Annual Financial Report - 34 of 54

RNS Number : 0477I

HSBC Holdings PLC

20 March 2015

Capital	Page	App¹		Tables	Page

Capital overview	239			Capital ratios	239

Capital management			257	Total regulatory capital and risk-weighted assets	239
Approach and policy			257
Stress testing			257
Risks to capital			257
Risk-weighted asset targets			257
Capital generation			258

Capital measurement and allocation			258
Regulatory capital			258
Pillar 1 capital requirements			258
Pillar 2 capital requirements			259
Pillar 3 disclosure requirements			260

Risk-weighted assets	239			RWAs by risk type	240
				RWAs by global businesses	240
				RWAs by geographical regions	240
Credit risk RWAs	240			Credit risk exposure - RWAs by geographical region	240
				Credit risk exposure - RWAs by global businesses	240
				RWA movement by geographical regions by key driver - credit risk - IRB only	242
				RWA movement by global businesses by key driver - credit risk - IRB only	242
Counterparty credit risk and market risk RWAs	243			Counterparty credit risk RWAs	243
				RWA movement by key driver - counterparty credit risk - advanced approach	243
				Market risk RWAs	244
				RWA movement by key driver - market risk - internal model based	244
				Capital and RWA movements by major driver - CRD IV end point basis	245
Operational risk RWAs	244
RWA movement by key driver - basis of preparation and supporting notes			260
Credit risk drivers - definitions and quantifications			260
Counterparty risk drivers - definitions and quantifications			261
Market risk drivers - definitions and quantifications			261

Capital structure	245			Source and application of total regulatory capital	245
				Composition of regulatory capital	246
				Reconciliation of regulatory capital from transitional basis to an estimated CRD IV end point basis	247
Regulatory balance sheet	248			Reconciliation of balance sheets - financial accounting to regulatory scope of consolidation	249
Regulatory and accounting consolidations	248

Leverage ratio	251			Estimated leverage ratio	251
Leverage ratio: basis of preparation			261

Regulatory developments	252
Regulatory capital buffers	252			Capital requirements framework	254
Regulatory stress testing	254
RWA developments	254
Leverage ratio proposals	255
Banking structural reform and recovery and resolution planning	255
Other regulatory updates	256

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 and stress testing related requirements.

Capital highlights

· The transitional CET1 ratio of 10.9% was up from 10.8% at the end of 2013 as a result of continued capital generation and management initiatives offset by RWA growth, foreign exchange movements and regulatory changes.

· The end point CET1 ratio of 11.1% was up from 10.9% at the end of 2013 as a result of similar drivers.

Capital overview

(Unaudited)

Capital ratios

(Unaudited)

	At 31 December
	2014	2013
	%	%
CRD IV transitional
Common equity tier 1 ratio	10.9	10.8
Tier 1 ratio	12.5	12.0
Total capital ratio	15.6	14.9

CRD IV end point
Common equity tier 1 ratio	11.1	10.9

Basel 2.5
Core tier 1 ratio	n/a	13.6
Tier 1 ratio	n/a	14.5
Total capital ratio	n/a	17.8

Total regulatory capital and risk-weighted assets

(Unaudited)

	CRD IV	CRD IV
	transitional at	transitional estimated at	Basel 2.5 at
	31 Dec 2014	31 Dec 2013	31 Dec 2013
	US$m	US$m	US$m
Common equity tier 1 capital	133,200	131,233
Core tier 1 capital			149,051
Additional tier 1 capital	19,539	14,408	9,104
Tier 2 capital	37,991	35,538	35,854

Total regulatory capital	190,730	181,179	194,009

Risk-weighted assets	1,219,765	1,214,939	1,092,653

On 1 January 2014, CRD IV came into force and capital and RWAs at 31 December 2014 are calculated and presented on the Group's interpretation of final CRD IV legislation and final rules issued by the PRA. Prior to 1 January 2014, RWAs and capital were calculated and presented in accordance with the previous regime under CRD III, also referred to as 'Basel 2.5'. As a result, unless otherwise stated, comparatives for capital and RWAs at 31 December 2013 are on a Basel 2.5 basis.

The capital and RWAs on a CRD IV basis incorporate the effect of the PRA's final rules as set out in the PRA Rulebook. This transposed various areas of national discretion within the final CRD IV legislation into UK law. In its final rules, the PRA did not adopt most of the CRD IV transitional provisions available, instead opting for an acceleration of the CRD IV end point definition of common equity tier 1 ('CET1') capital. However, CRD IV transitional provisions for unrealised gains were applied, such that unrealised gains on investment property and available-for-sale securities are not recognised for capital until 1 January 2015. As a result, our transitional capital ratio in 2014 is slightly lower than the comparable end point capital ratio.

In April 2014, the PRA published its rules and supervisory statements implementing some of the CRD IV provisions relating to capital buffers, further details of which are provided in the 'Regulatory capital buffers' section on page 252.

In June 2014, the PRA published its revised expectations in relation to capital ratios for major UK banks and building societies, namely that from 1 July 2014 we are expected to meet a 7% CET1 ratio using the CRD IV end point definition. This applies alongside CRD IV requirements.

Despite the rules published to date, there remains continued uncertainty around the amount of capital that UK banks will be required to hold. This relates specifically to the quantification and interaction of capital buffers and Pillar 2. The PRA is currently consulting on their revised approach to Pillar 2, the PRA buffer and its interaction with the CRD IV buffers. Furthermore, there are a significant number of draft and unpublished EBA technical and implementation standards due in 2015.

Our approach to managing Group capital is designed to ensure that we exceed current regulatory requirements and that we respect the payment priority of our capital providers. Throughout 2014, we complied with the PRA's regulatory capital adequacy requirements, including those relating to stress testing. We are also well placed to meet our expected future capital requirements.

During 2014, we managed our capital position to meet an internal target CET1 ratio on an end point basis of greater than 10%. This has since been reviewed, and in 2015 we expect to manage Group capital to meet a medium-term target for return on equity of more than 10%. This is modelled on a CET1 ratio on an end point basis in the range of 12% to 13%.

A summary of our policies and practices regarding capital management, measurement and allocation is provided in the Appendix to Capital on page 257.

Risk-weighted assets

(Unaudited)

CRD IV contributed to an increased capital requirement.

The key changes introduced were:

· securitisation positions which were previously deducted 50% from core tier 1 and 50% from total capital, are now included in RWAs at 1,250%;

· an additional capital charge to cover the risk of mark-to-market losses on expected counterparty risk referred to as credit valuation adjustment ('CVA') risk;

· deferred tax assets and significant investments, subject to thresholds, are now risk weighted at 250%;

· increased risk weights on exposures to financial institutions, referred to as asset value correlation ('AVC'); and

· new requirements for exposures to central counterparties ('CCP'). There are enhanced incentives for clearing OTC derivative transactions through CCP.

RWAs by risk type

(Unaudited)

	CRD IV transitional and end point		Basel 2.5 basis
	2014	2013	2013
	US$bn	US$bn	US$bn

Credit risk	955.3	936.5	864.3
Standardised approach	356.9	358.6	329.5
IRB foundation approach	16.8	13.5	13.6
IRB advanced approach	581.6	564.4	521.2

Counterparty credit risk	90.7	95.8	45.8
Standardised approach	25.2	36.6	3.6
Advanced approach	65.5	59.2	42.2

Market risk	56.0	63.4	63.4

Operational risk	117.8	119.2	119.2

At 31 December	1,219.8	1,214.9	1,092.7

Of which:
US run-off portfolios	99.2	142.3	104.9
Legacy credit in GB&M	44.1	63.7	26.4
US CML and Other	55.1	78.6	78.5
Card and Retail Services¹	-	1.1	1.1

For footnotes, see page 256.

RWAs by global businesses

(Unaudited)

	CRD IV transitional and end point	Basel 2.5 basis
	2014	2013
	US$bn	US$bn
Retail Banking and Wealth Management	205.1	233.5
Commercial Banking	432.4	391.7
Global Banking and Markets	516.1	422.3
Global Private Banking	20.8	21.7
Other	45.4	23.5

At 31 December	1,219.8	1,092.7

RWAs by geographical regions²

(Unaudited)

	CRD IV transitional and end point	Basel 2.5 basis
	2014	2013
	US$bn	US$bn

Europe	375.4	300.1
Asia	499.8	430.7
Middle East and North Africa	63.0	62.5
North America	221.4	223.8
Latin America	88.8	89.5

At 31 December	1,219.8	1,092.7

For footnote, see page 256.

Credit risk RWAs

(Unaudited)

Credit risk exposure - RWAs by geographical region

	Europe	Asia³	MENA	North America	Latin America	Total
	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn
CRD IV basis
IRB approach	216.1	213.1	15.6	142.0	11.6	598.4
IRB advanced approach	203.3	213.1	11.6	142.0	11.6	581.6
IRB foundation approach	12.8	-	4.0	-	-	16.8
Standardised approach	47.1	186.0	39.0	29.6	55.2	356.9

RWAs at 31 December 2014	263.2	399.1	54.6	171.6	66.8	955.3
Basel 2.5 basis
IRB advanced approach	157.1	182.9	11.2	161.5	8.5	521.2
IRB foundation approach	9.8	-	3.8	-	-	13.6
Standardised approach	44.5	165.9	40.0	22.7	56.4	329.5

RWAs at 31 December 2013	211.4	348.8	55.0	184.2	64.9	864.3

For footnote, see page 256.

