HSBC Holdings Regulatory News (HSBA)

Market risk

Market risk is the risk that movements in market factors, such as foreign exchange rates, interest rates, credit spreads, equity prices and commodity prices, will reduce our income or the value of our portfolios.

There were no material changes to our policies and practices for the management of market risk in 2015.

A summary of our market risk management framework including current policies is provided in the Appendix to Risk on page 210.

Market risk in 2015

Global economic growth remained subdued in 2015, with a number of headwinds present. The slowdown of the mainland Chinese economy dampened global trade flows and caused volatility in currency and global stock markets. Market concerns persist as to the scale of the slowdown and the potential for further depreciation of the renminbi.

Performance among developed markets was uneven, with the US and UK performing better than the eurozone, where the risk of a Greek exit faded in the second half of the year and ECB monetary policy remained supportive. Emerging market economies were affected by falling commodity prices as mainland Chinese demand slowed along with the prospect of monetary policy normalisation in the US. This led to capital outflows from emerging markets and a significant depreciation in several key currencies against the US dollar.

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. Non-trading VaR increased during the year as higher interest rates, especially in US dollars, caused the duration of non-trading assets to increase.

Trading portfolios

Trading VaR predominantly resides within Global Markets. This was lower at 31 December 2015 than at 31 December 2014 due to a decrease in interest rate trading VaR. During the year, trading VaR remained relatively stable trading in a tight range, with the effects of increased market volatility on VaR offset by reduced positions.

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 ($m)

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

Trading VaR, 99% 1 day29

(Audited)

For footnotes, see page 192.

The Risk not in VaR ('RNIV') framework captures risks from exposures in the HSBC trading book which are not captured well by the VaR model. For 2015, the VaR-based RNIVs are included within metrics for each asset class whereas in 2014 they were included within portfolio diversification. Adjusting for the impact of the RNIV reclassification, portfolio diversification reduced in comparison to 2014.

Back-testing

In 2015, the Group experienced one profit exception, due primarily to profits from increased volatility in foreign exchange currencies arising from the sharp fall in the Chinese stock market and its effect on global markets.

There was 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 2015. The back-testing result excludes exceptions due from changes in fair value adjustments.

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

Non-trading portfolios

Non-trading VaR of the Group includes contributions from all global businesses. There is no commodity risk in the non-trading portfolios. The increase of non-trading VaR during 2015 was due primarily to the lengthening of the duration in the non-trading book from higher interest rates, especially US rates. There was no overall trend in the non-trading VaR during the year and no significant movements. The increase in non-trading interest rate and credit spread VaR components were offset by an increase in portfolio diversification effects.

Non-trading VaR also includes the interest rate risk of non-trading financial instruments held in portfolios managed by Balance Sheet Management ('BSM'). The management of interest rate risk in the banking book is described further in 'Non-trading interest rate risk' below, including the role of BSM.

Non-trading VaR excludes the insurance operations which are discussed further on page 180.

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 ($m)

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

Non-trading VaR, 99% 1 day

(Audited)

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. This section and the sections below describe the scope of HSBC's management of market risks in non-trading books.

Equity securities classified as available for sale

Fair value of equity securities

(Audited)

For footnotes, see page 192.

The table above sets out the maximum possible loss on shareholders' equity from available-for-sale equity securities. The fair value of equity securities classified as available for sale reduced from $10.7bn to $5.9bn. The decrease in Other strategic investments was largely due to the disposal of the Industrial Bank investment.

Market risk balance sheet linkages

The information below and on page 171 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

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 that the 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 54, HSBC's net trading income in 2015 was $8,723m (2014: $6,760m). 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

For our policies and procedures for managing structural foreign exchange exposures, see page 215 of the Appendix to Risk.

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

Non-trading interest rate risk

For our policies regarding the funds transfer pricing process for non-trading interest rate risk and liquidity and funding risk, see page 207 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 RMM. 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 held to maturity or 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.

Interest rate risk behaviouralisation

For our policies regarding interest risk behaviouralisation, see page 215 of the Appendix to Risk.

