Interim Management Statement 1Q 2014

Financial performance commentary

1Q14 compared with 1Q13

·      Reported profit before tax of US$6.8bn in 1Q14 was US$1.6bn or 20% lower than in 1Q13, primarily reflecting lower gains (net of losses) from disposals and reclassifications. Notably, our results in 1Q13 included a US$1.1bn accounting gain arising from the reclassification of Industrial Bank as a financial investment following its issue of additional share capital to third parties. This was partly offset in 1Q14 by favourable fair value movements of US$0.1bn on our own debt designated at fair value resulting from changes in credit spreads compared with adverse movements of US$0.2bn in 1Q13.

·      On an underlying basis, profit before tax was US$1.0bn or 13% lower than in 1Q13. This was primarily driven by lower revenue, partly offset by lower LICs and operating expenses.

·      Reported revenue was US$15.9bn in 1Q14, US$2.5bn lower than in 1Q13, in part reflecting lower gains (net of losses) from disposals and reclassifications. On an underlying basis, revenue of US$15.7bn was US$1.4bn or 8% lower driven by a number of significant items which were recorded in 1Q13, as follows:

-      a net gain on completion of the Ping An disposal of US$553m; and

-      foreign exchange gains on sterling debt issued by HSBC Holdings of US$442m.

This was partly offset by:

-      a loss of US$279m recognised following the write-off of allocated goodwill relating to our GPB business in Monaco;

-      a loss of US$199m on early termination of cash flow hedges in the US run-off portfolio in RBWM; and

-      a loss on the sale of an HFC Bank UK secured loan portfolio of US$138m.

In addition, 1Q14 revenue included:

-      a favourable DVA of US$31m (compared with US$472m in 1Q13) in GB&M on derivative contracts;

-      adverse fair value movements on non-qualifying hedges of US$142m compared with favourable movements of US$84m in 1Q13; and

-      a loss of US$30m on sales of several tranches of real estate secured accounts in the US run-off portfolio in RBWM.

Excluding these items, revenue was US$0.4bn lower:

-      in RBWM, revenue was US$0.3bn lower reflecting reduced net interest income following the sale of the non-real estate portfolio in 2013 and lower average balances in the US run-off portfolio. In our Principal RBWM business, revenue decreased by US$0.1bn, mainly reflecting the run-off of our Canadian consumer finance business, lower mortgage fees in the US and lower overdrafts and investment fees in Europe. These factors were partly offset by higher revenue from savings and deposits, mainly in Europe and Asia;

-      in GB&M, total revenue was US$0.2bn or 4% lower, although this included higher revenue in Legacy Credit of US$0.1bn as we actively managed the portfolio. The reduction in revenue was driven by a decrease of US$0.2bn in Balance Sheet Management, as 1Q13 included higher gains from the re-positioning of the portfolio for risk management purposes. Although market conditions were challenging, GB&M increased market share in several product categories including equity and debt capital markets, advisory and lending. However, overall revenue in Capital Financing decreased as volume growth across the business was more than offset by spread and fee compression. Revenue in Rates, Foreign Exchange and Credit also fell as these businesses were affected by subdued activity levels. By contrast, revenue grew in our Equities business as client flows increased; and

-      in GPB, revenue was US$0.1bn lower, reflecting a managed reduction in client assets as we continued to reposition the business, which led to a reduction in fee and trading income. We attracted positive net new money in areas that we have targeted for growth, including our home and priority markets and the high net worth client segment.

These factors were partly offset by:

-      CMB, where revenue rose by US$0.2bn. This was primarily due to higher net interest income, mainly in Asia from average balance sheet growth and in the UK from a rise in deposit balances and wider lending spreads. In addition, revenue grew from increased collaboration with GB&M, notably in Asia, and from higher term lending fees in the UK.

·      LICs of US$0.8bn were US$0.4bn lower than in 1Q13 on a reported basis, and US$0.3bn lower on an underlying basis, primarily from reductions in North America and Europe.

-      In North America, the decrease of US$0.3bn reflected reduced balances and lower levels of new impaired loans in the US run-off portfolio, together with improvements in US housing market conditions, although the rate of improvement was lower than in 2013.

-      In Europe, the decrease of US$0.1bn was mainly driven by lower specific impairments in CMB in the UK.

