HSBC Holdings Regulatory News (HSBA)

Market risk

There were no material changes to our policies and practices for the management of market risk in 2014.

A summary of our market risk management framework including current policies is provided in the Appendix to Risk on page 221.

Market risk in 2014

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Global financial markets were characterised by low inflation and weak global growth, leading monetary authorities to maintain accommodative policies, using measures such as low interest rates and asset purchases.

With US data showing GDP growth, the US Federal Reserve's asset purchase programme came to an end. Despite this, US dollar bond yields fell further. Market focus switched to actions that the ECB can take to address the issues of low growth and deflation. A sustained period of deflation would have a severe detrimental impact on countries already in recession and with high debt to GDP ratios. 2014 can be characterised as a period of benign rates and equity markets in the G7 group of countries.

Against this backdrop, we maintained an overall defensive risk profile in our trading businesses. Defensive positions are characterised by low net open positions or the purchase of volatility protection via options trades. The lower trading VaR from defensive positioning was offset by an increase caused by lower diversification and regulatory changes to the calibrations used in calculating VaR. Non-trading VaR declined during the year as low interest rates, especially in US dollars, caused the duration of non-trading assets to decrease.

Trading portfolios

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Trading VaR predominantly resides within Global Markets. This was higher at 31 December 2014 than at 31 December 2013 due to an increase in interest rate trading VaR, the removal of diversification effects within risk not in VaR ('RNIV') and lower portfolio diversification benefit across asset classes.

The daily levels of total trading VaR over the last year are set out in the graph below.

Daily VaR (trading portfolios), 99% 1 day (US$m)

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The Group trading VaR for the year is shown in the table below.

Trading VaR, 99% 1 day34

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For footnotes, see page 202.

Back-testing

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In 2014, the Group experienced one loss exception and two profit exceptions.

The loss exception was due primarily to losses from increased volatility in foreign exchange currencies and interest rates in some developed markets combined with flattening yield curves.

The profit exceptions were driven by thetightening of spreads, and exposures to emerging market foreign exchange and interest rates. There is no evidence of model errors or control failures.

The graph below shows the daily trading VaR against hypothetical profit and loss for the Group during 2014. It excludes exceptions that were exempted by the PRA for regulatory capital purposes.

Back-testing of trading VaR against hypothetical profit and loss for the Group (US$m)

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Non-trading portfolios

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Non-trading VaR of the Group includes contributions from all global businesses. There is no commodity risk in the non-trading portfolios. The decrease of non-trading VaR during 2014 was due primarily to the shortening of the duration in the non-trading book from lower interest rates, especially in US dollars. The credit spread risks component also added to a lower non-trading VaR as a result of the reduction in the overall position combinedwith lower volatilities and credit spread baselines utilised in the VaR calculations. This movement included the reduction in credit spread risks relating to the Group's holdings of available-for-sale debt securities (excluding those held in insurance operations which are discussed further on page 194.

In the year, the decline in non-trading interest rate and credit spread VaR components was offset by a decrease in diversification benefit.

The daily levels of total non-trading VaR over the last year are set out in the graph below.

Daily VaR (non-trading portfolios), 99% 1 day (US$m)

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The Group non-trading VaR for the year is shown in the table below.

Non-trading VaR, 99% 1 day

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The management of interest rate risk in the banking book is described further in 'Non-trading interest rate risk' below, including the role of Balance Sheet Management ('BSM').

Non-trading VaR excludes equity risk on available-for- sale securities, structural foreign exchange risk and interest rate risk on fixed rate securities issued by HSBC Holdings, the management of which is described in the relevant sections below. These sections together describe the scope of HSBC's management of market risks in non-trading books.

The effect of movements in VaR credit spreads on our available-for-sale debt securities was US$81m (2013: US$113m) at 31 December 2014. This sensitivity includes the gross exposure for the securities investment conduits ('SICs') consolidated within our balance sheet based on credit spread VaR. This sensitivity excludes losses which would have been absorbed by the capital note holders.

The decrease in this sensitivity at 31 December 2014 compared with 31 December 2013 was due mainly to reducing the overall positions and lower volatilities and credit spread baselines observed during the year.

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For footnotes, see page 202.

The fair value of equity securities classified as available for sale can fluctuate considerably. The table above sets out the maximum possible loss on shareholders' equity from available-for-sale equity securities. The increase in other strategic investments was largely due to the increase in the market value of the Industrial Bank investment offsetting the decrease in private equity holdings from the disposal of various direct and private equity fund investments.

