HSBC Holdings Regulatory News (HSBA)

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Pillar 3 Disclosures at 31 December 2019 continued… 

The Incremental Risk Charge

The incremental risk charge ('IRC') measures the default and migration risk of issuers of traded instruments.

IRC risk factors include credit migration, default, product basis, concentration, hedge mismatch, recovery rate and liquidity. The PDs are floored to reflect the lack of historical data on defaults and a period of stress is used to calibrate the spread changes for the relevant ratings. The IRC model is validated quarterly by stressing key model parameters and reviewing the response of the model.

The IRC is a stand-alone charge generating no diversification benefit with other charges. IRC relies on a range of liquidity horizons from three months, corresponding to the regulatory floor, to one year. A wide range of criteria can indicate the liquidity of a position. The liquidity horizon for the IRC measure depends on a set of factors such as issuer features, including rating, sector, geography and size of positions, including product, maturity and concentration.

The IRC transition matrices are calibrated using transition and default data published by three rating agencies (S&P, Moody's and Fitch) as the starting point, in combination with internal rules for flooring. The average of the three matrices is computed for each sector. The PDs are then floored: sovereign PDs are consistent with IRB, while a 3 basis point floor is applied to corporates' and banks' PDs.

The IRC correlation matrix is derived from historical CDS spreads data, covering the latest two-year VaR period. The returns estimation window is set equal to either three or 12 months, depending on the liquidity horizon of each obligor. First, each obligor is mapped to six sector/rating categories; then the correlation matrix is obtained by computing the arithmetic mean of correlations for each category.

IRC increased during the first half of the year, driven mainly by exposures to the U.S., Japan and Brazil sovereigns. After peaking in Q3, IRC decreased mainly as a result of the Rates business actively reducing our exposures arising from U.S. government debt asset swaps.

Structural foreign exchange exposures represent net investments in subsidiaries, branches and associates whose functional currency is not the US dollar. An entity's functional currency is normally that of the primary economic environment in which it operates.

Exchange differences on structural exposures are recognised in 'Other comprehensive income'. We use the US dollar as our presentation currency in our consolidated financial statements because the US dollar and currencies linked to it form the major currency bloc in which we transact and fund our business.

Our consolidated balance sheet is, therefore, affected by exchange differences between the US dollar and all the non-US dollar functional currencies of underlying subsidiaries.

Our structural foreign exchange exposures are managed with the primary objective of ensuring, where practical, that our consolidated capital ratios and the capital ratios of individual banking subsidiaries are largely protected from the effect of changes in exchange rates. We hedge structural foreign exchange exposures only in limited circumstances.

Details of our structural foreign exchange exposures are provided in the Market risk section, on page 136 of the Annual Report and Accounts 2019.

Interest rate risk in the banking book ('IRRBB') is the potential adverse impact of changes in interest rates on earnings and capital. The component of IRRBB that can be economically neutralised in the market is transferred to BSM to manage, in accordance with internal transfer pricing rules. In its management of IRRBB, the Group aims to balance mitigating the effect of future interest rate movements, which could reduce net interest income against the cost of hedging. The monitoring of the projected net interest income and economic value of equity sensitivity under varying interest rate scenarios is a key part of this.

More details on our IRRBB and the net interest income sensitivity may be found on page 136 and page 140 of the Annual Report and Accounts 2019.

HSBC has documented policies and maintains systems and controls for the calculation of the prudent valuation adjustment ('PVA'). Prudent value represents a conservative estimate with a 90% degree of certainty of a price that would be received to sell an asset or paid to transfer a liability in orderly transactions occurring between market participants at the balance sheet date. HSBC's methodology addresses fair value uncertainties arising from a number of sources: market price uncertainty, bid-offer uncertainty, model risk, concentration, administrative costs, unearned credit spreads and investing and funding costs.

The net PVA charge was broadly unchanged due to some offsetting movements, notably:

• a $130m increase in mid-market value notably driven by deferral of day one profits which are no longer eligible to offset any additional valuation adjustment following an EBA statement;

• offset by a $110m reduction in other additional valuation adjustments, driven by a reduction in underlying exposures and reduced spreads.

The types of financial instruments for which the highest PVA is observed include (i) multi callable interest rate derivatives, (ii) asset backed securities and valuation adjustments related to non-collateralised derivatives.

