HSBC Holdings Regulatory News (HSBA)

Liquidity and funding

Liquidity risk is the risk that the Group does not have sufficient financial resources to meet its obligations as they fall due, or will have to do so at an excessive cost. The risk arises from mismatches in the timing of cash flows.

Funding risk is the risk that funding considered to be sustainable (and therefore used to fund assets) proves not to be sustainable over time.

There have been no material changes to the policies and practices for the management of liquidity and funding risks described in the Annual Report and Accounts 2014.

A summary of our current policies and practices regarding liquidity and funding is provided on page 215 of the Annual Report and Accounts 2014.

Our liquidity and funding risk management framework

The objective of our liquidity framework is to allow us to withstand very severe liquidity stresses. It is designed to be adaptable to changing business models, markets and regulations.

Our liquidity and funding risk management framework requires:

• liquidity to be managed by operating entities on a stand-alone basis with no implicit reliance on the Group or central banks;

• all operating entities to comply with their limits for the advances to core funding ratio; and

• all operating entities to maintain a positive stressed cash flow position out to three months under prescribed Group stress scenarios.

Liquidity and funding in the first half of 2015

The liquidity position of the Group remained strong in 1H15, as demonstrated by the key liquidity and funding metrics presented below. During the period, reported customer accounts decreased by 1% ($15bn) while reported loans and advances to customers decreased by 2% ($21bn), leading to a small reduction in our advances to deposits ratio to 71% (30 June 2014: 74%; 31 December 2014: 72%).

Wholesale senior funding markets

Conditions in wholesale debt markets deteriorated through the second quarter as the uncertainty around Greece affected market confidence. The path of interest rates and broader global economic uncertainty means further volatility can be expected; however global bank funding needs and regulatory proposals for increased loss absorbing capacity suggest continued volumes of primary market supply. We retained good access to debt capital markets with Group entities issuing $9.6bn of public transactions, of which $4.3bn was in the form of senior unsecured debt.

Liquidity regulation

The European adoption of the Basel Committee framework (legislative texts known as the Capital Requirements Regulation and Directive - CRR/CRD IV) was published in June 2013, requiring the reporting of the liquidity coverage ratio ('LCR') and the net stable funding ratio ('NSFR') to European regulators from 30 June 2014. A significant level of interpretation was involved in reporting and calculating the LCR as defined in the CRR text as certain areas were only addressed by the finalisation of the LCR regulation in January 2015. This will not become a regulatory standard until 1 October 2015. The European calibration of NSFR is pending following the Basel Committee's final recommendation in October 2014. We monitor NSFR in line with the relevant text from the Basel Committee of Banking Supervision (BCBS295), pending its implementation in Europe. Both Group NSFR and Group LCR as reported were above 100%.

Management of liquidity and funding risk

Our liquidity and funding risk management framework ('LFRF') employs two key measures to define, monitor and control the liquidity and funding risk of each of our operating entities. The advances to core funding ratio is used to monitor our structural long-term funding position, and the stressed coverage ratio, incorporating Group-defined stress scenarios, is used to monitor our resilience to severe liquidity stresses.

The three principal entities listed in the tables below represented 64% (30 June 2014: 67%; 31 December 2014: 66%) of the Group's customer accounts. Including the other principal entities, the figure was 93% (30 June 2014: 96%; 31 December 2014: 95%).

Advances to core funding ratio

The table below shows the extent to which loans and advances to customers in the listed principal banking entities were financed by reliable and stable sources of funding.

Advances to core funding ratios8

Advances to core funding ratios8 (continued)

For footnote, see page 86.

There were no material movements in 1H15 for any of the principal banking entities and all entities remained within their advances to core funding limits. The limits set for principal operating entities at 30 June 2015 ranged from 80% to 120%.

Stressed coverage ratios

The ratios tabulated below express stressed cash inflows as a percentage of stressed cash outflows over both one- month and three-month time horizons. Operating entities are required to maintain a ratio of 100% or more out to three months.

Inflows included in the numerator of the stressed coverage ratio are generated from liquid assets net of assumed haircuts, and cash inflows related to assets contractually maturing within the time period.

In general, customer advances are assumed to be renewed and as a result do not generate a cash inflow.

Stressed one-month and three-month coverage ratios8

The coverage ratio for HSBC UK increased due to strong growth in deposits over the period.

Sources of funding

Our primary sources of funding are customer current accounts and customer savings deposits payable on demand or at short notice. We issue wholesale securities (secured and unsecured) to supplement our customer deposits and change the currency mix, maturity profile or location of our liabilities.

The level of customer accounts continued to exceed the level of loans and advances to customers. The positive funding gap was predominantly deployed into liquid assets, cash and balances with central banks and financial investments, as required by the LFRF.