Market risk balance sheet linkages

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The information below and on page 180 aims to facilitate an understanding of linkages between line items in the balance sheet and positions included in our market risk disclosures, in line with recommendations made by the Enhanced Disclosure Task Force.

Balances included and not included in trading VaR

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The table represents account lines where there is some exposure to market risk according to the following asset classes:

A Foreign exchange, interest rate, equity and credit spread.

B Foreign exchange and interest rate.

C Foreign exchange, interest rate and credit spread.

The table above splits the assets and liabilities into two categories:

· those that are included in the trading book and are measured by VaR; and

· those that are not in the trading book and/or are not measured by VaR.

The breakdown of financial instruments included and not included in trading VaR provides a linkage with market risk to the extent that it is reflected in our risk framework. However, it is important to highlight thatthe table does not reflect how we manage market risk, since we do not discriminate between assets and liabilities in our VaR model.

The assets and liabilities included in trading VaR give rise to a large proportion of the income included in net trading income. As set out on page 49, HSBC's net trading income in 2014 was US$6,760m (2013: US$8,690m). Adjustments to trading income such as valuation adjustments do not feed the trading VaR model.

Market risk linkages to the accounting balance sheet

For information on the accounting policies applied to financial instruments at fair value, see Note 13 on the Financial Statements.

Structural foreign exchange exposures

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For our policies and procedures for managing structural foreign exchange exposures, see page 226 of the Appendix to Risk.

For details of structural foreign exchange exposures see Note 33 on the Financial Statements.

Non-trading interest rate risk

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For our policies regarding the funds transfer pricing process for non-trading interest rate risk and liquidity and funding risk, see pages 226 and 219, respectively, of the Appendix to Risk.

Asset, Liability and Capital Management ('ALCM') is responsible for measuring and controlling non-trading interest rate risk under the supervision of the Risk Management Meeting. Its primary responsibilities are:

· to define the rules governing the transfer of non-trading interest rate risk from the global businesses to BSM;

· to define the rules governing the interest rate risk behaviouralisation applied to non-trading assets/liabilities (see below);

· to ensure that all market interest rate risk that can be neutralised is transferred from the global businesses to BSM; and

· to define the rules and metrics for monitoring the residual interest rate risk in the global businesses, including any market risk that cannot be neutralised.

The different types of non-trading interest rate risk and the controls which we use to quantify and limit exposure to these risks can be categorised as follows:

· risk which is transferred to BSM and managed by BSM within a defined market risk mandate, predominantly through the use of fixed rate liquid assets (government bonds) held in available-for-sale portfolios and/or interest rate derivatives which are part of fair value hedging or cash flow hedging relationships. This non-trading interest rate risk is reflected in non-trading VaR, as well as in our net interest income (see below) or economic value of equity ('EVE') sensitivity;

· risk which remains outside BSM because it cannot be hedged or which arises due to our behaviouralised transfer pricing assumptions. This risk is not reflected in non-trading VaR, but is captured by our net interest income or EVE sensitivity and corresponding limits are part of our global and regional risk appetite statements for non-trading interest rate risk. A typical example would be margin compression created by unusually low rates in key currencies;

· basis risk which is transferred to BSM when it can be hedged. Any residual basis risk remaining in the global businesses is reported to ALCO. This risk is not reflected in non-trading VaR, but is captured by our net interest income or EVE sensitivity. A typical example would be a managed rate savings product transfer-priced using a Libor-based interest rate curve; and

· model risks which cannot be captured by non-trading VaR, net interest income or EVE sensitivity, but are controlled by our stress testing framework. A typical example would be prepayment risk on residential mortgages or pipeline risk.

For our policies regarding interest risk behaviouralisation, see page 226 of the Appendix to Risk.

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For our BSM governance framework, see page 227 of the Appendix to Risk.

Third-party assets in BSM decreased by 9% during 2014. Deposits with central banks reduced by US$31bn, predominantly in Europe due to a combination of reduced repo activity and a decrease in balances with the ECB as deposit rates became negative. Loans and advances to banks decreased by US$6bn, mainly in Hong Kong and the rest of Asia. Financial investments reduced by US$8bn due to foreign exchange movements, net sales and maturities in Hong Kong and the Americas, partially offset by the increased deployment of funds into securities in Asia.

Third-party assets in Balance Sheet Management

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For footnote, see page 202.

