Interim Report - 7 of 25

Geographical regions

In the analysis of profit and loss by geographical region that follows, operating income and operating expenses include intra‑HSBC items of US$1,630m (first half of 2011: US$1,567m; second half of 2011: US$1,854m).

Profit/(loss) before tax

Total assets47

Risk-weighted assets60

For footnotes, see page 100.

Economic background 

The UK economy remained weak in the first half of 2012. In the second quarter, the level of real Gross Domestic Product ('GDP') fell by 0.7%, the third consecutive quarterly contraction. Despite this, the unemployment rate fell slightly to 8.1% in the three months to May, from 8.4% at the end of 2011, although much of the job creation was in part-time work. Consumer Prices Index ('CPI') inflation fell sharply from 4.2% in December 2011 to 2.4% in June, in part reflecting the removal of last year's rise in VAT from the annual comparison. The Bank of England left interest rates unchanged at 0.5% but loosened monetary policy by extending its programme of asset purchases by £50bn to £325bn (US$510bn). Strains in the banking system arising from the eurozone sovereign crisis contributed to a tightening in credit conditions for both households and firms, prompting the UK authorities to announce more direct measures aimed at boosting the flow of credit.

The eurozone economy continued to face stresses related to the sovereign debt crisis in the first half of 2012. While the economy as a whole stagnated in the first quarter, divergences between countries in the north of the region and those in the south continued to widen. Concerns surrounding the health of the financial sector led the ECB to provide greater liquidity through a long-term repo operation in February 2012. As oil prices eased, eurozone inflation began to moderate towards the ECB's price stability target, allowing it to maintain the refi rate at 1.0% in the period. Worries over the sovereign bond market and the banking sector intensified during the first half of 2012, and the eurozone member states offered up to €100bn (US$124bn) of financial assistance to recapitalise the Spanish banking sector.

Review of performance

Our European operations reported a pre-tax loss of US$0.7bn, compared with a profit of US$2.1bn in the first half of 2011. On a constant currency basis, pre-tax profits declined by US$2.7bn.

In the first half of 2012, we reported adverse fair value movements of US$1.6bn due to the change in credit spreads on the Group's own debt held at fair value, compared with adverse fair value movements of US$71m in the first half of 2011. On an underlying basis, pre-tax profits decreased by 55% due to higher operating expenses as a result of a rise in customer redress provisions, coupled with a credit relating to pension obligations in the UK in the first half of 2011 which did not recur.

Profit/(loss) before tax by country within global businesses

For footnote, see page 100.

We continued to make progress in rationalising our operation in Europe using the Group's five filters framework, reducing fragmentation in the region by announcing an exit from operations in Slovakia and entering into agreements to sell our equities broking business in Greece, certain private banking assets in Monaco and our Irish insurance businesses in run-off. We have progressed with the business exits announced in 2011, primarily in Eastern Europe. The disposal of non-core businesses improved capital discipline by simplifying our European portfolio and concentrating our operations on businesses where we can deliver sustainable profits and growth.

We maintained our focus on improving our cost efficiency and organisational effectiveness. Building on the significant initiatives in 2011 across Europe, we announced a restructuring programme in the UK to align each of our businesses to their respective global business operating models in order to reduce bureaucracy and complexity and lower our costs in a sustainable way. As a result of this and other initiatives across the region, total restructuring costs (including impairment of assets) of US$200m were incurred, notably in the UK.

In RBWM, we delivered further strong growth in mortgage balances in the UK, reflecting the success of our competitive offerings and marketing campaigns. Our share of new UK mortgage lending remained at 11% in the first half of the year, which was significantly higher than our total market share of 6%, while maintaining a conservative loan to value ratio of 56%. We have committed to lend at least £17bn (US$26bn) to UK mortgage customers in 2012, of which £4bn (US$6bn) is specifically set aside for first time buyers and had approved new mortgage lending of more than £10bn (US$15bn) at the end of June 2012. In Continental Europe, we continued to target the mass affluent market and build a strong credit card business in Turkey.

