Interim Report - 22 of 26

Footnotes to Financial Statements

1 The following tables also form an integral part of these financial statements: 'Maximum exposure to credit risk' (page 92), 'Gross loans and advances by industry sector' (page 93), 'Gross loans and advances to customers by industry sector and by geographical region', (page 93), 'Movement in impairment allowances on loans and advances to customers and banks' (page 117), and Composition of regulatory capital within 'Capital structure'(page 161).

2 Adjustment to bring changes between opening and closing balance sheet amounts to average rates. This is not done on a line-by-line basis, as details cannot be determined without unreasonable expense.

3  The movement in reserves relating to equity-settled share-based payment arrangements is recognised in 'Retained earnings' in the 'Consolidated statement of change in equity', with effect from 1 January 2011. Previously, it was disclosed separately in a 'Share-based payment reserve' within 'Other reserves'. Comparative data have been restated accordingly. The adjustment reduced 'Other reserves' and increased 'Retained earnings' by US$1,765m at 30 June 2011 (30 June 2010: US$1,268m; 31 December 2010; US$1,755m). There was no effect on basic or diluted earnings per share following this change.

4 No deduction (30 June 2010: US$1m; 31 December 2010: nil) in respect of issue costs incurred during the period is included in share premium.

5 Cumulative goodwill amounting to US$5,138m has been charged against reserves in respect of acquisitions of subsidiaries prior to 1 January 1998, including US$3,469m charged against the merger reserve arising on the acquisition of HSBC Bank. The balance of US$1,669m was charged against retained earnings.

6 Retained earnings include 77,926,453 (US$968m) of own shares held within HSBC's insurance business, retirement funds for the benefit of policyholders or beneficiaries within employee trusts for the settlement of shares expected to be delivered under employee share schemes or bonus plans, and the market-making activities in Global Markets (30 June 2010: 127,950,817 (US$1,578m); 31 December 2010: 123,331,979 (US$1,799m)).

7 Amounts transferred to the income statement in respect of cash flow hedges include US$345m gain (30 June 2010: US$129m loss; 31 December 2010: US$734m gain) taken to 'Net interest income' and US$149m loss (30 June 2010: US$1,515m loss; 31 December 2010: US$1,074m gain) taken to 'Net trading income'.

8 Statutory share premium relief under Section 131 of the Companies Act 1985 (the 'Act') was taken in respect of the acquisition of HSBC Bank in 1992, HSBC France in 2000 and HSBC Finance in 2003 and the shares issued were recorded at their nominal value only. In HSBC's consolidated financial statements the fair value differences of US$8,290m in respect of HSBC France and US$12,768m in respect of HSBC Finance were recognised in the merger reserve. The merger reserve created on the acquisition of HSBC Finance subsequently became attached to HSBC Overseas Holdings (UK) Limited ('HOHU'), following a number of intra-Group reorganisations. At 30 June 2011, nil (30 June 2010: nil; 31 December 2010: nil) was transferred from this reserve to retained earnings as a result of impairment in HSBC Holdings' investment in HOHU. During 2009, pursuant to Section 131 of the Companies Act 1985, statutory share premium relief was taken in respect of the rights issue and US$15,796m was recognised in the merger reserve. The merger reserve includes the deduction of US$614m in respect of costs relating to the rights issue, of which US$149m was subsequently transferred to the income statement. Of this US$149m, US$121m was a loss arising from accounting for the agreement with the underwriters as a contingent forward contract. The merger reserve excludes the loss of US$344m on a forward foreign exchange contract associated with hedging the proceeds of the rights issue.

9 During June 2010, HSBC Holdings issued US$3,800m of Perpetual Subordinated Capital Securities, Series 2 ('capital securities'), on which there were US$82m of external issuance costs and US$23m of intra-Group issuance costs which are classified as equity under IFRSs. The capital securities are exchangeable at HSBC Holdings' option into non-cumulative US dollar preference shares on any coupon payment date. Interest on the capital securities is paid quarterly and may be deferred at the discretion of HSBC Holdings. The capital securities may only be redeemed at the option of HSBC Holdings.

(a) Compliance with International Financial Reporting Standards

The interim consolidated financial statements of HSBC have been prepared in accordance with the Disclosure Rules and Transparency Rules of the Financial Services Authority and IAS 34 'Interim Financial Reporting' ('IAS 34') as issued by the International Accounting Standards Board ('IASB') and as endorsed by the EU.

