Half-year Report - 2022 Interim Report - Part 3

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.

The implementation of our business strategy, which includes our business transformation plans, remains a key focus. As we implement change initiatives, we actively manage the execution risks. We also perform periodic risk assessments, including against strategies, to help ensure retention of key personnel for our continued safe operation.

We aim to use a comprehensive risk management approach across the organisation and across all risk types, underpinned by our culture and values. This is outlined in our risk management framework, including the key principles and practices that we employ in managing material risks, both financial and non-financial. The framework fosters continual monitoring, promotes risk awareness and encourages sound operational and strategic decision making. It also supports a consistent approach to identifying, assessing, managing and reporting the risks we accept and incur in our activities. We continue to actively review and develop our risk management framework and enhance our approach to managing risk.

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

Group Risk and Compliance 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 121 to 124 of the Annual Report and Accounts 2021.

We actively managed the risks related to the Russia-Ukraine war and broader macroeconomic and geopolitical uncertainties, as well as the continued risks resulting from the Covid-19 pandemic and other key risks described in this section. In addition, we enhanced our risk management in the following areas:

•    We have continued to improve our risk governance decision making, particularly with regard to the governance of treasury risk to ensure senior executives have appropriate oversight and visibility of macroeconomic trends around inflation and interest rates.

•    We continued to develop our approach to emerging risk identification and management, including the use of forward-looking indicators to support our analysis.

•    We enhanced our enterprise risk reporting processes to place a greater focus on our emerging risks, including by capturing the materiality, oversight and individual monitoring of these risks.

•    We have further strengthened our third-party risk policy and processes to improve control and oversight of our material third parties that are key to maintaining our operational resilience, and to meet new and evolving regulatory requirements.

•    We made progress with our comprehensive regulatory reporting programme to strengthen our global processes, improve consistency, and enhance controls.

•    We enhanced, and continued to embed, the governance and oversight around model adjustments and related processes for IFRS 9 models and Sarbanes-Oxley controls.

•    Our climate risk programme continues to shape our approach to climate risk across four key pillars: governance and risk appetite; risk management; stress testing; and disclosures.

•    We continued to improve the effectiveness of our financial crime controls, deploying advanced analytics capabilities into new markets. We are refreshing our financial crime policies, ensuring they remain up-to-date and address changing and emerging risks. We continue to monitor regulatory changes.

During the first half of 2022, 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 risks related to geopolitical and macroeconomic risk, Covid-19, climate risk and the interbank offered rate ('Ibor') transition.

Geopolitical and macroeconomic risk

The Russia-Ukraine war has had far-reaching geopolitical and economic implications. HSBC is monitoring the direct and indirect impacts of the war, and continues to respond to the extensive sanctions and trade restrictions that have been imposed, noting the challenges that arise in implementing the complex, novel and ambiguous aspects of certain of these sanctions. Numerous sanctions have been imposed against the Russian government and its officials, alongside individuals with close ties to the Russian government and a number of Russian financial institutions and companies. Russia has implemented certain countermeasures in response.

Our business in Russia principally serves multinational corporate clients headquartered in other countries and is not accepting new business or customers, and is consequently on a declining trend. Following a strategic review, HSBC Europe BV (a wholly-owned subsidiary of HSBC Bank plc) has entered into an agreement to sell its wholly-owned subsidiary HSBC Bank (RR) (Limited Liability Company), subject to regulatory approvals.

Global commodity markets have been significantly impacted by the Russia-Ukraine war and the Covid-19 pandemic, leading to sustained supply chain disruptions. This has resulted in product shortages appearing across several regions, and increased prices for both energy and non-energy commodities, such as food. We do not expect these to ease significantly at least until the end of 2022. In turn, this has had a significant impact on global inflation.

Rising global inflation is also prompting central banks to tighten monetary policy. The US Federal Reserve Board ('FRB') delivered a 75bps increase in the Federal Funds rate in June 2022, and a further 75bps increase in July, with several more rate rises expected in the second half of 2022 and into 2023. Financial markets currently expect the FRB to raise the Federal Funds rate above 3% by the end of 2022, although the pace of rate increases could decline if there is a sustained economic slowdown. The European Central Bank lagged the FRB but has started raising its benchmark rates, with a 0.5% increase in July 2022. Further incremental increases are now anticipated in light of inflation forecasts. Uncertainty over the economic outlook could nevertheless slow the pace of tightening, and keep fiscal policies broadly accommodative for some time. We continue to monitor our risk profile closely in the context of uncertainty over monetary policy.