In CMB, we continued to invest in the UK in the business by recruiting additional international commercial managers who focus exclusively on international customers. We launched a £4bn (US$6bn) International SME Fund to support UK businesses that trade, or aspire to trade, internationally, and had approved new loans of more than £2.5bn (US$4bn) at the end of June 2012. We also committed to increase gross new lending facilities to UK SMEs by £12bn (US$18bn). We continued to invest in our businesses in Turkey and Germany to support business growth. Our focus on international customers, together with targeted growth initiatives including deposit acquisition and regional pricing strategies, led to a rise in Payments and Cash Management and Global Trade and Receivable Finance income. CMB's partnership with GB&M delivered income growth of 12% compared with the first half of 2011 to more than US$370m, notably from foreign exchange products, as we continued to support our commercial customers' financing and treasury risk management requirements.

In GB&M, we continued to focus on cross-border initiatives to enable us to capture opportunities from increasing trade flows and connect to faster-growing markets. We won a number of mandates in our Payments and Cash Management business, reflecting investment in these areas in previous years. In April 2012, HSBC issued the first international renminbi bond outside sovereign Chinese territory reflecting our commitment to establish the UK as a leading offshore renminbi centre. In addition, we actively reduced our legacy credit exposure in Europe by exiting certain positions. We will seek to further reduce the size of this portfolio as opportunities become available. The financial effect of the legacy credit portfolio on the results of our Europe operations can be seen on page 38.

Within our GPB business, we concentrated on navigating a number of regulatory challenges affecting the industry, by implementing a new target operating model designed to enable us to manage the business globally, better service the needs of clients through global product offerings, and improve risk and compliance standards. We continued to provide access to international investment opportunities and we put in place dedicated resources in both CMB and GPB to increase referral activity and jointly service the diverse corporate and personal investment needs of the Group's largest ultra-high net worth clients.

The forthcoming legislation in relation to the report of the UK Independent Commission on Banking ('ICB'), which will define the products, services and customers which are either required to be within the ring-fenced bank or prohibited from it, is likely to require us to make major changes to our corporate structure and the business activities we conduct in the UK through our major banking subsidiary, HSBC Bank. These changes would take an extended period to implement, and would have a significant effect on the costs of both establishing and running the ongoing operations as restructured (see page 106).

The following commentary is on a constant currency basis.

Net interest income decreased by 5%, mainly due to the decline in Balance Sheet Management revenues as yield curves continued to flatten and interest rates remained low, together with a reduction in the available-for-sale debt security portfolio as a result of disposals. In addition, there was a fall in effective yields and a reduction in the size of the legacy Credit portfolio. This was partly offset by higher net interest income in CMB, driven by an increase in average term lending balances in the UK and Continental Europe as a result of targeted campaigns in 2011 and the first half of 2012. Net interest income also benefited from strong residential mortgage balance growth in RBWM in the UK and deposit growth across the region as a result of marketing campaigns. This was offset in part by strong competition for deposits in the UK which resulted in lower deposit spreads.

Net fee income was broadly in line with the first half of 2011. Fees in RBWM increased due to lower commissions paid as a result of the non-renewal and transfer to third parties of certain contracts in the Irish reinsurance business. This was largely offset by lower fee income in GPB due to a fall in average assets under management which was driven by net new money outflows, a fall in client numbers and adverse movements in the financial markets in the second half of 2011. In addition, in GB&M, primary revenues in the Rates business decreased as a result of a reduction in bond issuances and lower equity capital markets revenues, which were driven by a decline in deal volumes due to the challenging economic environment.

Net trading income decreased by 5%, mainly due to adverse foreign exchange movements on trading assets held as economic hedges of foreign currency debt designated at fair value, compared with gains in the first half of 2011. These offset favourable foreign exchange movements on the foreign currency debt which is reported in 'Net expense from financial instruments designated at fair value'. Revenues in our legacy Credit portfolio (see page 284) declined due to write-downs compared with net releases in the first half of 2011. There were also adverse movements on non-qualifying hedges in European operating entities as interest rates fell. In addition, there were unfavourable fair value movements on structured liabilities as spreads tightened, along with lower Equities revenues, reflecting a less favourable trading environment.

These factors were partly offset by higher Rates trading revenues, notably in the first quarter of 2012 following the ECB's announcement of the LTRO. Excluding legacy credit, Credit trading revenues increased as credit spreads tightened resulting in gains on corporate bonds. In addition, Foreign Exchange reported strong revenue growth driven by a rise in customer activity, in part due to collaboration with CMB and a favourable trading environment for foreign exchange compared with the first half of 2011.