The consolidated financial statements of HSBC at 31 December 2010 were prepared in accordance with International Financial Reporting Standards ('IFRSs') as issued by the IASB and as endorsed by the 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 2010, there were no unendorsed standards effective for the year ended 31 December 2010 affecting the consolidated financial statements at that date, 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 2010 were prepared in accordance with IFRSs as issued by the IASB.

At 30 June 2011, there were no unendorsed standards effective for the period ended 30 June 2011 affecting these interim consolidated 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.

IFRSs comprise accounting standards issued by the IASB and its predecessor body as well as interpretations issued by the IFRS Interpretations Committee ('IFRIC') and its predecessor body.

During the period ended 30 June 2011, HSBC adopted a number of interpretations and amendments to standards which had an insignificant effect on these interim consolidated financial statements.

(b) Presentation of information

In accordance with HSBC's policy to provide meaningful disclosures that help investors and other stakeholders understand the Group's performance, financial position and changes thereto, the information provided in the Notes on the Financial Statements and the Interim Management Report goes beyond the minimum levels required by accounting standards, statutory and regulatory requirements and listing rules. In particular, HSBC has adopted the British Bankers' Association Code for Financial Reporting Disclosure ('the BBA Code'). The BBA Code aims to increase the quality and comparability of banks' disclosures and sets out five disclosure principles together with supporting guidance. In line with the principles of the BBA Code, HSBC assesses the applicability and relevance of good practice recommendations issued from time to time by relevant regulators and standard setters, enhancing disclosures where appropriate.

HSBC's consolidated financial statements are presented in US dollars which is also HSBC Holdings' functional currency. HSBC Holdings' functional currency is the US dollar because the US dollar and currencies linked to it are the most significant currencies relevant to the underlying transactions, events and conditions of its subsidiaries, as well as representing a significant proportion of its funds generated from financing activities. HSBC uses the US dollar as its presentation currency in its consolidated financial statements because the US dollar and currencies linked to it form the major currency bloc in which HSBC transacts and funds its business.

(c) Comparative information

These interim consolidated financial statements include comparative information as required by IAS 34, the UK Disclosure Rules and Transparency Rules and the Hong Kong Listing Rules.

(d) Use of estimates and assumptions

The preparation of financial information requires the use of estimates and assumptions about future conditions. The use of available information and the application of judgement are inherent in the formation of estimates; actual results in the future may differ from those reported. Management believes that HSBC's critical accounting policies where judgement is necessarily applied are those which relate to impairment of loans and advances, goodwill impairment, the valuation of financial instruments, the impairment of available-for-sale financial assets and deferred tax assets. These critical accounting policies are described on pages 33 to 36 of the Annual Report and Accounts 2010.

(e) Consolidation

The interim consolidated financial statements of HSBC comprise the financial statements of HSBC Holdings and its subsidiaries. The method adopted by HSBC to consolidate its subsidiaries is described on pages 251 to 252 of the Annual Report and Accounts 2010.

(f) Future accounting developments

At 30 June 2011, a number of standards and interpretations, and amendments thereto, had been issued by the IASB which are not yet effective for these consolidated financial statements, the most significant of which are described below. The IASB is continuing to work on projects on insurance, revenue recognition and lease accounting, which together with IFRS 9 and the standards described below, represent widespread and significant changes to accounting requirements from 2013.

IFRS 9 'Financial Instruments' is described on pages 252 and 253 of the Annual Report and Accounts 2010, including the second and third phases in the IASB's project to replace IAS 39, which address the impairment of financial assets measured at amortised cost and hedge accounting. The IASB did not finalise the replacement of IAS 39 by its stated target of June 2011, and the IASB and the US Financial Accounting Standards Board have agreed to extend the timetable beyond this date to permit further work and consultation with stakeholders. As a consequence, the IASB is consulting on its proposal to change the effective date of IFRS 9 to 1 January 2015 to facilitate the adoption of the entire replacement of IAS 39. The EU is not expected to endorse IFRS 9 until the completed standard is available. Therefore, HSBC remains unable to provide a date by which it plans to apply IFRS 9 and it remains impracticable to quantify the impact of IFRS 9 as at the date of publication of these consolidated financial statements.

Standards issued by the IASB but not endorsed by the EU

In May 2011, the IASB issued IFRS 10 'Consolidated Financial Statements' ('IFRS 10'), IFRS 11 'Joint Arrangements' ('IFRS 11') and IFRS 12 'Disclosure of Interests in Other Entities' ('IFRS 12'). The standards are effective for annual periods beginning on or after 1 January 2013 with early adoption permitted. IFRSs 10 and 11 are to be applied retrospectively.

