As filed with the Securities and Exchange Commission on March 10, 2008.
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549
FORM 20-F
For the transition period from N/A to N/ACommission file number: 1-14930
HSBC Holdings plc(Exact name of Registrant as specified in its charter)
8 Canada SquareLondon E14 5HQUnited Kingdom(Address of principal executive offices)Russell C PicotHSBC Holdings plc8 Canada SquareLondon E14 5HQUnited KingdomTel +44 (0) 20 7991 8888Fax +44 (0) 20 7992 4880(Name, Telephone, Email and/or Facsimile number and Address of Company Contact Person)
Securities registered or to be registered pursuant to Section 12(b) of the Securities Exchange Act of 1934:
Securities registered or to be registered pursuant to Section 12(g) of the Securities Exchange Act of 1934: None
Securities for which there is a reporting obligation pursuant to Section 15(d) of the Securities Exchange Act of 1934: None
Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the period covered by the annual report:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:
If “Other” has been checked in response to the previous question indicate by check mark which financial statement item the registrant has elected to follow.
If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
* Not for trading, but only in connection with the registration of American Depositary Shares.
Headquartered in London, HSBC is one of the largest banking and financial services organisations in the world. Its international network comprises some 10,000 properties in 83 countries and territories in Europe; Hong Kong; Rest of Asia-Pacific, including the Middle East and Africa; North America and Latin America.
With listings on the London, Hong Kong, New York, Paris and Bermuda stock exchanges, shares in HSBC Holdings plc are held by about 200,000 shareholders in over 100 countries and territories. The shares are traded on the New York Stock Exchange in the form of American Depositary Shares.
HSBC provides a comprehensive range of financial services to 128 million customers through four customer groups and global businesses: Personal Financial Services (including consumer finance); Commercial Banking; Global Banking and Markets; and Private Banking.
Contents
1 Detailed contents are provided on the referenced pages.
Certain defined terms
Back to Contents
1 Dividends declared in the year per ordinary share.
Data for 2004 to 2007 are presented based on financial statements prepared in accordance with IFRSs; data for 2003 in accordance with UK GAAP. Further information about the results is given in the consolidated income statement on page 337.
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The consolidated financial statements of HSBC and the separate financial statements of HSBC Holdings have been prepared in accordance with International Financial Reporting Standards (‘IFRSs’) as endorsed by the European Union (‘EU’). EU-endorsed IFRSs may differ from IFRSs as published by the International Accounting Standards Board (‘IASB’) if, at any point in time, new or amended IFRSs have not been endorsed by the EU. At 31 December 2007, there were no unendorsed standards effective for the year ended 31 December 2007 affecting these consolidated and separate financial statements, and there was no difference between IFRSs endorsed by the EU and IFRSs issued by the IASB in terms of their application to HSBC. Accordingly, HSBC’s financial statements for the year ended 31 December 2007 are prepared in accordance with IFRSs as issued by the IASB.
Information for 2003 has been prepared under previous HSBC policies in accordance with UK Generally Accepted Accounting Principles (‘UK GAAP’), which are not comparable with IFRSs.
HSBC uses the US dollar as its presentation currency because the US dollar and currencies linked to it form the major currency bloc in which HSBC transacts its business. Unless otherwise stated, the information presented in this document has been prepared in accordance with IFRSs.
When reference to ‘underlying’ or ‘underlying basis’ is made in tables or commentaries, comparative information has been expressed at constant currency (see page 131) and adjusted for the effects of acquisitions and disposals. A reconciliation of reported an d underlying profit before tax is presented on page 15.
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2007 was a year when large parts of the international financial system came under extraordinary strain. For HSBC to achieve another new high in earnings, despite these conditions and the exceptionally weak performance of our US business, underscores the value of the strategic focus we announced early last year to drive sustainable growth by concentrating on the faster growing markets of the world.
Pre-tax profits in 2007 increased by 10 per cent to US$24 billion and earnings per share rose by 18 per cent to US$1.65. Excluding the dilution gains arising from our strategic investments in mainland China, which I highlighted at the interim stage, profits grew by 5 per cent. Consistent with our strategy of focusing on emerging markets where we are the world’s leading international bank, profits from those businesses, excluding dilution gains, grew by 41 per cent to US$15 billion.
Our return on shareholders’ equity exceeded 15 per cent, revenue growth was in double digits for the fifth year running, our cost efficiency ratio improved and our capital ratios remained strong. HSBC’s financial strength in terms of both capital and liquidity is a powerful driver of sustainable growth and helps ensure continued resilience.
Strong operating performance in 2007
We produced exceptionally strong results in Asia-Pacific, Latin America and the Middle East while facing considerable business challenges in North America. In our customer groups, we also achieved record results in Commercial Banking and Private Banking, and a strong performance in Global Banking and Markets, despite write-downs arising from market turbulence in the second half of the year. In addition, Personal Financial Services produced record profits in emerging markets. Within
these customer groups, our insurance operations made further progress.
Our North American results continue to be adversely affected by high loan impairment charges as we respond to the impact on our portfolio of credit deterioration arising largely from housing market weakness in the US. The management team has taken vigorous action to address and mitigate the problem. In Europe, excluding the positive effect of movements in the fair value of HSBC’s own debt, performance was broadly in line with 2006. In the UK, Commercial Banking generated pre-tax profits of over US$2 billion for the first time and, in Turkey, further expansion of the branch network helped drive strong organic growth in numbers of personal and business customers.
Financial strength underpins our progressive dividend policy
The Directors have declared a fourth interim dividend for 2007 of US$0.39 per ordinary share (in lieu of a final dividend) which, together with the first three interim dividends for 2007 of US$0.17 already paid, will make a total distribution in respect of the year of US$0.90 per share (US$0.81 per share in respect of 2006), an increase of 11.1 per cent. The dividend will be payable on 7 May 2008 with a scrip dividend alternative, to shareholders on the register on 25 March 2008. HSBC’s dividend has increased by 10 per cent or more every year for 15 years.
A clear and compelling strategy playing to our strengths
At the beginning of 2007, we refreshed our strategy, considering how we should shape HSBC for the future. Our deliberations were influenced by some fundamental long-term trends that will shape tomorrow’s world: emerging markets will continue to grow faster than mature ones; world trade will continue to grow faster than world output; and people are living longer than ever before with all the implications that has for long-term savings and pensions.
Our thinking was also informed by a clear appreciation of HSBC’s strengths. We believe that the global leadership we have built in emerging markets and in trade, and our international perspective, are compelling advantages that set HSBC apart for our customers, our shareholders and our people.
As we explained in March 2007, our conclusion was that the Group should place renewed emphasis on investing in fast moving emerging markets in Asia-Pacific, the Middle East and Latin America. We
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believe we can grow strongly and sustainably. We achieved our position as the number one international bank in Asia-Pacific and the Middle East over many years; by contrast, we have built one of Latin America’s largest financial services businesses in little more than a decade.
In mature markets, we are determined to focus our businesses on areas where we can build on our unique global franchise, so as to benefit from the long-term trend of increasing international connectivity. We have international customer bases across many of our businesses, from the largest corporates, through to small or medium-sized enterprises, to the internationally mobile mass affluent and other personal customers with specific international requirements. We have developed a clear approach which is enabling our business to focus strongly on these groups of customers now and in the years ahead.
Where opportunities arise, we shall seek to redeploy capital towards emerging markets through divestment of assets of greater strategic value to others. In France, we have received a firm cash offer of US$3.1 billion for our seven, separately branded, regional banks and have entered into exclusive discussions. This potential transaction, which is subject to necessary approvals and consultation, could complete in mid-2008. We remain committed to France through our HSBC-branded network serving retail and commercial customers and through our activities in Global Banking and Markets, Private Banking, asset management and insurance. During 2007, we acquired the 50 per cent of Erisa, our French insurance business, which we did not own.
We will also build businesses, in both our emerging and mature markets, that help our customers with their long-term savings needs, as demographics and wealth creation trends around the world make this ever more important to them.
Finally, we will shape our business operations so that we use our scale to deliver better, more efficient services to our customers. Their use of technology increasingly dictates how they interact with us. We increasingly employ technology to create better products which we can deliver globally at lower cost. As we grow our direct banking business, we will create opportunities to meet more of our customers’ financial needs.
Building on our position as the world’s leading international emerging markets bank
During 2007, we continued to build our businesses in emerging markets organically. For example, on a like-for-like basis, risk-weighted assets in these areas grew by 42 per cent compared with 16 per cent for the Group as a whole.
As the leading international bank in the country of our birth, China, we were delighted to be among the first to incorporate locally in the mainland. We have built the largest branch network of any international bank and we have significant and profitable strategic investments in our Chinese associates.
In mainland China, through our own businesses and in conjunction with our associates, we achieved for the first time in our history a profit before tax of over US$1 billion, in addition to over US$7 billion generated in Hong Kong.
As China continues to reshape itself as a 21st century powerhouse, HSBC seeks to play a constructive role in its continued progressive economic and social development. We were the first international bank to establish and open a rural bank. Hang Seng Bank has agreed to acquire 20 per cent of Yantai City Commercial Bank in the fast growing Bohai region of China.
Elsewhere in Asia-Pacific, we have sought to further strengthen our position through a series of investments in faster-growing economies. In South Korea, we have agreed to acquire 51 per cent of Korea Exchange Bank for US$6.5 billion, subject to regulatory approvals. In Taiwan, we acquired Chailease Credit Services, a factoring company serving commercial customers, and agreed to acquire the assets, liabilities and operations of The Chinese Bank, which will extend our network by 39 branches and bring us many new customers.
As foreign investment rules are eased, we have made significant investments to expand our business in Vietnam with the acquisition of a further 5 per cent interest in Techcombank, bringing our stake to 14.4 per cent, and the purchase for some US$255 million of a 10 per cent interest in Bao Viet, the leading insurance company in the country.
The latter investment reflects our determination to increase the contribution of insurance to Group earnings. We also entered into agreements to invest in a 26 per cent interest in a new life insurance joint venture in India, in partnership with two of the larger state-owned banks, and to acquire just under 50 per cent of Hana Life Insurance Company in South Korea. We have entered a number of strategic
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alliances to ensure that we have the best products for our customers and the support to grow our activities.
A fifth consecutive year of rising oil prices facilitated growth in public and private investment in the Middle East. As a result, infrastructure development accelerated and consumption and employment rose. Our businesses in the Middle East were well positioned to benefit from this and have had an excellent year.
Our acquisition of Grupo Banistmo in Central America and Banco Nazionale in Argentina in 2006 strengthened our existing business. 2007 has been a year of integrating these operations. It is a testimony to the strength of our Latin American businesses that we have been able to grow profits by 26 per cent to over US$2 billion while investing in the integration, and despite the increase in loan impairment charges in Mexico as our loan portfolio began to mature.
A people business
It is people, of course, who define an organisation; and any business’s success is dependent on the calibre of its staff. 2007 was a demanding year in many respects and it is testament to the talent and professionalism of my 330,000 colleagues around the world that HSBC successfully met its challenges and excelled in so many areas. I would like to take this opportunity to extend my personal thanks to my colleagues – their commitment and expertise have greatly benefited the Group and our shareholders.
Measuring the results of our strategy
Today we are publishing, for the first time, the key metrics which we will use to measure our performance in future. These include a number of measures that cover financial performance, customer recommendation and employee engagement.
In financial terms we are aiming for a return on equity in a range over the investment cycle of 15-19 per cent; a cost efficiency ratio in the range of 48-52 per cent; Tier 1 capital under the Basel II framework of 7.5 -9.0 per cent; and total shareholder return in the top half of that achieved by our peers.
Financial measures are important but not sufficient: it is our people and our relationship with customers that will drive our business and ultimately determine our success. For the first time, in 2007, 290,000 HSBC colleagues completed our new global people survey, allowing us to benchmark ourselves and, over time, raise our game. Similarly, we have established customer engagement metrics which enable us to measure and improve our service to them. We have set ourselves challenging targets to
increase both employee and customer engagement. They will help us build on our position as the world’s number one global banking brand.
Changes to your Board
Independent oversight of our company and of the execution of strategy is the responsibility of one of the most experienced and international Boards in the world. I am delighted that we will benefit from international business leaders of the calibre of José Luis Durán and Sam Laidlaw, who joined the Board as independent non-executive Directors on 1 January 2008. We also welcome two other global business leaders, Safra Catz and Narayana Murthy, who will join as independent non-executive Directors on 1 May 2008.
The Board will be further strengthened by the appointment of three executive directors: Vincent Cheng, effective 1 February 2008; and Sandy Flockhart and Stuart Gulliver, who will join the Board, effective 1 May 2008. These are three of our most talented and experienced executives - all emerging market specialists.
Baroness Dunn, Sir Brian Moffat and Lord Butler will retire as non-executive Directors at HSBC’s Annual General Meeting on 30 May 2008 and will not seek re-election. I should like to pay tribute to their tremendous contribution to HSBC. We have been privileged to enjoy their counsel and stewardship for so many years.
HSBC’s core strength in uncertain times
The outlook for the rest of 2008 is uncertain. The economic slowdown and the credit outlook in the US may well get worse before they get better. With significant parts of the international financial system in developed markets still in difficulty, HSBC’s emphasis on faster growing emerging markets means that we are better positioned than many of our competitors.
Emerging markets have only partly decoupled from the US. Hence, while these economies are exhibiting more domestic momentum, they will not be entirely immune from the impact of a US slowdown. However, the major long-term trends are still intact. Emerging markets will continue to outperform mature economies; and world growth, even in this year of relative weakness for the US economy, will be reasonable – albeit slower than in 2007. Meanwhile, trade and investment patterns will continue to evolve to reflect a more interconnected world, notwithstanding some signs of protectionist sentiment in several key mature markets. In particular, we will see further strategic investments
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from emerging markets into mature markets, as well as into other emerging markets, a trend from which we are well placed to benefit.
2008 is likely to be a year of caution in the financial sector until liquidity, transparency and the proper pricing of risk return to financial markets. We expect to be able to improve margins on the use of our capital and we will continue to invest in building market presence at a time when others with weaker capital positions are constrained.
The fundamentals of HSBC are very strong. The deleveraging of the financial system clearly plays to HSBC’s strengths, given our conservative balance sheet and international presence. There can be few banks in the world that are better positioned to withstand market turbulence and grasp strategic opportunities. We will continue to focus HSBC on the parts of the global economy that promise the best prospects for higher growth over the long term. We will continue to invest for profitable growth in line with our strategy, and we will do so while maintaining HSBC’s financial strength, which is at the heart of our success.
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HSBC is one of the largest banking and financial services organisation in the world, with a market capitalisation of US$198 billion at 31 December 2007.
Through its subsidiaries and associates, HSBC provides a comprehensive range of banking and related financial services. Headquartered in London, HSBC operates through long-established businesses and has an international network of some 10,000 properties in 83 countries and territories in five geographical regions: Europe; Hong Kong; Rest of Asia-Pacific, including the Middle East and Africa; North America and Latin America. Within these regions, a comprehensive range of financial services is offered to personal, commercial, corporate, institutional, investment and private banking clients. Services are delivered primarily by domestic banks, typically with large retail deposit bases, and consumer finance operations. Taken together, the five largest customers of HSBC do not account for more than one per cent of HSBC’s income.
The principal acquisitions made during the year are described on page 415. There were no significant disposals.
HSBC’s strategic direction reflects its position as ‘The world’s local bank’, combining the largest global emerging markets banking business and a uniquely cosmopolitan customer base with an extensive international network and substantial financial strength.
The Group’s strategy is aligned with key trends which are shaping the global economy. In particular, HSBC recognises that, over the long-term, emerging markets are growing faster than developed economies, world trade is expanding at a greater rate than GDP and life expectancy is lengthening everywhere. Against this backdrop, HSBC’s strategy is focused on delivering superior growth and earnings over time by building on the Group’s heritage and skills. Its origins in trade in Asia have had a considerable influence over the development of the Group and, as a consequence, HSBC has established a longstanding presence in many countries. This local knowledge and international breadth is supported by a substantial financial capability founded on balance sheet strength.
HSBC is, therefore, reshaping its business by investing primarily in the faster growing emerging markets and, in developed markets, focusing on businesses which have international connectivity. Central to these activities is the maintenance of HSBC’s financial strength and continued investment in the business.
The Group has identified three main business models for its customer groups and global businesses that embody HSBC’s areas of natural advantage:
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The Board of Directors and the Group Management Board monitors HSBC’s progress against its strategic objectives. Progress is assessed by comparison with the Group’s strategy, its operating plan targets and its historical performance using both financial and non-financial measures.
As a prerequisite for the vesting of performance shares, the Remuneration Committee must satisfy itself that HSBC’s financial performance has shown a sustained improvement in the period since the award date. In determining this, the Remuneration Committee takes into account HSBC’s financial performance with regard to the financial key performance indicators (‘KPIs’) described below. For awards made since 2005, the financial KPIs are
compared with the same group of 28 comparator banks as for the total shareholder return (‘TSR’) performance condition.
Financial KPIs
To support the Group’s strategy and ensure that HSBC’s performance can be monitored, management utilises a number of financial KPIs. The table below presents these KPIs for the period from 2004 to 2007. At a business level, the KPIs are complemented by a range of benchmarks which are relevant to the planning process and to reviewing business performance.
HSBC is publishing a number of key targets against which future performance can be measured. Financial targets have been set as follows: the return on average total shareholders’ equity over the medium term has been set at 15-19 per cent; the cost efficiency ratio has been set in the range of 48-52 per cent; and the TSR in the top half of that achieved by peers. The cost efficiency ratio has been set as a range within which the business is expected to remain in order to accommodate the need for continued investment in support of future business growth.
Financial KPIs – trend analysis
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Revenue growth provides an important guide to the Group’s success in generating business. In 2007, total revenue grew by 20.8 per cent to US$79.0 billion, 13.5 per cent on an underlying basis, reflecting HSBC’s expansion into new products and markets, improved brand recognition and refinements in segmentation to better meet customer needs. The trend maintained the strong performance in 2006 when the underlying increase was 10.5 per cent. Higher revenue was largely driven by balance sheet growth and strong contributions from faster-growing economies. Fair value gains also helped revenue growth. These gains were primarily driven by a widening of credit spreads on debt issued by HSBC Holdings and its subsidiaries and designated at fair value. The movements will reverse over the life of the debt unless it is repaid before its contractual maturity.
Revenue mix represents the relative distribution of revenue streams between net interest income, net fee income and other revenue. It is used to understand how changing economic factors affect the Group, to highlight dependence on balance sheet utilisation for income generation and to indicate success in cross-selling fee-based services to customers with loan facilities. This understanding assists management in making business investment decisions. Comparison of the revenue mix since 2005 shows a clear trend of net fee income increasing at a faster rate than net interest income. The percentage of revenue attributable to net interest income fell from 52.8 per cent in 2006 to 47.8 per cent in 2007. Net fee income grew by 1.6 percentage points to 27.9 per cent.
Cost efficiency is a relative measure that indicates the consumption of resources in generating revenue. Management uses this to assess the success of technology utilisation and, more generally, the productivity of the Group’s distribution platforms and sales forces. The cost efficiency ratio for 2007 improved over the previous two years notwithstanding the continued investment in HSBC’s businesses, particularly in emerging markets, and in improving the Group’s distribution and technology platforms.
Credit performance as measured by risk-adjusted margin is an important gauge for assessing whether credit is correctly priced so that the returns available after recognising impairment charges meet the Group’s required return parameters. The ratio for 2007 was 6.0 per cent, showing a decrease of 0.3 percentage points over 2006. The marginal decrease arose from the significant credit losses in the US, partly offset by the increase in income
mainly generated from the faster-growing economies.
Return on average invested capital measures the return on the capital investment made in the business, enabling management to benchmark HSBC against competitors. In 2007, the ratio of 15.3 per cent was 0.4 percentage points higher than that reported in 2006. This increase reflected the fact that profitability grew faster than the capital utilised in generating the profit. The main drivers were the higher income generated, mainly in the faster-growing economies, which was not consumptive of capital, and the fair value adjustment on the widening of credit spreads on debt issued by HSBC Holdings and its subsidiaries. Dilution gains of US$1.1 billion made on investments in HSBC’s associates also made a positive contribution towards the return on average invested capital ratio.
HSBC aims to deliver sustained dividend per share growth for its shareholders. The dividend growth for 2007, which is based on the year to which the dividends relate (rather than when they were paid), amounts to 11.1 per cent, a marginal increase of 0.1 percentage points over 2006. This basis differs from the disclosure in the five-year comparison on page 3. HSBC has delivered a compound rate of increase in dividends of 11.2 per cent per annum over the past five years.
Basic earnings per share (‘EPS’) is a ratio that shows the level of earnings generated per ordinary share. EPS is one of two KPIs used in rewarding employees and is discussed in more detail in the Director’s Remuneration Report on page 325. EPS for 2007 was US$1.65, an increase of 17.9 per cent on 2006. This demonstrated the benefit of diversified earnings as the losses in the US consumer finance business were more than compensated for by strong growth in other markets and products. In 2006, EPS grew by 2.9 per cent over that reported in 2005.
Return on average total shareholders’ equity measures the return on average shareholders’ investment in the business. This enables management to benchmark Group performance against competitors and its own targets. In 2007, the ratio was 15.9 per cent or 0.2 percentage points higher than in 2006. This is in line with management’s target of achieving a range of between 15 and 19 per cent.
Total shareholder return (‘TSR’) is used as a method of assessing the overall return to shareholders on their investment in HSBC, and is defined as the growth in share value and declared dividend income during the relevant period. TSR is a key performance measure in rewarding employees.
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In calculating TSR, dividend income is assumed to be invested in the underlying shares. As the comparator group includes companies listed on overseas markets, a common currency is used to ensure that TSR is measured on a consistent basis. The TSR benchmark is an index set at 100 and measured over one, three and five years for the purpose of comparison with the performance of a group of competitor banks which reflect HSBC’s range and breadth of activities. The TSR levels at the end of 2007 were 95.6, 111.3, and 158.8 over one, three and five years respectively. HSBC’s TSR over all above mentioned periods has underperformed the benchmark. This is attributed largely to the impact on the share price of the current weakness in the US sub-prime mortgage business and investor preference over this time for companies with smaller market values, particularly those for which there is the possibility of participating in domestic or regional consolidation.
Management believes that financial KPIs must remain relevant to the business so they may be changed over time to reflect changes in the Group’s composition and the strategies employed.
Non-financial KPIs
HSBC has chosen four non-financial KPIs which are important to the future success of the Group in delivering its strategic objectives. These non-financial KPIs are currently reported internally within HSBC on a local basis.
Employee engagement
Employee engagement is a measure of employees’ emotional and rational attachment to HSBC.
In 2007, HSBC conducted its first Global People Survey. This comprised questions designed to measure employee engagement levels consistently across the Group. The survey covers HSBC’s entire permanent global workforce, and responses were received from almost 290,000 employees, a response rate of 88 per cent.
The overall employee engagement index score was 60 per cent. The 2008 target is 62 per cent. Survey questions were grouped into twelve dimensions. Employees rated HSBC above the external global norms in all these dimensions. In two dimensions, reputation and corporate responsibility, employees rated HSBC as achieving the external best in class norm. The survey results have been shared with all employees and action plans are being developed at all levels of the organisation.
Brand perception
The score for brand perception is set by data from surveys that are conducted by accredited, independent, third party organisations. A weighted score card is used to produce an overall score on a 100 point scale which is then benchmarked against HSBC's main competitors. The scores from each market are weighted according to the risk adjusted revenues earned in that market to obtain the overall company score.
The 2007 brand scores for Personal Financial Services and Commercial Banking were ahead of the competitor averages by 6 and 7 points, respectively, on a 100 point scale. The 2008 brand perception target is to increase the gap to 9 points and 8 points, respectively.
Customer satisfaction
HSBC has regularly conducted customer satisfaction surveys in its main markets over many years. HSBC now uses a consistent measure of customer recommendation to gauge customer satisfaction with the services provided by the Group's Personal Financial Services business. This survey is also conducted by accredited, independent, third party organisations and the resulting recommendation scores are benchmarked against competitors.
The 2007 customer recommendation score for Personal Financial Services was ahead of the competitor average by 1 point on a 100 point scale. The 2008 target is to increase that gap to 2.5 points.
IT performance and systems reliability
HSBC tracks two key measures as indicators of IT performance; namely, the number of customer transactions processed and the reliability and resilience of systems measured in terms of service availability targets.
Number of customer transactions processed
The number of customer transactions processed is a reflection of the increasing usage of IT in each of the delivery channels used to service customers. Its aim is to manage the rate of increase in customer transaction costs effectively and ensure that customer growth is enabled in the appropriate channels. The transition of customer transactions from labour intensive (branch, call centre and others) to automated (credit card, internet, self-service and other e-channels) is occurring. The following chart shows the 2005, 2006 and 2007 volumes per delivery channel:
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Customer transactions
The call centre, internet and self-service transaction numbers for 2006 have been restated to align them with the definition of customer transactions adopted in 2007.
Percentage of IT services meeting or exceeding targets
HSBC’s IT function establishes with its end-users agreed service levels for systems performance, such as systems running 99.9 per cent of the time and credit card authorisations within two seconds, and monitors the achievement of each of these commitments. The following chart reflects the percentage of IT services meeting and/or exceeding the agreed service targets. Overall results in Europe, Hong Kong and Latin America were each affected by a single month’s service issue, which skewed a trend of flat or improving service performance.
HSBC measures its performance internally on a like-for-like basis, eliminating the effects of Group currency translation gains and losses, acquisitions and disposals and gains from the dilution of the Group’s interests in associates, which distort the year-on-year comparison. HSBC refers to this as its underlying performance.
The tables below show the underlying performance of HSBC for the year ended 31 December 2007 compared with the year ended 31 December 2006. Comparative information comparing the years ended 31 December 2006 and 2005 is also set out below. Equivalent tables are provided for each of HSBC’s customer groups and geographical segments in their respective sections below.
The main differences between HSBC’s reported and underlying financial performances were:
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For footnotes, see page 130.
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Summary
HSBC manages its business through two customer groups, Personal Financial Services and Commercial Banking, and two global businesses, Global Banking and Markets (previously Corporate, Investment Banking and Markets), and Private Banking.
Personal Financial Services incorporates the Group’s consumer finance businesses, reflecting their increasing integration within mainstream financial services around the world. The largest of these is HSBC Finance Corporation (‘HSBC Finance’), one of the leading consumer finance companies in the US.
Profit before tax
Total assets
Basis of preparation
The results are presented in accordance with the accounting policies used in the preparation of HSBC’s consolidated financial statements. HSBC’s operations are closely integrated and, accordingly, the presentation of customer group data includes internal allocations of certain items of income and expense. These allocations include the costs of certain support services and head office functions, to
the extent that these can be meaningfully attributed to operational business lines. While such allocations have been made on a systematic and consistent basis, they necessarily involve a degree of subjectivity.
Where relevant, income and expense amounts presented include the results of inter-segment funding as well as inter-company and inter-business line transactions. All such transactions are undertaken on arm’s length terms.
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Personal Financial Services
Strategic direction
HSBC’s strategic direction in Personal Financial Services is to use its global scale and local knowledge to grow profitably in selected markets. The strategy focuses on growth in:
Business highlights in 2007
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Commercial Banking enhances the customer experience through a strong multi-channel approach to customer relationships, leveraging HSBC’s IT platforms and operational processing capabilities. Additional value is captured through strong connectivity with each of the other customer groups.
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Reconciliation of reported and underlying profit before tax
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Global Banking and Markets
In 2007, the implementation of the ‘emerging markets-led and financing-focused’ strategy was completed and Corporate, Investment Banking and Markets was renamed Global Banking and Markets. HSBC’s strategy is to be a leading wholesale bank by:
Ensuring that this combination of product depth and distribution strength meets the needs of existing and new clients will allow Global Banking and Markets to achieve its strategic goals.
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Management view of total operating income
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Private Banking
The strategy for Private Banking is to be one of the world’s leading international private banks, by providing excellent client service.
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Client assets
Client assets by investment class
Europe
Asia
Americas
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Other
Notes
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Analysis by customer group and global business
Profit/(loss) before tax and balance sheet data
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Profit/(loss) before tax and balance sheet data (continued)
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Summary of geographical regions
In the analysis of profit by geographical regions that follows, operating income and operating expenses include intra-HSBC items of US$1,985 million (2006: US$1,494 million; 2005: US$938 million).
For footnote, see page 130.
Additional information on results in 2007 may be found in the ‘Report of the Directors: Financial Review’ on pages 131 to 191.
HSBC’s principal banking operations in Europe are HSBC Bank plc (‘HSBC Bank’) in the UK, HSBC France, HSBC Bank A.S. in Turkey, HSBC Bank Malta p.l.c., HSBC Private Bank (Suisse) S.A., HSBC Trinkaus & Burkhardt AG and HSBC Guyerzeller Bank AG. Through these operations HSBC provides a wide range of banking, treasury and financial services to personal, commercial and corporate customers across Europe.
Hong Kong
HSBC’s principal banking subsidiaries in Hong Kong are The Hongkong and Shanghai Banking Corporation Limited (‘The Hongkong and Shanghai Banking Corporation’) and Hang Seng Bank Limited (‘Hang Seng Bank’). The former is the largest bank incorporated in Hong Kong and is HSBC’s flagship bank in the Asia-Pacific region. It is one of Hong Kong’s three note-issuing banks, accounting for more than 65 per cent by value of banknotes in circulation in 2007.
Rest of Asia-Pacific (including the Middle East)
HSBC offers personal, commercial, global banking and markets services in mainland China, mainly through its local subsidiary, HSBC Bank (China) Company Limited (‘HSBC Bank China’), which was incorporated in March 2007. The bank’s network spans 18 major cities, comprising 18 branches and 44 sub-branches. Hang Seng Bank offers personal and commercial banking services and operates 10 branches, 14 sub-branches and one representative office in 10 cities in mainland China. HSBC also participates indirectly in mainland China through its three associates, Bank of Communications (19.01 per cent owned), Ping An Insurance (16.78 per cent) and Industrial Bank (12.78 per cent), and has a further interest of 8 per cent in Bank of Shanghai.
Outside Hong Kong and mainland China, HSBC conducts business in 21 countries in the Asia-Pacific region, primarily through branches and subsidiaries of The Hongkong and Shanghai Banking Corporation, with particularly strong coverage in India, Indonesia, South Korea, Singapore and Taiwan. HSBC’s presence in the Middle East is led by HSBC Bank Middle East Limited (‘HSBC Bank Middle East’), whose network of branches,
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subsidiaries and associates has the widest coverage in the region; in Australia by HSBC Bank Australia Limited; and in Malaysia by HSBC Bank Malaysia Berhad (‘HSBC Bank Malaysia’), which is the largest foreign-owned bank in the country by operating income and pre-tax profits. HSBC’s associate in Saudi Arabia, The Saudi British Bank (40 per cent owned), is the Kingdom’s sixth largest bank by total assets.
North America
HSBC’s North American businesses are located in the US, Canada and Bermuda. Operations in the US are primarily conducted through HSBC Bank USA, N.A. (‘HSBC Bank USA’) which is concentrated in New York State, and HSBC Finance, a national consumer finance company based in Chicago. HSBC Markets (USA) Inc. is the intermediate holding company of, inter alia, HSBC Securities (USA) Inc., a registered broker and dealer of securities and a registered futures commission merchant. HSBC Bank Canada and The Bank of Bermuda Limited (‘Bank of Bermuda’) operate in their respective countries.
Latin America
HSBC’s operations in Latin America and the Caribbean principally comprise HSBC México, S.A. (‘HSBC Mexico’), HSBC Bank Brasil S.A.-Banco Múltiplo (‘HSBC Bank Brazil’), HSBC Bank Argentina S.A. (‘HSBC Bank Argentina’) and HSBC Bank (Panama) S.A. (‘HSBC Bank Panama’), formerly Grupo Banistmo S.A., which owns subsidiaries in Costa Rica, Honduras, Colombia, Nicaragua and El Salvador. HSBC is also represented by subsidiaries in Chile, the Bahamas, Peru, Paraguay and Uruguay and by a representative office in Venezuela. In addition to banking services, HSBC operates insurance businesses in Mexico, Argentina, Brazil, Panama, Honduras and El Salvador. In Brazil, HSBC offers consumer finance products through its subsidiary, Losango.
Competitive environment
HSBC believes that open and competitive markets are good for both local economies and their participants. The Group faces very strong competition in the markets it serves. In personal and commercial banking, it competes with a wide range of institutions including commercial banks, consumer finance companies, retail financial service companies, savings and loan associations, credit unions, general retailers, brokerage firms and investment companies. In investment banking,
HSBC faces competition from specialist providers and the investment banking operations of other commercial banks.
