Interim Report - 15 of 28

RNS Number : 2019P

HSBC Holdings PLC

15 August 2014

 



Risk

Risk profile ......................................................	99
Managing risk .................................................	100
Top and emerging risks ..................................	100
Macroeconomic and geopolitical risk ..................	100
Macro-prudential, regulatory and legal risks to our business model ......................................	101
Risks related to our business operations, governance and internal control systems .........	104
Areas of special interest .................................	107
Financial crime compliance and regulatory compliance .....................................................	107
Regulatory stress tests .........................................	108
Credit risk .......................................................	109
Liquidity and funding .....................................	148
Market risk ......................................................	157
Operational risk .............................................	165
Compliance risk ..................................................	166
Reputational risk ................................................	168
Risk management of insurance operations .	169

There have been no material changes to our policies and practices regarding risk management and governance as described in the Annual Report and Accounts 2013 except that new enhanced global AML and sanctions policies and a globally consistent approach to the risk management of conduct were approved by the Board in the first half of 2014 as described in Compliance risk on page 166. In addition, the Financial Intelligence Unit was established in the Security and Fraud Risk and Financial Crime Compliance functions as described under Operational risk on page 165.

A description of the principal risks and uncertainties for the remaining six months of the financial year is on page 100.

A summary of our current policies and practices regarding risk is provided in the Appendix to Risk on page 266 of the Annual Report and Accounts 2013.

Risk profile

Managing our risk profile

·     A strong balance sheet is core to our philosophy.

·     Our portfolios remain aligned to our risk appetite and strategy.

·     Our risk management framework is supported by robust forward-looking risk identification.

Maintaining capital strength and strong liquidity position

·     Our common equity end point tier 1 capital ratio remains strong at 11.3%.

·     We have sustained our strong liquidity position throughout the first half of 2014.

·     The ratio of customer advances to deposits remains significantly below 90%.

Strong governance

·     Robust risk governance and accountability is embedded across the Group.

·     The Board, advised by the Group Risk Committee, approves our risk appetite.

·     Our Regulatory Compliance and Financial Crime Compliance functions provide intense focus on these areas.

·     Our global risk operating model supports adherence to globally consistent standards and risk management policies across the Group.

Our top and emerging risks

·     Macroeconomic and geopolitical risk.

·     Macro-prudential, regulatory and legal risks to our business model.

·     Risks related to our business operations, governance and internal control systems.

Managing risk

Robust risk governance and accountability are embedded throughout the Group, fostering a continuous monitoring of the risk environment and an integrated evaluation of risks and their interactions.

Our risk governance framework ensures the appropriate oversight of and accountability for the effective management of risk, including financial crime risk, at Group, regional and global business levels.

Our risk profile is underpinned by our core philosophy of maintaining a strong balance sheet and liquidity position, and capital strength. We continued to sustain a conservative risk profile during the first half of 2014 by managing and, where appropriate, reducing exposure to the most likely areas of stress:

·      we managed selectively our exposure to sovereign debt and bank counterparties to ensure that the overall quality of the portfolio remained strong;

·      we regularly assessed higher-risk countries and adjusted our risk appetite and exposures accordingly;

·      we repositioned certain portfolios through our six filters process (see page 13) and our focus on selected products or customer segments;

·      we made our client selection filters more robust in managing the risk of financial crime; and

·      we mitigated risks, for example reputational and operational, when they were forecast to exceed our risk appetite.

The diversification of our lending portfolio across global businesses and regions, together with our broad range of products, ensured that we were not overly dependent on a limited number of countries or markets to generate income and growth.

Top and emerging risks

During the first half of 2014, senior management paid particular attention to a number of top and emerging risks.

Our approach to identifying and monitoring top and emerging risks is described on page 17. Our current ones are as follows:

Macroeconomic and geopolitical risk

Emerging markets slowdown

Increased geopolitical risk

Emerging markets slowdown

Economic growth in emerging markets remained weak in the first half of 2014. Monetary policy in a number of emerging markets was restrictive to counter the risk of capital outflows which could have had negative effects on economic growth. Political tensions in certain countries, including Syria, Ukraine and Thailand, deterred investors and increased the risk that they would fail to meet financing requirements. Forthcoming elections in a number of countries may increase instability and put pressure on currencies.