Credit risk exposure - RWAs by global businesses

	Principal RBWM	RBWM (US run-off portfolio)	Total RBWM	CMB	GB&M	GPB	Other	Total
	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn
CRD IV basis
IRB approach	55.9	47.3	103.2	217.4	255.6	10.2	12.0	598.4
IRB advanced approach	55.9	47.3	103.2	209.4	248.1	10.0	10.9	581.6
IRB foundation approach	-	-	-	8.0	7.5	0.2	1.1	16.8

Standardised approach	60.4	4.8	65.2	181.8	70.1	6.6	33.2	356.9

RWAs at 31 December 2014	116.3	52.1	168.4	399.2	325.7	16.8	45.2	955.3
Basel 2.5 basis
IRB advanced approach	58.4	72.6	131.0	183.2	192.8	10.4	3.8	521.2
IRB foundation approach	-	-		6.3	5.8	0.1	1.4	13.6
Standardised approach	60.6	3.1	63.7	169.3	71.6	6.9	18.0	329.5

RWAs at 31 December 2013	119.0	75.7	194.7	358.8	270.2	17.4	23.2	864.3

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

Standardised approach

For portfolios treated under the standardised approach, credit risk RWAs increased by US$27.4bn, which reflected a reduction of US$13.6bn due to foreign exchange movements.

Corporate growth in Asia, Europe, North America and Latin America, including term and trade-related lending, increased RWAs by US$25.0bn, of which growth in our associate, BoCom, accounted for US$6.4bn.

The move to a CRD IV basis increased RWAs on 1 January 2014 by US$7.1bn. This movement mainly comprised material holdings and deferred tax asset amounts in aggregate below the capital threshold risk-weighted at 250% US$28.3bn, partially offset by the reclassification of non-credit obligation assets to the IRB approach for reporting purposes US$16.3bn and the netting of collective impairments against exposure at default under the standardised approach US$3.5bn.

During the year, several individually immaterial portfolios moved from the IRB approach to the standardised approach, increasing standardised RWAs by US$6.0bn and reducing IRB RWAs by US$4.8bn.

The disposal of our operations in Jordan, Pakistan, Colombia and Kazakhstan reduced RWAs by US$1.0bn.

In Asia, movement in the fair value of our material holdings, mainly in Industrial Bank, resulted in an increase in RWAs of US$5.9bn. This was partially offset by the reclassification of Vietnam Technological and Commercial Joint Stock Bank from an associate to an investment, which reduced RWAs by US$1.1bn.

Internal ratings-based approach

Credit risk RWA movements by key driver for portfolios treated under the IRB approach are set out in the tables on page 242 and 243. For basis of preparation on Credit risk, Counterparty credit risk and Market risk RWA flow, see Annual Reports and Accounts Appendix to Capital on page 257. For portfolios treated under the IRB approach, credit risk RWAs increased by US$63.6bn which reflected a reduction of US$20.1bn due to foreign exchange movements driven by the strengthening of the US dollar against other currencies.

Acquisitions and disposals

In GB&M, the sale of ABSs in North America reduced RWAs by US$4.2bn. Additionally, GB&M continued to manage down the securitisation positions held through the sale of certain structured investment conduit positions, lowering RWAs by US$3.0bn in Europe. The disposal of our businesses in Kazakhstan, Colombia, Pakistan and Jordan resulted in a reduction in RWAs of US$1.2bn in Europe, Latin America, the Middle East and North Africa.

Book size

Book size movement reflected higher corporate lending, including term and trade-related lending, increasing RWAs by US$40.3bn in Asia, Europe and North America for CMB and GB&M. Sovereign book growth in GB&M increased RWAs by US$3.3bn, mainly in Asia, Latin America, the Middle East and North Africa.

In North America, in RBWM, continued run‑off of the US CML retail mortgage portfolios resulted in a RWA reduction of US$6.9bn.

Book quality

RWAs reduced by US$8.5bn in the US run-off portfolio, primarily due to continued run-off which resulted in an improvement in the book quality of the residual portfolio.

Book quality improvements in the Principal RBWM business of US$5.9bn related to model recalibrations reflecting improving property prices in the US and favourable changes in portfolio mix reducing RWAs in Europe.

A ratings upgrade for securitisation portfolio resulted in a decrease in RWAs of US$3.2bn.

This was partially offset by adverse movements in average customer credit quality in corporate, sovereign and institutional portfolios in Europe, North America, Middle East, North Africa, Asia and Latin America increased RWAs by US$7.6bn.

Model updates

In Europe, a loss given default ('LGD') floor applied to UK corporate portfolios resulted in an increase in RWAs of US$19.0bn in CMB and GB&M.

This was partially offset by model updates in North America, primarily the implementation of new risk models for the US mortgage run-off portfolio, resulting in a decrease in RWAs of US$6.2bn.

Methodology and policy changes

Methodology and policy updates increased RWAs by US$52.2bn.

CRD IV impact

The rise related to the implementation of CRD IV rules at 1 January 2014, which increased RWAs by US$48.2bn. The main CRD IV movements arose from securitisation positions that were previously deducted from capital and are now included as a part of credit risk RWAs and risk-weighted at 1250%, resulting in a US$40.2bn increase in GB&M, primarily Europe. CRD IV also introduced an asset valuation correlation multiplier for financial counterparties, producing a US$9.2bn increase in RWAs primarily in GB&M in Asia and Europe.

Internal updates

A decrease in RWAs of US$9.2bn arose from the set-off of negative AFS reserves against EAD for GB&M legacy credit portfolios.

In Asia, internal methodology changes associated with trade finance products accounted for a reduction in RWAs of US$4.9bn.

Additionally, the transfer of individually immaterial portfolios moving to the standardised approach reduced IRB RWAs by US$4.8bn in Principal RBWM and CMB in most regions and increased RWAs in the standardised approach by US$6.0bn.

The reclassification of part of the mortgage portfolio led to a decrease in RWAs of US$4.5bn in North America, of which US$4.1bn was in the run-off portfolio.

External updates

Selected portfolios with a low default history, mainly in Europe, Asia and North America, were subjected to external updates with the introduction of LGD floors applied to corporates and institutions, increasing RWAs by US$9.8bn. A further RWA floor was introduced on retail mortgages in Asia, resulting in an increase of US$1.7bn.

Non-credit obligation assets

The reclassification of non-credit obligation assets from the standardised to the IRB approach for reporting purposes increased RWAs under the latter approach by US$16.3bn and reduced the STD RWAs by the same amount.

RWA movement by geographical regions by key driver - credit risk - IRB only

(Unaudited)

	Europe	Asia	MENA	North America	Latin America	Total
	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn
RWAs at 1 January 2014 on Basel 2.5 basis	166.9	182.9	15.0	161.5	8.5	534.8

Foreign exchange movement	(11.6)	(4.0)	(0.2)	(2.4)	(1.9)	(20.1)
Acquisitions and disposals	(3.5)	-	(0.7)	(4.2)	(0.1)	(8.5)
Book size	11.4	19.5	1.8	2.9	2.0	37.6
Book quality	(1.5)	-	(0.8)	(10.3)	1.4	(11.2)
Model updates	19.4	0.3	-	(6.1)	-	13.6
New/updated models	19.4	0.3	-	(6.1)	-	13.6

Methodology and policy	35.0	14.4	0.5	0.6	1.7	52.2
Internal updates	(11.7)	(5.2)	(0.2)	(6.4)	(0.1)	(23.6)
External updates	2.2	8.5	(0.2)	0.7	0.1	11.3
CRD IV impact	37.0	5.7	0.4	4.9	0.2	48.2
NCOA moving from STD to IRB	7.5	5.4	0.5	1.4	1.5	16.3


Total RWA movement	49.2	30.2	0.6	(19.5)	3.1	63.6

RWAs at 31 December 2014 on CRD IV basis	216.1	213.1	15.6	142.0	11.6	598.4

RWAs at 1 January 2013 on Basel 2.5 basis	150.7	162.3	12.6	187.1	11.2	523.9

Foreign exchange movement	3.3	(4.5)	(0.5)	(1.9)	(1.0)	(4.6)
Acquisitions and disposals	(1.5)	-	-	(8.6)	(1.7)	(11.8)
Book size	2.1	21.2	1.4	(10.6)	0.2	14.3
Book quality	(1.5)	5.3	1.3	(10.8)	(0.3)	(6.0)
Model updates	11.6	-	0.1	(0.2)	-	11.5
Portfolios moving onto IRB approach	13.4	-	-	-	-	13.4
New/updated models	(1.8)	-	0.1	(0.2)	-	(1.9)

Methodology and policy	2.2	(1.4)	0.1	6.5	0.1	7.5
Internal updates	(0.2)	(7.8)	0.1	(0.6)	0.1	(8.4)
External updates	2.4	6.4	-	7.1	-	15.9


Total RWA movement	16.2	20.6	2.4	(25.6)	(2.7)	10.9

RWAs at 31 December 2013 on Basel 2.5 basis	166.9	182.9	15.0	161.5	8.5	534.8

For footnote, see page 256.