Global tensions over trade, technology and ideology are manifesting themselves in divergent regulatory standards and compliance regimes, presenting long-term strategic challenges for multinational businesses.

The US-China relationship remains complex, with tensions over a number of critical issues. The US has recently articulated its approach to perceived strategic competition with China based on an intent to 'invest, align and compete'. The US, the UK, the EU, Canada and other countries have imposed various sanctions and trade restrictions on Chinese persons and companies. These include the freezing of assets of government officials, and the implementation of investment and import/export restrictions targeting certain Chinese companies.

There is a continued risk of additional sanctions being imposed by the US and other governments in relation to human rights and other issues with China, and this could create a more complex operating environment for the Group and its customers.

China has in turn announced a number of its own sanctions and trade restrictions that target, or provide authority to target, foreign individuals and companies. It has also promulgated laws that provide a legal framework for imposing further sanctions and export restrictions.

These and any future measures and countermeasures that may be taken by the US, China and other countries may affect the Group, its customers and the markets in which the Group operates.

As the geopolitical landscape evolves, 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, creating additional compliance, reputational and political risks for the Group. We maintain dialogue with our regulators in various jurisdictions on the impact of legal and regulatory obligations on our business and customers.

The impact of the Covid-19 pandemic and second order impacts from other geopolitical events remain uncertain and may lead to significant credit losses on specific exposures, which may not be fully captured in ECL estimates. To help mitigate this risk, model outputs and management adjustments are closely monitored and independently reviewed at the Group and country level for reliability and appropriateness. For further details on model risk, see page 209 of the Annual Report and Accounts 2021.

Political disagreements between the UK and the EU, notably over the future operation of the Northern Ireland Protocol, has stalled the creation of a framework for voluntary regulatory cooperation in financial services following the UK's withdrawal from the EU. While negotiations are continuing, it is unclear whether or when an agreement over the Northern Ireland Protocol will be reached, particularly as the UK government is currently in a period of political uncertainty amid a leadership election to replace Boris Johnson as prime minister.

In June 2022, the UK government published proposed legislation that seeks to amend the Protocol in a number of respects. The terms of such proposal may be subject to legal challenge by the EU, and any such dispute, together with any action that the EU may take in response, could further complicate the terms of trade between the UK and the EU and potentially prevent progress in other areas such as financial services. We are monitoring the situation closely, including the potential impacts on our customers. 

Our global presence and diversified customer base should help mitigate the direct impacts on our financial position of the absence of a comprehensive EU-UK agreement on financial services. Our wholesale and markets footprint in the EU provides a strong foundation for us to build upon. Over the medium to long term, the UK's withdrawal from the EU may impact markets and increase economic risk, particularly in the UK, which could adversely impact our profitability and prospects for growth in this market.

Expanding data privacy, national security and cybersecurity laws in a number of markets could pose potential challenges to intra-group data sharing. These developments could increase financial institutions' compliance burdens in respect of cross-border transfers of personal information, and degrade our enterprise-wide financial crime risk management capabilities.

Risks related to Covid-19

Despite the successful roll-out of vaccines around the world, the Covid-19 pandemic and its effect on the global economy have continued to impact our customers and organisation. The emergence of new variants and sub-variants pose a continuing risk. The global vaccination roll-out has helped reduce the social and economic impact of the Covid-19 pandemic, although there continues to be divergence in the speed at which vaccines have been deployed. Countries continue to differ in their approach to restrictions on activity and travel, and if these differences persist, this could prolong or worsen supply chain and international travel disruptions. Most notably, China's government-imposed lockdown restrictions in major cities, which were only eased recently, have impacted China's economy, Asian tourism and global supply chains.

Central banks in major markets - with the exception of mainland China - are raising interest rates, with the speed of such tightening varying across jurisdictions based on specific macroeconomic conditions. Policy tightening in several major emerging markets is also underway in order to counteract rising inflation and the risk of capital outflows. Governments are also expected to make fiscal support more targeted as the appetite for broad lockdowns and public health restrictions decreases. Government debt has risen in most advanced economies, and is expected to remain high into the medium term. High government debt burdens have raised fiscal vulnerabilities, increasing the sensitivity of debt service costs to interest rate increases, and potentially reducing the fiscal space available to address future economic downturns.