Under IFRS 10, there will be one approach for determining consolidation for all entities, based on the concept of power, variability of returns and their linkage. This will replace the current approach which emphasises legal control or exposure to risks and rewards, depending on the nature of the entity. IFRS 11 places more focus on rights and obligations than on legal form, and introduces the concept of a joint operation. IFRS 12 includes the disclosure requirements for subsidiaries, joint arrangements and associates and introduces new requirements for unconsolidated structured entities.

HSBC is currently assessing the impact of these new IFRSs, but it is impracticable to quantify their effect as at the date of publication of these consolidated financial statements.

In May 2011, the IASB also issued IFRS 13 'Fair Value Measurement' ('IFRS 13'). This standard is effective for annual periods beginning on or after 1 January 2013 with early adoption permitted. IFRS 13 is required to be applied prospectively from the beginning of the first annual period in which it is applied. The disclosure requirements of IFRS 13 do not require comparative information to be provided for periods prior to initial application.

IFRS 13 establishes a single source of guidance for all fair value measurements required or permitted by IFRSs. The standard clarifies the definition of fair value as an exit price, which is defined as a price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions, and enhances disclosures about fair value measurement.

HSBC is currently assessing the impact of this new IFRS but it is impracticable to quantify its effect as at the date of publication of these consolidated financial statements.

In June 2011, the IASB issued amendments to IAS 19 'Employee Benefits' ('IAS 19 revised'). The revised standard is effective for annual periods beginning on or after 1 January 2013 with early adoption permitted. IAS 19 revised must be applied retrospectively.

The most significant amendment for HSBC is the replacement of interest cost and expected return on plan assets by a finance cost component comprising the net interest on the net defined benefit liability or asset. This finance cost component is determined by applying the same discount rate used to measure the defined benefit obligation to the net defined benefit liability or asset. The difference between the actual return on plan assets and the return included in the finance cost component in the income statement will be presented in other comprehensive income. The effect of this change is to increase the pension expense by the difference between the current expected return on plan assets and the return calculated by applying the relevant discount rate.

Based on an initial estimate of the impact of this particular amendment on the 2010 consolidated financial statements, the change would decrease pre-tax profit, with no effect on the pension liability. The effect on total operating expenses and pre-tax profit is not expected to be material. The effect at the date of adoption will depend on market interest rates, rates of return and the actual mix of scheme assets at that time.

(g) Changes in composition of the Group

There were no material changes in the composition of the Group.

The accounting policies adopted by HSBC for these interim consolidated financial statements are consistent with those described on pages 253 to 270 of the Annual Report and Accounts 2010, with the exception of the presentation of the consolidated statement of changes in equity which no longer includes a separate 'Share-based payment reserve' which has now been incorporated into retained earnings. The methods of computation applied by HSBC for these interim consolidated financial statements are consistent with those applied for the Annual Report and Accounts 2010.

The Directors declared after the end of the period a second interim dividend in respect of the financial year ending 31 December 2011 of US$0.09 per ordinary share, a distribution of approximately US$1,604m which will be payable on 6 October 2011. No liability is recorded in the financial statements in respect of this dividend.

Dividends to shareholders of the parent company

1 HSBC Holdings issued Perpetual Subordinated Capital Securities of US$3,800m in June 2010.

On 15 July 2011, HSBC paid a further coupon on the capital securities of US$0.508 per security, a distribution of US$45m. No liability is recorded in the financial statements in respect of this coupon payment.

Basic earnings per ordinary share was calculated by dividing the profit attributable to ordinary shareholders of the parent company by the weighted average number of ordinary shares outstanding, excluding own shares held. Diluted earnings per ordinary share was calculated by dividing the basic earnings, which require no adjustment for the effects of dilutive potential ordinary shares, by the weighted average number of ordinary shares outstanding, excluding own shares held, plus the weighted average number of ordinary shares that would be issued on conversion of dilutive potential ordinary shares.