RWA movement by global businesses by key driver - credit risk - IRB only

(Unaudited)

	Principal RBWM	RBWM (US run-off )	Total RBWM	CMB	GB&M	GPB	Other	Total
	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn	US$bn
RWAs at 1 January 2014 on Basel 2.5 basis	58.4	72.6	131.0	189.5	198.5	10.6	5.2	534.8
Foreign exchange movement	(2.6)	-	(2.6)	(8.7)	(8.1)	(0.2)	(0.5)	(20.1)
Acquisitions and disposals	-	-	-	-	(8.2)	-	(0.3)	(8.5)
Book size	1.8	(6.9)	(5.1)	23.2	21.1	(0.5)	(1.1)	37.6
Book quality	(5.7)	(8.6)	(14.3)	2.8	(0.2)	(0.3)	0.8	(11.2)
Model updates	0.6	(6.2)	(5.6)	12.2	7.0	-	-	13.6
New/updated models	0.6	(6.2)	(5.6)	12.2	7.0	-	-	13.6

Methodology and policy	3.4	(3.6)	(0.2)	(1.6)	45.5	0.6	7.9	52.2
Internal updates	(3.0)	(3.9)	(6.9)	(5.0)	(11.2)	(0.5)	-	(23.6)
External updates	1.8	-	1.8	2.5	6.3	0.5	0.2	11.3
CRD IV impact	-	-	-	(0.7)	48.6	0.2	0.1	48.2
NCOA moving from STD to IRB	4.6	0.3	4.9	1.6	1.8	0.4	7.6	16.3

Total RWA movement	(2.5)	(25.3)	(27.8)	27.9	57.1	(0.4)	6.8	63.6

RWAs at 31 December 2014 on CRD IV basis	55.9	47.3	103.2	217.4	255.6	10.2	12.0	598.4

	RBWM US$bn	CMB US$bn	GB&M US$bn	GPB US$bn	Other US$bn	Total US$bn
RWAs at 1 January 2013 on Basel 2.5 basis	163.1	169.0	177.7	9.6	4.5	523.9
Foreign exchange movement	(0.4)	(1.5)	(2.7)	0.1	(0.1)	(4.6)
Acquisitions and disposals	(10.1)	(0.1)	(1.6)	-	-	(11.8)
Book size	(12.7)	14.5	13.5	(0.7)	(0.3)	14.3
Book quality	(6.4)	3.5	(3.4)	0.3	-	(6.0)
Model updates	(0.2)	10.1	(1.0)	2.6	-	11.5
Portfolios moving onto IRB approach	-	10.0	0.8	2.6	-	13.4
New/updated models	(0.2)	0.1	(1.8)	-	-	(1.9)

Methodology and policy	(2.3)	(6.0)	16.0	(1.3)	1.1	7.5
Internal updates	(2.3)	(3.4)	(0.6)	(2.1)	-	(8.4)
External updates	-	(2.6)	16.6	0.8	1.1	15.9


Total RWA movement	(32.1)	20.5	20.8	1.0	0.7	10.9

RWAs at 31 December 2013 on Basel 2.5 basis	131.0	189.5	198.5	10.6	5.2	534.8

Counterparty credit risk and market risk RWAs

(Unaudited)

Counterparty credit risk RWAs

(Unaudited)

	CRD IV basis	Basel 2.5 basis
	2014	2013
	US$bn	US$bn

Advanced approach	65.5	42.2
CCR IRB approach	62.0	42.2
CVA	3.5	-

Standardised approach	25.2	3.5
CCR standardised approach	4.4	3.5
CVA	18.0	-
CCP	2.8	-

	-
RWAs at 31 December	90.7	45.7

RWA movement by key driver - counterparty credit risk - advanced approach

(Unaudited)

	CRD IV basis	Basel 2.5 basis
	2014	2013
	US$bn	US$bn

RWAs at 1 January	42.2	45.7
	0
Book size	1.6	(0.9)
Book quality	(0.6)	(2.7)
Model updates	0.1	-
Methodology and policy	22.2	0.1
Internal updates	(3.8)	0.1
External regulatory updates	9.0	-
CRD IV impact	17.0	-

Total RWA movement	23.3	(3.5)

RWAs at 31 December	65.5	42.2

Market risk RWAs

(Unaudited)

	CRD IV basis	Basel 2.5 basis
	2014	2013
	US$bn	US$bn
Internal model based
VaR	7.3	4.9
Stressed VaR	10.4	9.4
Incremental risk charge	20.1	23.1
Comprehensive risk measure	-	2.6
Other VaR and stressed VaR	6.8	12.2

Internal model based	44.6	52.2
Standardised approach	11.4	11.2

At 31 December	56.0	63.4

RWA movement by key driver - market risk - internal model based

(Unaudited)

	CRD IV basis	Basel 2.5 basis
	2014	2013
	US$bn	US$bn

RWAs at 1 January	52.2	44.5

Acquisitions and disposals	(2.2)	-
Movement in risk levels	(4.2)	(14.5)
Model updates	-	17.6
Methodology and policy	(1.2)	4.6
Internal updates	(3.8)	4.6
External updates	2.6	-


Total RWA movement	(7.6)	7.7

RWAs at 31 December	44.6	52.2

Counterparty credit risk RWAs

Counterparty credit risk RWAs increased by US$45.0bn, in 2014. The RWA increase of US$21.7bn for the standardised approach mainly relates to the implementation of CRD IV on 1 January 2014, which introduced CVA and CCP RWAs.

Advanced approach

Book size

The increase in book size was mainly driven by business movements and the impact of the strengthening of the US dollar against other currencies on the mark to market of derivatives contracts.

Model updates

In Europe, an LGD floor applied to UK corporate portfolios resulted in an increase in RWAs of US$2.2bn. This was offset by a decrease in RWAs of US$2.0bn due to model updates to the Internal Model Method ('IMM') used for selected portfolios in London.

Methodology and policy changes

The CVA and AVC multiplier for financial counterparties introduced by the implementation of CRD IV increased RWAs by US$6.8bn and US$10.2bn, respectively, on 1 January 2014.

Within external regulatory and policy updates, selected portfolios were subject to PRA LGD floors, which increased RWAs by US$7.5bn, mainly in Europe and Asia. Additionally, guidance received in the fourth quarter of 2014 led to the application of a 'potential future
exposure' charge on sold options, contributing to a US$1.5bn increase in RWAs.

Decreases in RWAs from internal methodology updates were mainly driven by additional CVA exemptions following internal due diligence and review alongside a more efficient allocation of collateral in Europe, which decreased RWAs by US$3.8bn.

Market risk RWAs

Total market risk RWAsdecreased by US$7.4bn in 2014.

Standardised approach

The market risk RWA movements for portfolios not within the scope of modelled approaches resulted in an increase of US$0.2bn. The increase in RWAs of US$2.6bn related to CRD IV treatment of trading book securitisation positions that were previously deducted from capital. This was offset by reductions in RWAs of US$2.5bn for interest rate position risk, primarily in Latin America due to the introduction of the scenario matrix method for options and a general reduction in positions in Latin America and the US.

Internal model based

Acquisitions and disposals

The sale of our correlation trading portfolio, reduced comprehensive risk measure RWAs by US$2.0bn. The disposal of our business in Kazakhstan resulted in a reduction of US$0.2bn in RWAs.

Movement in risk levels

Movement in risk levels reflected a decrease mainly in VaR and Stressed VaR as a result of reduced FX and Equity trading positions.

Methodology and policy changes

The increase in RWAs from external updates related mainly to the introduction, for collateralised transactions, of the basis between the currency of trade and the currency of collateral into the VaR calculation and the removal of the diversification benefit from Risks not in VaR ('RNIV') calculations, driving an increase of US$6.7bn.

This was partially offset by decreases in RWAs of US$4.3bn from Internal updates, mainly due to refinements in the RNIV calculation for the Equities and Rates desks.

Further decreases in RWAs following regulatory approval for a change in the basis of consolidation for modelled market risk charges delivered a reduction in RWAs of US$4.1bn.

Operational risk RWAs

The reduction in operational risk RWAs of US$1.4bn was due to the full amortisation of operational risk RWAs for the US CRS portfolio disposed of in May 2012, combined with a lower three-year average operating income.

Capital and RWA movements by major driver - CRD IV end point basis

(Unaudited)

	CET1
	capital	RWAs
	US$bn	US$bn
CRD IV end point basis at 1 January 2014⁴	132.5	1,214.9
Accounting profit for the period	13.7	-
Regulatory adjustments to accounting profit	(1.0)	-
Dividends net of scrip⁵	(7.5)	-
Regulatory change: LGD floors		38.6
Corporate lending growth	-	64.8
Management initiatives:	2.2	(66.3)
- legacy reduction and run‑off	2.2	(43.0)
- portfolio and entity disposals	-	(5.2)
- RWA initiatives	-	(18.1)

Exchange differences	(8.4)	(33.6)
Other movements	4.5	1.4

CRD IV end point basis at 31 December 2014	136.0	1,219.8

RWAs increased in the year, primarily from corporate lending growth and regulatory change. These have been largely offset by management initiatives and foreign exchange movements. Management initiatives include legacy reduction and run-off, portfolio and entity disposals and a number of other initiatives including a better alignment of VaR scope to management's view of risk, improved collateral allocation, increased use of IMM and a review of product mappings to regulatory categories.

Capital structure

Source and application of total regulatory capital

(Audited)

	CRD IV transitional	Basel 2.5
	Year to 31 Dec 2014 US$m	Year to 31 Dec 2013 US$m
Movement in total regulatory capital
Opening common equity/core tier 1 capital⁴	131,233	138,789
Contribution to common equity/core tier 1 capital from profit for the period	12,678	17,124
Consolidated profits attributable to shareholders of the parent company	13,688	16,204
Removal of own credit spread net of tax	(328)	920
Debit valuation adjustment	254
Deconsolidation of insurance entities and SPE entities	(936)

Net dividends including foreseeable net dividends⁵	(7,541)	(6,987)
Dividends net of scrip recognised under Basel 2.5		(6,987)
Update for fourth interim dividend scrip take-up in excess of plan	1,108
First interim dividend net of scrip	(1,766)
Second interim dividend net of scrip	(1,686)
Third interim dividend net of scrip	(1,835)
Fourth foreseeable interim dividend	(4,131)
Add back: planned scrip take-up	769

Decrease in goodwill and intangible assets deducted	2,424	535
Ordinary shares issued	267	297
Foreign currency translation differences	(8,356)	(1,294)

Other, including regulatory adjustments	2,495	587

Closing common equity/core tier 1 capital	133,200	149,051

Opening additional/other tier 1 capital⁴	14,408	12,259
Issued hybrid capital securities net of redemptions	4,961	(1,151)
Unconsolidated investments	17	(2,004)
Other, including regulatory adjustments	153	-

Closing tier 1 capital	152,739	158,155

Opening other tier 2 capital⁴	35,538	29,758
Issued tier 2 capital securities net of redemptions	2,414	1,609
Unconsolidated investments	26	6,447
Other, including regulatory adjustments	13	(1,960)

Closing total regulatory capital	190,730	194,009

For footnotes, see page 256.