Third-party assets in Balance Sheet Management

For our BSM governance framework, see page 216 of the Appendix to Risk.

Third-party assets in BSM decreased by 9% during 2015. Deposits with central banks reduced by $32bn, predominantly in North America and Europe, in line with reduced repo and reverse repo activity. This reduced activity is also reflected in a reduction of $29bn in non-trading reverse repurchase agreements. Financial investments increased by $29bn mainly due to increased deployment of funds into securities in Asia.

Third-party assets in Balance Sheet Management

Sensitivity of net interest income

The table on the next page sets out the effect on our accounting net interest income (excluding insurance) projections of a series of four quarterly parallel shocks of 25 basis points to the current market-implied path of interest rates worldwide at the beginning of each quarter from 1 January 2016. The sensitivities shown represent the change in the expected base case 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 rates of assets and liabilities used are derived from current yield curves, thereby reflecting current market expectations of the future path of interest rates. The scenarios therefore represent interest rate shocks which occur to the current market implied path of rates. 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 216.

Assuming no management response, a sequence of such rises ('up-shock') would increase expected net interest income for 2016 by $1,251m (2015: $885m), while a sequence of such falls ('down-shock') would decrease planned net interest income by $2,258m (2015: $2,089m).

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 NII 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 on the next page 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 215 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.

Sensitivity of net interest income34

(Audited)

For footnote, see page 191.

These estimates are based on certain assumptions, principally:

· all non-interest rate risk variables remain constant; and

· the size and composition of HSBC's balance sheet remains as it was at 31 December 2015.

We expect NII to rise in the rising rate scenario and fall in the falling rate scenario. This is due to a structural mismatch between our assets and liabilities (on balance we would expect our assets to reprice more quickly, and to a greater extent, than our liabilities).

We are more sensitive to both up and down shocks relative to 31 December 2014. In the up-shock we benefit from BSM positioning in US dollars. In the down-shock we lose due to larger rate decreases on deployment of US and HK dollar deposits given the higher rate environment.

Sensitivity of capital and reserves

Under CRD IV, available-for-sale ('AFS') reserves are included as part of CET1 capital. We measure the potentialdownside risk to the CET1 ratio due to interest rate and credit spread risk in the AFS portfolio by the portfolio's stressed VaR, using a 99% confidence level and an assumed holding period of one quarter. At December 2015, the stressed VaR of the portfolio was $2.8bn.

We monitor the sensitivity of reported cash flow hedging reserves to interest rate movements on a monthly basis by assessing the expected reduction in valuation of cash flow hedges due to parallel movements of plus or minus 100bps in all yield curves. These particular exposures form only a part of our overall interest rate exposures.

The table below describes the sensitivity of our cash flow hedge 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.

Sensitivity of cash flow hedging reported reserves to interest rate movements

Defined benefit pension schemes

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.

For details of our defined benefit schemes, including asset allocation, see Note 6 on the Financial Statements, and for pension risk management see page 189.

Additional market risk measures applicable only to the parent company

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 2015 was as follows:

HSBC Holdings - foreign exchange VaR

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

HSBC Holdings monitors NII 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 NII over a five-year 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 NII for the next five years by $247m (2014: increase of $600m), while a sequence of such falls would decrease planned NII by $266m (2014: decrease of $539m).

Sensitivity of HSBC Holdings' net interest income to interest rate movements34

For footnote, see page 191.

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

Interest rate repricing gap table

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

Repricing gap analysis of HSBC Holdings

Operational risk

Operational risk is the risk to achieving our strategy or objectives as a result of inadequate or failed internal processes, people and systems or from external events.

Responsibility for minimising operational risk lies with HSBC's management and staff. All regional, global business, country, and functional staff are required to manage the operational risks 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 217.

Operational risk management framework

HSBC's Operational Risk Management Framework ('ORMF') is our overarching approach for managing operational risk. The purpose of the ORMF is to make sure we fully identify and manage our operational risks in an effective manner and remain within our targeted levels of operational risk within the Group's risk appetite, as defined by the Board. Articulating our risk appetite for material operational risks helps the organisation understand the level of risk HSBC is willing to accept. 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 and assists management in determining whether further action is required.

