Annual Financial Report - 22x of 44

with central banks considered strong, the proportion of balances classified as strong increased from 90% to 98%.

Loans and advances held at amortised cost, on which credit quality has been assessed, decreased by 4% to US$1,121bn. The decline was mainly in North America, following the reclassification of certain lending balances to assets held for sale. Despite the reclassification of balances, the proportion of the Group's loans and advances held at amortised cost and categorised as strong and good were broadly in line with the end of 2010, at 54% and 22% respectively.

Trading assets, on which credit quality has been assessed, decreased by 10% to US$309bn in 2011. This reflected a reduction in our holdings of government and highly-rated corporate debt securities and equity positions, notably in Europe. Despite the decline in balances, the proportion of balances classified as strong remained stable at 75%.

The following tables set out our distribution of financial instruments by measures of credit quality:

Distribution of financial instruments by credit quality

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Distribution of financial instruments by credit quality (continued)

For footnotes, see page 185.

Past due but not impaired gross financial instruments

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Past due but not impaired loans are those for which the customer is in the early stages of delinquency and has failed to make a payment, or a partial payment, in accordance with the contractual terms of the loan agreement. This is typically where a loan is less than 90 days past due and there are no other indicators of impairment.

Further examples of exposures past due but not impaired include individually assessed mortgages that are in arrears more than 90 days where there are no other indicators of impairment, 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. Where groups of loans are collectively assessed for impairment, collective impairment allowances are recognised for loans classified as past due but not impaired.

At 31 December 2011, US$20.0bn of loans and advances held at amortised cost were classified as past due but not impaired (2010: US$22.7bn). The largest concentration of these balances is in HSBC Finance. The decrease compared with 2010 was primarily due to the reclassification of the Card and Retail Services business to held for sale and the continued run-off of the CML portfolio.

Past due but not impaired loans and advances to customers and banks by geographical region8

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Past due but not impaired loans and advances to customers and banks by industry sector8

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For footnote, see page 185.

Ageing analysis of days past due but not impaired gross financial instruments

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For footnote, see page 185.

Renegotiated loans and forbearance

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The contractual terms of a loan may be modified for a number of reasons including changing market conditions, customer retention and other factors not related to the current or potential credit deterioration of a customer. When the contractual payment terms of a loan have been modified because we have significant concerns about the borrower's ability to meet contractual payments when due, these loans are classified as 'renegotiated loans'. For the purposes of this disclosure the term 'forbearance' is synonymous with the renegotiation of loans for these purposes.

In the Annual Report and Accounts 2011, the Group has separately presented all renegotiated loans by credit quality classification and has adopted a more stringent impaired loan disclosure convention for portfolios with significant levels of forbearance as described on page 133.

The following tables show the Group's holdings of renegotiated loans and advances to customers by industry sector, geography and credit quality classification.

Renegotiated loans and advances to customers

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Renegotiated loans and advances to customers by geography

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2011 compared with 2010

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Renegotiated loans totalled US$46.0bn at 31 December 2011 (2010: US$48.1bn). The most significant volume of renegotiation activity took place in North America and, at 31 December 2011, amounted to US$28.5bn or 62% of total renegotiated loans (2010: US$32.0bn or 66%), substantially all of which were retail loans held by HSBC Finance. Of the total renegotiated loans in North America, US$17.8bn were presented as impaired at 31 December 2011 (2010: US$22.0bn), and the ratio of total impairment allowances to impaired loans at 31 December 2011 was 28% (2010: 25%).

Europe was the next largest region for renegotiation activity which, at 31 December 2011, amounted to US$11.5bn (2010: US$10.7bn), constituting 25% of total renegotiated loans (2010: 22%). Of the total renegotiated loans in Europe, US$6.0bn were presented as impaired at 31 December 2011 (2010: US$4.8bn), and the ratio of total impairment allowances to impaired loans at 31 December 2011 was 30% (2010: 28%). The renegotiated loans in Europe were largely concentrated in the commercial real estate sector 41% (2010: 39%) and the corporate and commercial sector 32% (2010: 31%). The commercial real estate sector, particularly in the UK, faced a weakening in property values and a reduction in institutions funding commercial real estate lending. The commercial real estate mid-market sector continued to experience higher levels of renegotiation activity than is evident with larger corporates, where borrowers are generally better capitalised and have access to wider funding market opportunities. In all cases, in assessing the acceptability of renegotiated loans, we consider the ability to service interest as a minimum and reduce capital repayments as available. Despite Europe, and the UK in particular, holding the single largest retail lending portfolio in the Group, renegotiations of retail loans in this region were limited due to the quality of the residential mortgage book.

