HSBC 2008 Annual Report Download - page 278

HSBC HOLDINGS PLC
Report of the Directors: Risk (continued)
Capital management and allocation
276
There are also limitations on the amount of
collective impairment allowances which may be
included as part of tier 2 capital. For regulatory
purposes, banking associates are proportionally
consolidated, rather than being recognised using
the equity method used for financial reporting.
The carrying amounts of investments in the
capital of banks that exceed certain limits and the
excess of expected losses over impairment
allowances are deducted 50 per cent from each of
tier 1 and tier 2 capital in the published disclosures.
This also applies to deductions of investments in
insurance subsidiaries and associates, but the
FSA has granted a transitional provision, until
31 December 2012, under which those insurance
investments that were acquired before 20 July 2006
may be deducted from the total of tier 1 and tier 2
capital instead. HSBC has elected to apply this
transitional provision.
The basis of calculating capital changed with
effect from 1 January 2008 and the effect on both
tier 1 capital and total capital is shown in the table
below, ‘Capital Structure’. The Group’s capital base
is reduced compared with Basel I by the extent to
which expected losses exceed the total of individual
and collective impairment allowances on IRB
portfolios. These collective impairment allowances
are no longer eligible for inclusion in tier 2 capital.
For disclosure purposes, this excess of expected
losses over total impairment allowances in IRB
portfolios is deducted 50 per cent from core equity
tier 1 and 50 per cent from tier 2 capital. In addition,
a tax credit adjustment is made to tier 1 capital to
reflect the tax consequences insofar as they affect the
availability of tier 1 capital to cover risks or losses.
Expected losses derived under Basel II rules
represent losses that would be expected in the
scenario of a severe downturn over a 12-month
period. This definition differs from loan impairment
allowances, which only address losses incurred
within lending portfolios at the balance sheet date
and are not permitted to recognise the additional
level of conservatism that the regulatory measure
requires by the adoption of through-the-cycle,
downturn and stressed conditions that may not exist
at the balance sheet date.
The effect of deducting the difference between
expected losses and total impairment allowances is
to equate the total effect on capital with the
regulatory definition of expected losses. As expected
losses are based on long-term estimates and
incorporate through-the-cycle considerations, they
are expected to be less volatile than actual loss
experience. The impact of this deduction, however,
may vary from time to time as the accounting
measure of impairment moves closer to or further
away from the regulatory measure of expected
losses.
The FSA’s rules permit the inclusion of profits
in tier 1 capital to the extent that they have been
verified in accordance with the FSA’s General
Prudential Sourcebook by the external auditor.
Verification procedures covering profits for the year
to 31 December 2008 were completed by the
external auditor on 2 March 2009 and therefore these
profits have been included in the Group’s tier 1
capital. Technically, from 1 January 2008, the FSA’s
regulatory reporting forms defer the recognition of
these profits in tier 1 capital until the conclusion of
the external auditor’s procedures.
Basel II provides three approaches of increasing
sophistication to the calculation of pillar 1 credit
risk capital requirements. The most basic, the
standardised approach, requires banks to use external
credit ratings to determine the risk weightings
applied to rated counterparties, and groups other
counterparties into broad categories and applies
standardised risk weightings to these categories.
The next level, the internal ratings-based (‘IRB’)
foundation approach, allows banks to calculate their
credit risk capital requirements on the basis of their
internal assessment of the probability that a
counterparty will default (‘PD’), but with
quantification of exposure at default (‘EAD’)
and loss given default (‘LGD’) estimates being
subject to standard supervisory parameters. Finally,
the IRB advanced approach allows banks to use their
own internal assessment of not only PD but also the
quantification of EAD and LGD. The regulatory
measure of expected losses is calculated by
multiplying PD by EAD and LGD. The capital
resources requirement under the IRB approaches is
intended to cover unexpected losses and is derived
from a formula specified in the regulatory rules,
which incorporates these factors and other variables
such as maturity and correlation.
For credit risk, with FSA approval, HSBC has
adopted the IRB advanced approach for the majority
of its business with effect from 1 January 2008, with
the remainder on either IRB foundation or
standardised approaches. For consolidated group
reporting, the FSA’s rules permit the use of other
regulators’ standardised approaches where they are
considered equivalent. The use of other regulators’
IRB approaches is subject to the agreement of the
FSA. A rollout plan, over the next few years, is in
place to extend coverage of the advanced
approaches, for both local and consolidated Group