HSBC Holdings Regulatory News (HSBA)

We recognise that the primary role of risk management is to protect our customers, business, colleagues, shareholders and the communities that we serve, while ensuring we are able to support our strategy and provide sustainable growth. As we move forward with the transformation programme announced in February, it will be critical that we actively manage the execution risks arising from our transformation plans.

We use a comprehensive and newly updated risk management framework across the organisation and all risk types, underpinned by the Group's culture and values. This outlines the key principles, policies and practices that we employ in managing material risks, both financial and non-financial.

All our people are responsible for the management of risk, with the ultimate accountability residing with the Board. Our Global Risk function, led by the Group Chief Risk Officer, plays an important role in reinforcing the Group's culture and values. It focuses on creating an environment that encourages our people to speak up and do the right thing.

Global Risk is independent from the global businesses, including our sales and trading functions, to provide challenge, oversight and appropriate balance in risk/reward decisions.

A summary of our current policies and practices regarding the management of risk is set out in the 'Risk management' section on pages 73 to 76 of the Annual Report and Accounts 2019.

We have actively managed the risks resulting from the Covid-19 outbreak and its impacts on our customers and operations during the first half of 2020, as well as other key risks described in this section.

We supplemented our existing approach to risk management with additional tools and practices to mitigate and manage risks. We increased our focus on the quality and timeliness of the data used to inform management decisions, such as through increased frequency of governance touch points informed by early warning indicators and prudent active risk management of our risk appetite.

In addition, we enhanced our risk management in the following areas:

• In January 2020, we simplified our approach and articulation of risk management through the combination of our enterprise risk management framework and our operational risk management framework.

• Capital risk management practices continued to be enhanced across the Group through the Capital Risk Management function, focusing on both adequacy of capital and sufficiency of returns.

• The global model risk policy and associated standards were revised to improve how we manage model risk and meet enhanced external expectations. The new policy will be implemented over a six-month period commencing 1 May 2020.

• We continued to focus on simplifying our approach to non-financial risk management. We are driving more effective oversight and better end-to-end identification and management of non-financial risks.

• We combined the second line of defence Operational Risk and second line of defence Resilience Risk sub-functions. By bringing the two teams together, we expect to benefit from improved stewardship, better risk management capabilities and better outcomes for our customers.

• We continued to improve the effectiveness of our financial crime controls in accordance with our specific regulatory obligations. We continued to invest in both advanced analytics and artificial intelligence, which remain key components of our next generation of tools to fight financial crime.

During the first half of 2020, a number of areas were considered as part of our top and emerging risks because of the effect they have on the Group. In this section we have focused on geopolitical and macroeconomic risk, risks related to Covid-19, risks to our operations and portfolios in Asia-Pacific, the UK's withdrawal from the EU, model risk and interbank offered rate ('Ibor') transition.

Geopolitical and macroeconomic risk

The Covid-19 outbreak dominated the political and economic landscape for the first six months of 2020. The twin shocks of a public health emergency and the resultant economic fallout have been felt around the world, and hit both advanced and emerging markets. The closure of borders threatened medical and food supplies for many markets, and there is the potential for countries and territories to focus efforts on building resilient supply chains closer to home to be less vulnerable to global shocks.

The Covid-19 outbreak has heightened existing US-China tensions. US executive branch and congressional action has put pressure on the initial 'phase one' provisions under the trade agreement signed in January. Frictions span an increasing range of issues, including trade, technology and human rights. The Covid-19 outbreak has accelerated US efforts to reduce reliance on China in strategic industries such as sensitive technology, pharmaceuticals and precursor chemicals.

Hong Kong also emerged as an additional source of tension in US-China relations, with potential ramifications for the Group, including the impact of sanctions, as well as regulatory, reputational and market risks for the Group. While Hong Kong has experienced lower levels of social unrest in 2020, disagreements over the interpretation of the 'one country, two systems' model may continue to drive protest activity in the lead up to Hong Kong's legislative council elections. For further details see 'Risks to our operations in Asia-Pacific'.

While UK-China relations have historically been shaped by strong trade and investment, there are also emerging challenges. Following the passage of the Hong Kong national security law, the UK has offered residency rights and a path to citizenship to eligible British National (Overseas) passport holders in Hong Kong. In addition, both the UK and Hong Kong have suspended their extradition treaties with each other. The rollout of the UK 5G telecommunications network has also complicated relations. On 14 July, new restrictions on Chinese company Huawei were announced under the Telecoms Security Bill. These issues have the potential to impact bilateral commercial relationships adversely.

Emerging and frontier markets are suffering particularly heavily from the Covid-19 outbreak, in light of healthcare shortcomings, widespread labour informality, exposure to commodities production and often weak policy frameworks and buffers. Multilateral institutions have mobilised support for the weaker frontier markets, with the World Bank and G-20 marshalling efforts to implement a standstill on debt to public sector institutions. The International Monetary Fund has also, to date, lent $25bn in emergency funds to over 70 countries. However, negotiations on debt to the private sector will prove more difficult, and may result in sovereign debt restructuring and defaults for several countries. Most developed markets are expected to recover from the crisis, albeit after some permanent business closures and job losses. The majority of developed markets are also expected to not achieve pre-crisis growth rates or activity levels for the foreseeable future. These countries and territories should be able to shoulder the higher public deficits and debts necessary to offset private sector weaknesses, given the continuing low cost of servicing public debt. However, a group of weaker developed markets, including some members of the EU, entered the Covid-19 crisis on weak economic and fiscal footing and suffered high healthcare and economic costs. Although eurozone progress in mutualisation of the debt should help support recoveries and keep debt servicing costs down in the near term, there are concerns that permanently higher debt burdens will eventually lead to economies questioning their sustainability.

