Interim Report - 15 of 26

Wholesale lending

Wholesale lending covers the range of credit facilities granted to sovereign borrowers, banks, non‑bank financial institutions and corporate entities. Our wholesale portfolios are well diversified across geographical and industry sectors, with certain exposures subject to specific portfolio controls. Loan impairment charges fell during the first half of 2011, as economies generally demonstrated signs of recovery.

We continued to closely manage our exposure to sovereign debt in the first half of 2011. The overall quality of the portfolio was strong with most in‑country and cross-border limits extended to countries with high-grade internal credit risk ratings. We regularly update our assessment of higher risk countries and adjust our risk appetite accordingly.

The eurozone as a whole retained substantial economic and financial strength and demonstrated positive signs of economic recovery in the first half of 2011, despite the stresses from the financial crisis.

However, the transfer of private sector liabilities to sovereign bodies which started after the 2007 financial crisis continued to put pressure on government balance sheets. The resulting fiscal imbalance in some industrialised economies led to intensified market concerns about sovereign credit risk in these countries.

In the first half of 2011, there were periods of significant market volatility related to a number of sovereigns in the eurozone, notably Greece, Ireland, Portugal, Italy and Spain. Sovereign spreads remained high and the lack of market access eventually resulted in Portugal joining Greece and Ireland in seeking bailout funding amounting to €78bn (US$113bn) from the European Financial Stability Facility ('EFSF') and International Monetary Fund ('IMF') in early April 2011. Political instability in Greece, Ireland and Portugal also exacerbated the situation and all three countries were downgraded by major credit rating agencies during the period. Italy and Spain made progress in implementing fiscal adjustments and banking reforms but still experienced volatility in credit spreads.

The tables overleaf summarise our exposures to selected eurozone countries, including:

·; governments and central banks of selected eurozone countries along with near/quasi government agencies;

·; banks; and

·; other financial institutions and other corporates.

Exposures to banks, other financial institutions and other corporates are based on the country of domicile of the counterparty.

The countries presented were selected because during the period they exhibited levels of market volatility which exceeded other eurozone countries and demonstrated fiscal or political uncertainty which may persist through the second half of 2011. In addition, certain of these countries exhibit high sovereign debt to GDP ratios and short to medium-term maturity concentration of those liabilities. An analysis of loans and advances to customers by significant countries is provided on page 95.

Off-balance sheet exposures mainly relate to commitments to lend and the amount shown in the tables represents the maximum amount that could be drawn down by the counterparty.

Eurozone sovereigns and agencies

Concerns remained over the capacity of certain sovereign borrowers to refinance given the problems with market liquidity and the uncertainty surrounding support arrangements in the longer term.

In July 2011, the second Greek support package was formalised as EU leaders announced a 3-year programme that included €109bn (US$158bn) of new loans and a target of €37bn (US$54bn) in bondholder commitments. In addition, EFSF rules were changed to allow EFSF to buy bonds on the secondary market, finance the recapitalisation of banks and provide pre-emptive credit lines to eurozone countries under pressure in debt markets. This is intended to help contain the fears of contagion to other eurozone countries. HSBC in principle supports this programme, which is expected to trigger a selective default as predicted by two of the three major rating agencies.

In the second half of 2011, we expect that the ECB and eurozone countries will continue to focus on resolving intra-eurozone imbalances, rebuilding public finances, improving fiscal discipline, strengthening the banking system and managing cross-border risk. Concerns of contagion of the debt crisis in Greece, Ireland and Portugal to other peripheral countries, notably Italy and Spain, may persist, causing the risk premium on most European countries to remain high.

At 30 June 2011, our exposure to the sovereign and agency debt of Greece, Ireland, Italy, Portugal and Spain was US$8.2bn. Of the total financial investments available for sale, approximately 43% matures within one year, 27% between one and three years and 30% in excess of three years.