In mainland China, whilst the absolute level of GDP growth remained relatively high, the rate of growth declined more sharply than expected as a result of tighter central government controls over local government finances and the shadow banking sector. The economic situation in Argentina remained challenging following the devaluation of the peso in early 2014, the US Supreme Court's decision to oblige Argentina to repay hold-out debt holders and the subsequent technical default by the country.

Potential impact on HSBC

·     We earn a significant proportion of our profits from our operations in emerging markets. HSBC's results could be adversely affected by a prolonged slowdown in emerging market growth.

·     Global trade and capital flows may contract as a result of weaker economic growth in emerging markets, the introduction of protectionist measures, the emergence of geopolitical risks or increasing redenomination risk. This may also curtail our profitability.

Mitigating actions

·     We closely monitor developments in emerging markets to ensure trends are identified, the implications for specific customers or customer segments are assessed and appropriate action is taken as circumstances evolve.

·     We have conducted a number of stress tests to assess the effect of changes in economic conditions in Asia, and particularly in mainland China, on our operations. These factored in a China hard landing scenario (see page 139 of

the Annual Report and Accounts 2013). In the first half of 2014, we ran a further stress test which assumed a significant deceleration of growth in mainland China and a sharp contraction in Hong Kong (see page 108).

Increased geopolitical risk

Our operations are exposed to risks arising from political instability and civil unrest in a number of countries, which may have a wider effect on regional stability and regional and global economies.

Geopolitical risk rose in the first half of 2014 as a result of the crisis in Ukraine and the possibility of military escalation and/or civil war. Further sanctions against the Russian government remain a possibility, which could affect foreign investment in Russia.

Geopolitical risk remained high in the Middle East with the crisis between Israel and Palestine, unrest in Egypt, the civil war in Syria and the conflict in Iraq. Negotiations continued on restricting the scope of Iranian nuclear activities, which add to the risks in the region.

In Asia, there was no easing in the maritime sovereignty disputes involving mainland China and Japan as the Chinese government sought to extend its influence over the South and East China Seas.

In Turkey, the continued political uncertainty led to market volatility and placed the currency under pressure.

Potential impact on HSBC

·     Our results are subject to the risk of loss from unfavourable political developments, currency fluctuations, social instability and changes in government policies on matters such as expropriation, authorisations, international ownership, interest-rate caps, foreign exchange transferability and tax in the jurisdictions in which we operate. Actual conflict could put our staff in danger and bring physical damage to our assets.

Mitigating actions

·     We monitor the geopolitical and economic outlook, in particular in countries where we have material exposures and a physical presence. Our internal credit risk rating of sovereign counterparties takes these factors into account and drives our appetite for conducting business in those countries. Where necessary, we adjust our country limits and exposures to reflect our appetite and mitigate risks as appropriate.

·     Our sanctions screening processes and governance have been strengthened through our Global Standards programme.

Macro-prudential, regulatory and legal risks to our business model

     Regulatory developments affecting our business model and Group profitability

     Regulatory investigations, fines, sanctions, commitments and consent orders and requirements relating to conduct of business and financial crime negatively affecting our results and brand

     Dispute risk

Financial service providers face increasingly stringent and costly regulatory and supervisory requirements, particularly in the areas of capital and liquidity management, conduct of business, operational structures and the integrity of financial services delivery. Increased government intervention and control over financial institutions, together with measures to reduce systemic risk, may significantly alter the competitive landscape locally, regionally and/or globally for some or all of the Group's businesses. These measures may be introduced as formal requirements in a super-equivalent manner and to differing timetables by regulatory regimes.

Regulatory developments affecting our business model and Group profitability

Several regulatory changes are likely to affect the activities both of the Group as a whole and of some or all of our principal subsidiaries. These changes include:

·     the UK's Financial Services (Banking Reform) Act 2013 which gave effect to the recommendations of the Independent Commission on Banking ('ICB') in relation to the ring-fencing of our UK retail banking activities from wholesale banking, together with the structural separation of other activities as envisaged in the legislation and rules adopted in the US (including the Volcker Rule adopted in December 2013 under the Dodd-Frank Act) and potential changes across the EU (including a proposed Regulation on structural measures for EU credit institutions);

·     requirements flowing from arrangements for the recovery and resolution of the Group and its individual operating entities, which may have different effects in different countries;

·     the implementation of extra-territorial laws, including the Foreign Account Tax Compliance Act ('FATCA') and other related initiatives to share tax information such as those pursued by the OECD;