·      Reported operating expenses in 1Q14 of US$8.9bn were 5% lower than in 1Q13. On an underlying basis, operating expenses fell by US$0.2bn, reflecting the effect of significant items:

-      the non-recurrence of regulatory investigation provisions in GPB recorded in 1Q13 of US$119m;

-      a customer remediation provision connected to our former CRS business recorded in 1Q13 of US$100m;

-      lower UK customer redress programme charges of US$83m compared with US$164m in 1Q13. Charges for the period included estimated redress for possible mis‑selling in previous years in respect of PPI; and

-      lower restructuring and other related costs of US$35m.

Excluding these items, operating expenses were 2% higher than in 1Q13 reflecting increased investment in Global Standards, Risk and Compliance and wage inflation, partly offset by cost saving initiatives.

·      Our cost efficiency ratio increased by 4.9 percentage points on a reported basis to 55.7% and by 3.7 percentage points to 56.3% on an underlying basis reflecting lower revenue.

·      The number of FTEs at the end of the quarter was 255,200, an increase of 1,100 on 31 December 2013, reflecting continued investment in Global Standards, Compliance and business growth initiatives, primarily in RBWM and CMB, partly offset by sustainable savings initiatives and the disposal of our operations in Colombia.

·      The effective tax rate of 18.8% was lower than the UK corporation tax rate of 21.5%. This reflected the recurring benefits from tax exempt income from government bonds held in a number of Group entities and the recognition of the Group's share of post-tax profits of associates and joint ventures within the Group's pre-tax income. The lower effective tax rate in 1Q13 of 15.7% was driven by the benefits arising from the non-taxable gain on profits associated with the reclassification of Industrial Bank as a financial investment and the Ping An sale.

·      On 7 May 2014, the Board announced a first interim dividend for 2014 of US$0.10 per ordinary share.

1Q14 compared with 4Q13

·      Reported profit before tax was US$2.8bn or 71% higher than in 4Q13, despite lower gains (net of losses) from disposals of US$18m compared with US$1.0bn in 4Q13 which primarily arose from the sale of our Panama operations. 1Q14 included favourable fair value movements of US$0.1bn on own credit spread compared with adverse movements of US$0.7bn in 4Q13.

·      On an underlying basis, profit before tax was US$3.1bn or 89% higher than in 4Q13, reflecting higher revenue and lower LICs and operating expenses.

·      Reported revenue of US$15.9bn in 1Q14 was 5% higher than in 4Q13. On an underlying basis, revenue was US$1.1bn or 7% higher, driven by GB&M. This was notably in Rates, Foreign Exchange and Credit following particularly muted customer activity in 4Q13 compared with 1Q14.

·      LICs were US$0.3bn lower than in 4Q13 on both a reported and underlying basis. LICs fell in the majority of our regions, notably by US$0.2bn in Latin America reflecting lower specific impairments in CMB in Mexico relating to homebuilders due to a change in public housing policy in 2013, and in Brazil across a number of corporate exposures. In North America, LICs fell by US$0.1bn, mainly driven by lower collective charges in the US, in part reflecting the CML portfolio run-off.

·      Operating expenses for 1Q14 were US$1.7bn lower than in 4Q13 on a reported basis and US$1.6bn lower on an underlying basis. This primarily reflected a number of significant items including the bank levy of US$0.9bn recorded in 4Q13, lower UK customer redress charges of US$0.3bn and a decrease in restructuring and related costs. The remaining operating expenses were US$0.3bn lower, primarily reflecting incremental cost saving initiatives.

Balance sheet commentary

·      Reported loans and advances to customers increased by US$17.7bn in the quarter. Excluding FX movements of US$2.2bn, the growth was driven by GB&M and CMB customers in Asia, relating to term lending. In addition, there was growth in Europe in GB&M from Capital Financing and corporate overdraft balances that did not meet the criteria for netting, partly offset by a reduction in credit card balances in RBWM and a fall in CMB lending.

·      Reported customer accounts balances were broadly unchanged during 1Q14, with growth in Europe offset by a decrease in North America. The increase in Europe was driven by growth in balances in GB&M that did not meet the criteria for netting and an increase in RBWM. In North America, the fall in balances primarily reflected re-pricing.

