Interim Report - 19 of 25

RNS Number : 6306J

HSBC Holdings PLC

10 August 2012

 



Capital

Capital overview ......................................................	196
Risk-weighted assets .................................................	196
Movement in tier 1 capital in the first half of 2012 .	197
Capital structure .......................................................	198
Future developments ................................................	199
Appendix to Capital .................................................	202

Our objective in the management of Group capital is to maintain efficient levels of well diversified and varied forms of capital to support our business strategy and meet our regulatory requirements.

Capital management

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. It is our objective to maintain a strong capital base to support the risks inherent in our business and invest in accordance with our five filters framework, exceeding regulatory capital requirements at all times.

Capital measurement and allocation

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

A summary of our policies and practices regarding capital management, measurement and allocation is provided in the Appendix to Capital on page 202.

Capital overview

In the first half of 2012, there were no material changes to our capital management policies.

Capital ratios

	At		At		At
	30 Jun		30 Jun		31 Dec
	2012		2011		2011
	%		%		%
Core tier 1 ratio ........	11.3		10.8		10.1
Tier 1 ratio ...............	12.7		12.2		11.5
Total capital ratio .....	15.1		14.9		14.1
Core tier 1 target range ..................................	9.5 - 10.5

Eligibility requirements for non-equity instruments under Basel III rules are still to be clearly defined in the UK. We therefore refrained from issuing any such capital securities during the first half of 2012.

Risk-weighted assets

RWAs by risk type

	At		At		At
	30 Jun		30 Jun		31 Dec
	2012		2011		2011
	US$m		US$m		US$m
Credit risk .................	931,724		947,525		958,189
Standardised approach ...............................	389,142		357,537		372,039
IRB foundation approach ...............	8,822		5,848		8,549
IRB advanced approach ...............	533,760		584,140		577,601
Counterparty credit risk ........................	49,535		52,985		53,792
Internal models method ..................	9,819		9,036		10,229
Mark-to-market method ..................	39,716		43,949		43,563
Market risk ...............	54,281		44,456		73,177
Operational risk ........	124,356		123,563		124,356
Total .........................	1,159,896		1,168,529		1,209,514
Of which:
Run-off portfolios .	170,023		171,106		181,657
Legacy credit in GB&M ...............	47,730		29,107		50,023
US CML and Other	122,293		141,999		131,634
Card and Retail Services1 ............	-		52,684		52,080

For footnote, see page 201.

Market risk RWAs

	At		At
	30 Jun		31 Dec
	2012		2011
	US$m		US$m
VAR ............................................	8,201		11,345
Stressed VAR ...............................	11,466		19,117
Incremental risk charge ...............	4,613		5,249
Comprehensive risk measure .......	5,354		6,013
VAR and stressed VAR from CRD equivalent jurisdictions ............	11,167		12,957
FSA standard rules .......................	13,480		18,496
	54,281		73,177

Market risk RWA comparatives in the above table were not available for June 2011, as Basel 2.5 was introduced on 31 December 2011. These new rules implemented stressed VAR and the comprehensive risk measure, which resulted in changes to our existing incremental risk charge methodology, and the requirement to treat trading book securitisations under FSA standard rules. The resulting effect was partially offset by additional diversification benefits from consolidation of our approved US model on a line‑by-line basis rather than by aggregation.

RWAs by global businesses

	At		At		At
	30 Jun		30 Jun		31 Dec
	2012		2011		2011
	US$bn		US$bn		US$bn
Total .........................	1,159.9		1,168.5		1,209.5
Retail Banking and Wealth Management ...............................	298.7		365.0		351.2
Commercial Banking .	397.8		363.3		382.9
Global Banking and Markets .................	412.9		385.4		423.0
Global Private Banking ...............................	21.8		23.9		22.5
Other ........................	28.7		30.9		29.9

RWAs reduced by US$50bn to US$1,160bn in the first half of 2012, due to movements in credit risk and market risk. The US$26bn decrease in credit risk RWAs was primarily attributable to the sale of the US Card and Retail Services business in North America, which was completed in May 2012, reducing RWAs in RBWM by US$39bn. In addition, we have continued to manage down the residual balances in the US CML and other portfolios by a further US$9bn of RWAs. Growth in Rest of Asia-Pacific provided an offsetting increase in credit risk RWAs of US$24bn. This was primarily attributable to loan growth in our mainland China associates,

