capital nature that are not denominated in the functional currency of either the provider or the recipient are accounted for as financial assets. Changes in the carrying amount of these assets due to exchange differences are taken directly to the income statement. These loans, and the associated foreign exchange exposures, are eliminated on a Group consolidated basis.
The principal tools used in the management of market risk are the projected sensitivity of HSBC Holdings’ net interest income to future changes in yield curves and interest rate gap re-pricing tables for interest rate risk, and VAR for foreign exchange rate risk.
Net interest income sensitivity
HSBC Holdings monitors net interest income sensitivity over a 5-year time horizon reflecting the longer-term perspective on interest rate risk management appropriate to a financial services holding company. The table below sets out the effect on HSBC Holdings’ future net interest income over a 5-year time horizon of an incremental 25 basis point parallel fall or rise in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 January 2009.
Assuming no management action, a series of such rises would decrease HSBC Holdings’ planned net interest income for 2009 by US$60 million (2008: decrease of US$23 million) and decrease cumulative net interest income by US$554 million over a 5-year period from 1 January 2009 (2008: decrease of US$104 million), while a series of such falls would increase planned net interest income by US$60 million (2008: increase of US$23 million) and increase cumulative net interest income by US$554 million over a 5-year period from 1 January 2009 (2008: increase of US$104 million). These figures incorporate the impact of any option features in the underlying exposures.
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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)
HSBC Holdings’ principal exposure to changes in its net interest income from movements in interest rates arises on short-term cash balances, floating rate loans advanced to subsidiaries and fixed rate debt capital securities in issue which have been swapped to floating rate.
The interest rate sensitivities tabulated above are illustrative only and are based on simplified scenarios. The figures represent the effect of pro forma movements in net interest income based on the projected yield curve scenarios, HSBC Holdings’ current interest rate risk profile and assumed changes to that profile during the next five years. Changes to assumptions concerning the risk profile over the next five years can have a significant impact on the net interest income sensitivity for that period. The figures do not take into account the effect of actions that could be taken to mitigate this interest rate risk, however.
The projected increase in HSBC Holdings’ sensitivity to moves in interest rates is mainly due to new interest-bearing capital issues, the funds from which have been largely invested in non-interest bearing equity investments in subsidiaries.
Interest repricing gap table
The interest rate repricing gap table below analyses the full term structure of interest rate mismatches within HSBC Holdings’ balance sheet. The year on year increase in the negative net interest rate gap in the up to 1 year time bucket is due to an increase in non-interest bearing equity investments in subsidiaries which has been funded by new issues of interest bearing liabilities and by the capitalisation of interest bearing loans to subsidiaries.
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As part of the continuous enhancement and development of HSBC’s management tools, the net interest income sensitivity projection over a 5-year horizon and the interest rate repricing table shown above have replaced the VAR analysis disclosed in the 2007 Annual Report and Accounts as the principal measures used to monitor interest rate risk for HSBC Holdings. These enhanced reports are considered to be more suitable risk management measures for the longer term profile of a bank holding company balance sheet.
Value at risk
Total foreign exchange VAR arising within HSBC Holdings in 2008 and 2007 was as follows:
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.
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A significant part of a lessor’s return from operating leases is dependent upon its management of residual value risk. This arises from operating lease transactions to the extent that the values recovered from disposing of leased assets or re-letting them at the end of the lease terms (the ‘residual values’) differ from those projected at the inception of the leases. The business regularly monitors residual value exposure by reviewing the recoverability of the residual value projected at lease inception. This entails considering the potential of re-letting of operating lease assets and their projected disposal proceeds at the end of their lease terms. Provision is made to the extent that the carrying values of leased assets are impaired through residual values not being fully recoverable.
The net book value of equipment leased to customers on operating leases by the Group includes projected residual values at the end of current lease terms, to be recovered through re-letting or disposal in the following periods:
Residual values(Unaudited)
Operational risk is the risk of loss arising through fraud, unauthorised activities, error, omission, inefficiency, systems failure or from external events. It is inherent to every business organisation and covers a wide spectrum of issues. The terms ‘error’, ‘omission’ and ‘inefficiency’ include process failures, systems/machine failures and human error.
The objective of HSBC’s operational risk management is to manage and control operational risk in a cost effective manner within targeted levels of operational risk consistent with the Group’s risk appetite, as defined by the Group Management Board.
A formal governance structure provides oversight over the management of operational risk. A Global Operational Risk and Control Committee, which reports to the Risk Management Meeting, meets quarterly to discuss key risk issues and review
the effective implementation of the Group’s operational risk management framework.
In each of HSBC’s subsidiaries, business managers are responsible for maintaining an acceptable level of internal control, commensurate with the scale and nature of operations. They are responsible for identifying and assessing risks, designing controls and monitoring the effectiveness of these controls. The operational risk management framework helps managers to fulfil these responsibilities by defining a standard risk assessment methodology and providing a tool for the systematic reporting of operational loss data.
A centralised database is used to record the results of the operational risk management process. Operational risk self-assessments are input and maintained by the business unit. To ensure that operational risk losses are consistently reported and monitored at Group level, all Group companies are required to report individual losses when the net loss is expected to exceed US$10,000.
Further details of the HSBC approach to Operational Risk Management can be found in the Capital and Risk Management Interim Pillar 3 Disclosures 2008.
Legal risk(Unaudited)
Each operating company is required to implement procedures to manage legal risk that conform to HSBC standards. Legal risk falls within the definition of operational risk and includes contractual risk, dispute risk, legislative risk and non-contractual rights risk.
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
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litigation against third parties.
The GMO legal department oversees the global legal function and is headed by a Group General Manager who reports to the Group Chairman. There are legal departments in 54 of the countries in which HSBC operates. There are also regional legal functions in each of Europe, North America, Latin America, the Middle East, and Asia-Pacific.
Operating companies must notify the appropriate legal department immediately any litigation is either threatened or commenced against HSBC or an employee. The appropriate regional legal department must be immediately advised (and must in turn immediately advise the GMO legal department) of any action by a regulatory authority, where the proceedings are criminal, or where the claim might materially affect the Group’s reputation. Further, any claims which exceed US$1.5 million or equivalent must also be advised to the appropriate regional legal department and the regional legal department must immediately advise the GMO legal department if any such claim exceeds US$5 million. All such matters are then reported to the Risk Management Meeting of the Group Management Board in a monthly paper.
An exception report must be made to the local compliance function and escalated to the Head of Group Compliance in respect of any breach which has given rise to a fine and/or costs levied by a court of law or regulatory body where the amount is US$1,500 or more, and material or significant issues are reported to the Risk Management Meeting of GMB and/or the Group Audit Committee.
In addition, operating companies are required to submit quarterly returns detailing outstanding claims where the claim (or group of similar claims) exceeds US$10 million, where the action is by a regulatory authority, where the proceedings are criminal, where the claim might materially affect the Group’s reputation, or, where the GMO legal department has requested returns be completed for a particular claim. These returns are used for reporting to the Group Audit Committee and the Board of HSBC Holdings, and disclosure in the Interim Report and Annual Report and Accounts, if appropriate.
Global security and fraud risk(Unaudited)
Security and fraud risk issues are managed at Group level by Global Security and Fraud Risk. This unit, which has responsibility for physical, fraud, information and contingency risk, and security and business intelligence, is fully integrated within the central GMO Risk function. This facilitates
synergies between it and other risk functions, such as with Global Retail Risk Management in the selection, design and implementation of systems and processes to protect the Group against fraud by deterring fraudulent activity, detecting it where it does occur and mitigating its effects.
HSBC operates a number of pension plans throughout the world, as described in Note 8 on the Financial Statements. Some of these pension plans are defined benefit plans, of which the largest is the HSBC Bank (UK) Pension Scheme.
In order to fund these benefits, sponsoring group companies (and in some instances, employees) make regular contributions in accordance with advice from actuaries and in consultation with the scheme’s Trustees (where relevant). The defined benefit plans invest these contributions in a range of investments designed to meet their long-term liabilities.
The level of these contributions has a direct impact on the cash flow of the Group and would normally be set to ensure that there are sufficient funds to meet the cost of the accruing benefits for the future service of active members. However, higher contributions will be required when plan assets are considered insufficient to cover the existing pension liabilities as a deficit exists. Contribution rates are typically revised annually or triennially, depending on the plan. The agreed contributions to the HSBC Bank (UK) Pension Scheme are revised triennially.
A deficit in a defined benefit plan may arise from a number of factors, including:
The plan’s investment strategy is determined in the light of the market risk inherent in the investments and the consequential impact on potential future contributions.
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Ultimate responsibility for investment strategy rests with either the Trustees or, in certain circumstances, a Management Committee. The degree of independence of the Trustees from HSBC differs in different jurisdictions. For example, the HSBC Bank (UK) Pension Scheme, which accounts for approximately 63 per cent of the obligations of the Group’s defined benefit pension plans, is overseen by a corporate Trustee. This scheme’s Trustee regularly monitors the market risks inherent in the scheme.
The safeguarding of HSBC’s reputation is of paramount importance to its continued prosperity and is the responsibility of every member of staff. HSBC regularly reviews its policies and procedures for safeguarding against reputational and operational risks. This is an evolutionary process which takes account of relevant developments and industry guidance such as The Association of British Insurers’ guidance on best practice when responding to environmental, social and governance (‘ESG’) risks.
HSBC has always aspired to the highest standards of conduct and, as a matter of routine, takes account of reputational risks to its business. Reputational risks can arise from a wide variety of causes, including ESG issues and operational risk events. As a banking group, HSBC’s good reputation depends upon the way in which it conducts its business, but it can also be affected by the way in which clients, to whom it provides financial services, conduct themselves. The training of Directors on appointment includes reputational matters.
A Group Reputational Risk Committee (‘GRRC’) has been established at which relevant Group functions with responsibility for activities and functions which attract reputational risk are represented. The primary role of the GRRC is to consider areas and activities presenting significant reputational risk and, where appropriate, to make recommendations to the Risk Management Meeting and GMB for policy or procedural changes to mitigate such risk.
Standards on all major aspects of business are set for HSBC and for individual subsidiaries, businesses and functions. Reputational risks, including ESG matters, are considered and assessed by the Board, GMB, the Risk Management Meeting, subsidiary company boards, board committees and senior management during the formulation of policy and the establishment of HSBC standards. These
policies, which form an integral part of the internal control system (see page 299), are communicated through manuals and statements of policy and are promulgated through internal communications and training. The policies cover ESG issues and set out operational procedures in all areas of reputational risk, including money laundering deterrence, counter-terrorist financing environmental impact, anti-corruption measures and employee relations. The policy manuals address risk issues in detail and co-operation between GMO departments and businesses is required to ensure a strong adherence to HSBC’s risk management system and its sustainability practices.
Sustainability risks arise from the provision of financial services to companies or projects which run counter to the needs of sustainable development; in effect this risk arises when the environmental and social effects outweigh economic benefits. Within Group Management Office, a separate function, Group Corporate Sustainability, is mandated to manage these risks globally working through local offices as appropriate. Its risk management responsibilities include:
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HSBC operates a bancassurance model which provides insurance products for customers with whom the Group has a banking relationship. Insurance products are sold to all customer groups, mainly utilising retail branches, the internet and phone centres. Personal Financial Services customers attract the majority of sales and comprise the majority of policyholders. HSBC offers its customers a wide range of insurance and investment products, many of which complement other bank and consumer finance products.
Many of these insurance products are manufactured by HSBC subsidiaries. The Group underwrites the insurance risk and retains the risks and rewards associated with writing insurance contracts, retaining both the underwriting profit and the commission paid by the manufacturer to the bank distribution channel within the Group. HSBC’s exposure to risks associated with manufacturing insurance contracts in its subsidiaries and its management of these risks are discussed below.
Where the Group considers it operationally more effective, third parties are engaged to manufacture insurance products for sale through HSBC’s banking network. The Group works with a limited number of market-leading partners to provide the products. These arrangements earn HSBC a commission.
HSBC’s bancassurance business operates in all five of the Group’s geographical regions with over 30 legal entities, the majority of which are subsidiaries of banking legal entities, manufacturing insurance products. Management of these insurance manufacturers set their own control procedures in addition to complying with guidelines issued by the Group Insurance Head Office. This is headed by HSBC’s Managing Director of Insurance, supported by a Chief Operating Officer, Chief Financial Officer and Chief Risk Officer, the latter appointed in 2008. The role of Group Insurance Head Office includes setting the control framework for monitoring and measuring insurance risk in line with Group practices, and drawing up insurance-specific policies and guidelines for inclusion in the Group Instruction Manuals. The control framework for monitoring risk includes the Group Insurance Risk Committee, which oversees the status of the significant risk categories in the insurance
operations. Four sub-committees report to the Committee, focusing on market and liquidity risk, credit risk, operational and insurance risk. The processes and controls employed to monitor each risk are described under their respective headings below.
The main contracts manufactured by HSBC are as follows:
Life insurance business (Audited)
Life insurance contracts with discretionary participation features (‘DPF’) allow policyholders to participate in the profits generated from such business, which may take the form of annual bonuses and a final bonus, in addition to providing cover on death. Certain minimum return levels are also guaranteed. The largest portfolio is in Hong Kong.
Credit life insurance business is written to underpin banking and finance products. The policy pays a claim if the holder of the loan is unable to make repayments due to early death or unemployment.
Annuities are contracts providing regular payments of income from capital investment for either a fixed period or during the annuitant’s lifetime. Payments to the annuitant either begin on inception of the policy (immediate annuities) or at a designated future date (deferred annuities).
Term assurance and critical illness policies provide cover in the event of death (term assurance) and serious illness.
Linked life insurance contracts pay benefits to policyholders which are typically determined by reference to the value of the investments supporting the policies.
Investment contracts with DPF allow policyholders to participate in the profits generated by such business. The largest portfolio is written in France. Policyholders are guaranteed to receive a return on their investment plus any discretionary bonuses. In addition, certain minimum return levels are guaranteed.
Unit-linked investment contracts are those where the principal benefit payable is the value of assigned assets.
Other investment contracts include pension contracts written in Hong Kong.
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Non-life insurance business (Audited)
Non-life insurance contracts include motor, fire and other damage to property, accident and health, repayment protection and commercial insurances.
Motor insurance business covers vehicle damage and liability for personal injury. For fire and other damage to property, the main focus in most markets is providing individuals with home and contents insurance, with cover for selected commercial customers largely written in Asia and Latin America.
A very limited portfolio of liability business is written, other than that included in the motor book.
Credit non-life insurance is concentrated in North America and Europe, and is originated in conjunction with the provision of loans. Payment protection insurance (‘PPI’) products were suspended in the UK pending a final report from the Competition Commission on their provision by the financial services industry. The report was issued in early 2009. The business is in the process of assessing the impact of the reported findings on credit protection products in the UK.
Given the nature of the contracts written by the Group, the risks to which HSBC’s insurance operations are exposed fall into two principal categories: insurance risk and financial risk. The following section describes the nature and extent of these risks and HSBC’s approach to managing them. The majority of the risk in the insurance business derives from manufacturing activities.
Insurance risk (Audited)
Insurance risk is a risk, other than financial risk, transferred from the holder of a contract to the issuer, in this case HSBC. 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. The cost of a claim can be influenced by many factors, including mortality and morbidity experience, lapse and surrender rates and, if the policy has a savings element, the performance of the assets held to support the liabilities. Performance of the underlying assets is affected by changes in both interest rates and equity prices (see page 263).
HSBC’s insurance risk appetite is proposed by local businesses and authorised centrally. The Group manages its exposure to insurance risk by applying formal underwriting, reinsurance and claims-
handling procedures designed to ensure compliance with regulations. This is supplemented with stress testing.
Insurance contracts sold by HSBC relate, in the main, to core underlying banking activities, such as savings and investment products, and credit life products. The Group’s manufacturing focuses on personal lines, i.e. contracts written for individuals, which tend to be of higher volume and lower individual value than commercial lines. They thus contribute to diversifying insurance risk.
Life and non-life business insurance risks are controlled by high-level policies and procedures set centrally, supplemented as appropriate with measures which take account of specific local market conditions and regulatory requirements. For example, manufacturing entities are required to obtain authorisation from Group Insurance Head Office to write certain classes of business, with restrictions applying to commercial and liability non-life insurance, in particular.
Local ALCOs and Risk Management Committees are required to monitor certain risk exposures, mainly for life business where the focus is on reviewing the risks associated with the duration and cash flow matching of insurance assets and liabilities.
Reinsurance is also used as a means of mitigating exposure, in particular to aggregations of catastrophe risk. Specific examples are as follows:
Although reinsurance provides a means of managing insurance risk, such contracts expose the Group to counterparty risk, the risk of default by the reinsurer (see page 267).
The following tables provide an analysis of HSBC’s insurance risk exposures by geographical region and by type of business. By definition, HSBC is not exposed to insurance risk on investment
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contracts, so they are not included in the insurance risk management analysis.
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. Accordingly, separate tables are 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
Analysis of life insurance risk – liabilities to policyholders(Audited)
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 because policies are typically priced by reference to the risk being underwritten.
(Audited)
The above table of liabilities to life insurance policyholders highlights that the most significant products are investment contracts with DPF issued in France, insurance contracts with DPF issued in Hong Kong and unit-linked contracts issued in Hong Kong, Latin America and Europe.
The liabilities for long-term contracts are set by reference to a range of assumptions which include lapse and surrender rates, mortality and expense levels. These assumptions typically reflect each
entity’s own experience. Economic assumptions, such as investment returns and interest rates, are usually based on market observable data. Changes in underlying assumptions affect the liabilities. The sensitivity of profit after tax and shareholders’ equity to changes in both economic and non-economic assumptions are considered below.
Insurance risk arising from life insurance depends on the type of business, and varies considerably. The principal risks are mortality, morbidity, lapse, surrender and expense levels.
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The main contracts which generate exposure to mortality and morbidity risks are term assurance contracts and annuities. These risks are monitored on a regular basis, and are primarily mitigated by medical underwriting and by retaining the ability in certain cases to amend premiums in the light of experience. The risk associated with lapses and surrenders is generally mitigated by the application
of surrender charges, though other management actions, such as managing the level of bonus payments to policyholders, may be taken. Expense risk is generally managed through pricing. The level of expenses in the contract will be one of the factors considered when setting premiums rates.
The above table of non-life net written insurance premiums provides an overall summary of the non-life insurance activity of the Group. Motor business is written predominantly in Europe and Latin America and represented the largest class of non-life business in 2008. Fire and other damage to property business is written in all major markets, most significantly in Europe. Credit non-life insurance, which is originated in conjunction with
the provision of loans, is concentrated in the US and Europe.
The main risks associated with non-life business are underwriting risk and claims experience risk. Underwriting risk is the risk that HSBC does not charge premiums appropriate to the cover provided and claims experience risk is the risk that portfolio experience is worse than expected. HSBC manages these risks through pricing (for example, imposing
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restrictions and deductibles in the policy terms and conditions), product design, risk selection, claims handling, investment strategy and reinsurance policy. The majority of non-life insurance contracts are renewable annually and the underwriters have the right to refuse renewal or to change the terms and conditions of the contract at that time.
