Annual Financial Report - 32 of 48

RNS Number : 3860B

HSBC Holdings PLC

03 April 2013

Capital

	Page	App¹	Tables	Page

Capital overview .........................................	282		Capital ratios .............................................................	282

Capital management .................................		293
Approach and policy .....................................		293
Stress testing ..................................................		293
Risks to capital ..............................................		293
Risk-weighted asset targets .............................		294
Capital generation .........................................		294

Capital measurement and allocation ......		294
Regulatory capital ..........................................		294
Pillar 1 capital requirements ..........................		295
Pillar 2 capital requirements ..........................		296
Pillar 3 disclosure requirements ......................		296

Risk-weighted assets .................................	282		RWAs by risk type .......................................................	282
			Market risk RWAs ........................................................	282
			RWAs by global businesses .........................................	282
			RWAs by geographical regions ...................................	283
Credit risk RWAs ...........................................	283		RWA movement by key driver - credit risk - IRB only .	283
Counterparty credit risk and market risk RWAs ...................................................................	284		RWA movement by key driver - counterparty credit risk - IRB only ..............................................	284
			RWA movement by key driver - market risk - internal model based ...........................................................	284
Operational risk RWAs ..................................	285

RWA movement by key driver - basis of preparation and supporting notes ........		296
Credit risk drivers - definitions and quantification .............................................		296
Market risk drivers - definitions and quantification .............................................		298

Movement in total regulatory capital in 2012...........................................................	285		Source and application of total regulatory capital .....	285

Capital structure ........................................	286		Composition of regulatory capital ..............................	286
			Regulatory impact of management actions ................	287
			Reconciliation of accounting and regulatory balance sheets ........................................................	287
Regulatory and accounting consolidations ......	288
Basel III and its implementation in Europe ....	288

Basis of preparation of the estimated effect of the CRD IV end point applied to the 31 December 2012 position ....................		298	Estimated effect of CRD IV end point rules applied to the 31 December 2012 position ..............................	289
Regulatory adjustments applied to core tier 1 in respect of amounts subject to CRD IV treatment ...................................................		298
Changes to capital requirements introduced by CRD IV ......................................................		300

Future developments .................................	291
Systemically important banks ........................	291
UK regulatory reform ....................................	291
Structural banking reform ..............................	292

1. Appendix to Capital

Our objective in the management of Group capital is to maintain appropriate levels of capital to support our business strategy and meet our regulatory requirements.

Capital highlights

· Core tier 1 capital ratio 12.3%, up from 10.1% in 2011, as a result of capital generation and management actions.

· CRD IV, which implements Basel III in Europe, remains unfinalised and the timetable for implementation is uncertain.

Capital overview

Capital ratios

(Unaudited)

	At 31 December
	2012	2011
	%	%

Core tier 1 ratio ........	12.3	10.1
Tier 1 ratio ...............	13.4	11.5
Total capital ratio ....	16.1	14.1

Our approach to managing Group capital has been to ensure that we exceed current, and are well placed to meet expected future, regulatory requirements. Within the remit of Pillar 2, the FSA has defined a common equity tier 1 ('CET1') capital resources floor for the Group. This is expressed as a minimum target CETI ratio calculated on a Basel III end point basis, to be achieved by December 2013. In effect this accelerates our full implementation date for Basel III even though there remains uncertainty around the precise requirements in Europe.

We currently manage our capital position to meet an internal target CET1 ratio in the range 9.5%‑10.5% for 31 December 2013 and will review this on an ongoing basis.

The eligibility requirements in the UK for non‑equity capital securities, under Basel III rules, remained under review so we did not issue any such capital securities during 2012.

A summary of our policies and practices regarding capital management, measurement and allocation is provided in the Appendix to Capital on page 294.

Risk-weighted assets

RWAs by risk type

(Unaudited)

	At 31 December
	2012	2011
	US$m	US$m

Credit risk ......................	898,416	958,189
Standardised approach ....	374,469	372,039
IRB foundation approach ....................................	10,265	8,549
IRB advanced approach ..	513,682	577,601

Counterparty credit risk .	48,319	53,792
Standardised approach¹ ...	2,645	3,163
IRB approach .................	45,674	50,629

Market risk ....................	54,944	73,177
Operational risk .............	122,264	124,356

Total ..............................	1,123,943	1,209,514

Of which:
Run-off portfolios ......	145,689	181,657
Legacy credit in GB&M ................................	38,587	50,023
US CML and Other .....	107,102	131,634
Card and Retail Services² .................	6,858	52,080

For footnotes, see page 292.

Market risk RWAs

(Unaudited)

	At 31 December
	2012	2011
	US$m	US$m

VAR ................................	7,616	11,345
Stressed VAR ...................	11,048	19,117
Incremental risk charge ...	11,062	5,249
Comprehensive risk measure .......................	3,387	6,013
Other VAR and stressed VAR.............................	11,355	12,957

Internal model based........	44,468	54,681

FSA standard rules ...........	10,476	18,496

	54,944	73,177

RWAs by global businesses

(Unaudited)

	At 31 December
	2012	2011
	US$bn	US$bn
Retail Banking and Wealth Management ................................	276.6	351.2
Commercial Banking ..	397.0	382.9
Global Banking and Markets ..................	403.1	423.0
Global Private Banking ................................	21.7	22.5
Other ..........................	25.5	29.9

Total ..........................	1,123.9	1,209.5

RWAs by geographical regions³

(Unaudited)

	At 31 December
	2012	2011
	US$bn	US$bn

Total ..........................	1,123.9	1,209.5

Europe ........................	314.7	340.2
Hong Kong .................	111.9	105.7
Rest of Asia-Pacific ....	302.2	279.3
MENA ........................	62.2	58.9
North America ...........	253.0	337.3
Latin America ............	97.9	102.3

For footnote, see page 292.

RWAs reduced by US$86bn to US$1,124bn in 2012, due to a combination of management actions and business growth.

Credit risk RWAs

(Unaudited)

Credit risk RWAs are calculated using three approaches as permitted by the UK regulator. For consolidated Group reporting we have adopted the advanced IRB approach for the majority of our business, with a small proportion on the foundation IRB approach and the remaining portfolios being on the standardised approach.

For portfolios treated under the standardised approach, credit risk RWA movements were primarily due to the increase of US$30bn in our associates in mainland China, mainly from loan growth in BoCom and Industrial Bank. This was partially offset by the first tranche sale of Ping An, which resulted in its banking subsidiary no longer being included in the regulatory consolidation for RWAs. The remaining holding, at year end, was treated as a deduction from capital, giving a year-on-year reduction in RWAs of US$21bn. For further details see page 39.

In Europe, a reduction in standardised RWAs for CMB and GB&M of US$6.5bn reflected reduced corporate lending in selected eurozone countries and a movement to the IRB supervisory slotting approach for the shipping portfolio in Greece. In Latin America, corporate lending growth in the region was more than offset by the reduction in corporate exposure from the sale of operations in Costa Rica, El Salvador and Honduras, and the managing down of vehicle finance and payroll loan portfolios in Brazil.

Credit risk RWA movements by key driver for portfolios treated under the IRB approach are set out in the table below. For the basis of preparation, see the Appendix to Capital on page 298. Foreign exchange movements had an impact of US$6.2bn; the discussion of the remaining drivers excludes the effect of foreign exchange.

