Half-year Report - Part 3 of 3

Overview

Treasury risk is the risk of having insufficient capital, liquidity or funding resources to meet financial obligations and satisfy regulatory requirements, together with the financial risks arising from the provision of pensions and other post-employment benefits to staff and their dependants. Treasury risk also includes the risk to our earnings or capital due to non-trading book foreign exchange exposures and changes in market interest rates.

Treasury risk arises from changes to the respective resources and risk profiles driven by customer behaviour, management decisions or the external environment.

Approach and policy

Our objective in the management of treasury risk is to maintain appropriate levels of capital, liquidity, funding, foreign exchange and market risk to support our business strategy, and meet our regulatory and stress testing-related requirements.

Our approach to treasury management is driven by our strategic and organisational requirements, taking into account the regulatory, economic and commercial environment. We aim to maintain a strong capital and liquidity base to support the risks inherent in our business and invest in accordance with our strategy, meeting both consolidated and local regulatory requirements at all times.

Our policy is underpinned by our risk management framework, our internal capital adequacy assessment process ('ICAAP') and our internal liquidity adequacy assessment process ('ILAAP'). The risk framework incorporates a number of measures aligned to our assessment of risks for both internal and regulatory purposes. These risks include credit, market, operational, pensions, non-trading book foreign exchange risk and interest rate risk in the banking book.

A summary of our current policies and practices regarding the management of treasury risk is set out on pages 169 to 173 of the Annual Report and Accounts 2020.

Treasury risk management

Key developments in the first half of 2021

•    We continued to develop the Treasury Risk Management function, which was established in 2020. This function is a dedicated second line of defence, providing independent oversight of treasury activities across capital risk, liquidity and funding risk, non-trading book foreign exchange risk (including structural and other banking book foreign exchange risk), and interest rate risk in the banking book, together with pension risk.

•    We announced the next phase of our strategic plan on 23 February 2021. We intend to maintain a common equity tier 1 ('CET1') ratio above 14%, managing in the range of 14% to 14.5% in the medium term. Our dividend policy aims to deliver sustainable cash dividends, while retaining the flexibility to invest and grow the business in the future, supplemented by additional shareholder distributions, if appropriate. Reflecting the current improved economic outlook and operating environment in many of our markets, we now expect to move to within our target dividend payout ratio range of 40% to 55% of reported earnings per ordinary share ('EPS') in 2021. In line with our dividend policy, we will retain the flexibility to adjust EPS for non-cash significant items.

•    We continued to build our recovery and resolution capabilities in line with the Group's resolution strategy to meet requirements from the Bank of England ('BoE') under its Resolvability Assessment Framework ahead of 1 January 2022. We met our compliance deadline of 31 March 2021 for valuation in resolution requirements, and continue to enhance our capabilities in preparation for the submission of a resolvability self-assessment report to the BoE in October 2021.

•    The BoE's Financial Policy Committee reconfirmed its guidance on the path for the UK countercyclical capital buffer rate. It expects to maintain the rate at 0% until at least December 2021 and, due to the usual 12‐month implementation lag, any subsequent increase would therefore not be expected to take effect until the end of 2022 at the earliest. The Hong Kong Monetary Authority ('HKMA') has maintained the countercyclical capital buffer rate at 1% for Hong Kong, but it will continue to monitor credit and economic conditions closely. The countercyclical capital buffer rate will be reviewed on a quarterly basis or more frequently.

•    The Group's CET1 ratio was 15.6% and the leverage ratio, calculated in accordance with the Capital Requirements Regulation, was 5.3% at 30 June 2021. All of the Group's material operating entities were above capital risk appetite levels. The Group continues to maintain and plan for the appropriate resources required to manage its risks and deliver its strategic objectives, including the potential sale of the retail banking business in France, while supporting local economies.

•    All of the Group's material operating entities were above regulatory minimum levels of liquidity and funding at 30 June 2021. The Group and all entities had significant surplus liquidity, and maintained heightened liquidity coverage ratios throughout the first half of 2021.

•    We revised the approach to calculate the Group liquidity coverage ratio ('LCR'). The new methodology better reflects free transferability of liquidity from third countries (comprising countries other than the UK and those in the EEA) in consideration with currency convertibility and regulatory intra-Group limits. Based on the consolidation methodology, the Group LCR was 134% at 30 June 2021. A risk appetite has been set against the Group LCR.

•    Central bank interest rates remain at historically low levels, although a vaccine-led economic recovery and rising inflation indicators have contributed to an increase in interest rate yields and a steepening of yield curves in our major markets in the first half of 2021. Against a backdrop of high and rising asset valuations, monetary policies have generally remained accommodative, but rising inflation is posing a policy dilemma for some central banks. We continued to monitor our risk profile closely in the context of a possible tightening in monetary policy.