Following the UK's departure from the EU, an end to the transition period on 31 December 2020 without a free-trade agreement or an extension of the negotiating period would likely lead to a reversion of UK-EU trade to WTO rules from 2021. The absence of formal arrangements could further set back the expected gradual recovery of the UK and EU economies from recessions caused by the Covid-19 outbreak.

The contraction in the global economy has had varying effects on our customers, with many of them experiencing financial difficulties. This has resulted in an increase in expected credit losses ('ECL') and risk-weighted assets ('RWAs'). For further details on customer relief programmes, see page 66. For further details on RWAs, see page 79.

Risks related to Covid-19

The Covid-19 pandemic and its effect on the global economy have impacted our customers and our performance, and the future effects of the pandemic are uncertain. The outbreak necessitated governments to respond at unprecedented levels to protect public health, local economies and livelihoods. It has affected regions at different times and varying degrees as it has developed. The varying government measures in response have added challenges, given the rapid pace of change and significant operational demands. The speed at which countries and territories will be able to unwind their lockdown measures and return to pre-Covid-19 economic levels will vary based on the levels of infection and local political decisions. There remains a risk of subsequent waves of infection.

Government restrictions imposed around the world to limit the spread of Covid-19 resulted in a sharp contraction in global economic activity in the first half of 2020. At the same time governments also took steps designed to soften the extent of the damage to investment, trade and labour markets. Economic activity is expected to gradually recover in the second half of the year but there is significant uncertainty associated with the pace and scale of recovery. In our Central scenario, GDP contracts sharply in 2020 in all our major markets, except China, reflective of the widespread nature of government restrictions. GDP growth in China is expected to be positive in 2020, although the growth rate is expected to be significantly lower compared with previous years. Strong recovery in economic activity in our major markets is expected in 2021, but this is contingent on the successful containment of the virus and the evolution of other top risks, including the UK's relationship with the EU following the transition period, political unrest in Hong Kong and tensions between the US and China. It also relies on the willingness and ability of households and businesses to return towards pre-crisis spending levels. While GDP is expected to grow strongly in our major markets in 2021, the Central scenario projects a more gradual decline in the unemployment rate in these key markets. For further details on our central scenario see 'Measurement uncertainty and sensitivity analysis' on page 56.

There is a material risk of a renewed drop in economic activity. The economic fallout from Covid-19 risks increasing inequality across markets that have already suffered from social unrest. This will leave the burden on governments and central banks to maintain or increase fiscal and monetary stimulus. After financial markets suffered a sharp fall in the early phases of the spread of Covid-19, they rebounded but still remain volatile. Depending on the degree to which global economic growth suffers permanent losses, financial asset prices may suffer a further sharp fall.

Governments and central banks in major economies have deployed extensive measures to support their local populations. Measures implemented by governments included income support to households and funding support to businesses. Central bank measures included cuts to policy rates, support to funding markets and asset purchases. These measures are expected to be unwound gradually as government restrictions ease and as economic activity increases. Central banks are expected to maintain record-low interest rates for a considerable period of time and the debt burden of governments is expected to rise significantly.

We initiated market-specific measures to support our personal and business customers through these challenging times. These included mortgage assistance, payment holidays, the waiving of certain fees and charges, and liquidity relief for businesses facing market uncertainty and supply chain disruption. We are also working closely with governments, and supporting national schemes that focus on the parts of the economy most impacted by Covid-19. In the UK, this included providing access to the various government support schemes from the beginning. In Hong Kong, we provided prompt liquidity relief to businesses facing market uncertainty and supply chain pressures. For further details of our customer relief programmes, see page 66.

Central bank and government actions and support measures taken in response to the Covid-19 outbreak, and our responses to those, have created, and may in the future create restrictions in relation to capital. This has limited and may in the future limit management's flexibility in managing the business and taking action in relation to capital distribution and capital allocation. For example, in response to a written request from the Prudential Regulation Authority ('PRA'), we cancelled the fourth interim dividend for 2019 of $0.21 per ordinary share. Similar requests were also made to other UK incorporated banking groups. We also announced that until the end of 2020, we will make no quarterly or interim dividend payments or accruals in respect of ordinary shares. We also plan to suspend share buy-backs in respect of ordinary shares in 2020 and 2021.

It is recognised that all of the above measures and actions, and our responses to those, expose the Group to heightened risks. The rapid introduction and varying nature of the government support schemes, as well as customer expectations, can lead to risks as the Group implements large-scale changes in a short period of time. This has led to increased operational risks, including complex conduct considerations, increased reputational risk and increased risk of fraud. These risks are likely to be heightened further as and when those government support schemes are unwound. Central bank and government actions and support measures, and our responses to those, have also led to increased litigation risk, including lawsuits that have been and may continue to be brought in connection with our cancellation of the fourth interim dividend for 2019.

At 30 June 2020, our CET1 ratio was 15.0%, compared with 14.7% at 31 December 2019, and our liquidity coverage ratio ('LCR') was 148%. Our capital, funding and liquidity position is expected to help us to continue supporting our customers throughout the Covid-19 outbreak.