Non-financial 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. Sound non-financial risk management is central to achieving good outcomes for our customers. Non-financial risk is relevant to every aspect of our business and is managed through the operational risk management framework ('ORMF'). It covers a wide spectrum of issues, such as resilience risk, financial crime and fraud, regulatory compliance, reporting and tax risk, legal risk, model risk, people risk and failure in other principle risk processing. 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 non-financial risk.

Operational risk is part of non-financial risk. Table

65

 reports our operational risk capital requirements by region and global business.

Responsibility for managing non-financial risk lies with our people. During 2019, we continued to strengthen our approach to managing non-financial risk as set out in the ORMF. The framework sets out our approach to governance and risk appetite. It provides a single view of non-financial risks that matter the most and associated controls. The enhancement and embedding of the risk appetite framework for non-financial risk, and the improvement of the consistency of the adoption of the end-to-end risk and control assessment processes were a particular focus in 2019. While there remains more to do, we made progress in strengthening the control environment and the management of non-financial risk.

Activity to strengthen the three lines of defence model continued to be a key focus in 2019. The first line of defence owns the risk and is accountable for identifying, assessing, managing key existing and emerging risks. The second line of defence sets the policy and control standards to manage risks, and provides advice and guidance to support these policies. It also challenges the first line to ensure it is managing risk effectively. The third line of defence is Internal Audit, which provides independent assurance to the Board and management that our risk management approach and processes are designed and operating effectively.

The Non-Financial Risk Management Board ('NFRMB') is a formal governance committee established to provide strategic direction and oversight of the management of non-financial risk and is a sub-committee of the Group Risk Management Meeting ('GRMM').

Operational risk is organised as a specific risk discipline within Global Risk and is headed by the Group Head of Operational Risk. The Group Head of Operational Risk is responsible for establishing and maintaining the ORMF, as well as monitoring the level of operational losses and the effectiveness of the internal control environment supported by their second line of defence functions. The Group Head of Operational Risk is accountable to the Group Chief Risk Officer in respect of this element of the overall enterprise-wide risk management framework.

We have codified our ORMF in a high-level standard, supplemented by detailed policies. These policies explain our approach to identifying, assessing, monitoring and controlling non-financial risk, and give guidance on mitigating actions to be taken when weaknesses are identified.

Monitoring non-financial risk exposure against risk appetite on a regular basis, and setting out our risk acceptance process, drives risk awareness in a more forward-looking manner. This assists management in determining whether further action is required.

Risk scenario analysis across material legal entities provides a top down, forward-looking assessment of risks to help determine whether they are being effectively managed within our risk appetite or whether further management action is required. In each of our subsidiaries, business managers are responsible for maintaining an appropriate level of internal control, commensurate with the scale and nature of operations. They are responsible for identifying and assessing risks, designing controls and monitoring the effectiveness of these controls. The ORMF helps managers to fulfil these responsibilities by defining a standard risk assessment methodology and providing a tool for the systematic reporting of operational loss data.

Risk and control assessment approach

Non-financial risk and control assessments 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 non-financial risks, an assessment of the effectiveness of controls, and a tracking mechanism for action plans so that they can proactively manage non-financial risks within acceptable levels. Appropriate means of mitigation and controls are considered. These include:

• making specific changes to strengthen the internal control environment; and

• investigating whether cost-effective insurance cover is available to mitigate the risk.

Recording

We use a Group-wide risk management system to record the results of our non-financial risk management process. Non-financial risk and control assessments, as described above, are input and maintained by business units. Business management monitors and follows up the progress of documented action plans. Operational risk losses are entered into the Group-wide risk management system and reported to governance on a monthly basis. Loss capture thresholds are in line with industry standards.

HSBC has an internal liquidity and funding risk management framework ('LFRF'), which aims to allow it to withstand very severe liquidity stresses. It is designed to be adaptable to changing business models, markets and regulations. The management of liquidity and funding is primarily undertaken locally (by country) in our operating entities in compliance with the Group's LFRF, and with practices and limits set by the GMB through the RMM and approved by the Board. Our general policy is that each defined operating entity should be self-sufficient in funding its own activities.

The key aspects of the internal LFRF which is used to ensure that HSBC maintains an appropriate overall liquidity risk profile are:

• each entity must manage liquidity and funding risk on a stand-alone basis without reliance on other members of the group or central banks, unless pre-approved;

• minimum liquidity coverage ratio ('LCR') requirement; and

• minimum net stable funding ratio ('NSFR') requirement or other appropriate metric.