•    We maintained a significant focus on the switchover from Ibor index curves to RFRs for in-scope currencies. Despite considerable complexity, we are on track to complete changes to our funds transfer pricing, external issuance and hedging by the end of the year across the Group.

For quantitative disclosures on capital ratios, own funds and RWAs, see pages 87 to 88. For quantitative disclosures on liquidity and funding metrics, see pages 90 to 92. For quantitative disclosures on interest rate risk in the banking book, see pages 92 to 93.

Capital, liquidity and funding risk management processes

Assessment and risk appetite

Our capital management policy is underpinned by a global capital management framework and our ICAAP. The framework incorporates key capital risk appetites for CET1, total capital, minimum requirements for own funds and eligible liabilities ('MREL'), and double leverage. The ICAAP is an assessment of the Group's capital position, outlining both regulatory and internal capital resources and requirements resulting from HSBC's business model, strategy, risk profile and management, performance and planning, risks to capital, and the implications of stress testing. Our assessment of capital adequacy is driven by an assessment of risks. These risks include credit, market, operational, pensions, insurance, structural foreign exchange and interest rate risk in the banking book. Climate risk is also considered as part of the ICAAP, and we are continuing to develop our approach. The Group's ICAAP supports the determination of the consolidated capital risk appetite and target ratios, as well as enables the assessment and determination of capital requirements by regulators. Subsidiaries prepare ICAAPs in line with global guidance while considering their local regulatory regimes to determine their own risk appetites and ratios.

HSBC Holdings is the provider of equity capital and MREL-eligible debt to its subsidiaries and also provides them with non-equity capital where necessary. These investments are funded by HSBC Holdings' own equity capital and MREL-eligible debt.

HSBC Holdings seeks to maintain a prudent balance between the composition of its capital and its investments in subsidiaries, including management of double leverage. Double leverage reflects the extent to which equity investments in operating entities are funded by holding company debt. Where Group capital requirements are less than the aggregate of operating entity capital requirements, double leverage can be used to improve Group capital efficiency provided it is managed appropriately and prudently in accordance with risk appetite. Double leverage is a constraint on managing our capital position, given the complexity of the Group's subsidiary structure and the multiple regulatory regimes under which we operate. As a matter of long-standing policy, the holding company retains a substantial portfolio of high-quality liquid assets ('HQLA'), which at 30 June 2021 was in excess of $13bn. The portfolio of HQLA helps to mitigate holding company cash flow risk, and underpins the strength of support the holding company can offer its subsidiaries in times of stress. Further mitigation is provided by additional tier 1 ('AT1') securities issued in excess of the regulatory requirements of our subsidiaries.

We aim to ensure that management at Group and entity level have oversight of our liquidity and funding risks by maintaining comprehensive policies, metrics and controls. We manage liquidity and funding risk at an operating entity level to make sure that obligations can be met in the jurisdiction where they fall due, generally without reliance on other parts of the Group. Operating entities are required to meet internal minimum requirements and any applicable regulatory requirements at all times. These requirements are assessed through the ILAAP, which ensures that operating entities have robust strategies, policies, processes and systems for the identification, measurement, management and monitoring of liquidity risk over an appropriate set of time horizons, including intra-day. The ILAAP informs the validation of risk tolerance and the setting of risk appetite. It also assesses the capability to manage liquidity and funding effectively in each major entity. These metrics are set and managed locally but are subject to robust global review and challenge to ensure consistency of approach and application of the Group's policies and controls.

Planning and performance

Capital and risk-weighted asset ('RWA') plans form part of the annual operating plan that is approved by the Board. Capital and RWA forecasts are submitted to the Group Executive Committee on a monthly basis, and capital and RWAs are monitored and managed against the plan. The responsibility for global capital allocation principles rests with the Group Chief Financial Officer supported by the Group Capital Management Meeting. This is a specialist forum addressing capital management, reporting into the HSBC Holdings Asset and Liability Management Committee ('Holdings ALCO').

Through our internal governance processes, we seek to strengthen discipline over our investment and capital allocation decisions, and to ensure that returns on investment meet management's objectives. Our strategy is to allocate capital to businesses and entities to support growth objectives where returns above internal hurdle levels have been identified and in order to meet their regulatory and economic capital needs. We evaluate and manage business returns by using a return on average tangible equity measure.

Funding and liquidity plans form part of the annual operating plan that is approved by the Board. The Board-level appetite measures are the LCR and net stable funding ratio ('NSFR'). An internal liquidity metric ('ILM') was introduced in January 2021 to supplement the LCR and NSFR metrics. In addition, we use a wider set of measures to manage an appropriate funding and liquidity profile, including legal entity depositor concentration limits, intra-day liquidity, forward-looking funding assessments and other key measures.