Internal capital generation contributed US$5.1bn to common equity tier 1 capital, being profits attributable to shareholders of the parent company after regulatory adjustment for own credit spread, debit valuation adjustment, deconsolidation of insurance entities and net of dividends. The 2014 fourth interim dividend is net of planned scrip.

Composition of regulatory capital

		CRD IV transitional		Basel 2.5
	Ref	At 31 Dec 2014 (Audited) US$m	Estimated at 31 Dec 2013 (Unaudited) US$m	At 31 Dec 2013 (Audited) US$m
Tier 1 capital
Shareholders' equity		166,617	164,057	173,449
Shareholders' equity per balance sheet⁶	a	190,447	181,871	181,871
Foreseeable interim dividend⁵		(3,362)	(3,005)
Preference share premium	b	(1,405)	(1,405)	(1,405)
Other equity instruments	c	(11,532)	(5,851)	(5,851)
Deconsolidation of special purpose entities⁷	a	(323)	(1,166)	(1,166)
Deconsolidation of insurance entities	a	(7,208)	(6,387)

Non-controlling interests		4,640	3,644	4,955
Non-controlling interests per balance sheet	d	9,531	8,588	8,588
Preference share non-controlling interests	e	(2,127)	(2,388)	(2,388)
Non-controlling interests transferred to tier 2 capital	f	(473)	(488)	(488)
Non-controlling interests in deconsolidated subsidiaries	d	(851)	(757)	(757)
Surplus non-controlling interests disallowed in CET1		(1,440)	(1,311)

Regulatory adjustments to the accounting basis		(6,309)	(2,230)	480
Unrealised (gains)/losses in available-for-sale debt and equities⁸		(1,378)	-	1,121
Own credit spread⁹		767	1,112	1,037
Debit valuation adjustment		(197)	(451)
Defined benefit pension fund adjustment¹⁰	g	(4,069)	(1,731)	(518)
Reserves arising from revaluation of property		(1,375)	(1,281)	(1,281)
Cash flow hedging reserve		(57)	121	121

Deductions		(31,748)	(34,238)	(29,833)
Goodwill and intangible assets	h	(22,475)	(24,899)	(25,198)
Deferred tax assets that rely on future profitability (excludes those arising from temporary differences)	n	(1,036)	(680)
Additional valuation adjustment (referred to as PVA)		(1,341)	(2,006)
Investments in own shares through the holding of composite products of which HSBC is a component (exchange traded funds, derivatives and index stock)		(1,083)	(677)
50% of securitisation positions				(1,684)
50% of tax credit adjustment for expected losses				151
Negative amounts resulting from the calculation of expected loss amounts	i	(5,813)	(5,976)	(3,102)
		-
Common equity/core tier 1 capital		133,200	131,233	149,051

Additional tier 1 capital
Other tier 1 capital before deductions		19,687	14,573	16,110
Preference share premium	b	1,160	1,160	1,405
Preference share non-controlling interests	e	1,955	1,955	2,388
Allowable non-controlling interest in AT1	d	884	731
Hybrid capital securities	j	15,688	10,727	12,317

Deductions		(148)	(165)	(7,006)
Unconsolidated investments¹¹		(148)	(165)	(7,157)
50% of tax credit adjustment for expected losses				151

Tier 1 capital		152,739	145,641	158,155

		CRD IV transitional		Basel 2.5
	Ref	At 31 Dec 2014 (Audited) US$m	Estimated at 31 Dec 2013 (Unaudited) US$m	At 31 Dec 2013 (Audited) US$m

Tier 2 capital
Total qualifying tier 2 capital before deductions		38,213	35,786	47,812
Reserves arising from revaluation of property and unrealised gains in available-for-sale equities				2,755
Collective impairment allowances	k			2,616
Allowable non-controlling interest in tier 2	d	99	86
Perpetual subordinated debt	l	2,218	2,218	2,777
Term subordinated debt	m	35,656	33,242	39,364
Non-controlling interests in tier 2 capital	f	240	240	300
		240
Total deductions other than from tier 1 capital		(222)	(248)	(11,958)
Unconsolidated investments¹¹		(222)	(248)	(7,157)
50% of securitisation positions				(1,684)
50% negative amounts resulting from the calculation of expected loss amounts	i			(3,102)
Other deductions				(15)


Total regulatory capital		190,730	181,179	194,009

For footnotes, see page 256.

The references (a) - (n) identify balance sheet components on page 249 which are used in the calculation of regulatory capital.

Reconciliation of regulatory capital from transitional basis to an estimated CRD IV end point basis

(Unaudited)

	At 31 Dec 2014	Estimated at 31 Dec 2013
	US$m	US$m

Common equity tier 1 capital on a transitional basis	133,200	131,233
Unrealised gains arising from revaluation of property	1,375	1,281
Unrealised gains in available for sale reserves	1,378	-

Common equity tier 1 capital end point basis	135,953	132,514

Additional tier 1 capital on a transitional basis	19,539	14,408
Grandfathered instruments: Preference share premium	(1,160)	(1,160)
Preference share non-controlling interests	(1,955)	(1,955)
Hybrid capital securities	(10,007)	(10,727)
Transitional provisions:
Allowable non-controlling interest in AT1	(487)	(366)
Unconsolidated investments	148	165

Additional tier 1 capital end point basis	6,078	365

Tier 1 capital end point basis	142,031	132,879

Tier 2 capital on a transitional basis	37,991	35,538
Grandfathered instruments:
Perpetual subordinated debt	(2,218)	(2,218)
Term subordinated debt	(21,513)	(21,513)
Transitional provisions:
Non-controlling interest in tier 2 capital	(240)	(240)
Allowable non-controlling interest in tier 2	396	345
Unconsolidated investments	(148)	(165)

Tier 2 capital end point basis	14,268	11,747

Total regulatory capital end point basis	156,299	144,626

The capital position presented on a CRD IV transitional basis follows the CRD IV legislation as implemented in the UK via the PRA's final rules in the Policy Statement ('PS 7/13') issued in December 2013, and as incorporated in the PRA Rulebook.

The effects of draft EBA technical standards are not generally captured in our numbers. These could have additional effects on our capital position and RWAs.

Whilst CRD IV allows for the majority of regulatory adjustments and deductions from CET1 to be implemented on a gradual basis from 1 January 2014 to 1 January 2018, the PRA has largely decided not to make use of these transitional provisions. Due to the exclusion of unrealised gains on investment property and available-for-sale securities which are only capable of being recognised in CET1 capital from 1 January 2015, and PRA acceleration of unrealised losses on these items, our CET1 capital and ratio is lower on a transitional basis than it is on an end point basis.

For additional tier 1 and tier 2 capital, the PRA followed the transitional provisions timing as set out in CRD IV to apply the necessary regulatory adjustments and deductions. The effect of these adjustments is being phased in at 20% per annum from 1 January 2014 to 1 January 2018.

Furthermore, non-CRD IV compliant additional tier 1 and tier 2 instruments benefit from a grandfathering period. This progressively reduces the eligible amount by 10% annually, following an initial reduction of 20% on 1 January 2014, until they are fully phased out by 1 January 2022.

Under CRD IV, as implemented in the UK, banks are required to meet a minimum CET1 ratio of 4.0% of RWAs (increasing to 4.5% from 1 January 2015), a minimum tier 1 ratio of 5.5% of RWAs (increasing to 6% from 1 January 2015) and a total capital ratio of 8% of RWAs. Alongside CRD IV requirements, from 1 July 2014, the PRA expects major UK banks and building societies to meet a 7% CET1 ratio using the CRD IV end point definition. Going forward, as the grandfathering provisions fall away, we intend to meet these regulatory minima in an economically efficient manner by issuing non-common equity capital as necessary. At 31 December 2014, the Group had US$19.8bn of CRD IV compliant non-common equity capital instruments, of which US$3.5bn of tier 2 and US$5.7bn of additional tier 1 were issued during the year (for details on the additional tier 1 instruments issued during the year see Note 35 on the Financial Statements). At 31 December 2014, the Group also had US$37.1bn of non-common equity capital instruments qualifying as eligible capital under CRD IV by virtue of the application of the grandfathering provisions, after applying the 20% reduction outlined above.

Regulatory balance sheet

Regulatory and accounting consolidations

(Unaudited)

The basis of consolidation for the purpose of financial accounting under IFRS, described in Note 1 on the Financial Statements, differs from that used for regulatory purposes as described in 'Structure of the regulatory group' on page 13 of the Pillar 3 Disclosures 2014 report. The table below provides a reconciliation of the financial accounting balance sheet to the regulatory scope of consolidation.

Interests in banking associates are equity accounted in the financial accounting consolidation, whereas their exposures are proportionally consolidated for regulatory purposes in accordance with PRA's application of EU legislation.

Subsidiaries engaged in insurance activities are excluded from the regulatory consolidation, leaving the investment to be recorded at cost. In prior years, the investment of these insurance subsidiaries was recorded at the net asset value. This change in treatment from 1 January 2014 has been aligned to the capital treatment under CRD IV where we have excluded post-acquisition reserves from our CET1 capital and the investment to be deducted from CET1 (subject to thresholds) valued at cost.

