Annual Financial Report - Part 5

We use a top and emerging risks process to provide a forward-looking view of issues with the potential to threaten the execution of our strategy or operations over the medium to long term.

We proactively assess the internal and external risk environment, as well as review the themes identified across our regions and global businesses, for any risks that may require global escalation. We update our top and emerging risks as necessary.

Our current top and emerging risks are as follows.

Externally driven

Geopolitical and macroeconomic risks

The Russia-Ukraine war has had far-reaching geopolitical and economic implications. HSBC is monitoring the impacts of the war and continues to respond to the further economic sanctions and trade restrictions that have been imposed on Russia in response. In particular, significant sanctions and trade restrictions imposed against Russia have been put in place by the UK, the US and the EU, as well as other countries. Such sanctions and restrictions have specifically targeted certain Russian government officials, politically exposed persons, business people, Russian oil imports, energy products, financial institutions and other major Russian companies. In addition, there have been put in place more generally applicable investment, export, and import bans and restrictions. In response to such sanctions and trade restrictions, as well as asset flight, Russia has implemented certain countermeasures.

Further sanctions, trade restrictions and Russian countermeasures may adversely impact the Group, its customers and the markets in which the Group operates by creating regulatory, reputational and market risks. Our business in Russia principally serves multinational corporate clients headquartered in other countries, 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 and governmental approvals.

Global commodity markets have been significantly impacted by the Russia-Ukraine war and localised Covid-19 outbreaks, leading to continued 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 in the near term. In turn, this has had a significant impact on global inflation. Relatively mild weather, until recently, and diversification of fuel sources have nevertheless helped regions most dependent on Russian supply to substantially reduce risks of rationing over the winter months.

China's policy measures issued at the end of 2022 have increased liquidity and the supply of credit to the mainland China commercial real estate sector. Recovery in the underlying domestic residential demand and improved customer sentiment will be necessary to support the ongoing health of the sector. We will continue to monitor the sector closely, notably the risk of further idiosyncratic real estate defaults and the potential associated impact on wider market, investor and consumer sentiment. Given that parts of the global economy are in, or close to, recession, the demand for Chinese exports may also diminish.

Rising global inflation has prompted central banks to tighten monetary policy. Since the beginning of 2022, the US Federal Reserve Board ('FRB') has delivered a cumulative 450 basis point ('bps') increase in the Federal Funds rate. The European Central Bank lagged the FRB initially, but its benchmark rate has subsequently been increased by 300bps since July 2022. As of mid-February 2023, interest-rate futures suggested market uncertainty as to whether the FRB would begin to ease monetary policy over the 12-month horizon. Should monetary policy rates move materially higher than current expectations, a realignment of market expectations could cause turbulence in financial asset prices.

Financial markets have also shown reduced appetite for expansionary fiscal policies in the context of high debt ratios. Following the fiscal statement of 23 September 2022 by the UK government, there was a fall in the value of sterling and a sharp rise in the yields of UK government securities, known as gilts. Following this, the Bank of England reversed its plan to begin selling its gilt holdings from September 2022, and the UK government reversed most of the previously announced fiscal measures. We continue to monitor our risk profile closely in the context of uncertainty over global macroeconomic policies.

Higher inflation and interest rate expectations around the world - and the resulting economic uncertainty - have had an impact on expected credit losses and other credit impairment charges ('ECL'). The combined pressure of higher inflation and interest rates may impact the ability of our customers to repay debt. Our Central scenario, which has the highest probability weighting in our IFRS 9 'Financial Instruments' calculations of ECL, assumes low growth and a higher inflation environment across many of our key markets. However, due to the rapidly changing economic conditions, the potential for forecast dispersion and volatility remain high, impacting the degree of accuracy and certainty of our Central scenario forecast. The level of volatility 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 the same likelihood of occurrence across our key markets. There is also uncertainty with respect to the relationship between the economic drivers and the historical loss experience, which has required adjustments to modelled ECL in cases where we determined that the model was unable to capture the material underlying risks.

For further details of our Central and other scenarios, see 'Measurement uncertainty and sensitivity analysis of ECL estimates' on page 153.