Profit attributable to ordinary shareholders of the parent company

Basic and diluted earnings per share

1 Weighted average number of ordinary shares outstanding.

2 Weighted average number of ordinary shares outstanding assuming dilution.

Included within 'Employee compensation and benefits' are components of net periodic benefit cost related to HSBC's defined benefit pension plans and other post-employment benefits, as follows:

HSBC revalues its defined benefit post-employment plans each year at 31 December, in consultation with the plans' local actuaries. The assumptions underlying the calculations are used to determine the expected income statement charge for the year going forward. At 30 June each year, HSBC revalues all plan assets to current market prices. HSBC also reviews the assumptions used to calculate the defined benefit obligations (the liabilities of the plans) and updates the carrying amount of the obligations if there have been significant changes as a consequence of changes in assumptions.

Retirement benefit liabilities for the Group have reduced from US$3.9bn at 31 December 2010 to US$3.0bn at 30 June 2011, US$0.7bn of this reduction being in respect of the HSBC Bank (UK) Pension Scheme funded defined benefit plan ('the principal plan'). A small net retirement benefit asset was recognised for the principal plan as at 30 June 2011 as a result of this reduction, which was mainly due to the change in indexation of deferred pensions, discussed below, and changes in actuarial assumptions.

Changes in actuarial assumptions increased the defined benefit obligation for the principal plan by US$36m, recognised directly in other comprehensive income as an actuarial loss. The net increase resulted from an increase in inflation assumptions and the effect of changes to assumed commutation factors, less the effect of an increase in the nominal discount rate. However, the actual return on the plan assets of the principal plan was higher than the expected return by US$179m, recognised as an actuarial gain directly in other comprehensive income.

A change in indexation for deferred pensions was one of the most significant reasons for the reduction in the defined benefit of the principal plan. The expected cash flows of the principal plan were historically projected by reference to the Retail Prices Index ('RPI') swap curve in calculating the liability recognised. The Occupational Pensions (Revaluation) Order 2010 confirmed the UK government's intention to move to using the Consumer Prices Index ('CPI') rather than RPI as the inflation measure for determining the minimum pension increases to be applied to the statutory index-linked features of retirement benefits. Historical annual CPI increases have generally been lower than annual RPI increases. The rules of the principal plan prescribe that annual increases for pensions in payment are in line with RPI, but for deferred pensions, i.e. pensions for members of the scheme who have left HSBC employment but whose pensions are yet to commence, are linked to the statutory index prior to retirement. However, consistent with communications to Scheme members, HSBC has historically used RPI in calculating the pension liability for deferred pensions.

In May 2011, the trustee of the principal plan communicated to scheme members the impact on scheme benefits of the UK government's announcement. At 30 June 2011, HSBC used CPI in calculating the pension liability recognised, which resulted in a reduction of the principal plan's liabilities in respect of deferred pensioners of US$587m. A corresponding gain was recognised as a credit to past service cost and is included within 'Employee compensation and benefits' in the income statement.

The discount rates used to calculate HSBC's obligations under its defined benefit pension and post-employment healthcare plans were as follows:

Discount rates

The inflation rate used to calculate the principal plan obligation at 30 June 2011 was 3.8%. (30 June 2010: 3.5%; 31 December 2010: 3.7%). Other than described above, there were no material changes to other assumptions.

Actuarial gains and losses

1 Other movements include changes in the effect of the limit on plan surpluses.

Actuarial gains and losses comprise experience adjustments on plan assets and liabilities as well as adjustments arising from changes in actuarial assumptions. The experience gains and losses on plan assets arise as a result of the difference between the expected returns on the plan assets and the actual movement in the value of the plan assets during the period. The changes in actuarial assumptions arise as a result of changes in the plan assumptions, primarily discount rates and inflation rates, as previously described.

Total cumulative net actuarial losses, including the cumulative effect of the limit on plan surpluses recognised in equity at 30 June 2011, were US$4,738m (30 June 2010: US$4,742m cumulative losses; 31 December 2010: US$4,720m cumulative losses). Of this the cumulative effect of the limit on plan surpluses was US$65m (30 June 2010: US$29m; 31 December 2010: US$47m).

On 17 June 2010, HSBC Bank plc agreed with the Trustee to accelerate the reduction of the deficit of the plan with a special contribution of £1,760m (US$2,638m) in June 2010 followed by a revised payment schedule in the following years, as shown below:

1 The payment schedule was agreed with the Trustee in pounds sterling and the equivalent US dollar amounts are shown at the exchange rate effective as at 30 June 2011.

The next actuarial valuation of the principal plan is due to be made as at 31 December 2011.