The regulatory consolidation does not include special purpose entities ('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 table 5 of the Pillar 3 Disclosures 2014 report.

Reconciliation of balance sheets - financial accounting to regulatory scope of consolidation

(Unaudited)

		At 31 December 2014
		Accounting balance sheet	Deconsolidation of insurance/ other entities	Consolidation of banking associates	Regulatory balance sheet
	Ref	US$m	US$m	US$m	US$m
Assets
Cash and balances at central banks		129,957	-	30,731	160,688
Items in the course of collection from other banks		4,927	-	80	5,007
Hong Kong Government certificates of indebtedness		27,674	-	-	27,674
Trading assets		304,193	(720)	2,357	305,830
Financial assets designated at fair value		29,037	(28,791)	3,312	3,558
Derivatives		345,008	(94)	353	345,267
Loans and advances to banks		112,149	(2,727)	7,992	117,414
Loans and advances to customers		974,660	(10,809)	116,484	1,080,335
of which:
- impairment allowances on IRB portfolios	i	(6,942)	-	-	(6,942)
- impairment allowances on standardised portfolios		(5,395)	-	(2,744)	(8,139)
Reverse repurchase agreements - non-trading		161,713	(30)	7,510	169,193
Financial investments		415,467	(50,420)	33,123	398,170
Capital invested in insurance and other entities		-	2,542	-	2,542
Current tax assets		1,309	(16)	-	1,293
Prepayments, accrued income and other assets		75,176	(5,295)	8,501	78,382
of which:
- goodwill and intangible assets of disposal groups held for sale	h	8	-	-	8
- retirement benefit assets	g	(5,028)	-	-	(5,028)
- impairment allowances on assets held for sale		(16)	-	-	(16)
of which:
- IRB portfolios	i	(16)	-	-	(16)
- standardised portfolios			-	-
Interests in associates and joint ventures		18,181	-	(17,479)	702
of which:
- positive goodwill on acquisition	h	621	-	(606)	15

Goodwill and intangible assets	h	27,577	(5,593)	571	22,555
Deferred tax assets	n	7,111	163	474	7,748

Total assets		2,634,139	(101,790)	194,009	2,726,358

Liabilities and equity
Hong Kong currency notes in circulation		27,674	-	-	27,674
Deposits by banks		77,426	(21)	40,530	117,935
Customer accounts		1,350,642	(535)	141,858	1,491,965
Repurchase agreements - non-trading		107,432	-	-	107,432
Items in course of transmission to other banks		5,990	(3)	-	5,987
Trading liabilities		190,572	(42)	50	190,580
Financial liabilities designated at fair value		76,153	(6,317)	-	69,836
of which:
- term subordinated debt included in tier 2 capital	m	21,822	-	-	21,822
- hybrid capital securities included in tier 1 capital	j	1,495	-	-	1,495

Derivatives		340,669	37	331	341,037
Debt securities in issue		95,947	(7,797)	3,720	91,870
Current tax liabilities		1,213	(138)	317	1,392
Liabilities under insurance contracts		73,861	(73,861)	-	-
Accruals, deferred income and other liabilities		53,396	(3,659)	5,145	54,882
of which:
- retirement benefit liabilities		3,208	(2)	56	3,262
- contingent liabilities and contractual commitments		234	-	-	234
of which:
- credit-related provisions on IRB portfolios	i	132	-	-	132
- credit-related provisions on standardised portfolios		102	-	-	102
Provisions		4,998	(63)	-	4,935
Deferred tax liabilities		1,524	(1,009)	2	517
Subordinated liabilities		26,664	-	2,056	28,720
of which:
- hybrid capital securities included in tier 1 capital	j	2,761	-	-	2,761
- perpetual subordinated debt included in tier 2 capital	l	2,773	-	-	2,773
- term subordinated debt included in tier 2 capital	m	21,130	-	-	21,130

		At 31 December 2014
		Accounting balance sheet	Deconsolidation of insurance/ other entities	Consolidation of banking associates	Regulatory balance sheet
	Ref	US$m	US$m	US$m	US$m

Total shareholders' equity	a	190,447	(7,531)	-	182,916
of which:
- other equity instruments included in tier 1 capital	c, j	11,532	-	-	11,532
- preference share premium included in tier 1 capital	b	1,405	-	-	1,405

Non-controlling interests	d	9,531	(851)	-	8,680
of which:
- non-cumulative preference shares issued by subsidiaries included in tier 1 capital	e	2,127	-	-	2,127
- 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	173	-	-	173


Total liabilities and equity at 31 December 2014		2,634,139	(101,790)	194,009	2,726,358

		At 31 December 2013
		Accounting balance sheet	Deconsolidation of insurance/ other entities	Consolidation of banking associates	Regulatory balance sheet
	Ref	US$m	US$m	US$m	US$m
Assets
Trading assets		303,192	32	1,686	304,910
Loans and advances to customers		1,080,304	(13,182)	110,168	1,177,290
of which:
- . impairment allowances on IRB portfolios	i	(9,476)	-	-	(9,476)
- . impairment allowances on standardised portfolios	k	(5,667)	-	(2,465)	(8,132)

Financial investments		425,925	(52,680)	31,430	404,675
Capital invested in insurance and other entities		-	9,135	-	9,135
Interests in associates and joint ventures		16,640	-	(15,982)	658
of which:
- . positive goodwill on acquisition	h	608	-	(593)	15

Goodwill and intangible assets	h	29,918	(5,369)	631	25,180
Other assets		815,339	(37,634)	57,477	835,182
of which:
- . goodwill and intangible assets of disposal groups held for sale	h	3	-	-	3
- . retirement benefit assets	g	2,140	-	-	2,140
-.. impairment allowances on assets held for sale		(111)	-	-	(111)
of which:
- IRB portfolios	i	-	-	-	-
- standardised portfolios	k	(111)	-	-	(111)


Total assets at 31 December 2013		2,671,318	(99,698)	185,410	2,757,030

Liabilities and equity
Deposits by banks		129,212	(193)	33,296	162,315
Customer accounts		1,482,812	(711)	142,924	1,625,025
Trading liabilities		207,025	(129)	161	207,057
Financial liabilities designated at fair value		89,084	(13,471)	-	75,613
of which:
- . term subordinated debt included in tier 2 capital	m	18,230	-	-	18,230
- . hybrid capital securities included in tier 1 capital	j	3,685	-	-	3,685

Debt securities in issue		104,080	(9,692)	1,021	95,409
Retirement benefit liabilities	g	2,931	(11)	56	2,976
Subordinated liabilities		28,976	2	2,961	31,939
of which:
- . hybrid capital securities included in tier 1 capital	j	2,873	-	-	2,873
- . perpetual subordinated debt included in tier 2 capital	l	2,777	-	-	2,777
- . term subordinated debt included in tier 2 capital	m	23,326	-	-	23,326

Other liabilities		436,739	(73,570)	4,991	368,160
of which:
-.. contingent liabilities and contractual commitments		177	-	-	177
of which:
- credit-related provisions on IRB portfolios	i	155	-	-	155
- credit-related provisions on standardised portfolios	k	22	-	-	22

		At 31 December 2013
		Accounting balance sheet	Deconsolidation of insurance/ other entities	Consolidation of banking associates	Regulatory balance sheet
	Ref	US$m	US$m	US$m	US$m

Total shareholders' equity	a	181,871	(1,166)	-	180,705
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	8,588	(757)	-	7,831
of which:
- . non-cumulative preference shares issued by subsidiaries included in tier 1 capital	e	2,388	-	-	2,388
- . 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	188	-	-	188


Total liabilities and equity at 31 December 2013		2,671,318	(99,698)	185,410	2,757,030

The references (a) - (n) identify balance sheet components which are used in the calculation of regulatory capital on page 246.

Leverage ratio

(Unaudited)

For a detailed basis of preparation of the leverage ratio, see the Appendix to Capital, page 261.

Estimated leverage ratio

(Unaudited)

	EU Delegated Act basis at 31 Dec 2014	Basel III 2010 basis at 31 Dec 2013
	US$bn	US$bn

Total assets per accounting balance sheet	2,634	2,671

Deconsolidation of insurance/other entities	(104)
Capital invested in insurance entities	2
Consolidation of banking associates	194

Total assets per regulatory/accounting balance sheet	2,726	2,671
Adjustment to reverse netting of loans and deposits allowable under IFRS	38	93

Reversal of accounting values:	(525)	(482)
Derivatives	(345)	(282)
Repurchase agreement and securities finance	(180)	(200)

Replaced with values after applying regulatory rules:
Derivatives:	166	239
Mark-to-market value	81	69
Deductions of receivables assets for cash variation margin	(82)
Add-on amounts for potential future exposure	148	170
Exposure amount resulting from the additional treatment for written credit derivatives	19

Repurchase agreement and securities finance:	188	147
Gross securities financing transactions assets	269
Netted amounts of cash payables and cash receivables of gross securities financing transactions assets	(89)
Securities financing transactions assets netted under Basel III 2010 framework		147
Measurement of counterparty risk	8

Addition of off balance sheet commitments and guarantees:	396	388
Guarantees and contingent liabilities	67	85
Commitments	321	295
Other	8	8

Exclusion of items already deducted from the capital measure	(36)	(28)

Exposure measure after regulatory adjustments	2,953	3,028

Tier 1 capital under CRD IV (end point)	142	133

Estimated leverage ratio (end point)	4.8%	4.4%

In January 2014, the Basel Committee published its finalised leverage ratio framework, along with public disclosure requirements applicable from 1 January 2015, updating its 2010 recommendations.