Sensitivity of net interest income

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The table below sets out the effect on our future accounting net interest income (excluding insurance) of an incremental 25 basis points parallel rise or fall in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 January 2015. The sensitivities shown represent the change in the base case projected net interest income that would be expected under the two rate scenarios assuming that all other non-interest rate risk variables remain constant, and there are no management actions. In deriving our base case net interest income projections the re-pricing rate of assets and liabilities used is derived from current yield curves. The interest rate sensitivities are indicative and based on simplified scenarios. The limitations of this analysis are discussed in the Appendix to Risk on page 227.

Assuming no management response, a sequence of such rises ('up-shock') would increase planned net interest income for 2015 by US$885m (2014: US$938m), while a sequence of such falls ('down-shock') would decrease planned net interest income by US$2,089m (2014: US$1,734m).

The net interest income ('NII') sensitivity of the Group can be split into three key components; the structural sensitivity arising from the four global businesses excluding BSM and Markets, the sensitivity of the funding of the trading book (Markets) and the sensitivity of BSM.

The structural sensitivity is positive in a rising rate environment and negative in a falling rate environment. The sensitivity of the funding of the trading book is negative in a rising rate environment and positive in a falling rate environment, and in terms of the impact on profit the change in net interest income would be expected to be offset by a similar change in net trading income. The sensitivity of BSM will depend on its position. Typically, assuming no management response, the sensitivity of BSM is negative in a rising rate environment and positive in a falling rate environment.

The NII sensitivity figures below also incorporate the effect of any interest rate behaviouralisation applied and the effect of any assumed repricing across products under the specific interest rate scenario. They do not incorporate the effect of any management decision to change the HSBC balance sheet composition.

See page 227 in the Risk Appendix for more information about interest rate behaviouralisation and the role of BSM.

The NII sensitivity in BSM arises from a combination of the techniques that BSM use to mitigate the transferred interest rate risk and the methods they use to optimise net revenues in line with their defined risk mandate. The figures in the table below do not incorporate the effect of any management decisions within BSM, but in reality it is likely that there would be some short-term adjustment in BSM positioning to offset the NII effects of the specific interest rate scenario where necessary.

The NII sensitivity arising from the funding of the trading book is comprised of the expense of funding trading assets, while the revenue from these trading assets is reported in net trading income. This leads to an asymmetry in the NII sensitivity figures which is cancelled out in our global business results, where we include both net interest income and net trading income. It is likely, therefore, that the overall effect on profit before tax of the funding of the trading book will be much less pronounced than shown in the figures below.

The up-shock sensitivity remained broadly unchanged in 2014. The down-shock sensitivity increased predominantly due to a change in BSM's interest rate risk profile in US dollars.

Sensitivity of projected net interest income39

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For footnote, see page 202.

We monitor the sensitivity of reported reserves to interest rate movements on a monthly basis by assessing the expected reduction in valuation of available-for-sale portfolios and cash flow hedges due to parallel movements of plus or minus 100bps in all yield curves. These particular exposures form only a part of ouroverall interest rate exposures. The accounting treatment of our remaining interest rate exposures, while economically largely offsetting the exposures shown in the below table, does not require revaluation movements to go to reserves.

The table below describes the sensitivity of our reported reserves to the stipulated movements in yield curves and the maximum and minimum month‑end figures during the year. The sensitivities are indicative and based on simplified scenarios. The change in sensitivity of reported reserves is predominantly due to a reduction in the available-for-sale securities portfolio.

Sensitivity of reported reserves to interest rate movements

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Defined benefit pension schemes

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Market risk arises within our defined benefit pension schemes to the extent that the obligations of the schemes are not fully matched by assets with determinable cash flows.

HSBC's defined benefit pension schemes

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For details of our defined benefit schemes, see Note 6 on the Financial Statements, and for pension risk management see page 200.

Additional market risk measures applicable only to the parent company

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The principal tools used in the management of market risk are VaR for foreign exchange rate risk and the projected sensitivity of HSBC Holdings' net interest income to future changes in yield curves and interest rate gap repricing tables for interest rate risk.

Foreign exchange risk

Total foreign exchange VaR arising within HSBC Holdings in 2014 was as follows:

HSBC Holdings - foreign exchange VaR

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The foreign exchange risk largely arises from loans to subsidiaries of a capital nature that are not denominated in the functional currency of either the provider or the recipient and which are accounted for as financial assets. Changes in the carrying amount of these loans due to foreign exchange rate differences are taken directly to HSBC Holdings' income statement. These loans, and most of the associated foreign exchange exposures, are eliminated on consolidation.