As disclosed in 'Related party transactions' on page 368 in the Annual Report and Accounts 2010, the principal plan entered into collateralised swap transactions with HSBC to manage the inflation and interest rate sensitivity of the Scheme's pension obligations. At 30 June 2011, the swaps had a positive fair value of US$2,457m to the Scheme (30 June 2010: US$1,891m positive to the Scheme; 31 December 2010: US$2,173m positive to the Scheme). All swaps were executed at prevailing market rates and within standard market bid-offer spreads.

1 Overseas tax included Hong Kong profits tax of US$453m (first half of 2010: US$426m; second half of 2010: US$536m). Subsidiaries in Hong Kong provided for Hong Kong profits tax at the rate of 16.5% (2010: 16.5%) on the profits for the period assessable in Hong Kong. Other overseas subsidiaries and overseas branches provided for taxation at the appropriate rates in the countries in which they operate.

The following table reconciles the overall tax expense which would apply if all profits had been taxed at the UK corporation tax rate of 26.5% (2010: 28%):

The effective tax rate for the first half of 2011 was 14.9% compared with 34.7% for the first half of 2010. The lower tax charge in the first half of 2011 included the benefit of deferred tax recognised in respect of foreign tax credits, partly offset by a current tax charge in respect of prior periods in a number of jurisdictions. The tax charge in the first half of 2010 included US$1.6bn attributable to a taxable gain arising from an internal reorganisation within our North American operations.

The UK government has announced that the main rate of corporation tax for the year beginning 1 April 2011 will reduce by 2 percentage points from 28% to 26% to be followed over a period of three years by further 1 percentage point reductions to 23% for the year beginning 1 April 2014. This results in a weighted average rate of 26.5% for 2011 (2010: 28%). It is not expected that the proposed future rate reductions will have a significant effect on the UK net deferred tax asset recognised at 30 June 2011 of US$237m.

For the period ended 30 June 2011, HSBC's share of associates' tax on profit was US$418m (30 June 2010: US$356m; 31 December 2010: US$418m), which is included within share of profit in associates and joint ventures in the income statement.

Of the total net deferred tax assets of US$6.8bn at 30 June 2011 (30 June 2010: US$5.0bn; 31 December 2010: US$5.9bn), US$5.2bn (30 June 2010: US$3.5bn; 31 December 2010: US$4.0bn) arose in respect of HSBC's US operations where there has been a recent history of losses. Management's updated analysis is consistent with the assumption that it is probable that there will be sufficient taxable income to support the deferred tax assets that have been recognised in respect of the US operations as at 30 June 2011.

Trading securities valued at fair value1

1 Included within these figures are debt securities issued by banks and other financial institutions of US$40,033m (30 June 2010: US$35,424m; 31 December 2010: US$37,170m), of which US$8,311m (30 June 2010: US$8,399m; 31 December 2010: US$8,330m) are guaranteed by various governments.

2 Includes securities that are supported by an explicit guarantee issued by the US Government.

3 Excludes asset-backed securities included under US Treasury and US Government agencies.

Trading securities listed on a recognised exchange and unlisted

1 Included within listed securities are US$3,080m (30 June 2010: US$3,384m; 31 December 2010: US$3,254m) of investments listed in Hong Kong.

2 Unlisted treasury and other eligible bills primarily comprise treasury bills not listed on a recognised exchange but for which there is a liquid market.

Loans and advances to banks held for trading

Loans and advances to customers held for trading

The accounting policies which determine the classification of financial instruments and the use of assumptions and estimation in valuing them are described on pages 253 to 270 and 34 to 36, respectively, of the Annual Report and Accounts 2010.

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.

The following table sets out the financial instruments carried at fair value.

Financial instruments carried at fair value and bases of valuation

The increase in Level 1 assets and liabilities reflects a significant increase in settlement account balances, which vary considerably in proportion with the level of trading activity. The increase in Level 1 assets also reflects increased holdings of debt securities, driven by higher issuances of and customer demand for government and government agency debt securities. A rise in short bond positions, which was in line with the growth in the Rates portfolio, contributed to the increase in Level 1 and Level 2 trading liabilities. The increase in Level 2 assets reflects higher reverse repo balances used to cover short positions, notably in Europe, North America and Latin America, and an increase in repo balances contributed to the growth in Level 2 liabilities.

There were no material transfers between Level 1 and Level 2 in the period.

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 compliance with all relevant accounting standards.

Further details of the control framework are included on pages 308 to 309 of the Annual Report and Accounts 2010.

Determination of fair value

Fair values are determined according to the following hierarchy:

·; Level 1 - quoted market price: financial instruments with quoted prices for identical instruments in active markets.