In June 2014, the PRA published its revised expectations in relation to the leverage ratio for major UK banks and building societies, namely that from 1 July 2014, we are expected to meet a 3% end point tier 1 leverage ratio,

calculated using the CRD IV definition of capital for the numerator and the Basel 2014 exposure measure for the denominator.

In October 2014, the European Commission adopted a delegated act to establish a common definition of the leverage ratio for EU banks (based on the Basel revised definition). This was published in the EU's Official Journal in January 2015.

Under CRD IV, the legislative proposals and final calibration of the leverage ratio are expected to be determined following a review of the revised Basel proposals and the basis of the EBA's assessment of the impact and effectiveness of the leverage ratio during a monitoring period between 1 January 2014 and 30 June 2016.

In January 2015, the PRA issued a letter setting out the approach to be taken for calculating the leverage ratio for 2014 year end disclosures. While the numerator continues to be calculated using the final CRD IV end point tier 1 capital definition, the exposure measure is now calculated based on the EU delegated act (rather than the Basel 2014 definition used in the Interim Report 2014). Reporting on the basis of the EU Delegated Act (rather than the Basel 2014 definition) results in an immaterial 2bps positive difference.

Our leverage ratio for 2013 as disclosed above and in our Annual Report and Accounts 2013 was based on the Basel 2010 text at the direction of the PRA. The change to reporting on the EU Delegated Act from the Basel 2010 text contributes a US$115bn increase in the exposure measure. Key changes include:

· A change to the regulatory scope of consolidation increases the exposure measure by US$132bn.

· The netting of securities financing transactions ('SFT's) is based on the accounting criteria and an additional add-on for counterparty risk increases the exposure measure by US$66bn.

· The inclusion of written credit derivatives at a notional amount increases the exposure measure by US$23bn.

· Revision to permit the offsetting of cash variation margin against derivative assets and liabilities results in a decrease in the exposure measure of US$65bn.

· A change to the Credit Conversion Factors ('CCF's) applied to off-balance sheet exposures decreases the exposure measure by US$41bn.

For further details on the basis of preparation, see page 261.

It should be noted that the UK specific leverage ratio proposals published in October 2014 by the Financial Policy Committee ('FPC') are conceptually different to the Basel and CRD IV leverage frameworks and are not yet in place. Further details of the UK proposals can be found under 'Leverage ratio proposals' on page 255.

Regulatory developments

(Unaudited)

Regulatory capital buffers

CRD IV establishes a number of capital buffers, to be met with CET1 capital, broadly aligned with the Basel III framework. CRD IV contemplates that these will be phased in from 1 January 2016, subject to national discretion.

Automatic restrictions on capital distributions apply if a bank's CET1 capital falls below the level of its CRD IV combined buffer. This is defined as the total of the capital conservation buffer ('CCB'), the countercyclical capital buffer ('CCyB'), the global systemically important institutions ('G-SII's) buffer and the systemic risk buffer ('SRB') as these become applicable. The PRA have proposed that the use of the PRA buffer will not result in automatic restrictions on capital distributions.

In April 2014, HM Treasury published the statutory instrument 'Capital Requirements (Capital Buffers and Macro-Prudential Measures) Regulations 2014' transposing into UK legislation the main provisions in CRD IV related to capital buffers, with the exception of the SRB. In January 2015, HM Treasury published amendments to this statutory instrument in order to transpose the SRB.

The PRA is the designated authority for the G‑SIIs buffer, the other systemically important institutions ('O-SII's) buffer and the CCB. In April 2014, they published rules and supervisory statements implementing the main CRD IV provisions in relation to these buffers. The Bank of England is the designated authority for the CCyB and other macro prudential measures. Whilst the PRA is the designated authority for applying and determining the SRB, the FPC is responsible for creating the SRB framework for calibration.

G-SII buffer

The G-SII buffer (which is the EU implementation of the Basel G-SIB buffer) is to be met with CET1 capital and will be phased in from 1 January 2016. In October 2014, finalised technical standards on the methodology for identification of G-SIIs were published in the EU's Official Journal and came into effect from 1 January 2015.

In November 2014, the FSB and the Basel Committee updated the list of G-SIBs, using end-2013 data. The add‑on of 2.5% previously assigned to HSBC was left unchanged.

Following direction from the PRA to UK banks in its Supervisory Statement issued in April 2014, and in accordance with the EBA final draft Implementing Technical Standards ('ITS') and guidelines published in June 2014, we published the EBA template in July 2014. This disclosed the information used for the identification and scoring process which underpins our G-SIB designation. The final ITS for disclosure requirements were published in September 2014, and will form the basis of our future 2015 disclosure of G-SII indicators.

Capital conservation buffer

The CCB was designed to ensure banks build up capital outside periods of stress that can be drawn down when losses are incurred and is set at 2.5% of RWAs. The PRA will phase-in this buffer from 1 January 2016 to 1 January 2019.

Countercyclical and other macro-prudential buffers

CRD IV contemplates a countercyclical buffer in line with Basel III, in the form of an institution-specific CCyB and the application of increased requirements to address macro-prudential or systemic risk.

In January 2014, the FPC issued a policy statement on its powers to supplement capital requirements, through the use of the CCyB and the Sectoral Capital Requirements ('SCR') tools. The CCyB is expected to be set in the range of 0‑2.5% of relevant credit exposures RWAs, although it is uncapped. Under UK legislation, the FPC is required to determine whether to recognise any CCyB rates set by other EEA countries before 2016.

In June 2014, the FPC set the CCyB rate for UK exposures at 0%. At its September 2014 meeting, the FPC left the CCyB rate for UK exposures unchanged at 0% and recognised the 1% CCyB rates introduced by Norway and Sweden to become effective from 3 October 2015. In January 2015, the HKMA announced the application of a CCyB rate of 0.625% to Hong Kong exposures, to apply from 1 January 2016. In accordance with UK legislation and PRA supervisory statement PS 3/14, this rate will directly apply to the calculation of our institution-specific CCyB rate from 1 January 2016.

The institution-specific CCyB rate for the Group will be based on the weighted average of the CCyB rates that apply in the jurisdictions where relevant credit exposures are located. Currently the Group's institution specific CCyB is zero. The SCR tool is not currently deployed in the UK.

Systemic risk buffer

In addition to the measures above, CRD IV sets out an SRB for the financial sector as a whole, or one or more sub-sectors, to be deployed as necessary by each EU member state with a view to mitigating structural macro‑prudential risk.

In January 2015, the legislative changes necessary to transpose the SRB were implemented. The SRB is to be applied to ring fenced banks and building societies (over a certain threshold), which are together defined as 'SRB institutions'. The SRB can be applied on an individual, sub-consolidated or consolidated basis and is applicable from 1 January 2019. By 31 May 2016, the FPC is required to create a framework for identifying the extent to which the failure or distress of SRB institutions will pose certain long-term non-cyclical systemic or macro-prudential risks. The PRA will apply this framework to determine whether specific SRB institutions would be subject to an SRB rate, and the level at which the buffer would be applied, and is able to exercise supervisory
judgement to determine what the rate should be. Where applicable, the buffer rate must be set in the range of 1% to 3%. The buffer rate would apply to all the SRB institution's exposures unless the PRA has recognised a buffer rate set in another member state. If the SRB is applied on a consolidated basis it is expected that the higher of the G-SII or SRB would apply, in accordance with CRD IV.

Pillar 2 and the 'PRA buffer'

Under the Pillar 2 framework, banks are already required to hold capital in respect of the internal capital adequacy assessment and supervisory review which leads to a final determination by the PRA of individual capital guidance under Pillar 2A and Pillar 2B. Pillar 2A was previously met by total capital, but since 1 January 2015, in accordance with the PRA supervisory statement SS 5/13, is met with at least 56% CET1.

Pillar 2A guidance is a point in time assessment of the amount of capital the PRA considers that a bank should hold to meet the overall financial adequacy rule. It is therefore subject to change pending annual assessment and the supervisory review process. During 2014, the Group Pillar 2A guidance amounted to 1.5% of RWAs, of which 0.9% was to be met by CET1. In February 2015, this was revised to 2.0% of RWAs, of which 1.1% is to be met by CET1 and is effective immediately.

In January 2015, the PRA published a consultation on the Pillar 2 Framework. This set out the methodologies that the PRA proposed to use to inform its setting of firms' Pillar 2 capital requirements, including proposing new approaches for determining Pillar 2 requirements for credit risk, operational risk, credit concentration risk and pension obligation risk.

As part of CRD IV implementation, the PRA proposed to introduce a PRA buffer, to replace the capital planning buffer ('CPB') (known as Pillar 2B), also to be held in the form of CET1 capital. This was reconfirmed in the recent PRA consultation on the Pillar 2 framework. It is proposed that a PRA buffer will avoid duplication with CRD IV buffers and will be set for a particular firm depending on its vulnerability in a stress scenario or where the PRA has identified risk management and governance failings. In order to address weaknesses in risk management and governance, the PRA propose a scalar applied to firms' CET1 Pillar 1 and Pillar 2A capital requirements. Where the PRA considers there is overlap between the CRD IV buffers and the PRA buffer assessment, the PRA proposes to set the PRA buffer as the excess capital required over and above the CCB and relevant systemic buffers. The PRA buffer will, however, be in addition to the CCyB and sectoral capital requirements.

The PRA expects to finalise the Pillar 2 framework in July 2015, with implementation expected from 1 January 2016. Until this consultation is finalised and revised rules and guidance issued, there remains uncertainty as to the exact buffer rate requirements, and their ultimate capital impact.

Overall capital requirements

Following the developments outlined above, details are beginning to emerge of the various elements of the capital requirements framework. However, there remains residual uncertainty as to what HSBC's precise end point CET1 capital requirement will be. Elements of the capital requirements that are known or quantified to date are set out in the diagram below. Time-varying elements such as the macro-prudential tools, the Pillar 2 requirements, and systemic buffers are subject to change.