Our Central scenario used to calculate credit impairment assumes that economic growth continues in the second half of 2022, with GDP in our key markets surpassing pre-pandemic levels. It is assumed that private sector growth accelerates as pandemic-related fiscal support is withdrawn. However, there is a high degree of uncertainty associated with economic forecasts in the current environment and there are significant risks to our Central scenario. The degree of uncertainty varies by market, depending on exposure to commodity price increases, supply chain constraints, the monetary policy response to inflation and the public health policy response to the Covid-19 pandemic. As a result, our Central scenario for impairment has not been assigned an equal likelihood of occurrence across our key markets.

We continue to monitor the situation closely, and given the significant uncertainties related to the post-pandemic landscape, additional mitigating actions may be required.

For further details of our Central and other scenarios, see 'Measurement uncertainty and sensitivity analysis of ECL estimates' on page 67.

Climate risk

The pace of regulatory developments focusing on climate risk management, disclosures, and stress testing and scenario analysis continued to increase in 2022. The Russia-Ukraine war has impacted global commodity markets, with short-term supply concerns driving changes in energy policy in Europe. While these policy changes may affect the near-term climate transition path for HSBC and our customers, we remain committed to our climate ambition to align our own operations and supply chain to net zero by 2030, and the financed emissions from our portfolio of customers to net zero by 2050. As announced in March 2022, we intend to publish a climate transition plan in 2023, and have committed to a science-aligned phase-down of fossil fuel finance, and a review of our wider financing and investment policies critical to achieving net zero by 2050.

Our most material risks in terms of managing climate risk relate to corporate and retail client financing within our banking portfolio, but there are also significant responsibilities in relation to asset ownership by our insurance business and employee pension plans, as well as from the activities of our asset management business. We continue to monitor the impacts of climate risk, and further embed our approach across our key risk areas, priority regions and businesses.

We have refreshed our credit risk policy to further embed climate risk considerations into our corporate credit decisions for new money requests. We also delivered training to select colleagues in the Risk function to raise awareness of the likely impacts that climate risk could have on certain high transition risk sectors, as well as associated credit risk considerations. We continue to develop guidance for our other higher transition risk sectors. To help with risk assessment, our developing client transition and physical risk questionnaire is currently live for select customers in 10 sectors and 31 countries and territories to improve our understanding of transition risk and physical risk exposure.

We are also focused on embedding climate considerations into retail credit risk management processes and are implementing metrics to support monitoring of exposure to properties with heightened physical risk exposure within our mortgage portfolios.

We are considering transition risk by assessing the potential risk to the UK, which is our largest mortgage market, using current and potential energy efficiency ratings for individual properties, sourced from property energy performance certificate ('EPC') data. The UK government has set out policies and proposals that aim to deliver increased economic growth and decreased emissions in its 'Clean growth strategy', including a stated ambition to improve the EPC ratings of housing stock. In line with this, we are working towards improving the proportion of properties within our UK residential mortgage portfolio with an EPC rating of C or above, and on improving the EPC data coverage. We have approximately 54% of properties in our UK portfolio with a valid EPC certificate dated within the last 10 years, as at May 2022.

In addition to financial risks arising in our corporate and retail banking portfolio, we could also face increased reputational, legal and regulatory risks as we make progress towards our net zero ambition, as stakeholders are likely to place a greater focus on our actions, investment decisions and disclosures related to this ambition. We will also face these same risks if we are perceived to mislead stakeholders regarding our climate strategy, the climate impact of a product or service, or regarding the commitments of our customers. We have published internal guidance and established an advisory group to raise awareness and provide advice on these risks to existing governance forums.

We continued to develop our climate stress testing and scenario capabilities, including model development, and delivered regulatory climate stress tests. These are being used to further improve our understanding of our risk exposures for use in risk management and business decision making.

While climate risk reporting - and in particular reporting on financed emissions - has improved over time, we continue to focus on data quality and consistency with the development of our risk appetite and metrics.