RWA movement by key driver - credit risk - IRB only

(Unaudited)

	Europe	Hong Kong	Rest of Asia- Pacific	MENA	North America	Latin America	Total
	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn

RWAs at 1 January 2012 .......	156.5	68.0	82.3	12.9	254.5	12.0	586.2

Foreign exchange movement .	4.7	0.1	0.8	(0.2)	0.7	0.1	6.2
Acquisitions and disposals .......	-	-	(0.1)	(0.7)	(40.3)	(0.9)	(42.0)
Book size ...............................	(1.8)	3.6	5.4	1.0	(7.6)	(0.6)	-
Book quality ..........................	(6.6)	1.5	(1.1)	(0.3)	(17.9)	0.1	(24.3)
Model updates ........................	0.4	-	-	0.1	-	-	0.5
Portfolios moving onto IRB approach .................	1.4	-	-	0.1	-	-	1.5
New/updated models ...........	(1.0)	-	-	-	-	-	(1.0)

Methodology and policy ........	(2.5)	(3.0)	4.8	(0.2)	(2.3)	0.5	(2.7)
Internal updates ..................	(1.3)	(3.0)	4.8	(0.2)	(2.3)	0.5	(1.5)
External updates .................	(1.2)	-	-	-	-	-	(1.2)


Total RWA movement ..........	(5.8)	2.2	9.8	(0.3)	(67.4)	(0.8)	(62.3)

RWAs at 31 December 2012 ..	150.7	70.2	92.1	12.6	187.1	11.2	523.9

Management actions in the North America RBWM business, most notably the disposal of the Card and Retail Services business and the non-strategic branches in upstate New York, reduced RWAs by US$40bn.

Movements in book quality in the RBWM North America retail business accounted for US$14bn of the US$18bn reduction in RWAs. These retail reductions were mainly due to a refinement in risk metrics for mortgage exposures with a US$6.1bn RWA impact attained through recalibration with more recent data observations. Further reductions of US$7.4bn were due to positive credit quality migration and the progression of assets into default as a result of the challenging conditions in the US mortgage market. As assets approach and go into default, capital requirements are increasingly reflected in an expected loss deduction from capital, rather than having a direct effect on RWAs (see 'Deductions' within 'Composition of regulatory capital' on page 286). Additionally, RBWM continued to manage down the residual balances in our North America retail portfolios through a combination of run-off and write-off which resulted in a reduction in RWAs of US$12bn. In our North America wholesale portfolios, there was an increase in book size with RWA growth of US$4.9bn, mainly in our CMB and GB&M businesses. This was partially offset by favourable movements in book quality for those portfolios which reduced RWAs by US$4.5bn.

Corporate and commercial lending and trade finance activity in our CMB and GB&M businesses were the primary drivers of the book size RWA growth of US$9.0bn in Rest of Asia-Pacific and Hong Kong, while the book quality was relatively stable overall. Data enhancements in Rest of Asia-Pacific and Hong Kong allowed us to improve the quantification of exposure and risk metrics, and are reflected in internal methodology and policy updates.

In Europe, rating agency actions on ABSs held in GB&M business were one of the main drivers for the movement in book quality of a reduction of US$6.6bn in RWAs. Lower grade investments are deducted from capital rather than risk-weighted, such that the effect is reflected in reduced RWAs and increased capital deductions (see 'Deductions' within 'Composition of regulatory capital' on page 286). Other drivers of the movement in book quality included an improvement in the credit quality of the corporate portfolio in CMB and retail portfolios in RBWM. Reductions in the Europe IRB book size were from lower corporate and institutional exposures in GB&M, partly offset by corporate exposure growth in the top CMB markets. A change in methodology for the regulatory treatment of European Economic Area ('EEA') central bank exposures, to include them in the standardised approach, resulted in a reduction of US$1.2bn.

In the Middle East and Latin America, book size and book quality levels were stable, with the main credit risk RWA movements reflecting mergers and acquisitions, including purchases in Oman and the UAE and disposals in Costa Rica, Honduras and El Salvador.

Counterparty credit risk and market risk RWAs

(Unaudited)

Trading portfolio movements for the modelled approaches to market risk and counterparty credit risk ('CCR') RWAs are outlined in the tables below. For the basis of preparation, see the Appendix to Capital on page 295.

RWA movement by key driver - counterparty credit

risk - IRB only

(Unaudited)

	US$bn

RWAs at 1 January 2012 ......................	50.6

Book size ..............................................	(0.8)
Book quality .........................................	0.1
Model updates .......................................	(0.2)
Methodology and policy........................	(4.0)
Internal updates .................................	(4.0)
External updates ................................	-


Total RWA movement .........................	(4.9)

RWAs at 31 December 2012 .................	45.7

CCR RWAs decreased by US$4.9bn during the year, primarily due to methodology and policy changes in GB&M. The main drivers of the change arose through the increased application of counterparty netting within the calculation and from counterparty data refinement which allowed us to apply lower potential future exposure add-on factors. There were reductions in book size in North America, due to a decrease in the GB&M legacy credit portfolio and from maturing trades, and in Latin America due to reduced repo activity with central banks and lower exposure in respect of derivative transactions.

RWA movement by key driver - market risk -

internal model based

(Unaudited)

	US$bn

RWAs at 1 January 2012 ......................	54.7

Foreign exchange movement and other .	(0.4)
Movement in risk levels ........................	(7.4)
Model updates .......................................	-
Methodology and policy........................	(2.4)
Internal updates .................................	(2.4)
External updates ................................	-


Total RWA movement .........................	(10.2)

RWAs at 31 December 2012 .................	44.5

Market risk RWAs decreased by US$10bn in 2012 with the main driver being a reduction in risk levels of US$11bn in GB&M, primarily as a result of decreasing VAR due to reductions in exposure and improvements in market conditions. The factors affecting the reductions in VAR also drove the reductions in the levels of stressed VAR. The effect was partly offset by a US$4.0bn risk level increase in the incremental risk charge as a result of a recalibration of the sovereign correlation matrix. RWA changes due to methodology and policy of US$2.4bn were due to a reduction in the VAR multiplier in France.

Market risk RWA movements for portfolios not within scope of modelled approaches showed a reduction of US$8.0bn. This was mainly driven by management actions by GB&M to reduce legacy positions in North America.

Operational risk RWAs

(Unaudited)

Operational risk RWAs remained stable in 2012, being calculated on a three-year average of revenues.

Movement in total regulatory capital in 2012

(Audited)

Source and application of total regulatory capital

	At 31 December
	2012 US$m	2011 US$m
Movement in total regulatory capital
(Audited)
Opening core tier 1 capital ......................................................................................................	122,496	116,116
Contribution to core tier 1 capital from profit for the year .................................................	17,827	14,011
Consolidated profits attributable to shareholders of the parent company .........................	14,027	16,797
Removal of own credit spread net of tax .........................................................................	3,800	(2,786)

Net dividends .......................................................................................................................	(5,613)	(5,271)
Dividends ........................................................................................................................	(8,042)	(7,501)
Add back: shares issued in lieu of dividends .......................................................................	2,429	2,230

Decrease in goodwill and intangible assets deducted ..............................................................	1,686	582
Ordinary shares issued ..........................................................................................................	594	96
Foreign currency translation differences ..............................................................................	989	(2,705)
Other, including regulatory adjustments ...............................................................................	810	(333)

Closing core tier 1 capital ..................................................................................................	138,789	122,496

Opening other tier 1 capital ....................................................................................................	17,094	17,063
Hybrid capital securities redeemed .......................................................................................	(776)	-
Unconsolidated investments.................................................................................................	(4,120)	71
Other, including regulatory adjustments ...............................................................................	61	(40)

Closing tier 1 capital ..........................................................................................................	151,048	139,590

Opening tier 2 capital .............................................................................................................	30,744	34,376
Redeemed capital .................................................................................................................	(1,483)	(3,360)
Other, including regulatory adjustments ...............................................................................	497	(272)

Closing total regulatory capital ........................................................................................	180,806	170,334

We complied with the FSA's capital adequacy requirements throughout 2011 and 2012. Internal capital generation contributed US$12bn to core tier 1 capital, being profits attributable to shareholders of

the parent company after regulatory adjustment for own credit spread and net of dividends. The table below sets out the composition of our capital under the current regulatory requirements.