Capital requirements framework (end point)

In addition to the capital requirements tabulated above, we will need to consider the effect of FSB proposals published in November 2014 in relation to total loss absorbing capacity ('TLAC') requirements. For further details, see page 256.

Regulatory stress testing

The Group is subject to supervisory stress testing in many jurisdictions. These supervisory requirements are increasing in frequency and in the granularity with which results are required. As such, stress testing represents a key focus for the Group.

In October 2013, the Bank of England published an initial discussion paper 'A framework for stress testing the UK banking system'. The framework replaces the current stress testing for the capital planning buffer with annual concurrent stress tests, the results of which are expected to inform the setting of the PRA buffer, the CCyB, sectoral capital requirements and other FPC recommendations to the PRA. In April 2014, the Bank of England published details of the UK stress testing exercise, which the Group subsequently participated in. The results of this exercise were published in December 2014.

Throughout 2014, the Group participated in various stress testing exercises in a number of different jurisdictions. For further details on all stress testing exercises, see page 122.

RWA developments

Throughout 2014, regulators issued a series of recommendations and consultations designed to revise the various components of the RWA regime and increase related reporting and disclosures.

UK

In March 2014, the FPC published that it was minded to recommend that firms report and disclose capital ratios using the standardised approach to credit risk as soon as practicable in 2015 following a Basel review of the standardised approach.

In June 2014, the PRA issued its consultation CP12/14, which proposed changes to the credit risk rules in two areas. Firstly, a proposal that exposures on the advanced internal ratings-based ('AIRB') approach for central governments, public sector entities, central banks and financial sector entities would be moved to the foundation approach from June 2015. Secondly, a proposal to introduce stricter criteria for the application of the standardised risk weight for certain commercial real estate ('CRE') exposures located in non-EEA countries, which would be dependent upon loss rates in these jurisdictions over a representative period. In October, the PRA published a policy statement ('PS 10/14') containing final rules on the second proposal, which introduces more stringent criteria for the application of risk weights to non-EEA CRE exposures from April 2015.

EU

In May 2014, the EBA published a consultation on benchmarks of internal approaches for calculating own funds requirements for credit and market risk exposures in RWAs. This follows a series of benchmarking exercises run in 2013 to better understand the drivers of differences observed in RWAs across EU institutions. The future annual benchmarking exercise outlined in the consultation paper aims to improve the comparability of capital requirements calculated using internal modelled approaches and will be used by regulators to inform their policy decisions.

In June 2014, the EBA published a consultation on thresholds for the application of the standardised approach for exposures treated under permanent partial use and the IRB roll-out plan. The finalised Regulatory Technical Standards ('RTS') is yet to be published.

In December 2014, the list of non-EEA countries deemed to have equivalent regulatory regimes for CRD IV purposes was published in the EU's Official Journal, and became effective on 1 January 2015. This equivalence evaluation affects the treatment of exposures across

a number of different areas in CRD IV, such as the treatment of exposures to third country investment firms, credit institutions and exchanges; standardised risk weights applicable to exposures to central governments, central banks, regional governments, local authorities and public sector entities; and the calculation of RWAs for exposures to corporates, institutions, central governments and central banks under the IRB approach.

International

Throughout 2014, the Basel Committee published proposals across all Pillar 1 risk types, to update standardised, non-modelled approaches for calculating capital requirements and to provide the basis for the application of a capital floor.

In particular, in March 2014, the Basel Committee published finalised proposals for the standardised approach for calculating counterparty credit risk exposures for OTC derivatives, exchange traded derivatives and long settlement transactions. Following this, another technical paper on the foundations of the new standard was published in August 2014. The new approach is proposed to replace both the current exposure measure and the standardised method and is expected to come into effect on 1 January 2017.

In October 2014, the Basel Committee also published a consultation and a Quantitative Impact Study ('QIS') to revise the standardised approach for calculating operational risk. The proposals seek to establish a new unitary standardised approach to replace the current non-model-based approaches, which comprise the basic indicator approach and the standardised approach, including its variant the alternative standardised approach. An implementation date is yet to be proposed.

In December 2014, the Basel Committee undertook a further consultation on its fundamental review of the trading book. This included revisions to the market risk framework that was published for consultation in October 2013. The Committee intends to carry out a further QIS in early 2015 to inform finalised proposals expected at the end of 2015.

In December 2014, the Basel Committee published a revised framework for securitisation risk, which will come into effect on 1 January 2018.

In December 2014, the Basel Committee also published a consultation paper on revisions to the Standardised Approach for credit risk. Proposals include a reduced reliance on external credit ratings; increased granularity and risk sensitivity; and updated risk weight calibrations. Proposed calibration for risk weights are indicative only and will be further informed by responses from this consultation and results from a QIS.

Additionally, in December 2014, the Basel Committee published a consultation on the design of a capital floor framework, which will replace the Basel I floor. The calibration of the floor is, however, outside the scope of this consultation. The Committee has stated its intention to publish final proposals including calibration and implementation timelines by the end of 2015.

All finalised Basel Committee proposals for standardised approaches for calculating risk requirements and the introduction of a revised capital floor would need to be transposed into EU requirements before coming into legal effect.

Leverage ratio proposals

In October 2014, the FPC published final recommendations on the design of a UK specific leverage ratio framework and calibration. This followed an earlier FPC consultation in July 2014 on the design of the framework. The FPC finalised recommendations included a minimum leverage ratio of 3% to be implemented as soon as practicable for UK G-SIBs and major UK banks and building societies, a supplementary leverage ratio buffer applied to systemically important firms of 35% of the relevant risk‑weighted systemic risk buffer rates, and a further countercyclical leverage ratio buffer ('CCLB') of 35% of the relevant risk-weighted CCyB. The minimum leverage ratio is to be met 75% with CET1 and 25% with AT1, and both the supplementary leverage ratio buffer and CCLB are to be met 100% with CET1. The FPC recommended that HM Treasury provide the FPC with the necessary powers to direct the PRA to set leverage ratio requirements implementing the above mentioned calibration and framework.

HM Treasury published a consultation paper in November 2014, which responded to and agreed with the FPC recommendations in relation to the design of the leverage ratio framework. Specifically, HM Treasury agreed that the FPC should be granted powers to direct the PRA on a minimum requirement, additional leverage ratio buffer (for G-SIBs, major UK banks and building societies, including ring fenced banks) and a CCLB. HM Treasury did not, however, provide any views on the calibration. The consultation paper included legislative changes to provide the FPC with new powers. In February 2015, HM Treasury published a summary of responses, alongside the draft instrument which was laid before Parliament.

Banking structural reform and recovery and resolution planning

In the EU, the Bank Recovery and Resolution Directive ('BRRD') was finalised and published in June 2014. This came into effect from 1 January 2015, with the option to delay implementation of bail-in provisions until 1 January 2016. Regardless of this, the UK introduced bail-in powers from 1 January 2015. The UK transposition of the BRRD builds on the resolution framework already in place in the UK. In January 2015, the PRA published a policy statement containing updated requirements for recovery and resolution planning which revises PRA rules that have been in force since 1 January 2014. In addition, the EBA has produced a number of RTS, some of which are yet to be finalised, that will further inform the BRRD requirements.

In December 2013, the UK's Financial Services (Banking Reform) Act 2013 received royal assent, which implements ring‑fencing recommendations of the ICB. This has been supplemented though secondary legislation which was finalised in July 2014. In October 2014, the PRA published a consultation paper on ring-fencing rules. The PRA intends to undertake further consultation and finalise ring-fencing rules in due course, with implementation by 1 January 2019.

In January 2014, the European Commission also published legislative proposals on ring-fencing trading activities from deposit taking and a prohibition on proprietary trading in financial instruments and commodities. This is currently under discussion in the European Parliament and the Council.

For further details of the policy background and the Group's approach to recovery and resolution planning, see page 14.

Total loss absorbing capacity proposals

In November 2014, as part of the 'too big to fail' agenda, the FSB published proposals for total loss absorbing capacity ('TLAC') for G-SIBs.

The FSB proposals include a minimum TLAC requirement in the range of 16-20% of RWAs and a TLAC leverage ratio of at least twice the Basel III tier 1 leverage ratio. The TLAC requirement is to be applied in accordance with individual resolution strategies, as determined by the G-SIB's crisis management group. A QIS is currently underway, the results of which will inform finalised proposals. The conformance period for the TLAC requirement will also be influenced by the QIS, but will not be before 1 January 2019. Once finalised, it is expected that any new TLAC standard should be met alongside the Basel III minimum capital requirements.

The draft proposals require G-SIBs to be subject to a minimum TLAC requirement with the precise requirement to be informed by the QIS. There are a number of requirements relating to the types of liabilities which can be used to meet the TLAC requirement, the composition of TLAC, and the location of liabilities within a banking group, in accordance with its resolution strategy. The TLAC proposals are expected to be finalised in 2015 and will then need to be implemented into national legislation.

Other regulatory updates

In January 2015, the EBA published revised final draft RTS on prudent valuation. Finalised requirements will need to be adopted by the European Commission and published in the EU's Official Journal before coming into effect.

In June 2014, the EBA and Basel Committee each issued a consultation on the Pillar 3 disclosures. The final EBA guidelines were issued in December 2014 and entail additional process and governance around the Pillar 3 report, as well as semi-annual or quarterly disclosure of key capital, ratio, RWA, leverage and risk model information, exceeding the scope of our current interim disclosures. The guidelines are subject to implementation by national supervisors and are expected to enter into force in 2015.