The internal LFRF and the risk tolerance limits were approved by the Group Risk Committee and the Board on the basis of recommendations made by the RMM.

Asset, Liability and Capital Management ('ALCM') teams are responsible for the application of the LFRF at a local operating entity level. The elements of the LFRF are underpinned by a robust governance framework, the two major elements of which are:

• Group, regional and entity level asset and liability management committees ('ALCOs'); and

• an internal liquidity adequacy assessment process ('ILAAP') used to validate risk tolerance and set risk appetite.

All operating entities and Group are required to prepare an internal liquidity adequacy assessment ('ILAA') document at an appropriate frequency. The final objective of the ILAA, approved by the relevant Board of Directors, is to verify that the entity and subsidiaries maintain liquidity resources which are adequate in both amount and quality at all times, ensuring that there is no significant risk that its liabilities cannot be met as they fall due, maintaining a prudent funding profile.

Management of liquidity and funding risk

Liquidity coverage ratio

The LCR aims to ensure that a bank has sufficient unencumbered high-quality liquid assets ('HQLA') to meet its liquidity needs in a 30 calendar day liquidity stress scenario. For the calculation of the LCR, HSBC follows the EU Regulation LCR Delegated Act 2015/61.

Net stable funding ratio

HSBC uses the NSFR or other appropriate metric as a basis for ensuring operating entities raise sufficient stable funding to support their business activities. The NSFR or other appropriate metric requires institutions to maintain a minimum amount of stable funding based on assumptions of asset liquidity.

Currency mismatch in the LCR

The Group's internal liquidity and funding risk management framework requires all operating entities to monitor the LCR for material currencies. Limits are set to ensure that outflows can be met, given assumptions on stressed capacity in the FX swap markets.

Governance

ALCM teams apply the LFRF at both an individual entity and Group level. Regional and local ALCM teams are responsible for the implementation of Group-wide and local regulatory policy at a legal entity level. Balance Sheet Management ('BSM') has responsibility for cash and liquidity management.

Liquidity Risk Management carry out independent review, challenge and assurance of the appropriateness of the risk management activities undertaken by ALCM and BSM. Their work includes setting control standards, advice on policy implementation, and review and challenge of reporting.

Internal Audit provide independent assurance that risk is managed effectively.

More details on the concentration of funding and liquidity sources may be found on page 133 of the Annual Report and Accounts 2019.

Analysis of on-balance sheet encumbered and unencumbered assets and off-balance sheet collateral

On-balance sheet encumbered and unencumbered assets

The table on the following page summarises the total on-balance sheet assets capable of supporting future funding and collateral needs, and shows the extent to which they are currently pledged for this purpose. This disclosure aims to facilitate an understanding of available and unrestricted assets that could be used to support potential future funding and collateral needs.

Off-balance sheet collateral

The fair value of assets accepted as collateral that we are permitted to sell or repledge in the absence of default was $468bn at 31 December 2019 (2018: $483bn). The fair value of any such collateral actually sold or repledged was $295bn (2018: $329bn). We are obliged to return equivalent securities. These transactions are conducted under terms that are usual and customary to standard reverse repo, stock borrowing and derivative transactions.

The fair value of collateral received and re-pledged in relation to reverse repos, stock borrowing and derivatives is reported on a gross basis. The related balance sheet receivables and payables are reported on a net basis where required under IFRS offset criteria. As a consequence of reverse repo, stock borrowing and derivative transactions where the collateral received could be sold or re-pledged but had not been, we held $173bn (2018: $154bn) of unencumbered collateral available to support potential future funding and collateral needs at 31 December 2019.

Under the terms of our current collateral obligations under derivative contracts (which are ISDA compliant CSA contracts and contracts entered into for pension obligations), and based on an estimate of the positions at 31 December 2019, we calculate that we could be required to post additional collateral of up to $0.2bn (2018: $0.2bn) in the event of a one-notch downgrade in third-party agencies' credit rating of HSBC's debt. This would increase to $0.4bn (2018: $0.4bn) in the event of a two-notch downgrade.

For further details on liquidity and funding risk management, see page 131 onwards of the Annual Report and Accounts 2019.