Activities to strengthen our risk culture and better embed the use of the ORMF continued in 2015. In particular, we continued to streamline our operational risk management processes, procedures and tool sets to provide more forward-looking risk insights and more effective operation of the ORMF. The ORMF comprises the 14 key components set below.

Key components of HSBC's ORMF

Three lines of defence

HSBC has implemented an activity-based 'three lines of defence' model (an industry best practice approach) to underpin our approach to managing operational risk using the ORMF. It makes clear who does what within HSBC to manage operational risks on a daily basis.

· The first line of defence owns the risks and is responsible for identifying, recording, reporting and managing them and ensuring that the right controls and assessments are in pace to mitigate these risks.

· The second line of defence sets the policy and guidelines for managing the risks and provides advice, guidance and challenge to the first line of defence on effective risk management.

· The third line of defence is Internal Audit which helps the Board and Executive Management to protect the assets, reputation and sustainability of the Group.

Operational risk in 2015

During 2015, our operational risk profile continued to be dominated by compliance risk (mainly conduct-related) and we continued to incur losses relating to events from previous years. Conduct-related costs included in significant items are outlined on page 97. A range of mitigating actions are being taken to prevent future conduct-related incidents.

For further information see 'Compliance risk' on page 178 and for details of the investigations and legal proceedings see Note 40 on the Financial Statements.

Other operational risks included:

· compliance with regulatory agreements and orders: failure to implement our obligations under the US DPA could have a material adverse effect on our results and operations. The work of the Monitor is discussed on page 116, with compliance risk described below;

· level of change creating operational complexity: the Global Risk function is engaged with business management in business transformation initiatives to ensure robust internal controls are maintained as we execute our change agenda;

· fraud risks: our loss prevention performance remains strong in most markets, but the introduction of new technologies and ways of banking mean that we continue to be subject to fraud attacks as new attack vectors are developed. We continue to increase monitoring and enhance detective controls to mitigate these risks in accordance with our risk appetite;

· information security: the security of our information and technology infrastructure is crucial for maintaining our banking services and protecting our customers and the HSBC brand. As with other financial institutions and multinational organisations, we continue to be exposed to cyber threats, and the focus of attacks such as 'distribution of denial of service' which can affect the availability of customer-facing websites. Programmes of work are ongoing to strengthen internal security controls to prevent unauthorised access to our systems and network, as well as improvements to the controls and security applied to protect our customers utilising digital channels. Strong engagement and support within the industry, government agencies and intelligence providers helps to ensure we keep abreast of the current developments; and

· third-party risk management: we are strengthening our core third-party risk management capability particularly related to the management of vendor risks. A supplier performance management programme has been implemented with our most material suppliers and screening of suppliers is in place to help enable us to identify if any are on a sanctions list and if we should therefore exit the relationship.

Other operational risks are also monitored and managed through the use of the ORMF.

Further information on the nature of these risks is provided in 'Top and emerging risks' on page 110.

Frequency and amount of operational risk losses

The profile of operational risk incidents and associated losses is summarised below, showing the distribution of operational incidents in terms of their frequency of occurrence and total loss amount in US dollars.

Operational losses were lower in 2015 than in 2014, reflecting a reduction in losses incurred relating to large legacy conduct-related events. Our total loss was driven primarily by provisions raised in respect of the mis-selling of the PPI policies, foreign exchange rate investigations and litigation.

As in previous years, the operational risk incident profile in 2015 comprised high frequency low impact events and high impact events that occurred much less frequently.

Losses due to external fraud, such as card fraud, occurred more often than other types of incident, but the amounts involved were often small in value. The value of fraud incidents in 2015 was lower than in 2014, due to the strengthened control environment.

Frequency of operational risk incidents by risk category (individual loss ≥$10k)

Distribution of operational risk losses in US dollars by risk category

Compliance risk

Compliance risk arises from activities subject to rules, regulations, Group policies and other formal standards, including those relating to AML, counter-terrorist and proliferation financing, sanctions compliance, anti-bribery and corruption, conduct of business and other regulations.