Capital structure

Composition of regulatory capital

(Audited)

		At 31 December
		2012	2011
	Ref	US$m	US$m
Tier 1 capital
Shareholders' equity ......................................................................................................		167,360	154,148
Shareholders' equity per balance sheet⁴ .....................................................................	a	175,242	158,725
Preference share premium .........................................................................................	b	(1,405)	(1,405)
Other equity instruments ...........................................................................................	c	(5,851)	(5,851)
Deconsolidation of special purpose entities⁵ ..............................................................	a	(626)	2,679

Non-controlling interests ..............................................................................................		4,348	3,963
Non-controlling interests per balance sheet ...............................................................	d	7,887	7,368
Preference share non-controlling interests ................................................................	e	(2,428)	(2,412)
Non-controlling interests transferred to tier 2 capital ...............................................	f	(501)	(496)
Non-controlling interests in deconsolidated subsidiaries .............................................	d	(610)	(497)

Regulatory adjustments to the accounting basis .............................................................		(2,437)	(4,331)
Unrealised losses on available-for-sale debt securities⁶ ...............................................		1,223	2,228
Own credit spread ......................................................................................................		112	(3,608)
Defined benefit pension fund adjustment⁷ ..................................................................	g	(469)	(368)
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities ......................................................................................		(3,290)	(2,678)
Cash flow hedging reserve .........................................................................................		(13)	95

Deductions ....................................................................................................................		(30,482)	(31,284)
Goodwill and intangible assets ....................................................................................	h	(25,733)	(27,419)
50% of securitisation positions .................................................................................		(1,776)	(1,207)
50% of tax credit adjustment for expected losses ......................................................		111	188
50% of excess of expected losses over impairment allowances ..................................	i	(3,084)	(2,846)


Core tier 1 capital .....................................................................................................		138,789	122,496

Other tier 1 capital before deductions ...........................................................................		17,301	17,939
Preference share premium .........................................................................................	b	1,405	1,405
Preference share non-controlling interests ................................................................	e	2,428	2,412
Hybrid capital securities ............................................................................................	j	13,468	14,122

Deductions ....................................................................................................................		(5,042)	(845)
Unconsolidated investments⁸ ....................................................................................		(5,153)	(1,033)
50% of tax credit adjustment for expected losses ......................................................		111	188


Tier 1 capital ..............................................................................................................		151,048	139,590

Tier 2 capital
Total qualifying tier 2 capital before deductions ............................................................		48,231	48,676
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities ......................................................................................		3,290	2,678
Collective impairment allowances .............................................................................	k	2,717	2,660
Perpetual subordinated debt .......................................................................................	l	2,778	2,780
Term subordinated debt .............................................................................................	m	39,146	40,258
Non-controlling interests in tier 2 capital .................................................................	f	300	300

Total deductions other than from tier 1 capital		(18,473)	(17,932)
Unconsolidated investments⁸ ....................................................................................		(13,604)	(13,868)
50% of securitisation positions .................................................................................		(1,776)	(1,207)
50% of excess of expected losses over impairment allowances ..................................	i	(3,084)	(2,846)
Other deductions .......................................................................................................		(9)	(11)


Total regulatory capital ............................................................................................		180,806	170,334

For footnotes, see page 292.

The references (a) - (m) identify balance sheet components on page 287 which are used in the calculation of regulatory capital.

Regulatory impact of management actions

(Unaudited)

	At 31 December 2012
	Risk- weighted assets	Core tier 1 capital	Tier 1 capital	Total regulatory capital

Reported capital ratios before management actions ...................		12.3%	13.4%	16.1%

Reported totals (US$m) ............................................................	1,123,943	138,789	151,048	180,806
Management actions completed in 2013 (US$m) ......................
Dilution of our shareholding in Industrial Bank and the subsequent change in accounting treatment ........................	(38,073)	981	(423)	(1,827)
Completion of the second tranche of the sale of Ping An ......	-	553	4,637	7,984

Estimated total after management actions completed in 2013 (US$m) .............................................................................	1,085,870	140,323	155,262	186,963

Estimated capital ratios after management actions completed in 2013..........................................................................................		12.9%	14.3%	17.2%

Reconciliation of accounting and regulatory balance sheets

(Unaudited)

		At 31 December 2012
		Accounting balance sheet	Decon- solidation of insurance/ other entities	Consolidation of banking associates	Regulatory balance sheet
	Ref	US$m	US$m	US$m	US$m
Assets
Trading assets .........................................................		408,811	(144)	1,477	410,144
Loans and advances to customers ...........................		997,623	(11,957)	119,698	1,105,364
of which:
- impairment allowances on IRB portfolios .......	i	(10,255)	-	-	(10,255)
- impairment allowances on STD portfolios ......	k	(5,857)	-	(2,726)	(8,583)

Financial investments .............................................		421,101	(50,256)	33,110	403,955
Capital invested in insurance and other entities ......		-	8,384	-	8,384
Interests in associates and joint ventures ................		17,834	-	(17,127)	707
of which:
- positive goodwill on acquisition ......................	h	670		(640)	30

Goodwill and intangible assets .................................	h	29,853	(4,983)	687	25,557
Other assets ............................................................		817,316	(34,672)	82,469	865,113
of which:
- goodwill and intangible assets of disposal groups held for sale ....................................................	h	146	(117)	-	29
- retirement benefits assets ................................	g	2,846	-	-	2,846
-. impairment allowances on asset held for sale ..		(703)	-	-	(703)
of which:
- IRB portfolios .............................................	i	(691)	-	-	(691)
- STD portfolios ............................................	k	(12)	-	-	(12)


Total assets ..........................................................		2,692,538	(93,628)	220,314	2,819,224

		At 31 December 2012
		Accounting balance sheet	Decon- solidation of insurance/ other entities	Consolidation of banking associates	Regulatory balance sheet
	Ref	US$m	US$m	US$m	US$m
Liabilities and equity
Deposits by banks ...........................................		107,429	(202)	51,296	158,523
Customer accounts ..........................................		1,340,014	(652)	158,631	1,497,993
Trading liabilities ............................................		304,563	(131)	119	304,551
Financial liabilities designated at fair value ......		87,720	(12,437)	-	75,283
of which:
- term subordinated debt included in tier 2 capital.................................................... ..	m	16,863	-	-	16,863
- hybrid capital securities included in tier 1 capital.................................................... ..	j	4,696	-	-	4,696

Debt securities in issue .....................................		119,461	(11,390)	1,888	109,959
Retirement benefits liabilities ..........................	g	3,905	(21)	52	3,936
Subordinated liabilities .....................................		29,479	3	2,953	32,435
of which:
- hybrid capital securities included in tier 1 capital. ....................................................	j	2,828	-	-	2,828
- perpetual subordinated debt included in tier 2 capital ..................................................	l	2,778	-	-	2,778
- term subordinated debt included in tier 2 capital .................................................. …	m	23,873	-	-	23,873

Other liabilities ...............................................		516,838	(67,562)	5,375	454,651
of which:
-. contingent liabilities and contractual commitments ..........................................		301	-	-	301
of which:
- credit-related provisions on IRB portfolios ................................................................	i	267	-	-	267
- credit-related provisions on STD portfolios ................................................	k	34	-	-	34

Total shareholders' equity ...............................	a	175,242	(626)	(0)	174,616
of which:
- other equity instruments included in tier 1 capital .....................................................	c, j	5,851	-	-	5,851
- preference share premium included in tier 1 capital ..................................................	b	1,405	-	-	1,405

Non-controlling interests ................................	d	7,887	(610)	0	7,277
of which:
- non-cumulative preference shares issued by subsidiaries included in tier 1 capital ....	e	2,428	-	-	2,428
- non-controlling interests included in tier 2 capital, cumulative preferred stock ..........	f	300	-	-	300
- non-controlling interests attributable to holders of ordinary shares in subsidiaries included in tier 2 capital ............................................	f,m	201	-	-	201


Total liabilities and equity .........................		2,692,538	(93,628)	220,314	2,819,224

For footnote, see page 292.

The references (a) - (m) identify balance sheet components which are used in the calculation of regulatory capital on page 286.

Regulatory and accounting consolidations

(Unaudited)

The basis of consolidation for financial accounting purposes is described in Note 1 on the Financial Statements and differs from that used for regulatory purposes. The table above provides a reconciliation of the financial accounting balance sheet to the regulatory balance sheet. Not all items are reconcilable, due to regulatory adjustments that are applied, for example to non-core capital instruments before they can be included in the Group's regulatory capital base. It is the regulatory balances, and not the financial accounting balance sheet, which form the basis for the regulatory capital calculations. Investments in banking associates are equity accounted in the financial accounting consolidation, whereas their assets and liabilities are proportionally consolidated for regulatory purposes. Subsidiaries and associates engaged in insurance and non-financial activities are excluded from the regulatory consolidation and are deducted from regulatory capital. The regulatory consolidation does not include SPEs where significant risk has been transferred to third parties. Exposures to these SPEs are risk-weighted as securitisation positions for regulatory purposes. Entities in respect of which the basis of consolidation for financial accounting purposes differs from that used for regulatory purposes can be found in the Pillar 3 Disclosures 2012 report.