RWAs by geographical regions²

	At		At		At
	30 Jun		30 Jun		31 Dec
	2012		2011		2011
	US$bn		US$bn		US$bn
Total .........................	1,159.9		1,168.5		1,209.5
Europe ......................	329.5		315.7		340.2
Hong Kong ................	108.0		110.8		105.7
Rest of Asia-Pacific ...	303.2		241.1		279.3
MENA ......................	63.0		58.1		58.9
North America ..........	279.2		335.8		337.3
Latin America ...........	99.8		110.5		102.3

For footnote, see page 201.

evenly split between CMB and GB&M. Growth in corporate lending also increased GB&M RWAs in this region.

The decrease in market risk RWAs of US$19bn reflected a reduction in positions and the tightening of credit default swap spreads, reducing the stressed VAR and VAR components of market risk.

The decrease in counterparty credit risk RWAs of US$4bn was primarily driven by a reduction in mark-to-market of credit derivatives and an increased application of regulatory netting.

Movement in tier 1 capital in the first half of 2012

Source and application of tier 1 capital

	Half-year to
	30 June                2012              US$m		30 June                2011               US$m		31 December                2011               US$m
Movement in tier 1 capital
Opening core tier 1 capital ...........................................................................	122,496		116,116		125,762
Contribution to core tier 1 capital from profit for the period ...................	10,011		9,315		4,696
Consolidated profits attributable to shareholders of the parent company ..	8,438		9,215		7,582
Removal of own credit spread net of tax ...................................................	1,573		100		(2,886)
Net dividends ................................................................................................	(3,447)		(2,672)		(2,599)
Dividends ..................................................................................................	(4,454)		(4,006)		(3,495)
Add back: shares issued in lieu of dividends ................................................	1,007		1,334		896
(Increase)/decrease in goodwill and intangible assets deducted ........................	769		(1,374)		1,956
Ordinary shares issued ...................................................................................	263		13		83
Foreign currency translation differences .......................................................	(364)		4,471		(7,176)
Other, including regulatory adjustments ........................................................	941		(107)		(226)
Closing core tier 1 capital .............................................................................	130,669		125,762		122,496
Opening other tier 1 capital .........................................................................	17,094		17,063		17,351
Hybrid capital securities redeemed ................................................................	(776)		-		-
Other, including regulatory adjustments ........................................................	(53)		288		(257)
Closing tier 1 capital ....................................................................................	146,934		143,113		139,590

We complied with the FSA's capital adequacy requirements throughout 2011 and the first half of 2012. Internal capital generation contributed US$7bn to core tier 1 capital, being profits

attributable to shareholders of the parent company after regulatory adjustment for own credit spread and net of dividends.