Regulators routinely monitor and investigate the competitiveness of the financial services industry (of which HSBC is a part) in a number of areas, particularly in the UK and continental Europe. HSBC’s policy is to co-operate and work positively with all its regulators, providing data and perspective on those issues which affect all financial service providers both directly and through industry bodies.
Global factors
Market liquidity
The ‘credit crunch’ disruption in credit markets that began in the latter half of 2007 is resulting in the movement of assets back on to banks’ balance sheets, absorbing capital and constraining banks’ ability to lend. The disruption has created an imbalance between the supply and demand for many classes of financial assets and has led to the traditional buyers of debt adopting a very cautious approach to the purchase of any securities which are neither fully transparent in risk profile nor of assured liquidity. Although this liquidity strain began in the asset-backed securities markets, it has since spread to more traditional investment classes. In this environment, the scope for a bank to originate assets beyond its capacity to hold them to term is limited by its available capital and funding resources. This environment is less disruptive to banks that fund their lending through deposits than those that rely on the securitisation markets for funding.
Progressive alignment of the capital adequacy framework towards economic capital
As major banks move to the new Basel II capital adequacy framework (see ‘Basel II’ on page 284), their capital requirements will necessarily be more closely matched with their risk profiles. In an environment of economic uncertainty, many banks may need to reduce lending due to forecast increases in capital requirements arising from deterioration in the quality of their credit risk exposures. This reduction in risk appetite may potentially accelerate the deterioration in credit quality as credit availability is restricted during a downturn in the economic cycle. When coupled with a lack of market liquidity, this may lead to polarisation within the banking system. Banks with greater capital and liquidity resources are better placed to meet the ongoing banking requirements of their customers than other banks which are more constrained in this regard.
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Advances in technology
Customer transaction volumes continue to grow at a rate considerably ahead of the growth in underlying balances or accounts, leading many banks to seek to reduce unit costs per service transaction in order to maintain margins. The deployment of automated secure transaction channels requires significant investment, providing a competitive advantage to banks with larger scale. Despite widespread adoption by both banks and customers of new distribution channels, the expected reduction in volumes of transactions through traditional channels has been slow to materialise and many banking customers continue to prefer to use them. The younger generation of customers, however, tends to be more comfortable with system-aided self-service, particularly for savings accounts, credit cards and simple investments. HSBC expects the sophistication of products sold in direct channels and adoption rates to increase, as the use of 24-hour self-service channels, such as ATMs, internet, mobile, and voice response units becomes increasingly commonplace.
Regulation
Initiatives such as Basel II, together with the increasingly international scope of financial services, have raised the level of cooperation between regulatory authorities in different countries. Enhanced understanding of how risks are originated and dispersed in modern financial markets has reinforced the need to address how best to regulate the increasingly integrated and international nature of banking and financial services; this has been evidenced most recently in coordinated discussions on the global liquidity disruption. In addition, the enlargement of the EU, the introduction of the Markets in Financial Instruments Directive (‘MIFID’) and the continued effort to endorse consistent standards and enforcement has encouraged regulatory bodies to work together more closely. Interaction and cooperation have led to competitive and regulatory issues emerging in one country rapidly being taken up in other jurisdictions. Uniform global standards, however, continue to be complicated by differing local interpretations, or additional local regulation.
Regional factors
Across Europe, in all sectors, HSBC competes with a growing range of institutions. These markets are characterised by rapid innovation, margin compression through competition and a constant flow of new entrants. Regulators monitor the financial services sector closely and conduct reviews
into the long-term evolution of the industry. Legislators are enforcing legislation with the aim of improving competition and protecting consumers.
In November 2007, the European Commission announced that in order to improve the competitiveness and efficiency of European retail financial services markets, reviews would be undertaken to improve customer choice and mobility within the single market; better facilitate retail insurance markets; achieve progress towards adequate and consistent rules for the distribution of retail investment products; and promote financial education, financial inclusion and adequate redress for consumers.
Following a long running investigation, the Competition Directorate-General determined that MasterCard’s multilateral interchange fees for cross-border payment card transactions violate EU competition rules. MasterCard has six months to comply or respond. HSBC is fully engaged in the case through its membership of MasterCard.
A number of key EU measures intended to facilitate development of the single market and increase competition came into effect during the year; principally, transposition of the Markets in Financial Instruments Directive in November 2007. Implementation of phase 1 of the Single Euro Payments Area programme occurred in January 2008.
UK
Financial services, including retail banking, is a highly competitive sector in the UK, led by several national and international institutions which compete on both price and service quality. Domestic acquisitions or mergers are limited. The sector is closely regulated, and a series of investigations with particular relevance to Personal Financial Services remain in progress.
In July 2007, a group of seven banks (including HSBC) and one building society announced that they had agreed with the Office of Fair Trading (‘OFT’) that the legal status and enforceability of certain of the charges applied to their personal customers in relation to unauthorised overdrafts should be tested in the High Court. Certain preliminary issues in the case came before the High Court in a trial starting in January 2008 and this part of the case concluded in February 2008. At the date of this report, judgement in the case is awaited. The OFT is also conducting a market study into competition for personal current accounts.
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The Competition Commission (‘CC’) commenced an investigation into the payment protection insurance (‘PPI’) market in February 2007 and published its Emerging Thinking document in November 2007. Provisional findings are due in May 2008 and the final report towards the end of the year. Similarly, the Financial Services Authority (‘FSA’) conducted the third phase of its review of the sales processes and systems around the sale of PPI policies and is now undertaking further assessment of firms’ performance in this area.
In December 2007, the CC announced its decision to lift the price controls imposed in 2003 on HSBC and the other three largest banks providing services to small and medium-sized enterprises in the UK. This is expected to result in greater competition and innovation within the market.
During 2007, the OFT continued to investigate competition issues in connection with the setting of multilateral interchange fees for domestic credit card payments.
In 2007, interest rates in the eurozone increased while growth in real estate investment stabilised. Income tax relief on new personal real estate loans was introduced following the presidential elections, though potential benefits to customers were offset by higher interest rates. Real estate mortgage loans remained the primary product by which banks attracted new customers and, as a result, competitive pricing led to decreased margins.
The French government introduced various fiscal incentives in the second half of 2007 which reduced tax on overtime pay and introduced a cap on the total tax paid by households at 50 per cent of income. These measures increased the disposable income of wealthier individuals who qualify for HSBC Premier and Private Banking services.
The commercial treasury bills market contracted and companies had difficulty obtaining facilities in the second half of 2007 due to market uncertainty. This trend is expected to continue in 2008.
The lending market remained active in 2007, initially driven by investment-related loans and, subsequently, as interest rates declined and market uncertainty increased, by property loans. A robust labour market and rising household wealth supported growth in consumer spending. As a result, demand for personal loans and credit cards rose.
In the middle of 2007, downward pressure on interest rates and an overall improvement in the property market led to increased demand for mortgages. Prices for high-end properties rose, though competition in traditional mortgage products remained fierce.
Rising equity markets stimulated sales of investment products and related loans. After a lull in demand in August and September, when disruption to money markets intensified as the implications for asset-backed securities of the growing credit crisis were reassessed, the market experienced intense volatility, accentuated by the possibility of a recession in the US.
Funds were attracted to Hong Kong during the year in anticipation of sustained appreciation of the renminbi as well as a positive outlook for the mainland Chinese stocks listed in Hong Kong. Deposit growth remained robust throughout the year and the status of Hong Kong as the chief financial centre to service the needs of businesses in Southern China was enhanced.
The business environment in the region remained highly competitive, notwithstanding increased demand for credit in Asian countries partially resulting from lower interest rates. In particular, short-term interest rates in mainland China, India, Indonesia, Malaysia and Singapore were less than the nominal Gross Domestic Product (‘GDP’) growth rate.
Mainland China
The People’s Bank of China indicated that it would continue to apply tight monetary policy to address excess domestic liquidity, to curb lending and to strengthen macro-economic conditions. Loan growth in mainland China remained robust despite this tightening and the benchmark one-year lending rate increased to 7.47 per cent by the end of 2007. The renminbi reserve requirement ratio for depository financial institutions increased to 14.5 per cent.
India
Loan growth in 2007 slowed due to earlier monetary tightening and adverse regulatory policies which restricted the activities of recovery agents. Aggressive growth strategies by several banks compressed margins and reduced overall asset quality.
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Middle East
The competitive environment in the Middle East intensified during 2007 as the regional economy prospered on the back of record oil prices, which prompted a surge in infrastructure development and construction activities. The Dubai International Finance Centre and the Qatar Financial Centre continued to attract a number of international institutions to set up operations in the region, particularly in the investment and private banking sectors.
Islamic banking activities continued to grow as a percentage of the market with the establishment of two prominent banks during the year. A number of competitor banks introduced innovative products and launched reward programmes to attract and retain customers.
Malaysia, South Korea, Indonesia and Taiwan
Competition in the Malaysian banking sector remained high as average lending rates continued to decline, despite no change to central bank policy. Banks in South Korea faced increased funding costs as they competed for deposits with securities firms who offered competitive rates on cash management accounts. Measures to cool the real estate sector also resulted in deterioration of asset quality for loans associated with real estate and construction. Loan growth in Indonesia increased in late 2007, as the central bank of Indonesia continued to ease monetary policy. In Taiwan, loan demand increased in 2007 although it remained relatively low.
US
The Group’s principal US subsidiaries, HSBC Bank USA and HSBC Finance, faced unprecedented shifts and uncertainties in the credit environment as the US housing market continued to deteriorate. This precipitated significant changes in the competitor landscape.
Increased payments on resetting adjustable-rate mortgages (‘ARMs’), together with falling house prices, led to turmoil in the mortgage industry as deteriorating credit quality led to a loss of appetite among buyers of securitised mortgages in the secondary market. The contraction of this important funding source undermined the business models of many market participants and over 100 competitors closed, declared bankruptcy or were taken over in 2007. Influences on the market for securitised mortgages had consequential effects on broader credit markets and resulted in a general tightening
of credit availability, with particular impact on financial institutions exposed to sub-prime residential mortgages. Illiquidity in the markets for related credit derivatives impacted the valuation of such instruments.
The remaining sub-prime mortgage providers tightened underwriting standards and increased rates to reduce volumes, as they were obligated to retain originated loans. Previously, most of these loans had been packaged and sold to third party investors on the secondary market. Major market participants acted to reduce the number of foreclosures resulting from ARMs by offering m odified loan terms to customers in financial distress. These initiatives were supported and encouraged by federal and state regulators. HSBC was one of the first institutions to take a lead in this respect.
Regulatory scrutiny of the credit card industry increased in 2007 and, although no new major legislation was announced, a number of institutions, including HSBC, amended credit card terms and changed certain charging practices, benefiting customers but at a cost to lenders. Notwithstanding this, credit card competition remained fierce throughout 2007, with the launch of a number of innovative new products including environmentally-themed initiatives and online substitutes for traditional cards.
In Canada, the six largest banks retained their significant presence in the country’s financial services industry. Markets remained competitive, however, with largely equivalent products being offered by banks, insurance companies and other financial institutions. Canadian financial markets felt the effects of the downturn in US residential property markets as certain asset-backed commercial paper conduits experienced difficulty funding their obligations. A group of Canadian and international banks established accords to support these vehicles.
Mexico
In Mexico, the banking industry remained centred around the five largest institutions (including HSBC), which control 80 per cent of the banking system’s assets. Penetration of the formal financial system remained low compared with other developing economies in the region, while demographics indicated a young and growing population. Bank financing to the private sector was less than 20 per cent of GDP, indicating significant room for growth. In this context, the overall banking
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system continued to expand credit rapidly and loan growth has exceeded 20 per cent per annum over the last two years.
In 2007, eight new banking licences were granted and over 350 non-bank intermediaries entered the consumer market. An amendment to legislation late in 2007 granted specialised banking licenses with reduced regulatory requirements. This is expected to further boost competitive forces.
Mexican banks faced additional legislation with the imposition of tariff restrictions on deposit account fees and ATM commissions. HSBC continued to increase its market share in core consumer, commercial and corporate banking products, and sought to differentiate itself through customer service. HSBC is well positioned to capitalise on economic growth with its extensive branch and ATM network.
Central America
HSBC has financial services operations in Panama, El Salvador, Costa Rica, Honduras, Colombia and Nicaragua. Central America’s banking industry has attracted significant foreign investment in recent years due to its expanding domestic economies. In the last two years, a number of international groups established major retail banking operations through a series of purchases. In El Salvador and Costa Rica, foreign banks and local governments own the majority of banking institutions. Panama, Honduras and Guatemala continued to be served by several large, independent domestic banking institutions.
International banks operating in Central America increased their presence and, hence, the availability of reliable financing sources. These banks are also expected to accelerate the adoption of improved corporate and risk management practices in the region, together with a more efficient allocation of resources.
In Brazil, the top ten banking groups accounted for 71 per cent of banking assets and 87 per cent of branches, unchanged from 2006. These groups include local state-owned banks, privately-owned banks and large foreign banks (including HSBC). Privately-owned banks continued to grow their market share (from 57 per cent in 2006 to 62 per cent in 2007), through consolidation and growth in credit operations, due to the positive economic conditions. Further consolidation took place when Banco Santander acquired Banco Real as part of the successful consortium bid for ABN Amro.
Total lending as a percentage of GDP was 35 per cent, remaining relatively low by international standards. Improved access to financial services and increased participation in the formal economy indicate the potential for further growth in the financial services sector.
Argentina
International financial groups and local banks with largely equivalent product and service offerings formed HSBC’s major competition in Argentina.
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Profit/(loss) before tax by country within customer groups and global businesses
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Year ended 31 December 2007 compared with year ended 31 December 2006
Economic briefing
In the UK, GDP growth accelerated in 2007 to 3.1 per cent from 2.9 per cent in 2006, mainly as a result of buoyant consumer and investment spending. Net trade depressed GDP growth through 2007, and the current account deficit reached a record 5.7 per cent of GDP in the third quarter of the year. Employment growth was fairly subdued, rising by approximately 0.7 per cent during the year. Consumer Price Index (‘CPI’) inflation reached a decade-long high of 3.1 per cent in March but subsequently fell back to 2.1 per cent by the year-end, close to the Bank of England’s 2 per cent target. After a strong start to the year, nominal house prices declined and housing activity diminished in the final months of 2007. The Bank of England raised interest rates by 75 basis points during 2007 to a peak of 5.75 per cent, but subsequently reduced them to 5.5 per cent at the end of 2007.
The expansion of the eurozone economy continued steadily in 2007, with GDP growth of 2.7 per cent. As in the UK, much of the momentum
came from strength in business investment and exports as global demand remained strong, particularly from emerging markets. Consumption was relatively subdued, despite declining unemployment, although fiscal reforms (particularly in Germany) are believed to have depressed household expenditure. Eurozone inflation increased steadily during the second half of the year to an annual rate of 3.1 per cent in December, driven largely by rises in food and energy prices. The European Central Bank (‘ECB’) raised interest rates by 50 basis points during 2007, to finish the year at 4 per cent.
In Turkey , economic activity softened as the year progressed, with GDP rising by 3.9 per cent during the first three quarters of 2007 against the comparable period of 2006. Headline inflation remained under pressure from increases in energy and food prices, though core indicators improved markedly, prompting Turkey’s central bank to cautiously ease monetary policy. The current account deficit stabilised at about 7 per cent of GDP with rising service sector receipts from tourism, although high energy costs may cause the trade balance to deteriorate.
Review of business performance
European operations reported a pre-tax profit of US$8.6 billion, compared with US$7.0 billion in 2006, an increase of 23 per cent. On an underlying basis, pre-tax profits improved by 13 per cent.
In March 2007, HSBC acquired its partner’s shares in life, property and casualty insurer, HSBC
Assurances. The results of HSBC Assurances are excluded from the underlying commentary below.
In Commercial Banking, growth in deposit and lending balances in the UK and ongoing business expansion in Turkey and Malta led to steady growth in revenues. This was partly offset by increased loan impairment charges and higher costs associated with
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business expansion. In Global Banking and Markets, higher income from most businesses was offset by trading losses in Credit and Rates and increased costs. Strong profit growth in Private Banking was driven by an increased client appetite for discretionary portfolios, a rise in lending volumes and further improvements in cross-referrals. In Personal Financial Services, a fall in pre-tax profits reflected ex gratia payments expensed in respect of overdraft fees applied in previous years and a provision for reimbursement of certain charges on historic will trusts and other related services. The ‘Other’ segment benefited from a US$1.3 billion fair value gain in HSBC’s own debt.
The following commentary is on an underlying basis.
Personal Financial Services reported a pre-tax profit of US$1.6 billion, a decrease of 31 per cent compared with 2006. Income growth lagged cost growth, principally as a result of ex gratia payments expensed in respect of overdraft fees applied in previous years which are subject to current legal challenge.
In the UK, HSBC continued to concentrate on enhancing services offered to customers, with the intention of making HSBC the ‘Best Place to Bank’. HSBC Premier was relaunched simultaneously in 35 countries, including the UK. All Personal Internet Banking customers now have the ability to send money in over 80 currencies to 234 countries. To make its fees and charges more transparent, HSBC in the UK began to show warning messages on ATMs if the customer’s cash withdrawal would cause a fee to be incurred.
In France, successful marketing campaigns continued to improve brand awareness and grow customer numbers, specifically HSBC Premier and Student accounts. The latter benefited from the signing of 120 partnerships with business schools.
In Turkey, the benefit of significant growth from new customer acquisition, boosted by successful cross-sell activities and higher balances, more than offset increased costs incurred in supporting business expansion.
Net interest income was broadly in line with 2006. In the UK, effective deposit pricing, coupled with interest rate rises in the first half of 2007, led to wider deposit spreads and higher balances. This benefit was partly offset by lower margins on mortgages as customers switched to fixed rate products.
Average unsecured lending balances in the UK declined by 5 per cent as HSBC restricted its
credit appetite to customers who satisfied tighter underwriting criteria. Spreads narrowed as the portfolio mix shifted towards these better quality, lower-yielding loans.
Savings balances grew by 15 per cent, driven by competitive rates and new products, such as the Online Bonus Savers, a ‘one click’ savings product offering real-time account opening, instantly ready for funding. Together with improved spreads, this contributed to a 29 per cent increase in net interest income on savings products.
Average current account balances in the UK increased to US$31 billion. Sales of HSBC’s premium service, fee-based current accounts (HSBC Premier and Plus) remained major drivers of underlying performance, with significant year-on-year sales growth.
UK credit card balances grew by 4 per cent in a declining market, with growth concentrated in the Partnership card and Marks and Spencer (‘M&S Money’) portfolios. This benefit was more than offset by pressure on spreads driven by a run-off in higher-yielding accounts in the Partnership cards business. In line with the Group’s risk-based concentration on a narrower range of customers, HSBC disposed of part of its non-core credit card portfolio, principally the Marbles brand, in the last quarter of 2007.
In light of changing market conditions, significant investment was made in retraining the mortgages sales force during 2007. Average mortgage balances were broadly in line with last year, while the portfolio mix shifted towards fixed rate products. This, together with base rate rises, caused spreads to tighten.
In France, customer acquisition and the consolidation of existing relationships resulted in an 8 per cent rise in average deposit balances, higher than the overall market increase. Average lending balances grew by 16 per cent, mainly property-related lending. The benefit of these increases in volumes was more than offset by narrower spreads due to competitive pressures and maturing of previously higher-yielding hedging products. As a result, net interest income fell by 11 per cent.
In Turkey, net interest income increased by 17 per cent due to strong balance sheet growth. HSBC added over 600,000 new personal customers during 2007, significantly exceeding its target. Average deposit balances rose by 28 per cent, largely driven by customer recruitment through new branch openings and ongoing efforts to build brand awareness. Deposit spreads remained narrow as
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interest rates started to decline during the second half of 2007 following rate rises earlier in the year. Average lending balances increased by 28 per cent. The income benefit from these increases was partly offset by the impact of market-wide credit calming measures which, together with increased competition, adversely affected margins on lending and credit cards.
Net fee income increased by 13 per cent, largely driven by higher sales of fee-earning packaged current accounts in the UK and credit cards in Turkey, where HSBC recorded significant growth of over 740,000 new cards. This was partly offset by a US$25 million decrease in credit card default fees in the UK as HSBC reduced its fee following the outcome of an investigation by the OFT in April 2006. In France, fee income grew by 7 per cent through improved transactional commissions, mainly from increased sales of packaged accounts and higher life insurance fees.
In the UK, pensions and life investment sales increased as did home and motor insurance sales, the success of the M&S Money motor insurance campaign led to M&S Money rising to fourth in the market for online sales. However, the insurance results were adversely affected by lower income from payment protection products and flood claims in the summer.
Net trading income largely reflected the fair value measurement of embedded options linked to government regulated home savings products in France. In 2006, there was a large gain; this did not recur in 2007.
Gains on the sale of financial investments in 2007 included a share in HSBC’s sale of Marfin Popular Bank, an investment acquired in a share swap agreement with The Cyprus Popular Bank as part of the sale of HSBC’s stake in the latter in 2006. In addition, a gain arose from the merger of two payment services providers and there were two further gains on the share of profits from the MasterCard Incorporated IPO, although to a lesser extent than in 2006.
Other operating income declined significantly, due to a fall in the present value of in-force (‘PVIF’) long-term insurance business, following a change in FSA regulations which permitted certain rules relating to the calculation of actuarial liabilities for the long-term insurance business to be relaxed. This was offset by a corresponding reduction in provisions reported in ‘Net insurance claims and movements in liabilities to policyholders’. HSBC recorded a loss on the disposal of the Marbles brand cards portfolio, offset by the sale of other card
portfolios at a profit. In 2006, HSBC benefited from a share of the gain on the sale of its stake in The Cyprus Popular Bank.
Loan impairment charges and other credit risk provisions of US$2.0 billion were 4 per cent higher than in 2006. In the UK consumer finance business, refinements to the methodology used to calculate roll-rate percentages resulted in a higher charge in the first half of the year. Excluding this, loan impairment charges were marginally lower than in 2006. Loan impairment charges in the second half of 2007 were lower than in the first half of the year, as overall credit quality improved following measures taken in the recent past to tighten underwriting standards and improve the credit quality of new business. Although losses from mortgage lending remained low, maximum loan to value ratios were reduced during the year to mitigate the effects of a possible housing market downturn. In France, loan impairment charges remained low, albeit higher than in 2006, as credit quality remained good. In Turkey, credit quality remained stable and growth in loan impairment charges followed increases in lending balances.
Operating expenses were 11 per cent higher than in 2006. In the UK, US$227 million arose from ex gratia payments expensed in respect of overdraft fees applied in previous years, and a further US$169 million was provided for reimbursement of certain charges on historic will trusts and other related services.
HSBC concentrated discretionary investment on technology that promotes straight-through processing, allowing customers to purchase products online. This will improve processing time and reduce errors caused by human intervention. As part of the ongoing branch refurbishment programme, a further 52 branches were refurbished during 2007.
In France, operating expenses rose as HSBC made further investments to take advantage of Group synergies. In October 2007, IT systems were successfully migrated onto HSBC’s core banking platform. This will enable HSBC France to integrate its branded operations and benefit from the Group’s expertise in technology, process and products. In Turkey, ongoing investment in capacity and infrastructure to support business growth, as evidenced by the opening of 45 branches during 2007, contributed to a 17 per cent increase in operating expenses.
Commercial Banking reported a pre-tax profit of US$2.5 billion, an increase of 4 per cent. Revenues rose by 12 per cent as a result of both balance sheet growth and an increase in fee-based
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product income, driven by customer recruitment and the expansion of the small and mid-market segments in Turkey and Malta. These benefits were partly offset by higher loan impairment charges, principally on corporate relationship managed accounts in the UK and increased operating expenses from ongoing business expansion throughout the region.
HSBC continued to expand the scope of its services in European emerging markets with the recruitment of a further 36 relationship managers. HSBCnet was launched in Armenia, Kazakhstan, Malta, Poland, the Czech Republic and Slovakia during the year. Significant income growth was recorded in Armenia and Poland, countries which offer potential for high GDP growth going forward and demand for conventional trade services.
In support of HSBC’s strategy to be the leading international commercial bank, dedicated international corporate teams were established in London and Paris to drive and support cross-border business. Global Links and International Business Centres are now available in 11 European countries, simplifying cross-border account opening for customers and more than tripling successful outward referrals over 2006.
Net interest income increased by 7 per cent in 2007, largely from growth in the UK, Turkey, Germany and Malta. In the UK, a 10 per cent growth in deposit balances was primarily driven by a successful negotiated-rate deposit product launched in 2005. This helped fund lending growth of 14 per cent, which was largely the result of strong growth in corporate and structured banking and customer numbers in commercial centres. These income benefits were partly offset by narrower margins on loans and overdrafts as a result of increasingly competitive market conditions.
In France, HSBC continued to increase its client base, reflecting the ongoing success of initiatives to raise its brand profile and improve customer segmentation. HSBC reinforced its position as the leading international bank and increased the recruitment of new customers, particularly small businesses with high potential. Average lending balances increased by 19 per cent and average deposit balances, boosted by the financial markets crisis in the second half of the year, increased by 22 per cent. The income benefit of this balance sheet growth was more than offset by competitive pressures on margins and the maturity of previously higher-yielding hedging products. As a result, net interest income was slightly lower than 2006.
Net interest income in Turkey increased by 46 per cent, as HSBC continued to develop its
service offerings for its micro, small and mid-market business customers. Income benefited from growth of 108 per cent in small and micro customer lending together with a 114 basis point increase in spreads. This upward trend in lending spreads was driven by new product bundles and growth in Commercial Banking’s profitable overdraft account. Average deposit balances rose by 4 per cent in Turkey, in part due to an increase in cash management clients, with wider margins further benefiting income.
Net fee income increased by 18 per cent. Excluding Commercial Banking’s share of Insurance Brokers’ fees previously reported in the ‘Other’ segment, net fee income rose by 5 per cent. In the UK, a modest increase in net fee income was driven by growth in foreign exchange fees and card activity following the small-business credit card product successfully launched in May 2006. In Turkey, net fee income grew by 42 per cent, driven by investment banking, advisory and structured finance transactions, mainly due to a 15 per cent increase in corporate clients. Trade products also drove fee income and referrals from other HSBC Group offices which further contributed to the increase. In France, net fee income grew by 9 per cent, as customer acquisition and the consolidation of existing relationships led to a 9 per cent increase in transaction fees.
Gains on the sale of financial investments in 2007 reflected Commercial Banking’s share of HSBC’s sale of Marfin Popular Bank, an investment acquired in a share swap agreement with The Cyprus Popular Bank Limited (‘Cyprus Popular Bank’), as part of the sale of HSBC’s stake in the latter in 2006. 2007 benefited from further gains on the share of profits from the MasterCard Incorporated IPO, to a similar extent as in 2006.
Other operating income declined significantly, due to a fall in the PVIF long-term insurance business, following a change in FSA regulations. This was offset by a corresponding reduction in provisions reported in ‘Net insurance claims and movements in liabilities to policyholders’. The non-recurrence of Commercial Banking’s US$38 million share of the gain on the sale of HSBC’s stake in Cyprus Popular Bank also contributed to the fall in other operating income.
Loan impairment charges and other credit risk provisions remained low despite a 23 per cent rise on levels recorded in 2006. In the UK, loan impairment charges increased; this was concentrated in four large corporate accounts. In France, credit quality remained good and loan impairment charges stayed
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low despite balance sheet growth. In Turkey, increased charges reflected growth in lending volumes as general credit quality remained satisfactory.
Excluding Insurance Brokers, operating expenses increased by 7 per cent. Across Europe, costs were higher as a result of sales staff recruitment and other costs to support business development and expansion, particularly in Turkey and Eastern Europe. In addition, France incurred incremental restructuring costs relating to the migration of IT systems onto HSBC’s core banking platform.
Global Banking and Markets in Europe reported a pre-tax profit of US$2.5 billion, broadly in line with 2006 despite write-downs in credit, structured credit derivatives and certain positions in leveraged and acquisition finance, resulting from the challenging credit market in the second half of 2007. Apart from these product lines, the Global Markets and Global Banking businesses reported robust growth complemented by significant gains on principal investments. The cost efficiency ratio deteriorated by 3 percentage points.
Total operating income increased by 7 per cent to US$7.6 billion. Strong foreign exchange and equities trading income drove revenue growth, enhanced by higher advisory fees and fair value gains in financing and capital markets. Securities services benefited from higher transaction volumes driven by increased market volatility. A rise in revenues from payments and cash management and principal investments further boosted income. This growth was partly offset by significant write-downs in credit and structured derivatives.
In the UK, payments and cash management income grew due to higher customer balances, which rose as the liquidity crisis led customers to increase their cash balances. In Turkey, higher balance sheet management revenues contributed US$12 million.
Net fee income was 28 per cent higher, with robust growth in income from financing businesses in line with greater market activity in the UK and France in the first half of 2007. In securities services, a rise in volumes and new client mandates drove the increase in revenues. Assets under custody grew by 16 per cent.
Overall, income from trading activities fell due to US$713 million of write-downs reported in credit, structured credit derivatives and leveraged and acquisition finance in the UK. These were partly offset by strong growth in foreign exchange driven by market volatility and a weakening US dollar. In
equities, strong trading income from core products was supplemented by a gain from the sale of Euronext shares. In France, the continuing trend of higher income from structured derivatives reflected the benefit of investment to enhance capabilities. The credit market dislocation also led to an adverse fair value adjustment in respect of loan commitments outstanding when global credit spreads widened in the second half of 2007.
The UK principal investments business benefited a small number of significant realisations during the year. Gains less losses from financial investments rose to US$1.1 billion.
A net recovery on loan impairment charges, albeit lower than in 2006, reflected the continued low level of corporate credit defaults.
Operating expenses rose by 12 per cent to US$5.2 billion. Operational costs rose in Global Markets, particularly in structured derivatives where the French businesses invested to support local revenue growth. Costs also rose in payments and cash management and securities services, driven by the rise in business volumes. Additional staff costs resulted from recruitment in selected businesses during 2006.
HSBC’s share of profits from associates recovered due to the non-recurrence of an impairment charge on a private equity investment held by an associate in 2006.
Private Banking reported a pre-tax profit of US$915 million, an increase of 11 per cent. A strong performance in Switzerland was driven by the promotion of advisory and discretionary mandates, with existing clients further leveraging their portfolios. Profits in the UK declined as a result of lower gains from the partial disposal of the Hermitage Fund. Excluding this transaction, UK revenue increased strongly. The cost-efficiency ratio increased slightly by 0.9 percentage points to 56.9 per cent, affected by lower investment gains in 2007. Despite this, the cost efficiency ratio is one of the strongest in the industry.
Net interest income rose by 14 per cent to US$793 million. Switzerland contributed the majority of the increase. Loans and advances to customers increased by 31 per cent to US$13.8 billion, as existing clients further leveraged their portfolios to take advantage of alternative investment opportunities. Monaco and Germany also contributed to the rise in net interest income. In Germany, net interest income increased by 14 per cent due to a large growth in deposits. Similarly, in Monaco, customer accounts rose, augmented by
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higher lending balances as existing clients increased their leverage.
Net fee income increased by 15 per cent to US$1.0 billion, mainly due to a 10 per cent increase in funds under management in Switzerland with discretionary and advisory funds generating higher annual fees. Client investments in structured products and brokerage fees also contributed to the rise in fee income. In the UK, fees increased by 10 per cent, driven by a rise in wealth and loan fees.
Trading income was 63 per cent higher at US$170 million, mainly driven by foreign exchange trading by clients in Switzerland.
Gains from financial investments decreased by 23 per cent to US$115 million. This primarily related to a gain from a partial disposal of a seed capital investment in the Hermitage Fund which was lower than that recognised from an earlier disposal in 2006.
Client assets, which include deposits and funds under management, grew by 19 per cent to US$258.4 billion. The large growth in client assets was driven by positive market performance and US$20.2 billion of net new money, with Switzerland contributing US$7.1 billion and the UK and Monaco contributing US$3.7 billion and US$3.6 billion each. The growth in cross-referrals continued, with inward referrals from other customer groups contributing US$3.9 billion to total client assets.
Operating expenses were 15 per cent higher than in 2006, driven by business expansion. More front-office staff, higher performance-related bonuses, IT and marketing costs all contributed to the rise. The overall increase in operating expenses was partially offset by the effect of a change in pension arrangements.