Balance sheet of insurance manufacturing subsidiaries by type of contract(Audited)
A principal tool used by HSBC to manage its exposure to insurance risk, in particular for life insurance contracts, is asset and liability matching. Models are used to assess the effect of a range of future scenarios on the values of financial assets and associated liabilities, and ALCOs employ the outcomes in determining how the assets and liabilities should be matched. The scenarios include stresses applied to factors which affect insurance risk such as mortality and lapse rates. Of particular importance is the need to match the expected pattern of cash inflows with the benefits payable on the underlying contracts, which can extend for many years. The table below shows the composition of assets and liabilities and demonstrates that there
were sufficient assets to cover the liabilities to policyholders at the end of 2008. It may not always be possible to achieve a complete matching of asset and liability durations, partly because there is uncertainty over policyholder behaviour, which introduces uncertainty over the receipt of all future premiums and the timing of claims, and partly because the duration of liabilities may exceed the duration of the longest available dated fixed interest investments. In an environment where interest rates and yield curves are falling, insurance operations are exposed to re-investment risk as higher yielding assets held in the portfolio mature and are replaced with lower yielding assets. Given the objective to hold rather than trade investments, the current portfolio of assets includes debt securities issued at a time when coupon rates were higher than those observed in the current market. As a result, the current yield of the debt securities exceeds that which may be obtained on current issues. Management action has been taken in relation to certain participating contracts to reduce short-term bonus rates paid to policyholders to manage the immediate strain on the business. Should interest rates and yield curves stay low for prolonged periods, further management actions may be needed.
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Balance sheet of insurance manufacturing subsidiaries by type of contract (continued)(Audited)
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The table below shows the composition of assets and liabilities by region and demonstrates that there
were sufficient assets to cover the liabilities to policyholders for each region at the end of 2008.
Balance sheet of insurance manufacturing subsidiaries by geographical region (Audited)
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Insurance operations > Financial risks > Market risk
Financial risks(Audited)
HSBC’s insurance businesses are exposed to a range of financial risks, including market risk, credit risk and liquidity risk. Market risk includes interest rate risk, equity risk and foreign exchange risk. The nature and management of these risks is described below.
Manufacturing subsidiaries are exposed to financial risks, for example, when the proceeds from financial assets are not sufficient to fund the obligations arising from non-linked insurance and investment contracts. Certain insurance-related activities undertaken by HSBC subsidiaries such as insurance broking, insurance management (including captive management) and the administration and intermediation of insurance, pensions and annuities are exposed to financial risks, but not to a significant extent.
Risk management procedures which reflect local market conditions and regulatory requirements may be implemented by HSBC’s insurance manufacturing subsidiaries in addition to policies provided for Group-wide application through the Group Instruction Manuals. In many jurisdictions, local regulatory requirements prescribe the type, quality and concentration of assets that these subsidiaries must maintain to meet insurance liabilities. Within each subsidiary, ALCOs are responsible for ensuring that exposures to financial risks remain within local requirements and risk mandates (as agreed with Group Insurance Head Office), and ensure compliance with the control framework established centrally through the Group Instruction Manuals.
The following table analyses the assets held in HSBC’s insurance manufacturing subsidiaries at 31 December 2008 by type of contract, and provides a view of the exposure to financial risk:
Financial assets held by insurance manufacturing subsidiaries(Audited)
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The table demonstrates that for linked contracts, HSBC typically designates assets at fair value. For non-linked contracts, the classification of the assets is driven by the nature of the underlying contract.
The table also shows that approximately 62.9 per cent of financial assets was invested in debt securities at 31 December 2008 (2007: 55.4 per cent) with 19.7 per cent (2007: 30.3 per cent) invested in equity securities.
In life linked insurance, premium income less charges levied is invested in a portfolio of assets. HSBC manages the financial risks of this product on behalf of the policyholders by holding appropriate assets in segregated funds or portfolios to which the liabilities are linked. Typically, HSBC retains some exposure to market risk as the market value of the linked assets influences the fees charged by HSBC and thereby affects the recoverability of expenses incurred by the Group in managing the product. The assets held to support life linked liabilities represented 19.4 per cent of the total financial assets of HSBC’s insurance manufacturing subsidiaries at the end of 2008 (2007: 29.7 per cent).
Market risk(Audited)
Insurance and investment products manufactured by HSBC’s insurance manufacturing subsidiaries typically comprise features or combinations of features which may not be easily or exactly replicated by investments. Market risk arises when mismatches occur between product liabilities and the investment assets which back them; for example, mismatches between asset and liability yields and maturities give rise to interest rate risk.
Description of market risk(Audited)
The main features of products manufactured by HSBC’s insurance manufacturing subsidiaries which generate market risk, and the market risk to which these features expose the subsidiaries, are discussed below.
Long-term insurance or investment products may incorporate either one investment return guarantee or a combination thereof, divided into the following categories:
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Subsidiaries manufacturing products with guarantees are usually exposed to falls in market interest rates as they result in lower yields on the assets supporting guaranteed investment returns payable to policyholders. In the current market environment, in which interest rates are falling, managing this risk is of increasing importance.
The table below shows, in respect of each category of guarantee, the total liabilities to policyholders established for guaranteed products, the range of investment returns (net of operating costs) implied by the guarantees, and the range of current yields of the investment portfolios supporting the guarantees.
A certain number of these products have been discontinued, including the US$576 million deferred annuity portfolio in HSBC Finance where, as highlighted in the above table, the current portfolio yield is less than the guarantee. On acquisition of this block of business by HSBC Finance, a provision was established to mitigate the shortfall in yields. There has been no further deterioration in the shortfall since acquisition. There are a limited number of additional contracts where the current portfolio yield is less than the guarantee implied by the contract.
The proceeds from insurance and investment products with DPF are primarily invested in bonds with a proportion allocated to equity securities in order to provide customers with the potential for enhanced returns. Subsidiaries with portfolios of
such products are exposed to the risk of falls in the market price of equity securities when they cannot be fully reflected in the discretionary bonuses. An increase in market volatility could also result in an increase in the value of the guarantee to the policyholder.
Long-term insurance and investment products typically permit the policyholder to surrender the policy or let it lapse at any time. When the surrender value is not linked to the value realised from the sale of the associated supporting assets, the subsidiary is exposed to market risk. In particular, when customers seek to surrender their policies when asset values are falling, assets may have to be sold at a loss to fund redemptions.
A subsidiary holding a portfolio of long-term insurance and investment products, especially with
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DPF, may attempt to reduce exposure to its local market by investing in assets in countries other than that in which it is based. These assets may be denominated in currencies other than the subsidiary’s local currency. It is often not cost effective for the subsidiary to hedge the foreign exchange exposure associated with these assets, and this exposes it to the risk that its local currency will strengthen against the currency of the related assets.
For unit-linked contracts, market risk is substantially borne by the policyholder, but HSBC typically remains exposed to market risk as the market value of the linked assets influences the fees HSBC earns for managing them.
How the risks are managed(Audited)
HSBC’s insurance manufacturing subsidiaries manage market risk by using some or all of the following techniques, depending on the nature of the contracts they write:
During 2008, the credit, market and liquidity risk functions in Group Insurance Head Office were strengthened by the creation of two new positions, Chief Credit Officer and Chief Market and Liquidity Risk Officer, both reporting to the Chief Risk Officer. Also, due diligence procedures were enhanced during the current lower yield environment to more critically assess embedded risk in respect of new products, for example, those including options and guarantees within the contract. When such product features are identified, the product proposal is reviewed by Group Insurance Head Office to ensure that the key risks are identified and that the related risk management procedures are adequate. The frequency with which management reviews certain exposures is increased in markets demonstrating increasing volatility to ensure that any matters arising are dealt with in a timely fashion.
Each insurance manufacturing subsidiary is required to have a market risk mandate which specifies the investment instruments in which it is permitted to invest and the maximum quantum of market risk which it is permitted to retain. It is the responsibility of the subsidiary’s ALCO and the Market and Liquidity Risk Committee (subcommittee to the Group Insurance Risk Committee) to ensure that each mandate is consistent with local regulations. All mandates are reviewed and agreed annually by Group Insurance Head Office, and aggregate limits are approved by the Risk Management Meeting of GMB. During 2008, market risk mandates were enhanced in some of the major insurance subsidiaries by introducing stop loss limits and management action limits designed to control risk in certain portfolios.
How the exposures to risks are measured(Audited)
HSBC’s insurance manufacturing subsidiaries monitor exposures against mandated limits regularly and report these quarterly to Group Insurance Head Office. Exposures are aggregated and reported to senior risk management forums in the Group, including the Group Insurance Market and Liquidity Risk Committee, Group Insurance Risk Committee and the Group Stress Test Review Group.
The standard measures used to quantify the market risks are as follows:
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Although these measures are relatively straightforward to calculate and aggregate, there are limitations with them. The most significant limitation is that a parallel shift in yield curves of one basis point does not capture the non-linear relationships between the values of certain assets and liabilities and interest rates. Non-linearity arises, for example, from investment return guarantees and certain product features such as the ability of policyholders to surrender their policies. If the yields on investments held to support contracts with guarantees are less than the investment returns implied by the guarantees, shortfalls will be to the account of HSBC.
HSBC recognises these limitations and augments its standard measures with stress tests which examine the effect of a range of market rate scenarios on the aggregate annual profits and total equity of the insurance manufacturing subsidiaries.
HSBC’s insurance manufacturing subsidiaries report the results of their stress tests every quarter to Group Insurance Head Office, where the reports are consolidated and reviewed by the Group Insurance Market and Liquidity Risk Meeting and the Group Stress Test Review Group.
HSBC’s insurance manufacturing subsidiaries identify the assets and liabilities in their financial statements whose values are sensitive to each category of market risk and revalue them at various market rates. The outcome of the exercise is expressed in terms of the effect on profit for the year and total equity under the stress-tested assumptions, after taking into consideration tax and accounting treatments where material and relevant.
The following table illustrates the effect on the aggregated profit for the year and total equity under various interest rate, equity price, foreign exchange rate and credit spread scenarios. Where appropriate, the impact of the stress on the PVIF is included in the results of the stress tests. The relationship between the values of certain assets and liabilities and the risk factors may be non-linear and, therefore, the results disclosed cannot be extrapolated to measure sensitivities to different levels of stress. The sensitivities are stated before allowance for the effect of management actions which may mitigate changes in market rates, and for any factors such as policyholder behaviour that may change in response to changes in market risk.
Sensitivity of HSBC’s insurance subsidiaries to risk factors (Audited)
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The sensitivity of the net profit after tax of HSBC’s insurance subsidiaries to the effects of increases in credit spreads is a fall of US$73 million (2007: US$15 million fall). The sensitivity is consistent with the other sensitivities noted above, and is calculated using simplified assumptions based on a one-day movement in credit spreads over a two-year period. A confidence level of 99 per cent, consistent with the Group’s VAR, has been applied. The effect of movements in credit spreads became more significant in 2008 due to increased volatility in credit spreads.
Credit risk (Audited)
Credit risk can give rise to losses through default and can lead to volatility in income statement and balance sheet figures through movements in credit spreads, principally on the US$33.2 billion (2007: US$29.8 billion) non-linked bond portfolio. The exposure of the income statement to the effect of changes in credit spreads is small (see the table on page 266). 49 per cent of the financial assets held by insurance subsidiaries are classified as either held to maturity or available for sale, and consequently any changes in the fair value of these financial investments, absent impairment, would have no impact on the profit after tax.
HSBC sells certain unit-linked life insurance contracts which are reinsured with a third-party. These insurance contracts include market return guarantees which are underwritten by the third-party. HSBC is exposed to credit risk to the extent that the third-party (the counterparty) is unable to meet the terms of the guarantees. As highlighted in ‘Market Risk’ above, the cost to the Group of market return guarantees increases when interest rates fall, equity markets fall or market volatility increases. In addition, when determined by reference to a discounted cash flow model in which the discount rate is based on current interest rates, guarantee costs increase in a falling interest rate environment. As a consequence of the rise in these costs, the Group’s counterparty exposure to the guarantees under the reinsurance agreement at 31 December 2008 was greater than at 31 December 2007. During 2008, sales of these contracts ceased, reflecting the adjusted risk appetite of the business.
The exposure to credit risk products and the management of the risks associated with credit protection products are included in the description of life and non-life insurance risk on pages 257 to 258. HSBC’s insurance manufacturing subsidiaries are responsible for the credit risk, quality and performance of their investment portfolios. Investment credit mandates and limits are set by the subsidiaries and approved by their local insurance ALCOs and Credit Risk functions before being submitted to Group Credit Risk for concurrence. The form and content of the mandates must accord with centrally set investment credit risk guidance regarding credit quality, industry sector concentration and liquidity restrictions, but allow for the inclusion of local regulatory and country-specific conditions. The assessment of the creditworthiness of issuers and counterparties is based primarily upon internationally recognised credit ratings and other publicly available information.
Investment credit exposures are monitored against limits by the local insurance manufacturing subsidiaries, and are aggregated and reported to Group Credit Risk, the Group Insurance Credit Risk Meeting and the Group Insurance Risk Committee. Stress testing is performed by Group Insurance Head Office on the investment credit exposures using credit spread sensitivities and default probabilities. The stresses are reported to the Group Insurance Risk Committee.
As noted above, under certain circumstances, the Group is able to dilute the effect of investment losses by sharing them with policyholders. However, when, for example, a contract includes a guarantee, losses which would result in a breach of the guaranteed benefits due to the policyholder are borne by the Group.
In response to adverse credit market conditions, various initiatives were introduced during 2008 to better manage and report credit risk, including an Early Warning Report which is produced on a weekly basis to identify investments which may be at risk of future impairment. This report is circulated to senior management in Group Insurance Head Office and the Regional Chief Risk Officers, and risk reduction strategies are implemented when considered appropriate. Similarly, a watch list of investments with current credit concerns is circulated weekly.
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Credit quality (Audited)
The following table presents an analysis of treasury bills, other eligible bills and debt securities within HSBC’s insurance business by measures of credit quality. The definitions of the four credit quality classifications are included on page 217. Only assets
supporting non-linked liabilities are included in the table as financial risk on assets supporting linked liabilities is predominantly borne by the policyholder. 93.7 per cent (2007: 88.7 per cent) of the assets included in the table are invested in investments rated as ‘Strong’.
Treasury bills, other eligible bills and debt securities in HSBC’s insurance subsidiaries (Audited)
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Issuers of treasury bills, other eligible bills and debt securities in HSBC’s insurance subsidiaries (Audited)
Credit risk also arises when part of the insurance risk incurred by HSBC is assumed by reinsurers. The credit risk exposure to reinsurers is monitored by Group Insurance Head Office and is reported quarterly to the Group Insurance Risk Committee and the Group Insurance Credit Risk Meeting.
The split of liabilities ceded to reinsurers and outstanding reinsurance recoveries, analysed by Standard & Poor’s reinsurance credit rating data or their equivalent, is shown below. The Group’s exposure to third parties under the reinsurance agreement described in the Credit Risk section above is included in this table.
Reinsurers’ share of liabilities under insurance contracts (Audited)
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Liquidity risk (Audited)
It is an inherent characteristic of almost all insurance contracts that there is uncertainty over the amount of claims liabilities that may arise, and the timing of their settlement and this leads to liquidity risk.
To fund the cash outflows arising from claims liabilities, HSBC’s insurance manufacturing subsidiaries primarily utilise liquidity from the following sources:
HSBC’s insurance manufacturing subsidiaries manage liquidity risk by utilising some or all of the following techniques:
Every quarter, HSBC’s insurance manufacturing subsidiaries are required to complete and submit liquidity risk reports to Group Insurance Head Office for collation and review by the Group Insurance Market and Liquidity Risk Meeting. Liquidity risk is assessed in these reports by measuring changes in expected cumulative net cash flows under a series of stress scenarios designed to determine the effect of reducing expected available liquidity and accelerating cash outflows. This is achieved by, for example, assuming new business or renewals are lower, and surrenders or lapses are greater, than expected.
The following tables show the expected undiscounted cash flows for insurance contract liabilities and the remaining contractual maturity of investment contract liabilities at 31 December 2008. As indicated in the analyses of life and non-life insurance risks on pages 257 to 258, a significant proportion of the Group’s non-life insurance business is viewed as short term, with the settlement of liabilities expected to occur within one year of the period of risk. There is a greater spread of expected maturities for the life business where, in a large proportion of cases, the liquidity risk is borne in conjunction with policyholders (wholly in the case of unit-linked business).
The profile of the expected maturity of the insurance contracts as at 31 December 2008 remained comparable with 2007.
Expected maturity of insurance contract liabilities (Audited)
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Remaining contractual maturity of investment contract liabilities(Audited)
Present value of in-force long-term insurance business(Audited)
The HSBC life insurance business is accounted for using the embedded value approach which, inter alia, provides a comprehensive framework for the evaluation of insurance and related risks. The present value of the in-force long-term (‘PVIF’) asset at 31 December 2008 was US$2.0 billion (2007: US$2.0 billion). The present value of the shareholders’ interest in the profits expected to emerge from the book of in-force policies at 31 December can be stress-tested to assess the ability of the life business book to withstand adverse developments. A key feature of the life insurance business is the importance of managing the assets, liabilities and risks in a coordinated fashion rather than individually. This reflects the greater interdependence of these three elements for life insurance than is generally the case for non-life insurance.
The following table shows the effect on the PVIF of reasonably possible changes in the main economic assumptions, namely the risk-free and risk discount rates, across all insurance manufacturing subsidiaries.
Sensitivity of PVIF to changes in economic assumptions(Audited)
Due to certain characteristics of the contracts, the relationships may be non-linear and the results of the stress-testing disclosed above should not be extrapolated to higher levels of stress. In calculating the various scenarios, all assumptions are held stable except when testing the effect of the shift in the risk-free rate, when consequential changes to investment returns, risk discount rates and bonus rates are also incorporated. The sensitivities shown are before actions that could be taken by management to mitigate effects and before consequential changes in policyholder behaviour.
The following table shows the movements recorded during the year in respect of total equity and PVIF of insurance operations:
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Movements in total equity and PVIF of insurance operations(Audited)
Non-economic assumptions(Audited)
The policyholder liabilities and PVIF are determined by reference to non-economic assumptions which include, for non-life manufacturers, claims costs and expense rates and, for life manufacturers, mortality and/or morbidity, lapse rates and expense rates. The table below shows the sensitivity of profit for the year to, and total equity at, 31 December 2008 to reasonably possible changes in these non-economic assumptions at that date across all insurance manufacturing subsidiaries, with comparatives for 2007.
The cost of claims is a risk associated with non-life insurance business. An increase in claims costs would have a negative effect on profit. The main exposures to this scenario are in the UK, Hong Kong and Latin America.
Mortality and morbidity risk is typically associated with life insurance contracts. The effect of an increase in mortality or morbidity on profit depends on the type of business being written. For a portfolio of term assurance contracts, an increase in mortality usually has a negative effect on profit as the number of claims increases. For a portfolio of annuity contracts, an increase in mortality rates typically has a positive effect on profit as the period
over which the benefit is being paid to the policyholder is shortened. However, when an annuity contract includes life cover, the positive effect on profit of the increase in mortality may be offset by the benefits payable under the life insurance. The largest exposures to mortality and morbidity risk exist in France, Hong Kong and the UK.
Sensitivity to lapse rates is dependent on the type of contracts being written. For insurance contracts, the cost of claims is funded by premiums received and income earned on the investment portfolio supporting the liabilities. For a portfolio of term assurance, an increase in lapse rates typically has a negative effect on profit due to the loss of future premium income on the lapsed policies. For a portfolio of annuity contracts, an increase in lapse rates has a positive effect on profit as the obligation to pay future benefits on the lapsed contracts is extinguished. France, Hong Kong and the UK are the sites which are most sensitive to a change in lapse rates.