Capital structure

	At 30 June		At 30 June		At 31 December
	2012		2011		2011
	US$m		US$m		US$m
Composition of regulatory capital
Tier 1 capital
Shareholders' equity ...................................................................................	160,606		154,652		154,148
Shareholders' equity per balance sheet3 ...................................................	165,845		160,250		158,725
Preference share premium ......................................................................	(1,405)		(1,405)		(1,405)
Other equity instruments ........................................................................	(5,851)		(5,851)		(5,851)
Deconsolidation of special purpose entities4 ...........................................	2,017		1,658		2,679
Non-controlling interests ...........................................................................	4,451		3,871		3,963
Non-controlling interests per balance sheet ............................................	7,921		7,287		7,368
Preference share non-controlling interests .............................................	(2,412)		(2,445)		(2,412)
Non-controlling interests transferred to tier 2 capital .............................	(496)		(507)		(496)
Non-controlling interests in deconsolidated subsidiaries ..........................	(562)		(464)		(497)
Regulatory adjustments to the accounting basis ..........................................	(3,308)		888		(4,331)
Unrealised losses on available-for-sale debt securities5 .............................	1,208		3,290		2,228
Own credit spread ...................................................................................	(2,115)		(773)		(3,608)
Defined benefit pension fund adjustment6 ...............................................	(116)		1,211		(368)
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities ....................................................................	(2,387)		(3,085)		(2,678)
Cash flow hedging reserve .......................................................................	102		245		95
Deductions .................................................................................................	(31,080)		(33,649)		(31,284)
Goodwill capitalised and intangible assets ................................................	(26,650)		(29,375)		(27,419)
50% of securitisation positions ...............................................................	(1,364)		(1,274)		(1,207)
50% of tax credit adjustment for expected losses ....................................	145		126		188
50% of excess of expected losses over impairment allowances ...............	(3,211)		(3,126)		(2,846)
Core tier 1 capital ..................................................................................	130,669		125,762		122,496
Other tier 1 capital before deductions .........................................................	17,110		18,339		17,939
Preference share premium ......................................................................	1,405		1,405		1,405
Preference share non-controlling interests .............................................	2,412		2,445		2,412
Hybrid capital securities ..........................................................................	13,293		14,489		14,122
Deductions .................................................................................................	(845)		(988)		(845)
Unconsolidated investments7 ..................................................................	(990)		(1,114)		(1,033)
50% of tax credit adjustment for expected losses ....................................	145		126		188
Tier 1 capital ...........................................................................................	146,934		143,113		139,590
Tier 2 capital
Total qualifying tier 2 capital before deductions .........................................	47,205		50,544		48,676
Reserves arising from revaluation of property and unrealised gains on available-for-sale equities ....................................................................	2,387		3,085		2,678
Collective impairment allowances8 .........................................................	2,551		2,772		2,660
Perpetual subordinated debt ....................................................................	2,778		2,782		2,780
Term subordinated debt ..........................................................................	39,189		41,605		40,258
Non-controlling interests in tier 2 capital ...............................................	300		300		300
Total deductions other than from tier 1 capital ..........................................	(18,415)		(19,873)		(17,932)
Unconsolidated investments7 ..................................................................	(13,834)		(15,471)		(13,868)
50% of securitisation positions ...............................................................	(1,364)		(1,274)		(1,207)
50% of excess of expected losses over impairment allowances ...............	(3,211)		(3,126)		(2,846)
Other deductions ....................................................................................	(6)		(2)		(11)
Total regulatory capital .........................................................................	175,724		173,784		170,334

For footnotes, see page 201.

Futuredevelopments 

Basel III

The regulation and supervision of financial institutions continues to undergo significant change in response to the global financial crisis. In December 2010, the Basel Committee issued two documents: 'A global regulatory framework for more resilient banks and banking systems' and 'International framework for liquidity risk measurement, standards and monitoring', which together are commonly referred to as 'Basel III'. In June 2011, the Basel Committee issued a revision to the former document setting out the finalised capital treatment for counterparty credit risk in bilateral trades.

The Basel III rules set out the minimum common equity tier 1 ('CET1') ratio requirement of 4.5% and an additional capital conservation buffer requirement of 2.5%, to be phased in sequentially from 1 January 2013, becoming fully effective on 1 January 2019. Any additional countercyclical capital buffer requirements will also be phased in, starting in 2016 to a proposed maximum level of 2.5% effective on 1 January 2019, although individual jurisdictions may choose to implement larger countercyclical capital buffers. The leverage ratio is subject to a supervisory monitoring period which commenced on 1 January 2011, and a parallel run period which will last from 1 January 2013 until 1 January 2017. Further calibration of the leverage ratio will be carried out in the first half of 2017 with a view to migrating to a pillar 1 requirement from 1 January 2018.

In addition to the criteria detailed in the Basel III proposals, the Basel Committee issued further minimum requirements in January 2011 to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss. Instruments issued on or after 1 January 2013 may only be included in regulatory capital if the new requirements are met. The capital treatment of securities issued prior to this date will be phased out over a 10-year period commencing on 1 January 2013.

Effect of Basel III

In order to provide some insight into the possible effects of the Basel III rules on HSBC, we have estimated the Group's pro forma CET1 ratio on the basis of our interpretation of those rules applied to our position at 30 June 2012.

The Basel III changes, which will be progressively phased in, relate to increases in RWAs, increased capital deductions and new regulatory adjustments. We estimate that applying the increased capital requirements which come into effect on 1 January 2013 to our 30 June 2012 core tier 1 ratio would lower it by 100bps to 10.3%.