·     changes in the regime for the operation of capital markets, notably mandatory central clearing of over the counter ('OTC') derivatives, including under the Dodd-Frank Act and the EU's European Market Infrastructure Regulation ('EMIR');

·     changes arising from the increasing focus by regulators on how institutions conduct business, particularly with regard to the delivery of fair outcomes for customers, promoting effective competition in the interests of consumers (including the recently announced proposals for an investigation by the UK Competition and Markets Authority on the personal current account and SME banking market in the UK) and ensuring the orderly and transparent operation of global financial markets. Focus also increases on remuneration and on increasing management accountability, the latter to meet requirements under CRD IV and the UK Banking Reform Act;

·     the implementation of significant parts of CRD IV which are yet to be finalised and applied, notably the UK application of the capital buffer framework and its interaction with Pillar 2 and the Financial Policy Committee's ('FPC's) July 2014 consultation on proposals for the development of a UK leverage ratio;

·     the ECB Asset Quality Review ('AQR'), which may require a substantial recapitalisation among eurozone banks;

·     the tightening by regulators in a number of countries of credit controls on mortgage lending and unsecured portfolios; and

·     the continued risk of further changes to regulation relating to taxes affecting financial service providers, including financial transaction taxes.

Potential impact on HSBC

·     Proposed changes in and/or the implementation of regulations including mandatory central clearing of OTC derivatives, EMIR, ring-fencing and similar requirements, the Volcker Rule, recovery and resolution plans, FATCA and findings from competition orientated enquiries and investigations may affect the manner in which we conduct our activities and how the Group is structured. These measures have the potential to increase our cost of doing business and curtail the types of business we can carry out, with the consequent risk of decreased profitability.

·     Mandatory central clearing of OTC derivatives also brings new risks to HSBC in our role as a clearing member, as we will be required to underwrite losses incurred by central clearing counterparties from the default of other clearing members and their clients. Hence central clearing brings with it a new element of interconnectedness between clearing members and clients which we believe may increase rather than reduce our exposure to systemic risk.

·     Increased regulation of conduct of business (including incentive structures and remuneration) and management accountability may affect the industry in areas such as employee recruitment and retention, product pricing and profitability in both retail and wholesale markets. HSBC's businesses may be affected by these developments.

·     Potential market disruption from the AQR, including the possible re-emergence of concerns over the eurozone, may affect us directly through our exposure to eurozone banks and sovereigns, and indirectly should there be any diminution in economic activity in the eurozone.

Mitigating actions

·     We are engaged closely with governments and regulators in the countries in which we operate to help ensure that the new requirements are considered properly and can be implemented in an effective manner.

·     We are focused on developing a global approach to the risk management of conduct and have established a Conduct & Values Committee as a sub-committee of the Board to oversee the framework and its implementation across the Group.

·     We have enhanced our governance around central clearing counterparties and appointed specialists to manage the associated liquidity and collateral risks.

Regulatory investigations, fines, sanctions, commitments and consent orders and requirements relating to conduct of business and financial crime negatively affecting our results and brand

Financial service providers are at risk of regulatory sanctions or fines related to conduct of business and financial crime. The incidence of regulatory proceedings and other adversarial proceedings against financial service firms is increasing.

Regulatory commitments and consent orders

In December 2012, HSBC Holdings, HSBC North America Holdings Inc. ('HNAH'), and HSBC Bank USA, N.A. ('HSBC Bank USA') entered into agreements with US and UK authorities in relation to investigations regarding past inadequate compliance with AML and sanctions laws. Among other agreements, HSBC Holdings and HSBC Bank USA entered into a five-year deferred prosecution agreement ('US DPA') with the US Department of Justice ('DoJ') and HSBC Holdings entered into a two-year DPA with the District Attorney of New York County (the 'DANY DPA'). HSBC Holdings also entered into an undertaking with the FSA (revised as the 'FCA Direction' following the UK regulatory restructuring in April 2013) to comply with certain forward-looking obligations with respect to AML and sanctions requirements. In addition, HSBC Holdings entered into a cease and desist order with the US Federal Reserve Board ('FRB') with respect to compliance with US AML and sanctions requirements.

The agreements with the DoJ and the FRB and the FCA Direction require us to retain an independent monitor to evaluate our progress in fully implementing our obligations and produce regular assessments of the effectiveness of our Financial Crime Compliance function. The Monitor is discussed on page 15.