At 31 December

2019

, we had equity investments in the non-trading book of $

5.9

bn (

2018

: $5.0bn). These consist of investments held for the purposes shown in Table

68

.

We make investments in private equity primarily through managed funds that are subject to limits on the amount of investment. We risk-assess these commitments to ensure that industry and geographical concentrations remain within acceptable levels for the portfolio as a whole, and perform regular reviews to substantiate the valuation of the investments within the portfolio.

Exchange traded investments amounted to $0.5bn (2018: $0.7bn), with the remainder being unlisted. These investments are held at fair value in line with market prices.

On a regulatory consolidation basis, the net realised gain from disposal of equity securities amounted to $0.1bn (2018: $0.1bn). Unrealised gains on FVOCI equities of $0.6bn at 31 December 2019 were fully recognised in CET1.

Details of our accounting policy for equity investments measured at FVOCI and the valuation of financial instruments may be found on page 244 of the Annual Report and Accounts 2019. A detailed description of the valuation techniques applied to private equity may be found on page 269 of the Annual Report and Accounts 2019.

1 Includes holdings in government-sponsored enterprises and local stock exchanges.

We operate an integrated bancassurance model that provides insurance products principally for customers with whom we have a banking relationship.

The insurance contracts we sell relate to the underlying needs of our banking customers, which we can identify from our point-of-sale contacts and customer knowledge. The majority of sales are of savings and investment products and term and credit life contracts.

By focusing largely on personal and small- and medium-sized enterprises ('SMEs') lines of business, we are able to optimise volumes and diversify individual insurance risks.

We choose to manufacture these insurance products in HSBC subsidiaries based on an assessment of operational scale and risk appetite. Manufacturing insurance allows us to retain the risks and rewards associated with writing insurance contracts by keeping part of the underwriting profit and investment income within the Group.

We have life insurance manufacturing subsidiaries in Argentina, mainland China, France, Hong Kong, Malaysia, Malta, Mexico, Singapore and the UK. We also have a life insurance manufacturing associate in India.

Where we do not have the risk appetite or operational scale to be an effective insurance manufacturer, we engage with a handful of leading external insurance companies in order to provide insurance products to our customers through our banking network and direct channels. These arrangements are generally structured with our exclusive strategic partners and earn the Group a combination of commissions, fees and a share of profits. We distribute insurance products in all of our geographical regions.

Insurance products are sold through all global businesses, but predominantly by RBWM and CMB through our branches and direct channels worldwide.

The risk profile of our insurance manufacturing businesses is measured using an economic capital approach. Assets and liabilities are measured on a market value basis, and a capital requirement is defined to ensure that there is a less than one-in-200 chance of insolvency over a one-year time horizon, given the risks to which the businesses are exposed. The methodology for the economic capital calculation is largely aligned to the pan-European Solvency II insurance capital regulations.

Subsidiaries engaged in insurance activities are excluded from the regulatory consolidation by excluding assets, liabilities and post-acquisition reserves, leaving the investment of these insurance subsidiaries to be recorded at cost and deducted from CET1 subject to thresholds (amounts below the thresholds are risk-weighted).

Further details of the management of financial risks and insurance risk arising from the insurance operations are provided on page 146 of the Annual Report and Accounts 2019.

Climate change can create physical risks such as severe weather events of increasing severity and/or frequency. Transition risk, in the context of climate change, is the possibility that a customer's ability to meet its financial obligations will deteriorate due to the global movement from a high-carbon economy to a low-carbon economy.

We are a signatory to the disclosure recommendations by the Financial Stability Board's Task Force on Climate-related Financial Disclosures.

Refer to page 22 of the Annual Report and Accounts 2019 for our disclosure under the framework.

Credit risk

Table 69 sets out IRB exposures by obligor grade for central governments and central banks, institutions and corporates, all of which are assessed using our 23-grade CRR master scale. We benchmark the master scale against the ratings of external rating agencies. Each CRR band is associated with an external rating grade by reference to long-run default rates for that grade, represented by the average of issuer-weighted historical default rates. The correspondence between the agency long-run default rates and the PD ranges of our master scale is obtained by matching a smoothed curve based on those default rates with our master scale reference PDs. This association between internal and external ratings is indicative and may vary over time. In these tables, the ratings of S&P are cited for illustration purposes, although we also benchmark against other agencies' ratings in an equivalent manner.