·      Other significant balance sheet movements in the quarter included a rise in trading assets and liabilities, mainly in Europe and North America. This reflected an increase in customer activity and a resultant increase in settlement account balances.

Capital and risk-weighted assets

On 1 January 2014, CRD IV came into effect, implementing the Basel III framework within the European Union.

At 1Q14, the CRD IV transitional basis CET1 capital ratio reduced to 10.7%, from 10.8% at 31 December 2013. Similarly the end-point CET1 capital ratio reduced to 10.8% from 10.9%. This largely reflected increased RWAs resulting from regulatory change.

Internal capital generation contributed US$4.5bn to CRD IV end point CET 1 capital, being profits attributable to shareholders of the parent company after regulatory adjustment for own credit spread and net of the first interim dividend. The dividend is net of planned scrip, and we have benefited from a higher fourth interim dividend scrip take-up.

On 1 January 2014, the move from the historical regulatory regime to a CRD IV transitional basis increased RWAs by US$122.2bn. This movement mainly consisted of credit valuation adjustment, asset value correlation, amounts in aggregate below the capital threshold risk-weighted at 250% and selected securitisation positions which moved from capital deductions to RWAs.

Selected portfolios with low default history were subject to PRA LGD floors, with an impact of US$17.3bn in RWAs; this is reported under methodology and policy changes. In addition, the PRA required a floor to be applied to the UK corporate LGD model, resulting in an increase in RWAs of US$17.1bn, as reported under model updates.

Business growth in CMB and GB&M in Asia and Europe from higher term lending to corporate customers increased RWAs by US$7.3bn, while additional increases occurred for corporate and sovereign exposures in Asia resulting from adverse movements in customer credit standing with an RWA impact of US$2.3bn.

Internal ratings-based ('IRB') RWA reductions of US$10.1bn from internal updates related to immaterial portfolios moving to the Standardised approach, with a reduction in IRB RWAs of US$4.8bn and methodology changes associated with trade finance products which accounted for a reduction in RWAs of US$4.6bn. Immaterial portfolios moving to the Standardised approach increased Standardised RWAs by US$6.0bn.

US retail run-off portfolio RWAs reduced by US$8.2bn as a result of a combination of factors, including the implementation of new risk models for the mortgage portfolios and favourable shifts in portfolio quality, as lower quality exposures continue to run off.

Net interest margin

Net interest margin was lower than in 1Q13 as a result of lower yields on customer lending, primarily in North America and Latin America. In North America this was driven by the effect of the disposals of the CML non-real estate loan portfolio and select tranches of CML first lien mortgages in the US in 2013. Both North America and Latin America were also affected by a change in the composition of their lending portfolios as they focused on growing secured, lower yielding balances, for both corporate and Premier customers. Yields on customer lending also fell in Europe and Asia, although to a lesser extent. However, yields on our surplus liquidity increased, notably in Asia, in line with market rate rises in mainland China and active management of our portfolios.

Cost of funds on customer accounts fell, albeit to a lesser extent than yields on customer lending, across most regions. In addition, the cost of debt issued by the Group decreased, primarily in Europe and in North America, as higher cost funding matured. The effects of these reductions were partially offset by an increase in the cost of funds in Latin America from rising interest rates in Brazil and from the continued change in the funding base, substituting wholesale deposits for medium-term notes.

In addition, the net interest margin reduced due to the significant increase in reverse repurchase agreements and repurchase agreements arising from the change in 4Q13 in the way that GB&M manage these activities. This had the effect of increasing average interest-earning assets, without a correspondingly large increase in net interest income, as these agreements are typically lower-yielding and have a lower cost of funds than the rest of the portfolio.

The decline in net interest margin from 4Q13 was lower than the reduction experienced from 1Q13 and was driven by North America and Latin America. It similarly reflected the change in the composition of lending portfolios, both as a result of disposals of selected tranches of CML first lien mortgages in the US during 4Q13 and the continued shift towards secured, lower-yielding balances in both regions, as noted above. Additionally, Latin America was affected by a significant rise in its cost of funds, as interest rates rose in Brazil.

Trading conditions since 31 March 2014 and outlook

We continued to experience muted customer activity in April.