In many of our markets, the Covid-19 outbreak has led to a weakening in GDP, a key input used for calculating ECL, and there remains the risk of more adverse economic scenarios given its ongoing impact. Furthermore, ECL will also increase from other parts of our business impacted by the disruption to supply chains. The impact will vary by sectors of the economy, with heightened risk to the oil and gas, transport and discretionary consumer sectors being observed in the first stages of the outbreak. The impact of the outbreak on the long-term prospects of businesses in these sectors is uncertain and may lead to significant ECL charges on specific exposures, which may not be fully captured in ECL estimates. In addition, in times of crisis, fraudulent activity is often more prevalent, leading to potentially significant ECL charges.

The significant changes in economic and market drivers, customer behaviours and government actions caused by Covid-19 have also impacted the performance of financial models. These include retail and wholesale credit models such as IFRS loss models, as well as capital models, traded risk models and models used in the asset/liability management process. This has required more ongoing monitoring and more frequent testing across the Group, particularly for credit models. It also has resulted in the use of compensating controls, specifically as underlays on top of model outputs to provide a more appropriate assessment. By their nature, such compensating controls require a significant degree of management judgement and assumptions to be applied, and there is a risk that future actual results/performance may differ from such judgements and assumptions.

The performance and usage of models over the next 12 to 18 months will continue to be impacted by the consequences of the Covid-19 outbreak. It is too early in the current situation to be certain of the magnitude of change required for models at HSBC. However, it is likely that capital, credit risk and IFRS 9 models will need to be recalibrated, or in some cases may need to be replaced with the development of alternative models. The effectiveness of the existing models will depend in large part on the depth and length of the economic downturn faced by the world's economies.

As a result of the Covid-19 outbreak, business continuity plans have been implemented. Despite high levels of working from home, the majority of our service level agreements, both internal and external, are being maintained. We have experienced no major impacts to the supply chain from our third-party service providers. The risk of damage or theft to our physical assets or criminal injury to our employees remains unchanged. No significant incidents have impacted our buildings or staff. Expedited decisions to ensure the continuity of critical customer services are being documented through governance.

There remain significant uncertainties in assessing the duration of the Covid-19 outbreak and its impact, and how this will evolve through 2020 and beyond. The actions taken by the various governments and central banks, in particular in the UK, mainland China, Hong Kong and the US, provide an indication of the potential severity of the downturn and post-recovery environment, which from a commercial, regulatory and risk perspective could be significantly different to past crises and persist for a prolonged period. A prolonged period of significantly reduced economic activity as a result of the impact of the outbreak would have a materially adverse effect on our financial condition, results of operations, prospects, liquidity, capital position and credit ratings. This would, in turn, have an impact on our ability to meet our financial targets as set out in our business update in February 2020 and also adversely affect our future dividend policy. We continue to monitor the situation closely, and given the novel or prolonged nature of the outbreak, additional mitigating actions may be required.

Risks to our operations and portfolios in Asia-Pacific

The global Covid-19 outbreak has fuelled existing tensions within the US-China bilateral relationship. Disagreements over trade, technology, human rights and the status of Hong Kong could result in people, sanctions, regulatory, reputational and market risks for the Group. The extent to which both countries can overcome these tensions and coordinate their responses to the outbreak is likely to have an important bearing on the post-Covid-19 global economy and geopolitical order.

The rapid rollout of 5G in 2020 and its importance to future standard setting and economic growth is likely to lead to heightened corporate and national competition over ownership of the relevant technologies.

Hong Kong has also emerged as an additional source of tension in US-China relations, with potential ramifications for the Group. In June, China passed the Hong Kong national security law, which is now in force in Hong Kong. In response, the US took steps to terminate the preferential treatment afforded to Hong Kong under the 1992 Hong Kong Policy Act. Additionally, the US President signed into law the Hong Kong Autonomy Act and issued an Executive Order, providing authority to impose primary sanctions against entities and individuals determined to have undermined Hong Kong's autonomy. The Act also provides authority to impose secondary sanctions against non-US financial institutions determined to have conducted a significant transaction for any individual or entity subject to primary sanctions under the Act. Disagreements over the interpretation of the 'one country, two systems' model is likely to affect protest activity in Hong Kong, and may prompt further US executive branch or congressional action. Tensions in the UK-China relationship have been heightened over disagreements about future UK 5G networks and Hong Kong. In response to the introduction of the Hong Kong national security law, the UK has offered residency rights and a path to citizenship to eligible British National (Overseas) passport holders in Hong Kong. The UK and Hong Kong extradition treaties have also recently been suspended.

As geopolitical tensions rise, the compliance by multinational corporations with their legal or regulatory obligations in one jurisdiction may be seen as supporting the law or policy objectives of that jurisdiction over another jurisdiction, creating additional risks for the Group. Geopolitical tensions will continue to present challenges for HSBC.

Process of UK withdrawal from the EU

The UK left the EU on 31 January 2020 and entered a transition period until 31 December 2020, during which negotiations have been taking place on the future relationship. At this stage it remains unclear what that relationship will look like, potentially leaving firms with little time to adapt to changes, which may enter into force on 1 January 2021.

Our programme to manage the impact of the UK leaving the EU has now been largely completed. The programme base case scenario assumes the UK exits the transition period without the existing passporting or regulatory equivalence framework that supports cross-border business. Priority has been given to ensuring we can continue to service our European Economic Area ('EEA')-based customers once this framework falls away, with three main areas of activity:

• extension of our product and balance sheet capabilities in continental Europe, mainly in HSBC France and its branches in the Netherlands and Ireland;

• migration of HSBC Bank plc's EEA clients to HSBC France and other affiliates within the EU; and

• the transfer of HSBC Bank plc's EEA branch businesses to HSBC France.