Expense rate risk is the exposure to a change in expense rates. To the extent that increased expenses cannot be passed on to policyholders, an increase in expense rates will have a negative impact on profits.
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Sensitivity analysis(Audited)
HSBC’s capital management approach is driven by its strategy and organisational requirements, taking into account the regulatory, economic 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. Through its structured internal governance processes, HSBC also maintains 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 actual market stresses which occurred throughout the financial system in 2008 have been used to inform capital planning and further develop the stress scenarios employed by the Group. The Group has identified the following as being the material risks faced and managed through the Capital Management Framework; credit, market, operational, interest rate risk in the banking book, pension fund, residual and insurance risks. All of these risks pose a significantly greater challenge in severe downturn economic conditions and the management response to these risks has, correspondingly, been intensified.
During 2008, with the Group now operating under Basel II, it targeted a tier 1 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. For 2009 onwards, in light of revised market expectations on capital strength and higher volatility of capital requirements resulting from procyclicality embedded within the Basel II rules, the upper end of the target tier 1 range is being
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extended to 10 per cent.
HSBC’s capital management process continues to stress the advantages and flexibility afforded by a strong capital position and, through its policies, seeks to maintain a conservative stance with regard to equity leverage.
The Capital Management Framework covers the different capital measures within which HSBC manages its capital in a consistent and aligned manner. These include 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 deemed necessary 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.
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 the 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(Audited)
In June 2006, the Basel Committee on Banking Supervision published ‘International Convergence of Capital Measurement and Capital Standards’, known as Basel II. 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.
The FSA supervises HSBC on a consolidated basis and therefore 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.
Various limits are applied to elements of the capital base. The amount of innovative tier 1 securities cannot exceed 15 per cent of overall tier 1 capital, qualifying tier 2 capital cannot exceed tier 1 capital, and qualifying term subordinated loan capital cannot exceed 50 per cent of tier 1 capital.
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There are also limitations on the amount of collective impairment allowances which may be included as part of tier 2 capital. For regulatory purposes, banking associates are proportionally consolidated, rather than being recognised using the equity method used for financial reporting.
The carrying amounts of investments in the capital of banks that exceed certain limits and the excess of expected losses over impairment allowances are deducted 50 per cent from each of tier 1 and tier 2 capital in the published disclosures. This also applies to deductions of investments in insurance subsidiaries and associates, but the FSA has granted a transitional provision, until 31 December 2012, under which those insurance investments that were acquired before 20 July 2006 may be deducted from the total of tier 1 and tier 2 capital instead. HSBC has elected to apply this transitional provision.
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 core equity 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 by the adoption of through-the-cycle, downturn and stressed conditions that may not exist at the balance sheet 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. As expected losses are based on long-term estimates and incorporate through-the-cycle considerations, they are expected to be less volatile than actual loss experience. 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 auditor. Verification procedures covering profits for the year to 31 December 2008 were completed by the external auditor on 2 March 2009 and therefore these profits have been included in the Group’s 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.
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 (‘LGD’) estimates 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. The regulatory measure of expected losses is calculated by multiplying PD by EAD 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 for the majority of its business with effect from 1 January 2008, with the remainder on either IRB foundation or standardised approaches. For consolidated group reporting, the FSA’s rules permit the use of other regulators’ standardised approaches where they are considered equivalent. The use of other regulators’ IRB approaches is subject to the agreement of the FSA. A rollout plan, over the next few years, is in place to extend coverage of the advanced approaches, for both local and consolidated Group
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reporting, leaving a small residue of exposures on the standardised approach.
Market risk is derived from fluctuations on trading book assets arising from changes in values, income, interest and foreign exchange rates and is measured using VAR models with FSA permission or the standard rules prescribed by the FSA. Counterparty credit risk in the trading book and the non-trading book is the risk that the counterparty to a transaction may default before completing the satisfactory settlement of the transaction. Three counterparty credit risk calculation approaches are defined by Basel II to determine exposure values, being the standardised, mark to market and the internal model method. These exposure values are then used to determine capital requirements using one of the credit risk approaches, standardised, IRB foundation and IRB advanced. Across the Group, HSBC uses both VAR and standard rules approaches for market risk and the mark to market and internal model method approaches for counterparty credit risk. It is the longer-term aim of HSBC to migrate more positions from standard rules to VAR for market risk and from mark to market to internal model method for counterparty credit risk.
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. Both these approaches use an average of the last three financial years’ revenues. Finally, the advanced measurement approach uses banks’ own statistical analysis and modelling of operational risk data to determine capital requirements. HSBC has adopted the standardised approach to the determination of Group operational risk capital requirements.
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 the levels of capital that it needs to hold. The pillar 2 process culminates in the FSA providing firms with Individual Capital Guidance (‘ICG’). The ICG replaces the trigger ratio and is set as a capital resources requirement higher than that required under pillar 1.
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. On 10 November 2008, HSBC published summary qualitative pillar 3 disclosures (‘Interim Pillar 3 Disclosures 2008’) for 30 June 2008 on the investor relations section of its website, www.hsbc.com. HSBC expects to publish the first full set of pillar 3 disclosures for 31 December 2008, including quantitative tables, during the first half of 2009.
During 2007, HSBC was supervised under Basel I. Under Basel I, banking operations are categorised as either trading book or banking book and risk-weighted assets are determined accordingly. Banking book risk-weighted assets are measured by means of a hierarchy of risk weightings classified according to the nature of each asset and counterparty, taking into account any eligible collateral or guarantees. Banking book off-balance sheet items giving rise to credit, foreign exchange or interest rate risk are assigned weights appropriate to the category of the counterparty, taking into account any eligible collateral or guarantees. Trading book risk-weighted assets are determined by taking into account market-related risks such as foreign exchange, interest rate and equity position risks, and counterparty risk.
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Movement in tier 1 capital(Audited)
HSBC complied with the FSA’s capital adequacy requirements throughout 2008 and 2007. Opening tier 1 capital at 1 January 2008 was reduced by US$3.3 billion arising from the transition to Basel II. Profits attributable to shareholders of the parent company of US$5.7 billion included goodwill write-offs of US$10.6 billion and profits from own credit spread, net of deferred tax, of US$4.7 billion, neither of which impact regulatory capital. The resulting contribution to tier 1 capital was therefore US$11.6 billion. Dividends to shareholders of US$11.3 billion were partly offset by shares issued, including those issued in lieu of dividends, of US$4.1 billion and innovative tier 1 securities issued of US$2.1 billion. The strengthening US dollar caused foreign currency translation differences, mainly on the investment in non-US dollar subsidiaries, which reduced tier 1 capital by US$11.8 billion.
Movement in risk-weighted assets(Unaudited)
Total RWAs increased by US$24 billion. The transition to Basel II at 1 January 2008 increased RWAs by US$41 billion, meaning that RWAs on a Basel II basis fell by US$17 billion during the year. Foreign exchange translation effects are estimated to have reduced RWAs by US$80 billion, again a result of the strengthening US dollar, particularly against sterling, resulting in an estimated underlying increase of US$63 billion. Of this underlying increase, US$26 billion was due to credit and counterparty risk RWAs, reflecting decreases in North America being more than offset by increases in both Europe and Asia. Market risk RWAs increased by US$24 billion primarily due to the impact of market volatility. Operational risk RWAs increased by US$13 billion because the three year averaging of gross revenues used in the calculation now includes revenues for 2008 in place of 2005.
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Risk-weighted assets by principal subsidiary(Unaudited)
In order to give an indication of how HSBC’s capital is deployed, the table below analyses the disposition
of risk-weighted assets by principal subsidiary. The risk-weighted assets are calculated using FSA rules and exclude intra-HSBC items.
Risk-weighted assets by principal subsidiary (Unaudited)
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Mr Robertson brings to the Board a background in international corporate advisory with a wealth of experience in mergers and acquisitions, merchant banking, investment banking and financial markets. During his career he has worked in France, Germany, the UK and the USA.
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Age 58. Group Company Secretary. Appointed a Group General Manager in 2006. Joined HSBC in 1980. Company Secretary of HSBC Holdings plc since 1990. Chairman of the Disclosure Committee. A member of the Listing Authority Advisory Committee of the Financial Services Authority and of the Primary Markets Group of the London Stock Exchange. Corporation Secretary of The Hongkong and Shanghai Banking Corporation Limited from 1986 to 1992 and Company Secretary of HSBC Bank plc from 1994 to 1996.
Age 62. An Adviser to the Board since 1998. Solicitor. A former partner in Norton Rose. A Director of The Bank of Bermuda Limited and HSBC Private Banking Holdings (Suisse) SA. A non-executive Director of Kowloon Development Company Limited and Shui On Land Limited.
Age 52. Group Head of Human Resources. A Group Managing Director since 25 February 2008. Joined HSBC in 1992. Appointed a Group General Manager in June 2007. Global Head of Human Resources for Global Banking and Markets, Private Banking, Global Transaction Banking and HSBC Amanah from 1996 to June 2007.
E Alonso
Age 53. Group Managing Director and Head of HSBC Latin America and the Caribbean. A Group Managing Director since 1 May 2008. Joined HSBC in 1997. Appointed a Group General Manager in 2006. Chairman Grupo Financiero HSBC, S.A. de C.V. and HSBC México, S.A., Institución de Banca Múltiple, Grupo Financiero HSBC. Deputy Chief Executive of HSBC Investment Bank Brasil S.A. – Banco de Investimento. Director of HSBC Argentina Holdings S.A. and HSBC Bank Brasil S.A. – Banco Múltiplo. Managing Director of HSBC (Brasil) Administradora de Consorcio Ltda. and HSBC Serviços e Participaçoes Ltda. President of the Board of Directors of HSBC Bank (Panamá) S.A.
C C R Bannister
Age 50. Group Managing Director, Insurance. A Group Managing Director since 2006. Joined HSBC in 1994. Chairman of HSBC Insurance Holdings Limited and Director of HSBC Insurance Brokers Limited since 16 January 2009. Chief Executive Officer, HSBC Group Private Banking from 1998 to 2006. Deputy Chief Executive Officer, HSBC Securities (USA) Inc. from 1996 to 1997.
K M Harvey
Age 48. Group Chief Technology and Services Officer. A Group Managing Director since 1 October 2008. Joined HSBC Finance in 1989. Group Chief Information Officer from 2004 to 30 September 2008. President of HSBC Technology and Services (USA) Inc. from 2003 to 2004. Group Executive for HSBC North America from 1993 to 2002. Managing Director of Data Processing, HFC Bank Limited from 1992 to 1993. Director of Banking Systems, HSBC North America from 1990 to 1992.
A C Hungate
Age 42. Global Head of Personal Financial Services and Marketing. Joined HSBC as a Group Managing Director in September 2007. Chairman of HSBC Bank A.S. since 6 January 2009. Formerly Managing Director, Asia Pacific at Reuters. Worldwide Chief Marketing Officer of Reuters between 2002 and 2005.
D D J John
Age 58. Deputy Chairman and Chief Executive, HSBC Bank plc. A Group Managing Director since 2006. Joined HSBC Bank plc in 1971. Deputy Chief Executive of HSBC Bank plc from 2005 to 2006 and Chief Operating Officer from 2003 to 2005. Deputy Chairman and Chief Executive Officer, HSBC Bank Malaysia Berhad from 1999 to 2002.
B P McDonagh
Age 50. Chief Executive Officer, HSBC North America Holdings Inc. A Group Managing Director since 21 February 2008. Joined HSBC in 1979. A Director of HSBC Bank Canada, HSBC Finance Corporation, HSBC Latin America Holdings (UK) Limited and HSBC North America Holdings Inc. Chief Executive Officer, HSBC Finance Corporation and Chief Operating Officer of HSBC North America Holdings Inc. from February 2007 to 21 February 2008. Chief Operating Officer, HSBC Bank USA, N.A. from 2004 to 2006.
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Y A Nasr
Age 54. Group Managing Director, Strategic Investments. Chairman and Chief Executive of HSBC Bank Middle East Limited. A Group Managing Director since 2004. Joined HSBC in 1976. Deputy Chairman of HSBC Bank Egypt S.A.E. and a Director of HSBC Private Banking Holdings (Suisse) SA. Deputy Chairman of HSBC Bank Middle East Limited from May 2007 to 1 December 2008. President, HSBC Bank Brasil S.A. – Banco Múltiplo from 2003 to 2006. President and Chief Executive Officer of HSBC USA Inc. and HSBC Bank USA, N.A. from 1999 to 2003. President and Chief Executive Officer of HSBC Bank Canada from 1997 to 1999.
B Robertson
Age 54. Group Chief Risk Officer. A Group Managing Director since 25 February 2008. Joined HSBC in 1975. Appointed a Group General Manager in 2003. Group General Manager, Group Credit and Risk from 2005 to September 2007. Head of Global Banking and Markets for North America from 2003 to 2005.
P A Thurston
Age 55. Managing Director, UK Banking. A Group Managing Director since 1 May 2008. Joined HSBC in 1975. Appointed a Group General Manager in 2003. A Director of HSBC Bank plc since 1 June 2008. Former Chairman of Grupo Financiero HSBC, S.A. de C.V. and former Chief Executive Officer of HSBC México, S.A., Institución de Banca Múltiple, Grupo Financiero HSBC.
Age 48. Chief Executive Officer, HSBC Turkey. Joined HSBC in 1990. Appointed a Group General Manager in 2005.
S Assaf
Age 48. Head of Global Markets. Joined HSBC in 1994. Appointed a Group General Manager on 29 May 2008.
R S Beck
Age 42. Group General Manager, Communications Director. Joined HSBC in 1989. Appointed a Group General Manager on 29 May 2008.
R E T Bennett
Age 57. Group General Manager, Legal and Compliance. Joined HSBC in 1979. Appointed a Group General Manager in 1998.
N S K Booker
Age 50. Chief Executive Officer, HSBC Finance Corporation and Deputy Chief Executive Officer, HSBC North America Holdings Inc. Joined HSBC in 1981. Appointed a Group General Manager in 2004.
P W Boyles
Age 53. Chief Executive Officer, HSBC France. Joined HSBC in 1975. Appointed a Group General Manager in 2006.
D C Budd
Age 55. Chairman of HFC Bank Limited and a Director of HSBC Bank plc. Joined HSBC in 1972. Appointed a Group General Manager in 2005.
Z J Cama
Age 61. Group General Manager International. Joined HSBC in 1968. Appointed a Group General Manager in 2001.
R P Contractor
Age 51. Group General Manager, Service Delivery. Joined HSBC in 1987. Appointed a Group General Manager on 27 October 2008.
S N Cooper
Age 41. President and Chief Executive Officer, HSBC Korea. Joined HSBC in 1989. Appointed a Group General Manager on 29 May 2008.
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J E Coverdale
Age 52. Managing Director, The Saudi British Bank. Joined HSBC in 1977. Appointed a Group General Manager on 29 May 2008.
T M Detelich
Age 52. President, Consumer and Mortgage Lending, HSBC Finance Corporation. Joined HSBC Finance Corporation in 1976. Appointed a Group General Manager in 2006.
I M Dorner
Age 54. Deputy Chairman and Chief Executive Officer, HSBC Bank Malaysia Berhad. Joined HSBC in 1986. Appointed a Group General Manager in 2007.
A S El Anwar
Age 62. Chairman and Chief Executive Officer, HSBC Bank Egypt S.A.E. Joined HSBC in 1991. Appointed a Group General Manager on 29 May 2008.
C Engel
Age 51. Regional Director Personal Financial Services, HSBC Asia Pacific. Joined HSBC in 2003. Appointed a Group General Manager on 29 May 2008.
D L Fried
Age 47. Regional Head of Insurance, HSBC Asia Pacific. Joined HSBC in 1984. Appointed a Group General Manager on 29 May 2008.
A Y M Fung
Age 48. Head of Global Markets and Treasurer, HSBC Asia Pacific. Joined HSBC in 1996. Appointed a Group General Manager on 29 May 2008.
J D Garner
Age 39. Group General Manager, Personal Financial Services and Direct Businesses, HSBC Bank plc. Joined HSBC in 2004. Appointed a Group General Manager in 2006.
J L Gordon
Age 56. President and Chief Executive Officer, HSBC Bank Canada. Joined HSBC in 1987. Appointed a Group General Manager in 2005.
M Hussain
Age 48. Chief Executive Officer, Global HSBC Amanah and Global Banking and Markets, Middle East and North Africa. Joined HSBC in 1993. Appointed a Group General Manager on 29 May 2008.
A M Keir
Age 50. Group General Manager, Commercial Banking, HSBC Europe and Global Co-Head Commercial Banking. Joined HSBC in 1981. Appointed a Group General Manager in 2006.
N L Kidwai
Age 51. Chief Executive Officer, HSBC India. Joined HSBC in 2002. Appointed a Group General Manager in 2006.
M J W King
Age 52. Group General Manager, Internal Audit. Joined HSBC in 1986. Appointed a Group General Manager in 2002.
P J Lawrence
Age 47. Head of Global Banking and Markets, HSBC USA. President and Chief Executive Officer, HSBC Bank USA, N.A. and HSBC USA Inc. Director of HSBC North America Holdings Inc. Joined HSBC in 1982. Appointed a Group General Manager in 2005.
M Leung
Age 56. Global Co-Head Commercial Banking. Joined HSBC in 1978. Appointed a Group General Manager in 2005.
A Long
Age 53. Head of Global Transaction Banking. Joined HSBC in 1977. Appointed a Group General Manager on 29 May 2008.
A M Losada
Age 54. President and Chief Executive Officer, HSBC Argentina. Joined HSBC in 1973. Appointed a Group General Manager on 29 May 2008
A M Mahoney
Age 46. Group General Manager and Head of International, HSBC Bank plc. Joined HSBC in 1983. Appointed a Group General Manager in 2006.
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C M Meares
Age 51. Chief Executive Officer, Global Private Banking. Joined HSBC in 1980. Appointed a Group General Manager in 2006.
W G Menezes
Age 63. Group General Manager and Head of Group Cards. Joined HSBC Finance Corporation in 1996. Appointed a Group General Manager in 2006.
M S McCombe
Age 42. Global Chief Executive Officer, HSBC Global Asset Management. Joined HSBC in 1987. Appointed a Group General Manager on 29 May 2008.
K Newman
Age 51. Director of One HSBC. Joined HSBC in 1989. Appointed a Group General Manager in 2006.
R C F Or
Age 59. Vice-Chairman and Chief Executive, Hang Seng Bank Limited. A Director of The Hongkong and Shanghai Banking Corporation Limited. Joined HSBC in 1972. Appointed a Group General Manager in 2000.
K Patel
Age 60. Group General Manager, Chief Executive Officer, HSBC Africa. Joined HSBC in 1984.
Appointed a Group General Manager in 2000. Chairman, Emerging Europe and Africa from 2003 to 2006. Chairman, Global Investment Bank from 2000 to 2003.
L J Peña-Kegel
Age 49. Chief Executive, HSBC Mexico S.A. Joined HSBC on 15 May 2008. Appointed a Group General Manager on 29 May 2008.
R C Picot
Age 51. Group Chief Accounting Officer. Joined HSBC in 1993. Appointed a Group General Manager in 2003.
C D Spooner
Age 58. Head of Group Financial Planning & Tax. Joined HSBC in 1994. Appointed a Group General Manager in 2007.
P T S Wong
Age 57. Executive Director, Hong Kong and Mainland China, The Hongkong and Shanghai Banking Corporation Limited. Joined HSBC in 2005. Appointed a Group General Manager in 2005.
R J L Yorke
Age 41. President and Chief Executive Officer, HSBC China. Joined HSBC in 1989. Appointed a Group General Manager on 29 May 2008.