The impact on our CET1 ratio from 1 January 2013 will result from changes to both our capital requirement and capital resource position. The decrease in the CET1 ratio attributable to the increase in capital requirements is primarily due to the new credit valuation adjustment ('CVA') capital charge, and also due to risk-weighting securitisation positions which were previously deducted from capital at 1,250%, and increasing the financial correlation charge. The effect on the CET1 ratio is reduced by the change from securitisation capital deductions to RWAs.

In addition to the implications for CET1 capital, tier 1 capital and tier 2 capital will be affected by the derecognition of non-qualifying capital instruments. These changes will be phased in over 10 years from 1 January 2013, and will further reduce the tier 1 ratio and the total capital ratio by an estimated 10bps and 40bps, respectively, in 2013 excluding new issues of qualifying capital instruments.

The changes to capital deductions and regulatory adjustments, including those for deferred tax assets, material holdings, excess expected losses and unrealised losses on available-for-sale portfolios, will be phased in over a five-year period starting on 1 January 2014.

The above is partially mitigated by the run-off of positions including legacy credit in GB&M and the US CML portfolio. This will occur in the period up until 2019.

We are also considering hedging the CVA capital charge using credit default swaps as another potential mitigating action.

CRD IV

In July 2011, the European Commission published proposals for a new Regulation and Directive, known collectively as CRD IV, to give effect to the Basel III framework in the EU. The majority of the Basel III proposals are in the Regulation, removing national discretion, except for countercyclical and capital conservation buffers, which are in the Directive.

The CRD IV proposals, which are expected to apply from 1 January 2013, require all fair value positions to be included at their prudent value for the purpose of calculating regulatory capital. The regulatory basis of prudent value differs from the accounting basis for calculating fair values of financial instruments under IAS 39. It is proposed that when the accounting value is greater than the regulatory value, the difference should be deducted from CET1.

Our current methodology for calculating CVA for accounting purposes is described in Note 8 on the Financial Statements and is principally based on the use of probabilities of default from historical rating transition matrices, consistent with our approach to the management of derivative counterparty risk.

At present there is no formalised guidance, though it is expected that we will be required for the purposes of establishing a prudent regulatory value to calculate CVA based on a probability of default derived from relevant credit default swaps. A difference between the accounting and regulatory methodologies, therefore, would result in an overall adverse adjustment to CET1. Should the accounting treatment in future more closely align with the regulatory methodology, there would be an offsetting reduction in the regulatory adjustment applied to CET1.

We continue to monitor the interaction of the accounting and regulatory treatments as they evolve and assess our respective methodologies accordingly.

The Regulation additionally sets out provisions to harmonise prudential regulatory and financial reporting in the EU, commonly known as COREP and FINREP, respectively. In December 2011, the European Banking Authority ('EBA') published a consultative document proposing measures to specify uniform formats, frequencies and dates of prudential reporting to the regulator.

During the first half of 2012, the EBA issued a number of consultations on the draft regulatory technical standards which will form part of the Regulation. Further consultative documents are expected during the year and we will continue to assess the effect on HSBC.

The CRD IV legislation is in draft and remains subject to agreement by the European Parliament, Council and Commission.

Trading activities

In May 2012, the Basel Committee issued a consultative document, 'Fundamental review of the trading book'. The paper sets out proposals for a revised market risk framework, including enhanced risk measurement under both the internal models-based and standardised approaches, and specific measures for trading book capital requirements. This aims to strengthen capital standards for market risk, and thereby contribute to a more resilient banking sector.

Systemically important banks

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

The rules set out an indicator-based approach to G-SIBs assessment employing five broad categories: size, interconnectedness, lack of substitutability, cross-jurisdictional activity and complexity. The designated G-SIBs will be required to hold minimum additional CET1 capital of between 1% and 2.5%, depending on their relative systemic importance as indicated by their assessed score. We expect to be required to hold capital towards the upper end of the range. A further 1% charge may be applied to any bank which fails to make progress or regresses in performance within the assessment categories set out above. The requirements, initially for those banks identified in November 2014 as G-SIBs, will be phased in from 1 January 2016, becoming fully effective on 1 January 2019. National regulators have discretion to introduce higher thresholds than these minima.