These objectives were largely completed by the end of 2019. The current priority is to complete the migration of remaining customers to one of our entities in the EU.

Product offering and client migration

To accommodate customer migrations and new business after the UK's departure from the EU, we expanded and enhanced our existing product offering in France, the Netherlands and Ireland.

The UK's departure from the EU's financial services regulatory framework at the end of the transition period without alternative equivalence-type arrangements, or a trade deal being in place, is likely to have an impact on our clients' operating models, including their working capital requirements, investment decisions and access to financial markets infrastructure. Our priority is to provide continuity of service, while minimising the level of change for our customers.

Due to our base case scenario we are required to migrate some EEA-incorporated clients from the UK to HSBC France, or another EEA entity. This has now mostly been completed for clients we expect can no longer be serviced from the UK. We are working in close collaboration with any remaining clients to make the transition as smooth as possible before the end of December 2020. We have been in close contact with these clients since the beginning of the transition period and will support them in the final phase of their migration to one of our entities in the EU. We are also considering the application of regulatory regimes in certain EU member states that allow cross-border business with third-country firms and the extent to which those may permit continued servicing of some EEA clients from the UK following the transition period.

Employees

The migration of EEA-incorporated clients requires us to strengthen our local teams in the EU, and France in particular. Given the scale and capabilities of our existing business in France, we are well prepared to take on additional roles and activities. Looking beyond the transfer of roles to the EU, we are also providing support to our employees who are UK citizens resident in EEA countries, and employees who are citizens of an EU member state resident in the UK.

Across the programme, we have made good progress in terms of ensuring we are prepared for the UK leaving the transition period under the terms described above. However, there remain execution risks, many of them linked to the uncertain outcome of negotiations.

Model risk

The economic consequences of the Covid-19 outbreak on macroeconomic variables that are used in models are outside of the bounds for which IFRS 9 models have been built and calibrated to operate. Moreover, the complexities of current governmental support programmes and regulatory guidance on the treatment of customer impacts, such as forbearance, payment holidays and the unpredictable pathways of the Covid-19 outbreak, have not previously been factored into the modelling. Consequently, IFRS 9 models under the current economic conditions are generating outputs that do not accurately assess the actual level of credit quality. Therefore, overlays based on expert analysis are necessary to reflect ECL.

In the short term, the focus is on refining model inputs and outputs in a consistent and explainable manner, including the use of model overlays. Wider ranging model changes for risk and loss models will take time to develop and need more real data on which models can be trained to be meaningful. Given the remaining significant uncertainties of Covid-19 and its impacts, it is too early to determine if model recalibration or redevelopment will be required.

Ibor transition

The Financial Stability Board has observed that the decline in interbank short-term unsecured funding poses structural risks for interest rate benchmarks that reference these markets. In response, regulators and central banks in various jurisdictions have convened national working groups to identify alternative benchmark rates (near risk-free rates or RFRs) for these Ibors and, where appropriate, to facilitate an orderly transition to these rates.

Following the announcement by the UK's Financial Conduct Authority ('FCA') in July 2017 that it will no longer persuade or require banks to submit rates for London interbank offered rate ('Libor') after 2021, the national working groups for the affected currencies were tasked with facilitating an orderly transition of the relevant Libors to their chosen RFRs. The euro working group is also responsible for facilitating an orderly transition of the Euro Overnight Index Average ('Eonia') to the euro short-term rate ('€STER') as a result of Eonia not being made compliant with the EU Benchmark Regulation.

Regulators have reiterated that firms cannot rely on Libor being published after the end of 2021 but acknowledge that Covid-19 may impact on transition plans.

National working groups, regulators and governments have also recognised that certain Libor contracts genuinely have no, or inappropriate, alternatives and no realistic ability to be renegotiated or amended prior to Libor's cessation. In response, the US government and the European Commission intend to implement legislation that gives market participants the confidence to transition these 'tough legacy' contracts to the recommended benchmark replacement without the fear of legal repercussions. Similarly, in June 2020, the UK government announced that it would grant powers to the FCA to enable continued publication of a Libor number using a different and more robust methodology and inputs, and therefore reduce disruption to any holders of these tough legacy contracts. However, there is no certainty as to whether the FCA will exercise these powers or what form the revised methodology would take, and the FCA has consequently encouraged users of Libor to renegotiate or amend as many contracts as possible before Libor's cessation.

HSBC established the Ibor transition programme with the objective of facilitating an orderly transition from Libor and Eonia for HSBC and its clients. During the first half of 2020, our Libor transition has continued to develop, as detailed below.

Develop RFR product capabilities

Our global businesses continue to develop their capabilities to offer RFR-based products and the supporting processes and systems. The Covid-19 outbreak has impacted the speed with which we are able to develop these capabilities and many of our customers' readiness to adopt RFR-based products. Consequently, the sale of Libor and Eonia contracts with maturities beyond 2021, known as legacy contracts, will continue for longer than initially anticipated. This is likely to increase the volume of legacy contracts that will need to be transitioned.

Transition legacy contracts

The programme is also continuing to develop the capability to transition legacy Libor and Eonia contracts on a larger scale. The Covid-19 outbreak has also affected the pace with which many of our customers will have been preparing to adopt RFR-based products. Therefore, it has likely affected the pace at which they will transition their legacy contracts to RFRs. Consequently, we expect legacy contract transition to occur over a shortened time period. In combination with the greater number of legacy contracts requiring transition, this increases the overall level of execution risk on the transition process, which could potentially increase the level of conduct and operational risks.