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Report of the Directors: Governance (continued)
The objective of the management structures within HSBC, headed by the Board of Directors of HSBC Holdings and led by the Group Chairman, is to deliver sustainable value to shareholders. Implementation of the strategy set by the Board is delegated to the Group Management Board under the leadership of the Group Chief Executive.
HSBC Holdings has a unitary Board of Directors. The authority of each Director is exercised in Board Meetings where the Board acts collectively as a unit. At 2 March 2009, the Board comprises the Group Chairman, Group Chief Executive, four other executive Directors and 15 non-executive Directors. The names and brief biographical particulars of the Directors are listed on pages 281 to 285. The Group Chairman, Group Chief Executive and four other executive Directors are employees who carry out executive functions in HSBC in addition to their duties as Directors. Non-executive Directors are not HSBC employees and do not participate in the daily business management of HSBC. Non-executive Directors bring an external perspective, constructively challenge and help develop proposals on strategy, scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. The non-executive Directors have a wealth of experience across a number of industries and business sectors, including the leadership of large, complex multinational enterprises. The roles of non-executive Directors as members of Board committees are described on pages 290 to 291. It is estimated that non-executive Directors devote 24 days per annum to HSBC business after an induction phase, with Committee members devoting significant additional time.
The Board is responsible for managing the business of HSBC Holdings and, in doing so, may exercise all of the powers of HSBC Holdings, subject to any relevant laws and regulations and to the Memorandum and Articles of Association. In particular, the Board may exercise all the powers of the Company to borrow money and to mortgage or charge all or any part of the undertaking, property or assets (present and future) of HSBC Holdings and may also exercise any of the powers conferred on it by the Companies Act 1985 and Companies Act 2006 (as appropriate) and/or by shareholders. The Board is able to delegate and confer on certain Directors holding executive office any of its powers, authorities and discretions (including the power to sub-delegate) for such time and on such terms as it
thinks fit. In addition, the Board may establish any local or divisional boards or agencies for managing the business of HSBC Holdings in any specified locality and delegate and confer on any local or divisional board, manager or agent so appointed any of its powers, authorities and discretions (including the power to sub-delegate) for such time and on such terms as it thinks fit. The Board may also, by power of attorney or otherwise, appoint any person or persons to be the agent of HSBC Holdings and may delegate to any such person or persons any of its powers, authorities and discretions (including the power to sub-delegate) for such time and on such terms as it thinks fit.
The Board sets the strategy for the Group and approves the operating plans presented by management for the achievement of the strategic objectives. The operating plans ensure the efficient disposition of HSBC’s resources for the achievement of these objectives. The Board delegates the management and day-to-day running of HSBC to the Group Management Board but retains to itself approval of certain matters including operating plans and performance targets, procedures for monitoring and control of operations, the authority or the delegation of authority to approve credit, market risk limits, acquisitions, disposals, investments, capital expenditure or realisation or creation of a new venture, specified senior appointments, and any substantial change in balance sheet management policy.
The Directors who served during the year were, Lord Butler, S A Catz, V H C Cheng, J D Coombe, Baroness Dunn, J L Durán, R A Fairhead, D J Flint, A A Flockhart, W K L Fung, M F Geoghegan, S K Green, S T Gulliver, J W J Hughes-Hallett, W S H Laidlaw, J R Lomax, Sir Brian Moffat, Sir Mark Moody-Stuart, G Morgan, N R N Murthy, S W Newton, S M Robertson, J L Thornton and Sir Brian Williamson.
The Board of Directors meets regularly and Directors receive information between meetings about the activities of committees and developments in HSBC’s business.
Eight Board meetings were held during 2008. The table that follows gives details of each Director’s attendance at meetings of the Board, Group Audit Committee, Nomination Committee and Remuneration Committee held whilst he or she was a Director or member during 2008.
During 2008, the non-executive Directors and the Group Chairman met twice without the other executive Directors. In addition, the non-executive
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Directors met once without the Group Chairman to appraise the Group Chairman’s performance.
In addition to the meetings of the principal Committees referred to in the following pages,
12 other meetings of Committees of the Board (not shown in the table below) were held during the year to discharge business delegated by the Board.
All those who were Directors at the time attended the 2008 Annual General Meeting.
Group Chairman and Group Chief Executive
The roles of Group Chairman and Group Chief Executive are separated and held by experienced full-time Directors.
There is a clear division of responsibilities at the head of the Company between the running of the Board and the executive responsibility for running HSBC’s business. The Group Chairman’s responsibilities include the long-term strategic development of HSBC, the development of relationships with governments and other significant external parties and performance management of the Group Chief Executive. The Group Chairman also monitors the performance of the Group Finance Director and, subject to the Group Chief Executive’s
recommendation, approves risk, capital allocation and capital investment decisions within authorities delegated by the Board. The Group Chief Executive has responsibility for developing business plans and delivering performance against these.
S K Green became Group Chairman at the conclusion of the Annual General Meeting in 2006 and M F Geoghegan succeeded S K Green as Group Chief Executive. The appointments were made after consulting with representatives of major institutional investors and explaining the succession planning and independent external search process undertaken. S K Green and M F Geoghegan stood for re-election at the 2006 Annual General Meeting and were both
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re-elected ahead of taking up their new roles from the conclusion of that Meeting.
Board balance and independence of Directors
The Board includes a strong presence of both executive and non-executive Directors such that no individual or small group can dominate the Board’s decision making. Following the 2009 Annual General Meeting, the Board will comprise 21 Directors, 14 of whom are independent non-executive Directors. The size of the Board is appropriate given the complexity and geographical spread of HSBC’s business and the significant time demands placed on the non-executive Directors, particularly those who serve as members of Board committees.
The Board has appointed S M Robertson as the senior independent non-executive Director. The principal role of the senior independent non-executive Director is to support the Group Chairman in his role, to lead the non-executive Directors in the oversight of the Group Chairman and to ensure there is a clear division of responsibility between the Group Chairman and Group Chief Executive. The senior independent non-executive Director is also available to shareholders to express concerns which the normal channels have failed to resolve or would be inappropriate.
The Board considers all of the non-executive Directors to be independent in character and judgement. W K L Fung has served on the Board for more than nine years, however, and in that respect only, does not meet the usual criteria for independence set out in the UK Combined Code on corporate governance. The Board has therefore determined S A Catz, M K T Cheung (appointed a Director with effect from 1 February 2009), J D Coombe, J L Durán, R A Fairhead, J W J Hughes-Hallett, W S H Laidlaw, J R Lomax, Sir Mark Moody-Stuart, G Morgan, N R N Murthy, S M Robertson, J L Thornton and Sir Brian Williamson to be independent. In reaching its determination of each non-executive Director’s independence the Board has concluded that there are no relationships or circumstances which are likely to affect a Director’s judgement and any relationships or circumstances which could appear to do so were considered not to be material.
When determining independence the Board considers that calculation of the length of service of a non-executive Director begins on the date of his or her first election by shareholders as a Director of HSBC Holdings. Given the complexity and geographical spread of HSBC’s business, the
experience of previous service on a subsidiary company Board can be a considerable benefit to HSBC and does not detract from a Director’s independence.
In accordance with the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited, each non-executive Director determined by the Board to be independent has provided an annual confirmation of his or her independence to HSBC Holdings.
Information, induction and ongoing development
The Board regularly reviews reports on progress against financial objectives, on business developments and on investor and external relations and receives reports from the Chairmen of Board Committees and from the Group Chief Executive. The Board receives regular reports and presentations on strategy and developments in the customer groups and principal geographical areas. Regular reports are also provided to the Board, the Group Audit Committee and the Group Management Board on credit exposures and the loan portfolio, asset, liability and risk management, liquidity, litigation and compliance and reputational issues. The agenda and supporting papers are distributed in advance of all Board and Committee meetings to allow time for appropriate review and to facilitate full discussion at the meetings. All Directors have full and timely access to all relevant information and may take independent professional advice if necessary.
The Directors have free and open contact with management at all levels. Group Managing Directors and Group General Managers meet informally with Directors after Board meetings. Board offsite visits are made each year to enable Directors to see at first hand the operations of subsidiary companies in local environments and to meet management, employees and customers. In 2008 the Board visited Dubai.
Full, formal and tailored induction programmes, with particular emphasis on internal controls, are arranged for newly appointed Directors. The programmes consist of a series of meetings with other Directors and senior executives to enable new Directors to receive information and familiarise themselves with HSBC’s strategy, operations and internal controls. Prior to their appointment, each Director receives comprehensive guidance on the duties and liabilities of a Director of HSBC Holdings. Opportunities to update and develop skills and knowledge, through externally run seminars and
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through briefings by senior executives, are provided to all Directors.
Performance evaluation
In November 2008, ICSA Board Evaluation Limited was commissioned to assist S K Green, Group Chairman, in conducting an evaluation of the effectiveness of the Board. This followed ICSA’s evaluation of the Board in 2007. His evaluation investigated the performance of the Board as a whole and, in that context, the main Board committees and individual Directors. The evaluation examined whether eight key areas met the Board’s needs and expectations: Board role and responsibilities; oversight; Board meetings; information received; support for the Board; Board composition; working together; and outcome and achievements. The report on the evaluation has been reviewed by the Board and has been used by the non-executive Directors, led by the senior independent non-executive Director, in their evaluation of the performance of the Group Chairman. The review concluded that the Board and its committees were functioning effectively. It is the intention of the Board of HSBC Holdings to continue to review its performance and that of its Directors annually.
Appointment, retirement and re-election of Directors
The Board may at any time appoint any person who is willing to act as a Director, either to fill a vacancy or as an addition to the existing Board, but the total number of Directors shall not exceed twenty-five. Any Director so appointed by the Board shall retire at the Annual General Meeting following his or her appointment and shall be eligible for re-election but is not taken into account in determining the number of Directors who are to retire by rotation at such meeting. The Board may appoint any Director to hold any employment or executive office and may revoke or terminate any such appointment. Shareholders may, by ordinary resolution, appoint a person as a Director or remove any Director before the expiration of his period of office. At each Annual General Meeting, one third of the Directors who are subject to retirement by rotation are required to retire and may offer themselves for re-election by shareholders. In addition to those required to retire by rotation, any Director who was not elected or re-elected at either of the preceding two Annual General Meetings and any non-executive Director who has served in office for a continuous period of nine years or more at the date of the Annual General Meeting is required to retire and may offer him or herself for reelection by shareholders.
J L Durán and W S H Laidlaw were appointed non-executive Directors on 1 January 2008.
V H C Cheng was appointed an executive Director on 1 February 2008. On 1 May 2008 A A Flockhart and S T Gulliver were appointed executive Directors and S A Catz and N R N Murthy were appointed non-executive Directors. Lord Butler, Baroness Dunn and Sir Brian Moffat retired as Directors at the conclusion of the Annual General Meeting held on 30 May 2008. S W Newton retired as a Director on 10 October 2008. J R Lomax and J L Thornton were appointed non-executive Directors on 1 December 2008. M K T Cheung was appointed a non-executive Director on 1 February 2009.
All of the Directors will retire at the forthcoming Annual General Meeting and offer themselves for re-election. None of the non-executive Directors seeking re-election has a service contract. All of the executive Directors seeking re-election are employed on rolling contracts which require 12 months’ notice to be given by either party.
Following the performance evaluation of the Board, the Group Chairman has confirmed that all of the non-executive Directors continue to perform effectively and to demonstrate commitment to their roles.
Brief biographical particulars of all Directors are given on pages 281 to 285.
Relations with shareholders
The Board ensures all Directors, including non-executive Directors, develop an understanding of the views of major shareholders through attendance at analyst presentations and other meetings with institutional investors and their representative bodies. Directors also met with representatives of institutional shareholders in 2008 to discuss corporate governance matters.
All executive Directors and other senior executives hold regular meetings with institutional investors and report to the Board on those meetings.
Institutional shareholders were consulted on the framework of Directors’ remuneration and the proposed changes to the HSBC Share Plan which were approved at the 2008 Annual General Meeting.
During 2008, S M Robertson, senior independent non-executive Director, Sir Mark Moody-Stuart and other non-executive Directors met and corresponded with institutional investors and their representatives to discuss strategy, remuneration policy and governance. S M Robertson, the senior independent non-executive Director is also available to shareholders
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should they have concerns which contact through the normal channels of Group Chairman, Group Chief Executive, Group Finance Director or other executives has failed to resolve or for which such contact would be inappropriate. Invitations to meet S M Robertson prior to his appointment as senior independent non-executive Director were extended to the Group’s largest shareholders. The senior independent non-executive Director may be contacted through the Group Company Secretary at 8 Canada Square, London E14 5HQ.
Conflicts of interest, indemnification of Directors, relevant audit information and contracts of significance
One of the amendments to HSBC Holdings’ Articles of Association approved by shareholders at the 2008 Annual General Meeting gave the Board authority, with effect from 1 October 2008, to approve Directors’ conflicts and potential conflicts of interest. The Board has adopted a policy and procedures for the approval of Director’s conflicts or potential conflicts of interest. The Board’s powers to authorise conflicts are operating effectively and the procedures are being followed. A review of situational conflicts which have been authorised, including the terms of authorisation, will be undertaken annually.
The Articles of Association of HSBC Holdings provide that Directors are entitled to be indemnified out of the assets of the Company against claims from third parties in respect of certain liabilities arising in connection with the performance of their functions, in accordance with the provisions of the UK Companies Act 2006. Such indemnity provisions have been in place during the financial year but have not been utilised by the Directors.
Each person who is a Director at the date of approval of this report confirms that so far as the Director is aware, there is no relevant audit information of which the Company’s auditor is unaware; and the Director has taken all the steps that he or she ought to have taken as a Director in order to make himself or herself aware of any relevant audit information and to establish that the Company’s auditor is aware of that information. This confirmation is given pursuant to section 234ZA of the UK Companies Act 1985 and should be interpreted in accordance therewith and subject to the provisions thereof.
None of the Directors had, during the year or at the end of the year, a material interest, directly or indirectly, in any contract of significance with HSBC Holdings or any of its subsidiary undertakings.
Corporate governance codes
HSBC is committed to high standards of corporate governance. HSBC Holdings has complied throughout the year with the applicable code provisions of the Combined Code on Corporate Governance issued by the Financial Reporting Council and the Code on Corporate Governance Practices in Appendix 14 to the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited.
The Board of HSBC Holdings has adopted a code of conduct for transactions in HSBC Group securities by Directors that complies with The Model Code in the Listing Rules of the Financial Services Authority and with The Model Code for Securities Transactions by Directors of Listed Issuers (‘Hong Kong Model Code’) set out in the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited, save that The Stock Exchange of Hong Kong Limited has granted certain waivers from strict compliance with the Hong Kong Model Code, primarily to take into account accepted practices in the UK, particularly in respect of employee share plans. Following a specific enquiry, each Director has confirmed he or she has complied with the code of conduct for transactions in HSBC Group securities throughout the year.
Differences in HSBC Holdings/New York Stock Exchange corporate governance practices
Under the NYSE’s corporate governance rules for listed companies and the applicable rules of the SEC, as a NYSE-listed foreign private issuer, HSBC Holdings must disclose any significant ways in which its corporate governance practices differ from those followed by US companies subject to NYSE listing standards. HSBC Holdings believes the following to be the significant differences between its corporate governance practices and NYSE corporate governance rules applicable to US companies.
US companies listed on the NYSE are required to adopt and disclose corporate governance guidelines. The Listing Rules of the UK Financial Services Authority require each listed company incorporated in the UK to include in its Annual Report and Accountsa narrative statement of how it has applied the principles of the Combined Code and a statement as to whether or not it has complied with the code provisions of the Combined Code throughout the accounting period covered by the Annual Report and Accounts. A company that has not compliedwith the Code provisions, or complied
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with only some of the Code provisions or (in the case of provisions whose requirements are of a continuing nature) complied for only part of an accounting period covered by the report, must specify the Code provisions with which it has not complied, and (where relevant) for what part of the reporting period such non-compliance continued, and give reasons for any non-compliance. As stated above, HSBC Holdings complied throughout 2008 with the applicable code provisions of the Combined Code. The Combined Code does not require HSBC Holdings to disclose the full range of corporate governance guidelines with which it complies.
Under NYSE standards, companies are required to have a nominating/corporate governance committee, composed entirely of independent directors. In addition to identifying individuals qualified to become Board members, this committee must develop and recommend to the Board a set of corporate governance principles. HSBC’s Nomination Committee complies with the Combined Code, which requires a majority of members to be independent. All four members of the Committee are independent non-executive Directors. The Committee’s terms of reference do not require the Committee to develop and recommend corporate governance principles for HSBC Holdings. As stated above, HSBC Holdings is subject to the corporate governance principles of the Combined Code.
Pursuant to NYSE listing standards, non-management directors must meet on a regular basis without management present and independent directors must meet separately at least once per year. During 2008, HSBC Holdings’ non-executive Directors met twice as a group with the Group Chairman, but without other executive Directors present, and met once as a group without the Group Chairman or other executive Directors present. HSBC Holdings’ practice, in this regard, complies with the Combined Code.
In accordance with the requirements of the Combined Code, HSBC Holdings discloses in its annual report how the Board, its committees and the Directors are evaluated (on page 293) and it provides extensive information regarding Directors’ compensation in the Directors’ Remuneration Report (on pages 315 to 328). The terms of reference of HSBC Holdings’ Audit, Nomination and Remuneration Committees are available at www.hsbc.com/boardcommittees.
NYSE listing standards require US companies to adopt a code of business conduct and ethics for directors, officers and employees, and promptly disclose any waivers of the code for directors or executive officers. In addition to the Group Business
Principles and Values, which apply to the employees of all HSBC companies, pursuant to the requirements of the Sarbanes-Oxley Act the Board of HSBC Holdings has adopted a Code of Ethics applicable to the Group Chairman and the Group Chief Executive, as the principal executive officers, and to the Group Finance Director and Group Chief Accounting Officer. HSBC Holdings’ Code of Ethics is available on www.hsbc.com/codeofethics or from the Group Company Secretary at 8 Canada Square, London E14 5HQ. If the Board amends or waives the provisions of the Code of Ethics, details of the amendment or waiver will appear at the same website address. During 2008, HSBC Holdings made no amendments to its Code of Ethics and granted no waivers from its provisions. The Group Business Principles and Values are available on www.hsbc.com/businessprinciplesandvalues.
Under NYSE listing rules applicable to US companies, independent directors must comprise a majority of the Board of directors. Currently, two thirds of HSBC Holdings’ Directors are independent.
Under the Combined Code the HSBC Holdings Board determines whether a Director is independent in character and judgement and whether there are relationships or circumstances which are likely to affect, or could appear to affect, the Director’s judgement. Under the NYSE rules a director cannot qualify as independent unless the board affirmatively determines that the director has no material relationship with the listed company; in addition the NYSE rules prescribe a list of circumstances in which a director cannot be independent. The Combined Code requires a company’s board to assess director independence by affirmatively concluding that the director is independent of management and free from any business or other relationship that could materially interfere with the exercise of independent judgement.
Lastly, a chief executive officer of a US company listed on the NYSE must annually certify that he or she is not aware of any violation by the company of NYSE corporate governance standards. In accordance with NYSE listing rules applicable to foreign private issuers, HSBC Holdings’ Group Chief Executive is not required to provide the NYSE with this annual compliance certification. However, in accordance with rules applicable to both US companies and foreign private issuers, the Group Chief Executive is required promptly to notify the NYSE in writing after any executive officer becomes aware of any material non-compliance with the NYSE corporate governance standards applicable to HSBC Holdings.