Net expense from financial instruments designated at fair valueincreased by US$700m. Excluding adverse fair value movements due to the change in credit spreads on our own debt held at fair value, net income from financial instruments designated at fair value of US$669m in the first half of 2012 compared with a net expense of US$165m in the first half of 2011. This was driven by favourable foreign exchange movements on foreign currency debt designated at fair value issued as part of our overall funding strategy, compared with adverse foreign exchange movements in the same period in 2011, with an offset reported in 'Net trading income'. In addition, investment returns on the fair value of assets held to meet liabilities under insurance and investment contracts were higher than in the first half of 2011 as market conditions improved. To the extent that these investment gains were attributed to policyholders holding unit-linked insurance policies and insurance or investment contracts with DPF, the corresponding movement in liabilities to customers is recorded under 'Net insurance claims incurred and movement in liabilities to policyholders'.

Gains less losses from financial investments increased by US$148m. Balance Sheet Management reported significantly higher gains on the disposal of available-for-sale debt securities, mainly in the UK, as part of structural interest rate risk management activities. This was partly offset by realised losses on the disposal of specific bond positions in the legacy credit portfolio, higher impairment charges on available-for-sale equity investments and lower realised gains from the sale of available-for-sale equity investments due to weaker economic conditions.

Net earned insurance premiums decreased by 17%, primarily due to lower life insurance sales in RBWM in France of investment contracts with DPF resulting from the adverse economic environment and increased competition from other banking products. In addition, there was a reduction in premiums due to the non-renewal and transfer to third parties of certain contracts in our Irish business during 2011.

Other operating income decreased by 26%, largely reflecting the non-recurrence of the benefit from a refinement of the calculation of the PVIF asset during the first half of 2011 (see footnote 27 on page 100), together with a reduction in the PVIF asset in the first half of 2012 due to the effect of experience and assumption updates. In addition, losses arose on the sale of certain syndicated loans.

Net insurance claims incurred and movement in liabilities to policyholders decreased by 7%. This reflected lower reserves established for new business in line with the decline in premiums in France, together with the non-renewal and transfer to third parties of certain contracts in our Irish business during 2011. This was partly offset by an increase in the movement in liabilities to policyholders reflecting investment gains in the first half of 2012.

Loan impairment charges and other credit risk provisions decreased by 9% to US$1.0bn. This mainly reflected a continued reduction in impairments in RBWM, primarily in the UK, as we focused our lending growth on higher quality assets and continued to pro-actively monitor and identify customers facing financial hardship. This resulted in lower delinquency rates across both the secured and unsecured lending portfolios. In CMB, loan impairment charges were higher due to individually assessed provisions across a range of sectors, reflecting the challenging economic conditions. In GB&M, we incurred higher loan impairment charges due to a small number of significant individually assessed provisions, together with a rise in loan impairment charges in our legacy Credit business. These were partly offset by lower credit risk provisions, primarily driven by reduced impairments on available-for-sale ABSs in legacy credit due to losses arising in the underlying collateral pools, which generated lower charges, coupled with a fall in the impairment charge on Greek sovereign debt.

Operating expenses in the first half of 2012 included additional provisions of US$1.3bn relating to UK customer redress programmes for the possible mis-selling of PPI policies and interest rate protection products in previous years, compared with a charge of US$598m (US$611m as reported) in the first half of 2011 (see page 248). In addition, restructuring costs (including impairment of assets) of US$200m were incurred, largely in the UK, compared with US$86m in the first half of 2011. The first half of 2011 also included a credit of US$570m (US$587m as reported) relating to defined benefit pension obligations in the UK, which did not recur.

Excluding these items, operating expenses increased, mainly driven by higher performance costs in GB&M reflecting the increase in net operating income. This was partly offset by a decline in operating expenses in RBWM as average staff numbers fell as a result of organisational

effectiveness programmes and disposals. We achieved sustainable cost savings of about US$280m in the first half of 2012, which enabled us to reinvest and support business growth.

Operating expenses in Europe

Profit/(loss) before tax and balance sheet data - Europe

Profit/(loss) before tax and balance sheet data - Europe (continued)