·; Level 2 - valuation technique using observable inputs:financial instruments with quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in inactive markets and financial instruments valued using models where all significant inputs are observable.

·; Level 3 - valuation technique with significant unobservable inputs: financial instruments valued using valuation techniques where one or more significant inputs are unobservable.

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. Further details on fair values determined using valuation techniques are included on pages 309 to 310 of the Annual Report and Accounts 2010.

HSBC has, for swaps with collateralised counterparties and in significant currencies, adopted a discounting curve that reflects the overnight interest rate ('OIS discounting'). Prior to 2010, in line with market practice, discount curves did not reflect this overnight interest rate component but were based on a term LIBOR rate. During the period, HSBC applied an OIS discounting curve to an expanded range of significant currencies in line with evolving market practice. The financial effect of this change was not significant.

Fair value adjustments 

Fair value adjustments are adopted when HSBC considers that there are additional factors that would be considered by a market participant that are not incorporated within the valuation model. The magnitude of fair value adjustments depends upon many entity-specific factors, and therefore fair value adjustments may not be comparable across the banking industry.

HSBC classifies fair value adjustments as either 'risk-related' or 'model-related'. The majority of these adjustments relate to Global Banking and Markets.

Movements in the level of fair value adjustments do not necessarily result in the recognition of profits or losses within the income statement. For example, as models are enhanced, fair value adjustments may no longer be required. Similarly, fair value adjustments will decrease when the related positions are unwound, but this may not result in profit or loss.

Global Banking and Markets fair value adjustments

Fair value adjustments declined by US$246m during the period. The most significant movement was a reduction of US$163m in credit risk adjustment driven by a variety of factors including reduction in exposure to monoline insurers and credit derivative product companies and inclusion of mandatory break clauses within the calculation methodology.

Detailed descriptions of risk-related and model-related adjustments are provided on page 311 of the Annual Report and Accounts 2010.

Credit risk adjustment methodology

HSBC calculates a separate credit risk adjustment for each HSBC legal entity, and within each entity for each counterparty to which the entity has exposure. The calculation of the monoline credit risk adjustment and sensitivity to different methodologies that could be applied is described on page 131. Of the total credit risk adjustment at 30 June 2011 of US$1,192m (30 June 2010: US$1,493m; 31 December 2010: US$1,355m), US$735m (30 June 2010: US$926m; 31 December 2010: US$836m) relates to the credit risk adjustment taken against non-monoline counterparties. The methodology for calculating the credit risk adjustment for non‑monoline counterparties is described below.

HSBC calculates the credit risk adjustment by applying the probability of default of the counterparty to the expected positive exposure to the counterparty and multiplying the result by the loss expected in the event of default. The calculation is performed over the life of the potential exposure.

The probability of default is based on HSBC's internal credit rating for the counterparty, taking into account how credit ratings may deteriorate over the duration of the exposure through the use of historical rating transition matrices. For most products, to calculate the expected positive exposure to a counterparty, HSBC uses a simulation methodology to incorporate the range of potential exposures across the portfolio of transactions with the counterparty over the life of an instrument. The simulation methodology includes credit mitigants such as counterparty netting agreements and collateral agreements with the counterparty. A standard loss given default assumption of 60% is generally adopted. HSBC does not adjust derivative liabilities for HSBC's own credit risk, such an adjustment is often referred to as a 'debit valuation adjustment'.

For certain types of exotic derivatives where the products are not currently supported by the simulation, or for derivative exposures in smaller trading locations where the simulation tool is not yet available, HSBC adopts alternative methodologies. These may involve mapping to the results for similar products from the simulation tool or where such a mapping approach is not appropriate, a simplified methodology is used, generally following the same principles as the simulation methodology. The calculation is applied at a trade level, with more limited recognition of credit mitigants such as netting or collateral agreements than used in the simulation methodology described previously.

The methodologies do not, in general, account for 'wrong-way risk'. Wrong-way risk arises where the underlying value of the derivative prior to any credit risk adjustment is positively correlated to the probability of default of the counterparty. Where there is significant wrong-way risk, a trade specific approach is applied to reflect the wrong-way risk within the valuation.

HSBC includes all third party counterparties in the credit risk adjustment calculation and does not net credit risk adjustments across HSBC Group entities. During the period, there were no material changes made by HSBC to the methodologies used to calculate the credit risk adjustment.

Fair value valuation bases

Financial instruments measured at fair value using a valuation technique with significant unobservable inputs - Level 3