HSBC Bank USA is also subject to an agreement entered into with the Office of the Comptroller of the Currency ('OCC') in December 2012, the Gramm-Leach-Bliley Act Agreement ('GLBA Agreement'). See pages 144 and 556 of the Annual Report and Accounts 2013 for further information on the GLBA Agreement and other consent orders, respectively.

Potential impact on HSBC

·     It is difficult to predict the outcome of the regulatory proceedings involving our businesses. Unfavourable outcomes may have a material adverse effect on our reputation, brand and results, including loss of business and withdrawal of funding.

·     Our significant involvement in facilitating international capital flows and trade exposes the Group to the risk of financial crime or inadvertently breaching restrictions and sanctions imposed by the Office of Foreign Assets Control ('OFAC') and other regulators.

·     Breach of the US DPA at any time during its term may allow the DoJ to prosecute HSBC Holdings or HSBC Bank USA in relation to the matters which are the subject of the US DPA. Breach of the DANY DPA may allow the District Attorney of New York County to prosecute HSBC Holdings in relation to the matters which are the subject of that DPA.

·     Failure to comply with the requirements of consent orders or the GLBA within the time periods specified in them or otherwise as may be extended, could result in supervisory action (see page 145 of the Annual Report and Accounts 2013 for more information about the consequences of not complying with the GLBA) Any such action could have a material adverse effect on the consolidated results and operation of HSBC.

Mitigating actions

·     Steps to address many of the requirements of the DPAs, the FCA Direction, the GLBA Agreement and associated regulatory agreements have either already been taken or are under way in consultation with the relevant regulatory agencies. These include simplifying the Group's control structure, strengthening the governance structure with new leadership appointments, revising key policies and implementing consistent procedures and controls shaped by the highest or most effective standards available in any location where the Group operates to detect, deter and protect against financial crime through our Global Standards programme. In addition, we have substantially increased spending and staffing in the Financial Crime Compliance and Regulatory Compliance functions in the past few years.

·     There can be no assurance that these remedial measures taken to date will be effective or that we will not have to take additional remedial measures in the future to comply with the terms of the DPAs, the FCA Direction or the GLBA Agreement.

Conduct of business

Regulators in the UK and other countries have continued to increase their focus on 'conduct' matters including sales processes and incentives (including remuneration practices), product and investment suitability and more general conduct of business and market conduct concerns.

In the UK, the FCA are making increasing use of existing and new powers of intervention and enforcement, including powers to consider past business undertaken and implement customer compensation and redress schemes or other, potentially significant, remedial work. They are also regulating areas of activity not previously regulated by them, such as consumer credit, and considering competition issues in the markets they regulate. Additionally, the FCA and other regulators increasingly take actions in response to customer complaints or where they see poor customer outcomes, either specific to an institution or more generally in relation to a particular product. There have been recent examples of this approach by regulators in the context of the possible mis-selling of PPI, of interest rate hedging products for SMEs and of wealth management products.

The Group also continues to be subject to a number of other regulatory proceedings, including investigations and reviews by various national regulatory, competition and enforcement authorities related to certain past submissions made by panel banks and the process for making submissions in connection with the setting of Libor, Euribor and other benchmark interest rates. There are also investigations into currency benchmarks and credit default swaps.

Potential impact on HSBC

·     Regulators in the UK and other countries may identify future industry-wide mis-selling, market conduct or other issues that could affect the Group. This may lead from time to time to significant direct costs or liabilities and/or changes in the practices of such businesses. Also, decisions taken by bodies such as the Financial Ombudsman Service in the UK (or similar overseas bodies) in relation to customer complaints could, if applied to a wider class or grouping of customers, have a material adverse effect on the operating results, financial condition and prospects of the Group.

Mitigating actions

·     Programmes to actively manage and mitigate conduct risk have been initiated in all global businesses and functions.

·     Incentive plans introduced in RBWM in 2013 and 2014 have removed the formulaic link between product sales and variable pay, focusing instead on relationship management activities that support meeting customer needs, improving customer outcomes and sales quality.

·     HSBC and its subsidiaries are cooperating fully with all regulatory investigations and reviews.

Dispute risk

HSBC is party to legal proceedings and regulatory matters in a number of jurisdictions arising out of its normal business operations. Further details are provided in Note 25 on the Financial Statements.

Potential impact on HSBC

·     Dispute risk gives rise to potential financial loss and significant reputational damage which could adversely affect customer and investor confidence.

