Interim Report - 12 of 21

Regulatory and supervisory developments have largely been shaped by the Leaders, Finance Ministers and Central Bank Governors of the Group of Twenty ('the G20'). In looking to address the systemic failures that caused the financial crisis, the G20 has issued several statements highlighting the following priorities:

·; a stronger international framework for prudential regulation, ensuring increased liquidity and regulatory capital buffers and enhanced quality of capital;

·; an increased role for colleges of supervisors to coordinate oversight of systemically significant institutions such as HSBC, and effective coordination of resolution regimes for failed banks;

·; convergence towards a single set of high-quality, global, independent accounting standards on financial instruments, loan loss provisioning, off-balance sheet exposures and the impairment and valuation of financial assets;

·; strengthening of the regulation of hedge funds and credit rating agencies, and an improved infrastructure for derivative transactions, including central counterparty clearing of over-the-counter derivatives;

·; design and implementation of a system which will allow for the restructuring or resolution of financial institutions, without taxpayers ultimately bearing the burden;

·; measures on financial sector compensation arrangements to prevent excessive short-term risk taking and mitigate systematic risk on a globally consistent basis; and

·; a fair and substantial contribution by the financial sector towards paying for any burden associated with government interventions, where they occur, to repair and reduce risks from the financial system or fund the resolution of problems.

The Financial Stability Board ('FSB') was established by the G20 to help address these issues, specifically assessing vulnerabilities affecting the financial system, monitoring and advising on market developments and best practice in meeting regulatory standards. The FSB has provided a number of interim and progress reports to the G20, including reports on the reform of compensation structures and on reducing the moral hazard of systemically important financial institutions.

The key steps that have been taken by governments, regulators and accounting standard setters towards meeting the aims set out by the G20 are described below.

Global

Regulation

In December 2009, the Basel Committee on Banking Supervision (the 'Basel Committee') issued its draft proposals, commonly referred to as Basel III, for greater consistency, quality and transparency in regulatory capital requirements, and greater resilience on the part of international banks to liquidity stresses. The proposals aim to exclude lower quality instruments from core capital, significantly reduce banks' structural reliance on short-term funding and reduce banks' leverage by setting a minimum ratio of capital to assets.

In July 2010, the Basel Committee issued a consultation paper as part of the approach to addressing the issue of pro-cyclicality identified in their December 2009 paper. Also in July 2010, the Basel Committee announced that its oversight body, the Group of Governors and Heads of Supervision, had reached broad agreement on the overall design of the capital and liquidity reform package. Calibration and phase-in arrangements are to be finalised towards the end of 2010, and further material is expected on contingent capital and systemically significant banks. It is not possible to assess the financial impact of these reforms on HSBC.

Accounting standards

In June 2010, the International Accounting Standards Board ('IASB') and the Financial Accounting Standards Board in the US ('FASB') renewed their commitment to achieving convergence in the accounting for financial instruments. In particular, the IASB re-prioritised its work programme to focus on its response to the financial crisis. The key steps taken by the Boards to date are:

·; In November 2009, the IASB issued IFRS 9 'Financial Instruments', effective for accounting periods beginning on or after 1 January 2013, to address the classification and measurement of financial assets. This is the first phase of its project to replace IAS 39 and simplify the accounting for financial instruments.

·; In November 2009, the IASB exposed its proposals for changes to the impairment rules for financial assets measured at amortised cost. The proposals are intended to result in the earlier recognition of impairment losses.

·; In May 2010, the IASB exposed its proposals for changes to the classification and measurement of financial liabilities. The proposals are intended to address the volatility in profit and loss caused by changes in an entity's own credit risk.

·; In May 2010, the FASB issued an Accounting Standards Update, setting out its proposed comprehensive approach to financial instrument classification and measurement, impairment, and revisions to hedge accounting. To date the proposals of the FASB differ significantly from those of the IASB and it is unclear whether convergence will be achieved.