Within Other, fair value movements in HSBC’s own debt and related derivatives resulted in gains of US$1.3 billion, largely as a consequence of movements in credit spreads. These movements will reverse through the income statement over the life of the debt unless the debt is repaid before its contractual maturity. This segment also benefited from a US$73 million adjustment to the embedded value of HSBC’s associate, HSBC Assurances, prior to the acquisition of its remaining capital, from which date it was accounted for as a subsidiary.
Year ended 31 December 2006 compared with year ended 31 December 2005
UK GDP growth increased in 2006 to 2.9 per cent from 1.8 per cent in 2005. This followed a recovery in both household and company spending. CPI inflation increased through the year from 1.9 per cent in January to 3 per cent in December, following large increases in the price of petrol and gas. The Bank of England raised interest rates from 4.5 per cent to 5 per cent, citing concerns about spare capacity, rapid money growth and the possibility of inflation staying above target for some time. House price inflation remained strong but consumer spending appeared unaffected. Secured lending continued to increase although unsecured lending plateaued. There was evidence that a number of households were struggling with the burden of debt as personal insolvencies and repossessions increased. Employment rose, although by less than the increase in available workers as migrant inflows remained strong and the participation rate of UK residents in the labour force increased. As a result, the unemployment rate increased, contributing to constrained wage growth throughout the year despite relatively high rates of headline inflation.
The recovery in the eurozone economy gathered momentum through the course of 2006. GDP rose by approximately 2.7 per cent, the fastest rate since 2000. Much of the improvement reflected increases in exports and investment, as global demand remained strong and corporate activity and profits rose. Consumer spending remained subdued, despite a gradual rise in employment. German growth improved sharply, while growth in France and Italy was less impressive. Eurozone inflation was heavily affected by rises in energy and food prices. Inflation, excluding energy and food, remained contained at just 1.7 per cent. The ECB increased the key policy interest rate from 2.25 per cent at the beginning of 2006 to 3.5 per cent in December. The ECB continued to describe monetary policy as ‘accommodative’, thereby effectively ending the year with a bias towards tightening.
Turkey’s economy slowed markedly in the third quarter, with year-on-year GDP growth of 3.4 per cent, down from 7.8 per cent in the second quarter. The current account deficit continued to widen, reaching 8 per cent of GDP in December, partly from high-energy prices but also from the increasing substitution of imported materials for local ones due to the overvalued currency. More than half of the deficit was financed by healthy foreign direct investment inflows. The International
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Monetary Fund’s programme for Turkey remained on track.
European operations reported a pre-tax profit of US$7.0 billion compared with US$6.4 billion in 2005, an increase of 10 per cent. On an underlying basis, pre-tax profits grew by 8 per cent. Underlying net operating income increased by 8 per cent, in line with operating expenses. Commercial Banking delivered a third successive year of growth, driven by strong balance sheet growth in the UK and organic expansion in Turkey. Record profits in Private Banking were driven by strong client asset inflows, a more sophisticated product mix and lending growth. Global Banking and Markets made encouraging gains in trading activities, and operating expenses rose in line with net operating income. In Personal Financial Services, net operating income growth slowed as HSBC tightened its underwriting criteria on unsecured credit. An emphasis on deposit, wealth and insurance products contributed to an increase in costs, which were driven by infrastructure investment both in the physical environment and direct channels.
Personal Financial Services reported a pre-tax profit of US$1.9 billion, 2 per cent lower than in 2005. Net operating income rose by 4 per cent and loan impairment charges increased by slightly more than revenues as increasing numbers of debtors sought formal protection from their obligations.
Costs grew by 7 per cent, reflecting investment in infrastructure throughout the region, and the cost efficiency ratio rose by 1.2 percentage points to 59.2 per cent.
In the UK, HSBC responded to concerns over high levels of consumer indebtedness and the growth in personal bankruptcies and individual voluntaryarrangements (‘IVAs’) by adopting more selective underwriting criteria and reducing credit origination. Revenues from credit-related insurance declined as a consequence. In response, HSBC increased its focus on non credit-related income streams, particularly savings and high-value current accounts. Strong balance growth in these products was achieved through marketing initiatives, competitive pricing and the success of innovative propositions such as the packaged ‘Plus’ and ‘Passport’ current accounts, the latter supported by the implementation during the year of a more refined approach to customer segmentation.
Considerable strategic attention was given to enhancing product distribution and channel management. The branch refurbishment programme continued and improvements were made to direct banking, notably the introduction of self-service machines and the upgrading of cash machine service offerings. HSBC’s internet offering was also enhanced to offer personalised content and sales capabilities, with improved customer accessibility.
In France, a marked improvement in brand awareness after the 2005 rebranding to ‘HSBC France’, supported by competitive pricing, aided the recruitment of target customers and consequential
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balance sheet growth, most notably in residential property lending. Despite this growth, there was a decline in profit before tax, due to competitive pressures on margin and the time lag between incurring costs on customer acquisition and earning incremental revenue from future opportunities to cross-sell.
In Turkey profit before tax declined by 2 per cent, as revenue growth was offset by investment costs. Organic development was furthered by the opening of 37 new branches during the year, bringing the total to 193, and a number of marketing initiatives to build brand awareness. Balance sheet and revenue growth accelerated as a result, as did customer recruitment. Overall customer numbers stood at 2.3 million at the end of 2006.
Net interest income increased by 5 per cent to US$5.7 billion, substantially from balance sheet growth throughout the region.
In the UK, net interest income was driven by growth in savings, deposit and current accounts, with higher balances achieved through targeted sales and marketing efforts. Interest income from credit cards and mortgages also increased.
A focus on liabilities helped boost new UK savings account volumes markedly in a buoyant yet highly competitive savings market. HSBC’s competitive internet-based products were the key driver of growth. Cash invested in First Direct’s ‘e-savings’ product trebled; balances in HSBC’s ‘Online Saver’ increased sixfold. Overall, average savings balances, excluding money market investments, increased by 28 per cent and net interest income rose by 25 per cent.
Current account balances in the UK increased by 6 per cent to US$26.0 billion. Within this, the proportion of value-added packaged current accounts attracting fees rose significantly. The number of HSBC’s fee-based accounts more than doubled during 2006. In aggregate, packaged current account balances increased by 25 per cent and represented nearly half of the overall increase in current accounts. Spreads remained broadly in line with 2005.
Average UK credit card balances rose by 5 per cent, to US$13.7 billion, driven by promotional campaigns and marketing. Growth was strongest in M&S branded cards, which represented 4 percentage points of the increase, driven by an increased sales focus which included extensive media advertising. This was partly offset by declining balances within the store cards business and the cards business of HFC Bank Ltd (‘HFC’), reflecting HSBC’s more
restricted credit appetite. Spreads increased modestly compared with 2005.
Average UK mortgage balances rose by 11 per cent to US$68.9 billion, primarily in fixed rate mortgages. Growth was achieved through competitive pricing and targeted marketing strategies, including the launch of new fixed, discount and tracker-rate mortgages during the year. A slight narrowing of spreads reflected a change in mix away from variable rate mortgages to fixed rate mortgages, and the competitive positioning referred to above.
Average unsecured lending balances in the UK declined by 4 per cent, reflecting HSBC’s decision to contain growth through stricter underwriting criteria. Spreads narrowed, following the introduction in 2005 of preferential pricing for lower-risk customers, and a change in mix towards higher-value but lower-yielding loans.
In France, net interest income fell by 8 per cent. Spreads narrowed as older higher-yielding investments matured, while competitive pricing reduced lending yields, particularly in the residential mortgage market. These pressures on margin were only partially offset by strong balance sheet growth. Marketing campaigns building on the ‘HSBC France’ brand aided strong sales and customer recruitment, most notably in residential property lending and current accounts and also increased future cross-selling opportunities.
In Turkey, net interest income rose by 14 per cent. Lending grew strongly, substantially funded by deposit growth. Overall, deposit balances rose by over 50 per cent, largely driven by customer recruitment aided by the branch network expansion referred to above. Spreads widened following increases in overnight interest rates and the value of funds rose as a consequence. Marketing initiatives and cross-sales with credit card customers helped more than double average unsecured lending balances. Mortgage lending was also strong, with a 60 per cent increase in balances. Credit card balances rose by 22 per cent, with growth dampened by credit calming measures imposed by government regulation.
Net fee income increased by 8 per cent to US$2.5 billion. In the UK, rising sales of fee-earning packaged current accounts, travel money and investment products drove fee growth. Fees from unsecured lending also rose. These benefits were partly offset by lower creditor protection income, reflecting the steps taken by HSBC to constrain lending growth. Reduced loan sales and smaller average loans (the result of this initiative) led to both
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lower insurance sales and a reduction in average premiums.
In France, banking fees rose through higher sales of packaged current accounts. Transactional and overdraft fees and insurance distribution fees also increased, reflecting growth in the customer base. In Turkey, strong growth in lending volumes and, to a lesser extent, credit cards, helped drive fee income growth. Additional sales staff were recruited to reinforce the emphasis on wealth management, and the launch of new pension products also helped boost fees.
In 2006, MasterCard became publicly listed through an IPO, and the US$37 million gain from financial investments mainly reflected Personal Financial Services’ share of the proceeds of the IPO.
Responding to changes in work and shopping patterns among its customers and the increasing acceptance of direct channels. HSBC appraised its UK property portfolio during the year, and higher other operating income reflected Personal Financial Services’ share of revenue from branch sale and lease-back transactions. Personal Financial Services’ US$37 million share income on the sale of HSBC’s stake in Cyprus Popular Bank was also included within other operating income.
Lower sales of life and creditor repayment protection, which were driven by the constraints on personal lending growth referred to above, and a change in reinsurance arrangements at the end of 2005, contributed to the decrease in net earned insurance premiums. Lower sales of investment-linked insurance products, together with the effect of market movements on related insurance and investment assets, contributed to the decline in net income from financial instruments designated at fair value. This was largely offset by a corresponding decrease in net insurance claims and movements in policyholders’ liabilities.
Loan impairment charges and other credit risk provisions of US$1.8 billion were 6 per cent higher than in 2005, largely reflecting lending growth in the region.
In the UK, the 8 per cent rise in loan impairment charges was broadly in line with lending growth. Actions taken on underwriting and collection activities mitigated a continuation of the rising trend in personal bankruptcies and IVAs seen since the legislative change in 2004. In 2006, IVAs became the main driver of loan impairment growth across the industry as the availability and marketing of third-party debt reduction services increased.
Within the UK, loan impairment was most pronounced in consumer finance unsecured portfolios, in which delinquency also rose as the effect of interest rate increases on relatively high levels of indebtedness put pressure on household cash flows. In HSBC’s other portfolios, action undertaken by HSBC during 2005 and early 2006, predominantly tightening underwriting criteria and collections procedures, proved successful in improving credit quality indicators on more recently written debt. In the second half of 2006, HSBC strengthened the measures available to manage insolvencies and impaired debt including, inter alia , the further development of predictive modelling to enhance underwriting decisions.
In France, credit quality was sound notwithstanding strong growth in customer advances, and the loan impairment charge remained low. In Turkey, overall credit quality was also sound, and delinquency on credit cards improved following enhanced collections efforts and changes in government regulation. This was reflected in a 36 per cent reduction in loan impairment charges.
Operating expenses increased by 7 per cent. A US$57 million write-down of intangibles was attributed to card portfolios acquired in the UK which were written off in the light of the higher impairment charges being experienced. Excluding this item, the increase was 6 per cent, primarily reflecting investment in upgrading and expanding capacity and infrastructure across the region.
In the UK, 104 branches were refurbished during 2006. Responding to changing customer preferences and upgrading its customer service, HSBC extended its opening hours in certain branches, necessitating the recruitment of additional counter staff, and increased its IT investment in self-service machines and other direct banking channels, in the process improving cost efficiency.
In France, there was a 4 per cent rise in operating expenses, driven by the recruitment of additional sales staff, higher marketing expenditure to attract new customers, and the migration to a common IT infrastructure. In Turkey, the opening of 37 new branches and associated growth in numbers of sales staff and infrastructure costs drove a 26 per cent rise in costs. Marketing expenditure also increased in support of the growing consumer lending, insurance and pensions businesses.
Commercial Banking reported a pre-tax profit of US$2.2 billion, an increase of 14 per cent compared with 2005. Adjusting for the sale of the UK fleet management and vehicle finance leasing business, which was sold in the autumn of 2005,
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profit before tax grew by 17 per cent, driven by growth of 10 per cent in net operating income compared with just 4 per cent in costs. Revenues increased by 9 per cent through balance sheet growth, customer recruitment and improved cross-sales in the UK, and expansion of the middle market, small and micro-businesses in Turkey. The 4 per cent growth in operating expenses primarily reflected investment to support business expansion throughout the region. Credit quality was stable.
In the UK, HSBC invested to expand sales capacity and improve service through recruitment and the opening of commercial centres. To support HSBC’s strategic intention to lead the market in international commercial banking, a dedicated International Banking Centre was created which, as part of a global network, simplified cross-border account opening. HSBC also simplified and launched new foreign currency accounts. Significant progress was made in enhancing the functionality of HSBC’s award-winning internet banking, including the implementation of the UK’s first same-day high-value payments offering and the launch of HSBC’s first commercial direct banking proposition, Business Direct, which attracted over 19,000 small and micro business accounts during the year.
In France, HSBC increased customer recruitment by approximately one third by concentrating on improving brand awareness among commercial businesses. HSBC became the principal banker for the majority of new customers recruited. In Turkey, the establishment of eight centres, the recruitment of additional relationship management staff and a focus on maintaining high service levels contributed to a 40 per cent increase in the number of active customers as HSBC successfully sustained its efforts to grow its share of middle market, small and micro-business banking.
Net interest income increased by 8 per cent, largely driven by increases in the UK and Turkey. In France, the benefit of strong balance sheet growth was more than offset by competitive pressure on margins.
HSBC slowed the rate of growth in lending in the UK during 2006 by refining underwriting criteria and emphasising non-lending related revenue streams and, consequently, average lending balances rose by 8 per cent during the year and spreads remained broadly flat. Increased priority was given to raising deposits through transactional and savings accounts and, as a result, deposit balances rose by 37 per cent and current account balances by 8 per cent. The benefit of this volume growth was partly offset by spread compression on sterling-
denominated accounts as customers were offered more attractive pricing.
HSBC boosted the recruitment of small and micro business customers in the UK by holding commercial theme weeks and increasing client contact by embedding business specialists in selected branches. These initiatives delivered increases in the number of start-up accounts and the number of customers who switched their business from other banks to HSBC. Higher-value international and foreign currency accounts rose as a consequence.
Net interest income in France was broadly in line with 2005 as the benefit of strong balance sheet growth, driven by the acquisition of new customers and improved levels of customer retention, was offset by narrowing spreads from competitive market pressures and lower earnings from free funds.
Net interest income in Turkey increased by 41 per cent, driven by a doubling in lending balances. HSBC extended its geographic coverage through expansion of the branch network, including the launch of eight new centres dedicated to smaller commercial customers, and these boosted customer recruitment. The introduction of pre-approved credit limits for existing customers also contributed to lending growth, and the focus on attracting liability products helped more than double deposit balances.
Net fee income increased by 4 per cent to US$1.7 billion. Current account and money transmission fees rose as a result of customer recruitment and higher transaction volumes in most countries. In the UK, client workshops and other promotional activities were deployed to support increased sales of treasury products, boosting treasury revenue as foreign exchange volumes grew. In France a 2 per cent increase in income was largely in transactional current account fees, reflecting growth in the customer base.
Other operating income was 41 per cent lower than in 2005 and reflected lower asset finance revenues following the sale of the UK fleet management business referred to above. This was partly offset by the inclusion of Commercial Banking’s share of the gain on the sale of HSBC’s stake in Cyprus Popular Bank (US$38 million), and the income from UK branch sale and lease-back transactions.
Credit quality in Commercial Banking was stable in most countries. In the UK, loan impairment charges and other credit risk provisions fell by 16 per cent, largely due to the non-recurrence of an individual loan impairment allowance against a single customer in 2005. Excluding this, there was a
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modest decline in UK impairment charges, as the effect of lending growth was more than offset by improved credit quality, particularly in relation to HSBC’s larger exposures. In France, loan impairment charges, while remaining low, returned to a more normal level after relatively high recoveries in 2005. In Turkey, higher loan impairment charges reflected growth in lending.
Operating expenses decreased by 1 per cent. Excluding the sale of the UK fleet management activities referred to above, costs were 4 per cent higher than in 2005, reflecting investment to drive business growth throughout the region. As a result of revenues growing significantly faster than costs, there was a 3.1 percentage point improvement in the cost efficiency ratio. In the UK, increased costs reflected the recruitment of additional sales staff and higher IT expenditure. Costs in France fell by 2 per cent compared with 2005 as savings from cost control offset increases from the recruitment of additional sales staff and expenses associated with the migration to common IT platforms. In Turkey, recruitment and marketing costs incurred in support of the growing small and micro businesses drove a 38 per cent rise in expenses.
Global Banking and Markets reported a pre-tax profit of US$2.3 billion, an increase of 5 per cent, compared with 2005. A reduction in recoveries of loan impairment charges and lower private equity gains masked strong growth in core operating activities. Global Markets’ revenues were 36 per cent higher than in 2005 as robust performances in the global capital markets and securities services businesses were complemented by strong trading gains. The cost efficiency ratio improved modestly compared with 2005.
Total operating income was US$6.6 billion, 17 per cent higher than in 2005. This was despite the fact that in the UK, France and Turkey, balance sheet management revenues continued to fall, resulting in an overall decline of 56 per cent. This shortfall was partly offset by higher net interest income in securities services as customer volumes grew in higher-value products such as securities lending and foreign exchange. The lending business delivered a 13 per cent increase in corporate balances and corporate spreads remained broadly in line with 2005.
Net interest income in the payments and cash management business rose as deposit balances increased by 18 per cent. Surplus liquidity in the market fed higher business volumes. Increased transaction volumes resulting from new client
acquisitions and recent expansion initiatives also contributed to higher revenues.
Net fee income rose by 23 per cent, reflecting a 63 per cent fee increase in the global capital markets business and fees more than doubling in the securities services business. The financing and advisory businesses benefited from a higher number of deals mandated and a broader product range. Assets under custody grew by 22 per cent with notable increases in alternative fund assets, particularly from Ireland and Luxembourg.
In HSBC Global Asset Management, revenues increased significantly, boosted by a 4 per cent increase in funds under management and higher performance fees allied to revenues from disposals of property and structured finance fund investments.
Trading income increased with positive revenue trends in the key product areas where HSBC has invested, notably Credit and Rates, foreign exchange and structured derivatives. Revenues increased substantially, particularly in the area of interest rate derivatives, which benefited from opportunities created by a relatively volatile market. Additional gains were reported in emerging market bonds due to higher volumes, as investors adjusted their risk appetite and responded to a general improvement in market sentiment towards developing economies. Higher foreign exchange revenue was driven by greater customer volumes and increased trading opportunities offered by a combination of US dollar volatility and more uncertain economic conditions in emerging markets. Structured derivatives income increased by 88 per cent as HSBC leveraged its investment in this business to meet the needs of its institutional clients.
Gains from sales of financial investments, at US$413 million, were in line with 2005. Notable among the investments realised in the year were the sales of specialist property and structured finance fund investments by HSBC Global Asset Management.
Other income declined by 26 per cent as one-off gains from restructuring and syndication of assets in Global Investment Banking were not repeated.
The overall credit environment remained favourable with market liquidity supporting debt reconstruction as credit spreads tightened. As a result, HSBC achieved net recoveries for the third year in succession, albeit at a lower level than in 2005, when HSBC benefited from a release of collective impairment allowances in the second half.
Operating expenses were 14 per cent higher at US$4.2 billion, largely supporting volume growth
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in various businesses and performance-related compensation in Global Markets, where revenues increased by 36 per cent. Costs in 2006 also reflected the full-year effect of the investment made throughout 2005 as well as ongoing investment in product development, particularly in structured derivatives and Credit and Rates. In HSBC Global Asset Management, a robust performance resulted in higher staff and support costs.
A rise in operational expenditure was driven by increased volumes as well as new business won in respect of payments and cash management funds administration, securities services and Group Investment Businesses.
The decline in HSBC’s share of profits in associates and joint ventures reflected a loss arising from an impairment charge on a private equity investment within an associate. This was compounded by the non-recurrence of one-off gains realised in 2005, a significant proportion of which were recognised in the second half of the year.
Private Banking delivered a record pre-tax profit of US$805 million in Europe, an increase of 48 per cent compared with 2005. The cost efficiency ratio improved by 6.7 percentage points to 55.7 per cent. There was a US$108 million gain on the partial sale of an investment in the Hermitage Fund and, excluding this, pre-tax profit increased by 28 per cent. This result was achieved through growth in client assets, increased lending and transaction volumes and distribution of a broader and more sophisticated product range. Growth in intra-Group referrals with other customer groups was encouraging and also contributed to increased revenues.
Net interest income was 23 per cent higher at US$675 million, driven by balance sheet growth, primarily in the UK and Switzerland. Lending balances were 24 per cent higher and were funded by increased deposits. In the UK, the 31 per cent expansion of the lending book resulted primarily from growth in mortgage balances driven by a market which remained buoyant at the upper end. In Switzerland, an 18 per cent rise in lending largely reflected client appetite for leverage to facilitate equity and alternative investment opportunities.
Fee income increased by 19 per cent to US$869 million. This growth resulted from increased funds under management and a favourable mix change towards higher fee-generating discretionary and advisory managed funds, including the continued success of the Structured Investment Solutions (‘SIS’) and Core Investment Solutions (‘CIS’) products and the launch of the Actively
Managed Portfolio product. A significant performance fee came from the Hermitage Fund, a public equity fund dedicated to Russia, which was US$23 million greater than in 2005. The expansion of HSBC’s residential property advisory business, which opened new offices in the UK and France, also contributed to fee income growth.
Gains from financial investments in both 2005 and 2006 arose mainly from the sale of debt and investment holdings. Gains in 2006 included US$108 million from the partial disposal of HSBC’s investment in the Hermitage Fund.
Excluding gains from financial investments, trading and other operating income was marginally lower than in 2005.
Client assets, including deposits, rose by 18 per cent to US$218 billion. Net new money was US$19 billion, with the largest inflows arising in Switzerland and the UK. In Switzerland, improved brand awareness, successful product placement and cross-referrals with other customer groups, all contributed to significant net new money of US$11 billion. In the UK, net new money of US$3 billion was garnered from referrals from Commercial Banking and the retail network, new regional offices and continued growth in the underlying business. Net new money in Monaco and Germany exceeded US$1 billion and US$2 billion, respectively, also contributing to the growth in client assets. The value of clients’ investments in HSBC’s discretionary managed suite of SIS and CIS products grew very strongly, reaching US$1.7 billion.
Operating expenses were 13 per cent higher than in 2005 due to higher performance-related remuneration, recruitment of client-facing professionals across the region to support the growth of the business, and continued investment in the recently opened UK regional offices. The combination of HSBC’s principal trust businesses in Switzerland also added to costs in 2006 but is expected to bring efficiency gains in subsequent years. Overall increased expenses were more than offset by greater revenue generation which contributed to the 6.7 per cent improvement in the cost efficiency ratio.
In Other , increases in US interest rates led to higher earnings on capital, which were partly offset by increased subordinated debt-servicing costs.
Movements in the fair value of own debt and associated hedges were US$33 million, compared with an adverse movement of US$15 million in 2005, principally from movements in HSBC’s own credit spread. The fair value of own debt
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incorporates an element attributable to the credit spread on HSBC’s debt instruments. As HSBC’s credit spreads narrow, accounting losses are reported, and the reverse is true in the event of spreads widening. These valuation adjustments do
not alter the cash flows envisaged as part of the documented interest rate management strategy.
Operating expenses decreased by 5 per cent, driven by the non-recurrence of litigation expenses in France.
Profit/(loss) before tax and balance sheet data by customer group and global business
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Profit/(loss) before tax and balance sheet data by customer group and global business (continued)
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Profit/(loss) before tax by customer groups and global businesses
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Hong Kong’s economy remained robust during 2007, with the annual rate of growth of 6.3 per cent. Domestic consumption was the major contributor to economic expansion, supported by the strong labour market. The unemployment rate fell to 3.4 per cent, a nine year low, as the supply of labour remained very tight. Global increases in food and oil prices affected Hong Kong, but the territory also experienced wage inflation, rising import prices and growth in property rental costs. Inflation increased as a result, exceeding 3 per cent in the final quarter of the year.
In response to interest rate cuts in the US and capital inflows into the local market, Hong Kong’s main interest rate was cut on three separate occasions during the final months of 2007, with the prime rate ending the year at 6.75 per cent, down by one per cent from its high for the year. Local asset markets benefited accordingly. The previously very strong levels of export growth slowed in the second half of 2007, as demand from the US moderated and the reduction in mainland China’s export tax rebate in July temporarily affected Hong Kong’s re-exports. Despite relatively modest trade growth, external demand for Hong Kong’s services remained strong due to the buoyant tourism sector and increasing cross-border business activities, especially within the financial sector.
HSBC’s operations in Hong Kong reported a record pre-tax profit of US$7.3 billion, an increase of 42 per cent compared with US$5.2 billion in 2006. The underlying change was in line with the reported change. Net operating income increased by 32 per cent, double the rate of growth in operating expenses.
In Personal Financial Services, performance was driven by increased fee income, particularly from retail brokerage and investment products, as well as growth in net interest income following higher deposit balances and lending. In Commercial Banking, balance sheet growth was driven by customer acquisition, increased trade flows and supporting businesses expanding into mainland
China. In Global Banking and Markets, income growth reflected improved performance in balance sheet management, and strong results from the trading businesses and securities services in the buoyant economic environment. Higher demand for structured products and mutual funds drove the increased Private Banking profits. Cost efficiency ratios improved in all customer groups.
The commentary that follows is on an underlying basis.
Personal Financial Services reported a record pre-tax profit of US$4.2 billion, an increase of 47 per cent compared with 2006, largely driven by an increase in fee income in a year in which buoyant stock markets encouraged high volumes of share trading. The higher fee income, combined with
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growth in loan and deposit balances, generated a rise in net operating income of 37 per cent. The cost efficiency ratio improved to 27.2 per cent. Increased business volumes fed through to higher costs, but these were considerably lower than revenue gains as efficiencies were attained from productivity gains in the sales force and the increased use of automated channels and straight-through processing.
Net interest income grew by 16 per cent to US$3.3 billion in 2007, due to better margins and growth of average deposit balances. Effective balance sheet management and the successful marketing of key products, including HSBC Premier, further contributed to deposit growth.
Average customer deposits grew by 10 per cent, driven by a series of tactical campaigns and new deposit initiatives, including Deposits SmartPicks, which led to new customer acquisition. The relaunch of Premier, which incorporates seamless international banking connectivity and enhanced service benefits, supported strong growth in the number of customers using the service. At the end of 2007, the number of Premier customers was 15 per cent higher than at the end of 2006, at more than 290,000.
An active property market was underpinned by strong economic conditions and stable domestic interest rates throughout most of the year. The volume of new mortgages grew but spreads tightened in a competitive market. The cross-selling of mortgage-related insurance products, including HomeSurance, enhanced overall revenue and customer value. Premier customers were responsible for 45 per cent of new mortgage balances while the launch of a deposit-linked mortgage repayment plan was successful in strengthening customer relationships.
A number of credit card programmes were launched in 2007 which successfully increased overall card balances by 15 per cent, and the total number of cards in circulation rose by 6 per cent to 4.9 million at the end of the year. HSBC’s credit card business maintained its leading position in terms of cards in circulation, spending and balances.
HSBC’s development of its investment and wealth management platforms benefited from the buoyant stock market in Hong Kong. This led to an increase in fees from the sale of retail securities and retail investment funds, leading to a 103 per cent increase in net fee income to US$2.0 billion. This was mainly due to higher trading volumes, reflecting rising market turnover and value gains compared with the prior year.
The volume of retail securities transactions registered over 167 per cent growth with 80 per cent of trades performed online. In response to significant increases in market volumes during the year, online trading capacity was augmented to handle a four-fold increase in the peak number of users. In the fourth quarter, credit-related liquidity concerns, fears of a US recession and the implementation of measures in mainland China to dampen the economy led to equity market falls which slowed the rate of growth of fee income from share dealing and investment activities.
Over the course of 2007, investment market sentiment together with continued IPO activity, largely from mainland China, drove total funds under management higher. The introduction of new funds and the launch of awareness campaigns helped to boost income from retail investment funds and structured investment products by 144 per cent. WealthMaster, a new portfolio wealth management sales tool, was introduced during 2007 to support branch staff sales of these products. Equity market performance was a catalyst for significant increases in broking income in Hong Kong.
Credit card fee income rose by 20 per cent, as promotional campaigns led to increased cards in circulation and contributed to a 17 per cent rise in cardholder spending.
Life insurance commission income increased by 50 per cent, boosted by the launch of new products, LifeInvest and LifeSave, a medical cover policy incorporating retirement savings. HSBC extended its market leadership position for share of life insurance new business premiums. Emphasis on lower cost online channels increased the percentage of non-life policies sold through them to 53 per cent, while distribution through telemarketing channels also contributed to increased sales.
Loan impairment charges rose by 47 per cent due to increased card balances. Despite a rise in bankruptcies in Hong Kong, credit quality was stable and non-performing loans as a percentage of advances fell by 10 basis points.
Operating expenses rose by 16 per cent due to higher performance-related pay and a rise in premises costs as demand for space in Hong Kong put upward pressure on rents. Increased marketing expenses reflected business growth and the launch of new initiatives. Higher IT costs were also incurred as new systems were developed. The cost efficiency ratio improved as increased revenues were delivered by sales productivity gains and the use of direct channels.
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Commercial Banking reported pre-tax profits of US$1.6 billion, 23 per cent higher than in 2006, due to strong balance sheet growth. The rise in asset balances was supported by active marketing efforts and increased trade volumes in Hong Kong. Higher customer numbers across all segments helped to boost deposits and fee income rose as a result of a wider product range and increased sales of investment products. The cost efficiency ratio improved by 1.2 percentage points. While strong economic growth was a stimulus to revenue growth, HSBC also actively increased its customer base by opening business banking branches and adding frontline staff. Market share increased for key products, including remittances and the integrated account package, Business Vantage, which attracted 36,000 new accounts. Revenues from payments and cash management rose by 17 per cent. A series of reward programmes and customer events strengthened existing client relationships. The launch of SmartForms for cross-border as well as domestic account openings further improved accessibility to services for small businesses. Total customer numbers grew by 9 per cent.
Net interest income rose by 15 per cent as a result of higher deposits, as strong economic growth generated demand for savings products. New customers based in mainland China increased the small and mid-market client base and generated an increase in Hong Kong dollar deposits. Foreign currency deposits, including US dollars, also increased significantly as global interest rates rose and spreads were actively managed in a highly competitive market.
Overall, loans and advances to customers grew by 10 per cent as HSBC continued to increase its lending to manufacturers who were expanding their operations in mainland China, while intra-Asian trade flows continued to accelerate. HSBC also promoted its Green Equipment Financing option to borrowers in Hong Kong to enable them to finance energy-efficient equipment. Successful cross-border referrals rose by 95 per cent, due to continued initiatives promoting regional interaction. Hang Seng Bank also targeted the cross-border activity of small and medium-sized businesses by promoting its import and export products. Market competition squeezed asset spreads on lending to corporate and mid-market business customers.
Increased sales of packaged products to small and micro businesses were partially driven by lending campaigns for equipment financing and micro lending.
The business card launched by HSBC in 2006 was quickly adopted; in 2007, over 21,000 new business credit cards were issued. Spreads, however, tightened due to competitive pressures.
Net fee income of US$526 million was 16 per cent higher, driven by increased sales of investment products, remittances, and trade services. Demand from commercial clients for retail securities, unit trusts and structured products helped fee income from these products to rise by 173 per cent. Remittance income rose by 26 per cent, boosted by an increase in transaction volumes. In addition, a focus on straight-through processing and simplified account opening procedures attracted customers to fee-based products as the convenience of the internet and other direct options provided them with more flexible options for their business operations.
As a result of several commercial insurance marketing campaigns launched during the year, and a realigned sales force, insurance fee income increased by 11 per cent and net earned insurance premiums rose by 37 per cent. Composite sales teams were established to enable general insurance sales managers to also sell life products.
Improved trading income was underpinned by exchange rate volatility, which drove increased payments and trade activity as well as income from foreign exchange and derivatives. Targeted marketing and the enhancement of Business Internet Banking (‘BIB’) to include forward contracts helped to increase transactions. Trading between US and Hong Kong dollars and the hedging of renminbi transactions also led to higher transaction volumes.