Mitigating actions

·     We continue to focus on identifying emerging regulatory and judicial trends in order to limit exposure to litigation or regulatory enforcement action in the future.

·     We are enhancing our financial crime and regulatory compliance controls and resources.

Risks related to our business operations, governance and internal control systems

Heightened execution risk

People risk

Stress test impact risk

Social media risk

Internet crime and fraud

Information security risk

Data management

Model risk

Heightened execution risk

HSBC is facing heightened execution risk due to a number of factors including the volume and complexity of projects needed to meet regulatory requirements and support business initiatives which are moving into implementation phases in 2014; the degree of organisational change, including the restructuring of our Compliance function into two distinct sub-functions, Financial Crime Compliance and Regulatory Compliance; and external factors, including the challenging macroeconomic environment and the extent and pace of regulatory change. In addition, the implementation of our strategy to simplify our business, which involves withdrawing from certain markets, presents disposal risks.

Potential impact on HSBC

·     These factors may affect the successful delivery of our strategic priorities.

·     The potential risks of disposals include regulatory breaches, industrial action, loss of key personnel and interruption to systems and processes during business transformation. They can have both financial and reputational implications.

Mitigating actions

·     We have strengthened our prioritisation and governance processes for significant projects and have invested in our project implementation and IT capabilities.

·     Risks related to organisational change and disposals are subject to close management oversight.

·     Our planning and stress testing processes consider the effect of potential internal risks or risks arising from the external environment on our earnings and capital position and actions by management to mitigate them.

·      People risk

The demands being placed on the human capital of the Group are unprecedented. The cumulative workload arising from a regulatory reform programme that is often extra-territorial and still evolving is hugely consumptive of human resources, placing increasingly complex and conflicting demands on a workforce where the expert capability set is in short supply and globally mobile.

Potential impact on HSBC

·     Changes in remuneration policy and practice resulting from the new regulations under CRD IV apply globally to all employees of EU headquartered banks. The key change is the application of a cap on variable pay that can be paid to any 'material risk-taker' (being employees who have been identified as having a material impact on the institution's risk profile). This presents significant challenges for HSBC given the fact that as a worldwide business, a significant number of our material risk takers are based outside the EU.

·     The proposals for a senior persons regime are being made to set clearer expectations of the behaviour of both senior and more junior employees.

·     The PRA consultation on clawback proposes extending the Remuneration Code to require all PRA-authorised firms to amend employment contracts to be able to apply clawback to vested variable remuneration on a Group-wide basis.

·     Implementing organisational changes to support the Group's strategy has the potential to lead to increased staff turnover.

Mitigating actions

·     The changes in remuneration under the new CRD IV regulations has necessitated a review of our remuneration policy, especially the balance between fixed and variable pay, to ensure we can remain competitive on a total compensation basis and retain our key talent.

·     Risks related to organisational change and disposals are subject to close management oversight.

·     We continue to increase the level of specialist resources within Financial Crime Compliance, Regulatory Compliance and stress testing.

Stress test impact risk

The quantity, granularity and timelines of major regulatory stress test programmes give rise to a range of risks including:

·     governance, organisation and people risk, due to the concurrent nature of the stress test exercises;

·     data risk, arising from the unprecedented volume and granularity of data requested as part of these programmes;

·     model risk, due to the significant increase in the number of models used by the Group, the speed with which they have been introduced and the extended use of models in new areas;

·     regulatory and consent order risk, which may arise should regulators identify deficiencies in our stress test results and processes;

·     capital planning risk, should regulators' assessment of stress test results lead to them objecting to planned capital actions, including the payment of dividends;

·     execution risk, due to the number and complexity of stress tests under way at the same time;

·     disclosure risk, as the publication of stress test results by regulators may have an unexpected effect on a bank's business and/or reputation; and

·    

·     counterparty and market disruption risk, which could arise should a number of banks fail the stress test exercises.

Potential impact on HSBC

·     Banks will be assessed against qualitative as well as quantitative standards and may be judged to fall short against either. If such an event were to arise for HSBC or one of its regulated entities, regulators have a number of options to remedy or mitigate the perceived failing.

·     HNAH is required to re-submit its capital plan and make improvements to its stress testing processes following the FRB's objection to its capital plan on qualitative grounds (see page 108).