Basel III and its implementation in Europe

(Unaudited)

In July 2011, the European Commission published proposals for a new Regulation and Directive, known collectively as CRD IV, to give effect to the Basel III framework in the EU. The majority of the Basel III proposals are in the Regulation, removing national discretion. However, capital buffers such as those for countercyclical and capital conservation are in the Directive and are subject to transposition into national law by member states. CRD IV implementation has been delayed and the timetable for finalisation is uncertain.

In October 2012, the FSA wrote to large firms to set out the disclosures they are required to make of capital resources on a first year transitional basis under CRD IV. We have made these disclosures in appendix III of the Pillar 3 Disclosures 2012 report.

Following the FSA's setting of a Capital Resources Floor, and in order to manage our transition to Basel III under CRD IV, we provide below some insight for investors of the possible effects of these rules on our capital position. We have estimated our pro-forma CET1 ratio by applying our interpretation of the CRD IV draft July 2011 text post the transition period (end point CRD IV) to our balance sheet position at 31 December 2012.

In managing our capital position to meet our internal CET1 target, we consider management actions resulting from our six filters strategy that we either have already taken or would take, if the CRD IV rules were to be finalised in the July 2011 form. These are reflected in the table below under 'Estimated regulatory impact of management actions'. Other management actions could be taken depending upon the finalised rules and timing of implementation but, as such, have not been included.

The application of the CRD IV rules on this basis would translate into an estimated CET1 ratio of 9.0% before management actions and 10.3% after such actions, as detailed in the table below.

Estimated effect of CRD IV end point rules applied to the 31 December 2012 position

(Unaudited)

	At 31 December 2012
	RWAs US$m	Capital US$m

Reported core tier 1 capital under the current regime ...................................................................		138,789

Regulatory adjustments applied to core tier 1 in respect of amounts subject to CRD IV treatment
Investments in own shares through the holding of composite products of which HSBC is a component (exchange traded funds, derivatives, and index stock)..........................................		(1,322)
Surplus non-controlling interest disallowed in CET1 .................................................................		(2,299)
Removal of filters under current regime
- Unrealised gains/(losses) on available-for-sale debt securities .................................................		(1,223)
- Unrealised gains on available-for-sale equities........................................................................		2,088
- Reserves arising from revaluation of property ......................................................................		1,202
- Defined benefit pension fund liabilities .................................................................................		(1,596)
Excess of expected losses over impairment allowances deducted 100% from CET1 ..................		(3,084)
Removal of 50% of tax credit adjustment for expected losses ...................................................		(111)
Securitisations positions risk-weighted under CRD IV.................................................................		1,776
Deferred tax liabilities on intangibles ........................................................................................		267
Deferred tax assets that rely on future profitability (excluding those arising from temporary differences)		(456)
Additional valuation adjustment (referred to as PVA) ...............................................................		(1,720)
Debit valuation adjustment .......................................................................................................		(372)
Individually immaterial holdings in CET1 capital of banks, financial institutions and insurance in aggregate above 10% of HSBC CET1 ...................................................................................		(5,994)
Deductions under threshold approach
Amount exceeding the 10% threshold:
- Significant investments in CET1 capital of banks, financial institutions and insurance .........		(6,697)
Amount in aggregate exceeding the 15% threshold:
- Significant investments in CET1 capital of banks, financial institutions and insurance .........		(2,265)
- Deferred tax assets ...............................................................................................................		(1,532)

Estimated CET1 capital under CRD IV ...................................................................................		115,451

Reported total RWAs ...................................................................................................................	1,123,943

Changes to capital requirements introduced by CRD IV
Credit valuation adjustment ......................................................................................................	60,360
Counterparty credit risk (other than credit valuation adjustment) .............................................	25,682
Amounts in aggregate below 15% threshold and therefore subject to 250% risk weight .............	43,295
Securitisation positions and free deliveries risk-weighted under CRD IV ....................................	44,513
Investments in commercial entities now risk-weighted .............................................................	393
Deferred tax assets moved to threshold deduction under CRD IV ..............................................	(8,976)

Estimated total RWAs under CRD IV ....................................................................................	1,289,210

Estimated CET1 ratio ................................................................................................................		9.0%

	At 31 December 2012
	RWAs US$m	Capital US$m
Estimated regulatory impact of management actions
Management actions completed in 2013:
Dilution of our shareholding in Industrial Bank and the subsequent change in accounting treatment .............................................................................................................................	(38,880)	(2,150)
Completion of the second tranche of the sale of Ping An .........................................................	3,522	9,393

Estimated total after management actions completed in 2013 .....................................................	1,253,852	122,694

Estimated CET1 ratio after management actions completed in 2013 .................................		9.8%

Planned short-term management actions if rules are finalised in their current form: Mitigation of immaterial holdings⁹ ...........................................................................................	2,645	7,052

Estimated total after planned management actions ......................................................................	1,256,497	129,746

Estimated CET1 ratio after planned management actions ..................................................		10.3%

For the detailed basis of preparation, see page 298 of the Appendix to Capital.

The table above presents a reconciliation of our reported core tier 1 capital and RWAs position at 31 December 2012 to the pro-forma estimated CET1 end point capital and estimated RWAs based on our interpretation of the July 2011 draft CRD IV regulation, supplemented by FSA guidance and, in lieu of guidance, our expectation of how these draft rules will be updated following EU negotiations.

CRD IV is not yet in law and its provisions are subject to ongoing negotiation and amendment. As such, the finalised rules could have a materially different effect on CET1 and RWAs.

The CRD IV rule changes introduce a revised definition of regulatory capital, primarily focused on CET1 capital as the predominant form of going concern capital, with a greater quantum to be held by banks. There are increased capital deductions and new regulatory adjustments affecting this higher tier of capital. The new rules also introduce increased RWA requirements, mainly for CCR.

The largest impact on our CET1 capital is the deduction of unconsolidated significant investments in banks, financial institutions and insurance entities of US$9.0bn (shown as US$6.7bn and US$2.3bn in the table above). This results from a reallocation of current deductions to this higher tier of capital and new rules for calculating the amounts to be deducted.

Adding to the above, the regulatory treatment applied to immaterial unconsolidated investments in banks, financial institutions and insurance entities, whereby a maturity restriction does not recognise the netting of long and short positions when the short position is less than one year residual maturity, even though they are hedged from a market risk perspective. This results in an estimated deduction
of US$6.0bn. The effect on capital is exacerbated by its impact on the threshold for other deductions.

The rules are currently in draft and subject to ongoing negotiation. If they were to be finalised in their current form, the holdings of such positions would generate a disproportionate capital cost and potentially the relevant business could be curtailed, closed or our hedging would be adjusted to negate the impact.

Capital management initiatives and management actions already adopted by the Group, in accordance with our six filters strategic framework, have contributed to mitigating the effect of the future rules. In 2012, this included the continuing run-off of capital intensive portfolios including the US CML and the GB&M legacy credit portfolios and the sale of the Card and Retail Services business. Post year-end, we sold our remaining investment in Ping An and reduced our percentage holding in Industrial Bank following a private placement by the company.

Although the effect of the future CRD IV rules is shown above on an end point basis, the rules allow for a transition period of six years to phase in the new deductions and regulatory adjustments. On a CRD IV first year transitional basis our CET1 ratio, if applied to our year end 2012 position, would be 11.5% before management actions.

As a result of the capital resources floor, we currently manage our capital position to meet an internal target CET1 ratio on an end point basis for year end 2013. We will continue to manage our capital position to ensure that it exceeds current regulatory requirements and is well placed to meet expected future regulatory requirements. We will review our capital target ratios on an ongoing basis, reflecting any changes in the regulatory environment as they develop.