Loan impairment charges fell sharply by 59 per cent due to releases of provisions in a stable credit environment.
Expenses rose by 12 per cent as a result of higher staff costs and rising commercial rents. Staff cost increases reflected a combination of wage inflation, performance-related compensation and the costs of additional client-facing staff to support enhanced product offerings. In addition, marketing costs rose to support branding and campaign activity.
A total of 176,000 customers were registered as internet users at the end of 2007, reflecting wide adoption of direct channel offerings. The BIB site was relaunched in the first quarter of the year, leading to processing cost efficiencies. Call centres were also re-engineered to promote the sale of packaged products. Transactions through direct channels constituted 40 per cent of the total number of transactions.
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Global Banking and Markets in Hong Kong reported a pre-tax profit of US$1.6 billion, which represented a rise of 65 per cent compared with 2006. This was principally due to a recovery in balance sheet management revenues, a strong performance in Global Markets, including significant growth in fees from securities services, and higher income from payments and cash management. The cost efficiency ratio improved by 10.5 percentage points.
Total operating income increased by 43 per cent to US$2.6 billion, rising significantly as balance sheet management revenues recovered and Global Markets benefited from market volatility, boosting trading income from structured derivatives, foreign exchange and equities.
Along with the improvement in balance sheet management performance, net interest income growth was driven by the continued rise in deposit balances and related margins, reflecting the buoyant local markets.
Net fee income rose by 28 per cent as the strong equities market and healthy investor confidence drove increases in volumes in securities services. Assets under custody rose by 56 per cent due to strong growth in new business.
Trading income increased by 20 per cent, mainly from foreign exchange, structured derivatives, equities and rates. Global Markets benefited from interest rate volatility during the year and a buoyant equity market backed by mainland Chinese stocks listed in Hong Kong, as well as currency volatility as regional currencies rose against the US dollar. Structured products generated strong earnings, particularly due to higher sales of products incorporating equity derivatives. Initiatives taken in previous years to extend the product range, ongoing investments in technical and operating capabilities, and sustained cross-sales efforts stimulated revenue growth.
The corporate credit environment remained benign with a small loan impairment charge, compared with a net release in 2006.
Operating expenses of US$1.0 billion rose by 13 per cent, 30 percentage points less than revenue growth. The expansion of certain businesses, including equities, structured derivatives and securities services resulted in higher operational expenses. Staff cost growth reflected performance incentives in line with the rise in revenues, and higher staff numbers.
Private Banking reported a pre-tax profit of US$305 million. Excluding a US$39 million geographical reclassification, the underlying increase was 72 per cent. Client demand for structured products increased, encouraged by the buoyant stock market. The cost efficiency ratio improved by 6.4 percentage points to 43.1 per cent.
Excluding a US$42 million geographic reclassification, net interest income grew substantially. A significant rise was recorded in both deposits and lending. An increase in relationship managers and HSBC’s brand reputation attracted new deposits, and clients continued to leverage their investments due to the relatively low cost of borrowing. This was supported by improved treasury performance, as US dollar and Hong Kong dollar interest rates declined.
Fee income rose by 46 per cent as more clients invested in mutual funds to take advantage of the local stock market performance. In addition, the promotion of discretionary products further contributed to the rise in revenues. The SIS product, which provides clients with externally managed portfolios tailored to their specific needs, proved particularly popular.
Trading income also benefited from the strength of equity markets, with a 59 per cent increase to US$280 million. Demand for alternative funds and structured equity products was high, particularly for the Forward Accumulator, a product linked to the Hong Kong Stock Exchange.
Client assets grew by 43 per cent to US$72.7 billion. Net new money contributed to 49 per cent of the increase, driven by a rise in the number of relationship managers and a wide variety of discretionary products. Cross-referrals from other customer groups also increased, with inward referrals from other customer groups contributing US$898 million of net new money.
Operating expenses were 17 per cent higher at US$231 million, mainly due to increased employee numbers, predominantly in the front office, higher remuneration and performance-related bonuses awarded in order to retain key staff in a very buoyant market.
Within Other , the non-recurrence of gains in 2006 from the sale of properties and investments, notably the sale of UTI Bank Limited and the then Hang Seng head office building, resulted in a higher pre-tax loss in this segment.
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Hong Kong experienced sustained economic expansion in the second half of 2006 with growth,particularly in exports, regaining momentum following a mild slowdown in the second quarter. Domestic demand underpinned the economy throughout 2006 despite volatility in the stock market, which suffered a correction in the second quarter but recovered strongly in the second half of the year. Falling unemployment, improved household incomes and positive longer-term economic prospects were the key elements supporting domestic consumption. Hong Kong’s unemployment rate fell to a six-year low of 4.4 per
cent towards the end of 2006, and the labour market began to tighten in certain sectors, with wage pressure increasingly evident. Despite this, inflation remained low, averaging 2 per cent in 2006. Investment growth surged in the second half of the year as the local interest rate cycle peaked. The residential property market divided, with prices of luxury property exceeding levels last seen in the boom in 1997 while, elsewhere in the sector, activity and prices remained flat. At the same time, investment in the construction sector was weak in the absence of large-scale infrastructure projects and general uncertainty. Externally, trade performance improved in the second half of 2006 following difficulties in the first half of the year due to volatile external demand from western markets.
HSBC’s operations in Hong Kong reported a pre-tax profit of US$5.2 billion compared with US$4.5 billion in 2005, an increase of 15 per cent. On an underlying basis, pre-tax profit also grew by 15 per cent. Underlying net operating income increased by 14 per cent, driven by widening deposit spreads in Personal Financial Services and Commercial Banking and strong net fee income growth in all customer groups. In Global Banking and Markets, an increase in trading income offset the negative impact of lower balance sheet management income. Underlying operating expenses rose by 14 per cent.
Personal Financial Services pre-tax profits increased by 9 per cent to US$2.9 billion. Net operating income before impairment charges grew by 13 per cent, driven by higher income from savings and current accounts and increased fee income. Marketing activities were successful, helping HSBC enlarge its share of the credit card and mortgage markets and attract higher deposit balances. As a result, customer numbers increased by over 100,000. The cost efficiency ratio improved by 1.1 percentage points as cost growth of 9 per cent was restricted to less than the increase in net revenue. Credit quality remained favourable and
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loan impairment charges were low, although higher than in 2005 when a modest recovery was recorded.
Net interest income of US$2.9 billion was 10 per cent higher than in 2005, principally as a result of deposit growth and wider liability spreads. Average savings balances increased by 7 per cent to US$119 billion, reflecting the success of promotional campaigns and HSBC’s competitive pricing strategy, and supported by increased demand for deposit products in the rising interest rate environment. Effective deposit pricing amid rising interest rates led to wider deposit spreads.
HSBC increased its share of new mortgage business to 33 per cent, the highest of any lender, benefiting from the launch of a simplified, transparent pricing structure in the first half of 2006 which was supported by extensive media coverage. The relaunch of a number of key products and the introduction of a two-month interest free offer in the fourth quarter of 2006 also contributed to the increase in market share. Excluding the reduction in balances under the Government Home Ownership Scheme, HSBC’s mortgage portfolio grew by 7 per cent to US$23 billion.
Average cardholder balances increased by 16 per cent to US$3.5 billion and HSBC issued over 1 million new cards during 2006, which led to a 17 per cent rise in cards in issue to a record 4.6 million. The launch of a mass card acquisition programme comprising increased promotional activity, direct marketing and the use of incentives to increase cardholder spending contributed directly to this rise. As a result, HSBC’s share of the Hong Kong credit card market increased to 46 per cent of card receivable balances.
Net fee income increased by 32 per cent to US$977 million. Buoyant regional and global stock markets led to increased demand for equity-based products among local investors and HSBC responded by launching 69 new investment funds, including a number of innovative fund products, designed to meet investors’ changing demands in a rising interest rate environment. These launches were supported by greater marketing activity, improved pricing transparency and the development of new customer retention activities. As a result, sales of unit trusts rose by 61 per cent and fee income from the sale of investment products, and custody and broking activities increased by 39 per cent.
The increase in cards in issue led to a 24 per cent rise in credit card fees. Expansion of the current account base, partly due to higher sales of packaged products, led to increased remittance and account
servicing fees. HSBC focused on attracting additional funds from existing Premier customers during 2006 and deposits managed on their behalf increased by 29 per cent, reflecting the success of marketing campaigns and enhanced customer benefits.
Insurance fee income increased by 21 per cent and insurance premiums rose by 13 per cent. The development of HSBC’s retirement planning proposition was reflected in the launch of new savings, protection and medical insurance products, supported by increased promotional and marketing activity and the successful development of internet and telephone distribution channels. As a result, sales of life and non-life insurance products rose.
Gains less losses from financial investments increased to US$14 million, reflecting proceeds from the MasterCard Incorporated IPO. In July 2006, HSBC transferred most of its Asian card acquiring business into a joint venture with Global Payments Inc. HSBC retained a 44 per cent stake in the new venture and recognised an overall gain on transfer of US$55 million, of which US$12 million was allocated to the Hong Kong Personal Financial Services business and reported in ‘Other operating income’.
Following a net release in 2005, loan impairment charges of US$119 million reflected asset growth and lower releases and recoveries. In 2005, rising property prices led to the release of impairment allowances against HSBC’s mortgage lending portfolio and against restructured lending facilities, neither of which were repeated in 2006.
Increased staff numbers, additional marketing activity and higher IT expenditure led to a 9 per cent rise in operating expenses. Staff recruited to support extended opening hours, together with higher performance-related remuneration and annual pay rises, led to increased employment costs. These were mitigated by a reduction in branch back-office staff numbers as customers utilised lower-cost distribution channels for an increasing proportion of their banking business. Rising Hong Kong commercial property rental yields in 2006 coincided with the expansion of certain branches with high growth potential and resulted in higher premises costs. Marketing costs rose in support of promotional activity related to credit cards, insurance and wealth management products. Similarly, IT expenditure rose as improved portfolio management systems and enhanced channel capabilities were delivered in order to drive revenue growth.
In Commercial Banking , pre-tax profits increased significantly by 38 per cent to
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US$1.3 billion. Net operating income grew by 32 per cent, driven by higher deposit balances and fee income, increased liability spreads and lower loan impairment charges. Cost growth was comfortably within the growth in revenues, and the cost efficiency ratio improved by 1.1 percentage points to 26.1 per cent.
During 2006, HSBC launched a number of initiatives designed to further its position in the small business banking market, including customer service enhancements, improvements to account opening procedures and targeted promotional activity. As a result, Commercial Banking customer numbers increased (by 13,000 to 377,000), as did the number of products sold per customer. Investments to enhance the attractiveness of HSBC’s distribution channels improved customer service, facilitated customer acquisition and encouraged the migration of routine transactions to automated channels.
Net interest income rose by 23 per cent to US$1.3 billion. Deposit and current account balances increased by 10 per cent, partly due to the deployment of a team dedicated to attracting deposits from small businesses, and other service enhancements. BusinessVantage, HSBC’s market leading integrated account for business, reinforced its leadership position through increased promotional activity, including a new referral programme. HSBC opened over 25,000 new BusinessVantage accounts in 2006, 21 per cent more than in 2005. Interest rate rises led to a 30 basis point widening of deposit and current account spreads and contributed to increased demand for savings products.
Non-trade lending balances increased by 16 per cent to US$16.8 billion. The continued strength of the Hong Kong economy and, most importantly, its proximity to the strongly growing mainland Chinese market, led to increased business activity among mid-market clients, resulting in higher demand for credit. Lending to the property and retail sectors was particularly strong, while manufacturers with operations in mainland China raised borrowings to fund further expansion and take advantage of both the growing Chinese domestic market and the strong export climate. HSBC’s regional alignment programme, which is designed to identify and capitalise on cross-border financing opportunities between Hong Kong, mainland China, Taiwan and Vietnam was instrumental in contributing to the growth in mid-market lending balances.
Growth in small business lending was facilitated through a streamlined lending process and the adoption of a new credit scorecard. As a result, the number of small business customers borrowing from
HSBC increased by 12 per cent and small business lending balances rose by 9 per cent. Increased competition led to a 12 basis point narrowing of asset spreads.
Net fee income of US$454 million was 13 per cent higher than in 2005. Cash management and remittance fees increased by 18 per cent, driven by growth in the number of current account customers, enhancements to the product range and increased cross-border remittances. Robust local equity markets prompted the launch of 88 new investment products amid resurgent demand. Sales of unit trusts were consequently 15 per cent higher, while derivative and structured product sales rose by 83 per cent.
The establishment of a new Commercial Banking insurance business in October 2005 contributed to life insurance policy sales more than doubling and an 18 per cent rise in non-life policies in force. As a result, insurance fee income more than doubled and premium income increased by 23 per cent.
Effective promotion contributed to a 31 per cent rise in receivables finance fee income, while increased hedging activity and a rise in the value of multi-currency transactions by Commercial Banking customers contributed to a 57 per cent increase in treasury income.
The transfer of the majority of HSBC’s card acquiring business into a joint venture with Global Payments Inc. realised a gain of US$13 million for Commercial Banking, reported in ‘Other operating income’. Fee income in HSBC’s remaining card acquiring business not included in the transfer rose by 43 per cent, reflecting an increase in the number of merchant customers and higher transaction values.
Loan impairment charges decreased by 59 per cent, principally due to the non-recurrence of significant charges against a single client in 2005. Credit quality remained strong and non-performing loans as a proportion of lending balances fell by 22 basis points to 62 basis points, reflecting prudent lending policies and risk mitigation procedures.
Operating expenses increased by 17 per cent to US$491 million to support the strong revenue opportunities evident in the market. The recruitment of additional sales and support staff and the development of the Commercial Banking insurance business contributed to higher staff numbers which, together with the effect of pay rises, resulted in higher staff costs. Marketing costs rose as HSBC stepped up its advertising and promotional activity, including the launch of the global Commercial
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Banking campaign to build market share. Cost efficiency was improved by the continuing migration of sales and transaction activity to lower-cost direct channels.
Global Banking and Markets reported a pre-tax profit of US$955 million, an increase of 3 per cent compared with 2005. Global Markets performance remained robust, with encouraging revenue growth in areas in which HSBC has invested, complemented by strong income growth in the securities services business. The cost efficiency ratio increased slightly, primarily due to the first full year effect of various growth initiatives taken in 2005.
Total operating income of US$1.8 billion was 7 per cent higher. Although balance sheet management reported an overall decline, revenues recovered modestly in the second half of 2006 as lower yielding positions matured. In Global Banking, net interest income from payments and cash management activity rose sharply as a 6 per cent increase in deposits was complemented by wider spreads. Revenues benefited from improved customer flows following the launch of services offered through HSBCnet in the latter part of 2005. Income from lending activities decreased as the benefit of higher lending balances was more than offset by the effect of spread compression resulting from an abundance of credit in a highly competitive market.
Net fee income rose by 24 per cent. Securities services reported a 28 per cent increase in fees as buoyant stock markets drove higher customer activity. Debt underwriting volumes increased as tightening credit spreads encouraged issuers to lock in to the favourable credit environment by extending the term of finance or by raising new debt in local markets. By contrast, equity underwriting fees declined.
HSBC Global Asset Management used HSBC’s extensive distribution network to take advantage of the global trend of strong investment flows to emerging markets. Higher fees reflected strong performance fees from HSBC’s emerging market funds. Client funds under management grew by 23 per cent to US$35 billion, as HSBC launched new funds to capture increased demand for equity-based investments. Fees from the asset and structured finance business also rose.
Net trading income increased by 18 per cent. HSBC retained its leadership position in foreign exchange, with revenues strengthening as trading activity increased in response to volatility in the value of the US dollar and economic conditions in
certain local markets. Investments in equity sales and trading operations in previous years led to higher revenues. HSBC also benefited from internal synergies linking product structuring and hedging capabilities with distribution scale, as foreign exchange option-linked deposits and other instruments were offered to retail and corporate customers.
Private Equity investments also performed strongly. However, Credit and Rates were adversely affected by lower volumes due to unfavourable market conditions in a rising interest rate environment.
The overall credit environment remained stable with a net recovery of US$27 million.
Operating expenses increased by 12 per cent to US$911 million, primarily due to the first full year effect of initiatives implemented in the second half of 2005 which extended the product range in Global Markets and strengthened the regional investment banking platform in Hong Kong.
Additional cost increase reflected a rise in performance-related remuneration coupled with higher operational costs in line with increased volumes, particularly in payments and cash management and securities services businesses.
Private Banking contributed a pre-tax profit of US$201 million, an increase of 5 per cent compared with 2005. Growth in client assets and rising sales of higher fee-generating discretionary managed products were partially offset by the adverse effect of a flattening yield curve on income from the investment of surplus liquidity. Demand for experienced private banking staff in Hong Kong was fierce as competitors built up their locally-based operations and, despite strong revenue growth, the resultant increase in staff costs led to a 5.2 percentage points deterioration in the cost efficiency ratio to 49.5 per cent.
Net interest income was US$76 million, in line with 2005. Steady growth in deposit balances was offset by competitive pressure on deposit rates and by a challenging interest rate environment for treasury management activities. Loans and advances to customers at 31 December 2006 were marginally lower than at the same point in 2005 as higher interest rates reduced clients’ appetite for credit.
There was excellent growth in fee income, which increased to US$123 million, a rise of 31 per cent. Growth in funds under management and success in increasing the proportion of clients’ assets invested in higher fee-earning discretionary managed assets contributed towards increased fee revenue.
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Fee income growth also benefited from increased client holdings of funds and alternative investments. Trading and other revenues were 18 per cent higher at US$199 million, driven largely by sales of bonds and structured products.
Client assets increased by 27 per cent to US$51 billion, with net new money inflows of US$8 billion. This growth was assisted by better marketing and successful product placement, including a broadening of the discretionary managed product range. Sales of HSBC’s discretionary managed SIS and CIS products, in which the value of investments by clients reached US$1.4 billion, continued to be a key driver of this asset class. Continued investment in relationship management, improved stock market performance and growing cross-referrals from within the Group, primarily the retail and commercial networks, also added to the growth.
Operating expenses were 31 per cent higher than in 2005, primarily due to increased staff costs driven by recruitment and the retention of front office staff in a competitive market, where demand for
experienced private bankers was high. Performance-related remuneration rose, reflecting strong revenue growth and a 19 per cent increase in customer relationship staff. Increased marketing expenditure and technology costs were incurred in support of growing the business.
The sale of part of HSBC’s interest in UTI Bank Limited resulted in gains of US$101 million, recognised in Other. The disposal of Hang Seng’s head office building realised a gain of US$100 million and the resulting reduction in HSBC’s investment property portfolio, together with slower growth in the Hong Kong property market, led to lower property revaluation gains.
Increased US interest rates led to higher costs of servicing US dollar denominated floating rate subordinated debt, partly offset by higher earnings on centrally held funds. In 2006, HSBC benefited from higher dividend income from strategic investments. Hong Kong head office and central IT costs rose, reflecting increased activity in support of HSBC’s growing Asian busi nesses, offset by higher recoveries from other customer groups.
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Loans and advances to customers (net) by country
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Customer accounts by country
Mainland China’s economy continued to grow strongly, with GDP rising by 11.4 per cent in 2007, the fifth consecutive year of double-digit growth; this was despite a combination of measures aimed at curbing investment, such as increases in interest rates and reserve ratios required for banks. Economic performance remained primarily dependent on investment and exports. Bank loan growth also remained very strong. Export growth slowed from very high levels as the year progressed, reflecting the mild downturn in global trade. Consumer spending grew steadily in 2007, with retail sales rising by about 16 per cent. Inflationary pressures increased, with consumer price inflation exceeding 6 per cent towards the end of the year, mainly due to higher food prices. Mainland China’s foreign exchange reserves rose further, to more than US$1.5 trillion, while the renminbi appreciated by over 5 per cent against the US dollar in 2007.
Japan’s economy, the largest in the region, expanded modestly in 2007. Private capital investment decelerated after five years of firm growth but a rise in exports, especially to Asia, drove overall growth. Private consumption also made a positive contribution, helped by a gradual increase in employees’ income. Core consumer price inflation remained around zero throughout the course of the year.
In the Middle East, economies continued to grow, although growth rates slowed slightly on those recorded in 2006, largely as a result of OPEC-mandated cuts in oil production. Underlying
economic performance was robust, however, led by continued non-oil sector growth. The catalyst for expansion was a fifth consecutive year of rising oil prices, which facilitated continued growth in public and private investment. Consumption rose as employment levels increased and low interest rates supported an ongoing expansion in credit. Strong population growth, accelerated in parts of the region by high levels of immigration, also boosted demand for credit. High oil revenues resulted in a further year of fiscal and current account surpluses throughout the Middle East, boosting reserves and holdings of overseas assets. Rapid economic growth, low interest rates and currency weakness increased inflation, however, fuelling demands in some quarters for adjustments to the long-standing dollar pegs. Regional equity markets recovered from their 2005-06 downturns to perform strongly in 2007.
Elsewhere in the region, the Indian economy expanded by 8.7 per cent in 2007, although there was evidence that recent interest rate rises and the strength of the rupee were slowing some areas of the economy, and inflationary pressures eased in 2007. The economies of Vietnam and Singapore recorded strong performances too, expanding by 8.5 per cent and 7.7 per cent, respectively in 2007. Growth was approximately 6 per cent in Indonesia and Malaysia. Domestic demand in all these countries has become an increasingly important source of GDP growth with investment, particularly in the construction sector, expanding rapidly. Inflationary pressures intensified in 2007, largely as a result of higher oil and food prices, but remained under control. The South Korean economy accelerated in 2007 as exports continued to flourish and household spending recovered from levels recorded in 2006.
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Concerns over liquidity growth prompted the central bank to increase interest rates by 50 basis points to 5 per cent during the year. A gradual cooling of demand and concerns over rapid exchange rate appreciation are expected to limit the scope for further interest rate rises in 2008. Buoyant exports supported economic growth in Taiwan, while
domestic demand remained lacklustre due to a lack of government initiatives which is expected to continue beyond the presidential and parliamentary elections scheduled for 2008. Generally robust economic performances in the Philippines, Thailand, and Pakistan in 2007 were overshadowed to varying degrees by political risks.
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HSBC’s operations in Rest of Asia-Pacific reported a pre-tax profit of US$6.0 billion compared with US$3.5 billion in 2006, an increase of 71 per cent. On an underlying basis, excluding dilution gains of US$1.1 billion, profit before tax increased by 34 per cent, bolstered by sustained growth and business expansion across the region.
In Global Banking and Markets, profit before tax increased significantly, driven by an enhanced product offering combined with buoyant local markets. Commercial Banking revenue benefited from increased customer volumes as a result of new and enhanced banking services. In Personal Financial Services, profit before tax rose as a result of strong balance sheet growth and increased contributions from associates. Private Banking delivered a solid performance, underpinned by robust stock markets and increasing wealth in the region.
HSBC’s three associates in mainland China, Ping An Insurance, Bank of Communications and Industrial Bank, all raised new capital in 2007 in the ‘A’ share market in Shanghai in which HSBC is not able as a foreign investor to participate. A similar dilution gain from Techcombank, in Vietnam, was recorded in the second half of 2007. The resulting dilution of the Group’s interests was considerably less than its share of the new monies raised and HSBC’s results therefore include within ‘Other’ aggregate pre-tax gains of US$1.1 billion which should be regarded as exceptional.
Personal Financial Services reported a pre-tax profit of US$760 million, an increase of 51 per cent compared with 2006, due to significant growth in operating income and in the contribution from associates. Loan impairment charges declined slightly with the absence of the exceptional credit card losses incurred in Taiwan in 2006 largely offset by new loan impairment charges from expansion in consumer lending throughout the region. Continued investment in the region’s emerging markets and in Japan resulted in a slight deterioration in the cost efficiency ratio.
Global and regional emphasis on distinctive product offerings, including HSBC Premier and HSBC Direct, as well as significant investment in branches and marketing, and growth of consumer assets in emerging markets, helped attract an additional 1.1 million active customers, bringing the total to over 9 million. 87 new branches in mainland China, India, Indonesia, the Philippines, Sri Lanka, Bangladesh and Malaysia expanded the total branch network to 410. These initiatives spurred brisk growth of the business, with double-digit revenue growth in most countries in the region.
HSBC Premier was relaunched in 22 markets in the region, extending international banking connectivity to 35 countries globally. The number of Premier customers within Rest of Asia-Pacific increased by 37 per cent.
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In mainland China, pre-tax profit grew by 71 per cent, as the share of profit from associates made significant progress. Operating income from own branded operations increased, though operating profit fell due to continuing investment expenditure in key regions within mainland China. The Chinese government’s Qualified Domestic Institutional Investors (‘QDII’) scheme, which allows mainland Chinese citizens to invest overseas, contributed to an increase in net fee income. HSBC’s own-branded network expanded to 18 branches and 44 sub-branches and, following local incorporation, HSBC began full renminbi-denominated services. HSBC was the first foreign bank to qualify to provide local currency services in Beijing. New branches were added in the key economic zones of the Pearl River Delta, the Yangtze River Delta and the Bohai Rim. In addition, Hang Seng Bank added an additional three branches and seven sub-branches, bringing its total to 25 outlets. HSBC has the largest branch network among foreign banks and remained focused on offering Premier services. This led to significant deposit growth and a 51 per cent rise in the total number of customers.
In the Middle East, pre-tax profit grew strongly, other than in Saudi Arabia, and in aggregate increased by 4 per cent. Revenue growth across the region was offset by a reduced contribution from HSBC’s associate in Saudi Arabia, which resulted from lower stock market-related income than the exceptional levels in 2006. Balance sheet growth continued in the UAE across core asset and liability lines, with the latter also benefiting from improved margins. Promotions were instrumental in raising credit card balances as well as related interest income and fees.
In Singapore, pre-tax profit increased by 33 per cent, largely attributable to strong sales of unit trusts, along with successful campaigns to increase credit card usage and deposit balances. Average deposit balances rose by 23 per cent compared with 2006.
In India, a pre-tax loss of US$70 million was recorded due to planned investment in growing a consumer finance business and higher loan impairment charges. The personal lending portfolio, excluding mortgages, grew by 67 per cent during 2007. Excellent growth in operating income was achieved across all key products with 23 per cent growth in the number of active customers to over 2.4 million. HSBC is among the market leaders in India in new credit card issuance and retail mutual funds distribution. The wealth management business continued to perform strongly with a 91 per cent increase in funds under management and the number of insurance policies in force more then doubled. The
credit card business continued to expand while also delivering operating income growth of 33 per cent.
In Malaysia, revenues grew robustly as strong income growth was achieved in cards and personal lending. HSBC also recorded significant deposit growth, with balances 12 per cent higher than last year.
In Indonesia, expansion of consumer finance and development of the wealth management business helped increase revenues which, with more moderate loan impairment charges, resulted in an improvement in profitability.
In Taiwan, a pre-tax loss of US$52 million was 70 per cent better than in 2006. Revenues and expenses were in line with the previous year, while loan impairment charges were lower due to the non-recurrence of regulatory changes.
Net interest income of US$2.0 billion was 23 per cent higher, driven by strong growth across the region, particularly in the Middle East, India, Malaysia, the Philippines, Indonesia, mainland China, Singapore, Thailand and South Korea, due to higher balances from personal lending, credit cards and deposit accounts.
Average deposit balances rose by 23 per cent, partly as a result of the global relaunch of HSBC Premier and the addition of 136 dedicated Premier outlets, which led to notable increases in Singapore, mainland China, Malaysia, India and the Middle East. In South Korea, Taiwan and the Middle East, deposit growth was boosted by the successful launch of HSBC Direct, the Group’s online savings offering, which attracted more than 376,000 accounts with total savings balances exceeding US$1.2 billion at the end of 2007. An online savings product was also launched in the Middle East. Deposit spreads widened, particularly in India and Australia during the first half of the year, as interest rates rose in much of the region.
Average asset balances also increased and spreads widened as the asset mix shifted towards higher margin products. Personal lending grew by 3 per cent despite the sale of mortgage portfolios in Australia in the second half of 2006 and in New Zealand in July 2007. Excluding these countries, personal lending grew by 8 per cent.
Cards in circulation rose to 8.9 million and card balances were 23 per cent higher than in 2006. Various promotional initiatives in the Middle East contributed to a 30 per cent rise in card accounts and a 62 per cent rise in balances, as card usage among consumers increased. Balances rose in India and Australia due to portfolio growth and, in the latter,
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increased use of point-of-sale financing. By the end of 2007, nearly 2.7 million credit cards were in circulation in India and over 1.2 million cards in the Middle East. In Malaysia, the Group is the third largest card issuer. Spreads in the region improved slightly due to lower funding costs.
The mortgage business in each market in Asia-Pacific was affected to varying degrees by competitive pressures on balances and margins, and by local regulatory requirements. Excluding Australia and New Zealand, which were affected by the portfolio sales, mortgage balances grew by 7 per cent. In the Middle East, mortgage balances more than doubled.
Net fee income rose by 40 per cent to US$766 million, with increases from most products, notably cards and the wealth management businesses.
Increased sales of unit trusts and other investment products across the region was a key driver of higher fee income. Funds under management rose by 57 per cent. In the Middle East, retail sales benefited from the strong performance of local markets (largely due to sustained higher oil prices), and improved volumes of key products. Strong investment sales were recorded in India, South Korea, Singapore and mainland China, where HSBC offered residents renminbi-denominated products through its QDII offerings.
Credit card fee income increased, primarily in the Middle East, India, the Philippines and Malaysia, due to a combination of additional cards in circulation, increased spending and higher balances.
Distribution capabilities for insurance products were expanded through strategic alliances and the addition of new branches. In addition, marketing campaigns promoted HSBC’s expertise in life and non-life products. As a result, insurance fees and new premiums rose by 170 per cent and 50 per cent respectively. The improved and extended sales management in the Middle East, Taiwan and India increased fees from the distribution of insurance products.
Loan impairment charges and other credit risk provisions declined by 1 per cent. Loan impairment charges were significantly lower in Taiwan due to the non-recurrence of regulatory measures which, in 2006, had led to an increase in loan impairment charges. In Indonesia, lower impairment charges were a result of an improved economic environment and continued collection efforts. The Middle East businesses benefited from lower delinquencies and better collections.
In India, higher loan impairment charges were due to volume growth of the portfolio, along with a change in the collection methods of staff and agencies and regulatory restrictions on collections. Loan impairment charges in Malaysia also increased. In Thailand, loan impairment charges rose from a previously low level, partly because of the one-off effect of a regulatory increase during the year in the minimum payment due on credit cards.
Ongoing expansion in the region led to increases in headcount and performance-related staff costs, particularly in mainland China and the Middle East, which contributed to a 27 per cent increase in operating expenses to US$2.1 billion. Staff numbers rose from 750 to nearly 1,900 in mainland China, primarily in new branches. In India, an additional 700 employees were added to drive business expansion, bringing the total to over 4,600. Additional staff in the Middle East were concentrated in the UAE, where the number of employees increased from nearly 1,200 to 1,500, reflecting investment in the region.
Investment expenditure during 2007 was focused on implementing new business initiatives in consumer finance, HSBC Direct and expansion in mainland China. In India, the consumer finance branch network and the credit card business were expanded. In Indonesia, HSBC added 36 consumer finance loan centres. In mainland China, key cities were identified for increased investment and a total of 27 new branches and sub-branches were opened.
Income from HSBC’s strategic investments in its associates increased by 45 per cent, predominantly due to an increased contribution from Ping An Insurance, which experienced steady growth in its key business segments as well as improved investment returns. In the Middle East, Saudi British Bank’s performance was lower than in 2006, as the local stock market did not reach the volume of activity seen in that year.
Commercial Banking reported a profit before tax of US$1.4 billion, 27 per cent higher than in 2006. The region’s economies performed strongly, and this generated excellent trade and investment flows. The launch of secure and enhanced online banking services, and new International Banking Centres established to support the increase in the customer base, contributed to strengthened deposit growth. Costs rose to fund investment in expansion in mainland China and India, initiatives directed at small and medium-sized businesses in selected countries and additional employee numbers to support this planned growth. The cost efficiency ratio was largely in line with 2006.
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In the Middle East, operating profit grew by 29 per cent, underpinned by strong economic growth and the success of new International Banking Centres and dedicated Business Banking Centres. Small-business banking was introduced in Bahrain, Qatar and Jordan. In the UAE, additional relationship managers in the business banking unit helped to drive a 30 per cent increase in revenues. The region performed well, particularly in deposits and trade-related lending.
