HSBC 2004 Annual Report Download - page 174

HSBC HOLDINGS PLC
Financial Review (continued)
172
• Similarly, in the US dollar bloc, the rise in
interest rates over the year increases the room to
lower deposit pricing in the event of falling
interest rates and Global Markets have been able
to position themselves to increase revenue if
rates fall. In addition, cash balances at the
holding company reduced as the Group acquired
businesses, principally Bank of Bermuda, M&S
Money and the investment in Bank of
Communications, increasing the negative impact
of rising interest rates.
• Global Markets increased its exposure to euro
assets, contributing to the increased sensitivity
to both rising and falling rates.
It can be seen from the above that projecting the
movement in net interest income from prospective
changes in interest rates is a complex interaction of
structural and managed exposures. In a rising rate
environment, the most critical exposures are those
managed within Global Markets.
Structural foreign exchange exposures
Structural foreign exchange exposures represent net
investments in subsidiaries, branches or associated
undertakings, the functional currencies of which are
currencies other than US dollars.
Revaluation gains and losses on structural
exposures are recorded in the statement of total
consolidated recognised gains and losses. The main
operating (or functional) currencies in which
HSBC’ s business is transacted are the US dollar, the
Hong Kong dollar, sterling, the euro, the Mexican
peso, the Brazilian real, and the Chinese renminbi.
As the US dollar and currencies linked to it form the
dominant currency bloc in which HSBC’ s operations
transact business, HSBC Holdings prepares its
consolidated financial statements in US dollars.
HSBC’ s consolidated balance sheet is therefore
affected by movements in exchange rates between
the US dollar and all the non-US dollar functional
currencies of underlying subsidiaries.
HSBC hedges structural foreign currency
exposures only in limited circumstances. HSBC’ s
structural foreign currency exposures are managed
with the primary objective of ensuring, where
practical, that HSBC’ s consolidated tier 1 ratio and
the tier 1 ratios of individual banking subsidiaries are
protected from the effect of changes in exchange
rates. This is usually achieved by ensuring that, for
each subsidiary bank, the ratio of structural
exposures in a given currency to risk-weighted assets
denominated in that currency is broadly equal to the
tier 1 ratio of the subsidiary in question.
Selective hedges were in place during 2004.
Hedging is undertaken using forward foreign
exchange contracts or by financing with borrowings
in the same currencies as the functional currencies
involved. There was no material effect from foreign
currency exchange rate movements on HSBC’ s tier 1
capital ratio during the period.
Management of insurance and financial risk
HSBC’s insurance underwriting operations, inter
alia, issue contracts that accept the transfer of
insurance risk, or accept financial risk, or both. This
section summarises these risks and the way that
HSBC manages them.
Insurance risk
The principal risk that HSBC faces under the
insurance risk transfer contracts that it underwrites is
that the eventual claims and benefit payments,
together with the costs of managing the business and
claims handling, exceed the aggregate amount of
premia received and investment income earned
thereon, pending settlement of claims. HSBC
controls this risk by modelling outcomes using
statistical techniques and by holding a diversified
portfolio of relatively homogeneous contracts which
is considered unlikely to be significantly different
from the expected outcome.
HSBC manages the risk of unexpectedly large
underwriting losses through its underwriting
strategy, reinsurance arrangements and claims
handling.
In conjunction with Group Credit and Risk, the
central management of HSBC’s insurance operations
places reinsurance contracts with the world’s larger
reinsurance companies. HSBC assesses the financial
strength and creditworthiness of all reinsurers by
reviewing publicly available financial information
such as credit grades provided by rating agencies.
HSBC also takes into account details of recent
payment history and the status of any ongoing
negotiations between HSBC’s insurance operations
and these third parties. Individual operating units
maintain records of the payment history of contract
holders with whom they conduct regular business.
Financial risk
HSBC’ s insurance operations are also exposed to
financial risk in circumstances when the proceeds
from financial assets are not sufficient to fund the
obligations arising from insurance and investment
contracts.
The framework for the management of these