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HSBC Holdings is required to submit annual and interim written affirmations of compliance with applicable NYSE corporate governance standards, similar to the affirmations required of NYSE-listed US companies.
Board committees
The Board has appointed a number of committees consisting of certain Directors, Group Managing Directors and, in the case of the Corporate Sustainability Committee, certain co-opted non-director members. The following are the principal committees:
Group Management Board
The Group Management Board meets frequently and operates as a general management committee under the direct authority of the Board. The objective of the Group Management Board is to maintain a reporting and control structure whereby all of the line operations of HSBC are accountable to individual members of the Group Management Board who report to the Group Chief Executive who in turn reports to the Group Chairman. The Board has set objectives and measures for the Group Management Board. These will align senior executives’ objectives and measures with the strategy and operating plans throughout HSBC. The members of the Group Management Board are M F Geoghegan (Chairman), V H C Cheng, D J Flint, A A Flockhart and S T Gulliver who are executive Directors, and A Almeida, E Alonso, C C R Bannister, K M Harvey, A C Hungate, D D J John, B P McDonagh, Y A Nasr, B Robertson and P A Thurston, all of whom are Group Managing Directors.
The Group Management Board exercises the powers, authorities and discretions of the Board in so far as they concern the management and day-to-day running of HSBC Holdings in accordance with such policies and directions as the Board may from time to time determine. Matters reserved for approval by the Board are described on page 290.
The Group Chief Executive reports to each meeting of the Board on the activities of the Group Management Board.
Group Audit Committee
The Group Audit Committee meets regularly with HSBC’s senior financial, credit and risk, internal audit, legal and compliance management and the external auditor to consider HSBC Holdings’ financial reporting, the nature and scope of audit reviews and the effectiveness of the systems of
internal control, compliance and risk management. The members of the Group Audit Committee throughout 2008 were, R A Fairhead (Chairman), J D Coombe and J W J Hughes-Hallett. J R Lomax was appointed a member of the Committee on 1 March 2009. S W Newton retired as a Director of HSBC Holdings and ceased to be a member of the Committee on 10 October 2008. All members of the Committee are independent non-executive Directors.
The Board has determined that R A Fairhead, J D Coombe and J W J Hughes-Hallett are independent according to SEC criteria, may be regarded as audit committee financial experts for the purposes of section 407 of the Sarbanes-Oxley Act and have recent and relevant financial experience.
Appointments to the Committee are made for periods of up to three years, extendable by no more than two additional three-year periods, so long as members continue to be independent.
Formal and tailored induction programmes are held for newly-appointed Committee members and appropriate training is provided on an ongoing and timely basis.
There were eight meetings of the Group Audit Committee during 2008. The table on page 291 gives details of Directors’ attendance at these meetings. Following each meeting the Committee reports to the Board on its activities.
At each meeting, the Committee has the opportunity to meet with the external auditor, without management present, to facilitate the discussion of any matter relating to its remit and any issue arising from the audit. Similar arrangements have been adopted for the Committee to meet with the internal auditor. The Committee also has the opportunity to meet with the Group Chief Executive at each of its meetings.
The terms of reference of the Committee, which are reviewed annually, are available at www.hsbc.com/boardcommittees. To ensure consistency of scope and approach by subsidiary company audit committees, the Group Audit Committee has established core terms of reference to guide subsidiary company Boards when adopting terms of reference for their audit committees. Subsidiary company audit committees are required to provide bi-annual certificates to the Committee or to an intermediate subsidiary company audit committee, relating to the financial statements and internal control procedures of the relevant subsidiary company.
The Group Audit Committee is accountable to the Board and assists it in meeting its responsibilities
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for maintaining an effective system of internal control and compliance and for meeting its external financial reporting obligations. The Committee undertakes an annual review of the effectiveness of HSBC’s system of internal control, which is described on page 299, and reviews the Company’s financial statements before they are considered by the Board.
Regular reports are received on the risks involved in HSBC’s business and how they are controlled and monitored by management which enable the Committee to review the effectiveness of HSBC’s risk management framework. Each year the Committee agrees a schedule of presentations to be made to it by management during the ensuing year on the operation of the risk control framework within the Group. The presentations specifically address risk indicators and performance measures such as indicators of credit, liquidity and interest rate risk. During 2008 the Committee received frequent presentations on global market risk and liquidity and reports on the US mortgage services business, credit performance in the US and the impact of the tightening of liquidity in the money markets. Comprehensive reports are received at each regular meeting from the Group Chief Risk Officer, the Head of Group Compliance, the Group General Manager, Legal and Compliance and the Group General Manager Internal Audit. Periodic presentations are made by other function heads and line management.
The reports from the Group General Manager Internal Audit include information on frauds and special investigations and weakness in internal controls identified through internal audit reports or reviews of regulatory reports and external auditors’ reports. The Committee monitors and reviews the effectiveness of the internal audit function and receives summaries of periodic peer reviews of HSBC’s principal internal audit functions. HSBC has adopted the Principles of the International Institute of Internal Auditors, which include a periodic external quality assurance review of the internal audit function. The first such review, undertaken by Independent Audit Limited, was presented to the Committee in 2008.
The Committee receives regular updates on changes in law, regulations and accounting standards and practices and the preparations being made to respond to those requirements. During 2008, the Committee received regular updates on the review of internal financial reporting controls required by section 404 of the Sarbanes-Oxley Act and the implementation of the Basel II capital adequacy requirements.
The Committee has approved procedures for the receipt, retention and handling of complaints regarding accounting, internal accounting controls and auditing matters. The Committee receives regular reports regarding the nature, investigation and resolution of material complaints and concerns from the Head of Group Compliance.
The Committee is directly responsible on behalf of the Board for the selection, oversight and remuneration of the external auditor. The Committee reviews and monitors the external auditor’s independence and objectivity and the effectiveness of the audit process, taking into consideration relevant professional and regulatory requirements.
The Committee reviews the strategy and approves the terms for the engagement of the external auditor for the audit of the Annual Report and Accounts. Regular reports on the progress of the audit facilitate the Committee’s assessment of the effectiveness of the audit.
The Committee receives reports from the external auditor on its own policies and procedures regarding independence and quality control and oversees the appropriate rotation of audit partners within the external auditor. The external auditor provides the Committee with an annual confirmation of its independence in accordance with industry standards.
On the recommendation of the Committee the Board has approved a policy for the employment by HSBC of former employees of the external auditor or its affiliates. The Committee monitors this policy through the receipt of an annual report of those former employees of the external auditor employed by HSBC and the number of former employees of the external auditor currently employed in senior positions in HSBC. The reports enable the Committee to consider whether there has been any impairment, or appearance of impairment, of the auditor’s judgement or independence in respect of the audit.
The Group Audit Committee has established policies for the pre-approval of specific services that may be provided by the principal auditor, KPMG Audit Plc and its affiliates (‘KPMG’). These policies are kept under review and amended as necessary to meet the dual objectives of ensuring that HSBC benefits in a cost effective manner from the cumulative knowledge and experience of its auditor, while also ensuring that the auditor maintains the necessary degree of independence and objectivity. These pre-approval policies apply to all services where HSBC Holdings or any of its subsidiaries pays for the service, or is a beneficiary or addressee of the
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HSBC’s key internal control procedures include the following:
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Board of Directors > Internal control / Directors’ interests
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covering all material controls, including financial, operational and compliance controls and risk management systems. The Group Audit Committee has received confirmation that management has taken or is taking the necessary action to remedy any failings or weaknesses identified through the operation of HSBC’s framework of controls.
Directors’ interests
Pursuant to the requirements of the UK Listing Rules and according to the register of Directors’ interests maintained by HSBC Holdings pursuant to section 352 of the Securities and Futures Ordinance of Hong Kong, the Directors of HSBC Holdings at 31 December 2008 had the following interests, all beneficial unless otherwise stated, in the shares and loan capital of HSBC and its associated corporations:
M F Geoghegan has an interest as beneficial owner in 280,000 ordinary shares of HK$5.00 each in Hang Seng Bank (representing less than 0.02 per cent of the shares in issue), which he held throughout the year.
S K Green has an interest as beneficial owner in €75,000 of HSBC Holdings plc 5½ per cent Subordinated Notes 2009, which he held throughout the year.
As Directors of HSBC France, S K Green and S T Gulliver each have an interest as beneficial owner in one share of €5 in that company (representing less than 0.01 per cent of the shares in issue). S K Green has held this interest throughout
the year. S T Gulliver has held this interest since 1 January 2009. The Directors have waived their rights to receive dividends on these shares and have undertaken to transfer these shares to HSBC on ceasing to be Directors of HSBC France.
As Directors of HSBC Private Banking Holdings (Suisse), S K Green and S T Gulliver each have an interest as beneficial owner in one share of CHF1,000 in that company (representing less than 0.01 per cent of the shares in issue), which they held throughout the year. The Directors have waived their rights to receive dividends on these shares and have undertaken to transfer these shares to HSBC on ceasing to be Directors of HSBC Private Banking Holdings (Suisse).
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No Directors held any short position as defined in the Securities and Futures Ordinance of Hong Kong in the shares and loan capital of HSBC and its associated corporations. Save as stated above, none of the Directors had an interest in any shares or debentures of HSBC or any associated corporation at the beginning or at the end of the year, and none of
the Directors or members of their immediate families were awarded or exercised any right to subscribe for any shares or debentures in any HSBC corporation during the year. Since the end of the year, the interests of each of the following Directors have increased by the number of HSBC Holdings ordinary shares shown against their name:
Since the end of the year, the non-beneficial interests of J W J Hughes-Hallett as Trustee of two Trusts have decreased by 102,948 HSBC Holdings ordinary shares.
There have been no other changes in the share and loan capital interests of the Directors from 31 December to the date of this Report. Any subsequent changes up to the last practicable date before the publication of the Notice of Annual General Meeting will be set out in the notes to that Notice.
At 31 December 2008, Directors and Senior Management held, in aggregate, beneficial interests
in 16,469,373 HSBC Holdings ordinary shares (0.14 per cent of the issued ordinary shares).
At 31 December 2008, executive Directors and Senior Management held, in aggregate, options to subscribe for 937,862 HSBC Holdings ordinary shares under the HSBC Holdings Executive Share Option Scheme, HSBC Holdings savings-related share option plans, HSBC Holdings Group Share Option Plan and HSBC Finance: 1996 Long-Term Executive Incentive Compensation Plan. These options are exercisable between 2009 and 2015 at prices ranging from £5.3496 to £7.8710 and US$10.66 to US$21.37 per share.
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At 31 December 2008, HSBC employed 325,000 full and part-time employees worldwide, compared with 330,000 at 31 December 2007 and 312,000 at 31 December 2006. The main centres of employment are the UK with approximately 58,000 employees; the US 38,000, India 37,000, Hong Kong 30,000, Brazil 25,000, Mexico 20,000, mainland China 15,000 and France 11,000. HSBC negotiates with recognised unions. The five highest concentrations of union membership are in Argentina, Brazil, mainland China, Malta and Mexico. It is HSBC’s policy to maintain well-developed communications and consultation programmes with unions and there have been no material disruptions to its operations from labour disputes during the past five years.
The first Group People Strategy was in place for 2008. This prioritised leadership and people capability in general, robust performance management complementing a market competitive reward strategy, and improving employee engagement. Particular emphasis was given in 2008 to increasing international mobility to broaden the internationalism and diversity of employee experience, and training was focused on risk awareness, change management, customer orientation and performance. There was significant improvement in employee engagement (see non-financial KPIs in page 19) and a key component of performance management was aligned objectives which were cascaded down from the Group Management Board level for the first time.
HSBC continues to be committed to creating a diverse and inclusive work environment reflective of its customer base, international workforce, and communities in which it operates. It has a Group-wide strategy, with Group oversight, that aims to improve gender, ethnicity and age diversity to ensure the long-term sustainability of the organisation, taking into account strategic global demographic changes. There is a particular focus on increasing gender and ethnic diversity at senior management levels. Diversity initiatives are implemented at a country level taking local and national laws into account. Employee network groups and mentoring programmes are promoted and established, where possible, to facilitate open discussion of workplace issues for employees belonging to minority groups, and to foster an environment that celebrates diversity.
Employee involvement
HSBC continues to value open communication with its employees. Employees are encouraged to discuss
operational and strategic issues, and ways of improving performance with their line manager. Open communication throughout the organisation is encouraged and opportunities to share individual perspectives are created through networking events, management blogs, international assignments and learning and development programmes. Information is regularly given to employees about employment matters and the financial and economic factors affecting HSBC’s performance. This is communicated via management channels, internal seminars, training programmes, in-house magazines and an intranet site accessible to the majority of HSBC’s employees worldwide. The Group’s Global People Survey in turn annually assesses employee engagement with HSBC.
Employment of disabled persons
HSBC believes in providing equal opportunities to all employees. The employment of disabled persons is included in this commitment and the recruitment, training, career development and promotion of disabled persons is based on the aptitudes and abilities of the individual. Should employees become disabled during employment, every effort is made to continue their employment and, if necessary, appropriate training is provided.
Remuneration policy
As the quality and commitment of its human capital is deemed fundamental to HSBC’s success, the Board’s stated strategy is to attract, retain and motivate the very best people; this strategy is referenced to the overall business strategy and the commercial environment.
In a business that is based on trust and relationships, HSBC’s broad policy is to recruit those who are committed to making a long-term career with the organisation since trust and relationships are built over time.
Remuneration is an important component in people’s decisions on which company to join and to stay with, but it is not the overriding one. It is HSBC’s experience that people are attracted to an organisation with strong and sound values, one which is meritocratic and competitive, and which offers challenging career development; it is also this type of people that HSBC seeks to attract.
In line with the overall principles applied to executive Directors by the Remuneration Committee as described on page 315 in the Directors’ Remuneration Report:
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Employee share plans
To help align the interests of employees with those of shareholders, share options are granted under all-employee share plans and discretionary awards of Performance Shares and Restricted Shares are made under the HSBC Share Plan. There have been no awards of discretionary share options since 30 September 2005.
Set out on pages 304 to 311 are particulars of outstanding employee share options, including those held by employees working under employment contracts that are regarded as ‘continuous contracts’ for the purposes of the Hong Kong Employment Ordinance. The options were granted at nil consideration. No options have been granted to substantial shareholders, suppliers of goods or services, or in excess of the individual limit for each share plan. No options were cancelled by HSBC during the year.
Employee share plans are subject to the
following limits on the number of HSBC Holdings ordinary shares that may be subscribed for. In any 10-year period not more than 10 per cent of the HSBC Holdings ordinary shares in issue from time to time (approximately 1,214 million HSBC Holdings ordinary shares at 2 March 2009) may in aggregate become issuable pursuant to the grant of options or be issued other than pursuant to options under all-employee share plans. In any 10-year period not more than 5 per cent of the HSBC Holdings ordinary shares in issue from time to time (approximately 607 million HSBC Holdings ordinary shares on 2 March 2009) may in aggregate be put under option under the HSBC Share Plan or be issuable pursuant to the HSBC Holdings Group Share Option Plan, the HSBC Executive Share Option Scheme, the HSBC Holdings Restricted Share Plan 2000 or the HSBC Share Plan. The number of HSBC Holdings ordinary shares that may be issued on exercise of all options granted on or after 27 May 2005 under the HSBC Share Plan and any other plans must not exceed 1,119,000,000 HSBC Holdings ordinary shares. Under the HSBC Holdings savings-related share option plans, the HSBC Share Plan, HSBC Holdings Group Share Option Plan and the HSBC Holdings Executive Share Option Scheme there were options outstanding over 231,257,004 HSBC Holdings ordinary shares at 31 December 2008. Particulars of options over HSBC Holdings shares held by Directors of HSBC Holdings are set out on page 326 of the Directors’ Remuneration Report.
The effect on earnings per share of granting share options and share awards is shown in diluted earnings per share on the face of the consolidated income statement, with further details disclosed in the Earnings per share Note 13 on the Financial Statements. The effect on basic earnings per share of dilutive share options and share awards would be to dilute it by 1.2 per cent.
All-employee share option plans
The HSBC Holdings Savings-Related Share Option Plan and the HSBC Holdings Savings-Related Share Option Plan: International are all-employee share plans under which eligible HSBC employees (those employed within the Group on the first working day of the year of grant) may be granted options to acquire HSBC Holdings ordinary shares. Employees may make contributions of up to £250 (or equivalent) each month over a period of one, three or five years which may be used on the first, third or fifth anniversary of the commencement of the relevant savings contract, at the employee’s election, to exercise the options. Alternatively, the employee
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may elect to have the savings, plus (where applicable) any interest or bonus, repaid in cash. Options granted over a one-year period will be exercisable within three months following the first anniversary of the commencement of the savings contract. Options granted over three or five-year periods will be exercisable within six months following the third or fifth anniversary of the commencement of the relevant savings contract. In the case of redundancy, retirement on grounds of injury or ill health, retirement at or after normal retirement age, the transfer of the employing business to another party, or a change of control of the employing company, options may be exercised before completion of the relevant savings contract.
Under the HSBC Holdings Savings-Related Share Option Plan and the HSBC Holdings Savings-Related Share Option Plan: International the option exercise price is determined by reference to the average market value of the ordinary shares on the five business days immediately preceding the invitation date, then applying a discount of 20 per cent (except for the one-year options awarded under the US sub-plan where a 15 per cent discount is applied). The exercise period of the options awarded under all-employee share plans may be advanced to an earlier date in certain circumstances,
for example on retirement, and may be extended in certain circumstances, for example on the death of a participant, the executors may exercise the option up to six months beyond the normal exercise period. The closing price per HSBC Holdings ordinary share on 29 April 2008, the day before options were awarded in 2008 under the HSBC Holdings Savings-Related Share Option Plan and the HSBC Holdings Savings-Related Share Option Plan: International, was £8.71. The all-employee share option plans will terminate on 27 May 2015 unless the Directors resolve to terminate the plans at an earlier date.
To encourage greater participation in the HSBC Holdings Savings-Related Share Option Plan: International, two amendments were approved at the 2005 Annual General Meeting. The first was the introduction of the facility to save and have option prices expressed in US dollars, Hong Kong dollars and euros as well as in pounds sterling. Where applicable, the US dollars, Hong Kong dollars and euro exercise prices are converted from the sterling exercise price at the applicable exchange rate on the working day preceding the relevant invitation date. The second amendment was to provide the choice of options over one year in addition to three and five year terms.
HSBC Holdings Savings-Related Share Option PlanHSBC Holdings ordinary shares of US$0.50
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Discretionary Share Plans
Note 10 on the Financial Statements gives detail on share-based payments, including awards of Performance Shares and Restricted Shares made in 2008.
The HSBC Share Plan was approved at the 2005 Annual General Meeting. Awards of Performance Shares are made under this Plan to executive Directors and other senior executives. The performance conditions for awards of Performance Shares are described under ‘Long-term incentive plan’ on page 318.
Awards of Performance Shares are directed to those senior executives who can influence corporate performance such as members of the Group Management Board.
Awards of Restricted Shares are typically made to other employees based on individual performance, business performance and competitive market practice.
Restricted Share awards define the number of shares to which the employee will become entitled, generally between one and three years from the date of the award, and normally subject to the individual remaining in employment. To date, all awards of Performance Shares and Restricted Shares have been satisfied by the transfer of existing shares.
Since September 2005, no awards of share options under the HSBC Share Plan have been granted. There may be particular circumstances in the future where option grants could be appropriate. No options were awarded under the HSBC Share Plan in 2008.