Compensation

To address concerns around the compensation arrangements of banks, in September 2009, the FSB published its implementation standards on compensation, focusing on areas where rapid progress was deemed necessary, including independent and effective Board oversight of compensation policies and practices, linkages of the total variable compensation pool to the overall performance of the firm and the need to maintain a sound capital base, alignment of compensation structures to risk, limitations on guaranteed bonuses and enhanced disclosure and supervisory oversight.

Europe

Regulation

In Europe, the European Union Council of Ministers (the 'Council') and European Parliament continue to discuss proposals for the establishment of a European Systemic Risk Board for macro-prudential oversight of the financial system, a European Banking Authority, a European Insurance and Occupational Pensions Authority and a European Securities and Markets Authority.

In February 2010, the European Commission issued a public consultation on the third set of proposed amendments to the EU Capital Requirements Directive ('CRD'), CRD 4 to reflect its proposed implementation of Basel III, with certain adjustments. These will supplement (i) CRD 2, covering own funds, large exposures, supervisory arrangements, qualitative standards for liquidity risk management and securitisation which will come into force on 31 December 2010; and (ii) CRD 3, covering disclosure of remuneration policies, effective 1 January 2011, and capital requirements for trading books and re-securitisations and disclosure of securitisation exposures, effective 31 December 2011.

In July 2010, the European Commission proposed further reforms to depositor and investor compensation schemes, including regular contributions by banks into the applicable national deposit guarantee scheme. The European Commission has also announced plans for legislation to promote greater central clearing of derivatives and to strengthen corporate governance.

In the UK, the Financial Services Act 2010, enacted in April 2010, established a requirement for UK banks to prepare recovery and resolution plans.

In June 2010, the UK Government announced that the UK Financial Services Authority ('FSA') will cease to exist in its present form and four new supervisory bodies will be established by the end of 2012:

·; the Prudential Regulation Authority, a subsidiary of the Bank of England, will be responsible for the prudential regulation of financial firms;

·; the Consumer Protection and Markets Authority ('CPMA') will regulate the conduct of financial firms providing services to consumers;

·; the Financial Policy Committee ('FPC'), chaired by the Governor of the Bank of England, will consider macro issues affecting economic and financial stability and take action in response. An interim FPC will be established in the second half of 2010, prior to any legislation; and

·; the Economic Crime Agency will take on functions currently fulfilled by a number of UK Government departments and agencies to tackle serious economic crime.

Pending these changes to supervision in the UK, the FSA continues to operate as before and, in June 2010, finalised its proposals for a new liquidity regime, including updated quantitative rules coupled with a narrow definition of liquid assets.

In July 2010, the FSA announced the implementation of its new powers granted by the Financial Services Act 2010, including the power to impose financial penalties on individuals and firms and more intense information-gathering in relation to financial stability to help identify potential threats to the UK financial market. Also in July 2010, the UK government published a consultation paper seeking views on whether it should merge the UK Listing Authority ('UKLA') with the Financial Reporting Council, the UK's independent regulator responsible for promoting high quality corporate governance and reporting, under the Department for Business, Innovation and Skills, or whether the UKLA should remain within the CPMA markets division.

Compensation

In December 2009, the governments of the UK and France introduced one-off taxes in respect of certain bonuses payable by banks and banking groups. In both countries the tax was levied at 50 per cent on bonuses awarded during a certain period and over a threshold amount. The taxes were liabilities of the employer and were payable on awards of both cash and shares. The provision held by HSBC in respect of the relevant tax payable, is US$325 million in the UK. The French liability of US$42 million was paid by the due date of 25 April 2010.

The FSA introduced new rules relating to the remuneration within UK banks and HSBC voluntarily determined to apply them to the Group on a global basis. On 29 July 2010, the FSA announced that it intends to update the rules to incorporate the effects of the EU's CRD 3 proposal and the Financial Services Act 2010.