Risks to capital and liquidity

Outside the stress testing framework, other risks may be identified that have the potential to affect our RWAs and/or capital position. Downside and Upside scenarios are assessed against our capital management objectives and mitigating actions are assigned as necessary. We closely monitor future regulatory changes and continue to evaluate the impact of these upon our capital requirements. These include the UK's implementation of amendments to the Capital Requirements Regulation, the Basel III Reforms, and the regulatory impact from the UK's withdrawal from the EU, as well as other regulatory statements including changes to IRB modelling requirements. 

Regulatory developments

The Prudential Regulation Authority ('PRA') has confirmed that software assets will need to be deducted in full from CET1 capital from 1 January 2022. This will reverse the beneficial changes to the treatment of software assets that were implemented as part of the EU's response to the Covid-19 pandemic. This change was anticipated and is expected to reduce capital resources and RWAs by $2.6bn.

In parallel with regulatory developments in the EU, the PRA is reviewing the requirements for the capitalisation of structural foreign exchange risk to align to a Pillar 1 approach. There remains a significant degree of uncertainty in the impact of the regulatory changes due to the number of national discretions and the need for further supporting technical standards to be developed. Furthermore, the impact does not take into consideration the possibility of offsets against Pillar 2, which may arise as shortcomings within Pillar 1 are addressed.

Overall we expect RWAs to increase by up to 5% as a result of these developments during 2022 and 2023.

Further impacts will occur with the introduction of a modelled RWA output floor under the Basel III reforms that will commence in 2023 with a five-year transitional provision. We estimate that there will be an additional RWA impact as a result of the output floor with effect from 2027.

Potential disposal of retail banking business in France

In relation to the potential sale of our retail banking business in France, we expect a reduction in the Group's CET1 ratio in the range of 15bps to 20bps, driven by the estimated loss on sale partly offset by the reduction in RWAs upon the estimated completion in 2023.

Regulatory reporting processes and controls

There is an ongoing focus on the quality of regulatory reporting by the PRA and other regulators globally. We continue to strengthen our processes and controls, following the commissioning of independent external reviews of various aspects of regulatory reporting, including at the request of our regulators. As part of the strengthening of our control environment, we are improving global consistency and control standards across a number of our processes. There may be an impact on some of our regulatory ratios such as the CET1 and LCR as a result. We are keeping the PRA and other relevant regulators informed of adverse findings from external and internal reviews.

Stress testing and recovery and resolution planning

The Group uses stress testing to evaluate the robustness of plans and risk portfolios, and to meet the requirements for stress testing set by supervisors. Stress testing also informs the ICAAP and ILAAP and supports recovery planning in many jurisdictions. It is an important output used to evaluate how much capital and liquidity the Group requires in setting risk appetite for capital and liquidity risk. It is also used to re-evaluate business plans where analysis shows capital, liquidity and/or returns do not meet their target.

In addition to a range of internal stress tests, we are subject to supervisory stress testing in many jurisdictions. These include the programmes of the Bank of England, the US Federal Reserve Board, the European Banking Authority, the European Central Bank and the Hong Kong Monetary Authority, as well as stress tests undertaken in other jurisdictions. The results of regulatory stress testing and our internal stress tests are used when assessing our internal capital requirements through the ICAAP. The outcomes of stress testing exercises carried out by the PRA and other regulators feed into the setting of regulatory minimum ratios and buffers.

The Group and subsidiaries have established recovery plans, which set out potential options management could take in a range of stress scenarios that could result in a breach of our internal capital buffers. This is to help ensure that our capital and liquidity position can be recovered even in an extreme stress event. All entities monitor internal and external triggers that could threaten their capital, liquidity or funding positions. Entities have established recovery plans providing detailed actions that management would consider taking in a stress scenario should their positions deteriorate and threaten to breach risk appetite and regulatory minimum levels.

Recovery and resolution plans form part of the integral framework safeguarding the Group's financial stability. The Group is committed to developing its recovery and resolution capabilities further in line with the BoE's Resolvability Assessment Framework requirements.

Measurement of interest rate risk in the banking book processes

Assessment and risk appetite

Interest rate risk in the banking book is the risk of an adverse impact to earnings or capital due to changes in market interest rates. It is generated by our non-traded assets and liabilities, specifically loans, deposits and financial instruments that are not held for trading intent or held in order to hedge positions held with trading intent. Interest rate risk that can be economically hedged may be transferred to the Markets Treasury business. Hedging is generally executed through interest rate derivatives or fixed-rate government bonds. Any interest rate risk that Markets Treasury cannot economically hedge is not transferred and will remain within the global business where the risks originate.