Loans and other receivables due from banks continued to exceed deposits taken from banks. The Group remained a net unsecured lender to the banking sector.

Consolidated funding sources and uses

Market risk

Market risk is the risk that adverse 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 the policies and practices for the management of market risk described in the Annual Report and Accounts 2014.

A summary of our market risk management framework including current policies is provided on page 221 of the Annual Report and Accounts 2014.

Market risk in the first half of 2015

Global markets were influenced by the Greek crisis and concerns about the slowdown in the mainland Chinese economy. Markets remained volatile given the uncertainties in the global economic outlook compounded by volatility in the oil and gas markets.

We maintained an overall defensive risk profile that resulted in a continued reduction in our trading value at risk ('VaR'). Non-trading VaR increased slightly during the first half of the year, driven by the expectations of an increase in US rates.

As a consequence of the Greek crisis, the yields on lower rated European government bonds increased but remained well below previous crisis peaks.

Although the Chinese government intervened through policy adjustments, mainly around interest rates and reserve requirements, the mainland Chinese equity markets fell during the latter part of the period under review.

In addition, divergent monetary policies were seen in the US and Europe. The US Federal Reserve Board continued to discuss a move to normalise monetary policy with an expected interest rate rise in 2015. This contrasted with the eurozone implementing its asset purchase programme earlier in the year.

Capital flows to emerging markets remained weak and are likely to stay uncertain as they await the timing of a possible US interest rate increase later this year.

Trading portfolios

Value at risk of the trading portfolios

Trading VaR resides within Global Markets. The VaR for trading activity at 30 June 2015 was lower than at 31 December 2014 due primarily to declines in interest rate trading VaR.

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

Trading VaR, 99% 1 day

For footnote, see page 86.

Back-testing

There were no loss or profit exceptions for the Group in 1H15.

Non-trading portfolios

Value at risk of the non-trading portfolios

Non-trading VaR of the Group includes contributions from all global businesses. There is no commodity risk in thenon-trading portfolios. The VaR for non-trading activity at 30 June 2015 was slightly higher than at 31 December 2014 driven by an increase in non-trading interest rate VaR, partially offset by an increase in diversification benefit.

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

Non-trading VaR, 99% 1 day

For footnote, see page 86.

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.

Non-trading interest rate risk

Our policies regarding the funds transfer priority process for managing non-trading interest rate risk and liquidity and funding risk are described on pages 226 and 219, respectively, of the Annual Report and Accounts 2014.

Third-party assets in Balance Sheet Management

Third-party assets in BSM in total did not change during 1H15, primarily as a result of the reclassification of $10bn of assets in Brazil to held for sale, offset by an increase of $6bn in financial investments due to increased deployment of commercial surplus funds into securities in Hong Kong. Notwithstanding the reclassification, BSM continues to manage Brazilian assets pending entity disposal.

Third-party assets in Balance Sheet Management

Sensitivity of net interest income

The table below sets out the effect on our future net interest income ('NII') of an incremental 25 basis points parallel rise or fall in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 July 2015.

The sensitivities shown represent the change in the base case projected NII 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 repricing rate of assets and liabilities used is derived from current yield curves. The interest rate sensitivities are indicative and based on simplified scenarios.

Assuming no management response, a sequence of such rises ('up-shock scenario') would increase planned net interest income for the 12 months to 30 June 2016 by $1,027m (to 31 December 2015: $885m), while a sequence of such falls ('down-shock scenario') would decrease planned net interest income by $1,905m (to 31 December 2015: $2,089m).

The NII sensitivity of the Group can be split into three key components; the structural sensitivity arising from the four global businesses excluding BSM and Global Markets, the sensitivity of the funding of the trading book (Global 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. The sensitivity of BSM depends on its position. Typically, assuming no management response, the sensitivity of BSM is negative in a rising rate environment and positive in a falling rate environment.

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

The NII sensitivity in BSM arises from a combination of the techniques that BSM uses to mitigate the transferred interest rate risk and the methods it uses to optimise net revenues in line with its 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 comprises 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 NII 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 is shown in the figures below.

The scenario sensitivities remained broadly unchanged in 1H15.

Sensitivity of projected net interest income

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

The table below describes the sensitivity of our reported reserves to the stipulated movements in yield curves and the maximum and minimum month‑end figures during the period. The sensitivities are indicative and based on simplified scenarios.

Sensitivity of reported reserves to interest rate movements

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' NII to future changes in yield curves and interest rate gap repricing for interest rate risk.

Foreign exchange risk

Total foreign exchange VaR arising within HSBC Holdings in the first half of 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.

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 is managed on a repricing gap basis. The interest rate repricing gap table below analyses the full-term structure of interest rate mismatches within HSBC Holdings' balance sheet.