Financial contribution

A joint statement was made by the UK, French and German governments in June 2010 announcing plans for the introduction of a bank levy in each country. The specific design of each may differ to reflect the different domestic circumstances and tax systems. In the UK, a consultation paper has been published indicating that the levy will be introduced from 1 January 2011. However, detailed legislation has yet to be finalised or enacted in any of the countries and it is therefore not possible to quantify the financial impact on the Group.

US

Regulation

In July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act ('the Act') was signed into law by the US president. The Act creates a number of regulatory agencies and offices with broad responsibilities for improving the safety of the financial system, including the creation of a Financial Stability Oversight Council to identify emerging risks to financial stability and advise the Federal Reserve Board ('FRB'), expanding the powers of the FRB to regulate capital and risk management requirements in systemically important financial institutions and establishing comprehensive regulation of over-the-counter derivatives including credit default swaps. US bank holding companies such as HSBC North America Holdings Inc. and non-bank financial companies deemed systemically significant by the new Council will be subject to enhanced prudential standards with respect to capital, liquidity, leverage and amounts of short-term debt, and subject to periodic stress tests. In addition, US bank holding companies may be required to replace certain securities at the holding company level which today constitute tier 1 capital under Basel I. The new requirements are planned to be phased in over the two years following enactment, and uncertainty remains over the details of the rule making. The implementation of the Act will require significant adjustments to operating regulations in the US and it is therefore not possible to quantify the financial impact on the Group.

Financial contribution

In January 2010, the US President announced his intention to seek Congressional support to enact legislation imposing a Financial Crisis Responsibility Fee for a period of at least ten years to be applied to financial institutions with more than US$50 billion of consolidated assets. There is no proposed or otherwise pending legislation in Congress which seeks to impose such a Financial Crisis Responsibility Fee on financial institutions, and it is therefore not possible to assess the financial impact on HSBC.

All HSBC's activities involve, to varying degrees, the analysis, evaluation, acceptance and management of risks or combinations of risks. The most important risk categories that the Group is exposed to are credit risk (including cross-border country risk), market risk, operational risk in various forms, liquidity risk, insurance risk, pension risk, residual value risk, reputational risk and sustainability (environmental and social) risk. Market risk includes foreign exchange, interest rate and equity price risks.

HSBC's risk management policies are designed to identify and analyse these risks, to set appropriate risk limits and controls, and to monitor the risks and adherence to limits by means of reliable and up-to-date administrative and information systems. HSBC regularly reviews its risk management policies and systems to reflect changes in law, regulation, markets, products and emerging best practice. Personal accountability, reinforced by the Group's governance structure and instilled by training and experience, helps to foster a disciplined and constructive culture of risk management and control.

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, but under risk oversight at Group level.

An overview of the Group's risk governance structure, including the responsibilities of the senior executive Risk Management Meeting ('RMM') and the Global Risk function, and of the risk appetite framework operated by the Group, is set out on page 199 of the Annual Report and Accounts 2009. The management of all HSBC's significant risks is also discussed there in detail. In February 2010, in response to the recommendations of the Walker Review, a Group Risk Committee of the Board comprising independent non-executive directors was established with responsibility for providing oversight and advice to the Board on all risk matters. There have been no other significant changes to the Group's risk management framework and methodology since 31 December 2009.

Credit risk is the risk of financial loss if a customer or counterparty fails to meet a payment obligation under a contract. It arises principally from direct lending, trade finance and leasing business, but also from off-balance sheet products such as guarantees and derivatives, and from the Group's holdings of debt and other securities. Among the risks to which the Group is exposed, credit risk generates the largest regulatory capital requirement.

The objectives of credit risk management, underpinning sustainable profitable business, are principally to maintain a strong culture of responsible lending, supported by a robust risk policy and control framework; to both partner and challenge the business line in defining and implementing risk appetite, with its continuous re-evaluation under actual and scenario conditions; and to ensure independent, expert scrutiny of credit risks, their costs and their mitigation.