Prior to 2005, discretionary awards of share options, with vesting subject to the attainment of a predetermined TSR performance condition, were made to employees at all levels of HSBC.
The vesting of these options was subject to the attainment of pre-determined relative TSR performance criteria, except in HSBC France (which was acquired in 2000) where performance criteria were phased in. Under the HSBC Holdings Group Share Option Plan, the maximum grant of options which could be granted to an employee in any one year (together with the Performance Share awards
under the HSBC Holdings Restricted Share Plan 2000) was 150 per cent (or in exceptional circumstances 225 per cent) of the employee’s annual salary at the date of grant plus any bonus paid in the previous year.
Under the HSBC Holdings Executive Share Option Scheme the maximum value of options which could be granted to an employee in any one year was four times the employee’s relevant earnings.
Subject to the attainment of the relative TSR performance condition where applicable, options are generally exercisable between the third and the tenth anniversary of the date of grant. Employees of a subsidiary that is sold or transferred out of HSBC may exercise options awarded under the HSBC Holdings Group Share Option Plan or the HSBC Holdings Executive Share Option Scheme within six or twelve months respectively of the sale or transfer, regardless of whether the performance condition is met.
The maximum value of options that may be granted to an employee in any one year under the HSBC Plan (when taken together with any Performance Share award made under the HSBC Share Plan) is 700 per cent of the employee’s annual salary at the date of grant.
The exercise price of options granted under the HSBC Share Plan, and previously under the HSBC Holdings Group Share Option Plan, is the higher of the average market value of the ordinary shares on the five business days prior to the grant of the option or the market value of the ordinary shares on the date of grant of the option. The exercise price of options granted under the HSBC Holdings Executive Share Option Scheme was the market value of the ordinary shares on the business day prior to the grant of the option. The HSBC Share Plan will terminate on 27 May 2015 unless the Directors resolve to terminate the Plan at an earlier date.
The exercise period of the options awarded under discretionary share incentive plans may be advanced to an earlier date in certain circumstances, for example on the sale of a business, or may be extended in certain circumstances, for example on the death of a participant the executors may exercise the option beyond the normal exercise period.
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HSBC Holdings Executive Share Option Scheme1 HSBC Holdings ordinary shares of US$0.50
HSBC Holdings Group Share Option Plan1 HSBC Holdings ordinary shares of US$0.50
HSBC Share PlanHSBC Holdings ordinary shares of US$0.50
Subsidiary company share plans
HSBC France and subsidiary company
When it was acquired in 2000, HSBC France and one of its subsidiary companies, HSBC Private Bank France, operated employee share option plans under
which options could be granted over their respective shares. No further options will be granted under either of these companies’ plans. The following are details of outstanding options to acquire shares in HSBC France and HSBC Private Bank France.
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HSBC FranceShares of €5
HSBC Private Bank FranceShares of €2
HSBC Finance and its subsidiaries
Following the acquisition of HSBC Finance in 2003, all outstanding options and equity-based awards over HSBC Finance common shares were converted into rights to receive HSBC Holdings ordinary shares in the same ratio as the share exchange offer for the acquisition of HSBC Finance (2.675 HSBC Holdings ordinary shares for each HSBC Finance common share) and the exercise prices per share were adjusted accordingly. No further options will be granted under any of these plans.
All outstanding options and other equity-based awards over HSBC Finance common shares granted before 14 November 2002, being the date the
transaction was announced, vested on completion of the acquisition. Options and equity-based awards granted on or after 14 November 2002 are exercisable on their original terms, save that they have been adjusted to reflect the exchange ratio.
The following are details of options and equity-based awards to acquire shares in HSBC Holdings.
At 31 December 2008, the HSBC (Household) Employee Benefit Trust 2003 held 1,687,279 HSBC Holdings ordinary shares and 196,455 American Depositary Shares, each of which represents five HSBC Holdings ordinary shares, which may be used to satisfy the exercise of employee share options.
HSBC Finance: 1996 Long-Term Executive Incentive Compensation PlanHSBC Holdings ordinary shares of US$0.50
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HSBC Finance: 1996 Long-Term Executive Incentive Compensation Plan1HSBC Holdings ordinary shares of US$0.50
Renaissance Holdings, Inc: Amended and Restated 1997 Incentive PlanHSBC Holdings ordinary shares of US$0.50
Bank of Bermuda
Following the acquisition of Bank of Bermuda in 2004, all outstanding options over Bank of Bermuda shares were converted into rights to receive HSBC Holdings ordinary shares based on the consideration of US$40 for each Bank of Bermuda share and the average closing price of HSBC Holdings ordinary shares, derived from the London Stock Exchange Daily Official List, for the five business days preceding the closing date of the acquisition. No
further options will be granted under any of these plans.
All outstanding options over Bank of Bermuda shares vested on completion of the acquisition. The following are details of options to acquire shares in HSBC Holdings. At 31 December 2008, the HSBC (Bank of Bermuda) Employee Benefit Trust 2004 held 1,877,056 HSBC Holdings ordinary shares which may be used to satisfy the exercise of these options.
Bank of Bermuda: Executive Share Option Plan 1997HSBC Holdings ordinary shares of US$0.50
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Bank of Bermuda: Share Option Plan 2000HSBC Holdings ordinary shares of US$0.50
Employee compensation and benefits
Note 8 on the Financial Statements gives details about employee compensation and benefits including pension plans.
Set out below is information in respect of the five individuals whose emoluments were the highest in HSBC for the year ended 31 December 2008.
Emoluments of 5 highest paid employees
Their emoluments were within the following bands:
The aggregate remuneration of Directors and Senior Management for the year ended 31 December 2008 was US$49,835,745.
The aggregate amount set aside or accrued to provide pension, retirement or similar benefits for Directors and Senior Management for the year ended 31 December 2008 was US$1,916,120.
Executive Directors and members of Senior Management are generally subject to notice periods of up to 12 months and a normal retirement age of 65.
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Sustainability at HSBC is about the Group’s long-term approach to managing economic, social and environmental issues that are within its influence. First and foremost, this is about achieving sustainable profit growth so that HSBC can continue to reward shareholders and employees, build long-lasting relationships with customers and suppliers, and invest in the business and in the communities where the Group operates, for future growth.
This is central to the Group’s strategy and acknowledges that HSBC’s continuing financial success depends, in part, on its ability to identify and address non-financial considerations which are material to the business, and to mitigate the risks and maximise the opportunities arising from them.
Corporate Sustainability Committee
Sustainability at HSBC is embedded into the business and is overseen by the Corporate Sustainability Committee of the HSBC Holdings Board.
The Corporate Sustainability Committee is responsible for advising the HSBC board, committees of the board and executive management on corporate sustainability policies, including environmental, social and ethical issues. At an operational level, these issues are managed on a day-to-day basis primarily by Group Human Resources, Group Risk and Group Corporate Sustainability.
The terms of reference of the Committee are available at www.hsbc.com/boardcommittees. The members of the Committee throughout 2008 were W K L Fung (appointed Chairman on 30 May 2008) and Sir Mark Moody-Stuart, each of whom is a non-executive Director, G V I Davis and Lord May, who are non-director members of the Committee. Lord Butler retired as a Director of HSBC Holdings and ceased to be a member of the Committee on 30 May 2008. N R N Murthy was appointed a member of the Committee on 21 November 2008.
There were four meetings of the Corporate Sustainability Committee during 2008. Following each meeting, the Committee reports to the Board on its activities.
Sustainability at HSBC
HSBC understands the business imperative of investing in its employees, the communities it serves and the environment it relies on. The Group’s priorities are the long-term development and engagement of its employees, increasing its understanding of risk arising from environmental,
social or reputational issues and investing in education and entrepreneurship to allow communities to build capacity and individuals to thrive.
HSBC focuses its environmental initiatives primarily on addressing and responding to issues associated with climate change including energy, water management and biodiversity. Social initiatives are centred on helping to support education and on enabling access to financial services to the world’s poor.
Climate change has the potential to have a material impact on HSBC’s customers and therefore on HSBC’s long-term success. In 2008, HSBC built on its understanding and expertise on responding to climate change and Lord Stern continued to advise the Group Chairman on economic development and climate change. HSBC was one of the first financial institutions to adopt the Climate Principles, a voluntary framework for action on climate change that covers all areas of financial services.
HSBC also participates in the Prince of Wales’ Accounting for Sustainability project which seeks to develop systems to help public and private sector organisations account more accurately for the wider social and environmental costs of their activities.
Sustainability risk
HSBC’s approach to managing sustainability risk is detailed on page 254.
Social and community investment
HSBC focuses its community investment activity on education and the environment because HSBC believes these are fundamental to building and developing communities and are prerequisites for economic growth. In 2008, HSBC made charitable donations totalling US$102 million (2007: US$101 million). Around half of the annual donation is channelled to education programmes and 25 per cent to environmental projects. The remainder is spent on country specific projects, disaster relief and matching staff contributions. No political donations were made during the year.
HSBC’s global education programme focuses on three major themes – financial literacy, disadvantaged children and environmental education. The global environmental programme is the HSBC Climate Partnership, a five year US$100 million commitment to working with The Climate Group, Earthwatch, Smithsonian Tropical Research Institute and WWF on tackling climate change.
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HSBC reports on its sustainability strategy and progress annually in the HSBC Sustainability Report which is verified by an external auditor and prepared using the Global Reporting Initiative. PricewaterhouseCoopers has been appointed for the 2008 reporting period and will verify the Group sustainability strategy and governance structure, the content of the report, carbon neutrality status and adherence to the Equator Principles. The HSBC Sustainability Report 2008 will be issued on 22 May 2009 and will be available at www.hsbc.com/sustainability
Health and safety
The maintenance of appropriate health and safety standards throughout HSBC remains a key responsibility of all managers and HSBC is committed to proactively managing all health and safety risks associated with its business. HSBC’s objectives are to identify, remove, reduce or control material risks of fires and of accidents or injuries to employees and visitors.
Group standards, instructions and related policies and procedures are set by Group Corporate Real Estate and implemented by Health, Safety and Fire Co-ordinators (‘HSFCs’) based in each country in which HSBC operates. The HSFC may call upon regional and Group resource by way of support at any time.
Despite the considerable international pressure on terrorist networks over the past few years, the global threat from terrorism persists. HSBC remains committed to maintaining its preparedness and to ensuring the highest standards of health and safety wherever in the world it operates.
Group Security provides regular risk assessments in areas of increased risk to assist management in judging the level of terrorist threat. In addition, Regional Security functions conduct regular security reviews to ensure measures to protect HSBC staff, buildings, assets and information are appropriate for the level of threat.
Supplier payment policy
The Company does not currently subscribe to any code or standard on payment practice. It is the Company’s policy, however, to settle terms of payment with those suppliers when agreeing the terms of each transaction, to ensure that those suppliers are made aware of the terms of payment, and to abide by the terms of payment.
It is HSBC Holdings’ practice to organise payment to its suppliers through a central accounts
payable function operated by its subsidiary, HSBC Bank. Included in the balance with HSBC Bank is the amount due to trade creditors which, at 31 December 2008, represented 22 days’ average daily purchases of goods and services received from such creditors, calculated in accordance with the Companies Act 1985, as amended by Statutory Instrument 2007/3495.
First, second and third interim dividends for 2008, each of US$0.18 per ordinary share, were paid on 9 July 2008, 8 October 2008 and 14 January 2009 respectively. Note 12 on the Financial Statements gives more information on the dividends declared in 2008. On 2 March 2009, the Directors declared a fourth interim dividend for 2008 of US$0.10 per ordinary share in lieu of a final dividend, which will be payable on 6 May 2009 in cash in US dollars, or in sterling or Hong Kong dollars at exchange rates to be determined on 27 April 2009, with a scrip dividend alternative. As the fourth interim dividend for 2008 was declared after the balance sheet date it has not been included as a creditor at 31 December 2008. The reserves available for distribution at 31 December 2008 are US$18,838 million.
A quarterly dividend of US$15.50 per 6.20 per cent non-cumulative US dollar preference share, Series A (‘Series A dollar preference share’), equivalent to a dividend of US$0.3875 per Series A American Depositary Share, each of which represents one-fortieth of a Series A dollar preference share, was paid on 17 March, 16 June, 15 September and 15 December 2008.
Dividends for 2009
The proposed timetable for interim dividends in respect of 2009 on the ordinary shares of US$0.50 is set out in the Shareholder Information section on page 448.
A quarterly dividend of US$15.50 per Series A dollar preference share (equivalent to a dividend of US$0.3875 per Series A American Depositary Share, each of which represents one-fortieth of a Series A dollar preference share) was declared on 11 February 2009 for payment on 16 March 2009.
Communication with shareholders
Communication with shareholders is given high priority. Extensive information about HSBC’s activities is provided in the Annual Report and
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Accounts, Annual Reviewand the Interim Reportwhich are sent to shareholders and are available on www.hsbc.com. There is regular dialogue with institutional investors and enquiries from individuals on matters relating to their shareholdings and the business of HSBC are welcomed and are dealt with in an informative and timely manner. All shareholders are encouraged to attend the Annual General Meeting or the informal meeting of shareholders held in Hong Kong to discuss the progress of HSBC.
Notifiable interests in share capital
As at 2 March 2009, the following disclosures of major holdings of voting rights have been made (and have not been amended or withdrawn) to the Company pursuant to the requirements of the Financial Services Authority Disclosure and Transparency Rule 5:
As at 31 December 2008, according to the register maintained by HSBC Holdings pursuant to section 336 of the Securities and Futures Ordinance of Hong Kong, The Royal Bank of Scotland Group plc had given notice that on 2 December 2008 it had a long position of 606,742,842 HSBC Holdings ordinary shares, representing 5.01 per cent of the ordinary shares in issue, a short position of 532,705,395 HSBC Holdings ordinary shares, representing 4.40 per cent of the ordinary shares in issue and a lending pool of 11,562,000 HSBC Holdings ordinary shares, representing 0.10 per cent in ordinary shares in issue. Since 31 December 2008, The Royal Bank of Scotland Group plc has given notice that on 9 January 2009 it had a long position of 552,481,458 HSBC Holdings ordinary shares, representing 4.56 per cent of the ordinary shares in issue, a short position of 507,430,390 HSBC Holdings ordinary shares, representing 4.19 per cent of the ordinary shares in issue and a lending pool of 15,919,328, representing 0.13 per cent in ordinary
shares in issue.
In compliance with the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited at least 25 per cent of the total issued share capital of HSBC Holdings has been held by the public at all times during 2008 and up to the date of this Report.
Dealings in HSBC Holdings shares
Except for dealings as intermediaries by HSBC Bank, HSBC Financial Products (France) and The Hongkong and Shanghai Banking Corporation, which are members of a European Economic Area exchange, neither HSBC Holdings nor any subsidiary has bought, sold or redeemed any securities of HSBC Holdings during the year ended 31 December 2008.
Annual General Meeting
The Annual General Meeting of HSBC Holdings will be held at the Barbican Hall, Barbican Centre, London EC2 on 22 May 2009 at 11.00am.
An informal meeting of shareholders will be held at Level 28, 1 Queen’s Road Central, Hong Kong on Tuesday 19 May 2009 at 4.30pm.
Resolutions to receive the Annual Report and Accounts, approve the Directors’ Remuneration Report, re-elect Directors and reappoint KPMG Audit Plc as Auditor will be submitted to the Annual General Meeting. KPMG Audit Plc has expressed its willingness to continue in office and the Group Audit Committee and the Board have recommended that KPMG Audit Plc be reappointed. Resolutions will also be submitted to the Annual General Meeting to renew the authorities for the allotment of shares, the disapplication of pre-emption rights and the purchase of ordinary shares. In addition, resolutions will be proposed to seek approval for changes to the Articles of Association and to continue to be able to call general meetings (other than Annual General Meetings) on 14 days’ notice.
A live webcast of the Annual General Meeting will be available on www.hsbc.com. From shortly after the conclusion of the Meeting until 30 June 2009 a recording of the proceedings will be available on www.hsbc.com.
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The Remuneration Committee meets regularly to consider human resource issues, particularly terms and conditions of employment, remuneration and retirement benefits. Within the authority delegated by the Board, the Committee is responsible for approving the remuneration policy of HSBC including the terms of bonus plans, share plans and other long-term incentive plans and for agreeing the individual remuneration packages of executive Directors and other senior Group employees taking into account the pay and conditions across the Group. No Directors are involved in deciding their own remuneration.
Following each meeting the Committee reports to the Board on its activities. The terms of reference of the Committee are available at www.hsbc.com/boardcommittees.
The members of the Remuneration Committee throughout 2008 were Sir Mark Moody-Stuart (Chairman), J D Coombe and G Morgan. At the conclusion of the Annual General Meeting on 30 May 2008 W S H Laidlaw became a member of the Committee.
There were seven meetings of the Remuneration Committee during 2008. The table on page 291 gives details of Directors’ attendance at these meetings.
The Committee appointed Deloitte LLP and Mercer Limited to provide independent advice on
executive remuneration issues during the year. Towers Perrin has been appointed by the Committee to provide remuneration data. As global firms, these firms also provided other consulting services to various parts of HSBC. Other consultants are used from time to time to advise on specific issues. During the year the Group Chief Executive provided regular briefings to the Committee. The Committee received advice from the Group Managing Director, Human Resources, A Almeida and the Head of Group Performance and Reward, J Beadle.
A global reward strategy for the Group was approved by the Remuneration Committee in 2007. This strategy provided a framework for the Remuneration Committee in carrying out its responsibilities during the year and includes the following key elements:
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The Committee also takes into account environmental, social and governance aspects when determining executive Directors’ remuneration and oversees senior management incentive structures to ensure that such structures take account of possible inadvertent consequences from these aspects.
A number of specific changes to remuneration policy for executive Directors and other senior executives were made in 2007 and communicated to shareholders in the 2008 Directors’ Remuneration Report. These changes, which are described in this report, were made to ensure closer alignment with HSBC’s business strategy. They take into account competitive market practice and follow through the Group’s global reward strategy for this senior executive population.
In order to ensure that executive Directors’ remuneration packages are competitive, having regard to the market in which the Company competes for executive talent, the Remuneration Committee determined to consider market data from a defined remuneration comparator group. This initial group comprised nine global financial services companies, namely Banco Santander, Bank of America, Barclays, BNP Paribas, Citigroup, Deutsche Bank, Royal Bank of Scotland, Standard Chartered and UBS. These companies were selected on the basis of their broadly similar business coverage, size and international scope, and are subject to annual review for continuing relevance.
Executive Director salaries are targeted at the median of the remuneration comparator group, with an opportunity for top quartile total compensation through variable pay for higher levels of performance. The actual positioning of total compensation will depend on the performance of the Group and individual performance assessed against a combination of financial and non-financial objectives within an annual balanced scorecard.
The performance-related aspects of the remuneration package consist of a bonus of up to 400 per cent of salary and Performance Share awards with a face value of up to 700 per cent of salary. Taking into account the expected value of awards, the performance-related elements of pay make up around 80 per cent of the total remuneration package. Annual bonus payments and Performance Share awards are not pensionable.
A significant proportion of total compensation will be delivered in HSBC Holdings shares. Share ownership guidelines were increased for executive
Directors and other senior executives to achieve further alignment with shareholder interests.
The above approach applies to all executive Directors with the exception of the Group Chairman, S K Green, whose variable compensation since 2007 has, at his request, been delivered exclusively through awards of Performance Shares and is thus no longer eligible to receive annual bonus payments; and S T Gulliver, whose variable compensation arrangements take into account wholesale banking market practice.