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. To date, the UK, the US, the EU and other countries have imposed various sanctions and trade restrictions on Chinese persons and companies. Although sanctions and trade restrictions are difficult to predict, increases in diplomatic tensions between China and the US and other countries could result in sanctions that could negatively impact the Group, its customers and the markets in which the Group operates. There is a continued risk of additional sanctions and trade restrictions being imposed by the US and other governments in relation to human rights, technology, 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.

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.

Negotiations between the UK and the EU over the operation of the Northern Ireland Protocol are continuing. While there are signs that differences may be diminishing, failure to reach agreement could have implications for the future operation of the EU-UK Trade and Cooperation Agreement.

In June 2022, the UK government published proposed legislation that seeks to amend the Protocol in a number of respects. In response, the EU launched infringement procedures against the UK, and is evaluating the UK response, received in September 2022. If the proposed legislation were to pass, and infringement procedures progressed, it could further complicate the terms of trade between the UK and the EU and potentially prevent progress in other areas such as financial services. 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. We are monitoring the situation closely, including the potential impacts on our customers. 

In August 2022, the US Inflation Reduction Act introduced a minimum tax of 15% with effect from 1 January 2023. It is possible that the minimum tax could result in an additional US tax liability over our regular US federal corporate tax liability in a given year, based on the differences between US book and taxable income (including as a result of temporary differences). Given its recent pronouncement, it is unclear at this time what, if any, impact the US Inflation Reduction Act will have on HSBC's US tax rate and US financial results. HSBC will continue to evaluate its impact as further information becomes available. In addition, potential changes to tax legislation and tax rates in the countries and territories in which we operate could increase our effective tax rate in the future.

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 financial impact on the Group of geopolitical risks in Asia is heightened due to the region's relatively high contribution to the Group's profitability, particularly in Hong Kong.

While it is the Group's policy to comply with all applicable laws and regulations of all jurisdictions in which it operates, geopolitical risks and tensions, and potential ambiguities in the Group's compliance obligations, will continue to present challenges and risks for the Group and could have a material adverse impact on the Group's business, financial condition, results of operations, prospects and strategy, as well as on the Group's customers.

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 obligations in respect of cross-border transfers of personal information, which may affect our ability to manage financial crime risks across markets.

Mitigating actions

•    We closely monitor geopolitical and economic developments in key markets and sectors and undertake scenario analysis where appropriate. This helps us to take portfolio actions where necessary, including through enhanced monitoring, amending our risk appetite and/or reducing limits and exposures.

•    We stress test portfolios of particular concern to identify sensitivity to loss under a range of scenarios, with management actions being taken to rebalance exposures and manage risk appetite where necessary.

•    We regularly review key portfolios to help ensure that individual customer or portfolio risks are understood and that our ability to manage the level of facilities offered through any downturn is appropriate.

•    We continue to manage sanctions and trade restrictions through the use of, and enhancements to, our existing controls.

•    We continue to monitor the UK's relationship with the EU, and assess the potential impact on our people, operations and portfolios.

•    We have taken steps, where necessary, to enhance physical security in geographical areas deemed to be at high risk from terrorism and military conflicts.

Technology and cybersecurity risk

Together with other organisations, we operate in an extensive and complex technology landscape, which needs to remain resilient in order to support customers, our organisation and financial markets globally. Risks arise where technology is not understood, maintained, or developed appropriately. We also continue to operate in an increasingly hostile cyber threat environment globally. These threats include potential unauthorised access to customer accounts, attacks on our systems or those of our third-party suppliers, and require ongoing investment in business and technical controls to defend against.

Mitigating actions

•    We continue to invest in transforming how software solutions are developed, delivered and maintained to improve system resilience. We continue to build security into our software development lifecycle and improve our testing processes and tools.

•    We continue to upgrade many of our IT systems, simplify our service provision and replace older IT infrastructure and applications. These enhancements supported global improvements in service availability during 2022 for both our customers and colleagues.

•    We continually evaluate threat levels for the most prevalent cyber-attack types and their potential outcomes. To further protect HSBC and our customers and help ensure the safe expansion of our global businesses, we continue to strengthen our controls to reduce the likelihood and impact of advanced malware, data leakage, exposure through third parties and security vulnerabilities.