Operating profit grew by 56 per cent in mainland China to US$46 million, reflecting growing lending volumes to mid-market customers and improved spreads on lending products. Lending volume growth resulted in part from increased cross-border activity, new branches and additional front-line employees.
In Singapore, profit before tax rose by 19 per cent, driven by higher net interest income from balance sheet growth. Enhancements to the receivables finance offering contributed to strong growth in fee income.
In India, profit before tax grew by 76 per cent. Growth was broadly based with both net interest income and net fee income registering healthy increases of 78 per cent and 57 per cent, respectively. Net interest income rose from wider asset spreads and balance sheet growth, driven by selective lending related to the booming Indian real estate sector. Higher foreign exchange volumes and treasury product sales drove growth in fee income.
Revenues in Malaysia rose by 9 per cent, again due to strong balance sheet growth, further supported by initiatives to grow deposit balances and complemented by improved liability margins. Lending rose, particularly due to corporate term lending, but competition resulted in narrower spreads. Results in 2006 benefited from net recoveries on loan impairment charges which did not recur.
Cross-border activity was facilitated in part through the cross-border referral system, Global Links, which was extended across most of the region. Regional alignments and the acceleration of cross-border activity led to an 87 per cent increase in successful referrals. A further 19 International Banking Centres were opened in 2007, taking the coverage to 26 of the region’s countries and territories.
Net interest income grew by 29 per cent to US$1.1 billion. The opening of new branches, an increased commercial presence supported by call centres, and the enhancement of BIB in Asia-Pacific contributed to customer acquisition, particularly in
mainland China, Malaysia, Vietnam and Mauritius, spurring deposit and loan growth.
The UAE drove a strong increase in net interest income in the Middle East. Deposits and lending each recorded substantial volume growth as the region continued to experience high levels of investment and business expansion which buoyed local economic activity. Trade flows in the region also benefited small and medium-sized businesses and their related deposits. Trade-related lending rose by 45 per cent.
In India, net interest income grew by 78 per cent, largely due to trade-related lending products in combination with growth in deposits. Both lending and deposits benefited from an increase in the number of frontline sales staff in provincial cities. Net interest income from small and medium-sized businesses rose by 49 per cent. Increased margins on current accounts reflected the higher interest rates in the region. Local incorporation in Mauritius allowed closer alignment with HSBC in India.
In mainland China, net interest income rose by 79 per cent as the opening of new branches and recruitment of additional frontline employees succeeded in attracting new deposits and additional sales of lending products. HSBC utilised country desks to facilitate a greater number of cross-border transactions with South Korea, Vietnam, Hong Kong and Taiwan, which partly contributed to the 68 per cent growth in commercial lending volumes. The widening of liability spreads also contributed to net interest income growth.
Net interest income also rose strongly in Singapore and Malaysia, mainly due to higher deposit balances. In Malaysia, improvements to direct channels helped to generate increased balances in current accounts, and spreads rose accordingly. Growth in South Korea was partly the result of the successful acquisition of new customers.
Net fee income increased by 26 per cent, largely due to the continued growth of trade services, particularly in the Middle East, and cross-border transaction fees in India.
Trade-related lending fees rose by 24 per cent. The majority of this increase arose in the Middle East, where intra-regional trade flows increased as a result of strong economic performance. In India, customer acquisition of SME businesses, in combination with higher volumes of transactions from existing customers, increased trade-related fees by 81 per cent. TradeSmart in Malaysia and Tradeline in Bangladesh were among the initiatives used to maintain HSBC’s reputation for providing
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strong support for small and medium-sized business trade.
Fees generated from small and micro businesses rose as the customer base increased, in part due to customer acquisition campaigns, enhanced internet banking capabilities and the acquisition of Chailease, a factoring company in Taiwan which facilitates cross-border transactions.
Trading income increased by 45 per cent, as volatility among Asian currencies resulted in increased business flows and higher volumes. Volatile exchange rates also drove demand for hedging products, leading to an improvement in foreign exchange earnings, particularly in India and Singapore. Additional volumes were driven by the launch of an online trading platform. In the Middle East, trading income rose due to higher demand from customers for foreign exchange and interest rate hedging products.
Loan impairment charges were US$61 million compared with a net release in 2006. The charges mainly arose in Thailand and Indonesia, largely due to portfolio growth and a small number of delinquent customer accounts. The overall increase in loan impairment charges was balanced by recoveries in the UAE, Singapore and Mauritius.
Total operating expenses grew by 28 per cent, as growth was supplemented by investment in branch expansion in India and mainland China, and small-business initiatives in the Middle East. Additional staff were recruited to support sales growth, business initiatives and general expansion. In mainland China, HSBC established a rural bank targeting micro borrowers. Continued emphasis on the use of lower cost delivery media resulted in a substantial rise in the number of customers registered for BIB; the number of transactions undertaken through internet channels was 4 million, an increase of 127 per cent compared with 2006.
Income from associates rose by 64 per cent. Bank of Communications and Industrial Bank in mainland China substantially increased their contributions compared with 2006, largely due to balance sheet growth.
Global Banking and Markets reported a record pre-tax profit of US$2.5 billion in Rest of Asia-Pacific, an increase of 44 per cent on 2006. Robust growth across most revenue lines was driven by the successful delivery of HSBC’s global products to clients throughout the region, against a backdrop of rapid growth in regional economies and continuing international and domestic investor confidence in local stock markets. In line with the strategy to build
an emerging markets-led and financing-focused business, there were strong revenue performances in Global Banking and Markets in India, mainland China, the Middle East, Singapore and Malaysia, which more than offset a 26 per cent increase in operating expenses. The cost efficiency ratio improved by 3.0 percentage points to 34.5 per cent. Total operating income increased by 37 per cent to US$3.3 billion with growth of over 20 per cent in all major countries, led by securities services, balance sheet management and foreign exchange trading.
Net interest income grew by 54 per cent, reflecting balance sheet growth and improved spreads compared with the first half of 2006. In an environment of buoyant local markets and favourable deposit spreads, payments and cash management and balance sheet management reported notable increases across the region, particularly in mainland China, Singapore and India. In the Middle East, growth in income was driven by higher liability balances and improved spreads.
Net fee income rose by 34 per cent to US$952 million with good performances throughout the region in securities services, driven by a sustained level of transaction volumes and investment flows. In securities services, assets under custody increased by 83 per cent, due to the successful transfer of Westpac’s sub-custody clients in Australia and New Zealand, and high market volumes, particularly in India. Additionally, there was especially high fee income in Singapore, particularly from financing and capital markets, and payments and cash management.
HSBC Global Asset Management income grew by 68 per cent, following continued success in distributing emerging market funds to the Japanese market and a second year of strong performance fees from BRIC (‘Brazil, Russia , India and China’) funds generating growth in Singapore.
A significant rise in trading income was mainly due to record revenues from foreign exchange trading, driven by increased customer flows as a result of volatility in exchange rates against the US dollar across the region. Rates trading also contributed, benefiting from favourable market conditions in most countries.
Operating expenses increased by 26 per cent, mainly in the Middle East, Singapore, India and mainland China. Increased technology and infrastructure costs were incurred in support of business expansion initiatives. Higher staff costs reflected increases in employee numbers and performance-related pay in response to robust growth in operating income.
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The share of profits in associates and joint ventures increased by 47 per cent, reflecting higher contributions from HSBC’s investments in Bank of Communication, Industrial Bank and Ping An Insurance, largely due to balance sheet growth.
Private Bankingreported a pre-tax profit of US$92 million, an increase of 15 per cent. Strong revenue growth was achieved in Singapore, with further improvements in Japan, underpinned by buoyant stock markets and rapidly expanding wealth across the region. However, this was offset by increases in operating expenses, with the result that the cost efficiency ratio worsened by 2.8 percentage points to 57.6 per cent.
Net interest income rose by 71 per cent to US$60 million, mainly due to increased lending volumes in Singapore and improved treasury performance, as US dollar and Hong Kong dollar interest rates declined.
In Singapore, increased client appetite for discretionary portfolios and the SIS multi-manager product contributed to the 23 per cent increase in net fee income.
Trading income marginally decreased, with increased demand for structured products being offset by higher funding costs.
Client assets grew by 21 per cent to US$20.3 billion, with strong growth in Singapore and Japan. Net new money of US$2.2 billion was mainly attributable to the recruitment of additional relationship managers and a wider range of discretionary products.
Operating expenses were up by 29 per cent to US$125 million. The majority of the rise was in Singapore, as a result of increased employee numbers, particularly in the front office, and alignment of salaries to market conditions to support future growth. Also contributing to the rise were operating expenses in India, which more than doubled as HSBC continued to build its Private Banking business there.
In Other, GSC activity increased substantially as the number of countries using service centres rose to 31 from 24 in 2006. Costs rose by 40 per cent to US$790 million following the opening of six new GSCs and the resultant increase in staff and administrative costs, all of which were recovered in the form of other operating income from HSBC’s customer groups.
Mainland China’s economy continued to grow strongly, with GDP rising by 10.7 per cent in 2006, the fourth consecutive year of double-digit growth. Despite the government’s stated intention of promoting consumption in favour of investment growth, economic performance remained primarily dependent on investment and exports. However, some success was achieved in this respect, as urban fixed-asset investment slowed significantly to about 22 per cent in the second half of 2006 from 31 per cent in the first half of the year. This resulted from a combination of measures, including several interest rate rises, increases in banks’ required reserve ratios, and the draining of liquidity via bill sales and ‘window guidance’, the exercise of influence by the authorities over the banks on policy matters, such as slowing lending growth.
Export growth remained strong, accelerating slightly during the second half of 2006 despite evidence of slower global growth. Although a slowdown in the US growth rate in 2007 could negatively affect mainland China’s exports, the slowdown in investment spending referred to above provides the authorities with the scope to ease policy and stimulate domestic spending if exports falter. Consumer spending rose steadily in 2006 with retail sales rising by about 13 per cent, and bank loans continued to grow rapidly. The inflationary environment remained benign, with consumer prices rising by less than 2 per cent. Mainland China’s foreign exchange reserves rose to above US$1 trillion, the world’s highest level. The currency appreciated gradually against the US dollar, with an increase of over 3 per cent in 2006.
Japan’seconomy, the largest in the region, grew in 2006. Export growth was steady despite a slight slowing in the second half of the year, and private capital investment remained firm, driven by record levels of corporate profits and the need to upgrade the capital stock to maintain global competitiveness. Consumer spending was disappointing, however, and was the major reason why GDP growth was less than expected. Core consumer prices generally rose.
Economic growth in the Middle East remained robust over the second half of the year, continuing a strong expansionary phase that HSBC estimates will result in GDP in the Gulf region doubling in the space of just four years. Buoyed by high oil prices and strong production, earnings from energy reached record highs in 2006. Strong revenue growth encouraged government spending across the region,
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particularly on capital projects. Private investment, from both domestic and foreign sources, was also high while abundant liquidity, rising employment and rapid population growth supported further increases in private consumption. Although interest rates rose, tracking those in the US over the course of the year, credit growth continued to be strong. Robust domestic demand and the weakness of the US dollar boosted inflationary pressures. Following corrections in the first half of 2006, the major regional stock exchange indices continued to trade at significant discounts to the record levels registered in late 2005, with markets remaining generally sluggish.
Elsewhere in the region, most economies continued to perform impressively, particularly India, Singapore and Vietnam. The main drivers of growth
were exports, demand for technology, and domestic consumption, with investment demand lagging behind. India was among the strongest performing economies in the world, with GDP growth of about 9 per cent in 2006. This led to some signs of overheating, with inflation rising during the year. The Reserve Bank of India responded by raising interest rates, and there may be more increases to come. GDP in Singapore grew by 8 per cent in 2006, in Vietnam by over 7 per cent and in Malaysia by approximately 6 per cent, their economies benefiting from generally low inflation and strong domestic and external demand. Most Asian currencies ended 2006 stronger than the US dollar. A US slowdown is a risk for the region.
HSBC’s operations in Rest of Asia-Pacific delivered a pre-tax profit of US$3.5 billion compared with US$2.6 billion in 2005, an increase of 37 per cent. On an underlying basis, pre-tax profits grew by 29 per cent, with the major change in composition of the Group being the additional 10 per cent stake purchased in Ping An Insurance in August 2005 which made that company a 19.9 per cent owned associate of HSBC.
Pre-tax profits in the region have nearly doubled in the past two years, justifying HSBC’s strategy of investing in emerging markets. Momentum in 2006 was strong, with underlying net operating income increasing by 26 per cent, notwithstanding a
significant rise in loan impairment charges arising primarily from industry-wide credit deterioration in the credit card portfolio in Taiwan, mainly in the first half of 2006. Significant increases in total operating income and pre-tax profits were reported in the Middle East, India, Singapore and Malaysia. In Taiwan, HSBC launched the direct savings proposition which had been received very positively in the US. HSBC’s strategic investments in mainland China, Bank of Communications and Industrial Bank, contributed to a 54 per cent underlying increase in income from associates.
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Personal Financial Services reported a pre-tax profit of US$477 million, 16 per cent lower than in 2005. Strong operating trends were masked by a US$160 million rise in loan impairment charges in Taiwan, which suffered from regulatory changes introduced to address high levels of consumer indebtedness. Pre-provision operating income increased by 29 per cent, driven by balance sheet growth, wider deposit spreads and increased fee income. Income growth was supported by business development activity which contributed to a 26 per cent increase in operating costs. The cost efficiency ratio improved by 1.3 percentage points.
The development of HSBC’s regional business continued apace, and double digit profit growth was achieved in 5 sites, namely the Middle East, mainland China, Malaysia, Singapore and the Philippines. Customer numbers increased by 1.5 million, or 21 per cent, to 8.9 million, through strong growth in the credit card business, increased marketing activity and expansion of the sales force. 36 new branches and 28 consumer loan centres were opened in 13 countries, most notably Indonesia, mainland China and the Middle East, and at the end of 2006, HSBC had 396 branches in Rest of Asia-Pacific region and 7.3 million cards in issue.
Net interest income increased by 24 per cent to US$1.6 billion. Average asset and liability balances grew strongly, while interest rate rises contributed to a 31 basis point widening of deposit spreads. Asset spreads were in line with 2005.
Average deposit balances rose by 16 per cent to US$34.4 billion, principally due to growth in the HSBC Premier customer base. Development of the Premier business was supported by a concerted customer acquisition campaign which included regional and local advertising and the establishment of new, dedicated Premier centres. Overall deposit balance growth was especially strong in Singapore, the Middle East and mainland China. In Singapore, promotional campaigns, which included a deposit product sale, contributed to a 23 per cent increase in liability balances while, in the Middle East, HSBC ran a deposit raising campaign with new product launches, marketing and internal sales incentives, leading to a 20 per cent rise in average deposit balances. In mainland China, growth in HSBC Premier, which accompanied the opening of 12 new Premier sub-branches, contributed to higher deposit balances.
Average loans and advances to customers rose by 16 per cent, driven by higher credit card advances and increased mortgage balances. Average card balances increased by 22 per cent to US$3.1 billion,
reflecting higher cardholder spending and a 21 per cent increase in cards in circulation. Over 2.5 million cards were issued during 2006, with new products launched in the Middle East, Sri Lanka and Singapore. HSBC ran marketing and incentive campaigns in a number of countries and card balances rose substantially in Malaysia, the Middle East, Indonesia, India and the Philippines.
Average mortgage balances increased by 13 per cent to US$18.9 billion, reflecting robust growth in Singapore, Taiwan, India and Malaysia. In Singapore, HSBC used targeted promotional rates to build market share and this, together with increased marketing activity, contributed to a 25 per cent increase in mortgage balances. In Taiwan, competitive pricing and customer retention initiatives contributed to a rise in customer numbers and resulted in a 22 per cent increase in average mortgage balances. In India, mortgage balances rose by 27 per cent, benefiting from increased marketing and direct sales efforts, while in Malaysia, the successful promotion of Homesmart, a flexible offset mortgage product, enabled HSBC to increase average mortgage balances by 10 per cent and widen spreads in a highly competitive market.
Personal lending balances increased by 22 per cent, partly as a result of significant growth in HSBC’s consumer finance business in India, Australia and Indonesia. In Indonesia, HSBC opened 28 dedicated consumer finance outlets while, in India, 25 new outlets were opened in branches. In Australia, consumer finance was developed in partnership with well known international retailers such as IKEA and Bang & Olufsen, together with established local retailers including Clive Peeters and Bing Lee. HSBC signed a number of exclusive supplier agreements with retailers and, as a result, the number of retail distribution outlets grew to more than 1,100, which enabled HSBC to increase its market share. In Malaysia, the success of HSBC’s instalment loan product, Anytime Money, which was relaunched in 2005, contributed to a 93 per cent rise in average personal lending balances. In the Middle East, HSBC focused on promoting a select portfolio of products following a product simplification exercise instigated in the fourth quarter of 2005 which led to a 22 per cent rise in personal lending balances. Investments in HSBC’s South Korean operations had immediate results and personal lending balances more than doubled.
Net fee income rose by 24 per cent to US$524 million. Regional card fees were 30 per cent higher, reflecting solid growth in cardholder spending while, in Indonesia, higher card fee income was a consequence of a rise in delinquencies.
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The robust performance of regional stock markets during 2006 contributed to strong demand for investment products and led to the launch of new investment funds, which together generated a 27 per cent increase in investment fee income, including custody and broking fees. Growth was particularly strong in South Korea, Taiwan, India and Singapore. Sales of investment products, including unit trusts, bonds and structured products, increased by 19 per cent to US$8.0 billion and funds under management grew by 19 per cent to US$8.6 billion.
HSBC continued to develop its regional insurance business by launching medical insurance in Singapore and establishing a Takaful joint venture in Malaysia, offering shariah-compliant insurance products. In the Middle East, cardholder credit insurance was launched in the fourth quarter of 2006. These product launches were supported by increased marketing activity and targeted investment to increase HSBC’s presence and market share. Consequently, the number of policies in force at the end of 2006 rose by 89 per cent to 800,000 and insurance fee income and insurance premiums rose by 12 per cent and 4 per cent respectively.
Other operating income increased by US$71 million due to gains on the sale of HSBC’s Australian stockbroking, margin lending and mortgage broker businesses. Additionally, HSBC established a joint venture with Global Payments Inc. to manage the majority of the bank’s Asian card acquiring business. This was transferred to the joint venture in July 2006, realising a gain of US$10 million in the region’s Personal Financial Services business.
Loan impairment charges and other credit risk provisions more than doubled to US$545 million, mainly due to higher charges for personal lending in Taiwan and Indonesia. In Taiwan, regulatory changes restricted collection activities and eased repayment terms for delinquent borrowers. These changes, coupled with a deteriorating credit environment, led to a US$160 million increase in loan impairment charges related mainly to the credit card portfolio, most of which were realised in the first half of 2006. In Indonesia, changes in minimum repayment amounts, along with hardship following a significant reduction in the government subsidy of fuel prices, led to increased delinquency rates on credit cards, also mainly in the first half of 2006. Elsewhere in the region, credit quality was broadly stable and growth in impairment charges followed increases in credit card and personal lending balances.
Operating expenses increased by 26 per cent to US$1.6 billion, largely tracking revenue growth.
Expansion of the branch network and development of sales and support functions led to higher staff numbers and, together with higher performance-related incentive payments, contributed to a rise in staff costs. The new branch openings increased premises and equipment costs. The establishment of a number of consumer finance businesses and HSBC Direct’s introduction in Taiwan were also factors in the rise of operating expenses.
Marketing costs rose as HSBC increased advertising and promotional activity directed to attracting new customers, enlarging HSBC’s share of the credit card, mortgage and unsecured personal lending markets and increasing deposit balances. In the Middle East, IT expenditure rose as HSBC introduced a new internet banking infrastructure, implemented HSBC’s WHIRL credit card system and made major updates to customer relationship management software.
Largely driven by a strong performance in HSBC’s strategic investment in Ping An Insurance, which reported record results in 2006, income from associates rose by 59 per cent. In Saudi Arabia there were buoyant revenues from stock trading and investment business, particularly in the first half of 2006 although, subsequently, turbulent local stock markets affected investor sentiment and contributed to lower income in the second half of the year.
Commercial Banking reported a pre-tax profit of US$1.0 billion, 25 per cent higher than in 2005. Pre-provision operating income increased by 25 per cent, driven by higher deposit and lending balances and widening liability spreads. The migration of routine activities to lower-cost channels helped to mitigate business expansion costs, and operating expenses consequently increased by 21 per cent. The cost efficiency ratio improved by 1.4 percentage points.
During 2006, HSBC focused on developing its cross-border business banking activities and increasing its presence in the small business market, supported by investment in delivery channels and increased promotional activity. International business banking benefited from the strong performance of HSBC’s two regional alignment programmes, centred on mainland China and the Middle East, together with the establishment of International Business Centres in seven sites including Australia, mainland China, India and Taiwan. In addition, new branches in mainland China, India, Malaysia, Bangladesh and Sri Lanka were complemented by enhancements to internet banking services in Malaysia and India and improved self-service terminals in a number of countries. The launch of
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HSBC’s inaugural global Commercial Banking advertising campaign, increased local marketing activity and the realisation of business development teams throughout the Asia-Pacific region contributed to an 8 per cent increase in Commercial Banking customer numbers to 177,000, with particularly strong growth in Malaysia, mainland China and India.
Net interest income rose by 33 per cent to US$848 million. Higher customer numbers contributed to increased average asset and liability balances, while interest rate rises led to wider liability spreads, partly offset by narrower asset spreads.
Interest rate rises also contributed to higher demand for deposit products and liability balances increased in a number of countries, most notably the Middle East, Singapore, Taiwan, Malaysia and India. In the Middle East, HSBC successfully initiated a targeted marketing campaign offering preferential savings rates to selected customers while, in Singapore and Taiwan, enhanced sales incentives contributed to growth in liability balances. In Malaysia, expansion of the branch network together with fresh marketing campaigns, competitive pricing and product enhancements increased customer numbers and led to a 31 per cent rise in average liability balances. In India, current account and deposit balances increased by 40 per cent, partly from liquidity chasing new IPOs, which surged in line with strong local equity markets.
In 2006, HSBC successfully launched a number of initiatives designed to increase asset balances throughout the Rest of Asia-Pacific region to deploy the additional deposit base being attracted. For example, in Malaysia, television and press advertising helped trigger a 31 per cent increase in average non-trade lending balances. Trade and Save marketing campaigns launched in Malaysia and India in the wake of higher regional trade flows, offered customer incentives designed to expand HSBC’s market share in trade lending. Targeted incentive programmes were also launched in Singapore, Sri Lanka, mainland China, South Korea and Indonesia. In the Middle East, strong demand for credit underpinned by robust economic expansion resulted in a 26 per cent rise in average lending balances.
Net fee income rose by 7 per cent to US$330 million as volume-related increases in trade fees were recorded in the Middle East and India. HSBC in India also benefited from higher fees from lending activities, reflecting growth in the number of borrowing customers, while payments and cash management fee income rose in the Middle East.
Trading income increased by 25 per cent. In the Middle East, HSBC continued to invest in its Commercial Banking treasury business to support an increasingly international customer base. As customer demands became more sophisticated, 15 new products were launched in 2006, while higher marketing activity and the establishment of an online e-trading platform also contributed to a rise in customer trading volumes. Increased hedging activity among Commercial Banking customers also led to increased foreign exchange earnings in India and Malaysia.
The transfer of the majority of HSBC’s Asian card acquiring business into a joint venture with Global Payments Inc. led to the recognition of a gain of US$10 million in Commercial Banking, reported in ‘Other operating income’.
Strong economic conditions supported a further net release of loan impairment charges, which decreased by 57 per cent compared with 2005. Underlying credit quality remained strong.
Operating expenses increased by 21 per cent to US$554 million in support of business expansion. HSBC recruited additional sales and support staff, increased its Commercial Banking presence in the branch network and committed to higher marketing activity in a number of countries, most notably the Middle East, India and mainland China. Strong revenue growth resulted in higher performance payments and this, together with salary inflation, added to rising staff costs. In South Korea, the Commercial Banking business expansion proceeded as planned, staff numbers more than doubled, and HSBC incurred higher premises, equipment and infrastructure costs as a consequence. In the Middle East, increased business volumes necessitated systems improvements which resulted in higher IT costs.
Income from HSBC’s strategic investments in associates increased by 47 per cent. Income from Bank of Communications rose by 45 per cent as a result of higher asset and liability balances, effective credit control and improvements in the cost efficiency ratio, while income from Industrial Bank was 55 per cent higher. In the Middle East, net releases of loan impairments, following net charges in 2005, led to strong growth in Commercial Banking income in The Saudi British Bank.
Global Banking and Markets delivered a record pre-tax profit of US$1.6 billion, an increase of 35 per cent compared with 2005. Positive revenue trends were reported across most countries, reflecting continued growth in HSBC’s wholesale banking businesses in emerging markets. The Middle East,
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India, Taiwan and Singapore accounted for 66 per cent of the increase in pre-tax profits. The cost efficiency ratio improved by 3.5 percentage points to 37.6 per cent.
Total operating income increased by 29 per cent compared with 2005 to US$2.3 billion. In Global Markets, the securities services business benefited from investment flows into and within emerging markets, leading to higher customer volumes in buoyant local markets.
In Global Banking, payments and cash management services increased in all countries, with significant contributions from businesses in India, the Middle East, Singapore and mainland China reflected in higher net interest income. The strength of domestic economies within emerging markets, coupled with the global trend of rising interest rates, drove deposit balances and improvements in spreads. Corporate lending income in the Middle East increased by 33 per cent as economic growth continued and infrastructure investment rose. These gains were partly offset by lower balance sheet management revenues.
Net fee income increased by 38 per cent to US$688 million. A significant increase in fee income in Global Markets was driven by higher securities services business volumes, reflecting improved investment sentiment and buoyant local markets, particularly in early 2006. Debt underwriting volumes increased, particularly in the Middle East, as lower credit spreads encouraged issuers to lock into the favourable credit environment by extending the term of finance or raising new debt in local markets.
In Global Banking, income from the advisory business was boosted by a steady flow of new deals, driven by the strong momentum provided by economic development in the Middle East. Trade finance and payments and cash management fee income also benefited from higher customer volumes.
HSBC Global Asset Management revenues more than doubled, reflecting higher funds under management and performance fees on emerging market funds.
Net trading income of US$717 million rose by 26 per cent, benefiting from an increasing interest rate environment and volatile foreign exchange markets. Although, generally, volatility levels were lower than those experienced in 2005, the emerging market correction in May 2006 combined with a rapid recovery in the second half of the year to stimulate a rise in foreign exchange and Credit and Rates volumes in most countries. HSBC also
benefited from higher foreign investment flows as investor confidence in the improved stability of emerging economies grew. In the second half of 2006, growth in revenues from retail structured investment products moderated as investors sought outright exposure to equities, and deposit yields improved. However, in the Middle East, there was strong demand for structured interest rate products among corporate and institutional customers and for risk management advisory products as clients continued to hedge exposures.
Gains on the disposal of financial investments were higher than in 2005, largely due to income from the sale of debt securities in the Philippines in 2006, together with the non-recurrence of losses on the disposal of US dollar securities in Japan in January 2005.
The net recovery in loan impairment charges declined significantly due to the non-recurrence of a large recovery in Malaysia in 2005.
Operating expenses increased by 18 per cent to US$869 million, in part due to an increase in performance-related incentives which reflected the robust growth in operating income. In the Middle East and India, higher staff costs also arose from additional recruitment to support the expansion of capabilities across various businesses.
In Global Markets, support costs increased in line with higher transaction volumes and greater product complexity, while a rise in payments and cash management activity, primarily in HSBC’s operations in India, mainland China, Singapore, South Korea and Indonesia, resulted in higher operational expense.
The share of profits in associates increased by 47 per cent, primarily reflecting higher contributions from HSBC’s investments in Bank of Communications in mainland China and The Saudi British Bank.
Private Banking reported a pre-tax profit of US$80 million, a modest increase compared with 2005. Revenue growth was strong across the region despite challenging market conditions, particularly in Singapore, with notable contributions from the onshore Private Banking operations launched in the Middle East and India during 2005. Employee benefits rose at a faster rate than revenue, driven by a fiercely competitive market for experienced private banking staff, and this led to a deterioration of the cost efficiency ratio from 50.7 per cent in 2005 to 54.5 per cent in 2006. Net interest income grew by 21 per cent to US$35 million. Growth was predominantly in
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Singapore, where treasury performance improved and unfavourable positions unwound, and India, where the recently launched business was successful in attracting deposits.
Fee income increased by 62 per cent to US$68 million, with significant growth in Singapore, India and the Middle East. Initiatives to attract clients to HSBC’s suite of discretionary managed products, particularly the SIS and CIS products, proved successful.
Trading and other operating income was slightly lower than in 2005, due to sluggish stock market performance and correspondingly subdued client activity.
Client assets increased by 12 per cent to US$16 billion, benefiting from the recruitment of front office staff, client appetite for investment in newly launched funds and the successful growth of recently launched onshore businesses in the region.
Investment in funds benefited from higher demand for HSBC and third party manager funds, including the SIS and CIS products in which the value of client investments grew to US$291 million. Higher deposits and investments in equities also contributed to the growth in client assets.
Operating expenses increased by 25 per cent, reflecting continued investment in the onshore Japanese operations and growth of the business in India. Staff costs rose as competition for front-office professionals intensified, putting upward pressure on staff rewards, and the full-year impact of the expansion in staff recruitment in 2005 fed through.
HSBC sold properties in Japan and India, realising gains of US$87 million in Other , US$77 million higher than in 2005. Costs and recoveries in the GSCs both rose, reflecting increased activity supported by higher staff numbers. Interest rate rises and higher retained earnings led to a doubling of earnings on centrally held funds.
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Profit before tax and balance sheet data by customer group and global business
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Profit before tax and balance sheet data by customer group and global business (continued)
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In the US, GDP growth in 2007 was 2.2 per cent, 0.7 percentage points less than that recorded in 2006 as the housing-led downturn gathered pace. Consumer spending in 2007 grew by 2.9 per cent, the weakest annual expansion since 2003. Housing activity continued to weaken in 2007, with residential investment falling by 17 per cent during the year. Both new and existing home sales also declined to new lows in 2007. The unemployment rate averaged 4.6 per cent in 2007, with the average
in the second half of the year slightly higher at 4.8 per cent. The trade deficit narrowed in 2007 as export growth strengthened. Consumer price inflation averaged around 4 per cent in the final quarter of 2007. This was largely due to higher energy prices; excluding food and energy, consumer price inflation averaged 2.3 per cent in the fourth quarter. The Federal Reserve lowered short-term interest rates by 100 basis points in the second half of 2007, from 5.25 per cent to 4.25 per cent, as policymakers attempted to mitigate the worst effects of the sub-prime related credit squeeze upon economic activity. 10-year note yields reached a high of 5.3 per cent in June 2007, before falling to
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4 per cent by the year-end. Declines in the final months of 2007 left the Standard & Poor’s S&P500 stock market index practically unchanged compared with the end of 2006.
Canadian GDP increased by 2.4 per cent during the first eleven months of 2007 compared with the equivalent period of 2006. Domestic demand remained strong despite tighter credit conditions in the latter part of the year, supported by the robust
labour market. The unemployment rate averaged 6 per cent for the year, reaching a historical low of 5.8 per cent in October. After hitting a high of 2.5 per cent in April, core consumer price inflation slowed to 1.5 per cent by the end of 2007. The Canadian dollar appreciated during the year, particularly in the second half. In July, the Bank of Canada raised its overnight interest rate from 4.25 per cent to 4.5 per cent before reversing this move in the final weeks of 2007.
HSBC’s operations in North America experienced a significant fall in pre-tax profits of 98 per cent in 2007, on both reported and underlying bases.
It is now clear that the US housing market is undergoing a significant correction and recovery is not likely in 2008. The US economy began to slow in the fourth quarter and recent evidence suggests that some parts of the country may already be in recession. As the housing market slump has affected the real economy, the deterioration in credit quality that began in the mortgage services business has extended to include other consumer finance businesses in the US. In HSBC, this was reflected in a 79 per cent rise in loan impairment charges and a loss before tax of US$1.5 billion in Personal Financial Services.
A loss of US$965 million in Global Banking and Markets arose from credit-related and liquidity event write-downs as asset-backed securities markets became illiquid and credit spreads widened markedly. Increased revenues in Commercial
Banking were the result of balance sheet growth achieved from the continued expansion of the business, although this revenue growth only partially offset rises in expenses and loan impairment charges. Private Banking profits rose significantly as a result of the launch of services in Canada, improved performances in the US and Bermuda and the non-recurrence of a significant loan impairment charge in 2006.