HSBC's Credit Risk function is part of Global Risk, reporting to the Group Chief Risk Officer. Its risk management and internal control procedures are designed for all stages of economic and financial cycles, including the current environment, and there were no significant changes during the first half of 2010. Progress has continued to be made in refining exposure measurement and monitoring, in the context of the Group's advanced internal ratings-based ('IRB') approach to Basel II (see 'Capital Management' on page 189) and in enhancing central risk oversight and independent review activities through the GMO working closely with regional risk offices under HSBC's target operating model for Global Risk.

Full details of the role and responsibilities of the Credit Risk management function are set out on page 201 of the Annual Report and Accounts 2009.

Credit exposure

Maximum exposure to credit risk

HSBC's exposure to credit risk is spread across many asset classes, including derivatives, trading assets, loans and advances to customers, loans and advances to banks and financial investments.

In the first half of 2010, credit exposure remained diversified across asset classes. However, the balance of exposure changed, reflecting an increase in lending to banks caused by a rise in reverse repo positions as well as increased netting through greater use of exchange counterparties for trading in certain trading assets and derivatives.

Exposure to residential mortgages in the personal lending portfolio remained significant. In the US, the credit quality of the residential mortgage portfolio improved, reflecting the economic recovery, but it continued to be affected by high levels of unemployment and weakened consumer confidence. In the UK, the low interest rate environment, targeted customer acquisition and tighter underwriting criteria ensured the credit quality of the mortgage portfolio remained high. In Hong Kong the residential mortgage portfolio remained well secured. See 'Areas of special interest - personal lending' on page 150.

Loss experience was concentrated as follows:

Percentage of the Group's loan impairment charges and other credit risk provisions

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 exposure to credit risk equals their carrying amount. For financial guarantees issued, the maximum exposure to credit risk 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, the maximum exposure to credit risk is the full amount of the committed facilities.

Maximum exposure to credit risk

For footnote, see page 196.

Collateral and other credit enhancements

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 International Swaps and Derivatives Association ('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-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.

The derivative offset amount in the above table relates to exposures where the counterparty has an offsetting derivative exposure with HSBC, a master netting arrangement is in place and the credit risk exposure is managed on a net basis, or the position is specifically collateralised, normally in the form of cash. These amounts do not qualify for net presentation for accounting purposes, because settlement may not actually be made on a net basis.

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 on an unsecured basis. 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 the personal sector, mortgages over residential properties;

·; in the commercial and industrial sector, charges over business assets such as premises, stock and debtors;

·; in the commercial real estate sector, charges over the properties being financed; and

·; in the financial sector, charges over financial instruments such as cash, debt securities and equities in support of trading facilities.

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.

The loans and advances offset adjustment in the table above primarily relates to customer loans and deposits, and balances arising from repo and reverse repo transactions. The offset relates to balances where there is a legally enforceable right of offset in the event of counterparty default, and therefore these balances represent a net exposure for credit risk management purposes. However, as there is no intention to settle these balances on a net basis under normal circumstances, they do not qualify for net presentation for accounting purposes.

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

Concentrations of credit risk exist 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.

Wrong-way risk is an aggravated form of concentration risk and arises when there is an adverse correlation between the counterparty's probability of default and the mark-to-market value of the underlying transaction. HSBC uses a range of tools to monitor and control wrong-way risk.

Securities held for trading

Total securities held for trading within trading assets were US$244 billion at 30 June 2010 (31 December 2009: US$259 billion). The largest concentration of these assets was to government and government agency securities, which amounted to US$128 billion, or 53 per cent of overall trading securities (31 December 2009: US$135 billion, 52 per cent). This included US$22 billion (31 December 2009: US$22 billion) of treasury and other eligible bills. Corporate debt and other securities were US$84 billion or 34 per cent of overall trading securities, in line with the level at 31 December 2009 of US$84 billion, or 32 per cent. Included within total securities held for trading were US$35 billion (31 December 2009: US$41 billion) of debt securities issued by banks and other financial institutions.