The proposals above form part of the FSB's broad mandate to reduce the potential moral hazard associated with G-SIBs. A further exercise of this mandate was the FSB's own direct consultation of October 2011. This proposed introducing, over the period 2012 to 2014, enhanced reporting by G-SIBs to the Basel Committee centrally. Further engagement with the financial industry at national and international level will be undertaken by the FSB during 2012.

In June 2012, complementing the G-SIBs proposal, the Basel Committee issued a consultative document, 'A framework for dealing with domestic systemically important banks'. The Committee set out an assessment methodology for domestic systemically important banks ('D-SIB's) which employs categories similar to those defined under the G‑SIB framework. In addition, they require higher loss absorbency requirements to be calibrated by national authorities and which are to be fully met by CET1. The proposals call for banks, identified as D-SIBs by their national authorities, to comply with the requirements in line with the phase-in arrangements for G-SIBs.

Potential effect on a G-SIB

The proposals described above indicate that the required minimum regulatory CET1 ratio for a G‑SIB may ultimately lie in the range of 8% to 9.5%.

Potential CET1 requirements from 1 January 2019

Minimum CET1                                                  4.5%

Capital conservation buffer                                  2.5%

G-SIB buffer                                                         1 - 2.5%

In addition to this, a G-SIB may be required to hold a countercyclical capital buffer. The countercyclical capital buffer is a macro-prudential tool at the disposal of national authorities that can be deployed when excess aggregate credit growth is judged to be increasing system-wide risk, and to protect the banking sector from future potential losses. Should a countercyclical buffer be required, it is expected to be held in the range of 0 - 2.5%.

Against the backdrop of eurozone instability, on a temporary basis, the EBA recommended banks aimed to reach a 9% core tier 1 ratio by the end of June 2012. We shall continue to review our target core tier 1 ratio of 9.5% to 10.5% as the applicable regulatory capital requirements evolve during the period until 1 January 2019.

UK banking reform

In September 2011, the Independent Commission on Banking ('ICB') recommended measures on capital requirements for UK banking groups. In June 2012, the UK Government published its consultation, 'Banking reform: delivering stability and supporting a sustainable economy', which set out its detailed proposals for implementing the recommendations of the ICB. For further details, see page 106.

Recovery and resolution

In November 2010, the G20 endorsed the FSB's report on reducing the moral hazard posed by systemically important financial institutions and, in November 2011 they endorsed the core recommendations set out in 'Key attributes of effective resolution regimes for financial institutions' which jurisdictions should implement to achieve these outcomes.

In June 2012, following international developments in this area, the European Commission published a legislative proposal for bank recovery and resolution. The aim of the proposed framework is to reduce implicit support for the banking sector and equip national regulators with common powers and tools for prevention, early intervention and resolution. The powers sought include the right to appoint a special manager and impose the sale of businesses, asset separation and the write-down of creditors (bail-in) to resolve banks in difficulties. The proposal from the European Commission is subject to negotiation with the European Parliament and European Council.

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 released immediately on disposal, but diminish over a 3-4 year period. On disposal of the Card and Retail Services business, the associated operational risk RWAs will be reported against the continuing business to the extent that the revenues are still included in the three-year average.

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

3  Includes externally verified profits for the half-year to 30 June 2012.

4  Mainly comprises unrealised losses on available-for-sale debt securities within SPEs which are excluded from the regulatory consolidation.

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

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

7  Mainly comprise investments in insurance entities.

8  Under FSA rules, collective impairment allowances on loan portfolios on the standardised approach are included in tier 2 capital.

Appendix to Capital Capital management and capital measurement and allocation

Capital management

Our policy on capital management is underpinned by a capital management framework ('the 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.

Capital measures

·  market capitalisation is the stock market value of the company;

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

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

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

The following material risks are managed through the framework: credit, market, operational, interest rate risk in the banking book, pension fund, insurance and residual risks.

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

The responsibility for global capital allocation principles and decisions rests with the GMB. Through our structured internal governance processes, we maintain discipline over our investment and capital allocation decisions and seek to ensure that returns on investment are adequate after taking into account capital costs. Our strategy is to allocate capital to businesses on the basis of their economic profit generation and their regulatory and economic capital requirements.