Personal Financial Services reported a pre-tax loss of US$1.5 billion, a decline of US$4.9 billion from 2006. Performance was significantly affected by rising loan impairment charges in the consumer finance business in mortgage lending, cards and branch personal lending. Actions taken to manage exposure and realign the business in response to changes in the market included stopping new purchases in mortgage services, tightening underwriting criteria, restricting the product range in consumer lending, decreasing
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credit lines and reducing the volume of balance transfers in credit cards, and restructuring the consumer lending branch network by closing some 400 branches of HSBC Finance to reflect expected lower demand. These measures gave rise to restructuring charges of US$103 million in the US in 2007.
US pre-tax losses of US$1.8 billion were predominantly due to higher loan impairment charges, trading losses in the wholesale mortgage origination business and lower income from fewer receivables in the correspondent mortgage services business. In line with industry trends, the credit quality of loans weakened steadily throughout the year, particularly those underwritten in 2005, 2006 and the first half of 2007.
In Canada, profit before tax rose by 2 per cent to US$265 million, benefiting from the strong local economy. Of this, the retail bank generated US$116 million, including an US$8 million gain on the sale of shares in the Montreal Exchange. Consumer finance operations added US$149 million through balance sheet expansion in the first part of the year, prior to a fourth quarter restructuring to align with changes in the US consumer finance operation.
Net interest income grew by 1 per cent to US$13.2 billion as growth in card and average deposit balances marginally offset a fall in US deposit margins. In the US, net interest income rose by 1 per cent as the mix of business changed to higher yielding activity and HSBC raised rates on new consumer finance mortgages to reflect increased risk. The beneficial effect on yields was, however, more than offset by the impact of non-performing assets and a higher cost of funds. Higher volumes of non-performing loans constrained revenue. Fewer mortgages repaid early as refinancing activity declined substantially, and this also resulted in lower prepayment penalties. These factors combined to limit HSBC’s ability to pass on in full the increased cost of funds in a higher average rate environment. This led to an overall decline in spreads.
In the US, average deposit balances were 19 per cent higher, reflecting growth in the online savings account and certificate of deposit products. A competitively priced special promotional rate offer in the first quarter of 2007 led to 147,000 new account openings and US$5 billion of new balances during the year, offset in part by decreases in money market term deposits. At 31 December 2007, online savings balances with HSBC Direct stood at US$11.5 billion, held by more than 620,000 customers. HSBC Premier customer numbers rose
by 16 per cent. Deposit spreads tightened, reflecting a change in the product mix from lower-paying savings accounts to the higher-paying offerings available online and in branches. HSBC Bank USA opened 26 new branches during the year.
The slowdown in the US housing market first noted in 2006 accelerated in 2007, with further deterioration in sales of new and existing homes and lower new-build activity. Market surveys showed a broad-based decline in house prices, especially for larger loans and in states that had experienced the fastest rates of house price appreciation in recent years. Average US mortgage balances declined by 2 per cent to US$123 billion.
Average mortgage balances originated through the consumer lending branch network rose by 18 per cent, primarily driven by lower levels of repayments and the severe contraction in market capacity, which drove qualifying borrowers to the few remaining market participants. Actions taken by HSBC to restrict the product range, increase collateral requirements, raise prices and close or consolidate about 400 branches of HSBC Finance during 2007 combined to curb lending growth towards the end of the year.
Yields on consumer lending mortgages declined overall due to increases in delinquency, loan modifications (which deferred scheduled moves to higher rates) and levels of non-performing loans, and decreases in repayments, which resulted in reduced prepayment penalties. Interest spreads narrowed as funding costs rose.
In the mortgage services business, average balances declined by 14 per cent to US$43 billion, reflecting HSBC’s decision to wind down this book in response to the deterioration in market conditions. Spreads fell, driven by higher non-performing loans and increased funding costs.
HSBC Bank USA’s average mortgage balances fell by 9 per cent to US$31 billion. HSBC continued to sell down new loan originations to government-sponsored enterprises and private investors and, with the exception of certain products, did not replace the existing portfolio being run-off. Interest rate spreads on the prime mortgage portfolio declined, primarily due to loan portfolio run off.
Average credit card balances increased by 14 per cent to US$29 billion. Volumes in the sub-prime and near-prime portfolios rose due to additional marketing to this segment in late 2006 and the first half of 2007. Expansion slowed during the second half of 2007 as HSBC restricted growth in customer loans and advances in light of the
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economic outlook. Beginning in the third quarter of 2007, HSBC decreased marketing expenditure in an effort to slow the growth of balances in the credit card portfolio. In the fourth quarter of 2007, to further slow this growth, HSBC slowed the rate of new account acquisition, tightened the criteria for authorising initial credit lines and for underwriting credit line increases, closed inactive accounts, decreased credit lines, reduced balance transfer volume and restricted access to cash. Excluding the one-off increase from a methodology change for effective interest on introductory rate credit card loans which increased yields in 2006, yields improved due both to repricing and a change in the product mix towards a higher proportion of sub-prime and near-prime balances, coupled with lower levels of promotional balances. Spreads widened on an underlying basis as rate increases preceded any rise in funding costs.
In retail services, average balances rose by 4 per cent to US$17 billion, driven by organic growth and the deepening of HSBC’s relationships with existing partners. Spreads widened as higher yields on promotional balances (due to fewer people choosing to pay balances during the introductory period), and the benefit of price increases more than offset higher funding costs. Risk mitigation measures enacted included the tightening of credit across selected retail businesses, especially the power sports sector, closure of inactive accounts and a reduction in the limits for certain other accounts.
Average vehicle loan balances grew by 5 per cent to US$13 billion despite the adverse effect on the motor vehicle market of higher interest rates, rising fuel prices and reduced incentive programmes from manufacturers. The main driver of growth was the successful expansion of the consumer direct channel, with online and direct sales rising by 52 per cent. Refinancing volumes were higher due to pricing and increased operational capacity. Interest rate spreads tightened as a result of a shift in portfolio mix toward higher credit quality loans.
Average balances in personal non-credit card loans rose by 4 per cent, with actions taken to reduce risk including a reduction in direct mail campaigns, the withdrawal of the personal homeowner loan product in September 2007, and tightening underwriting criteria. As a result balances declined towards the end of 2007. Spreads tightened as the benefits of a shift in mix to higher yielding products were offset by rising levels of non-performing loans, which reduced yields, and increased funding costs.
In Canada, net interest income rose by 14 per cent due to asset and deposit growth, partly offset by
competitive margin compression. Average deposit balances rose by 8 per cent as the rollout of the new high-rate and direct savings accounts continued. These products added US$935 million in new balances and some 11,900 in incremental customer numbers. HSBC Premier recorded a rise in customer numbers of 19,000. Deposit spreads were broadly unchanged as the effects of a change in mix to higher paying high-rate and direct savings products were offset by the benefits of an increased proportion of higher yielding deposits.
Average lending balances in Canada rose by 9 per cent as the strength of the economy and buoyant housing market drove demand for loans. While asset spreads at both the retail bank and the consumer finance business narrowed due to competitive pressure, overall spreads widened due to the increased proportion of higher yielding consumer finance products. Credit expansion was across all segments with the consumer finance operations achieving growth in their real estate secured, private label and credit card portfolios.
Net fee income rose by 24 per cent to US$4.6 billion, mainly from the US credit cards and retail services businesse s, reflecting growth in balances. In the US, net fee income rose by 25 per cent, largely from higher late, overlimit and Intellicheck fees in the credit card book. Revenues from enhancement services also rose, primarily from higher sales of services to new and existing customers, growth in balances and an increase in new accounts. In the fourth quarter of 2007, HSBC changed fee practices on credit cards to ensure they fully reflected HSBC’s brand principles. This reduced income by US$55 million in 2007 and is expected to have a full year effect of up to approximately US$250 million in 2008.
Taxpayer financial services generated fee income of US$247 million, 4 per cent lower than in the previous year due to changes in contractual terms which increased partner payments, and lower Internal Revenue Service receipts. Following a strategic review, pre-season and pre-file products and cross-collections were discontinued with effect from the beginning of the 2008 tax season.
Fee income in Canada rose by 3 per cent on higher investment administration fees from growth in funds under management, higher fees from the Immigrant Investor Programme, higher credit fees and service charges from credit expansion and increased foreign exchange income. This was partly offset by lower retail brokerage fees.
At the US retail bank, net fee income rose by 14 per cent to US$320 million, driven by increases
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in servicing fees on mortgages, credit card fees and deposit service charges.
Trading losses in 2007 were US$215 million compared with trading income of US$274 million in 2006. Conditions in the housing market meant that sub-prime mortgages could not be securitised, which led to significantly wider credit spreads and a considerable loss of market liquidity across all asset-backed securities classes. These two factors, the loss of liquidity and wider credit spreads, resulted in substantial reductions in the value of mortgages held for sale. In light of this, HSBC closed Decision One, its wholesale mortgage business, in the second half of 2007.
Gains less losses from financial instruments rose to US$176 million from US$14 million in 2006, due to the sale of MasterCard Inc. shares following its IPO.
Other operating income fell by 109 per cent. Losses on foreclosed properties rose due to the combined effect of an increase in the stock of such properties and a reduction in their value due to falling prices. Total foreclosed assets rose to US$1.0 billion from US$670 million in 2006. The fall in other operating income also reflected a US$123 million gain in 2006 (from the sale of HSBC’s investment in Kanbay, a global IT services firm) which did not recur in 2007.
Loan impairment charges and other credit risk provisions rose by 78 per cent to US$11.9 billion. US loan impairment charges rose by 79 per cent as the deterioration in housing credit markets extended to affect loans of all product types and vintages, particularly loans originated in 2005, 2006 and the first half of 2007. The combination of reduced financing options for consumers and weak or falling property values had a significant impact on delinquency levels. Developments in the credit markets have raised fundamental concerns about the viability of the ‘originate and distribute’ business model for securitising residential mortgages. The resulting industry-wide tightening of underwriting criteria, and the elimination of many loan products previously offered to consumers, reduced the general availability of credit and borrowers’ ability to refinance. This, in turn, exacerbated house price falls, most notably in those areas which had seen the most rapid appreciation in recent years.
Lower house prices reduced the equity which customers had in their homes, removing a key source of accessible funds and reducing customers’ capacity to deal with unexpected problems such as
unemployment or illness. Bankruptcy levels also increased from the exceptionally low levels seen in 2006 which followed changes in bankruptcy legislation in 2005.
In mortgage services, loan impairment charges rose by 41 per cent to US$3.1 billion. Due to the factors noted above, delinquencies increased at a higher rate than was expected from normal portfolio seasoning 1, particularly for second lien customers.
In consumer lending, loan impairment charges rose by 139 per cent to US$4.1 billion as evidence of credit quality deterioration was seen across the loan portfolio in the second half of 2007, in particular on first lien loans originated in 2006. There was also increased delinquency on second lien loans purchased between 2004 and the third quarter of 2006. Lower run-offs of loans, growth in average lending balances, normal seasoning and a rise in bankruptcy filings to historically more usual levels after the exceptional decline in 2006, also contributed to the rise. There was a marked increase in loan delinquency in those states most affected by the fall in home values.
Credit card impairment charges rose by 83 per cent to US$2.8 billion as a result of weaker economic trends, growth in balances, normal portfolio seasoning, a rise in bankruptcy rates closer to historical levels, and a shift in mix to a higher proportion of non-prime loans.
Loan impairment charges in Canada rose by 38 per cent, in line with the rise in loan balances and seasoning of the vehicle finance and credit card portfolios. In addition, an impairment charge on non-bank asset-backed commercial paper (‘ABCP’) was recognised in 2007.
Operating expenses rose by 2 per cent to US$7.6 billion. In the US, while origination costs fell as loan growth was curtailed, additional resources were deployed to collection activities and the retail bank added selectively to its branch distribution network. Within the consumer finance operations, restructuring costs in 2007 totalled US$103 million, following the decision to reposition the US consumer finance business, the closure of the wholesale mortgage services business and the reduction in the number of branches in the US consumer lending network to around 1,000 to align with the level of demand expected in light of the Group’s revised risk appetite. The retail bank incurred higher staff costs due to expansion of the branch network, higher average salaries due to normal annual pay increases, and a change in mix of
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staffing to support business growth initiatives. Also contributing was US$70 million of one-off costs arising from the indemnification agreement with Visa ahead of the company’s planned IPO.
Marketing costs to support the growth in Personal Financial Services lending increased in 2007, but in the second half expenditure on credit cards, co-branded credit cards and personal non-credit card marketing declined following the decision to slow loan growth in these portfolios. In HSBC Bank USA, marketing costs rose as a result of campaigns promoting the online savings product and investment in the HSBC brand, including the Newark Airport branding and the HSBC Premier relaunch. The expansion of the bank branch network in existing and new geographical areas also increased premises and other branch operating costs.
In Canada, operating expenses increased by 13 per cent due to the strategic growth of the branch network, marketing to support new products, related investment in systems, and higher transaction costs caused by the rise in customer numbers. Staff numbers, premises and equipment costs rose, partly due to the opening of five new branches. Marketing costs rose too, principally due to direct savings and brand awareness campaigns. The Canadian consumer finance business restructured its business model to align with changes in the US consumer finance operations, reducing lending through its branch network and closing the correspondent mortgage business. A total of 29 consumer finance branches were closed.
Commercial Banking’s pre-tax profits of US$920 million declined by 6 per cent compared with 2006. In the US, loan and deposit balances grew with the continuing expansion of the branch network outside its traditional base into 16 of the top 25 business centres by the end of the year, complemented by a restructuring of the branch sales force. Despite this growth, overall performance declined as business expansion costs, restructuring costs, lower gains on asset disposals, a slowdown in commercial and real estate activity and a deterioration in the credit environment more than offset the benefit of higher volumes.
In Canada, profit before tax was broadly flat at US$466 million, driven by strong balance sheet growth, notwithstanding the wider funding and liquidity pressures which arose from the freezing of the non-bank ABCP market in Canada in August.
In the US, net interest income rose by 10 per cent to US$804 million, driven by average deposit growth of 20 per cent and loan growth of 6 per cent. Organic expansion underpinned the increase, with
recently opened offices in Chicago, Washington DC and the West Coast contributing to growth. Net interest income growth slowed as a result of declining commercial real estate activity, with higher repayments and slower replacement business reflecting market conditions and credit appetite. There were also narrower spreads on deposits, as customers migrated to higher yielding products.
Average deposit balances in the US rose by 20 per cent, led by a 21 per cent increase in volumes from small business customers. The expansion of the network and targeted marketing initiatives were key factors in the rise. Spreads narrowed as the product mix changed towards higher yielding accounts, particularly among small business customers, partly offsetting the gains to income from higher balances.
Average loan balances in the US were 4 per cent higher. Loan growth was primarily due to strong activity in middle market lending, up 20 per cent, with growth coming equally from existing branches and geographic expansion. Overall loan growth was, however, much lower as a result of a slowdown in financing commercial real estate activity, where lending volumes fell by 6 per cent. Competitive pressures led to narrower spreads.
In Canada, net interest income rose by 14 per cent, driven by strong loan growth, particularly in Western Canada. Average deposit balances rose by 10 per cent, with volumes lifted by the success of the payments and cash management business. Spreads rose as repricing initiatives on key products offset the effects of competitive pressures and increased funding costs over the last four months of 2007, due to the disruption caused to the ABCP market by constrained liquidity, as described above.
Average lending balances rose by 17 per cent, buoyed by the strong economic backdrop. There was notable expansion in Western Canada, where the resource economy continued to underpin performance. Spreads were tighter due to spread compression on floating rate loans.
In Bermuda, net interest income increased by 15 per cent. Average deposit balances fell by 6 per cent, mainly due to lower than expected growth in volumes of fixed term deposits.
Net fee income was broadly unchanged at US$338 million. In the US, fee income was flat compared with 2006. The growth in deposit accounts and a focus on business debit cards for small and micro businesses led to a rise in deposit service charges and card fees. This was, however, offset by lower fees on the syndication of commercial real estate loans as balance activity declined. In Canada,
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fee income rose with the increase in activity volumes. Higher service charges and credit fees were the main fee generators.
Loan impairment charges rose by 151 per cent to US$191 million, reflecting the growth in the loan book. In the US, loan impairment charges rose by 91 per cent, mainly due to the higher probability of default among commercial real estate loans and a change in methodology for loan impairment allowances on a small business revolving loan portfolio. Several condominium development projects took longer to complete than intended, resulting in cash flow issues for some customers. This hindered their ability to obtain a mortgage at the end of the construction phase which, in some cases, precipitated downgrades by ratings agencies, all of which combined to generate increased impairment charges. In Canada, loan impairment charges increased due to exposures to certain sectors affected by the strength of the Canadian dollar. An impairment charge for non-bank ABCP was also taken. The risk reflected the historically low impairment charges incurred in 2006.
Operating expenses rose by 8 per cent to US$893million. US costs rose by 9 per cent as the expansion of the branch network led to higher staff and administration costs. Costs for collection activities also rose. In Canada, costs rose by 2 per cent due to an increase in headcount, higher staff incentives, increases in business licenses, taxes, and higher cheque clearing costs in line with rises in business activity levels. The tight labour market added upward pressure on staff costs and created challenges in filling vacancies, particularly in Western Canada.
Global Banking and Markets in North America reported a pre-tax loss of US$965 million, compared with a profit of US$423 million in 2006. Improvements across most businesses were overwhelmed by significant losses in mortgages, mortgage-backed securities and structured credit products held for trading, which were driven by widening credit spreads following the deterioration in credit markets in the second half of 2007. In addition, leveraged and acquisition finance recorded write-downs on underwriting positions held.
Total operating income of US$645 million was 69 per cent lower than 2006, reflecting the impact of the above-mentioned losses and write-downs, partly offset by higher net interest income from corporate lending and increased deposit balances in payments and cash management.
The 38 per cent rise in net interest income partly reflected increased lending driven by client demand
and higher outstanding unsyndicated loan balances in financing and capital markets.
Payments and cash management delivered a 43 per cent increase in net interest income as a result of growth in demand deposits, and a 15 per cent increase in transaction fees as higher volumes were generated from a wider range of product offerings.
Net fee income was 6 per cent ahead of 2006. Apart from the growth in payments and cash management referred to above, a strong performance in HSBC Global Asset Management reflected favourable market conditions in the first half of the year.
Trading losses of US$734 million compared with income of US$818 million in 2006. The decline was driven by write-downs in credit and structured derivatives, as detailed above, including US$282 million relating to monoline exposures, of which those below investment grade have been fully written down. These losses were only partly offset by strong foreign exchange revenues where trading volumes benefited from market volatility and positioning against a weakening US dollar. Trading income from the rates business also increased, driven by investor demand for lower risk products.
The credit market dislocation also led to an adverse fair value adjustment for loan commitments outstanding when global credit spreads widened in the second half of the year. Including this and the credit and structured derivatives write-downs referred to above, the total write-down was US$1.4 billion.
The benign corporate credit environment experienced in recent years continued and impairment charges were low, albeit higher than in 2006.
Operating expenses declined by 5 per cent, mainly as a result of reduced performance-related remuneration resulting from lower revenues. Expenses were also reduced by savings initiatives started in late 2006 and early 2007 though these were offset by the restructuring costs associated with the Group’s exit from the mortgage-backed securities business.
Private Banking reported a pre-tax profit of US$174 million. Excluding a US$39 million geographical reclassification, the underlying increase was 27 per cent, reflecting improvements in Bermuda and the US, the addition of Private Banking in Canada and a one-off gain from the sale of Wealth and Tax Advisory Services (‘WTAS’) to its management. The revenue growth was partially offset by increased costs from the launch of Private
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Banking in Canada. The cost efficiency ratio reflected this, remaining broadly flat at 69.3 per cent.
Net interest income increased by 14 per cent to US$273 million, excluding a US$42 million geographical reclassification. This was driven by new business in Canada and an increase in deposit volumes in Bermuda. Net interest income in the US remained broadly flat as a result of competitive pressures.
Growth in net fee income of 16 per cent to US$279 million was driven by higher investment in discretionary funds especially the multi-manager products offered in the US. WTAS also contributed to the rise; this business was subsequently sold on 31 December 2007 in order to enable Private Banking to focus on core activities. The sale resulted in an US$18 million gain in other operating income.
Client assets of US$58 billion, an increase of 35 per cent, reflected expansion into Canada, a market-driven rise in assets and net new money of US$933 million.
Loan impairment charges decreased by 71 per cent to US$10 million, reflecting the non-recurrence of a large single loan impairment charge in 2006.
Operating expenses rose by 17 per cent to US$415 million, with a rise in staff costs in both support and front-office positions and the launch of operations in Canada.
Within Other, profit before tax increased to US$1.5 billion, driven largely by significant fair value movements on HSBC’s own debt as a result of the widening of credit spreads and related derivatives in the second half of the year.
HSBC Technology USA Inc. and hsbc.com provide technology services across North America, the costs of which are recharged to specific entities. Increased activity during the period contributed to a 14 per cent rise in operating expenses which were recovered through ‘Other operating income’.
In the US, GDP growth in 2006 was 2.9 per cent. Growth in the second half of the year moderated to below 3 per cent, after average annualised growth of 4.1 per cent in the first half of the year. Consumer spending in 2006 grew by 3.4 per cent, with average annualised growth of 3.6 per cent in the second half of the year. Housing activity weakened substantially in 2006, with annualised declines in residential investment of 11 per cent in the second quarter
followed by annualised declines of 19 per cent in the third and fourth quarters of the year. There was some optimism that housing starts may have begun to stabilise by the year-end, with housing permits rising in December after ten successive monthly falls. Continued strong profits growth meant that business investment remained robust but industrial production weakened markedly towards the end of the year. The unemployment rate remained relatively low, averaging 4.6 per cent in 2006. The trade deficit stabilised through most of the year and narrowed in the final months of 2006 in response to strong global growth and a weaker US dollar. Inflation rose by 4.3 per cent in the first half of the year due to energy price rises but subsequently fell to an annual rate of about 2 per cent as energy prices declined. The Federal Reserve raised shor t-term interest rates by 1 per cent in the first half of 2006 to 5.25 per cent, but kept rates unchanged thereafter. After rising from 4.4 per cent to 5.2 per cent in the first half of 2006, 10-year note yields fell to a low of 4.4 per cent in early December before increasing to 4.7 per cent by the year-end. The S&P500 stock market index rose by 13.6 per cent in the year.
The Canadian economy slowed during 2006, with GDP growth falling from an annualised rate of 3.6 per cent at the beginning of the year to 1.7 per cent by the third quarter, largely reflecting slower export growth. Domestic demand remained robust and HSBC expects the momentum seen in 2006 to continue through 2007, supported by historically low levels of unemployment and a housing market which, although showing signs of moderation, remained strong throughout 2006. Although energy prices eased, 2006’s commodity boom was expected to continue benefiting the Canadian economy through 2007. Inflation remained problematic with core prices moving above the Bank of Canada’s preferred target rate of 2 per cent, and productivity remained relatively weak. Having raised its overnight interest rate from 3.25 per cent at the start of 2006 to 4.25 per cent in May, the Bank of Canada kept rates on hold for the rest of the year.
HSBC’s operations in North America reported a pre-tax profit of US$4.7 billion compared with US$5.9 billion in 2005, a decrease of 21 per cent. On an underlying basis, pre-tax profits declined by 25 per cent. Underlying net operating income before loan impairment charges was higher by 6 per cent, reflecting the income benefit of asset growth in Personal Financial Services . This revenue growth was more than offset by a significant rise in loan impairment charges in the correspondent mortgage
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services business within HSBC Finance, as slowing house price appreciation and the projected effect of interest rate resets impacted loss estimates from rising credit delinquency. This is described more fully below and on page 221. In Commercial Banking, investment in distribution channels delivered growth from increased lending and deposit taking. In Global Banking and Markets, strong trading results more than offset lower balance sheet
management revenues, which were constrained by compressed spreads in a flat interest rate yield curve environment. Underlying operating expenses increased by 13 per cent to support investment in business expansion and branch openings in the Personal Financial Services business.
Personal Financial Services generated a pre-tax profit of US$3.4 billion, a decrease of 23 per cent compared with 2005. Net operating income rose at a slower rate than cost growth, due to constrained balance sheet growth in the second half of the year, higher collection expense and significantly higher loan impairment charges. The increased loan impairment charges recognised in respect of HSBC Finance’s correspondent mortgage services business more than offset the non-recurrence of charges arising in respect of hurricane Katrina and the change in bankruptcy legislation in 2005. The cost efficiency ratio worsened as costs rose faster than revenues.
In the US, pre-tax profit of US$3.1 billion was 24 per cent lower than in 2005, reflecting the significantly higher loan impairment charges noted above and additional costs incurred in support of business expansion in both the consumer finance company and the retail bank. Beginning in 2004, HSBC implemented a growth strategy for its core banking network in the US which included building deposits over a three to five year period across multiple markets and segments utilising diverse
delivery systems. During 2006 the strategy included various initiatives, the most important of these being growing the deposit base by emphasising more competitive pricing and introducing high yielding products, including internet savings accounts. These have grown significantly since late 2005 to US$7 billion, of which US$6 billion arose in 2006 and US$5 billion of the 2006 growth was from new customers. Retail branch expansion in existing and new geographic markets was also a key initiative, with 25 new branches opened in 2006.
In Canada, profit before tax was 21 per cent lower, partly due to the absence of provision releases made in 2005 in the core banking operations. Revenues rose but this was offset by costs incurred in support of expansion in consumer finance and investments made in the bank distribution channels.
Net interest income of US$13.0 billion was 7 per cent higher than in 2005. In the US, there was strong growth in mortgages, cards and other personal non-credit card lending, particularly in the first half of the year, and this, coupled with higher deposit balances, led to a 6 per cent increase in net interest
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income as competition reduced both asset and deposit spreads.
Average deposit balances in the US rose by 21 per cent to US$32.2 billion, mainly led by the continued success of online savings. The HSBC Premier investor product also continued to grow strongly. During the year over 22,000 new accounts were opened and balances rose by 139 per cent as US$2.1 billion in incremental deposits were taken. Customers migrated to higher yielding products which led to a change in product mix, and the consequent reduction in spreads partly offset the benefits of balance growth.
There was a marked slowdown in the US housing market during 2006, although towards the end of the year demand for housing showed signs of stabilising. However, the supply of houses for sale remained high, with the overall outlook still uncertain. Average mortgage balances rose by 9 per cent to US$123.8 billion, with growth concentrated in non-prime balances in the mortgage services correspondent and branch-based consumer lending businesses. Prime mortgage balances originated and retained through the core banking network continued to decline. This reflected an ongoing strategic initiative to manage the balance sheet by selling the majority of new prime loan originations to government-sponsored enterprises and private investors, along with planned securitisations and the normal run-off of balances. Overall, yields improved from the combined effects of a change in product mix to higher-yielding non-prime mortgages and repricing initiatives. Despite this improvement in yields, spreads narrowed due to higher funding costs as interest rates rose, and this reduced the positive income benefit of the higher lending balances.
The following comments on mortgage lending relate to HSBC Finance as mortgage lending growth in 2006 was concentrated in this business.
In the branch-based consumer lending business, average mortgage balances grew by 15 per cent to US$41.2 billion as lending secured on real estate, which included a near-prime product introduced in 2003, was pursued. This growth was augmented by portfolio acquisitions, most notably the US$2.5 billion Champion mortgage portfolio purchased from KeyBank, NA in November 2006.
In the mortgage services correspondent business, average balances of US$49.9 billion were 28 per cent higher than in 2005. During 2005 and the first half of 2006, emphasis was placed on increasing both first and second lien mortgages by expanding sources for the purchase of loans from correspondents. In the second quarter of 2006,
HSBC began to witness deterioration in the performance of mortgages acquired in 2005, particularly in the second lien and portions of the first lien portfolios. This deterioration continued in the third quarter and began to affect the equivalent loans acquired in 2006. In the final quarter of 2006, the deterioration worsened considerably, mainly in first lien ARM balances and second lien loans.
A series of actions were initiated in the third quarter to mitigate risk in the affected components of the portfolio. These included revising pricing in selected origination segments, tightening underwriting criteria to eliminate or substantially reduce higher risk products (especially in respect of second lien, stated income (low documentation) and lower credit scoring segments), and enhancing segmentation and analytics to identify higher risk portions of the portfolio and increase collections. These initiatives led to a decline in overall portfolio balances during the second half of 2006, mostly attributable to lower purchases of second lien and certain higher-risk products, along with the normal run-off of balances.
Average credit card balances in the US rose by 6 per cent to US$26.8 billion. The market continued to be highly competitive with many lenders placing reliance on promotional rate offers to generate growth. HSBC took a strategic decision to reduce the amount of its equivalent offers and instead grew its HSBC branded prime, Union Privilege and non-prime portfolios largely from targeted marketing campaigns. Margins widened, reflecting improved yields as the product mix changed towards higher levels of non-prime and lower levels of promotional balances, coupled with other re-pricing initiatives undertaken on variable rate products. This more than offset the adverse effect of higher funding costs and augmented the income benefits of the increased loan book.
In the retail services business, average balances rose by 6 per cent to US$15.8 billion. This was mainly driven by newer merchants, changes in product mix and the launch of three co-branded programmes; the MasterCard and Visa partnerships with Best Buy and Saks Fifth Avenue, and the Neiman Marcus co-branded card with American Express. The positive income benefits from higher balances were more than o ffset by lower spreads, as a large proportion of the loan book priced at fixed rates was affected by higher funding costs. This was further affected by changes in the product mix as lower yielding department store card balances grew more strongly, and by competitive downward pricing pressures. Changes in merchant contractual obligations also led to lower net interest income,
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though this was offset by reduced partnership payments to those merchants.
Growth opportunities in the motor vehicle financing industry were particularly challenging in 2006, driven by a reduction in incentive programmes offered by manufacturers and a rising interest rate environment. Notwithstanding these factors, average balances rose by 12 per cent. This was led by strong organic growth in the near-prime portfolio from an increased emphasis on strengthening relationships with active dealers, and greater volumes generated from the consumer direct programme. Refinancing volumes rose, directly attributable to the successful consumer refinance programme, which recorded a 48 per cent increase in originations.
In Canada, net interest income rose by 16 per cent due to lending and deposit growth. Average mortgage balances grew as a result of the continued strength of the housing market and ongoing branch expansion in the consumer finance business. The strong economy drove higher levels of unsecured lending as consumer spending rose. Expansion of the consumer finance motor vehicle proposition and the launch of a MasterCard programme in 2005 contributed further to asset growth, while increased marketing activity led to a rise in personal non-credit card lending balances. Asset spreads narrowed, largely from lower yields which reflected changes in product mix and competitive market conditions.
Average deposit balances grew by 6 per cent compared with 2005, with the notable success of a new high rate savings account and a sale campaign celebrating HSBC’s 25th anniversary in Canada. Deposit spreads widened as interest rates rose, contributing further to the increase in net interest income.
Net fee income grew by 13 per cent to US$3.7 billion, with increases in both the US and Canada. The 13 per cent rise in the US was largely led by higher fees from the credit card and retail services businesses. Credit card fee income from the consumer finance business increased by 8 per cent, primarily from balance growth in the non-prime portfolio, improved interchange rates and lower fee charge-offs. Revenues from credit card partnership enhancement services rose due to greater sales volumes, expansion into new customer segments and balance growth.
Within the US retail services business, net fee income rose, reflecting lower merchant payments, in part due to changes in contract obligations with certain merchants. A rise in late fees from growth in customer account balances and higher fees on
overdue payments contributed further to the increase.
In the US mortgage-banking business, net fee income declined. Although mortgage loan service volumes grew in 2006, contributing additional fee income from the greater proportion of mortgages originated and then sold with mortgage servicing rights (‘MSRs’) retained, these benefits were more than offset by higher amortisation charges and lower releases of temporary impairment provisions on MSRs. The taxpayer financial services business generated higher fee income from increased loan volumes during the 2006 tax season.
In Canada, net fee income rose by 5 per cent to US$217 million. Continued growth in the wealth management business resulted in higher investment administration fees, and credit card fee income rose, driven by increased lending.
Trading income fell by 17 per cent, due to lower income on HSBC Finance’s Decision One mortgage balances held for resale to secondary market purchasers. This primarily reflected additional losses incurred following the repurchase of certain mortgages previously sold to external third parties which had subsequently gone into default. Higher losses on derivatives that did not meet the criteria for hedge accounting contributed further to the decrease.