In addition to the heightened conduct and operational risks, the process of adopting new reference rates may expose the Group to an increased level of financial risk, such as potential earnings volatility resulting from contract modifications and changes in hedge accounting relationships. Furthermore, the transition to RFRs could have a range of adverse impacts on our business, including legal proceedings or other actions regarding the interpretation and enforceability of provisions in Ibor-based contracts and regulatory investigations or reviews in respect of our preparation and readiness for the replacement of Ibor with RFRs. We continue to engage with industry participants, the official sector and our clients to support an orderly transition and the mitigation of the risks resulting from the transition.

Overview

Credit risk is the risk of financial loss if a customer or counterparty fails to meet an obligation under a contract. Credit risk arises principally from direct lending, trade finance and leasing business, but also from certain other products, such as guarantees and derivatives.

Credit risk in the first half of 2020

During 1H20, due to the unique market conditions in the Covid-19 outbreak, we expanded operational practices to provide short-term support to customers under the current policy framework. For further details of market-specific measures to support our personal and business customers, see page 66. There have been no material changes to credit risk policy.

A summary of our current policies and practices for the management of credit risk is set out in 'Credit risk management' on page 84 of the Annual Report and Accounts 2019.

Gross loans and advances to customers of $1,032bn decreased from $1,045bn at 31 December 2019. This decrease included adverse foreign exchange movements of $31bn. Loans and advances to banks of $77bn increased from $69bn at 31 December 2019. This included adverse foreign exchange movements of $2bn.

The change in expected credit losses and other credit impairment charges ('ECL') in the income statement for the period was $6.9bn. For further details, see the financial summary on page 25.

Summary of credit risk

The following disclosure presents the gross carrying/nominal amount of financial instruments to which the impairment requirements in IFRS 9 are applied and the associated allowance for ECL. The following tables analyse loans by industry sector and represent the concentration of exposures on which credit risk is managed.

The allowance for ECL increased from $9.4bn at 31 December 2019 to $14.5bn at 30 June 2020.

The allowance for ECL at 30 June 2020 comprised $13.5bn in respect of assets held at amortised cost, $0.7bn in respect of loan commitments and financial guarantees, and $0.2bn in respect of debt instruments measured at fair value through other comprehensive income ('FVOCI').

1 Total ECL is recognised in the loss allowance for the financial asset unless total ECL exceeds the gross carrying amount of the financial asset, in which case the ECL is recognised as a provision.

2 Includes only those financial instruments that are subject to the impairment requirements of IFRS 9. 'Prepayments, accrued income and other assets', as presented within the consolidated balance sheet on page 94, includes both financial and non-financial assets.

3 Represents the maximum amount at risk should the contracts be fully drawn upon and clients default.

4 Debt instruments measured at FVOCI continue to be measured at fair value with the allowance for ECL as a memorandum item. Change in ECL is recognised in 'Change for expected credit losses and other credit impairment charges' in the income statement.

The following table provides an overview of the Group's credit risk by stage and industry, and the associated ECL coverage. The financial assets recorded in each stage have the following characteristics:

• Stage 1: These financial assets are unimpaired and without a significant increase in credit risk for which a 12-month allowance for ECL is recognised.

• Stage 2: A significant increase in credit risk has been experienced on these financial assets since initial recognition

for which a lifetime ECL is recognised.

• Stage 3: There is objective evidence of impairment and the financial assets are therefore considered to be in default or otherwise credit impaired for which a lifetime ECL is recognised.

• POCI: Financial assets that are purchased or originated at a deep discount are seen to reflect the incurred credit losses on which a lifetime ECL is recognised.

1 Represents the maximum amount at risk should the contracts be fully drawn upon and clients default.

2 Purchased or originated credit impaired ('POCI').

Unless identified at an earlier stage, all financial assets are deemed to have suffered a significant increase in credit risk when they are 30 days past due ('DPD') and are transferred from stage 1 to stage 2. The following disclosure presents the ageing of stage 2 financial assets by those less than 30 and greater than 30 DPD and therefore presents those financial assets classified as stage 2 due to ageing (30 DPD) and those identified at an earlier stage (less than 30 DPD).

1 Days past due ('DPD'). Up-to-date accounts in stage 2 are not shown in amounts.

2 The days past due amounts presented above are on a contractual basis and include the benefit of any customer relief payment holidays granted.

1 Represents the maximum amount at risk should the contracts be fully drawn upon and clients default.

2 Purchased or originated credit impaired ('POCI').

1 Days past due ('DPD'). Up-to-date accounts in stage 2 are not shown in amounts.

Measurement uncertainty and sensitivity analysis of ECL estimates

The recognition and measurement of ECL involves the use of significant judgement and estimation. We form multiple economic scenarios based on economic forecasts, apply these assumptions to credit risk models to estimate future credit losses, and probability-weight the results to determine an unbiased ECL estimate.

Methodology

Our methodology in relation to the adoption and generation of economic scenarios is described on page 92 of the Annual Report and Accounts 2019. There have been no significant changes during the 1H20 period. While in keeping with HSBC's methodology, the exceptional nature of the current economic environment has led to extensive application of management's judgement in determining the range of possible outcomes, the number and severity of scenarios selected and the probability weights assigned.