The approach will be carefully and regularly reviewed during 2009 to take account of the volatile and challenging market conditions (see following section on HSBC Performance and Market Context) and, where appropriate, shareholders will be consulted on any proposed changes in policy. Any changes will also be described in future Directors’ Remuneration Reports.
The application of this policy to each component of executive Directors’ remuneration for 2008 is outlined in more detail below.
The last year was one of unprecedented volatility and turbulence in the global financial services sector which has continued into 2009. In determining remuneration levels for 2008 and considering approaches to remuneration for 2009, the Committee was mindful of this global market context. In this volatile market environment it is difficult to appropriately apply measures such as total shareholder return and earnings per share, and it is particularly important to take account of risk from a short and medium term perspective.
Within this market context, HSBC’s overall financial and non-financial performance was relatively strong in comparison to its peers.
The key achievements of the Group during 2008, with reference to its objectives set under the relevant balanced scorecard categories, are summarised below.
The financial objectives included a cost efficiency target ratio which, excluding the writing off of goodwill in the US, was met and improved on compared to 2007. Profit growth, as measured by earnings per share (‘EPS’), and return on capital, as measured by return on average total shareholder equity (‘ROE’), did not meet the targets set and were lower than the prior year, although the Group’s performance in these aspects relative to its peers remained strong.
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Process objectives focused on efficiency and qualitative measures which, in themselves, impact financial performance and mitigate risk. Although the Group did not meet its target to reduce operational losses as a percentage of revenue, the overall management of risk mitigation was judged to be strong, taking into account sound relationships with global regulatory bodies and the global investment community.
The Group improved its customer development score compared to the prior year, as measured by customer recommendation and brand health in its Personal Financial Services businesses and met its overall 2008 target relating to brand health. Both were assisted by a significant increase in intra-group referrals.
Regarding the Group’s human capital, HSBC exceeded its 2008 employee engagement target as measured in a global staff survey. All regions and businesses improved their engagement scores compared to 2007 and the Group’s 2008 score also exceeded the sector and global norms despite the challenging market environment.Some 316,000 (93 per cent) of staff worldwide participated in the 2008 survey, a 5 per cent increase on the prior year. This high and improving level of participation evidences alignment of employees to the Group.
Management of risk
Since 2008 the Group’s Risk function has been involved in the approval of relevant incentive plans. Within the Group’s wholesale businesses, where appropriate, specific conditionality will be applied to the release of HSBC Restricted Shares issued by way of deferred bonuses. From 2009, the concept of imputing the cost of capital in the determination of bonus funding will be expanded progressively across the Group, starting with the Group’s wholesale businesses. Further information relating to the Group’s approach to risk management is set out on pages 191 to 192.
Salary
The Committee reviews salary levels for executive Directors each year.
Given the relative positioning of current salaries against the remuneration comparator group, no increases in salaries were made in 2008 other than to reflect promotions to the Board.
For 2009, there will be no increase to salaries for executive Directors. A similar approach has been
adopted for other executives across the Group other than in exceptional circumstances.
The table below shows salaries in 2008 and with effect from 1 March 2009.
Annual bonus
In determining annual bonus awards, the Committee took into account the extent to which the Group’s annual objectives had been met under the balanced scorecard approach, the Group’s absolute and relative performance compared to its peers, and competitive market practice where discernable. The consequence of this is a material fall in bonus awards across the Group in 2008.
Within the policy parameters described above in the section Application to executive Directors, the Committee has determined that no cash bonuses will be paid to executive Directors for 2008. Instead, any bonuses will be in the form of HSBC Holdings Restricted Shares with vesting deferred for three years.
As noted above the Group Chairman, S K Green, is, at his request, no longer eligible to receive an annual bonus payment. In line with this, no bonus award is being made to him in respect of 2008. In view of general conditions in the financial markets, the Group Chief Executive, M F Geoghegan, the Group Finance Director, D J Flint, and the Chief Executive of Global Banking and Markets and HSBC Global Asset Management, S T Gulliver, have requested that they not be considered for a bonus in respect of 2008. The Remuneration Committee has therefore decided, in spite of the performance of HSBC and the wholesale businesses in relation to its comparators, not to award these individuals a deferred bonus.
Other executive Directors have been awarded bonuses in deferred form in line with performance under the balanced scorecard framework and the
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overall performance of the Group, as set out above, as well as their own part of the business.
For executive Directors with responsibility for Asia, performance against financial objectives was mixed. Whilst the target for return on equity was met, overall 2008 profitability did not meet its target. Performance against Process, Customer and People objectives was stronger and this included high customer recommendation and employee engagement scores.
For Global Banking and Markets, although the financial targets for 2008 were not met, the business remained profitable and relative performance against its peers was strong. Performance against Process, Customer and People objectives was strong and included high employee engagement scores and improved positions within global markets league tables.
The bonus awards, which are shown in the table below, have been fully deferred into HSBC Holdings Restricted Shares, issued under the HSBC Share Plan, with a vesting date three years from the date of the award. Bonus awards made in 2008, in respect of performance in 2007 are shown for reference.
Long-term incentive plan
Under the HSBC Share Plan, executive Directors, as with other participants in the Plan, are eligible to receive awards of Performance Shares with a face value at grant of up to a maximum of seven times salary. The performance conditions associated with these awards are detailed in the next section, ‘Arrangements from 2008’.
No awards of Performance Shares have been made to date in 2009. Awards may be granted later in 2009, taking into account performance and the market context at the time.
The face and expected values of individual awards made in 2008, in respect of the prior 2007 performance year, are shown for reference.
Arrangements from 2008
The performance measures for the long-term incentive awards of Performance Shares under the HSBC Share Plan were amended last year following approval by shareholders at the 2008 Annual General Meeting.
From 2008, the vesting of awards is based on three independent performance measures and an overriding ‘sustained improvement’ judgement by the Committee. The three Group measures are relative total shareholder return (40 per cent of the award); economic profit (40 per cent of the award); and growth in earnings per share (‘EPS’) (20 per cent of the award).
These measures provide a basis on which to measure HSBC’s absolute and relative performance over the long-term taking into account an external measure of value creation, a measure of the extent to which the return on capital invested in HSBC is in excess of a benchmark return and a direct measure of the profits generated for shareholders.
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Awards will not vest unless the Remuneration Committee is satisfied that HSBC Holdings’ financial performance has shown a sustained improvement in the period since the award date. In determining whether HSBC Holdings has achieved such sustained improvement the Remuneration Committee will take account of all relevant factors, in particular, comparisons against the TSR comparator group in areas such as revenue growth and mix, cost efficiency, credit performance, cash return on cash invested, dividend performance and TSR.
The performance conditions are measured over a three year performance period and awards forfeited to the extent that they have not been met.
The performance measures and the targets described below apply for awards made in 2008. The Remuneration Committee will review annually whether the performance targets remain appropriate and challenging, or should be recalibrated, for awards made thereafter, taking into account factors such as economic expectations, the industry’s outlook and shareholders’ interests. The Committee will consult in accordance with institutional shareholder guidelines on any further changes proposed to the nature of the performance measures and their percentage split referred to above.
TSR is measured against a comparator group comprising the largest global banks in the world as well as other banks against which HSBC competes for business on a regional and/or local level. These companies are:
During 2008, HBOS and Wachovia merged with other banks in the comparator group. The Committee determined that the comparator group will remain large enough to be statistically valid and as such it was not necessary to introduce any replacement banks.
To reflect the fact that the range of market capitalisations within the comparator group is very
wide, a free float market capitalisation (‘FFMC’) weighted method is used to calculate TSR performance. Under this approach, HSBC’s outperformance of the comparator group will be calculated by dividing the total FFMC of all of the companies that HSBC has outperformed in terms of TSR by the total FFMC of all of the companies in the comparator group.
The extent to which the TSR award will vest will be determined as follows:
In line with the commitment made to shareholders in 2008, the Remuneration Committee reviewed the methodology and concluded that it continues to be appropriate. The Committee then wrote to HSBC Holdings’ sixty largest shareholders advising them of this conclusion and offering them the opportunity to comment.
Economic Profit (‘EP’) is calculated as the average annual difference between return on invested capital and the Group’s benchmark cost of capital and is expressed as a percentage. EP is a key measure of shareholder value creation as it rewards management progressively to the extent that the return on the capital invested in HSBC by its shareholders is in excess of a threshold return, which itself exceeds the Group’s benchmark cost of capital.
For the awards made in 2008 the benchmark cost of capital is 10 per cent. Return on invested capital is based on the profit attributable to shareholders as defined in the Annual Report and Accounts.
The extent to which the EP award will vest will be determined as follows:
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Earnings per share award
Growth in Earnings per Share (EPS) is measured on a point to point basis, by comparing EPS in the third financial year of the performance period with EPS in the financial year preceding that in which the award is made. This approach is aimed at simplifying the use of EPS as a performance measure and takes into account feedback received during consultation with institutional shareholders.
If events occur which cause the Remuneration Committee to consider that a performance condition has become unfair or impractical in either direction, the right is reserved to the Remuneration Committee, if it considers it appropriate to do so, to amend, relax or waive the condition.
Awards will vest in full, immediately in cases of death. In the event of redundancy, retirement on grounds of injury or ill health and where a participant ceases to be employed by HSBC due to a company ceasing to be part of HSBC, awards will normally vest at the end of the vesting period on a time-apportioned basis to the extent that the performance conditions have been satisfied. In the event of a change of control, awards will normally vest immediately and on a time-apportioned basis to the extent that the performance conditions have been satisfied. Awards will normally be forfeited if the participant is dismissed for cause or resigns from HSBC. In all circumstances the Committee retains discretion to ensure fair and reasonable treatment.
Arrangements from 2005 to 2007
Vesting of the awards of Performance Shares made under the HSBC Share Plan from 2005 to 2007 is based on two independent measures, relative TSR and growth in EPS. The performance conditions are measured over a three-year performance period and awards forfeited to the extent that they have not been met. The vesting of 50 per cent of the awards is based on TSR and the remaining 50 per cent on growth in EPS.
TSR award
The comparator group of 28 banks for the TSR award comprises the largest banks in the world,
on the basis of their market capitalisation, their geographic spread and the nature of their activities:
The extent to which the TSR award will vest will be determined on a sliding scale based on HSBC’s relative TSR ranking, measured over the three years, against the comparator group as shown below:
The method for calculating EPS growth is described below. This is in line with the approach described in the 2005, 2006 and 2007 Directors’ Remuneration Reports, as well as in the circular containing the Notice of Annual General Meeting for 2005.
The percentage of the conditional award vesting will depend upon the absolute growth in EPS achieved over the three years (‘the performance period’). 30 per cent of the conditional shares will vest if the incremental EPS over the performance period is 24 per cent or more of EPS in the base year. The percentage of shares vesting will rise on a straight line proportionate basis to 100 per cent if HSBC’s incremental EPS over the performance period is 52 per cent or more of EPS in the base year.
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In the interests of clarity, this has been set out in graphical form in the chart below.
For the EPS element of the award, the base measure shall be EPS for the financial year preceding that in which the award is made (‘the base year’). Absolute growth in EPS will then be compared with the base year over three consecutive financial years commencing with the year in which the award is made. Incremental EPS will be calculated by expressing as a percentage of the EPS of the base year the difference each year of the three-year performance period between the EPS of that year and the EPS of the base year. These percentages will then be aggregated to arrive at the total incremental EPS for the performance period. As illustrated in the table below, an incremental EPS of 51 per cent over three years would equate to a compound annual growth rate of 8 per cent.
Illustration of incremental EPS of 51 per cent over three years.
If EPS in any of the Years 1, 2 or 3 is below the base year, then the percentage difference between that particular year and the base year is negative.
For this purpose, EPS means the profit attributable to the Shareholders (expressed in US dollars), excluding goodwill amortisation, divided by the weighted average number of Ordinary Shares in issue and held outside the Group during the year in question. In the event that the published EPS for the base year is restated during the performance period to adjust for changes in accounting standards, that restated EPS will be used for the purposes of the EPS performance condition.
In addition, awards will not vest unless the Remuneration Committee is satisfied that HSBC Holdings’ financial performance has shown a sustained improvement in the period since the award
date. In determining whether HSBC Holdings has achieved a sustained improvement in performance the Remuneration Committee will take account of all relevant factors but in particular comparisons against the comparator group in areas such as revenue growth and mix, cost efficiency, credit performance, cash return on cash invested, dividend performance and TSR.
Awards will vest in full immediately in cases of death. In the event of redundancy, retirement on grounds of injury or ill health, early retirement by agreement, normal retirement and where a participant ceases to be employed by HSBC due to a company ceasing to be part of HSBC, awards will normally vest at the end of the vesting period on a time-apportioned basis to the extent that the performance conditions have been satisfied. In the event of a change of control, awards will normally vest immediately and on a time-apportioned basis to the extent that the performance conditions have been satisfied. Awards will normally be forfeited if the participant is dismissed for cause or resigns from HSBC. In all circumstances the Committee retains discretion to ensure fair and reasonable treatment.
Arrangements from 2002 to 2004
Between 2002 and 2004, awards of Performance Shares were made under the HSBC Holdings Restricted Share Plan 2000. Vesting was based on HSBC’s relative TSR performance over a three-year period from the date of the award, with full vesting of awards and transfer of shares to participants being no earlier than the fifth anniversary of the date of award.
Only one set of awards (the 2003 award) was outstanding at the start of 2008. At the second and final re-test of this award the performance targets were not met and therefore the award lapsed.
The dilution limits set out in the HSBC share plans comply with the Association of British Insurers’ guidelines. The Company’s policy to date is to fund long-term incentive awards of Performance Shares and Restricted Shares under the HSBC Share Plan through employee benefit trusts which undertake market purchases of HSBC Holdings’ shares.
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Total shareholder return
Pursuant to the Directors’ Remuneration Report Regulations 2002, the graph below shows HSBC’s TSR performance against the FTSE 100 Index, for the five-year period ended 31 December 2008. The FTSE 100 Index has been chosen as this is a recognised broad equity market index of which HSBC Holdings is a member.
HSBC TSR and FTSE 100 Index
Source: IDC
Pensions
The normal retirement age for executive Directors is 65 with the exception of V H C Cheng, where no retirement age is specified in keeping with local legislation. The pension entitlements of the executive Directors for 2008 are set out on page 324.
Share ownership guidelines
To ensure appropriate alignment with shareholders HSBC operates a formal share ownership policy, expressed as a number of shares, for executive Directors and the Group Managing Directors. The Committee considers that material share ownership by executives creates a community of interest between the leadership and shareholders.
To demonstrate further alignment with shareholders the share ownership guidelines were significantly increased from 2008.
Under the guidelines, the shareholding is expected to be achieved within five years of the executive’s appointment or three years from the date of approval of amendments to the HSBC Share Plan on 30 May 2008, whichever is the later.
The executive Directors and Group Managing Directors are now required to build and retain the following shareholdings.
The Remuneration Committee will monitor compliance annually. The Committee will have full discretion in determining any penalties in cases of non-compliance, which could include a reduction of future awards of long-term incentives and/or an increase in the proportion of the annual bonus that is deferred into shares.
Service contracts
HSBC’s policy is to employ executive Directors on one-year rolling contracts although longer initial terms may be approved by the Remuneration Committee if considered appropriate. The Remuneration Committee will, consistent with the best interests of the Group, seek to minimise termination payments.
S K Green, M F Geoghegan, V H C Cheng, D J Flint, A A Flockhart and S T Gulliver have rolling service contracts with a notice period of 12 months for either party.
In the event of early termination of employment other than for cause, of S K Green, M F Geoghegan, V H C Cheng, D J Flint, A A Flockhart or S T Gulliver, HSBC is entitled to make a payment in lieu of notice equal to base salary, pension entitlements and other benefits.
D J Flint, AA Flockhart and S T Gulliver will be eligible to be considered for a bonus on termination of employment by HSBC other than for cause. S T Gulliver will also be eligible to be considered for a bonus upon termination of employment by either party within 12 months following a change of control.
On termination of employment by HSBC, other than for cause (or termination by either party within 12 months following a change of control), S K Green and M F Geoghegan will be eligible for a bonus calculated as not less than the average of the
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previous two years of bonus payments received, pro-rated for any part year worked to termination.
Dates of service contracts – executive Directors
Other directorships
Executive Directors, if so authorised by either the Nomination Committee or the Board, may accept appointments as non-executive directors of suitable companies which are not part of HSBC. Approval will not be given for executive Directors to accept a non-executive directorship of more than one FTSE 100 company nor the chairmanship of such a company. When considering a non-executive appointment, the Nomination Committee or Board will take into account the expected time commitment of such appointment. The time commitment for executive Directors’ external appointments will be reviewed as part of the annual Board review. Any remuneration receivable in respect of an external appointment is normally paid to HSBC, unless otherwise approved by the Remuneration Committee. D J Flint has elected to donate his fees as a non-executive Director of BP p.l.c. to charity.
Non-executive Directors are appointed for fixed terms not exceeding three years, subject to their re-election by shareholders at Annual General Meetings. Non-executive directors have no service contract and are not eligible to participate in HSBC’s share plans. Current non-executive Directors’ terms of appointment will expire as follows:
J R Lomax and J L Thornton were appointed non-executive Directors with effect from 1 December 2008 and M K T Cheung was appointed a non-executive Director with effect from 1 February 2009. Subject to their re-election by shareholders at the Annual General Meeting in 2009, their terms of appointment will expire in 2012.
Non-executive Directors’ fees are regularly reviewed and compared with other large international companies. The current fee, which was approved by shareholders in 2006, is £65,000 per annum.
A fee of £30,000 per annum is payable to the senior independent non-executive Director. In addition, non-executive Directors receive the following fees for service on Board Committees:
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The emoluments of the Directors of HSBC Holdings for 2008 were as follows:
V H C Cheng ceased membership of, and accrual of benefits under, the HSBC Group Hong Kong Local Staff Retirement Benefit Scheme – Defined Benefit Section on 31 July 2008. The rules of the Scheme provide for a lump sum payment of benefit (rather than an annual pension) and Mr Cheng received a cash retirement benefit payment of HKD46,614,583 on 3 September 2008 in respect of reaching the age of 60, the normal retirement age under the Scheme. Mr Cheng’s accrued benefit and its transfer value
under the Scheme at 31 December 2007 was HKD32,906,250 and the increase of the accrued benefit and transfer value during 2008 (less personal contributions) was HKD13,708,333. As Mr Cheng has ceased membership of the Scheme, no accrued benefit or transfer value remained in the Scheme at 31 December 2008. The employer contribution to Mr Cheng’s retirement benefits Scheme for the period 1 January 2008 to 31 July 2008 was HKD626,250.
With effect from 1 August 2008 Mr Cheng has been a member of the Hong Kong Special Administrative Region Mandatory Provident Fund
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(‘MPF’) and receives an executive allowance of 25 per cent of annual basic salary, less the mandatory contributions to the MPF by both the employer and employee, to fund personal pension arrangements. The mandatory employer contribution to the MPF in respect of Mr Cheng for the period 1 August 2008 to 31 December 2008 was HKD5,000.
D J Flint receives an executive allowance of 55 per cent of annual basic salary to fund personal pension arrangements.
A A Flockhart left the International Staff Retirement Benefits Scheme on 30 November 2008. With effect from 2 December 2008 employer contributions equivalent to 40 per cent of annual basic salary are now made to a personal pension plan in respect of Mr Flockhart. During 2008, employer contributions of HKD258,000 were paid into this plan.