Future developments

Systemically important banks

(Unaudited)

In parallel with the Basel III proposals, the Basel Committee issued a consultative document in July 2011, 'Global systemically important banks: assessment methodology and the additional loss absorbency requirement'. In November 2011, it published its rules and the Financial Stability Board ('FSB') issued the initial list of global systemically important banks ('G-SIB's). This list, which included HSBC and 28 other major banks from around the world, will be re-assessed periodically through annual re-scoring of the individual banks and a triennial review of the methodology.

The requirements, initially for those banks identified in November 2014 as G-SIBs, will be phased in from 1 January 2016, becoming fully effective on 1 January 2019. National regulators have discretion to introduce higher thresholds than the minima. In November 2012, the FSB published a revised list of G-SIBs and their current assessment of the appropriate capital charge. HSBC was assigned an add-on of 2.5%.

UK regulatory reform

(Unaudited)

The FSA supervises HSBC on a consolidated basis. However, the UK financial services regulatory structure is currently in the process of substantial reform. Legislation has been passed to abolish the FSA and establish three new regulatory bodies from 1 April 2013.

The three new bodies will comprise the Financial Policy Committee ('FPC') of the Bank of England, the Prudential Regulation Authority ('PRA') and the Financial Conduct Authority ('FCA'). The FPC will not directly supervise firms, being responsible for macro-prudential regulation and considering systemic risk affecting economic and financial stability. The PRA and the FCA will inherit the majority of the FSA's existing functions as the micro-prudential supervisors. Some subsidiaries such as HSBC Bank will be 'dual-regulated' firms, subject to prudential regulation by the PRA and to conduct regulation by the FCA. These reforms will endow the new regulatory bodies with additional powers. For example, under certain circumstances the PRA and FCA will be able to issue directions to unregulated qualifying parent undertakings such as HSBC Holdings.

In the case of the FPC, its January 2013 Draft Policy Statement, 'The Financial Policy Committee's power to supplement capital requirements', states that it will have two main powers: the first is to make recommendations, and the second is a power to direct the FCA and the PRA to adjust specific macro-prudential tools, namely the countercyclical capital buffer ('CCB') and sectoral capital requirements ('SCR's'). The UK Government is proposing to make the FPC responsible for setting the CCB, a Basel III global requirement applied to certain financial institutions in the UK. The CCB is a macro-prudential tool at the disposal of national authorities that can be deployed to protect the banking sector from future potential losseswhen the FPC judges that threats to financial stability have arisen in the UK which increase system-wide risk. Should a CCB be required, it is expected to be set in the range of 0‑2.5%.

It is also planned under the new legislation to give the FPC 'direction power', over SCR's. The SCR tool is more targeted and would allow the FPC to change capital requirements above minimum regulatory standards for exposures to three broad sectors judged to pose a risk to the system as a whole (residential property, including mortgages; commercial property; and other parts of the financial sector). However, on occasion this may be applied to more granular sub-sectors (for example, to mortgages with high loan to value or loan to income ratios at origination). This will include both banking book and trading book exposures and be irrespective of the domicile of the ultimate borrower.

The CCB and SCR tools are described as broad tools designed to reduce the likelihood and severity of financial crises, their primary purpose being to tackle cyclical risks. They provide the FPC with the means to increase the amount of capital that banks must hold when threats to financial stability are judged to be emerging. However, the scale of capital add-ons in respect of SCR has not been quantified.

There is also a proposal for a systemic risk buffer for the banking system as a whole (or a subset thereof) to mitigate structural macro-prudential risk.

Potential effect of regulatory proposals on HSBC's capital requirements

Given the above it is uncertain what HSBC's final capital requirement will be. However, quantified Pillar 1 capital requirements are as follows:

CET1 requirements from 1 January 2019

Minimum CET1 4.5%

Capital conservation buffer 2.5%

G-SIB buffer 2.5%

Against the backdrop of eurozone instability, on a temporary basis, the EBA recommended that banks aim to reach a 9% EBA defined core tier 1 ratio by the end of June 2012. In October 2012 the EBA announced that they would no longer monitor the core tier 1 ratio but instead expect banks to hold an equivalent nominal amount of capital. This new EBA recommendation on capital conservation will require banks to maintain a nominal amount of core tier 1 capital corresponding to the level of 9% of RWAs at the end of June 2012. This equates to US$104bn for HSBC. We will continue to review our internal target CETI ratio of 9.5% to 10.5% as the applicable regulatory capital requirements evolve during the period until 1 January 2019.

We also hold additional capital in respect of Pillar 2, the process of internal capital adequacy assessment and supervisory review which leads to a final determination by the FSA of individual capital guidance and any capital planning buffer that may be required.

Complementing the above, and also within the Pillar 2 process, the FSA first advised the Group in 2012 of a capital resources floor. This is expressed as a minimum target CET1 ratio calculated on a Basel III end point basis, to be achieved by December 2013.

In 2013 the FSA will introduce new industry-wide capital measures. They will floor all sovereign loss given defaults ('LGD's) at 45% and we estimate the effect of this to be an increase of US$19bn RWAs. Additionally, a stringent supervisory slotting approach for our UK commercial real estate portfolio will be introduced. For HSBC, this will roll out across the relevant business during 2013. Furthermore, the FSA have informed HSBC of a framework which will be used when assessing wholesale portfolios with a low number of defaults. This framework will impose LGD and exposure at default ('EAD') floors based on the foundation approach for portfolios with less than 20 events of default per country.

Structural banking reform

(Unaudited)

In September 2011, the Independent Commission on Banking ('ICB') recommended heightened capital requirements for UK banking groups. In June 2012, the UK Government published its consultation, 'Banking reform: delivering stability and supporting a sustainable economy', which set out its detailed proposals for implementing the ICB's recommendations, such as ring-fencing and bail-in debt. In October 2012, the UK Government published draft primary legislation. This legislation was presented for pre-legislative scrutiny to the UK's Parliamentary Commission on Banking Standards who presented their initial findings in December 2012. In February 2013, the UK Government responded to these findings and issued a revised Bill. The Government intends to enact the legislation by the end of this parliament in 2015 and to have reforms in place by 2019.

In October 2012, the Liikanen Report delivered its recommendations to the EC to reform the structure of the European banking sector. This also recommends ring-fencing, focused on isolating trading activities (rather than deposits as in the ICB recommendations) and, in principle, additional bail-in debt. We continue to monitor these developments.

Footnotes to Capital

1 The value represents marked-to-market method only.

2 Operational risk RWAs, under the standardised approach, are calculated using an average of the last three years' revenues. For business disposals, the operational risk RWAs are not released immediately on disposal, but diminish over a period of time. The RWAs for the Card and Retail Services business at 31 December 2012 represent the remaining operational risk RWAs for the business.

3 RWAs are non-additive across geographical regions due to market risk diversification effects within the Group.

4 Includes externally verified profits for the year ended 31 December 2012.

5 Mainly comprises unrealised gains/losses on available-for-sale debt securities related to SPEs.

6 Under FSA rules, unrealised gains/losses on debt securities net of tax must be excluded from capital resources.

7 Under FSA rules, any defined benefit asset is derecognised and a defined benefit liability may be substituted with the additional funding that will be paid into the relevant schemes over the following five-year period.

8 Mainly comprise investments in insurance entities and the AFS investment in Ping An. Due to the expiry of the transitional provision, with effect from 1 January 2013, material insurance holding companies acquired prior to 20 July 2006, will be deducted 50% from tier 1 and 50% from total capital.

9 This management action potentially arises only under rules on a CRD IV basis and has therefore not been included in the composition of regulatory capital table, which is drawn up on the basis of the current rules.

Appendix to Capital

Capital management, capital measurement and RWA movement

Capital management

(Audited)

Approach and policy

Our approach to capital management is driven by our strategic and organisational requirements, taking into account the regulatory, economic and commercial environment in which we operate. Pre-tax return on risk-weighted assets ('RoRWA') is an operational metric by which the global businesses are managed on a day-to-day basis. The metric combines return on equity and regulatory capital efficiency objectives. It is our objective to maintain a strong capital base to support the risks inherent in our business and invest in accordance with our six filters framework, exceeding both consolidated and local regulatory capital requirements at all times.