•    We continue to enhance our cybersecurity capabilities, including Cloud security, identity and access management, metrics and data analytics, and third-party security reviews. An important part of our defence strategy is ensuring our colleagues remain aware of cybersecurity issues and know how to report incidents.

•    We report and review cyber risk and control effectiveness at executive and non-executive Board level. We also report it across our global businesses, functions and regions to help ensure there is appropriate visibility and governance of the risk and its mitigating actions.

•    We participate globally in industry bodies and working groups to collaborate on tactics employed by cyber-crime groups and to work together preventing, detecting and defending against cyber-attacks on financial organisations globally.

Evolving regulatory environment risk

We aim to keep abreast of the emerging regulatory compliance and conduct agenda, which currently includes, but is not limited to: ESG matters; ensuring good customer outcomes; addressing customer vulnerabilities due to cost of living pressures; regulatory compliance; regulatory reporting; employee compliance, including the use of e-communication channels; and the proposed reforms to the UK financial services sector, known as the Edinburgh Reforms. We monitor regulatory developments closely and engage with regulators, as appropriate, to help ensure new regulatory requirements are implemented effectively and in a timely way. The competitive landscape in which the Group operates may be impacted by future regulatory changes and government intervention.

Mitigating actions

•    We monitor for regulatory developments to understand the evolving regulatory landscape and seek to respond with changes in a timely manner.

•    We engage with governments and regulators, responding to consultations with a view to help shaping regulations that can be implemented effectively. We hold regular meetings with relevant authorities to discuss strategic contingency plans, including those arising from geopolitical issues. 

•    Our simplified conduct approach aligns to our purpose and values, in particular the value 'we take responsibility'.

Financial crime risk

Financial institutions remain under considerable regulatory scrutiny regarding their ability to detect and prevent financial crime. These evolving challenges include managing conflicting laws and approaches to legal and regulatory regimes, and implementing an unprecedented volume and diverse set of sanctions, notably as a result of the Russia-Ukraine war.

Amid rising inflation and increasing cost of living pressures, we face increasing regulatory expectations with respect to managing internal and external fraud, and protecting vulnerable customers.

The digitisation of financial services continues to have an impact on the payments ecosystem, with an increasing number of new market entrants and payment mechanisms, not all of which are subject to the same level of regulatory scrutiny or regulations as banks. Developments around digital assets and currencies have continued at pace, with an increasing regulatory and enforcement focus on the financial crimes linked to these types of assets.

Expectations with respect to the intersection of ESG issues and financial crime, as our organisation, customers and suppliers transition to net zero, continue to increase. These are particularly focused on potential 'greenwashing', human rights issues and environmental crimes. In addition, climate change itself could heighten risks linked to vulnerable migrant populations in countries where financial crime is already more prevalent.

We also continue to face increasing challenges presented by national data privacy requirements, which may affect our ability to manage financial crime risks across markets.

Mitigating actions 

•    We continue to manage sanctions and trade restrictions through the use of, and enhancements to, our existing controls.

•    We continue to develop our fraud controls and invest in capabilities to fight financial crime through the application of advanced analytics and artificial intelligence.

•    We are looking at the impact of a rapidly changing payments ecosystem, as well as risks associated with direct and indirect exposure to digital assets and currencies, in an effort to maintain appropriate financial crime controls.

•    We are assessing our existing policies and control framework so that developments relating to ESG are considered and the risks mitigated.

•    We engage with regulators, policymakers and relevant international bodies, seeking to address data privacy challenges through international standards, guidance and legislation.

Ibor transition risk

Interbank offered rates ('Ibors') have previously been used extensively to set interest rates on different types of financial transactions and for valuation purposes, risk measurement and performance benchmarking.

Following the UK's Financial Conduct Authority ('FCA') announcement in July 2017 that it would no longer continue to persuade or require panel banks to submit rates for the London interbank offered rate ('Libor') after 2021, we have been actively working to transition legacy contracts from Ibors to products linked to near risk-free replacement rates ('RFRs') or alternative reference rates.