Mr Geoghegan receives an executive allowance of 50 per cent of annual basic salary to fund personal pension arrangements. In 2008, an employer
contribution was made to the HSBC Asia Holdings Pension Plan of £225,000 from a bonus sacrifice in respect of 2007 (in 2007, an employer contribution of £215,000 was made arising entirely from a bonus sacrifice in respect of 2006). There were no other employer contributions made to this plan.
S K Green ceased membership of the HSBC Bank (UK) Pension Scheme on 5 April 2006. Since 6 April 2006, Mr Green has been entitled to receive benefits from an Employer Funded Retirement Benefits Scheme which together with entitlements from the HSBC Bank (UK) Pension Scheme will provide benefits to Mr Green that would be broadly comparable to an accrual rate of one-thirtieth of pensionable salary for each year of pensionable service.
S T Gulliver left the International Staff Retirement Benefits Scheme on 31 March 2006. Employer contributions equivalent to 30 per cent of annual basic salary are now made to a personal pension plan in respect of Mr Gulliver. During 2008, employer contributions of £225,000 were paid into this plan.
The unfunded pension payments tabulated below, in respect of which provision has been made, were made during 2008 to five former Directors of HSBC Holdings.
The payments in respect of R Delbridge and Sir Brian Pearse were made by HSBC Bank plc as former Directors of that bank. The payment in respect of C F W de Croisset was made by HSBC France as a former Director of that bank.
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At 31 December 2008, the undernamed Directors held Performance Share awards, Restricted Share
awards and options to acquire the number of HSBC Holdings ordinary shares set against their respective names.
HSBC Holdings savings-related share option plansHSBC Holdings ordinary shares of US$0.50
The HSBC Holdings savings-related share option plans are all-employee share plans under which eligible HSBC employees may be granted options to acquire HSBC Holdings ordinary shares. Employees may make contributions of up to £250 (or equivalent) each month over a period of one, three or five years which may be used on the first, third or fifth anniversary of the commencement of the relevant savings contract, at the employee’s election, to exercise the options. The plans help align the interests of employees with the creation of shareholder value and, as such, exercise of the options is not subject to any performance conditions. The options were awarded for nil consideration and are exercisable at a 20 per cent discount to the average market value of the ordinary shares on the five business days immediately preceding the invitation date. No options lapsed during the year. There are no performance criteria conditional upon which the outstanding options are exercisable and there have been no variations to the terms and conditions since the awards were made. The market value of the ordinary shares at 31 December 2008 was £6.62. The highest and lowest market values during the year were £9.2775 and £6.1225. Market value is the mid-market price derived from the London Stock Exchange Daily Official List on the relevant date. Under the Securities and Futures Ordinance of Hong Kong, the options are categorised as unlisted physically settled equity derivatives.
Awards of Performance Shares HSBC Holdings Restricted Share Plan 2000
HSBC Holdings ordinary shares of US$0.50
Vesting of these awards was subject to the achievement of corporate performance conditions. Under the Securities and Futures Ordinance of Hong Kong, interests held through the HSBC Holdings Restricted Share Plan 2000 were categorised as the interests of a beneficiary of a trust.
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Awards of Performance Shares HSBC Share Plan
Vesting of these Performance Share awards is subject to the achievement of the corporate performance conditions set out on pages 318 to 319. Under the Securities and Futures Ordinance of Hong Kong, interests held through the HSBC Share Plan are categorised as the interests of a beneficiary of a trust.
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Awards of Restricted SharesHSBC Share Plan
Vesting of Restricted Share awards is normally subject to the Director remaining an employee on the vesting date. The vesting date may be advanced to an earlier date in certain circumstances, e.g. death or retirement. Under the Securities and Futures Ordinance of Hong Kong, interests held through the HSBC Share Plan are categorised as the interests of a beneficiary of a trust.
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The following statement, which should be read in conjunction with the Auditor’s statement of their responsibilities set out in their report on pages 330 and 331, is made with a view to distinguishing for shareholders the respective responsibilities of the Directors and of the Auditor in relation to the financial statements.
The Directors are responsible for preparing the Annual Report, the consolidated financial statements of HSBC Holdings and its subsidiaries (the ‘Group’) and holding company financial statements for HSBC Holdings (the ‘parent company’) in accordance with applicable law and regulations.
Company law requires the Directors to prepare Group and parent company financial statements for each financial year. The Directors are required to prepare the Group financial statements in accordance with IFRSs as adopted by the EU and have elected to prepare the parent company financial statements on the same basis. The Directors are also required to present additional information for US Shareholders. Accordingly these financial statements are framed to meet both UK and US requirements to give a consistent view to all shareholders.
The Group and parent company financial statements are required by law and IFRSs as adopted by the EU to present fairly the financial position of the Group and the parent company and the performance for that period; the Companies Act 1985 provides in relation to such financial statements that references in the relevant part of that Act to financial statements giving a true and fair view are references to their achieving a fair presentation. In addition, in order to meet certain US requirements, we are required to present our financial statements in accordance with IFRSs as adopted by the International Accounting Standards Board (‘IASB’). Currently, there are no differences in application to HSBC between IFRS endorsed by the EU and IFRS issued by the IASB.
In preparing each of the Group and parent company financial statements, the Directors are required to:
The Directors are required to prepare the financial statements on the going concern basis unless it is not appropriate. Since the Directors are satisfied that the Group and parent company have the resources to continue in business for the foreseeable future, the financial statements continue to be prepared on the going concern basis.
The Directors have responsibility for ensuring that sufficient accounting records are kept that disclose with reasonable accuracy at any time the financial position of the parent company and enable them to ensure that its financial statements comply with the Companies Act 1985.
The Directors have general responsibility for taking such steps as are reasonably open to them to safeguard the assets of the Group and to prevent and detect fraud and other irregularities. Under applicable law and regulations, the Directors also have responsibility for preparing a Directors’ Report, Directors’ Remuneration Report and the Corporate Governance statement on pages 281 to 314 that comply with that law and those regulations.
The Directors have responsibility for the maintenance and integrity of the Annual Report and Accounts as they appear on the company’s website. Legislation in the UK governing the preparation and dissemination of financial statements may differ from legislation in other jurisdictions.
The Directors, the names of whom are set out in the Report of Directors: Governance section on page 281 of this Annual Report, confirm to the best of their knowledge:
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We have audited the accompanying consolidated financial statements of HSBC Holdings plc and its subsidiary undertakings (together HSBC) on pages 333 to 447 which comprise the consolidated balance sheets as of 31 December 2008 and 2007, and the related consolidated income statements, consolidated cash flow statements and consolidated statements of recognised income and expense, for each of the years in the three-year period ended 31 December 2008, including the disclosures marked ‘audited’ within the critical accounting policies on pages 61 to 66, ‘Report of the Directors: Impact of Market Turmoil’ section on pages 144 to 187 and the ‘Report of the Directors: Risk’ section on pages 188 to 280. We have also audited HSBC’s internal control over financial reporting as of 31 December 2008, based on the framework for Directors’ internal control evaluation contained within the Combined Code (The Revised Turnbull Guidance), and the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). HSBC’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Assessment of Internal Controls. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the effectiveness of HSBC's internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on assessed risk. Our audits also included performing other such procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorisations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorised acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of HSBC as of 31 December 2008 and 2007, and the results of their operations and their cash flows for each of the years in the three-year period ended 31 December 2008, in conformity with International Financial Reporting Standards (‘IFRSs’) as adopted by the European Union (‘EU’) and IFRSs as issued by the International Accounting Standards Board (‘IASB’). Also, in our opinion, HSBC maintained, in all material respects, effective internal control over financial reporting as of 31 December 2008, based on the framework for Directors’ internal control evaluation contained within the Combined Code (The Revised Turnbull Guidance) and the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
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As discussed in Note 1 to the consolidated financial statements, HSBC has changed its method of accounting for certain financial assets in the year ended 31 December 2008 following the adoption of ‘Reclassification of Financial Assets (Amendments to IAS 39 Financial Instruments: Recognition and Measurement and IFRS 7 Financial Instruments: Disclosures).
KPMG Audit PlcLondon, England2 March 2009
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Consolidated statement of recognised income and expense for the year ended 31 December 2008
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The accompanying notes on pages 340 to 447, the audited sections of the ‘Report of the Directors: Risk’ on pages 188 to 280, ‘Critical accounting policies’ on pages 61 to 66 and ‘Impact of Market Turmoil’ on pages 144 to 187 form an integral part of these financial statements.
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In addition, awards of punitive damages in actions brought in the US or elsewhere may be unenforceable in the UK. The enforceability of any judgement in the UK will depend on the particular facts of the case as well as the laws and treaties in effect at the time.
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Reports, statements or information that HSBC Holdings files with the Securities and Exchange Commission are available at www.sec.gov. Investors can also request hard copies of these documents
upon payment of a duplicating fee, by writing to the SEC at the Office of Investor Education and Advocacy, 100 F Street N.E. Washington, DC 20549-0123 or by emailing PublicInfo@sec.gov. Investors should call the Commission at (202) 551 8090 if they require further assistance. Investors may also obtain the reports and other information that HSBC Holdings files at the offices of the New York Stock Exchange, Inc., 11 Wall Street, New York, NY 10005.
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The following is a summary, under current law, of the principal UK tax considerations that are likely to be material to the ownership and disposition of shares. The summary does not purport to be a comprehensive description of all the tax considerations that may be relevant to a holder of shares. In particular, the summary deals principally with shareholders who are resident in the UK for UK tax purposes and only with holders who hold the shares as investments and who are the beneficial owners of the shares, and does not address the tax treatment of certain classes of holders such as dealers in securities. Holders and prospective purchasers should consult their own advisers regarding the tax consequences of an investment in shares in light of their particular circumstances, including the effect of any national, state or local laws.
Taxation of dividends
Currently no tax is withheld from dividends paid by HSBC Holdings. However, dividends are paid with an associated tax credit which is available for set-off by certain shareholders against any liability they may have to UK income tax. Currently, the associated tax credit is equivalent to 10 per cent of the combined cash dividend and tax credit, i.e. one-ninth of the cash dividend.
For individual shareholders who are resident in the UK for taxation purposes and liable to UK income tax at the basic rate, no further UK income tax liability arises on the receipt of a dividend from HSBC Holdings. Individual shareholders who are liable to UK income tax at the higher rate on UK dividend income (currently 32.5 per cent) are taxed on the combined amount of the dividend and the tax credit. The tax credit is available for set-off against the higher rate liability, leaving net higher rate tax to pay equal to 25 per cent of the cash dividend. Individual UK resident shareholders are not entitled to any tax credit repayment.
Although non-UK resident shareholders are generally not entitled to any repayment of the tax credit in respect of any UK dividend received, some such shareholders may be so entitled under the provisions of a double taxation agreement between their country of residence and the UK. However, in most cases no amount of the tax credit is, in practice, repayable.
Information on the taxation consequences of the HSBC Holdings scrip dividends offered in lieu of the
2007 fourth interim dividend and the first, second and third interim dividends for 2008 was set out in the Secretary’s letters to shareholders of 3 April, 3 June, 3 September and 3 December 2008. In each case, the difference between the cash dividend foregone and the market value of the scrip dividend did not equal or exceed 15 per cent of the market value and accordingly, the price of HSBC Holdings US$0.50 ordinary shares (the ‘shares’) for UK tax purposes for the dividends was the cash dividend foregone.
Taxation of capital gains
The computation of the capital gains tax liability arising on disposals of shares in HSBC Holdings by shareholders subject to UK capital gains tax can be complex, partly depending on whether, for example, the shares were purchased since April 1991, acquired in 1991 in exchange for shares in The Hongkong and Shanghai Banking Corporation Limited, or acquired subsequent to 1991 in exchange for shares in other companies.
For capital gains tax purposes, the acquisition cost for ordinary shares is adjusted to take account of subsequent rights and capitalisation issues. Further adjustments apply where an individual shareholder has chosen to receive shares instead of cash dividends, subject to scrip issues made since 6 April 1998 being treated for tax as separate holdings. Any capital gain arising on a disposal may also be adjusted to take account of indexation allowance and, in the case of individuals, taper relief. Except for gains made by a company chargeable to UK corporation tax, any such indexation allowance is calculated up to 5 April 1998 only.
Changes to capital gains tax were made that apply to disposals of shares with effect from 6 April 2008. The changes included:
If in doubt, shareholders are recommended to consult their professional advisers.
Inheritance tax
Shares or ADSs held by an individual whose domicile is determined to be the US for the purposes
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of the United States-United Kingdom Double Taxation Convention relating to estate and gift taxes (the ‘Estate Tax Treaty’) and who is not for such purposes a national of the UK will not, provided any US Federal estate or gift tax chargeable has been paid, be subject to UK inheritance tax on the individual’s death or on a lifetime transfer of shares or ADSs except in certain cases where the shares or ADSs (i) are comprised in a settlement (unless, at the time of the settlement, the settlor was domiciled in the US and was not a national of the UK), (ii) is part of the business property of a UK permanent establishment of an enterprise, or (iii) pertains to a UK fixed base of an individual used for the performance of independent personal services. In such cases, the Estate Tax Treaty generally provides a credit against US Federal tax liability for the amount of any tax paid in the UK in a case where the shares or ADSs are subject to both UK inheritance tax and to US Federal estate or gift tax.
Stamp duty and stamp duty reserve tax
Transfers of shares by a written instrument of transfer generally will be subject to UK stamp duty at the rate of 0.5 per cent of the consideration paid for the transfer, and such stamp duty is generally payable by the transferee.
An agreement to transfer shares, or any interest therein, normally will give rise to a charge to stamp duty reserve tax at the rate of 0.5 per cent of the consideration. However, provided an instrument of transfer of the shares is executed pursuant to the agreement and duly stamped before the date on which the stamp duty reserve tax becomes payable, under the current practice of UK HM Revenue and Customs it will not be necessary to pay the stamp duty reserve tax, nor to apply for such tax to be cancelled. Stamp duty reserve tax is generally payable by the transferee.
Paperless transfers of shares within CREST, the UK’s paperless share transfer system, are liable to stamp duty reserve tax at the rate of 0.5 per cent of the consideration. In CREST transactions, the tax is calculated and payment made automatically. Deposits of shares into CREST generally will not be subject to stamp duty reserve tax, unless the transfer into CREST is itself for consideration.
Taxation – US residents
The following is a summary, under current law, of the principal UK tax and US federal income tax considerations that are likely to be material to the ownership and disposition of shares or ADSs by a holder that is a resident of the US for the purposes of
the income tax convention between the US and the UK (the ‘Treaty’), and is fully eligible for benefits under the Treaty (an ‘eligible US holder’). The summary does not purport to be a comprehensive description of all of the tax considerations that may be relevant to a holder of shares or ADSs. In particular, the summary deals only with eligible US holders that hold shares or ADSs as capital assets, and does not address the tax treatment of holders that are subject to special tax rules, such as banks, tax-exempt entities, insurance companies, dealers in securities or currencies, persons that hold shares or ADSs as part of an integrated investment (including a ‘straddle’) comprised of a share or ADS and one or more other positions, and persons that own, directly or indirectly, 10 per cent or more of the voting stock of HSBC Holdings. This discussion is based on laws, treaties, judicial decisions and regulatory interpretations in effect on the date hereof, all of which are subject to change. Under the current income tax treaty between the UK and the US, eligible US holders are no longer entitled to claim a special foreign tax credit in respect of dividends.
Holders and prospective purchasers should consult their own advisers regarding the tax consequences of an investment in shares or ADSs in light of their particular circumstances, including the effect of any national, state or local laws.
In general, the beneficial owner of a share or ADS will be entitled to benefits under the Treaty (and, therefore, will be an eligible US holder) if it is (i) an individual resident of the US, a US corporation meeting ownership criteria specified in the Treaty or other entity meeting criteria specified in the Treaty; and (ii) not also resident in the UK for UK tax purposes. Special rules, including a limitation of benefits provision, may apply. The Treaty benefits discussed below generally are not available to US holders that hold shares or ADSs in connection with the conduct of a business through a permanent establishment, or the performance of personal services through a fixed base, in the UK.
An eligible US holder must include cash dividends paid on the shares or ADSs in ordinary income on the date that such holder or the ADS depositary receives them, translating dividends paid in UK pounds sterling into US dollars using the exchange rate in effect on the date of receipt. Subject to certain exceptions for positions that are held for less than 61 days or are hedged, and subject to a foreign corporation being considered a ‘qualified foreign corporation’ (which includes not being classified for US federal income tax purposes as a passive foreign
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investment company), certain dividends (‘qualified dividends’) received by an individual eligible US holder before 2011 generally will be subject to US taxation at a maximum rate of 15 per cent. Based on the company’s audited financial statements and relevant market and shareholder data, HSBC Holdings believes that it was not treated as a passive foreign investment company for US federal income tax purposes with respect to its 2008 taxable year. In addition, based on the company’s current expectations regarding the value and nature of its assets, and the sources and nature of its income, HSBC Holdings does not anticipate being classified as a passive foreign investment company for its 2009 taxable year. Accordingly, dividends paid on the shares or ADSs generally should be treated as qualified dividends.
Gains realised by an eligible US holder on the sale or other disposition of shares or ADSs normally will not be subject to UK taxation unless at the time of the sale or other disposition the holder carries on a trade, profession or vocation in the UK through a branch or agency or permanent establishment and the shares or ADSs are or have been used, held or acquired for the purposes of such trade, profession, vocation, branch or agency or permanent establishment. Such gains will be included in income for US tax purposes, and will be long-term capital gains if the shares or ADSs were held for more than one year. A long-term capital gain realised by an individual holder generally is subject to US tax at a maximum rate of 15 per cent.
Stamp duty and stamp duty reserve tax – ADSs
If shares are transferred into a clearance service or depository receipt (‘ADR’) arrangement (which will include a transfer of shares to the Depository) UK stamp duty and/or stamp duty reserve tax will be payable. The stamp duty or stamp duty reserve tax is generally payable on the consideration for the transfer and is payable at the aggregate rate of 1.5 per cent.
The amount of stamp duty reserve tax payable on such a transfer will be reduced by any stamp duty paid in connection with the same transfer.
No stamp duty will be payable on the transfer of, or agreement to transfer, an ADS, provided that the ADR and any separate instrument of transfer or written agreement to transfer remain at all times outside the UK, and provided further that any such transfer or written agreement to transfer is not executed in the UK. No stamp duty reserve tax will
be payable on a transfer of, or agreement to transfer, an ADS effected by the transfer of an ADR.
On a transfer of shares from the Depository to a registered holder of an ADS upon cancellation of the ADS, a fixed stamp duty of £5 per instrument of transfer will be payable by the registered holder of the ADR cancelled.
US backup withholding tax and information reporting
Distributions made on shares and proceeds from the sale of shares or ADSs that are paid within the US, or through certain financial intermediaries to US holders, are subject to information reporting and may be subject to a US ‘backup’ withholding tax unless, in general, the US holder complies with certain certification procedures or is a corporation or other person exempt from such withholding. Holders that are not US persons generally are not subject to information reporting or backup withholding tax, but may be required to comply with applicable certification procedures to establish that they are not US persons in order to avoid the application of such information reporting requirements or backup withholding tax to payments received within the US or through certain financial intermediaries.
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Item 19. Exhibits
Documents filed as exhibits to this Form 20-F:
SIGNATURES
The registrant hereby certifies that it meets all of the requirements for filing on Form 20-F and that it has duly caused and authorized the undersigned to sign this annual report on its behalf.
Dated: 10 March 2009