Our policy on capital management is underpinned by a capital management framework which enables us to manage our capital in a consistent manner. The framework, which is approved by the GMB annually, incorporates a number of different capital measures including market capitalisation, invested capital, economic capital and regulatory capital. Following the FSA setting of a capital resources floor as a Basel III ratio, whilst also monitoring capital at a Group level on a Basel II basis, we set our internal target on an end point Basel III CET1 basis.

Capital measures

· market capitalisation is the stock market value of HSBC;

· invested capital is the equity capital invested in HSBC by our shareholders, adjusted for certain reserves and goodwill previously amortised or written off;

· economic capital is the internally calculated capital requirement which we deem necessary to support the risks to which we are exposed; and

· regulatory capital is the capital which we are required to hold in accordance with the rules established by the FSA for the consolidated Group and by our local regulators for individual Group companies.

Our assessment of capital adequacy is aligned to our assessment of risks, including: credit, market, operational, interest rate risk in the banking book, pension fund, insurance, structural foreign exchange risk and residual risks.

Stress testing

We incorporate stress testing in capital plans because it helps us to understand how sensitive the core assumptions in our capital plans are to the adverse effect of extreme but plausible events. Stress testing allows us to formulate our response and mitigate risk in advance of conditions exhibiting the identified stress scenarios. The actual market stresses which occurred throughout the financial system in recent years have been used to inform our capital planning process and enhance the stress scenarios we employ. In addition to our internal stress tests, others are undertaken, both at the request of regulators and by the regulators themselves using their prescribed assumptions. We take into account the results of all such regulatory stress testing when assessing our internal capital requirements.

Risks to capital

Outside the stress-testing framework, a list of top and emerging risks is regularly evaluated for their effect on the core tier 1 capital ratio. In addition, there are risks identified that are technically not within the scope of this list, but which still have the potential to affect our RWAs and/or capital position. These risks are also included in the evaluation of risks to capital. The downside or upside scenarios are assessed against our capital management objectives and mitigating actions are assigned as necessary. The responsibility for global capital allocation principles and decisions rests with the GMB. Through our internal governance processes, we seek to maintain discipline over our investment and capital allocation decisions and seek to ensure that returns on investment are adequate after taking into account capital costs. Our strategy is to allocate capital to businesses and entities on the basis of their ability to achieve established RoRWA objectives and their regulatory and economic capital requirements.

Risk-weighted asset targets

Top-down RWA targets are established for the global business lines, in accordance with the Group's strategic direction and risk appetite. As these targets are deployed to lower levels of management, action plans for implementation are developed. These may include growth strategies; active portfolio management; restructuring; business and/or customer-level reviews; RWA efficiency and optimisation initiatives and risk-mitigation. Our capital management process is articulated in the annual Group capital plan which is approved by the Board.

RWA targets are approved by the GMB on an annual basis and business performance against them is monitored through regular reporting to the Group ALCO. The management of capital deductions is also addressed in the RWA monitoring framework through additional notional charges for these items.

A range of analysis is employed in the RWA monitoring framework to identify the key drivers of movements in the position, such as book size and book quality. Particular attention is paid to identifying and segmenting items within the day-to-day control of the business and those items that are driven by changes in risk models or regulatory methodology.

Capital generation

HSBC Holdings is the primary provider of equity capital to its subsidiaries and also provides them with non-equity capital where necessary. These investments are substantially funded by HSBC Holdings' own capital issuance and profit retention. As part of its capital management process, HSBC Holdings seeks to maintain a prudent balance between the composition of its capital and its investment in subsidiaries.

Capital measurement and allocation

(Unaudited)

The FSA supervises HSBC on a consolidated basis and therefore receives information on the capital adequacy of, and sets capital requirements for, the Group as a whole. Individual banking subsidiaries are directly regulated by their local banking supervisors, who set and monitor their capital adequacy requirements. In 2012, we calculated capital at a Group level using the Basel II framework as amended for CRD III, commonly known as Basel 2.5.

Our policy and practice in capital measurement and allocation at Group level is underpinned by the Basel II rules and Basel III proposals. However, local regulators are at different stages of implementation and some local reporting, notably in the US, is still on a Basel I basis. In most jurisdictions, non-banking financial subsidiaries are also subject to the supervision and capital requirements of local regulatory authorities.

Basel II is structured around three 'pillars': minimum capital requirements, supervisory review process and market discipline. The CRD implemented Basel II in the EU and the FSA then gave effect to the CRD by including the latter's requirements in its own rulebooks.

Regulatory capital

For regulatory purposes, our capital base is divided into three main categories, namely core tier 1, other tier 1 and tier 2, depending on the degree of permanency and loss absorbency exhibited.

· core tier 1 capital comprises shareholders' equity and related non-controlling interests. The book values of goodwill and intangible assets are deducted from core tier 1 capital and other regulatory adjustments are made for items reflected in shareholders' equity which are treated differently for the purposes of capital adequacy;

· qualifying capital instruments such as non-cumulative perpetual preference shares and hybrid capital securities are included in other tier 1 capital; and

· tier 2 capital comprises qualifying subordinated loan capital, related non-controlling interests, allowable collective impairment allowances and unrealised gains arising on the fair valuation of equity instruments held as available for sale. Tier 2 capital also includes reserves arising from the revaluation of properties.

To ensure the overall quality of the capital base, the FSA's rules set restrictions on the amount of hybrid capital instruments that can be included in tier 1 capital relative to core tier 1 capital, and limits overall tier 2 capital to no more than tier 1 capital.

Pillar 1 capital requirements

Pillar 1 covers the capital resources requirements for credit risk, market risk and operational risk. Credit risk includes counterparty credit risk and securitisation requirements. These requirements are expressed in terms of RWAs.

Credit risk capital requirements

Basel II applies three approaches of increasing sophistication to the calculation of Pillar 1 credit risk capital requirements. The most basic, the standardised approach, requires banks to use external credit ratings to determine the risk weightings applied to rated counterparties. Other counterparties are grouped into broad categories and standardised risk weightings are applied to these categories. The next level, the internal ratings-based ('IRB') foundation approach, allows banks to calculate their credit risk capital requirements on the basis of their internal assessment of a counterparty's probability of default ('PD'), but their estimates of exposure at default ('EAD') and loss given default ('LGD') are subject to standard supervisory parameters. Finally, the IRB advanced approach allows banks to use their own internal assessment in both determining PD and quantifying EAD and LGD.

The capital resources requirement, which is intended to cover unexpected losses, is derived from a formula specified in the regulatory rules which incorporates PD, LGD, EAD and other variables such as maturity and correlation. Expected losses under the IRB approaches are calculated by multiplying PD by EAD and LGD. Expected losses are deducted from capital to the extent that they exceed total accounting impairment allowances.

For credit risk we have adopted the IRB advanced approach for the majority of our portfolios, with the remainder on either IRB foundation or standardised approaches.

Under our Basel II rollout plans, a number of our Group companies and portfolios are in transition to advanced IRB approaches. At the end of 2012, portfolios in most of Europe, Hong Kong, Rest of Asia-Pacific and North America were on advanced IRB approaches. Others remain on the standardised or foundation approaches under Basel II, pending definition of local regulations or model approval, or under exemptions from IRB treatment.

· Counterparty credit risk

CCR arises for OTC derivatives and securities financing transactions. It is calculated in both the trading and non-trading books and is the risk that the counterparty to a transaction may default before completing the satisfactory settlement of the transaction. Three approaches to calculating CCR and determining exposure values are defined by Basel II: standardised, mark-to-market and internal model method. These exposure values are used to determine capital requirements under one of the credit risk approaches: standardised, IRB foundation and IRB advanced.

We use the mark-to-market and internal model method approaches for CCR. Our longer-term aim is to migrate more positions from the mark-to-market to the internal model method approach.

· Securitisation

Securitisation positions are held in both the trading and non-trading books. For non-trading book securitisation positions, Basel II specifies two methods for calculating credit risk requirements, the standardised and the IRB approaches. Both rely on the mapping of rating agency credit ratings to risk weights, which range from 7% to 1,250%. Positions that would otherwise be weighted at 1,250% are deducted from capital.

