Interim Report - 15 of 28

the Annual Report and Accounts 2013). In the first half of 2014, we ran a further stress test which assumed a significant deceleration of growth in mainland China and a sharp contraction in Hong Kong (see page 108).

Increased geopolitical risk

Our operations are exposed to risks arising from political instability and civil unrest in a number of countries, which may have a wider effect on regional stability and regional and global economies.

Geopolitical risk rose in the first half of 2014 as a result of the crisis in Ukraine and the possibility of military escalation and/or civil war. Further sanctions against the Russian government remain a possibility, which could affect foreign investment in Russia.

Geopolitical risk remained high in the Middle East with the crisis between Israel and Palestine, unrest in Egypt, the civil war in Syria and the conflict in Iraq. Negotiations continued on restricting the scope of Iranian nuclear activities, which add to the risks in the region.

In Asia, there was no easing in the maritime sovereignty disputes involving mainland China and Japan as the Chinese government sought to extend its influence over the South and East China Seas.

In Turkey, the continued political uncertainty led to market volatility and placed the currency under pressure.

Potential impact on HSBC

·     Our results are subject to the risk of loss from unfavourable political developments, currency fluctuations, social instability and changes in government policies on matters such as expropriation, authorisations, international ownership, interest-rate caps, foreign exchange transferability and tax in the jurisdictions in which we operate. Actual conflict could put our staff in danger and bring physical damage to our assets.

Mitigating actions

·     We monitor the geopolitical and economic outlook, in particular in countries where we have material exposures and a physical presence. Our internal credit risk rating of sovereign counterparties takes these factors into account and drives our appetite for conducting business in those countries. Where necessary, we adjust our country limits and exposures to reflect our appetite and mitigate risks as appropriate.

·     Our sanctions screening processes and governance have been strengthened through our Global Standards programme.

Macro-prudential, regulatory and legal risks to our business model

Financial service providers face increasingly stringent and costly regulatory and supervisory requirements, particularly in the areas of capital and liquidity management, conduct of business, operational structures and the integrity of financial services delivery. Increased government intervention and control over financial institutions, together with measures to reduce systemic risk, may significantly alter the competitive landscape locally, regionally and/or globally for some or all of the Group's businesses. These measures may be introduced as formal requirements in a super-equivalent manner and to differing timetables by regulatory regimes.

Regulatory developments affecting our business model and Group profitability

Several regulatory changes are likely to affect the activities both of the Group as a whole and of some or all of our principal subsidiaries. These changes include:

·     the UK's Financial Services (Banking Reform) Act 2013 which gave effect to the recommendations of the Independent Commission on Banking ('ICB') in relation to the ring-fencing of our UK retail banking activities from wholesale banking, together with the structural separation of other activities as envisaged in the legislation and rules adopted in the US (including the Volcker Rule adopted in December 2013 under the Dodd-Frank Act) and potential changes across the EU (including a proposed Regulation on structural measures for EU credit institutions);

·     requirements flowing from arrangements for the recovery and resolution of the Group and its individual operating entities, which may have different effects in different countries;

·     the implementation of extra-territorial laws, including the Foreign Account Tax Compliance Act ('FATCA') and other related initiatives to share tax information such as those pursued by the OECD;

·     changes in the regime for the operation of capital markets, notably mandatory central clearing of over the counter ('OTC') derivatives, including under the Dodd-Frank Act and the EU's European Market Infrastructure Regulation ('EMIR');

·     changes arising from the increasing focus by regulators on how institutions conduct business, particularly with regard to the delivery of fair outcomes for customers, promoting effective competition in the interests of consumers (including the recently announced proposals for an investigation by the UK Competition and Markets Authority on the personal current account and SME banking market in the UK) and ensuring the orderly and transparent operation of global financial markets. Focus also increases on remuneration and on increasing management accountability, the latter to meet requirements under CRD IV and the UK Banking Reform Act;

·     the implementation of significant parts of CRD IV which are yet to be finalised and applied, notably the UK application of the capital buffer framework and its interaction with Pillar 2 and the Financial Policy Committee's ('FPC's) July 2014 consultation on proposals for the development of a UK leverage ratio;

·     the ECB Asset Quality Review ('AQR'), which may require a substantial recapitalisation among eurozone banks;

·     the tightening by regulators in a number of countries of credit controls on mortgage lending and unsecured portfolios; and

·     the continued risk of further changes to regulation relating to taxes affecting financial service providers, including financial transaction taxes.

Potential impact on HSBC

·     Proposed changes in and/or the implementation of regulations including mandatory central clearing of OTC derivatives, EMIR, ring-fencing and similar requirements, the Volcker Rule, recovery and resolution plans, FATCA and findings from competition orientated enquiries and investigations may affect the manner in which we conduct our activities and how the Group is structured. These measures have the potential to increase our cost of doing business and curtail the types of business we can carry out, with the consequent risk of decreased profitability.