The final Basel standards on 'Revised Pillar 3 disclosure requirements' were issued in January 2015. They mandate extensive use of standardised templates to enhance comparability between banks' disclosures as well as requiring a considerable volume of disclosures to be produced semi-annually, rather than annually as hitherto. The revised framework calls for disclosure at the latest from 2016 year-ends, concurrently with financial reports.

Footnotes to Capital

1 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 removed immediately on disposal, but diminish over a period of time. The RWAs for the CRS business represent the remaining operational risk RWAs for the business.

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

3 From 1 January 2014, the geographical region 'Asia' replaced the geographical regions previously reported as 'Hong Kong' and 'Rest of Asia-Pacific' (see Note 23 on the Financial Statements for further details). Comparative data have been re-presented to reflect this change.

4 CRD IV opening balances as at December 2013 were estimated based on the Group's interpretation of final CRD IV legislation and final rules issued by the PRA, details of which can be found in the basis of preparation on page 324 of the Annual Report and Accounts 2013.

5 This includes dividends on ordinary shares, quarterly dividends on preference shares and coupons on capital securities, classified as equity.

6 Includes externally verified profits for the year to 31 December 2014.

7 Mainly comprise unrealised gains/losses in available-for-sale debt securities related to SPEs.

8 Unrealised gains/losses in available-for-sale securities are net of tax.

9 Includes own credit spread on trading liabilities.

10 Under Basel 2.5 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.

11 Mainly comprise investments in insurance entities.

Appendix to Capital

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. Given that CRD IV has been in effect since 1 January 2014, during 2014 we managed our internal capital ratio target on an end point CRD IV CET1 basis of greater than 10%. We have since reviewed this and in 2015 expect to manage group capital to meet a medium-term target for return on equity of more than 10%. This is modelled on CET1 ratio on an end point basis in the range of 12% to 13%.

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 PRA 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, pensions, insurance, structural foreign exchange risk and residual risks.

Stress testing

In addition to our internal stress tests, the Group is subject to supervisory stress testing in many jurisdictions. Supervisory requirements are increasing in frequency and in the granularity with which the results are required. These exercises include the programmes of the PRA, the FRB, the EBA, the ECB and the HKMA, as well as stress tests undertaken in other jurisdictions. 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 our CET1 capital ratio. In addition, other risks may be identified which 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 meet the Group's management objectives. 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

RWA targets for our global businesses are established in accordance with the Group's strategic direction and risk appetite, and approved through the Group's annual planning process. 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 accuracy and allocation initiatives and risk mitigation. Our capital management process is articulated in the annual Group capital plan which forms part of the Annual Operating Plan that is approved by the Board.

Business performance against RWA targets 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.

Analysis is undertaken within 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 PRA 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 2013, we calculated capital at a Group level using the Basel II framework as amended for CRD III, commonly known as Basel 2.5, and also estimated capital on an end point CRD IV basis. From 1 January 2014, our capital at Group level is calculated under CRD IV and supplemented by PRA rules to effect the transposition of directive requirements.

Our policy and practice in capital measurement and allocation at Group level is underpinned by the CRD IV rules. However, local regulators are at different stages of implementation and some local reporting is still on a Basel I basis, notably in the US for the reporting of RWAs for some institutions during 2014. In most jurisdictions, non-banking financial subsidiaries are also subject to the supervision and capital requirements of local regulatory authorities.

The Basel III framework, similarly to Basel II, is structured around three 'pillars': minimum capital requirements, supervisory review process and market discipline. The CRD IV legislation implemented Basel III in the EU and, in the UK, the 'PRA rulebook CRR Firms Instrument 2013' transposed the various national discretions under the CRD IV legislation into UK law. The CRD IV and PRA legislation came into force on 1 January 2014.

Regulatory capital

For regulatory purposes, our capital base is divided into three main categories, namely common equity tier 1, additional tier 1 and tier 2, depending on their characteristics.

· Common equity tier 1 capital is the highest quality form of capital, comprising shareholders' equity and related non-controlling interests (subject to limits). Under CRD IV various capital deductions and regulatory adjustments are made against these items which are treated differently for the purposes of capital adequacy - these include deductions for goodwill and intangible assets, deferred tax assets that rely on future profitability, negative amounts resulting from the calculation of expected loss amounts under IRB, holdings of capital securities of financial sector entities and surplus defined benefit pension fund assets.

· Additional tier 1 capital comprises eligible non-common equity capital securities and any related share premium; it also includes qualifying securities issued by subsidiaries subject to certain limits. Holdings of additional tier 1 securities of financial sector entities are deducted.

· Tier 2 capital comprises eligible capital securities and any related share premium and qualifying tier 2 capital securities issued by subsidiaries subject to limits. Holdings of tier 2 capital securities of financial sector entities are deducted.

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

CRD IV 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 CRD IV rollout plans, a number of our Group companies and portfolios are in transition to advanced IRB approaches. At the end of 2014, global models for sovereigns, banks, large corporates and portfolios in most of Europe, Asia and North America were on advanced IRB approaches. Others remain on the standardised or foundation approaches pending definition of local regulations or model approval, or under exemptions from IRB treatment. In some instances, regulators have allowed us to transition from advanced to standardised approaches for a limited number of portfolios.

· Counterparty credit risk

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 CRD IV: 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.

In addition, CRD IV applies a capital requirement for CVA risk. 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.

· Securitisation

Securitisation positions are held in both the trading and non-trading books. For non-trading book securitisation positions, CRD IV 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%.

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 PRA.

Market risk capital requirement

The market risk capital requirement is measured using internal market risk models where approved by the PRA, or the standard rules of the EU Capital Requirement Regulation. Our internal market risk models comprise VaR, stressed VaR and the incremental risk charge. Since the sale of our correlation portfolio in September 2014, there is no market risk capital requirement associated with the comprehensive risk measure.

Operational risk capital requirement

CRD IV 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 PRA 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 our capital planning buffer where required.

Pillar 3 disclosure requirements

Pillar 3 of the Basel regulatory framework is related to market discipline and aims to make firms more transparent by requiring them to publish, at least annually, wide-ranging information on their risks and capital, and how these are managed. Our Pillar 3 Disclosures 2014 are published on our website, www.hsbc.com, under Investor Relations.

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

(Unaudited)

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. This is usually achieved by ensuring that, for each subsidiary bank, the ratio of structural exposures in a given currency to risk-weighted assets denominated in that currency is broadly equal to the capital ratio of the subsidiary in question. We hedge structural foreign exchange exposures only in limited circumstances.

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 effect 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 regulatory updates

This captures the effect on RWAs of changing the internal treatment of exposures. This may include, but is not limited to, a portfolio or a part of one moving from an existing IRB model onto a standardised model, identification of netting and credit risk mitigation.

External regulatory updates

This specifies the effect of 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 2014 this calculation was performed for each HSBC company with an IRB portfolio by global businesses, split by the main Basel categories of credit exposures, as described in the table below:


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.

Counterparty risk drivers - definitions and quantification

The RWA movement by key driver for counterparty credit risk calculates the credit risk drivers 5 and 6 at a more granular level, by using transaction level details provided by regional sites. 'Foreign exchange movement' is not a reported layer for counterparty risk drivers, as there is cross currency netting across the portfolio.

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'.

Leverage ratio: basis of preparation

(Unaudited)

The numerator, capital measure, is calculated using the 'end point' definition of tier 1 capital applicable from 1 January 2022, which is set out in the final CRD IV rules. This is supplemented with the EBA's Own Funds' RTS to the extent that these have been published in the EU's Official Journal of the European Commission as at the reporting date, as well as making reference to the PRA Rulebook where appropriate. The denominator, exposure measure, is calculated on the basis of the Leverage Ratio Delegated Act adopted by the European Commission in October 2014 and published in the EU's Official Journal in January 2015, which is aligned to the Basel 2014 leverage ratio framework. This follows the same scope of regulatory consolidation used for the risk-based capital framework, which differs to the 2010 Basel text that required banks to include items using their accounting balance sheet. The exposure measure generally follows the accounting value, adjusted as follows:

· on-balance sheet, non-derivative exposures are included in the exposure measure net of specific provisions or accounting valuation adjustments (e.g. accounting credit valuation adjustments);

· loans are not netted with deposits;

· the scope of netting for derivatives is extended to all scenarios where we would recognise a netting agreement for regulatory purposes;

· the scope for offsetting of cash variation margin against derivative assets and liabilities is extended subject to certain additional conditions including the requirement that the margin be exchanged daily and be in the same currency as the currency of settlement of the derivative contract. For these purposes we have considered this to include any currency that can be used to make payments under the derivative contract, the governing qualifying master netting agreement, or its associated credit support annex. Such offsetting is not permitted under the Basel 2010 text;

· the approach to netting securities financing transactions ('SFT's) is aligned to that permitted under IFRS, though for the purposes of the leverage ratio there is an additional counterparty credit risk add-on to the extent that an SFT is under collateralised. This represents a stricter requirement compared with the Basel 2010 text;

· there is an add-on for potential future exposure for both OTC and exchange-traded derivatives;

· the notional amount of written credit derivatives is included in the exposure measure, subject to offsets for purchased protection. This represents a stricter requirement compared with the Basel 2010 text;

· off-balance sheet items are converted into credit exposure equivalents through the use of credit conversion factors ('CCF's). Depending on the risk category of the exposure a CCF of 10%, 20%, 50% or 100% is applied. In contrast, the Basel 2010 text requires that off-balance sheet items are included in full except for commitments that are unconditionally cancellable at any time by HSBC without prior notice, where only 10% of the exposures are included; and

· items deducted from the end point tier 1 capital such as goodwill and intangible assets, are excluded.

This information is provided by RNS

The company news service from the London Stock Exchange

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