During the first half of 2011, an impairment charge of US$105m was recognised in respect of Greek sovereign and agency exposures classified as available for sale, reflecting the further deterioration in Greece's fiscal position and the recently announced support measures. The amount of the impairment charge represented the cumulative fair value loss on these securities as at 30 June 2011, and does not necessarily represent the expectation of future cash losses. The impairment charge was recycled from the available-for-sale reserve to the income statement. Our sovereign exposures to Ireland, Portugal, Italy and Spain are not considered to be impaired at 30 June 2011 because, despite financial difficulties in these countries, the situation is not severe enough to conclude that loss events have occurred which will have an impact on the future cash flows of these countries' sovereign securities.

Exposures to selected eurozone countries - sovereigns and agencies

Exposures to selected eurozone countries - banks

For footnote, see page 146.

Eurozone banks

The banking sector in the eurozone remained under stress, mainly as a result of governments having to finance large budget deficits, weaknesses in property markets and slow credit growth. The size of the financial sector's exposure to sovereign debt in some eurozone countries rendered the re-capitalisation of European banks critical.

Concerns about the size and quality of eurozone banks' exposure to weaker eurozone countries were entwined with concerns about their ability to obtain funding. It is estimated that European banks share over three quarters of the banks' public and private sector debt in Greece, Ireland, Portugal, Italy and Spain, with regional and local banks in the eurozone considered to be more vulnerable than the diversified global banks. The second Greek rescue package announced in July 2011 involves the private sector sharing some economic loss. This is likely to put a strain on the banks with significant holdings of Greek bonds. The details of the plan, level of take-up and application will become clear in the second half of the year.

We expect that the pace of reforms outlined by various policymakers will gather speed in the second half of 2011, most notably the Basel III proposals. These regulations will require banks to hold more capital and a higher quality of capital and implement new liquidity rules, and are likely to result in a rise in the cost of funding and put pressure on credit pricing. The European Banking Authority published the results of this year's stress test on 15 July 2011. We successfully passed these tests with a core tier 1 ratio of 8.5% under the modelled adverse scenario, exceeding the post-stress minimum core tier 1 capital requirement of 5% used in this exercise.

Our overall exposure within the eurozone is largely to the banks in stronger countries. We continue to closely monitor and manage eurozone bank exposures in the weaker countries, and are cautious in lending to this sector. We regularly update our assessment of higher-risk eurozone banks and adjust our risk appetite accordingly. We also, where possible, seek to play a positive role in maintaining credit and liquidity supply. We have not recognised any impairment in respect of the exposures outlined above.

Exposures to selected eurozone countries - other financial institutions and corporates

For footnotes, see page 146.

Other financial institutions and other corporates

The credit quality of the other financial institutions and other corporates portfolios remains strong with no significant impairments recognised in respect of these portfolios. The portfolios largely comprise large multinational corporates and other financial institutions with significant operations outside these countries that mitigate the risk. At 30 June 2011, our exposure to Greek shipping companies amounted to US$1.8bn. We believe the industry is less sensitive to the Greek economy as it is mainly dependent on international trade.

Personal lending

Our retail activities within these countries are limited, with our only significant exposures in Greece which amounted to US$1.2bn. Substantially all of this exposure is in the form of residential mortgage lending where the level of delinquencies is low.

US budget deficit

In the US, the large budget deficit, growing government indebtedness and continued failure to reach agreement on raising the Federal debt ceiling have resulted in increased scrutiny during the first half of 2011, to the extent that two major rating agencies placed their US sovereign debt rating on negative watch. While the need to build a political consensus around the interplay of budget discipline and an increase in the current sovereign debt ceiling has been the immediate concern, there is an underlying risk that lower growth, fiscal challenges and a general lack of political consensus will result in a deterioration in the US credit standing over the longer term.

While the potential effects of a US downgrade are broad and impossible to accurately predict, they could include a widening of sovereign and corporate credit spreads, devaluation of the US dollar and a general market move away from riskier assets.

We are monitoring events closely and have stress-tested our capital position for potential scenarios.