Forbearance activity within the Middle East and Latin America (primarily in Mexico and Brazil) was predominately undertaken in the commercial real estate and corporate and commercial sectors. Forbearance activity within Hong Kong and Rest of Asia-Pacific was insignificant.

HSBC Finance loan modifications and re‑ageing

HSBC Finance maintains loan modification and re‑age ('loan renegotiation') programmes in order to manage customer relationships, improve collection opportunities and, if possible, avoid foreclosure.

Since 2006, HSBC Finance has implemented an extensive loan renegotiation programme, and a significant portion of its loan portfolio has been subject to renegotiation at some stage in the life of the customer relationship as a consequence of the economic conditions in the US and the nature of HSBC Finance's customer base.

From late 2009 and continuing into 2011, the volume of loans that qualify for a new modification has reduced significantly. We expect this to continue to decline as HSBC Finance believes a decreasing percentage of its customers with unmodified loans would benefit from loan modification in a way that would avoid non-payment of future cash flows. In addition, volumes of new loan modifications are expected to decrease due to improvements in economic conditions over the long-term, the cessation of new real estate secured and personal non-credit card receivables originations, the continued run-off of the portfolio and, beginning in the second quarter of 2010, more stringent qualifying payment requirements for loan modifications.

Qualifying criteria

For an account to qualify for renegotiation it must meet certain criteria. However, HSBC Finance retains the right to decline a renegotiation. The extent to which HSBC Finance renegotiates accounts that are eligible under its existing policies will vary depending upon its view of prevailing economic conditions and other factors which may change from year to year. In addition, exceptions to policies and practices may be made in specific situations in response to legal or regulatory agreements or orders.

Renegotiated real estate secured and personal non-credit card receivables are not eligible for a subsequent renegotiation until 12 or 6 months, respectively, with a maximum of five renegotiation actions within a five-year period. Borrowers must be approved for a modification and generally make two minimum qualifying monthly payments within 60 days to activate a modification.

In certain circumstances where the debt has been restructured in bankruptcy proceedings, fewer or no payments may be required. Accounts whose borrowers are subject to a Chapter 13 plan filed with a bankruptcy court generally may be re-aged upon receipt of one qualifying payment, whereas accounts whose borrowers have filed for Chapter 7 bankruptcy protection may be re-aged upon receipt of a signed reaffirmation agreement. In addition, for some products, accounts may be re-aged without receipt of a payment in certain special circumstances (e.g. in the event of a natural disaster or a hardship programme).

Review of loan classification methodology

In the third quarter of 2011, HSBC Finance undertook a review of its loan classification methodology to provide greater differentiation of loans based on their credit risk characteristics. This review was performed partly as a result of updated

US guidance on 'troubled debt restructurings' and because an increasing percentage of the portfolio has been subject to forbearance in recent years, with the closure of the portfolio to new business. The review involved extensive statistical analysis of actual default experience in the portfolio. Amongst other improvements, this review resulted in changes to further differentiate the credit characteristics of forbearance cases, including those which return to performing status following forbearance. The review included consideration of the application of the Group's accounting policy for the recognition of impairment allowances for the CML portfolio, and changes to improve assumptions about default and severity rates for the purposes of measuring impairment allowances. The consequent changes did not result in a material change to impairment allowances recorded by HSBC Finance under IFRSs. However, the Group's revised impaired loan disclosure convention was adopted.

At 31 December 2011, renegotiated real estate secured accounts represented 86% (2010: 85%) of North America's total renegotiated loans, and US$16bn (2010: US$18.2bn) of renegotiated real estate secured loans in HSBC Finance were classified as impaired. Further details of HSBC Finance's real estate secured accounts and renegotiation programmes are provided below.

Gross loan portfolio of HSBC Finance real estate secured accounts

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For footnote, see page 185.

Number of renegotiated real estate secured accounts remaining in HSBC Finance's portfolio

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During 2011, the aggregate number of renegotiated loans reduced, despite renegotiation activity continuing, due to the run-off of the portfolio. Within the constraints of our Group credit policy, HSBC Finance's policies allow for multiple renegotiations under certain circumstances, and a number of accounts received a second (or further) renegotiation during the year which did not appear in the statistics presented above. These statistics present a loan as an addition to the volume of renegotiated loans on its first renegotiation only. At 31 December 2011, renegotiated loans were 56% (2010: 53%) of HSBC Finance's real estate secured accounts.