Mitigating actions

·     We created a Stress Testing Management Board with appropriate subordinate Steering Committees in early 2014, chaired by the Group Finance Director, to ensure appropriate senior management oversight and governance of the stress test programmes. Updates are provided at each meeting of the Risk Management Meeting of the GMB and the Group Risk Committee.

Social media risk

The rapid growth of social media increases the risk that speculation about HSBC or customer complaints, either specific to HSBC or more generally in relation to a particular product, may be spread through the use of these channels.

Potential impact on HSBC

·     This could have an adverse effect on our reputation and brand and potentially our share price.

Mitigating actions

·     We monitor social media activity globally, using a dedicated software platform. This enables us to identify, manage and respond to issues where required.

Internet crime and fraud

With the ever-growing acceptance of, and demand for, internet and mobile services by customers, HSBC is increasingly exposed to fraudulent and criminal activities via these channels. We also face the risk of breakdowns in processes or procedures and systems failure or unavailability, and our business is subject to disruption from events that are wholly or partially beyond our control, such as internet crime and acts of terrorism.

Potential impact on HSBC

·     Internet crime and fraud could result in financial loss and/or customer data and sensitive information being compromised. They may also give rise to losses in service to customers. The same threats apply equally when we rely on external suppliers or vendors to provide services to us and our customers.

Mitigating actions

·     We continually assess these threats as they evolve and adapt our controls to mitigate them.

·     We have increased our defences through enhanced monitoring and have implemented additional controls, such as two-factor authentication, to reduce the possibility of losses from fraud.

Information security risk

The security of our information and technology infrastructure is crucial for maintaining our banking applications and processes while protecting our customers and the HSBC reputation and brand. HSBC and other multinational organisations continue to be the targets of cyber-attacks, which may disrupt services including the availability of our external facing websites, compromise organisational and customer information or expose security weaknesses.

Potential impact on HSBC

·     Information security risk gives rise to potential financial loss and reputational damage which could adversely affect customer and investor confidence. Loss of customer data would also result in regulatory breaches which could result in fines and penalties being incurred.

Mitigating actions

·     We have invested significantly in addressing this risk through increased training to raise staff awareness of the requirements, enhanced multi-layered controls protecting our information and technical infrastructure, and heightened monitoring and management of potential cyber-attacks.

Data management

HSBC must have a clear data strategy to meet the volume, granularity, frequency and scale of regulatory and other reporting requirements as well as  to comply with the principles for effective risk data aggregation and risk reporting as set out by the Basel Committee on Banking Supervision ('the Basel Committee') in its paper.

Potential impact on HSBC

·     Ineffective data management could adversely affect our ability to aggregate and report complete, accurate and consistent data to regulators, investors and senior management on a timely basis.

·     Financial institutions that fail to meet their Basel Committee data obligations by the end of 2015 may face supervisory measures.

Mitigating actions

·      Since the Data Strategy Board was established in 2012, we have set the data strategy for the Group and defined Group-level principles, standards and policies to enable consistent data aggregation, reporting and management.

·      Key initiatives and projects to deliver our data strategy and work towards meeting our Basel Committee data obligations are in progress.

Model risk

HSBC uses models for a range of purposes in managing its business, including regulatory and economic capital calculations, stress testing, granting credit, pricing and financial reporting. Model risk is the potential for adverse consequences as a result of decisions based on incorrect model outputs and reports or the use of such information for purposes for which it was not designed. Model risk could arise from models that are poorly developed, implemented or used, or from the modelled outcome being misunderstood and acted upon inappropriately by management. The regulatory environment and supervisory concerns over banks' use of internal models to determine regulatory capital further contribute to model risk.

Potential impact on HSBC

·     HSBC could incur losses or be required to hold additional capital as a result of model limitations or failure.

·     Supervisory concerns over the internal models and assumptions used by banks in the calculation of regulatory capital have led to the imposition of risk weight and loss given default floors. Such changes have the potential to increase our capital requirement and/or make it more volatile.

Mitigating actions

·     We mitigate model risk through appropriate governance over model development, usage and validation, together with independent review, monitoring and feedback to ensure our models remain fit for purpose and compliant, where relevant, with regulatory expectations.

Areas of special interest

During the first half of 2014, there were a number of particular areas of focus as a result of the effect they have on the Group. Whilst these areas may already have been identified in Top and Emerging risks, further details of the actions taken in the last six months is provided below.