Within the IRB approach, we use the ratings-based method for the majority of our non-trading book securitisation positions, and the internal assessment approach for unrated liquidity facilities and programme-wide enhancements for asset-backed securitisations.

The majority of securitisation positions in the trading book are treated for capital purposes as if they are held in the non-trading book under the standardised or IRB approaches. Other traded securitisation positions, known as correlation trading, are treated under an internal model approach approved by the FSA.

Market risk capital requirement

The market risk capital requirement is measured using internal market risk models where approved by the FSA, or the FSA's standard rules. Our internal market risk models comprise VAR, stressed VAR, incremental risk charge and correlation trading under the comprehensive risk measure.

Operational risk capital requirement

Basel II includes a capital requirement for operational risk, again utilising three levels of sophistication. The capital required under the basic indicator approach is a simple percentage of gross revenues, whereas under the standardised approach it is one of three different percentages of total operating income less insurance premiums allocated to each of eight defined business lines. Both these approaches use an average of the last three financial years' revenues. Finally, the advanced measurement approach uses banks' own statistical analysis and modelling of operational risk data to determine capital requirements. We have adopted the standardised approach in determining our operational risk capital requirements.

Pillar 2 capital requirements

We conduct an Internal Capital Adequacy Assessment Process ('ICAAP') to determine a forward looking assessment of our capital requirements given our business strategy, risk profile, risk appetite and capital plan. This process incorporates the Group's risk management processes and governance framework. A range of stress tests are applied to our base capital plan. These, coupled with our economic capital framework and other risk management practices, are used to assess our internal capital adequacy requirements.

The ICAAP is examined by the FSA as part of its Supervisory Review and Evaluation Process, which occurs periodically to enable the regulator to define the individual capital guidance or minimum capital requirements for HSBC and capital planning buffer where required.

Pillar 3 disclosure requirements

Pillar 3 of Basel II is related to market discipline and aims to make firms more transparent by requiring them to publish specific, prescribed details of their risks, capital and risk management under the Basel II framework at least annually. Our Pillar 3 Disclosures 2012 report is published on the HSBC website, www.hsbc.com.

RWA movement by key driver - basis of preparation and supporting notes

(Unaudited)

Credit risk and counterparty credit risk drivers - definitions and quantification

The causal analysis of RWA movements splits the total movement in IRB RWAs into six drivers, described below. The first four relate to specific, identifiable and measurable changes. The remaining two, book size and book quality, are derived after accounting for movements in the first four specific drivers.

1. Foreign exchange movements

This is the movement in RWAs as a result of changes in the exchange rate between the functional currency of the HSBC company owning each portfolio and US dollars, being our presentation currency for consolidated reporting. Our structural foreign exchange exposures are managed with the primary objective of ensuring, where practical, that our consolidated capital ratios and the capital ratios of individual banking subsidiaries are largely protected from the effect of changes in exchange rates.

2. Acquisitions and disposals

This is the movement in RWAs as a result of the disposal or acquisition of business operations. This can be whole businesses or parts of a business. The movement in RWAs is quantified based on the credit risk exposures as at the end of the month preceding a disposal or following an acquisition.

3. Model updates

New/updated models

RWA movements arising from the implementation of new models and from changes to existing parameter models are allocated to this driver. This figure will also include changes which arise following review of modelling assumptions. Where a model recalibration reflects an update to more recent performance data, the resulting RWA changes are not assigned here, but instead reported under book quality.

RWA changes are estimated based on the impact assessments made in the testing phase prior to implementation. These values are used to simulate the impact of new or updated models on the portfolio at the point of implementation, assuming there were no major changes in the portfolio from the testing phase to implementation phase.

Portfolios moving onto IRB approach

Where a portfolio moves from the standardised approach to the IRB approach, the RWA movement by key driver statement shows the increase in IRB RWAs, but does not show the corresponding reduction in standardised approach RWAs as its scope is limited to IRB only.

The movement in RWAs is quantified at the date at which the IRB approach is applied, and not during the testing phase as with a new/updated model.

4. Methodology and policy

Internal updates

This captures the RWA impact resulting from changing the internal treatment of exposures. This may include, but is not limited to, identification of netting and credit risk mitigation.

External updates

This specifies the impact resulting from additional or changing regulatory requirements. This includes, but is not limited to, regulatory-prescribed changes to the RWA calculation. The movement in RWAs is quantified by comparing the RWAs calculated for that portfolio under the old and the new requirements.

5. Book size

RWA movements attributed to this driver are those we would expect to experience for the given movement in exposure, as measured by EAD, assuming a stable risk profile. These RWA movements arise in the normal course of business, such as growth in credit exposures or reduction in book size from run-offs and write-offs.

The RWA movement is quantified as follows:

· RWA and EAD changes captured in the four drivers above are excluded from the total movements to create an adjusted movement in EAD and RWA for the period.

· The average RWA to EAD percentage is calculated for the opening position and is applied to the adjusted movement in EAD. This results in an estimated book size RWA movement based on the assumption that the EAD to RWA percentage is constant throughout the period.

As the calculation relies on averaging, the output is dependent upon the degree of portfolio aggregation and the number of discrete time periods for which the calculation is undertaken. For each quarter of 2012 this calculation was performed for each HSBC company with an IRB portfolio, split by the main Basel categories of credit exposures, as described in the table below:

Basel categories of IRB credit exposures within HSBC
Central governments and central banks	Corporate foundation IRB	Qualifying revolving retail exposures
Institutions	Other advanced IRB	Retail SME
Corporate advanced IRB	Retail mortgages	Other retail

The total of the results is shown in book size within the RWA movement by key driver table.

6. Book quality

This represents RWA movements resulting from changes in the underlying credit quality of customers. These are caused by changes to IRB risk parameters which arise from actions such as, but not limited to, model recalibration, change in counterparty external rating, or the influence of new lending on the average quality of the book. The change in RWAs attributable to book quality is calculated as the balance of RWA movements after taking account of all drivers described above.

The RWA movement by key driver statement includes only movements which are calculated under the IRB approach. Certain classes of credit risk exposure are treated as capital deductions and therefore reductions are not shown in this statement. If the treatment of a credit risk exposure changes from RWA to capital deduction in the period, then only the reduction in RWAs would appear in the RWA movement by key driver tables. In this instance, a reduction in RWAs does not necessarily indicate an improvement in the capital position.

Market risk drivers - definitions and quantification

The RWA movement by key driver for market risk combines the credit risk drivers 5 and 6 into a single driver called 'Movements in risk levels'. The market risk RWA driver called 'Foreign exchange movements and other' includes foreign exchange movements and additional items which can not be reasonably assigned to any of the other drivers.

Basis of preparation of the estimated effect of the CRD IV end point applied to the 31 December 2012 position.

(Unaudited)

The table on page 289 presents a reconciliation of our reported core tier 1 and RWA position at 31 December 2012 to the pro-forma estimated CET1 and estimated RWAs based on the Group's interpretation of the draft July 2011 CRD IV legislation and/or guidance provided by the FSA and, in lieu of guidance, our current expectation of how these draft 2011 rules will be updated by subsequent EU deliberations.

CRD IV has not yet become law and its provisions are subject to on-going negotiation and amendment. In addition, formal Implementing Technical Standards ('ITS') due for issue by the EBA are still to be drafted and finalised, leaving the CRD IV rules subject to significant interpretation. Despite the uncertainty around a number of areas in the rules, our disclosures are based on the draft July 2011 CRD IV text. Pending finalisation of CRD IV, we have not definitively upgraded the models and systems used to calculate capital numbers in a CRD IV environment which, as a consequence, are subject to change. Consequently, the final CRD IV impact on the Group's CET1 and RWAs may be different from our current estimates.

The detailed basis of preparation is described below for items that are different from our current treatment under Basel II. For individual immaterial holdings in banks, financial institutions and insurance that are, in aggregate, above 10% of the Group's CET1 capital, we have included specific short term management actions that could be taken to negate the capital deduction. For other CRD IV proposals, additional management actions could also be taken dependent upon the finalised rules and timing of implementation but, as such, have not been included.