Corporate and Commercial forbearance

The majority of the increase in renegotiated loans activity for the commercial real estate sector in 2011 arose in Europe, which increased by US$617m. This increase predominately related to the renegotiation of a large exposure together with high levels of forbearance in the UK towards the end of 2011 reflecting current economic conditions, including a weakening in property values and a reduction in institutions funding commercial real estate lending.

In the corporate and commercial sector the increase in renegotiated loans in 2011 was again a result of increased forbearance activity in Europe. The increase related to renegotiations of a small number of larger lending arrangements provided to European corporate entities and economic pressures in Europe more generally. This was partially offset by repayments and write-offs of renegotiated loans in Europe, Rest of Asia-Pacific and Latin America.

In the financial sector the increase in renegotiated loans in 2011 primarily related to financial difficulties in one financial sector entity. In the government sector renegotiation activity was wholly due to increases in Latin America caused by term extension restructurings of municipal and local authority facilities.

Impaired loans disclosure

During 2011 we adopted a revised disclosure convention for the presentation of impaired loans and advances which affects the disclosure of loans and advances in the geographical regions with significant levels of forbearance activity. The previous impaired loan disclosure convention was that impaired loans and advances were those classified as CRR9, CRR10, EL9 or EL10 and all retail loans 90 days or more past due, unless individually they had been assessed as not impaired. Renegotiated loans that did not meet the above criteria were classified as 'neither past due nor impaired' or 'past due but not impaired' as appropriate, however these loans were assessed for impairment in accordance with the Group's accounting policy on the recognition of impairment allowances, as described on page 193.

The revised disclosure convention continues to be based on internal credit rating grades and, for retail exposures, 90 days or more past due status. However, it introduces a more stringent approach to the assessment of whether renegotiated loans are presented as impaired. Management believes that this revised approach better reflects the nature of risks and inherent credit quality in our loan portfolio as it is more closely calibrated to the types of forbearance concession granted and applies stricter requirements for the performance of renegotiated loans before they may be presented as no longer impaired. It also reflects developments in industry best practice disclosure, as well as a refinement of loan segmentation in our North America consumer lending business. The revised disclosure convention affects the disclosure presentation of impaired loans but does not affect the accounting policy for the recognition of impairment allowances.

Under this revised disclosure convention, impaired loans and advances are those that meet any of the following criteria:

·; loans and advances classified as CRR 9, CRR 10, EL 9 or EL 10 (a description of our internal credit rating grades is provided on page 191);

·; retail exposures 90 days or more past due, unless individually they have been assessed as not impaired; or

·; renegotiated loans and advances that have been subject to a change in contractual cash flows as a result of a concession which the lender would not otherwise consider, and where it is probable that without the concession the borrower would be unable to meet its contractual payment obligations in full, unless the concession is insignificant and there are no other indicators of impairment. Renegotiated loans remain classified as impaired until there is sufficient evidence to demonstrate a significant reduction in the risk of non-payment of future cash flows, and there are no other indicators of impairment.

For loans that are assessed for impairment on a collective basis, the evidence to support reclassification as no longer impaired typically comprises a history of payment performance against the original or revised terms, depending on the nature and volume of forbearance and the credit risk characteristics surrounding the renegotiation. For loans that are assessed for impairment on an individual basis, all available evidence is assessed on a case by case basis.

In HSBC Finance, where a significant majority of HSBC's loan forbearance activity occurs, the demonstrated history of payment performance is with reference to the original terms of the contract, reflecting the higher credit risk characteristics of this portfolio. The payment performance periods are monitored to ensure they remain appropriate to the levels of recidivism observed within the portfolio.

Further disclosure about loans subject to forbearance is provided on page 129. Renegotiated loans and forbearance disclosures are subject to evolving industry practice and regulatory guidance.

Impaired loan comparative data for 31 December 2010 have been restated to reflect the revised impaired loans disclosure convention. Restatement of comparative data prior to 31 December 2010 is not practicable as sufficient information is not available to determine what assumptions management would have made in applying the revised disclosure convention for those comparative periods. This includes information about assumptions that would have been made in establishing the revised, more stringent period of payment performance for renegotiated loans before they are regarded as unimpaired. The difficulty associated with determining these estimates relates principally to retail portfolios that are assessed for impairment on a collective basis; these estimates become more difficult when a longer period of time has passed since the credit condition occurred.

The following table shows the effect of the revised disclosure convention on total reported impaired loans and advances to customers for geographical regions with significant levels of forbearance.

Impaired loans and advances to customers

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Impairment of loans and advances

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For footnote, see page 185.

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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.

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