A US$20 million gain from the MasterCard Incorporated IPO was the key reason for the increase in gains from financial instruments.
Other operating income also rose, primarily driven by gains on various asset disposals. Most notably, a US$123 million profit was achieved on disposal of HSBC’s investment in Kanbay International Inc, a worldwide information technology services firm. Income from overnight and short-term money market investments also rose. These benefits were partly offset by greater losses incurred on sales of repossessed properties, following a 42 per cent rise in such properties as customers defaulted on their mortgage payments.
Loan impairment charges and other credit risk provisions of US$6.7 billion were 28 per cent higher than in 2005. In the US, loan impairment charges rose by 28 per cent despite the non-recurrence of significant charges which arose in 2005 following hurricane Katrina and increased levels of bankruptcy filings in the final quarter of the year. Loan impairment charges were also higher in the second half of 2006 compared with both the preceding half and the second half of 2005. The increase was primarily driven by significantly higher delinquencies and losses in the mortgage services
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correspondent business, concentrated in second lien and portions of first lien mortgages originated and purchased in 2005 and 2006. As noted previously, HSBC witnessed a deterioration in the performance of these 2005 originations during the first half of 2006. This deterioration continued into the third quarter and started to affect equivalent loans originated in 2006. In the final quarter of 2006, deterioration of these loans, largely the first lien adjustable-rate and second lien loans, worsened considerably. The heightened risk of loss was attributable to lower equity in homes as price growth moderated or reversed, together with a higher prospective interest burden from ARM resets. As many of these mortgages were being re-priced in an environment of higher interest rates, slower asset price appreciation and tightening credit, HSBC considers it highly likely that these factors will lead to increased instances of default in the future on both first and any associated second lien loans. Accordingly, a significant increase in loan impairment charges was recorded in the final quarter of the year.
Higher lending, the seasoning of the loan portfolio, and a return to more normal historical levels of delinquency from the exceptionally favourable credit conditions experienced in recent periods, all contributed to the overall increase in impairment charges in the US. This was partly offset by lower numbers and levels of bankruptcy filings and the positive effect of low unemployment. The credit card business, in addition, benefited from improved recovery rates from loans previously written off. Notwithstanding the accelerated credit weakness witnessed in the mortgage services correspondent business, credit performance as measured by delinquency and loss in the majority of the other lending portfolios, including mortgage balances originated through the branch-based consumer lending business gradually deteriorated from the seasoning of a growing portfolio and the rising proportion of credit card balances. Loan impairment charges in these portfolios were consequently higher in the second half of 2006 as these portfolios seasoned, coinciding with the weakening housing market.
In Canada, loan impairment charges were 38 per cent higher. This primarily reflected the non-recurrence of loan impairment releases from core banking operations, which occurred in 2005, as well as growth in both secured and unsecured lending balances and higher delinquency rates in the motor vehicle finance business.
Operating expenses grew by 12 per cent to US$7.4 billion. In the US, costs of US$6.7 billion
were 11 per cent higher than in 2005. In the consumer finance business, the rise was driven by increased headcount to support incremental collections activity, and greater volumes. Higher costs were incurred in marketing cards to support the launch of new co-branded credit cards, greater levels of mailing and other promotional campaigns in the cards and retail services businesses. IT and administrative expenses grew in support of higher asset balances. A lower level of deferred origination costs in the mortgage services business, due to a decline in volumes, contributed further to the cost growth.
In HSBC Bank USA, expense growth was primarily driven by branch staff costs from additional headcount recruited to support investment in business expansion and new branch openings. Greater emphasis placed on increasing the quality and number of branch staff dedicated to sales and customer relationship activities, which changed the staff mix, also contributed to cost growth. The continued promotion of the online savings product, new branch openings and branding initiatives at the John F. Kennedy International and LaGuardia airports in New York led to a rise in marketing costs. IT costs also grew following significant investment expenditure incurred on several key network efficiency projects.
In Canada, costs rose by 19 per cent, mainly due to higher staff and marketing costs. Staff costs grew by 13 per cent, with increased headcount supporting expansion of the consumer finance business and bank distribution network. Continuing investment in growing the wealth management business and higher incentive costs reflecting improved revenues also contributed to the increase. Marketing costs grew following external campaigns to improve brand awareness.
Commercial Banking’spre-tax profits rose by 4 per cent to US$957 million, largely driven by lending and deposit growth and higher fee income, partly offset by increased loan impairment charges. Costs rose mainly from geographical expansion in the US and branch and business expansion in Canada. The cost efficiency ratio worsened by 2.1 percentage points, as costs grew faster than revenues.
Net interest income grew by 15 per cent to US$1.4 billion. In the US, net interest income was 13 per cent higher, as HSBC continued to expand its geographical presence, notably in Boston, Connecticut, New Jersey, Philadelphia, Washington D.C., Chicago and Los Angeles. Average deposit balances rose by 30 per cent, aided by geographical
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expansion and greater focus placed on generating balances from commercial real estate companies and middle market customers. In particular, there was an increased emphasis on attracting high margin balances from cash management sales activities. Rising interest rates encouraged customers to transfer funds to higher yielding products and the resulting change in product mix led to a narrowing of liability spreads.
The 7 per cent growth in average lending balances was principally led by greater volumes generated from small business and middle market customers. This was achieved by a combination of geographical expansion, increased marketing activity and the recruitment of additional small-business relationship managers. Asset spreads narrowed due to competitive pricing pressures, particularly in the middle market customer segment, which partly offset the income benefits from higher lending volumes.
In Canada, net interest income increased by 14 per cent. The strong economy encouraged continued business investment by customers and this, in conjunction with HSBC’s reputation for customer service and relationship management, helped generate a 15 per cent growth in average lending balances. Loan spreads were broadly in line with 2005. There was a 35 per cent improvement in average deposit balances, driven by various factors including the acquisition of new customers, strengthening relationships with existing ones, and enhancing payment and cash management products. Deposit spreads widened as interest rates rose, augmenting the income benefits from higher balances.
Net interest income in Bermuda grew by 42 per cent, partly due to interest rate rises which widened deposit spreads. Deposit balances increased by 26 per cent, while increased cross-sales activity contributed to a 26 per cent rise in average lending balances.
Net fee income improved by 13 per cent to US$329 million. In the US, the 11 per cent rise was primarily due to an increase in syndication capabilities, which led to higher commercial mortgage fees, and from business expansion into new geographical markets. In Canada, growth in new lending business led to higher levels of service charges, and credit fees increased following the rise in customer numbers. Product enhancements and additions to the sales force helped grow fee income from payment and cash management services.
There was a small reduction in other operating income, largely due to the net effects of lower gains on asset disposals in the US.
Also in the US, the redemption of bonds issued by the Venezuelan government led to a US$19 million gain from financial instruments.
Loan impairment charges were US$74 million compared with a net release of US$21 million in 2005. In the US, the increase reflected strong growth in lending balances to small and middle market customers, higher write-offs in the small business segment and the exceptionally low charges recorded in 2005 compared with historical levels. Loan impairment charges rose in Canada following the non-recurrence of releases which occurred in 2005 and, in Bermuda, net releases compared with charges in 2005.
Operating expenses grew by 21 per cent to US$814 million. The 27 per cent rise in the US was driven by a combination of increased costs incurred in support of geographical expansion and the recruitment of additional sales staff to drive revenue growth. In Canada, operating expenses were 14 per cent higher from additional headcount recruited to support branch and network expansion and increased salary and bonus costs, which reflected improved revenues. Expenditure incurred in order to develop the business, largely due to HSBC brand campaigns, contributed further to cost growth.
Income from associates rose by US$34 million, including HSBC’s share from an equity investment in Wells Fargo HSBC Trade Bank N.A. of US$11 million in the US. Income from associates of US$22 million in Canada was attributable to higher gains and distributions from private equity fund investments. These funds, in which HSBC has maintained a minority interest, were established to provide institutional investors with access to private equity investment opportunities.
Global Banking and Markets reported a pre-tax profit of US$423 million, 28 per cent lower than in 2005. The result in 2005 benefited from a US$106 million favourable movement on ineffective hedges on HSBC’s own debt and, excluding this, profit before tax decreased by 12 per cent. The fall in profits was primarily due to a decline in balance sheet management revenues. Balance sheet management activity continued to be constrained by compressed spreads in a flat interest rate yield curve environment, with a resultant decrease of US$347 million. Operating expenses were higher by 19 per cent with a significant portion of the increase driven by the first full year effect of recruitment and business expansion in 2005, and by specific
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initiatives taken in early 2006. This investment in extending the trading platform, notably in mortgage-backed securities, structured derivatives, metals and foreign exchange, produced record trading revenues.
Net fee income and trading income also grew, reflecting the measures taken to strengthen HSBC’s presence in the region.
In Global Banking, net interest income in payments and cash management rose by 66 per cent, largely due to an over 50 per cent growth in balances.
Net fee income rose by 13 per cent to US$656 million. Increases in fee income within the newly expanded mortgage-backed securities and equity underwriting businesses were driven by higher volumes. The securities services business benefited from a combination of new client volumes and market-driven asset growth. However, income from debt underwriting activity declined due to fewer deals, particularly in the second half of the year. In Global Banking, higher transaction volumes in the recently enhanced payments and cash management business, and an increase in customer volumes driven by a wider product offering, led to higher net fee income.
HSBC’s operation in Canada reported a 31 per cent increase in fees, reflecting a growth in funds under management within HSBC Global Asset Management, coupled with higher fees from the lending business and securities services.
Net trading income more than doubled to US$818 million. In Global Markets, a wider product offering and improved sales capabilities drove significant gains across all major client-related activities. Revenues were further boosted by the first full year contribution from the mortgage-backed securities trading business. Credit and Rates benefited from tightening credit spreads and increased customer flows. Structured derivatives income more than doubled, reflecting successful product launches as well as increased sales of tailored solutions. Revenues in the foreign exchange business remained robust against the backdrop of a weakening US dollar.
In Canada, trading income more than doubled, with higher gains from foreign exchange; a result of increased volatility of the Canadian dollar against the US dollar.
Gains from financial investments were 79 per cent lower as income from the disposal of securities declined.
A 50 per cent increase in other income was driven in part by higher revenues in HSBC’s Sharia-compliant property fund business, which were offset by higher related costs.
The overall credit environment remained stable, although a small loan impairment charge of US$3 million compared unfavourably to a net release of US$64 million in 2005.
Operating expenses increased by 19 per cent to US$1,641 million, mainly due to the first full year effect of the business expansion which took place in 2005 and additional expenditure in early 2006. In Global Markets, cost growth was primarily driven by the mortgage-backed securities, structured derivatives and equity businesses. Staff costs increased by 11 per cent, reflecting the first full year effect of people recruited in 2005, performance incentives that rose in line with revenue and selective hires in early 2006.
Operational expenses in the payments and cash management and the securities services businesses increased as business volumes grew and the related support businesses were expanded.
HSBC’s share of profits from associates declined significantly reflecting the non-recurrence of distributions from a private equity associate.
Private Banking contributed a pre-tax profit of US$114 million, an increase of 12 per cent compared with 2005. HSBC’s onshore presence was enhanced by the opening of offices in Chicago and Greenwich, Connecticut. Revenue growth, driven by significantly higher core fees and commissions and improved trading results, was offset in part by loan impairment charges of US$35 million, US$29 million of which related to a single customer. The cost efficiency ratio improved by 6.2 percentage points to 70.4 per cent.
Net interest income increased by 15 per cent to US$212 million. A deposit-raising campaign proved successful at garnering funds, the total raised by the year-end reaching US$2.5 billion. Overall, deposit balances rose by 25 per cent and lending balances increased by 14 per cent. Deposit spreads were marginally lower than in 2005.
Net fee income grew strongly, increasing by 20 per cent to US$240 million. WTAS continued to expand its client base – it rose by 31 per cent in 2006 – and reported significant revenue growth, benefiting from restrictions placed on the major auditing firms with regard to providing personal tax advice to employees of audit clients. Higher funds under management and an increase in referrals with other
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HSBC businesses also contributed to the increased level of fee income.
A one-off gain of US$9 million arose from a partial disposal of a holding in the Hermitage Fund, offsetting the non-recurrence of US$9 million of income following the sale of a number of small trust businesses in 2005.
Client assets increased by 5 per cent to US$43 billion, with net new money of US$5 billion. This included a significant contribution from the higher fee-earning discretionary SIS and CIS products in which the value of client assets rose to US$1.4 billion.
Operating expenses of US$355 million were 10 per cent higher than in 2005. This rise was primarily attributable to hiring front office Private Banking staff and fee-earning staff within WTAS.
In Other, movements in the fair value of own debt and associated swaps resulted in losses of US$128 million in 2006, compared with profits of US$401 million in 2005.
Business expansion led to higher transaction volumes, which resulted in increased utilisation of IT systems and solutions. Branch expansion, the integration of Metris, and the launch of new products also contributed to an 8 per cent increase in costs and income at the group’s North American technology centre. In hsbc.com, accrued costs associated with the development of HSBC’s second generation internet banking platforms were recharged to other customer groups, which resulted in higher operating income.
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In response to fluctuations in export demand from the US, economic growth in Mexico moderated during the course of 2007, with GDP rising an estimated 3.1 per cent during the year, compared with 4.8 per cent in 2006. Inflationary pressures remained significant throughout 2007, with consumer price inflation averaging 4 per cent, driven by increases in international prices of commodities, which affected domestic food prices in the core index. As a result, the Bank of Mexico raised its
overnight interest rate by a total of 50 basis points, and has maintained its restrictive monetary policy despite reductions in interest rates by the US Federal Reserve.
The Brazilian economy expanded strongly in 2007, with GDP expected to have grown by 5.4 per cent compared with 3.7 per cent in 2006. As in 2006, growth was driven by domestic demand, with private consumption rising considerably. As a consequence, the average unemployment rate fell to 9.3 per cent in 2007 from 10 per cent in 2006. After declining to 3.1 per cent at the end of 2006, the annual rate of consumer price inflation climbed to 4.5 per cent by
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December 2007, mainly from higher food prices. The cycle of monetary easing which began in the third quarter of 2005 paused in October 2007 with the overnight rate at 11.25 per cent, the lowest level in several decades. After nine years of steady expansion, the trade balance surplus fell slightly in 2007, and is expected to decrease further in 2008. Balance of payments fundamentals, however, remained robust and, as a result, the Brazilian economy seemed less vulnerable to external shocks than in previous years.
The Argentine economy also performed strongly in 2007, with GDP expected to have risen by 8.7 per cent. This strength was a consequence of several factors such as a competitive exchange rate, spare capacity in the economy and a generally favourable external environment, which helped Argentina extend its fiscal and external surpluses into a fourth successive year. Less encouraging was the fact that inflation accelerated to about 13 per cent, up from 10 per cent in 2006. Although food inflation was part of the explanation, rapid demand growth was also a factor. 2007 was an election year, and as a result the rate of growth of fiscal spending
doubled to 45 per cent on an annual basis. As a consequence, the primary surplus fell by around 1.2 per cent of GDP.
Throughout the region as a whole, GDP growth roughly matched that of 2006. The slowdown in Mexico provided a contrast to better performances elsewhere in Central and Southern America. Central America grew by an estimated 6.3 per cent, up from 5.9 per cent in 2006 while, in South America, growth was an estimated 5.8 per cent, up from 5.3 per cent in 2006. The most dynamic economies in Central America were Panama (10.0 per cent growth in GDP) and the Dominican Republic (8.0 per cent), followed by Costa Rica (6.2 per cent) and Honduras (6.2 per cent). In South America, the fastest growing countries after Argentina were Peru (7.2 per cent growth in GDP), Venezuela (7.0 per cent) and Colombia (6.5 per cent). In general, inflation appears to be under control in Latin America, averaging around 5 per cent over the past three years. Only Venezuela and Argentina have experienced double-digit inflation, while the US dollar-based economies of Panama, Ecuador and El Salvador have better inflationary records.
HSBC’s operations in Latin America reported a pre-tax profit of US$2.2 billion compared with US$1.7 billion in 2006, representing an increase of 26 per cent. HSBC’s acquisitions of HSBC Bank Panama and Banca Nazionale in 2006 strengthened the existing business platform and geographical representation, and 2007 has been a year of
integrating these operations into HSBC. On an underlying basis, pre-tax profits rose by 14 per cent as increased revenues were partly offset by higher loan impairment charges, largely from Mexico, and increased operating costs across the region.
Both Mexico and Brazil made notable contributions to Commercial Banking’s pre-tax profits, which were 64 per cent higher than in 2006,
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Brazil from SMEs, Mexico from larger corporates. In Personal Financial Services, profit before tax increased by 12 per cent as strong growth in revenues was partly offset by increased loan impairment charges in Mexico. Profit before tax in Global Banking and Markets increased as strong growth in net fee and net interest income was partly offset by a decrease in trading income and higher costs related to business expansion.
Notwithstanding continuing investment and integration costs throughout the region, the cost efficiency ratio improved by 2.7 percentage points to 58.3 per cent.
Personal Financial Services reported pre-tax profits of US$893 million, 3 per cent higher than in 2006, as strong growth in revenues across the region was partly offset by increased loan impairment charges arising from the seasoning of recent organic business expansion, mainly in Mexico. Revenue rose by 21 per cent, driven by higher credit card balances in Mexico and an increased volume of personal and vehicle finance loans in Brazil. Four additional months of Banca Nazionale revenues in Argentina, a one-off adjustment to insurance embedded value in Mexico and gains from sales of financial investments in Brazil, also helped boost income. Loan impairment charges in Mexico rose significantly, driven by the growth in the past two years of the credit card portfolio and higher delinquencies in the self-employed lending business. Operating expenses increased by 12 per cent, mainly supporting expansion in the region; despite this, the cost efficiency ratio improved by 4.7 percentage points. Net interest income rose by 15 per cent, as steady asset and liability growth was recorded across the region.
In Mexico, net interest income rose by 27 per cent, driven by a strong performance in both asset and liability products. Credit cards, an area in which HSBC has worked to remedy its traditionally underweight position in Mexico, reached a market share of more than 10 per cent, up 3.5 percentage points compared with 2006. This reflected HSBC’s efforts to organically grow this portfolio. Growth was enhanced by marketing promotions and portfolio management programmes put in place to improve customer retention and card usage.
Demand for housing remained strong and mortgage lending continued to grow. HSBC’s mortgage positioning is based on speed of service and
competitive rates supported by marketing campaigns. HSBC Premier was relaunched in Mexico in 2007 and performed well, increasing cross-sales and income during the year.
On the liabilities side of the balance sheet, both term and demand deposits registered growth in line with market conditions. Overall spreads on Mexican peso-denominated accounts remained relatively stable while spreads on accounts in US dollars narrowed by 141 basis points.
In Brazil, net interest income increased by 7 per cent, as growth in private consumption fuelled a rise in loan volumes. Average customer loans were 28 per cent higher than in 2006. Customer deposits were 23 per cent higher, driven by a sales effort to garner deposits and the favourable economic outlook. Spreads on customer deposits narrowed by 23 basis points.
The vehicle finance loan portfolio grew significantly in the positive economic environment, while spreads narrowed due to competitive pressures. Net interest income on payroll loans grew as volumes expanded. Demand for personal instalment loans also continued to rise, driving net interest income higher on wider spreads.
Net interest income rose by 35 per cent in Argentina, as customer balances grew strongly and four additional months of Banca Nazionale revenues were included. Growth in customer lending reflected expansion in personal loans, car loans and credit cards, supported by cross-selling initiatives and an active marketing campaign. Customer liabilities increased mainly in demand and term deposit products.
Net fee income was 19 per cent higher, primarily from robust business growth across the region.
In Mexico, fee income grew by 35 per cent with the rapidly growing credit card customer base and continued sales of the Tu Cuenta packaged product the main contributors. Cards in force increased by 35 per cent, ATM cash withdrawals by 54 per cent and point of sale billing by 84 per cent during the year, all positively affecting commission income. Stricter guidelines on the imposition of late payment fees also led to higher income. Fees from Tu Cuenta rose strongly, following a 29 per cent growth in the number of accounts. A 6 per cent growth in the ATM network and increased customer activity led to a rise in HSBC’s market share in interbank transactions of more than 12 million transactions or 2 percentage points to 38 per cent, resulting in higher interbank fee income.
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In Brazil, fee income rose by 3 per cent on the back of growth in lending balances and a commensurate rise in credit facility fees. Fee income further benefited from re-pricing initiatives, particularly in current account fees.
Fee income in Argentina, higher by 12 per cent, primarily reflected an extra four months of Banca Nazionale revenues. Business growth in bancassurance and credit cards also contributed to improved fees.
The continued growth of insurance operations in the region, through increased product offerings and expanded distribution channels, led to higher insurance premiums and claims.
In Mexico, increased cross-selling activities in the branch network resulted in higher net insurance income, mainly driven by sales of a five-year life assurance product. Refinement of the recognition methodology used in respect of the PVIF long-term insurance contracts resulted in a one-off revenue increment in the first half of 2007.
In Brazil, income grew from higher sales volumes of pension and life assurance products. The growth in the life portfolio was driven by growth of 106 per cent in credit insurance products. Pension portfolio income grew by 48 per cent following targeted sales initiatives. Net insurance claims also grew substantially during the year. Increased premium income in Argentina was generated from higher sales volumes of general insurance and life protection policies, supported by innovative marketing campaigns.
Net gains from financial investments increased significantly, driven by a gain of US$97 million, following a sale of shares held in a credit bureau, a stock exchange and a derivatives exchange in Brazil.
Loan impairment charges rose by 70 per cent to US$1.5 billion, mainly due to higher delinquency from seasoned loan growth in Mexico.
Mexico reported a more than threefold increase in loan impairment charges to US$737 million, driven by higher impairments on credit cards following the targeted expansion in market share, and higher delinquencies from self-employed loan balances. The increase in loan impairment charge is part of the cost of building strong organic growth as portfolios season. Regular reviews are undertaken to improve the quality of new business, based on underwriting experience, improved collection strategies and better managed customer acquisition channels. Credit models were updated during 2007 to adjust to credit behaviour in underlying portfolios.
Loan impairment charges rose only modestly in Brazil, notwithstanding strong asset growth, reflecting the benign credit environment and the application of proactive risk management techniques. Increased loan impairment charges from the vehicle finance, cards, payroll loans and store loans portfolios were partially offset by lower loan impairment charges in overdrafts and personal loans. In Argentina, loan impairment charges grew by US$14 million, again mainly due to the inclusion of the Banca Nazionale portfolio, as well as organic loan growth.
Operating expenses of US$3.8 billion were 12 per cent higher, mainly because of activities undertaken in support of product and distribution expansion initiatives, and integrating recent acquisitions.
In Mexico, operating expenses increased by 14 per cent, as non-staff costs rose to support organic business growth. Staff costs were flat as increases to support business growth, mainly in debt collection and call centres, were offset by one-off curtailment and settlement gains from staff transferring out of the bank’s defined benefit healthcare scheme to a new defined contribution scheme. Growth in non-staff costs was mainly attributable to supporting credit card business growth and servicing, strengthening of IT infrastructure and higher marketing spend on product campaigns, promotions and sponsorships. Campaigns included the HSBC Premier relaunch, Tu Cuenta and insurance. The increased popularity of the cash-back facility on the Tu Cuenta account, where a customer receives a rebate on amounts spent by credit or debit cards, also drove up expenses.
In Brazil, operating expenses were 8 per cent higher. Staff costs included one-off expenditure incurred to enable the business to improve operational efficiencies and position itself for future growth. Union-agreed pay rises took effect during 2007. Non-staff expenses, including marketing campaigns, payroll acquisition costs and transactional taxes also increased in support of revenue growth.
Costs in Argentina rose by 39 per cent, mainly from the inclusion of four extra months of Banca Nazionale costs. The rise in expenses reflected both continued investment in infrastructure to support business growth, and general price rises evident in the economy as inflation rose. Increased marketing campaign spending was focused on cards, personal loans and the Premier relaunch.
Commercial Banking pre-tax profits rose by 46 per cent to US$740 million during 2007, mainly driven by significant growth in Brazil and Mexico.
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HSBC’s two-pronged objective to become the leading international bank and the best bank for small businesses delivered results as regional customer numbers grew by over 14 per cent. Income from payments and cash management rose by 8 per cent, while the network of International Banking Centres in Argentina, Brazil and Mexico was extended to improve regional coverage. Other developments included the launch of electronic account opening facilities in Mexico and BusinessDirect in Brazil.
Operating income showed an improvement on 2006, although this was partly offset by an increase in costs driven by expansion. As a result, the cost efficiency ratio improved by 0.4 percentage points to 54.3 per cent.
Net interest income rose by 17 per cent, mainly from an increase in both deposits and loans.
In Mexico, net interest income rose by 21 per cent to US$496 million, reflecting volume growth in deposits, commercial real estate lending, increased support for larger local and global commercial customers and strong volume growth in trade and factoring. Average lending balances rose by 37 per cent, primarily on large corporates, while spreads widened on small business loans. Spreads on deposit accounts narrowed. Customer relationship management campaigns resulted in new customer acquisition and increased cross-sales to existing customers.
In Brazil, net interest income increased by 10 per cent, mainly due to higher income from small and mid-market enterprises in the favourable economic environment. Increases in volumes were notable in the guaranteed account, giro facil, working capital facilities and rural loans.
Net interest income increased by 86 per cent in Argentina, due both to strong organic loan and deposit growth, and the inclusion of four additional months of Banca Nazionale revenues. Corporate and mid-market business grew significantly, reflecting the successful integration of the Banca Nazionale network, while the targeting of small and micro enterprises coupled with the launching of new products also helped drive portfolio growth. Customer loans and advances rose by 50 per cent while customer deposits increased by 33 per cent.
Net fee income was 14 per cent higher, driven by robust growth throughout the region.
In Mexico, fee income grew by 13 per cent across a broad product portfolio. Following a strategy to migrate more transactions to internet-based services, payment and cash management transactions increased by 11 per cent and active customers by
19 per cent, resulting in higher income generation. A growth in the number of ATMs led to higher income from ATM interbank charges. Increased use of credit cards at point of sale also increased fee income. Trust fees increased significantly, mainly due to market share gains in the structured products market. Growth in trade services was driven by the Group’s geographical presence and enhanced product capabilities, as market share and cross-selling activities increased. International factoring was also successfully launched during 2007.
In Brazil, fee income rose by 11 per cent, mainly on small and micro enterprises. Payments and cash management income increased, mainly on higher volumes. Current account income increased as a result of a re-pricing exercise and a rise in volumes. Fees from loans and funds under management also grew on higher volumes. More than 110,000 products were sold over e-channels, a significant increase on the previous year.
In Argentina, HSBC increased fee income by 48 per cent, primarily due to an additional four months of Banca Nazionale revenues combined with higher transaction volumes. The main product drivers behind the increase were current accounts, which rose by 38 per cent, and trade services, which grew by 39 per cent on higher volumes, placing HSBC among the top three banks in imports and exports in Argentina.
Trading income rose on the back of higher volumes of foreign exchange transactions and sales of treasury products in Brazil, which reflected higher market share and favourable market conditions. Foreign exchange trading income also increased in Argentina.
Net gains from financial investments rose by US$47 million, driven by a gain of US$45 million following a sale of shares held in a credit bureau, a stock exchange and a derivatives exchange in Brazil.
Loan impairment charges were 28 per cent lower at US$212 million.
In Mexico, HSBC recorded a net decrease in loan impairment charges as increased delinquency rates in the small and medium-sized business portfolios were offset by impairment allowance releases. Regular reviews aimed at strengthening consumer credit management and collections were put in place to better manage delinquency rates as the portfolio matures. Credit models were updated during 2007 to adjust to credit behaviour in underlying portfolios. Products with high credit losses were discontinued or restructured.
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Loan impairment charges rose by 4 per cent in Brazil despite a substantial growth in assets. This improved performance was mainly attributable to the small business segment and resulted from changes to credit initiation and collection strategies implemented during the year. In Argentina, HSBC reported a net release of loan impairment allowances following an improvement in the country’s economic performance during 2007 and increased collections of non-performing loans.
In line with Group strategy to expand in fast growing economies, operating expenses in the Latin America region rose by 21 per cent to US$1.1 billion.
In Mexico, operating expenses increased by 22 per cent, largely driven by higher transaction costs. Staff cost rises reflected an increase in salary and performance awards in line with profit generation. Growth in non-staff costs was attributable to higher marketing expenditure and a rise in transaction costs from increased business volumes.
In Brazil, operating expenses rose by 15 per cent following implementation of a union agreement on staff remuneration and one-off expenses incurred to improve future operational efficiencies. Non-staff costs, including transactional taxes, increased broadly in line with business expansion and revenue growth.
In Argentina, costs rose by 53 per cent, again mainly driven by the inclusion of four extra months of Banca Nazionale costs. Excluding this, expenses rose reflecting continued investment in support of business growth and the general price increase evident in the local market.
Global Banking and Markets in Latin America reported a pre-tax profit of US$517 million, which represented an increase of 1 per cent from 2006. Robust growth in net interest income and fees was partially offset by a decrease in trading income and an increase in costs relating to regional business expansion. Overall, this led to a deterioration in the cost efficiency ratio to 48.9 per cent.
Total operating income increased by 13 per cent to US$1.0 billion. This was chiefly driven by strong revenue growth in Brazil, which more than offset reduced trading income in Mexico, in comparison with the latter’s strong performance in 2006.
Net interest income increased by 13 per cent, driven by cross-referrals from Commercial Banking and an increased volume of deposit balances in the securities services business as the strong performance of Brazilian equity markets attracted foreign buyers. In Argentina, net interest income rose through an additional contribution from Banca Nazionale and higher spreads on customer loans.
Net fee income rose by 34 per cent to US$250 million, driven by a strong performance in Brazil. HSBC Global Asset Management revenues increased as a result of strong returns from funds with performance fees and the success of selling locally manufactured products into Asian markets. Increased IPO activity in Brazil boosted fees from financing and capital markets, both from advisory services and from underwriting new listings. Securities services also performed well in the region as new business volumes and strong local equity markets drove a 63 per cent increase in assets under custody.
Net income from trading activities decreased by 14 per cent to US$182 million, driven by performance in Mexico, where there were reduced revenue opportunities in Credit and Rates due to the relatively flat yield curve. This was partly offset by income growth from foreign exchange trading, driven by continuing market volatility.
Gains less losses from financial investments increased by 10 per cent, driven by a gain of US$46 million following a sale of shares held in a credit bureau, a stock exchange and a derivatives exchange in Brazil. These were partially offset by a lower level of disposals in Mexico in 2007.
There were continued but lower impairment releases, with a small number of significant releases in Argentina relating to impairments that arose during the 2001 debt crisis offsetting the non-recurrence of a large release in 2006 in Mexico.
Operating expenses increased by 23 per cent to US$481 million, and reflected HSBC’s investment in increasing operational capabilities in Brazil, cost growth in Argentina following the inclusion of Banca Nazionale and continued investment in infrastructure to support business growth. This caused the cost efficiency ratio to deteriorate by 4.1 percentage points.
Private Banking reported a pre-tax profit of US$25 million, an increase of 47 per cent. The cost efficiency ratio improved by one percentage point to 64.8 per cent. The upward trend in cross-referrals continued, particularly in Brazil, with inward referrals contributing US$495 million to total client assets.
Overall, revenues increased by 42 per cent to US$71 million, driven by Mexico and Brazil. In Mexico, balance sheet growth and brokerage fees drove revenues up. Higher investment in funds and cross-referrals in Brazil also contributed to the rise in fee income.
Client assets grew by 62 per cent to US$11.6 billion, of which US$1.8 billion represented
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net new money. The increase in net new money was driven by the acquisition of new clients, particularly in Brazil and Mexico, improved product offerings and cross-referrals from other customer groups in Brazil.
Operating expenses increased by 40 per cent to US$46 million to support business expansion, particularly in Brazil, and to create a platform for future growth in the region.
Profit before tax of US$3 million was reported within Other.
Mexico’s GDP growth improved significantly in 2006 to 4.8 per cent from 3.0 per cent in 2005, mostly in response to increased external demand from the US. Commercial bank credit continued to recover strongly, with over 80 per cent growth in real mortgage loans. By the end of 2006, headline inflation had increased to 3.8 per cent from 3.0 per cent earlier in the year, largely as a result of increases in agricultural supply prices. Record oil revenues, combined with high non-oil export growth and increasing inward remittances from Mexicans working outside the country produced an almost balanced current account for the year. Significant capital inflows, including an estimated US$18 billion in foreign direct investment, enabled the Government to reduce its external debt by more than US$12 billion and the Bank of Mexico to increase foreign exchange reserves.