Regulatory adjustments applied to core tier 1 in respect of amounts subject to CRD IV treatment

Investments in own shares through the holding of composite products of which HSBC is a component (exchange traded funds, derivatives, and index stock): the value of our holdings of own CET1 instruments, where it is not already deducted under IFRSs, is deducted from CET1. Under CRD IV, deduction comprises not only direct but also indirect, actual and contingent, banking and trading book gross long positions. Trading book positions are calculated net of short positions only where there is no counterparty credit risk on these short positions (this restriction does not apply to index positions). We have not recognised the benefit of non-index short positions, even where they are executed with central counterparties or are fully collateralised. Under current rules, there is no regulatory adjustment made on the amounts already deducted under IFRS rules.

Surplus non-controlling interest disallowed in CET1: non-controlling interests arising from the issue of common shares by our banking subsidiaries receive limited recognition. The excess over a minimum of 7% of the CET1 of the relevant subsidiary is not allowable in the Group's CET1 to the extent it is attributable to minority shareholders. Under current rules, there is no regulatory restriction applied to these items.

Unrealised gains/(losses) on available-for-sale debt securities: under CRD IV, there is no adjustment to remove from CET1 capital unrealised gains and losses on available-for-sale debt securities. Under current FSA rules, these are removed from capital (net of tax).

Unrealised gains on available-for-sale equities and reserves arising from revaluation of property: there is no adjustment for unrealised gains and losses on reserves arising from the revaluation of property and on available-for-sale equities. Under current FSA rules, unrealised net gains on these items are included in tier 2 capital (net of deferred tax) and net losses are deducted from tier 1 capital.

Defined benefit pension fund liabilities: the amount of retirement benefit liabilities as reported on the balance sheet is fully recognised in CET1 rather than being replaced by any committed funding plans as current FSA rules permit.

Excess of expected losses over impairment allowances deducted 100% from CET1: the amount of excess expected loss over impairment allowance is deducted 100% from CET1. Under current FSA rules, this amount is deducted 50% from core tier 1 ('CT1') and 50% from total capital.

Removal of 50% of tax credit adjustment for expected losses: the amount of expected losses in excess of impairment allowances that is deducted from CET1 capital is not reduced for any related tax effects. Under current FSA rules, any related tax credit offset is recognised 50% in CT1 and 50% in tier 1 capital.

Securitisation positions risk-weighted under CRD IV: securitisation positions that were deducted from core tier 1 under current rules have been included in RWAs at 1,250%.

Deferred tax liabilities on intangibles: the amount of intangible assets deducted from CET1 has been reduced by the related deferred tax liability. Under current rules, the goodwill and intangibles are deducted at their accounting value.

Deferred tax assets that rely on future profitability (excluding those arising from temporary differences): the deferred tax assets that rely on future profitability and do not arise from temporary differences are deducted 100% from CET1. The deferred tax assets that rely on future profitability and arise from temporary differences are subject to the separate threshold deduction approach detailed separately. Under current rules, these items receive a risk weighting of 100%.

Additional valuation adjustment (referred to as prudent valuation adjustment or 'PVA'): under current FSA rules, banks are required to comply with requirements for prudent and reliable valuation of any balance sheet position measured at market or fair value. Under CRD IV, all assets and derivatives measured at fair value are subject to specified standards for prudent valuation, covering uncertainty around the input factors into the fair value valuation models - namely, uncertainty around the mark to market of positions, model risk, valuation of less liquid positions and credit valuation adjustments ('CVA').

Where the accounting fair value calculated under IFRS is higher than the valuation amount resulting from the application of the prudential adjustments, this would result in an additional valuation adjustment or PVA deduction from common equity tier 1 capital.

Following FSA direction, we have included an estimate of the impact of PVA, although there is guidance outstanding following a recent consultation on a related EBA draft regulatory technical standard issued on 13 November 2012. Further clarity on the requirements following finalisation of the EBA process and discussions with our regulator could potentially change this figure.

Debit valuation adjustment ('DVA'): the amount of gains and losses on OTC derivative liabilities that results from changes to our own credit spread are derecognised from CET1.

Individually immaterial holdings in CET1 capital of banks, financial institutions and insurance in aggregate above 10% of HSBC CET1: under CRD IV, the investments in CET1 instruments of banks, financial institutions and insurance entities, where we have a holding of not more than 10% of the CET1 instruments issued by those entities, are deducted from CET1, to the extent the aggregate amount of such holdings exceeds 10% of our CET1 (calculated before any threshold deductions).

The estimated deduction follows the draft July 2011 CRD IV rules and guidance provided by the FSA, which impose a restriction on the netting of long and short positions held in the trading book, whereby the maturity of the short positions has to match the maturity of the long position, or have a residual maturity of no less than a year.

While rules are in draft and this aspect is still being debated, we have disclosed the impact of the rules as written. However, a range of management actions from adjustment to the hedging strategy, curtailment or closure of the business could be applied to mitigate the capital deduction.

Deductions under threshold approach: under CRD IV, where we have a holding of more than 10% of the CET1 instruments issued by banks, financial institutions and insurance entities which is not part of our regulatory consolidation, that holding is subject to a threshold deduction approach. Under current rules, these exposures are deducted 50% from tier 1 capital and 50% from total capital, except for certain insurance holdings that met the requirements under the transitional provision of the current rules and until 31 December 2012 were allowed to be deducted 100% from total capital.

Deferred tax assets that rely on the future profitability of the bank to be realised and which arise from temporary differences are also subject to this threshold deduction approach. Under current rules, these assets would be subject to 100% risk weighting.

Under CRD IV, the amount of such deferred tax assets and significant investments which individually and in aggregate exceed 10% and 15%, respectively, of our CET1 are fully deducted from CET1 capital. Amounts falling below the 10% and 15% thresholds are risk weighted at 250%.

Changes to capital requirements introduced by CRD IV

Credit valuation adjustment: introduced as a new requirement under CRD IV rules, this is a capital charge to cover the risk of mark‑to‑market losses on expected counterparty risk and referred to as a regulatory CVA risk capital charge.

We have estimated our regulatory CVA risk capital charge based on the draft July 2011 CRD IV text, calculated on a full range of OTC derivative counterparties without exemptions that may be available under the final CRD IV text. Where we have both specific risk VAR approval and internal model method approval for a product, the CVA VAR approach has been used to calculate the CVA capital charge. Where we do not hold both approvals, the standardised approach has been applied.

Counterparty credit risk (other than credit valuation adjustment): the additional requirements introduced by CRD IV and included in the CCR charge include: the increase in the asset value correlation multiplier for financial counterparties, additional requirements for collateralised counterparties, margin period of risk and new requirements for exposures to central clearing counterparties ('CCPs').

In estimating the amount included for CCPs, we have assumed that all our CCPs are 'qualifying' under the requirements of CRD IV, although this will ultimately depend on confirmation from the competent regulatory authority of the CCP in question that the CCP complies with all the recommendations for CCPs published by the Committee on payment and settlement systems and by the technical committee of the International Organisation of Securities Commissions. Where we do not have full data disclosed for a given CCP, we have assumed full deduction of default fund exposures.

Amounts in aggregate below 15% threshold and therefore subject to 250% risk weight: as explained above, items that fall under the threshold approach treatment under CRD IV, and which are below the 10% and 15% thresholds, are risk-weighted at 250%.

Securitisation positions and free deliveries risk-weighted under CRD IV: securitisation positions which were deducted 50% from core tier 1 and 50% from total capital, and free deliveries that were deducted from total capital under current rules, are now included in RWAs at 1,250%.

Investment in commercial entities now risk-weighted: under CRDIV investments in commercial entities that are not qualifying holdings are risk weighted. These were deducted under the current rules.

Deferred tax assets moved to threshold approach or deduction under CRD IV: deferred tax assets, which were risk-weighted at 100% under the standardised approach under current rules, are treated as a capital deduction from CET1 to the extent they rely on the future profitability of the bank to be realised. Those that do not rely on future profitability shall continue to be risk weighted.

This information is provided by RNS

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