The Asset, Liability and Capital Management ('ALCM') function uses a number of measures to monitor and control interest rate risk in the banking book, including:

•    net interest income sensitivity;

•    economic value of equity sensitivity; and

•    hold-to-collect-and-sell stressed value at risk.

Net interest income sensitivity

A principal part of our management of non-traded interest rate risk is to monitor the sensitivity of expected net interest income ('NII') under varying interest rate scenarios (i.e. simulation modelling), where all other economic variables are held constant. This monitoring is undertaken at an entity level by local ALCOs, where entities forecast both one-year and five-year NII sensitivities across a range of interest rate scenarios.

Projected NII sensitivity figures represent the effect of pro forma movements in projected yield curves based on a static balance sheet size and structure. The exception to this is where the size of the balances or repricing is deemed interest rate sensitive, for example, non-interest-bearing current account migration and fixed-rate loan early prepayment. These sensitivity calculations do not incorporate actions that would be taken by Markets Treasury or in the business that originates the risk to mitigate the effect of interest rate movements.

The NII sensitivity calculations assume that interest rates of all maturities move by the same amount in the 'up-shock' scenario. The sensitivity calculations in the 'down-shock' scenarios reflect no floors to the shocked market rates. However, customer product-specific interest rate floors are recognised where applicable.

Economic value of equity sensitivity

Economic value of equity ('EVE') represents the present value of the future banking book cash flows that could be distributed to equity providers under a managed run-off scenario. This equates to the current book value of equity plus the present value of future NII in this scenario. EVE can be used to assess the economic capital required to support interest rate risk in the banking book. An EVE sensitivity represents the expected movement in EVE due to pre-specified interest rate shocks, where all other economic variables are held constant. Operating entities are required to monitor EVE sensitivities as a percentage of capital resources.

Hold-to-collect-and-sell stressed value at risk

Hold-to-collect-and-sell stressed value at risk ('VaR') is a quantification of the potential losses to a 99% confidence level of the portfolio of securities held under a held-to-collect-and-sell business model in the Markets Treasury business. The portfolio is accounted for at fair value through other comprehensive income together with the derivatives held in designated hedging relationships with these securities. This is quantified based on the worst losses over a one-year period going back to the beginning of 2007 with an assumed holding period of 60 days.

Hold-to-collect-and-sell stressed VaR uses the same models as those used for trading book capitalisation and covers only the portfolio managed by Markets Treasury under this business model.

Capital risk in the first half of 2021

Capital overview

Following the end of the transition period following the UK's withdrawal from the EU, any reference to EU regulations and directives (including technical standards) should be read as a reference to the version onshored into UK law under the European Union (Withdrawal) Act 2018, as amended. Capital figures and ratios in the table above are calculated in accordance with the revisions to the Capital Requirements Regulation and Directive, as implemented ('CRR II'). The table presents them under the transitional arrangements in CRR II for capital instruments and after their expiry, known as the end point. The end point figures in the table above include the benefit of the regulatory transitional arrangements in CRR II for IFRS 9, which are more fully described below.

Where applicable, they also reflect government relief schemes intended to mitigate the impact of the Covid-19 outbreak.

Regulatory transitional arrangements for IFRS 9 'Financial Instruments'

We have adopted the regulatory transitional arrangements in CRR II for IFRS 9, including paragraph four of article 473a. Our capital and ratios are presented under these arrangements throughout the table above, including in the end point figures. Without their application, our CET1 ratio would be 15.5%.

The IFRS 9 regulatory transitional arrangements allow banks to add back to their capital base a proportion of the impact that

IFRS 9 has upon their loan loss allowances during the first five years of use. The impact is defined as:

•     the increase in loan loss allowances on day one of IFRS 9 adoption; and

•     any subsequent increase in ECL in the non-credit-impaired book thereafter.

Any add-back must be tax affected and accompanied by a recalculation of deferred tax, exposure and RWAs. The impact is calculated separately for portfolios using the standardised ('STD') and internal ratings-based ('IRB') approaches. For IRB portfolios, there is no add-back to capital unless loan loss allowances exceed regulatory 12-month expected losses.

The EU's CRR 'Quick Fix' relief package enacted in June 2020 increased from 70% to 100% the relief that banks may take for loan loss allowances recognised since 1 January 2020 on the
non-credit-impaired book.

In the current period, the add-back to CET1 capital amounted to $1.0bn under the STD approach with a tax impact of $0.2bn. At 31 December 2020, the add-back to the capital base under the STD approach was $1.6bn with a tax impact of $0.4bn.