Description of consensus economic scenarios

The economic assumptions presented in this section have been formed by HSBC, with reference to external forecasts specifically for the purpose of calculating ECL. The emergent nature of the Covid-19 outbreak at the end of 2019 meant that, consistent with other banks, HSBC's view of the distribution of risks, as disclosed in the Annual Report and Accounts 2019, did not, on a forward-looking basis, consider the impact of the virus. Our consensus Central scenario at the 2019 year-end projected moderate growth over a five-year horizon, with strong prospects for employment and a gradual increase in policy interest rates by central banks in the major economies of Europe and North America. The onset of the virus has led to a fundamental reassessment of our central forecast and the distribution of risks.

Economic forecasts are subject to a high degree of uncertainty in the current environment. Limitations of forecasts and economic models require a greater reliance on management judgement in addressing both the error inherent in economic forecasts and in assessing associated ECL outcomes.

The main factors that affect uncertainty across our key markets are:

• epidemiological concerns, including a possible resurgence of Covid-19 later in 2020 and in 2021;

• the ability of new or continued restrictions in individual markets to affect global growth due to deep cross-border trade and financial linkages;

• the ability of governments and central banks to continue to limit the economic damage through support measures;

• the potential for other geopolitical and macroeconomic risks to affect growth and economic stability as the world recovers from Covid-19-related restrictions; and

• market-specific differences in the progression of Covid-19 and the associated responses by public authorities that imply differentiation in the degree of uncertainty across our key markets. Earlier progression of Covid-19 in Hong Kong and in mainland China meant that economic forecasts for these markets demonstrated greater stability over the course of 2Q20 compared with the UK, where a rapidly evolving situation has led to a higher degree of uncertainty.

Economic forecasts and data released since the creation of scenarios in May confirmed the view of elevated uncertainty in some markets such as in the UK, where monthly GDP and unemployment data suggested a larger degree of estimation error than usual in short-term forecasts. The volatility in economic data and forecasts received since the generation of scenarios has been considered by management and is reflected in management's choice of scenarios, in probability weights and in its assessment of ECL outcomes.

The scenarios used to calculate ECL in the Interim Report 2020 are described below.

The consensus Central scenario

HSBC's Central scenario features a 'V-shaped' shock to economic activity, as characterised by a deep, initial contraction in GDP, followed by a sharp recovery. This V-shape in activity reflects the unique nature of this downturn and is driven by restrictions on mobility and activity imposed by governments to reduce the spread of Covid-19. The Central scenario further assumes that the stringent restrictions on activity, employed across several countries and territories in the first half of 2020, will not be repeated, allowing economic activity to rebound. Minimal long-term damage to economic prospects is expected, allowing economic growth across our key markets to return to forecast trend rates. Cross-region differences in the depth of the contraction, and the speed and scale of subsequent recovery, reflect timing differences in the progression of the Covid-19 outbreak, national level differences in restrictions imposed and the scale of support measures.

Global GDP is expected to contract by 3.9% in 2020 and grow by 4.8% in 2021 in the Central scenario. The average rate of global GDP growth is expected to be 2.7% over the forecast period 2020-2025, which is slightly lower than the average growth rate over the 2015-2019 period.

The unique circumstances surrounding the current fall in economic activity make it difficult to compare current prospects for global economic activity with previous recessions. However, we note that the depth of the contraction in economic activity and the subsequent recovery are both expected to be sharper than experienced during the last global economic downturn of 2008-2009 across our key markets (see chart below).Across the key markets, we note:

• Economic activity has fallen significantly in 1H20 across our major markets. The earlier outbreak of the virus in China and Hong Kong suggests that the trough in economic activity in these markets occurred in 1Q20, while in other major markets, the lowest point in activity is expected to have occurred in 2Q20. The Central scenario projects an annual contraction in GDP across almost all our major markets in 2020, the only exception being China, where annual GDP growth is expected to be positive, despite the strong fall in activity experienced in the first quarter of the year. GDP is expected to be positive across all our major markets in 2021.

• The unemployment rate is expected to rise sharply in most of our major markets, before reverting gradually to pre-crisis levels over the forecast horizon.

• Inflation is expected to fall sharply in 2020 in line with the slowdown in economic activity, before increasing to gradually converge to central bank targets in our key markets over the forecast period.

• Governments have provided extensive support to households and corporates in our key markets. Fiscal deficits are expected to increase sharply in 2020 before reducing in the later years of the projection period. Sovereign indebtedness is expected to increase sharply as a result.

• Major central banks have lowered their main policy interest rates, implemented emergency support measures for funding markets, and either restarted or increased quantitative easing programmes, in order to support economies and the financial system. Interest rate policy is expected to be highly accommodative over the projection horizon.

• The West Texas Intermediate oil price is forecast to average $37 per barrel over the projection period.

The Central scenario was first created with forecasts available in May, and subsequently updated in June to reflect significant changes to forecasts. The UK unemployment rate was the only variable to have been amended as a result of this update. Probability weights assigned to the Central scenario reflect both the higher level of uncertainty in the current global economic environment and relative differences across markets. Weights assigned to the Central scenario vary from 55% to 70%.

The following table describes key macroeconomic variables and the probabilities assigned in the consensus Central scenario.

Note: N/A - not required in credit models.

Note: Real GDP shown as year-on-year percentage change.

The consensus Upside scenario

Compared with the consensus Central scenario, the consensus Upside scenario features a faster recovery in economic activity during the first two years, before converging to long-run trends. Despite this feature, the scenario forecasts 2020 as a year in which global GDP growth contracts and several quarters elapse before economic activity reaches the level attained at the end of 2019, prior to the onset of the Covid-19 outbreak.