Sensitivity of net interest income

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HSBC Holdings monitors net interest income sensitivity over a five year time horizon reflecting the longer-term perspective on interest rate risk management appropriate to a financial services holding company. These sensitivities assume that any issuance where HSBC Holdings has an option to reimburse at a future call date is called at this date. The table below sets out the effect on HSBC Holdings' future net interest income over a fiveyear time horizon of incremental 25 basis point parallel falls or rises in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 January 2015.

Assuming no management actions, a sequence of such rises would increase planned net interest income for the next five years by US$600m (2013: increase of US$602m), while a sequence of such falls would decrease planned net interest income by US$539m (2013: decrease of US$464m).

Sensitivity of HSBC Holdings' net interest income to interest rate movements39

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For footnote, see page 202.

The interest rate sensitivities tabulated above are indicative and based on simplified scenarios. The figures represent hypothetical movements in net interest income based on our projected yield curve scenarios, HSBC Holdings' current interest rate risk profile and assumed changes to that profile during the next five years. Changes to assumptions concerning the risk profile over the next five years can have a significant impact on the net interest income sensitivity for that period. However, the figures do not take into accountthe effect of actions that could be taken to mitigate this interest rate risk.

The interest rate risk on the fixed-rate securities issued by HSBC Holdings is not included within the Group VaR but is managed on a repricing gap basis. The interest rate repricing gap table below analyses the full-term structure of interest rate mismatches within HSBC Holdings' balance sheet.

Repricing gap analysis of HSBC Holdings

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Operational risk

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Operational risk is relevant to every aspect of our business and covers a wide spectrum of issues, in particular legal, compliance, security and fraud. Losses arising from breaches of regulation and law, unauthorised activities, error, omission, inefficiency, fraud, systems failure or external events all fall within the definition of operational risk.

Responsibility for minimising operational risk lies with HSBC's management and staff. Each regional, global business, country, business unit and functional head is required to maintain oversight over the operational risks and internal controls of the business and operational activities for which they are responsible.

A summary of our current policies and practices regarding operational risk is provided in the Appendix to Risk on page 228.

Operational risk management framework

The Group Operational Risk function and the operational risk management framework ('ORMF') directs business management in discharging their responsibilities.

The ORMF defines minimum standards and processes, and the governance structure for operational risk and internal control across the Group. To implement the ORMF a 'three lines of defence' model is used for the management of risk, as described below:

Three lines of defence

A diagrammatic representation of the ORMF is presented on page 187.

Activity to embed the use of our operational risk management framework continued in 2014. At the same time, we are streamlining operational risk management processes and harmonising framework components and risk management processes. This is expected to lead to a stronger operational risk management culture and more forward-looking risk insights to enable businesses to determine whether material risks are being managed within the Group's risk appetite and whether further action is required. In addition, the Security and Fraud Risk and Financial Crime Compliance functions have built a Financial Intelligence Unit ('FIU') which provides intelligence on the potential risks of financial crime posed by customers and business prospects to enable better risk management decision-making. The FIU provides context and expertise to identify, assess and understand financial crime risks holistically in clients, sectors and markets.

Articulating our risk appetite for material operational risks helps the organisation understand the level of risk HSBC is willing to accept. The Group operational risk appetite statement is approved annually by the GRC. The Group risk appetite statement, which includes operational risk appetite metrics, was approved by the HSBC Holdings Board. Monitoring operational risk exposure against risk appetite on a regular basis and implementing our risk acceptance process drives risk awareness in a forward-looking manner. It assists management in determining whether further action is required.

Operational risk and control assessments ('RCAs') are performed by individual business units and functions. The risk and control assessment process is designed to provide business areas and functions with a forward looking view of operational risks and an assessment of the effectiveness of controls, and a tracking mechanism for action plans so that they can proactively manage operational risks within acceptable levels. Risk and control assessments are reviewed and updated at least annually.

Operational risk management framework

· RCAs are used to inform the evaluation of the effectiveness of controls over top risks.

· Key Indicators are used to help monitor the risks and controls.

· Scenarios provide management with a quantified view of our top and emerging operational risks.

· Internal incidents are used to forecast typical losses.

· External sources are used to inform the assessment of extreme scenarios.

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Appropriate means of mitigation and controls are considered. These include:

· making specific changes to strengthen the internal control environment;

· investigating whether cost-effective insurance cover is available to mitigate the risk; and

· other means of protecting us from loss.