Elevated risk of overheating in emerging markets

Market concerns emerged during the first half of 2011 about the overheating of certain emerging market countries, mainly due to the inflationary pressures, growth rates, risk of asset bubbles and large potentially volatile capital inflows they are experiencing. The policy makers in countries including mainland China, India and Brazil have taken steps to address these issues including increasing interest rates, restricting capital flows and raising reserve requirements. We regularly perform economic analyses and closely monitor our exposures to these countries.

Middle East and North Africa

Although significant unrest and political change were witnessed in the Middle East and North Africa in the first half of 2011, the majority of the Group's exposures in the region were concentrated in our associate investment in Saudi Arabia and in the UAE, where the respective political landscapes remained stable and economic growth continued to recover. In the remaining countries in which we have a presence and there was unrest or political change (or which exhibited similar socio-economic, political and demographic profiles to countries experiencing unrest), we continued to carefully monitor and respond to developments while assisting our customers in managing their own risks in the volatile environment.

We also continued to work closely with Dubai World and the various entities related to the Government of Dubai to address their prevailing issues. In March 2011, Dubai World signed a final deal with HSBC and other creditors restructuring US$25bn of its debt. The arrangement extends loan maturities for five to eight years at discounted rates, allowing Dubai World to sell off its non-core assets while focusing on its core earnings.

Commercial real estate

Our exposure to the commercial real estate sector is concentrated in Hong Kong, the UK and North America. In Hong Kong, the economy continued to grow and the market remained relatively buoyant during the first half of 2011, characterised by continuing demand and credit appetite. While the markets in the UK and North America have been relatively stable, this is in part supported by the continued low levels of interest rates.

On a constant currency basis, the aggregate of our commercial real estate and other property-related lending of US$110bn at 30 June 2011 was in line with our exposure at 31 December 2010 and represented 10% of total loans and advances to customers. In the first half of 2011, credit quality across this sector was generally stable but there remains risk of stress in certain markets.

Across our portfolios, credit risk is mitigated by long-standing and conservative policies on asset origination which focus on relationships with long-term customers and limited initial leverage. We also set and monitor sector risk appetite limits for the sector at Group and regional levels to detect and prevent higher risk concentrations. While individual regions may differ with regard to local market regulatory and legal structures and real estate market characteristics, typically origination loan-to-value ratios would be less than 65% across the Group.

Personal lending

We provide a broad range of secured and unsecured personal lending products to meet customer needs. Given the diverse nature of the markets in which we operate, the range is not standard across all countries but is tailored to meet the demands of individual markets while using appropriate distribution channels and, wherever possible, global IT platforms.

Personal lending includes advances to customers for asset purchases, such as residential property and motor vehicles, where the loans are typically secured by the assets being acquired. We also offer 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.

In the first half of 2011, credit quality in our personal lending portfolios improved, reflecting the continued recovery of economic conditions in most markets. Delinquency levels and loan impairment charges reduced as customer repayments remained strong, lending balances in the US run-off portfolios continued to decline and some higher-risk portfolios in Latin America, Rest of Asia-Pacific and the Middle East and North Africa were managed down.

The commentary that follows is on an underlying basis.

At 30 June 2011, total personal lending was US$439bn, slightly higher than at 31 December 2010 as growth in the UK and Hong Kong was partly offset by the continued planned decline in personal lending balances in the US. Within our RBWM business, total loan impairment charges and other credit risk provisions of US$4.3bn were 34% lower than in the first half of 2010 with the most significant fall in the US reflecting the reduction in balances and improved delinquency rates.

Total personal lending in the UK increased by 3% from 31 December 2010 to US$136bn. The increase was mainly due to growth in mortgage balances following the success of marketing campaigns and high levels of customer retention. (UK mortgage lending is discussed in greater detail on page 104). This was partly offset by a 3% fall in other personal lending balances, reflecting a reduction in unsecured lending products, specifically the credit cards portfolio.

In Hong Kong, total personal lending grew by 8% to US$62bn, mainly due to growth in residential mortgage lending as the property market in the region remained strong, and as a result of our leadership in new mortgage business. Personal lending balances in Rest of Asia-Pacific also reflected a strong property sector with residential mortgage lending growth of 8%, most notably in Singapore and Australia.