The scenario is consistent with a number of key upside risk themes. These include orderly global abatement of Covid-19 via successful containment and/or the development of a vaccine, deescalation of tensions between the US and China, continued support from fiscal and monetary policy, positive resolution of economic uncertainty in the UK, stronger oil prices and deescalation of geopolitical tensions in Hong Kong.

Probability weights assigned to the Upside scenario range from 0% to 10%. These weights reflect management's view of the

potential for more positive outcomes relative to the Central scenario in our key markets.

The consensus Downside scenario

Global real GDP growth contracts significantly in 2020 in the Downside scenario, accompanied by a sharp increase in unemployment, and falls in asset and consumer prices, before gradually recovering towards its long-run trend. Compared with the Central scenario, the recovery in economic activity is considerably weaker.

The scenario is consistent with our key downside risks. These include renewed outbreaks of Covid-19 and/or slower easing of restriction of travel and activity, an intensification of tensions between the US and China, a worsening of economic uncertainty in the UK, further risks to economic growth in Hong Kong and weaker commodity prices.

A broad range of weights has been assigned to the consensus Downside scenario. These range from 0% to 35% and reflect management's view of the dispersion of risks and severity across key markets.

UK management Downside scenario

The consensus Downside scenario was replaced with a management Downside scenario for the UK only, to reflect management's view of the dispersion of risks. Management took the view that this scenario provided a better representation of risks that lie in between the Central and the alternative Downside scenario. In this scenario, UK GDP falls 9.6% in 2020 and UK unemployment peaks at 8.5% in 2021. This scenario has been assigned a 20% probability.

Alternative Downside scenario

An alternative Downside scenario has been created to reflect management's view of extreme risks. This 'U-shaped' scenario assumes that a number of HSBC's top risks crystallise simultaneously and results in an extremely severe and prolonged recession. This scenario has been assigned a 5% probability across all markets except the UK where it has been assigned a 10% weighting.

The range of macroeconomic projections across the various scenarios are shown in the table below:

Note: The worst point refers to the quarter that is either the trough or peak in the respective variable. The figures provided represent the worst point across all four outer scenarios: the consensus Upside, the consensus Downside, the UK management Downside and the alternative Downside. These figures should not be directly compared with the annual averages presented in the previous table for the Central scenario. N/A - not required in credit models.

Note: Real GDP shown as year-on-year percentage change.

Critical accounting estimates and judgements

The calculation of ECL under IFRS 9 involves significant judgements, assumptions and estimates, as set out in the Annual Report and Accounts 2019 under 'Critical accounting estimates and judgements'. The level of estimation uncertainty and judgement has increased since 31 December 2019 as a result of the economic effects of the Covid-19 outbreak, including significant judgements relating to:

• the selection and weighting of economic scenarios, given rapidly changing economic conditions in an unprecedented manner, uncertainty as to the effect of government and central bank support measures designed to alleviate adverse economic impacts, and a widening in the distribution of economic forecasts. The key judgement is whether the economic effects of the pandemic are more likely to be temporary or prolonged, and the shape of recovery;

• estimating the economic effects of those scenarios on ECL, where there is no observable historical trend that can be reflected in the models that will accurately represent the effects of the economic changes of the severity and speed brought about by the Covid-19 outbreak. Modelled assumptions and linkages between economic factors and credit losses may underestimate or overestimate ECL in these conditions, and there is significant uncertainty in the estimation of parameters such as collateral values and loss severity; and

• the identification of customers experiencing significant increases in credit risk and credit impairment, particularly where those customers have accepted payment deferrals and other reliefs designed to address short-term liquidity issues, or have extended those deferrals, given limitations in the available credit information on these customers. The use of segmentation techniques for indicators of significant increases in credit risk involves significant estimation uncertainty.

How economic scenarios are reflected in ECL

The methodologies for the application of forward economic guidance into the calculation of ECL for wholesale and retail loans and portfolios are set out on page 95 of the Annual Report and Accounts 2019. These models are based largely on historical observations and correlations with default rates.

The severe projections at 30 June 2020 of macroeconomic variables are outside the historical observations on which IFRS 9 models have been built and calibrated to operate. Moreover, the complexities of governmental support programmes and regulatory guidance on treatment of customer impacts (such as forbearance and payment holidays) and the unpredictable pathways of the pandemic have never been modelled. Consequently, HSBC's IFRS 9 models, in some cases, generate outputs that appear overly conservative when compared with other economic and credit metrics. Post-model adjustments are required to ensure that an appropriate amount of ECL impairment is recognised.

These data and model limitations have been addressed in the short term using in-model and post-model adjustments. This includes refining model inputs and outputs and using post-model adjustments based on management judgement and higher level quantitative analysis for impacts that are difficult to model. To ensure a consistent framework, we identified the model segments where results were overly conservative based on historical benchmarks and defined the worst economic inputs where the model output is considered reliable. For example, in the case of probability of default ('PD') models for bank and sovereign exposures, based on the historical calibration data, the model was defined as producing meaningful results when the GDP growth input is not worse than five standard deviations below the long-term average. Re-running the models with these capped economic limits established boundary conditions used by credit experts as a starting point for further adjustments based on their own structured judgement and granular analysis. For the wholesale portfolio, this analysis produced a 'credit experts best estimate' to act as a benchmark against the modelled outcomes, and inform post-model adjustments. In the short term, the focus is on refining model inputs and outputs in a consistent and explainable manner, using post-model adjustments. Wider-ranging model changes will take time to develop and need more real data on which models can be trained.