Financial crime compliance and regulatory compliance

In recent years, we have experienced increasing levels of compliance risk as regulators and other agencies pursued investigations into historical activities, and we continue to work with them in relation to existing issues. This has included the matters giving rise to the DPAs reached with US authorities in relation to investigations regarding inadequate compliance with AML and sanctions law, and the related undertaking with the FCA (the 'FCA Direction'). The work of the Monitor, who has been appointed to assess our progress against our various obligations, including the DPAs, is discussed on page 15.

We have also responded to a number of investigations by the FCA into the mis-selling in the UK of certain products, including sales of PPI and of interest rate hedging products to SMEs. In addition, we have been involved in investigations and reviews by various regulators and competition enforcement authorities related to certain past submissions made by panel banks and the process for making submissions in connection with the setting of Libor, Euribor and other benchmark interest rates, along with investigations into currency benchmarks and credit default swaps.

It is clear from both our own and wider industry experience that the level of activity among regulators and law enforcement agencies in investigating possible breaches of regulations has increased, and that the direct and indirect costs of such breaches can be significant. Coupled with a substantial rise in the volume of new regulation, much of which has some element of extra-territorial reach, and the geographical spread of our businesses, we believe that the level of inherent compliance risk that we face as a Group will continue to remain high for the foreseeable future.

Further information about our compliance risk management and the changes being made may be found on page 166.

Regulatory stress tests

We are subject to regulatory stress testing in many jurisdictions, which have increased both in frequency and in the granularity of information required by supervisors.These exercises are designed to assess the resilience of banks to adverse market developments and ensure that they have robust, forward-looking capital planning processes that account for their unique risks and include among others, the programmes of the FRB, the European Banking Authority ('EBA'), the ECB, the PRA, and the HKMA.

HNAH participated in the Comprehensive Capital Analysis and Review ('CCAR') and Dodd-Frank Stress Testing ('DFAST') programmes of the FRB and HSBC Bank USA in the OCC's DFAST programme. HNAH and HSBC Bank USA made submissions under these programmes on 6 January 2014. On 26 March 2014, the FRB informed HNAH that it objected to HNAH's capital plan on qualitative grounds and a resubmission of its capital plan is required by 5 January 2015 together with improvements to its stress testing processes. However, the FRB approved the capital actions included in HNAH's CCAR submission and HNAH may proceed with the payment of dividends on the outstanding preferred shares and trust preferred securities of HNAH and its subsidiaries. HNAH also made its mid‑cycle DFAST submission in July 2014.

The Group is taking part in the PRA concurrent stress test programme involving all major UK banks. This exercise comprised the EBA base scenario and a stress scenario reflecting the vulnerabilities facing the UK banking system, including significant declines in the value of sterling, residential and commercial property prices and bond and equity
prices, along with a downturn in economic activity and rising unemployment. We made our submission to the PRA at the end of June 2014. The Group also participates in the complementary programme of regular data provision to the Bank of England under its Firm Data Submission Framework.

In addition, we are taking part in the stress test exercise run by the EBA. The base scenario covers a wide range of risks including credit, market, securitisation, sovereign and funding risks. The adverse macro-economic scenario includes country-specific shocks to sovereign bond spreads, short-term interest rates and residential property prices together with a decline in world trade, currency depreciation in Central and Eastern Europe and slow-downs or contractions in GDP growth around the world.

HSBC France and HSBC Malta are participating in the AQR, run as part of the ECB's comprehensive assessment prior to inception of the Single Supervisory Mechanism. The AQR involved the submission of loan tapes and a detailed file review. HSBC France and HSBC Malta are now subject to the ECB's stress testing process, which is currently under way using the EBA scenarios.

The Hongkong and Shanghai Banking Corporation participated in the HKMA stress test exercise in the first half of 2014. The HKMA stress scenario envisaged a significant deceleration of growth in mainland China and a sharper contraction in Hong Kong.

Disclosures by regulators of their evaluation of these exercises are expected to be announced later in the year and we expect to be assessed on both a quantitative and qualitative basis, the latter focusing on our portfolio quality, data provision, stress testing capability and internal management processes.

Stress testing is an increasingly important tool for regulators to assess vulnerabilities in the banking sector and in individual banks, the results of which could have a significant effect on minimum capital requirements, risk and capital management practices and planned capital actions including the payment of dividends going forward.

A summary of our stress testing and scenario analysis programme is provided on page 139 of the Annual Report and Accounts 2013.

 

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