Derivatives

Derivatives exposures at 30 June 2010 were US$288 billion, a rise of 15 per cent from 31 December 2009, with significant increases in interest rate derivatives reflecting movements in parts of the yield curve against a backdrop of low short-term official rates. Foreign exchange derivative volumes also increased, partly offset by lower credit derivatives as spreads narrowed. Derivatives exposure is shown gross under IFRSs. There was a matching movement in derivative liabilities.

Debt securities, treasury and other eligible bills

At 30 June 2010, total financial investments excluding equity securities of US$377 billion were 5 per cent higher than at 31 December 2009. Debt securities, at US$315 billion, represented the largest concentration of financial investments at 84 per cent of the total, compared with US$302 billion (84 per cent) at 31 December 2009. HSBC's holdings of corporate debt, ABSs and other securities were spread across a wide range of issuers and geographical regions, with 31 per cent invested in securities issued by banks and other financial institutions. In total, holdings in ABSs increased by US$5 billion due to a rise in asset prices as expectations of future losses reduced.

Investments in governments and government agencies of US$208 billion were 54 per cent of overall financial investments, 8 percentage points higher than at 31 December 2009. US$61 billion of these investments comprised treasury and other eligible bills.

More detailed analyses of securities held for trading and financial investments are set out in Notes 7 and 10 on the Financial Statements. For an analysis by credit quality, see page 159.

At 30 June 2010, the insurance businesses held diversified portfolios of debt and equity securities designated at fair value of US$23 billion (31 December 2009: US$25 billion) and debt securities classified as financial investments of US$36 billion (31 December 2009: US$35 billion). A more detailed analysis of securities held by the insurance businesses is set out on page 188.

Loans and advances

Gross loans and advances to customers at 30 June 2010 were US$915 billion, 1 per cent lower on a reported basis and 4 per cent higher on a constant currency basis than at 31 December 2009, and were well diversified across industry sectors and regions. The following commentary is on a constant currency basis. Corporate and commercial lending increased, partly offset by a decline in personal lending reflecting the run-off of the US consumer finance portfolios.

Personal lending was the largest single lending category at US$410 billion, 45 per cent of total customer lending. Residential mortgages of US$253 billion represented 28 per cent of total advances to customers, the Group's largest concentration in a single exposure type (31 December 2009: 29 per cent).

The corporate, commercial and financial lending categories amounted to 55 per cent of gross lending to customers at 30 June 2010. The largest industry concentrations were in non-bank financial institutions and commercial real estate lending at 11 per cent and 7 per cent, respectively, of total gross lending to customers.

Commercial, industrial and international trade lending increased by 8 per cent in the period, reflecting the ongoing trade-led recovery. Within this category, the largest concentration of lending was to the service sector, which accounted for 6 per cent of total gross lending to customers.

Lending to non-bank financial institutions principally comprised secured lending on trading accounts, primarily repo facilities.

Loans and advances to banks primarily represent amounts owing on trading accounts and HSBC's placing of its own liquidity on short-term deposit. Such lending was widely distributed across major institutions.

Further discussion of significant movements in credit quality of the personal lending and wholesale lending portfolios is set out in 'Areas of special interest' on pages 148 to 159.

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 Hongkong and Shanghai Banking Corporation, HSBC Bank, HSBC Bank Middle East and HSBC Bank USA, by the location of the lending branch.

Gross loans and advances by industry sector

For footnotes, see page 196.

Gross loans and advances to customers by industry sector and by geographical region

Gross loans and advances to customers by industry sector and by geographical region (continued)

For footnotes, see page 196.

Gross loans and advances to customers by country within Rest of Asia-Pacific, Middle East and Latin America