Repricing gap analysis of HSBC Holdings

Operational risk

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

Activity to further enhance and embed our Operational Risk Management Framework ('ORMF') continued in the first half of 2015. Responsibility for minimising operational risk lies with HSBC's management and staff.

All regional, global business, country, business unit and functional heads are required to manage the operational risks and internal controls of the business and operational activities for which they are responsible.

The diagrammatic representation of our ORMF is provided on page 187 of the Annual Report and Accounts 2014.

A summary of our current policies and practices regarding operational risk is provided on page 228 of the Annual Report and Accounts 2014.

Operational risk profile in the first half of 2015

During 1H15, our operational risk profile continued to be dominated by compliance risks and we continued to see losses that relate to events from prior years (significant events are outlined in Notes 17 and 19 on the Financial Statements). A number of mitigating actions are being undertaken to prevent future conduct-related incidents.

Operational risks include:

· 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 13, 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: while compared with the industry our loss performance remains strong in most markets, 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. We continue to be a target of increasingly sophisticated cyber-attacks such as 'distributed denial of service', in common with other banks and multinational organisations, 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, including lessons learnt from attacks experienced within the industry and information sharing with other financial institutions, government agencies and external

intelligence providers. Our UK operation is currently participating in an external penetration testing scheme called CBEST developed by the PRA that is aimed at assessing the ability of critical financial institutions to detect and defend against cyber-attacks;

· third-party risk management: we are strengthening our third-party risk management capability, particularly the management of vendor risks, including the implementation of the supplier performance management programme with our most important suppliers. Attention is also being paid to the screening of suppliers to enable us to identify if any of them are on a sanctions list and we should therefore exit such relationships. Vendor risk management is a core element of third-party risk management.

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

Compliance risk

Compliance risk is the risk that we fail to observe the letter and spirit of all relevant laws, codes, rules, regulations and standards of good market practice, and incur fines and penalties and suffer damage to our business as a consequence. Compliance risk falls within the definition of operational risk.

All Group companies and employees are required to observe the letter and spirit of all relevant laws, codes, rules, regulations and standards of good market practice. These include those relating to AML, counter-terrorist and proliferation financing, sanctions compliance, anti-bribery and corruption, conduct of business and market conduct. The compliance risk policies and practices are described on pages 189 and 229 of the Annual Report and Accounts 2014. There were no material changes to our policies and practices for the management of compliance risk in the first half of 2015 with the exception of the implementation of the new AML and sanctions policy procedures as outlined below.

Enhanced global AML and sanctions policies were approved in 2014. Global businesses and all in-scope countries had implemented new AML and sanctions policy procedures by the end of March 2015. The application of procedures required to embed them in our day to day business operations globally will remain a key focus during the rest of 2015. The overriding policy objective is for every employee to engage in only 'the right kind of business, conducted in the right way'.

Programmes to enhance the Group's standards of regulatory conduct ensuring the delivery of fair outcomes for customers and orderly and transparent operations in financial markets continued to progress in 1H15.

We have experienced increasing levels of compliance risk in recent years as regulators and other agencies pursued investigations into historical activities, and we have continued to work with them in relation to these matters. They are described in 'Areas of special interest' on page 59.

It is clear that the level of inherent compliance risk that we face will continue to remain high for the foreseeable future. However, we consider that good progress is being made and will continue to be made in ensuring that we are well placed to effectively manage those risks.

Whistleblowing

HSBC operates global disclosure lines (telephone and email) which are available to allow employees to raise concerns regarding potential wrongdoing when the normal channels for escalation are unavailable or inappropriate. Matters raised are independently investigated by appropriate subject matter teams. Outcomes including remedial action taken are reported to the Conduct & Values Committee, in respect of AML and sanctions matters to the Financial System Vulnerabilities Committee and in respect of audit and accounting matters to the Group Audit Committee.

Reputational risk

Reputational risk is the risk of failure to meet stakeholder expectations as a result of any event, behaviour, action or inaction, either by HSBC itself, our employees or those with whom we are associated, that might cause stakeholders to form a negative view of the Group. This may have financial or non-financial implications or have other consequences such as loss of confidence.

The reputational risk policies and practices are described on pages 199 and 235 of the Annual Report and Accounts 2014.

We have a zero tolerance for knowingly engaging in any business, activity or association where foreseeable reputational damage has not been considered and mitigated. There must be no barriers to open discussion and the escalation of issues that could affect the Group negatively. While there is a level of risk in every aspect of business activity, appropriate consideration of potential harm to HSBC's good name must be a part of all business decisions.

We have restructured our Reputational Risk Function and created a Reputational Risk Management team. This team's mandate is to provide bespoke advisory services to the business on reputational risks to the bank and to work with the Financial Crime and Regulatory Compliance teams to mitigate such risks where possible.