Anti-money laundering and sanctions

Revised global AML and sanctions policies were approved in 2014. During 2015, global businesses and countries introduced new AML and sanctions procedures arising from the new policies and focused on embedding the procedures required to effect these policies in our day to day business operations globally. This supported our ongoing effort to address the US DPA requirements. These actions were in line with our strategic target to implement the highest or most effective standards globally. The work of the Monitor, who was appointed to assess the effectiveness of our AML and sanctions compliance programme is discussed on page 116 and our progress on implementing Global Standards is detailed on page 21.

Anti-bribery and corruption

It is unethical, illegal, and contrary to good corporate governance to bribe or corrupt others. The Group is committed to preventing bribery and corruption, and to consistently applying the letter and spirit of applicable anti-bribery legislation in all markets and jurisdictions in which we operate. We have implemented a strategic programme to address bribery and corruption risks and are embedding a new global suite of policies that make it clear to all staff that Group members, employees or other associated persons or entities must not engage in, or otherwise facilitate, any form of bribery, whether direct or indirect.

The anti-bribery and corruption programme, from training to risk assessment, emphasises the importance of consistent and standardised procedures to drive the principles of 'detect, deter and protect' and ensure that they are incorporated into every aspect of business-as- usual activities.

We recognise that delivering fair outcomes for our customers and upholding financial market integrity is critical to a sustainable business model. We have taken a number of steps to raise our standards and deal with historical incidents, including the following:

· we published a new Global Conduct Policy in 2015 (following the approval and implementation of the global conduct approach and framework in 2014) for the management of conduct designed to ensure that we meet our strategic commitment to deliver fair outcomes for our customers, and not disrupt the orderly and transparent operation of financial markets;

· we launched communications programmes and global mandatory training in respect of conduct and the Group's required values and behaviours;

· we enhanced the product governance process to further ensure products are designed to meet customers' needs and are sold to suitable customer groupings. Post implementation and regular reviews are undertaken to help ensure products remain appropriate;

· we reviewed sales processes and sales incentive schemes, focusing on activity and rewards linked to values-based behaviour and good conduct;

· we enhanced our surveillance capabilities and tested new technologies to strengthen our capabilities to detect suspicious trading activity and misconduct;

· we undertook proactive reviews of our involvement in the benchmarking processes for rates and commodities; and

· we reviewed our insights into customer experience, our analysis of the root cause of complaints and our complaint handling to ensure we continually improve and deliver better outcomes for our customers.

The global businesses use a broad range of measures appropriate to their specific customer base and markets to assess ongoing effectiveness of the management of conduct, and enable action to be taken where potential conduct issues arise. The measures include information relating to sales quality, customer experience and market behaviour.

The CVC provides Board oversight of the Group's multiple efforts to raise standards of conduct and embed the behavioural values the Group stands for.

For further information on the CVC, see page 272.

Further information on our conduct is provided in the Strategic Report on page 40 and for conduct-related costs relating to significant items, see page 97.

We actively encourage our employees to raise concerns and escalate issues so they can be dealt with effectively. In most cases, individuals will raise their concerns with line management or Global Human Resources. However, wherean individual believes that their normal reporting channels are unavailable or inappropriate, it is important that they have alternative channels available to them to raise concerns confidentially without fear of personal repercussions. This is referred to as 'whistleblowing'.

To make whistleblowing simpler for our employees, we launched HSBC Confidential across the Group in August 2015 to provide a global platform offering telephone, email, web and mail options for whistleblowers to bring together all our existing whistleblowing channels. We also maintain an external email address for complaints regarding accounting and internal financial controls or auditing matters (accountingdisclosures@hsbc.com). Matters raised are independently investigated by appropriate subject matter teams and details of investigations and outcomes including remedial action taken are reported to the CVC. Matters raised in respect of audit, accounting and internal control over financial reporting are reported to the Group Audit Committee.