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 Ibor transition programme - which is tasked with the development of RFR products and the transition of legacy Ibor products - has continued to support the transition of a limited number of remaining contracts in sterling and Japanese yen Libor, which were published using a 'synthetic' interest rate methodology during 2022. The remaining 'tough legacy' sterling contracts have required protracted client discussions where contracts are complex or restructuring of facilities is required. The publication of 'synthetic' Japanese yen Libor ceased after 31 December 2022. In addition the FCA announced, in September and November 2022, that one month and six-month 'synthetic' sterling Libor rates will cease to be published from 31 March 2023, and three-month 'synthetic' sterling Libor will cease to be published after 31 March 2024. We have or are prepared to transition or remediate the remaining few contracts relying on 'synthetic' sterling settings, outstanding as at 31 December 2022, in advance of those cessation dates.

For the cessation of the publication of US dollar Libor from 30 June 2023, we have implemented the majority of required processes, technology and RFR product capabilities throughout the Group in preparation for upcoming market events. We will continue to transition outstanding legacy contracts through the first half of 2023. We have completed the transition of the majority of our uncommitted lending facilities, and continue to make steady progress with the transition of the outstanding legacy committed lending facilities. Transition of our derivatives portfolio is progressing well with most clients reliant on industry mechanisms to transition to RFRs. For the limited number of bilateral derivatives trades where an alternative transition path is required, client engagement is continuing. For certain products and contracts, including bonds and syndicated loans, we remain reliant on the continued support of agents and third parties, but we continue to progress those contracts requiring transition. We continue to monitor contracts that may be potentially more challenging to transition, and may need to rely upon legislative solutions. Additionally, following the FCA's consultation in November 2022 proposing that US dollar Libor is to be published using a 'synthetic' methodology for a defined period, we will continue to work with our clients to support them through the transition of their products if transition is not completed by 30 June 2023.

For the Group's own debt securities issuances, we continue to have instruments in US dollars, sterling, Japanese yen and Singapore dollars where the terms provide for an Ibor benchmark to be used to reset the coupon rate if HSBC chooses not to redeem them on their call dates. We remain mindful of the various factors that have an 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 to seeking to remediate or mitigate relevant risks relating to Ibor-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, as 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, as 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, as 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, which could potentially increase the risk of disputes;

•    model risk, as there is a risk that changes to our models to replace Ibor-related data adversely affect the accuracy of model outputs; and

•    market risk, because 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. Additionally the current stage of the Term Secured Overnight Financing Rate ('SOFR') market presents challenges for certain hedge accounting strategies.

While the level of risk is diminishing in line with our process implementation and continued transition of contracts, we will monitor these risks through the remainder of the transition of legacy contracts. Throughout 2023, we plan to continue to engage with our clients and investors to complete an orderly transition of contracts that reference the remaining demising Ibors.

Mitigating actions

•    Our global Ibor transition programme, which is overseen by the Group Chief Risk and Compliance Officer, will continue to deliver IT and operational processes to meet its objectives.

•    We carry out extensive training, communication and client engagement to facilitate appropriate selection of new rates and products.

•    We have dedicated teams in place to support the transition.

•    We have actively transitioned legacy contracts and ceased entering into new contracts based on demised or demising Ibors, other than those allowed under regulatory exemptions, and implemented associated monitoring and controls.

•    We assess, monitor and dynamically manage risks arising from Ibor transition, and implement specific mitigating controls when required.

•    We continue to actively engage with regulatory and industry bodies to mitigate risks relating to 'tough legacy' contracts.

Financial instruments impacted by Ibor reform

(Audited)

Interest Rate Benchmark Reform Phase 2, the amendments to IFRSs issued in August 2020, represents the second phase of the IASB's project on the effects of interest rate benchmark reform. The amendments address issues affecting financial statements when changes are made to contractual cash flows and hedging relationships.

Under these amendments, changes made to a financial instrument measured at other than fair value through profit or loss that are economically equivalent and required by interest rate benchmark reform, do not result in the derecognition or a change in the carrying amount of the financial instrument. Instead they require the effective interest rate to be updated to reflect the change in the interest rate benchmark. In addition, hedge accounting will not be discontinued solely because of the replacement of the interest rate benchmark if the hedge meets other hedge accounting criteria.