·     Mandatory central clearing of OTC derivatives also brings new risks to HSBC in our role as a clearing member, as we will be required to underwrite losses incurred by central clearing counterparties from the default of other clearing members and their clients. Hence central clearing brings with it a new element of interconnectedness between clearing members and clients which we believe may increase rather than reduce our exposure to systemic risk.

·     Increased regulation of conduct of business (including incentive structures and remuneration) and management accountability may affect the industry in areas such as employee recruitment and retention, product pricing and profitability in both retail and wholesale markets. HSBC's businesses may be affected by these developments.

·     Potential market disruption from the AQR, including the possible re-emergence of concerns over the eurozone, may affect us directly through our exposure to eurozone banks and sovereigns, and indirectly should there be any diminution in economic activity in the eurozone.

Mitigating actions

·     We are engaged closely with governments and regulators in the countries in which we operate to help ensure that the new requirements are considered properly and can be implemented in an effective manner.

·     We are focused on developing a global approach to the risk management of conduct and have established a Conduct & Values Committee as a sub-committee of the Board to oversee the framework and its implementation across the Group.

·     We have enhanced our governance around central clearing counterparties and appointed specialists to manage the associated liquidity and collateral risks.

Regulatory investigations, fines, sanctions, commitments and consent orders and requirements relating to conduct of business and financial crime negatively affecting our results and brand

Financial service providers are at risk of regulatory sanctions or fines related to conduct of business and financial crime. The incidence of regulatory proceedings and other adversarial proceedings against financial service firms is increasing.

Regulatory commitments and consent orders

In December 2012, HSBC Holdings, HSBC North America Holdings Inc. ('HNAH'), and HSBC Bank USA, N.A. ('HSBC Bank USA') entered into agreements with US and UK authorities in relation to investigations regarding past inadequate compliance with AML and sanctions laws. Among other agreements, HSBC Holdings and HSBC Bank USA entered into a five-year deferred prosecution agreement ('US DPA') with the US Department of Justice ('DoJ') and HSBC Holdings entered into a two-year DPA with the District Attorney of New York County (the 'DANY DPA'). HSBC Holdings also entered into an undertaking with the FSA (revised as the 'FCA Direction' following the UK regulatory restructuring in April 2013) to comply with certain forward-looking obligations with respect to AML and sanctions requirements. In addition, HSBC Holdings entered into a cease and desist order with the US Federal Reserve Board ('FRB') with respect to compliance with US AML and sanctions requirements.

The agreements with the DoJ and the FRB and the FCA Direction require us to retain an independent monitor to evaluate our progress in fully implementing our obligations and produce regular assessments of the effectiveness of our Financial Crime Compliance function. The Monitor is discussed on page 15.

HSBC Bank USA is also subject to an agreement entered into with the Office of the Comptroller of the Currency ('OCC') in December 2012, the Gramm-Leach-Bliley Act Agreement ('GLBA Agreement'). See pages 144 and 556 of the Annual Report and Accounts 2013 for further information on the GLBA Agreement and other consent orders, respectively.

Potential impact on HSBC

·     It is difficult to predict the outcome of the regulatory proceedings involving our businesses. Unfavourable outcomes may have a material adverse effect on our reputation, brand and results, including loss of business and withdrawal of funding.

·     Our significant involvement in facilitating international capital flows and trade exposes the Group to the risk of financial crime or inadvertently breaching restrictions and sanctions imposed by the Office of Foreign Assets Control ('OFAC') and other regulators.

·     Breach of the US DPA at any time during its term may allow the DoJ to prosecute HSBC Holdings or HSBC Bank USA in relation to the matters which are the subject of the US DPA. Breach of the DANY DPA may allow the District Attorney of New York County to prosecute HSBC Holdings in relation to the matters which are the subject of that DPA.

·     Failure to comply with the requirements of consent orders or the GLBA within the time periods specified in them or otherwise as may be extended, could result in supervisory action (see page 145 of the Annual Report and Accounts 2013 for more information about the consequences of not complying with the GLBA) Any such action could have a material adverse effect on the consolidated results and operation of HSBC.

Mitigating actions

·     Steps to address many of the requirements of the DPAs, the FCA Direction, the GLBA Agreement and associated regulatory agreements have either already been taken or are under way in consultation with the relevant regulatory agencies. These include simplifying the Group's control structure, strengthening the governance structure with new leadership appointments, revising key policies and implementing consistent procedures and controls shaped by the highest or most effective standards available in any location where the Group operates to detect, deter and protect against financial crime through our Global Standards programme. In addition, we have substantially increased spending and staffing in the Financial Crime Compliance and Regulatory Compliance functions in the past few years.

·     There can be no assurance that these remedial measures taken to date will be effective or that we will not have to take additional remedial measures in the future to comply with the terms of the DPAs, the FCA Direction or the GLBA Agreement.

Conduct of business

Regulators in the UK and other countries have continued to increase their focus on 'conduct' matters including sales processes and incentives (including remuneration practices), product and investment suitability and more general conduct of business and market conduct concerns.