Total personal lending balances in the US at 30 June 2011 were US$102bn, a decrease of 7% compared with the end of 2010. The decline reflected lower balances in our Card and Retail Services portfolio due to fewer active accounts, an increased focus by customers on reducing outstanding credit card debt and seasonal improvements in our collection activities as our customers used tax refunds to make repayments. Residential mortgage lending balances in the US continued to fall reflecting the run-off of our Consumer Lending and Mortgage Services portfolios. Based on current experience, we expect these portfolio balances to decline to between 40% and 50% of the 31 December 2010 balance.

For an analysis of loan impairment allowances and impaired loans, see page 115.

Total personal lending

For footnotes, see page 146.

Mortgage lending

We offer a wide range of mortgage products designed to meet customer needs, including capital repayment, interest-only, affordability and offset mortgages. The commentary that follows is on an underlying basis.

US mortgage lending

US mortgage lending balances, comprising residential and second lien lending, were US$64bn at 30 June 2011, a decline of 5% compared with the end of 2010. Overall, US mortgage lending represented 14% of the Group's total personal lending compared with 16% at the 31 December 2010.

Mortgage lending in HSBC Finance was US$47bn at 30 June 2011, a decline of 7% from 31 December 2010 due to the continued run‑off in the Consumer Lending and Mortgage Services portfolios and the seasonal improvement in collections as some customers used tax refunds to make repayments. The rate at which balances declined slowed in the first half of 2011, as we continued to be affected by the lack of refinancing opportunities available to our customers, improvements in the flow of balances into late stage delinquency and delays in the foreclosure processes. See page 106 for a breakdown of mortgage lending in HSBC Finance.

In HSBC Bank USA, mortgage lending balances were US$16bn at 30 June 2011, an increase of 2% compared with the end of 2010. We continued to sell the majority of new originations to the secondary market as a means of managing our interest rate risk and improving structural liquidity. Additions to our portfolio primarily comprise Premier relationship products.

Following an industry-wide examination into foreclosure practices in 2010, we temporarily suspended foreclosures while we worked to implement improvements in our processes. We worked closely with the regulators to address these issues quickly and effectively, and made several improvements to enhance our processes. We have now resumed foreclosures on a limited basis in certain states, but it will be a number of months before we fully resume foreclosures in all states as we need to ensure that all necessary enhancements have been satisfactorily implemented.

The effects of the industry-wide slowdown in foreclosures remains highly uncertain, particularly in the long-term, as servicers begin to increase foreclosure activity and sell properties in large numbers, which may result in a significant oversupply. This may lead to a substantial increase in losses on foreclosed properties.

A discussion of credit trends in the US mortgage lending portfolio and the steps taken to mitigate risk is provided in 'US personal lending - credit quality' on page 107.

Mortgage lending - rest of the world

Mortgage lending in the UK was US$112bn at 30 June 2011, the Group's largest concentration of this exposure. The balance was 4% higher than at the end of 2010. 

Our UK mortgage portfolio remained of high quality with an average loan-to-value ratio for new business of 53%. We restricted lending to purchase residential property for the purpose of rental, and almost all new business was originated through our own salesforce, with the self-certification of income not permitted. The majority of mortgage lending was to existing customers holding current or savings accounts with HSBC.

Loan impairment charges and delinquency levels in our UK mortgage book remained at low levels, reflecting the economic environment and low interest rates which helped to make mortgage repayments more affordable for customers, some of whom were actively reducing their outstanding debt levels.

In Hong Kong, mortgage lending was US$45bn, an increase of 7% compared with the end of 2010 as the local property market remained strong. The continued strong growth in the Hong Kong property market led the HKMA to reduce the maximum loan-to-value ratios for new loans in both the second half of 2010 and in June 2011. The quality of our mortgage book was good with an average loan-to-value ratio of 51% on new mortgage sales.

The following table shows the levels of mortgage lending products in the various portfolios in the US, the UK and the rest of the HSBC Group.

Mortgage lending products