Models will be recalibrated over time once the full impacts of Covid-19 are observed, but that will not occur in 2020. Therefore, we anticipate significant in-model and post-model adjustments for the foreseeable future.

Post-model adjustments

In the context of IFRS 9, post-model adjustments are short-term increases or decreases to the ECL at either a customer or portfolio level to account for late breaking events, model deficiencies and expert credit judgement applied following management review and challenge. We have internal governance in place to regularly monitor post-model adjustments and, where possible, to reduce the reliance on these through model recalibration or redevelopment, as appropriate. Depending on the path of the Covid-19 outbreak and the shape of the economic recovery, we anticipate the composition of modelled ECL and post-model adjustments may be revised significantly over 2020, particularly when the economy resumes positive GDP growth and the uncertainty over long-term unemployment abates.

Post-model adjustments made in estimating the reported ECL at 30 June 2020 are set out in the following table. The table includes adjustments in relation to data and model limitations resulting from Covid-19 economic conditions, and as a result of the regular process of model development and implementation. It shows the adjustments applicable to the scenario-weighted ECL numbers. Adjustments in relation to Downside scenarios are more significant, as results are subject to greater uncertainty.

Post-model adjustments at 31 December 2019 were an increase of $75m for the wholesale portfolio and $131m for the retail portfolio.

The adjustments relating to low-credit-risk exposures are mainly to highly rated banks, sovereigns and US government-sponsored entities, where modelled credit factors do not fully reflect the underlying fundamentals of these entities or the effect of government support and economic programmes in the Covid-19 environment.

Adjustments to corporate exposures principally reflect the outcome of the 'credit experts best estimate' review on wholesale corporate exposures. Post-model adjustments, both positive and negative, have been made where modelled rating migration, and ECL outputs based on historical relationships, produced results that were overly sensitive. This can be the case when using economic inputs that are well outside the range of historical experience. For retail lending, the net impact of model adjustments was much less significant. The adjustment, under low-risk counterparties and economies, was to reduce ECL on insurance portfolios due to model over-prediction of downgrades in the bank and sovereign portfolios.

The main retail lending post-model adjustment was in relation to the UK where modelled PD outputs for the Downside scenarios were adjusted to address model limitations, so as to be consistent with longer-term relationships between unemployment and defaults.

Economic scenarios sensitivity analysis of ECL estimates

Management considered the sensitivity of the ECL outcome against the economic forecasts as part of the ECL governance process by recalculating the ECL under each scenario described above for selected portfolios, applying a 100% weighting to each scenario in turn. The weighting is reflected in both the determination of a significant increase in credit risk and the measurement of the resulting ECL.

The ECL calculated for the Upside and Downside scenarios should not be taken to represent the upper and lower limits of possible ECL outcomes. The impact of defaults that might occur in future under different economic scenarios is captured by recalculating ECL for loans in stages 1 and 2 at the balance sheet date. The population of stage 3 loans (in default) at the balance sheet date is unchanged in these sensitivity calculations. Stage 3 ECL would only be sensitive to changes in forecasts of future economic conditions if the loss-given default ('LGD') of a particular portfolio was sensitive to these changes.

There is a particularly high degree of estimation uncertainty in numbers representing tail risk scenarios when assigned a 100% weighting.

For wholesale credit risk exposures, the sensitivity analysis excludes ECL and financial instruments related to defaulted obligors because the measurement of ECL is relatively more sensitive to credit factors specific to the obligor than future economic scenarios. Therefore, it is impracticable to separate the effect of macroeconomic factors in individual assessments.

For retail credit risk exposures, the sensitivity analysis includes ECL for loans and advances to customers related to defaulted obligors. This is because the retail ECL for secured mortgage portfolios including loans in all stages is sensitive to macroeconomic variables.

Wholesale and retail sensitivity

The wholesale and retail sensitivity analysis is stated inclusive of post-model adjustments, as appropriate to each scenario. The results tables exclude portfolios held by insurance business and small portfolios

In both the wholesale and retail analysis, the comparative period results for alternative Downside scenarios are not directly comparable to the current period, because they reflect different risk profiles relative with the Consensus scenarios for the period end.

Wholesale analysis

1 ECL sensitivities exclude portfolios utilising less complex modelling approaches.

2 ECL sensitivity includes off-balance sheet financial instruments that are subject to significant measurement uncertainty.

3 For the UK, this is the UK management Downside scenario.

4 Includes low credit-risk financial instruments, such as debt instruments at FVOCI, which have high carrying values but low ECL under all the scenarios.

In the wholesale portfolio, at 30 June 2020, the alternative Downside scenario reflected the most significant levels of ECL sensitivity, in absolute terms, in the UK, Hong Kong and mainland China due to potential for deterioration of the credit quality on those markets and levels of exposure.

ECL sensitivities demonstrated an increase from the 2019 year-end across all countries and territories, primarily due to the deterioration of economic forecasts under all scenarios.

The UK observed the highest sensitivity when compared with 4Q19, mainly due to the deterioration of economic forecasts, with an emphasis on the unemployment rate in the June 2020 economic forecasts.

The higher ECL sensitivities can all be observed for the alternative Downside scenario, which represents a prolonged recovery period and sharper impact relative to other scenarios.

Retail analysis