Our capital management process is articulated in the annual Group capital plan which is approved by the Board. The plan is drawn up with the objective of maintaining both an appropriate amount of capital and an optimal mix between its different components. HSBC Holdings and its major subsidiaries raise non-equity tier 1 capital and subordinated debt in accordance with Group guidelines on market and investor concentration, cost, market conditions, timing, capital composition and maturity profile. Each subsidiary manages its own capital to support its planned business growth and meet its local regulatory requirements within the context of the Group capital plan. Capital generated by subsidiaries in excess of planned requirements is returned to HSBC Holdings, normally by way of dividends, in accordance with the framework.

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

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

Regulatory and accounting consolidations

The basis of consolidation for financial accounting purposes is described on page 292 of the Annual Report and Accounts 2011 and differs from that used for regulatory purposes. Investments in banking associates are equity accounted in the financial accounting consolidation, whereas their exposures are proportionally consolidated for regulatory purposes. Subsidiaries and associates engaged in insurance and non-financial activities are excluded from the regulatory consolidation and are deducted from regulatory capital. The regulatory consolidation does not include SPEs where significant risk has been transferred to third parties. Exposures to these SPEs are risk-weighted as securitisation positions for regulatory purposes.

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

Regulatory capital

Our capital is divided into two tiers:

·     tier 1 capital is divided into core tier 1 and other tier 1 capital. Core tier 1 capital comprises shareholders' equity and related non-controlling interests. The book values of goodwill and intangible assets are deducted from core tier 1 capital and other regulatory adjustments are made for items reflected in shareholders' equity which are treated differently for the purposes of capital adequacy. Qualifying capital instruments such as non-cumulative perpetual preference shares and hybrid capital securities are included in other tier 1 capital; and

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

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

Pillar 1 capital requirements

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

Credit risk capital requirements

Basel II applies three approaches of increasing sophistication to the calculation of pillar 1 credit risk capital requirements. The most basic level, the standardised approach, requires banks to use external credit ratings to determine the risk weightings applied to rated counterparties and group other counterparties into broad categories and apply standardised risk weightings 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 the probability that a counterparty will default ('PD'), but subjects their quantified estimates of exposure at default ('EAD') and loss given default ('LGD') to standard supervisory parameters. Finally, the IRB advanced approach allows banks to use their own internal assessment in 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 businesses, with the remainder on either IRB foundation or standardised approaches.

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

·     Counterparty credit risk

Counterparty credit risk 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 counterparty credit risk and determining exposure values are defined by Basel II: standardised, mark-to-market and internal model method. These exposure values are used to determine capital requirements under one of the credit risk approaches: standardised, IRB foundation and IRB advanced.

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

·     Securitisation

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

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

Following the implementation of Basel 2.5, the majority of securitisation positions in the trading book are treated for capital purposes as if they are held in the non-trading book under the standardised or IRB approaches. Other traded securitisation positions, known as correlation trading, are treated under an internal model approach approved by the FSA.

Market risk capital requirement

The market risk capital requirement is measured using internal market risk models where approved by the FSA, or the FSA's standard rules.Following the implementation of Basel 2.5, our internal market risk models comprise VAR, stressed VAR, incremental risk charge and correlation trading under the comprehensive risk measure.

Operational risk capital requirement

Basel II includes a capital requirement for operational risk, again utilising three levels of sophistication. The capital required under the basic indicator approach is a simple percentage of gross revenues, whereas under the standardised approach it is one of three different percentages of gross revenues 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 risk management processes and governance of the Group. A range of stress tests are applied to our base capital plan. These, coupled with our economic capital framework and other risk management practices, are used to assess our internal capital adequacy requirements.

The ICAAP is examined by the FSA as part of its Supervisory Review and Evaluation Process, which occurs periodically to enable the FSA to define the Individual Capital Guidance or minimum capital requirements for HSBC.

Pillar 3 disclosure requirements

Pillar 3 of Basel II is related to market discipline and aims to make firms more transparent by requiring them to publish specific, prescribed details of their risks, capital and risk management under the Basel II framework at least annually. Our Pillar 3 disclosures for the year ended 31 December 2011 were published as a separate document on the Group Investor Relations website.

 

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