Methodologies we have used may develop over time in line with market practice and regulations, as well as owing to developments in climate science. Any developments in data and methodologies could result in revisions to reported data going forward, including on financed emissions, meaning that reported figures may not be reconcilable or comparable year-on-year. We may also have to reevaluate our progress towards our climate-related targets in future and this could result in reputational, legal and regulatory risks.

Ibor transition

The publication of sterling, Swiss franc, euro and Japanese yen Libor interest rate benchmarks, as well as Euro Overnight Index Average ('Eonia'), ceased from the end of 2021. Our interbank offered rate ('Ibor') transition programme - which is tasked with the development of new near risk-free rate ('RFR') products and the transition of legacy Ibor products - has continued to support the transition of a limited number of remaining contracts in these benchmarks to RFRs, or alternative reference rates.

During the first half of 2022, we continued to develop processes, technology and RFR product capabilities throughout our Group, particularly in entities that have US dollar Libor contracts that require transition. We also implemented controls and associated monitoring to help ensure we do not undertake any new US dollar Libor contracts, outside of agreed upon exemptions, to control the related risks. We have begun to engage with our clients to support them through the transition of their US dollar Libor and other demising Ibor contracts, with progress being made on the transition of trade, hedging and uncommitted lending facilities. We continue to actively engage in market and industry discussions around the transition of the remaining demising Ibors, including ceasing the use of 'synthetic' sterling and Japanese yen Libor.

While we have fewer than 50 lending and derivatives contracts remaining in Ibors that demised from the end of 2021, we continue to engage with our clients and industry bodies to help ensure that contracts can be transitioned with fair client outcomes.

For the Group's own debt securities issuances, in 2021 HSBC launched a consent solicitation to remediate Ibor references in five of its English law-governed regulatory capital and MREL sterling and Singapore dollar instruments. The proposed amendments were successfully adopted on all of the sterling instruments, but were not adopted with respect to the Singapore dollar instruments, as the minimum quorum requirements were not met. One of these instruments has since been redeemed. The terms of the remaining instrument provide for an Ibor benchmark being used to reset the coupon rate if HSBC chooses not to redeem it on the call date. We remain mindful of the various factors that impact on the Ibor remediation strategy for our regulatory capital and MREL instruments, including - but not limited to - timescales for cessation of relevant Ibor rates, constraints relating to the governing law of outstanding instruments, the potential relevance of legislative solutions and industry best practice guidance. We remain committed in seeking to remediate or mitigate relevant risks relating to Ibor benchmark demise, as appropriate, on our outstanding regulatory capital and MREL instruments before the relevant calculation dates, which may occur post-cessation of the relevant Ibor rate or rates.

For US dollar Libor and other demising Ibors, we continue to be exposed to, and actively monitor, risks including:

•    Regulatory compliance and conduct risks: The transition of legacy contracts to RFRs or alternative rates, or sales of products referencing RFRs, may not deliver fair client outcomes.

•    Resilience and operational risks: Changes to manual and automated processes, made in support of new RFR methodologies, and the transition of large volumes of Ibor contracts may lead to operational issues.

•    Legal risk: Issues arising from the use of legislative solutions and from legacy contracts that the Group is unable to transition may result in unintended or unfavourable outcomes for clients and market participants. This could potentially increase the risk of disputes.

•    Model risk: As a result of changes to our models, to replace Ibor-related data, there is a risk that the accuracy of model output is adversely affected.

•    Market risk: As a result of differences in Libor and RFR interest rates, we are exposed to basis risk resulting from the asymmetric adoption of rates across assets, liabilities and products.

Based on our experience in transitioning contracts referencing Ibors that demised from the end of 2021, and an assessment of the risks that relate to the transition of US dollar Libor contracts, we do not believe that our risk position has materially changed during the first half of 2022. Increased market and industry use of alternative rates, including the Secured Overnight Funding Rate ('SOFR'), have further reduced potential risks related to the transition away from US dollar Libor. We will continue to monitor market initiatives, and have developed controls and plans to help mitigate these risks. We will monitor these risks through the development of our product capabilities and the transition of legacy contracts, with a focus on fair client outcomes.

Throughout the remainder of 2022, and into 2023, we are committed to engaging with our clients and investors to complete an orderly transition of contracts that reference the remaining demising Ibors.

Additionally, following the recent announcement relating to the cessation of the Canadian dollar offered rate ('CDOR') after June 2024, we are assessing the impacts and will take appropriate actions to effect the transition.