In Brazil, GDP is expected to have grown by 2.6 per cent in 2006 compared with 2.3 per cent in 2005. Growth was driven by domestic demand, with private consumption increasing by 3.8 per cent and capital spending by 5.9 per cent. Net exports, by contrast, fell by 18 per cent in the first three quarters of the year compared with the same period in 2005, as the increase in domestic demand translated into higher imports rather than an expansion of output. The unemployment rate averaged 10.0 per cent in 2006, slightly up from 9.8 per cent averaged in 2005. Inflation continued to decline, to 3.1 per cent in 2006, compared with 5.7 per cent in 2005 and, as a result, the Central Bank continued to ease monetary policy. Overnight rates fell to 13.25 per cent in December 2006 from 17.25 per cent a year before. The trade balance continued to be robust, with a
surplus of US$46.1 billion in 2006, just above the amount achieved in 2005.
In Argentina , real GDP growth in 2006 exceeded 8.3 per cent and, after growing for four consecutive years at an average rate of approximately 9 per cent, the country’s GDP was nearly 15 per cent above 1998, when its recession began. The strong growth was due to a competitive exchange rate, a strong fiscal stance and a favourable business environment, which HSBC expects to continue in 2007. The main potential constraint on growth remains the risk of disruption in energy supply, where there has been a lack of investment and limited price adjustments for residential consumers since 2001/2. Inflation was approximately 10 per cent at the end of 2006, having tripled in the past three years, though it was below its peak of more than 12 per cent in 2005. Interest rates rose steadily in 2006 and the peso weakened slightly against the US dollar. Given Argentina’s higher inflation rate, however, the exchange rate appreciated in real terms.
HSBC’s operations in Latin America reported a pre-tax profit of US$1.7 billion compared with US$1.6 billion in 2005, an increase of 8 per cent. On an underlying basis, pre-tax profits rose by 5 per cent. Growth in profitability was constrained by the non-recurrence of one-off coverage bond receipts and other items related to the 2001 sovereign debt default and subsequent pesification in Argentina, which added US$122 million to 2005 profits. In addition, a gain of US$89 million from the sale of the property and casualty insurance business, HSBC Seguros de Automoveis e Bens Limitada, to HDI Seguros S.A., was recorded in 2005. Excluding these prior year profits, and on an underlying basis, profit before tax increased by 21 per cent, with net operating income increasing by 15 per cent and operating expenses by 12 per cent. Global Banking and Markets delivered a strong performance, driven by growth in fee and trading income, with notable success in bringing Latin American borrowers to global capital markets. Commercial Banking also grew well as domestic economies expanded. During 2006, HSBC made two significant acquisitions in the region. In May, HSBC acquired the Argentine banking operations of Banca Nazionale to build its distribution capabilities and, in November, HSBC Bank Panama in Central America, adding markets in five countries new to the Group.
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Personal Financial Services reported a pre-tax profit of US$800 million, a rise of 1 per cent over 2005, which had benefited from a US$89 million gain on the sale of the Group’s property and casualty insurance business in Brazil. Adjusting for this, pre-tax profits grew by 16 per cent, driven by 12 per cent growth in revenues and 10 per cent growth in costs. The underlying improvement in revenues was led by strong asset and deposit growth together with higher fee income, offset in part by consequential expense growth and a rise in impairment charges as the loan book both grew and seasoned.
In Mexico, profit before tax rose by 10 per cent. During 2006, 56,000 Personal Financial Services customers were transferred to the Commercial Banking customer group, where HSBC is better placed to meet their banking requirements. Adjusting for this, profits were 20 per cent higher, driven by strong balance sheet growth and improved fee income.
Adjusting for the gain in 2005 from the sale of the property and casualty business, pre-tax profits were 46 per cent higher in Brazil. The strong domestic economy stimulated robust growth in lending and a rise in the number of current account holders. During the year, a new and innovative internet banking service Meu HSBC (My HSBC) was introduced to Personal Financial Services customers, allowing them to conduct different types of transactions online using the same password as their ATM card.
In Argentina, profit before tax was marginally higher, with strong balance sheet growth, higher fees and improved revenues from the insurance business. This was largely offset by increased loan impairment charges and cost growth incurred in support of business expansion as HSBC prepared for an improving domestic economic environment.
Net interest income rose by 11 per cent to US$3.1 billion, largely from balance sheet growth partly offset by lower deposit spreads.
In Mexico, net interest income increased by 12 per cent to US$1.2 billion. Adjusting for the effect of customer account transfers to Commercial Banking, net interest income rose by 20 per cent, driven by strong growth in credit card and mortgage balances and increases in deposits which were generated by the ongoing success of the Tu Cuenta product. Overall, asset spreads improved as the relative increase in higher margin card balances led to a favourable change in the product mix. By contrast, deposit spreads narrowed as interest rates declined.
Excluding customer account transfers, average deposit balances in Mexico rose by 10 per cent. HSBC continued to be one of the market leaders with respect to balance growth, despite fierce competition from other banks, improving its market share by 35 basis points. A strong increase in low-cost deposits was reflective of the continuing success of Tu Cuenta, the first integrated financial services product of its kind offered locally, with nearly 400,000 new accounts opened in 2006. HSBC Premier performed well as 84,000 new customers were added during the year. Premier deposits
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represented over one third of the total personal deposit base at 31 December 2006. The income benefit from higher deposit balances was partly mitigated by reduced spreads in the falling interest rate environment, notwithstanding the positive shift in mix from growth in non-interest bearing deposit balances.
The credit card market in Mexico was buoyant in 2006 and HSBC’s business performed very successfully with average balances doubling to US$886 million. Various initiatives were implemented to develop the business, most notably cross-sales to Tu Cuenta customers, targeted customer relationship campaigns to existing clients, successful portfolio management strategies and promotions, development of new sales channels and improvements in card activation times. These initiatives helped HSBC become the market leader in credit card balance growth, improving market share by 2.3 per cent. The number of cards in circulation reached 1.7 million at the year end, representing an increase of 76 per cent.
Demand for housing from first time buyers remained strong in Mexico, and market conditions continued to be highly competitive. Average mortgage balances rose by 81 per cent to US$969 million, reflecting HSBC’s competitive pricing and innovation in product design. HSBC was the first bank in Mexico to market pre-approved online mortgages, and enhanced this offering with the subsequent introduction of Mortgage Express Approval, which provides customers with much faster access to details concerning the loan amount, duration and monthly payments at the point of application. Improvements in the processing of mortgage applications, upgraded customer service and increased marketing activity also contributed to the rise in lending balances. The income benefits of balance growth were partly offset by narrower spreads, driven by the highly competitive market conditions.
As the Mexican economy grew strongly, there was robust growth in personal and payroll lending balances. The introduction of a dedicated and mobile sales force during the second half of 2006 to expand distribution capabilities led to a fourfold increase in average personal lending balances during the year. This initiative also helped to reduce time to market, increase cross-sales and, through closer interaction with the branch network, improve client coverage. The popularity of the personal loan product, where customers apply directly via HSBC’s extensive and well-positioned ATM network grew, and this was the key driver behind a 37 per cent rise in average payroll loan balances.
In Brazil, net interest income increased by 9 per cent as lower inflation and the improving domestic economy triggered a rise in demand for credit which, in turn, contributed to strong lending growth. Average loan balances were 18 per cent higher, driven by rising customer numbers and increases in vehicle financing, pension and payroll loans. On the liability side, there was a 7 per cent rise in current account holders, largely driven by growth in the number of customers with payroll loans and greater levels of sales activity.
Average vehicle finance balances in Brazil rose by 36 per cent, led by continued portfolio growth as HSBC strengthened its relationships with car dealerships. The combined pension and payroll loan portfolios registered an 84 per cent increase in average balances, a consequence of increased borrowings per customer, portfolio acquisitions, and growing customer demand for these products. Spreads also improved, largely as a result of lower funding costs, which augmented the positive income benefits of balance growth. Average card balances rose by 19 per cent, with an increase of 27 per cent in the number of cards in issue, reflecting the launch of various initiatives aimed at improving retention, activation and utilisation. Spreads improved from lower funding costs and price increases initiated in the second half of 2005, complementing the benefits derived from higher lending volumes.
In Argentina, net interest income grew by 12 per cent, primarily driven by increased demand for credit card, other personal and motor vehicle lending. This was largely attributable to more effective promotional activity and productivity improvements in the telemarketing and branch channels. Higher funding costs, however, resulted in a narrowing of lending spreads, offsetting volume benefits. Deposit balances rose, reflecting the increased emphasis placed on growing liability products, the benefit from which was augmented by a widening of spreads.
Net fee income was 25 per cent higher, reflecting strong growth across the region generally.
Fee income grew by 21 per cent in Mexico, largely due to higher credit card and Tu Cuenta income. Fee income from cards rose by 51 per cent, reflecting a significant growth in the number of cards in circulation and improvements made in reducing activation times. The improvement in Tu Cuenta income was driven by sales of over 1 million new accounts and re-pricing initiatives. In order to capture a higher volume of ATM revenues, HSBC added 372 new machines to its already well-positioned network, which increased ATM fees from greater levels of transactional activity and a 22 per cent rise
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in transactions from non-HSBC customers. Growth in mutual fund fees was mainly driven by higher sales volumes and expanded product offerings in the stronger economic environment.
Fee income in Brazil rose by 25 per cent, largely from increased current account fees, reflecting growth in customer numbers, greater transaction volumes and re-pricing initiatives. Higher payroll and vehicle balances also led to increased fees from lending activities. In Argentina, higher credit card fees from balance growth, re-pricing initiatives on savings accounts, and the discontinuance of a free current account promotion led to an improvement in fee income.
Across the region, HSBC’s insurance businesses continued to perform well. Sales of insurance products in Mexico remained strong, with increased cross-selling through the branch network of simple insurance products together with other Personal Financial Services products containing insurance components. This led to a 19 per cent rise in net premiums, mainly in respect of individual life insurance products. In Brazil, excluding the effect of the property and casualty insurance business sold in 2005, insurance revenues rose, largely from life and pension products. In Argentina, increased advertising, partnerships with established local consumer brands and internal cross-selling initiatives led to a rise in motor, home and extended-warranty insurance premium income. Life and annuity premiums also increased in line with higher customer salaries. The ‘Maxima’ pension funds business delivered higher revenues helped by improvements in the economic climate and greater levels of employment.
Lower other operating income reflected the non-recurrence of profit on the sale of HSBC’s Brazilian property and casualty insurance business.
Loan impairment charges and other credit risk provisions rose by 15 per cent to US$764 million as lending grew and the loan book seasoned. In Mexico, the higher charge was primarily driven by the growth in credit card lending. In Brazil, loan impairment charges increased modestly, driven by growth in vehicle finance, instalment loans (credito parcelado) and credit card lending. As the credit environment weakened during the first half of the year, various measures were taken to mitigate the effects. These included tightening lending criteria, enhancing credit analytics, revising the collection policy, prioritising secured lending ahead of unsecured advances and strengthening credit operations. Following implementation of these measures, several key credit indicators showed improvement.
Operating expenses rose by 10 per cent. In Mexico, expense growth of 10 per cent was mainly driven by increased staff costs. This largely reflected the recruitment of 2,200 employees to improve customer service levels in branches and grow sales. Incentive costs increased as profits rose, and marketing costs grew as a result of various promotional campaigns. The continued expansion of the branch network and ATM infrastructure, together with the new HSBC headquarters building in Mexico City, led to increases in IT, premises and equipment costs.
In Brazil, expenses were 10 per cent higher. As in Mexico, this reflected the cost of new employees recruited to support business expansion, including the strengthening of credit operations, and new branch openings. This, together with annual pay rises and increased incentive payments, triggered a 13 per cent growth in staff costs. Advertising costs rose to promote brand awareness, while an HSBC Premier promotion led to higher marketing costs.
Costs grew by 26 per cent in Argentina, with higher staff costs driven by union-agreed pay rises in 2005, and increased incentives and commissions paid in light of revenue growth. Marketing costs also increased to support the launch of various promotions and campaigns.
Commercial Banking reported pre-tax profits of US$451 million, 17 per cent higher than in 2005. Growth in net operating income before loan impairment charges was strong at 26 per cent as domestic economies in the region grew and HSBC built market share. Cost growth in support of this expansion was held within revenue growth and the cost efficiency ratio improved by 2.5 per cent.
Net interest income rose by 24 per cent, largely driven by business expansion in Mexico and Brazil.
In Mexico, net interest income rose by 49 per cent, reflecting asset and deposit growth, in part due to the transfer of the 56,000 customers from Personal Financial Services noted above. As HSBC extended its presence in the small and middle market business segments, average deposit balances increased by 65 per cent (31 per cent excluding the transferred customer accounts), although the benefit of this volume growth was partly mitigated by lower deposit spreads in a falling rate environment.
Lending balances in Mexico were 41 per cent higher, primarily driven by strong demand in the rapidly growing real estate and residential construction sectors. During the final quarter of the year, HSBC opened an International Banking Centre to develop cross-border business for global
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Commercial Banking customers, with 75 business accounts acquired since its inception. Attention placed on higher yielding small and middle market businesses, following refinements made to the customer segmentation strategy, contributed to asset growth as greater emphasis was put on increasing revenues from this segment. These volume benefits were augmented by improved lending spreads from lower funding costs in the falling interest rate environment, which offset reduced yields.
In Brazil, net interest income was 12 per cent higher. Overall, lending balances rose by 16 per cent, primarily driven by small and middle market customers. The recruitment of additional relationship managers and sales staff, investments made in receivables financing and greater levels of promotional activity all combined to build HSBC’s position in this market segment. There was ongoing success from the giro fácil product, offering both revolving loan and overdraft facilities, with average balances recording a 13 per cent increase. Spreads widened as interest rates fell, further augmenting the income benefits of higher lending volumes.
A 42 per cent rise in net interest income in Argentina was primarily attributable to strong asset and liability growth. Average lending and deposit balances increased by 39 per cent and 19 per cent respectively, as customer numbers rose, particularly to the small and micro businesses, helped by favourable economic conditions and investment in new sales channels. Asset spreads declined, however, due to competitive market pressures on pricing, partly offsetting the income benefits of higher lending volumes. By contrast, deposit spreads improved.
Net fee income was 36 per cent higher, driven by robust increases across Mexico, Brazil and Argentina.
In Mexico, fee income rose by 28 per cent with notable success in increasing cross-sales activity. Growth in customer numbers contributed to higher transactional volumes which, combined with an expanded and improved product offering plus increased marketing activity and re-pricing initiatives, led to a 41 per cent rise in income from payments and cash management services. The Estimulo product offering, comprising a packaged suite of seven different products including a loan facility, continued to perform well with fee income nearly trebling compared with 2005. During the third quarter, a similar product, Estimulo Empresarial, was launched, targeting upper-end small business customers. This product encompasses a suite of eleven different services and since its introduction more than 165 clients have been signed, generating US$50 million of new loans. HSBC’s share of the
trade services market continued to grow, building on the Group’s international network and product capabilities. Fees from international factoring and domestic invoicing payment products also rose, as new products were successfully piloted and marketed to existing clients. The signing of new merchant customers led to higher transaction volumes and a subsequent 60 per cent rise in card acquiring fees.
In Brazil, fee income rose by 47 per cent as effective cross-selling led to an increase in the average number of products held per customer. Current account fee income grew from higher levels of transactional activity and tariff increases implemented in 2005. Pricing changes introduced part-way through 2006 led to higher revenues from payment and cash management services. There was improved fee income from assets under management, and additional marketing to promote trade products led to a rise in trade services fees.
Fee income in Argentina was 27 per cent higher, primarily from increases in account and trade services along with payments and cash management fees.
Loan impairment charges and other credit risk provisions doubled, reflecting strong lending growth, a higher proportion of small and micro business lending, and the seasoning of the portfolio.
In Mexico, strong growth in the lower-end small and micro business lending balances led to increased loan impairment charges during the year.
A 41 per cent rise in Brazil again reflected large increases in small and micro business lending balances and higher delinquency rates as the portfolio seasoned. This led to a 12 basis point increase in the proportion of impaired loans to assets. Various actions were undertaken to manage the effects of the weakening credit environment, with debt collection operations enhanced and closer cooperation forged between sales and collections staff. Changes were also made to underwriting criteria, coupled with revisions to sales staff incentive schemes. Following these measures, an improvement in credit quality was seen and charges reduced in the second half of the year compared with the first half. In Argentina, releases were lower than in 2005.
Operating expenses of US$822 million were 21 per cent higher than in 2005, as businesses expanded strongly across Latin America.
In Mexico, operating expenses rose by 26 per cent, largely driven by higher transactional volumes, new clients acquired and increased lending activity. Non-staff costs were higher, reflecting the marketing and IT-related support to business growth.
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In Brazil, expenses grew by 19 per cent, also largely from higher staff, marketing and administrative costs. Business expansion activities in the small and middle market customer segments followed the recruitment of 270 additional employees and this, together with union-agreed pay increases, were the principal drivers behind the 21 per cent rise in staff costs. Continued enlargement of the branch network, the opening of an International Banking Centre and new sales offices combined with increases in marketing and administration costs in support of business expansion, contributed further to cost growth. Costs in Argentina rose by 30 per cent, primarily staff costs which reflected annual pay increases and additional headcount driven by accelerated business activity. In supporting the growth of the business, there was increased expenditure on branding, technology and distribution, with ongoing improvements made to the internet banking service.
Global Banking and Markets reported a pre-tax profit of US$475 million, an increase of 30 per cent compared with 2005. HSBC’s strong global presence, together with selective investment in extending service and delivery capabilities in the region, resulted in higher volumes with new and existing clients. The cost efficiency ratio improved moderately.
Total operating income increased by 23 per cent to US$846 million compared with 2005. In Brazil, balance sheet management revenues grew significantly as relatively low short-term interest rates reduced funding costs. In Argentina, higher net interest income reflected an increase in index linked securities portfolios and a growing demand for credit as regional economies and market confidence continued their recent improvement. By contrast, in Mexico, balance sheet management revenues were constrained by a flattening of the interest rate curve and relatively stable market conditions.
Net interest income from payments and cash management rose by 64 per cent as customer volumes grew, reflecting new client mandates.
Net fee income increased by 29 per cent to US$167 million, predominantly through increased performance-related fees on emerging markets funds managed by HSBC Global Asset Management. Income in securities services benefited from strong equity market indices and growth in new business as assets under custody increased significantly to US$89 billion.
In Mexico, a 32 per cent rise in payments and cash management fees was driven by a wider product offering and the leveraging of established credit related products and services.
Higher revenues from trading activities in Brazil flowed from marketing the wider product range and enhanced delivery capabilities of Global Markets. Greater volatility in local markets resulted in higher business volumes in foreign exchange and currency derivatives. In Argentina, economic and political stability increased liquidity in the market with foreign exchange trading benefiting from greater customer activity. In Mexico, a 23 per cent increase in trading income was driven by a combination of successful positioning for a flattening yield curve and higher client volumes delivered through the extended suite of products.
A net release of US$26 million in loan impairment charges reflected a stable corporate credit environment and the implementation of improved risk management strategies in Mexico.
Operating expenses rose by 20 per cent to US$346 million, primarily driven by higher staff costs reflecting increased performance-related incentives in line with revenue growth, and pay rises agreed with local unions. Higher operational costs reflected increased volumes, particularly in payments and cash management and securities services businesses, and the continued investment in building the Global Banking and Markets’ business in the region.
Private Banking reported a pre-tax profit of US$14 million, a significant increase on 2005. Profit growth was strong in both Mexico and Brazil. In Brazil, revenue and cost benefits arose from initiatives to join up the business, including cross-referrals with other customer groups. Strong revenue growth in the newly launched business in Mexico resulted primarily from greater client participation in capital markets, notably commercial paper placements, which contributed towards a 53 per cent rise in fee income. This strong performance was reflected in the cost efficiency ratio which improved by 23.4 percentage points to 65.9 per cent.
Within Other , the non-recurrence of coverage bond receipts and other items related to the 2001 Argentinean sovereign debt crisis led to lower earnings.
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Products and services
Personal Financial Services provides over 125 million individual and self-employed customers with financial services in 57 countries. The selection of products and services offered in each of these given markets is determined by HSBC’s participation strategy in that market.
In markets where HSBC already has scale or, in the case of emerging markets where scale can be built over time, HSBC offers a full range of personal financial products and services. Typically, products provided include personal banking products (current and savings accounts, mortgages and personal loans, credit cards, and local and international payment services), together with consumer finance and wealth management services.
In other markets, HSBC participates more selectively, targeting only those customer segments which have strong international connectivity or where HSBC’s global scale is crucial.
HSBC Premier is a comprehensive banking and wealth management service for mass affluent, internationally orientated customers. This premium banking service provides personalised relationship management, a single online view of all international accounts, free international funds transfer between HSBC accounts, 24-hour priority telephone access, global travel assistance and wealth management services. There are now over 2.1 million HSBC Premier customers, who can use more than 280 specially designated Premier branches and centres in 37 countries and territories, either temporarily when visiting or on a more permanent basis if they require a banking relationship in more than one country.
There are some markets where HSBC maintains a Personal Financial Services presence in order to enhance international connectivity for the customer, principally for HSBC Premier. These markets offer a more limited range of products and services.
In certain selected markets, HSBC Direct provides products specifically tailored for the online market.
Wealth management (insurance and investment products and financial planning services) plays an important part in meeting the needs of customers. Insurance products distributed by HSBC through its direct channels and branch networks include loan protection, life, property and health insurance and pensions. Acting as both broker and underwriter,
HSBC continues to see opportunities to provide insurance products to more of its customer base. HSBC also makes available a wide range of investment products. A choice of third party and proprietary funds is offered, including traditional ‘long only’ equity and bond funds; structured funds that provide capital security and opportunities for an enhanced return; and ‘fund of funds’ products which offer customers the ability to diversify their investments across a range of best-in-class fund managers chosen after a rigorous and objective selection process. Comprehensive financial planning services covering customers’ investment, retirement, personal and asset protection needs are offered through qualified financial planning managers.
Delivering the right products and services for particular target markets is a fundamental requirement in any service business, and market research and customer analysis is essential to developing an in-depth understanding of significant customer segments and their needs. This understanding of the customer ensures that customer relationship management systems are effectively used to identify and fulfil sales opportunities, and to manage the sales process.
Personal customers prefer to conduct their financial business at times convenient to them, using the sales and service channels of their choice. This demand for flexibility is met through the increased provision of direct channels such as the internet and self-service terminals, in addition to traditional and automated branches and service centres accessed by telephone.
HSBC Finance’s operations in the US, the UK and Canada make credit available to customers not well catered for by traditional banking operations, facilitate point-of-sale credit in support of retail purchases and support major affiliate credit card programmes.
HSBC Finance is a major credit card issuer in the US, offering HSBC, Household Bank, and Orchard bank branded cards together with affiliation programmes such as the GM Card and the AFL-CIO Union Plus card. HSBC Finance is also a major provider of third party private label credit cards (or store cards) through 56 merchant relationships.
High net worth individuals and their families who choose the differentiated services offered within Private Banking are not included in this customer group.
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Commercial Banking
HSBC is one of the world’s leading and most international banks, with 2.8 million Commercial Banking customers in 64 locations, including sole proprietors, partnerships, clubs and associations, incorporated businesses and publicly quoted companies. At 31 December 2007, HSBC had total commercial customer account balances of US$238 billion and total commercial customer loans and advances, net of loan impairment allowances, of US$220 billion.
HSBC segments its Commercial Banking business into corporate, mid-market, small and micro businesses, allowing the development of tailored customer propositions while adopting a broader view of the entire Commercial Banking sector, from sole traders to top-end mid-market corporations. This allows HSBC to provide continuous support to companies as they grow in size both domestically and internationally, and ensures a clear focus on the small and micro business sectors, which are typically the key to innovation and growth in market economies.
HSBC places particular emphasis on geographical collaboration to meet its business customers’ needs and aims to be recognised as the leading international business bank and the best bank for small business in target markets. The range of products and services includes:
Financing: HSBC provides a range of short and longer-term financing options for Commercial Banking customers, both domestically and cross-border, including overdrafts, receivables finance, term loans and property finance. The Group offers forms of asset finance in five sites and has established specialised divisions providing leasing and instalment finance for vehicles, plant and equipment.
Payments and cash management: HSBC is a leading provider of domestic and cross-border payments, collections, liquidity management and account services worldwide. The Group’s extensive network of offices and direct access to numerouslocal clearing systems enhances its customers’ ability to manage their cash efficiently on a global basis.
International trade: HSBC finances and facilitates significant volumes of international trade, under both open account terms and traditional trade finance instruments. HSBC also provides international factoring, commodity and insured export finance, and forfaiting services. The Group utilises its extensive international network to build customer relationships at both ends of trade flows,
and maximises efficiency through expertise in documentary checking and processing, and highly automated systems.
Treasury and capital markets : Commercial Banking customers are volume users of the Group’s foreign exchange capabilities, including sophisticated currency and interest rate options.
Commercial cards : HSBC offers commercial card services in 39 countries. Commercial card issuing provides its customers with services which enhance cash management, improve cost control and streamline purchasing processes. HSBC offers card acquiring services, either directly or as part of a joint venture, enabling merchants to accept credit card payments either in store or on the internet.
Insurance : HSBC offers insurance services in 28 sites which cover a full range of commercial insurance products designed to meet the needs of businesses and their employees, including employee benefit, pension and healthcare programmes, and a variety of commercial risks such as buildings, marine, cargo, keyman and credit protection. These products are provided by HSBC either as an intermediary (broker, agent or consultant) or as a supplier of in-house or third party offerings. HSBC also provides insurance due diligence reviews, and actuarial and employee benefit consultancy services.
Wealth management services : These include advice and products related to savings and investments provided to Commercial Banking customers and their employees through HSBC’s worldwide network, with clients being referred to Private Banking where appropriate.
Investment banking : A small number of Commercial Banking customers need corporate finance and advisory support. These requirements are serviced by the Group on a client-specific basis.
Delivery channels : HSBC deploys a full range of delivery channels, including specific online and direct banking offerings such as HSBCnet and Business Internet Banking.
Global Banking and Markets provides tailored financial solutions to major government, corporate and institutional clients worldwide. Managed as a global business, Global Banking and Markets operates a long-term relationship management approach to build a full understanding of clients’ financial requirements. Sectoral client service teams comprising relationship managers and product specialists develop financial solutions to meet individual client needs. With dedicated offices in
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over 60 countries and access to HSBC’s worldwide presence and capabilities, this business serves subsidiaries and offices of its clients on a global basis.
Global Banking and Markets is managed as four principal business lines: Global Markets, Global Banking, Principal Investments and HSBC Global Asset Management. This structure allows HSBC to focus on relationships and sectors that best fit the Group’s footprint and facilitates seamless delivery of HSBC’s products and services to clients.
Global Markets
HSBC’s operations in Global Markets consist of treasury and capital markets services for supranationals, central banks, corporations, institutional and private investors, financial institutions and other market participants. Products include:
Global Banking
HSBC’s operations in Global Banking consist of financing, advisory and transaction services for corporations, institutional and private investors, financial institutions, and governments and their agencies. Products include:
HSBC Global Asset Management
This offers asset manageme nt products and services for institutional investors, intermediaries and individual investors and their advisers.
Other products include private equity, which comprises HSBC’s captive private equity funds, strategic relationships with third party private equity managers and other investments.
HSBC’s presence in all the major wealth-creating regions has enabled it to build one of the world’s leading private banking groups, providing private banking and trustee services to high net worth individuals and their families from 90 locations in 37 countries and territories, with client assets of US$421 billion at 31 December 2007.
HSBC Private Bank is the principal marketing name of the HSBC Group’s international private banking business which, together with HSBC Guyerzeller and the private banking activities of HSBC Trinkaus & Burkhardt, provides the services noted below.
Utilising the most suitable products from the marketplace, Private Banking works with its clients to offer both traditional and innovative ways to manage and preserve wealth while optimising returns. Products and services offered include:
Investment services : These comprise both advisory and discretionary investment services. A wide range of investment vehicles is covered, including bonds, equities, derivatives, options, futures, structured products, mutual funds and alternative products, such as hedge funds and fund of funds. By accessing regional expertise located within six major advisory centres in Hong Kong, Singapore, Geneva, New York, Paris and London, Private Banking seeks to select the most suitable investments for clients’ needs and investment strategies.
Global wealth solutions : These comprise inheritance planning, trustee and other fiduciary services designed to protect existing wealth and create tailored structures to preserve wealth for future generations. Areas of expertise include trusts,
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foundation and company administration, charitable trusts and foundations, insurance and offshore structures.
Specialist advisory services: Private Banking offers expertise in several specialist areas of wealth management including tax advisory and financial planning, family office advisory, corporate finance, consolidated reporting, industry services such as charities and foundations, media, shipping, diamonds and jewellery, and real estate planning. Specialist advisers are available to deliver products and services that are tailored to meet the full range of high net worth clients’ individual financial needs.
General banking services: These comprise treasury and foreign exchange, offshore and onshore deposits, credit and specialised lending, tailor-made loans and internet banking. Private Banking works to ensure its clients have full access to relevant skills and products available throughout HSBC, such as corporate banking, investment banking and insurance.
Property
At 31 December 2007, HSBC operated from some 10,500 operational properties worldwide, of which approximately 3,300 were located in Europe, 850 in Hong Kong and Rest of Asia-Pacific, 1,850 in North America and 4,500 in Latin America. These properties had an area of approximately 69.8 million square feet (2006: 65.4 million square feet). Freehold, long leasehold and short leasehold land and buildings carried on the balance sheet represented 35 per cent of HSBC’s operational space. In addition, properties with a net book value of US$1,346 million were held for investment purposes. Of the total net book value of HSBC properties, more than 73 per cent were owned or held under long-term leases.
HSBC’s operational properties are stated at cost, being historical cost or fair value at the date of transition to IFRSs (their deemed cost) less any impairment losses, and are depreciated on a basis calculated to write off the assets over their estimated useful lives. Properties owned as a consequence of an acquisition are recognised initially at fair value.
Valuation of freehold and leasehold land and buildings
HSBC’s freehold and long leasehold properties, together with all leasehold properties in Hong Kong, were valued in 2007. The value of these properties was US$2.2 billion in excess of their carrying amount in the consolidated balance sheet.
Further details are included in Note 23 on the Financial Statements.
Legal proceedings
HSBC is party to legal actions in a number of jurisdictions including the UK, Hong Kong and the US, arising out of its normal business operations. HSBC considers that none of the actions is material, and none is expected to result in a significant adverse effect on the financial position of HSBC, either individually or in the aggregate. Management believes that adequate provisions have been made in respect of such litigation. HSBC has not disclosed any contingent liability associated with these legal actions because it is not practicable to do so, except as disclosed below.
On 27 July 2007, the UK Office of Fair Trading (‘OFT’) issued High Court legal proceedings against a number of UK financial institutions, including HSBC Bank plc, to determine the legal status and enforceability of certain of the charges applied to their personal customers in relation to unauthorised overdrafts (the ‘charges ’). Certain preliminary issues in these proceedings were heard in a trial in the Commercial Division of the High Court on 17 January 2008. This trial concluded on 8 February 2008 and judgment, on the preliminary issues tested, is awaited.
The proceedings remain at a very early stage and may, if appeals on the preliminary issues (or, subsequently, on substantive issues) are pursued, take a number of years to conclude. A wide range of outcomes is possible, depending, initially, upon whether the Court finds that some, all, or none of the charges should be tested for fairness and/or tested as common law penalties and, if it does find that some or all of the charges should be so tested, upon the Court’s subsequent assessment of each charge across the period under review. Since July 2001, there have been a variety of charges applied by HSBC Bank plc across different charging periods under the then current contractual arrangements. HSBC Bank plc considers the charges to be and to have been valid and enforceable, and intends strongly to defend its position.
If, contrary to HSBC Bank plc’s current assessment, the Court should ultimately (after appeals) reach a decision adverse to HSBC Bank plc that results in liability for it, a large number of different outcomes is possible, each of which would have a different financial impact. Based on the facts currently available to it, and a number of assumptions, HSBC Bank plc estimates that the financial impact could be approximately
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US$600 million. To make an estimate of the potential financial impact at this stage with any precision is extremely difficult, owing to (among other things) the complexity of the issues, the
number of permutations of possible outcomes, and the early stage of the proceedings. In addition, the assumptions made by HSBC Bank plc may prove to be incorrect.
Footnotes to the Business Review
The footnotes below refer to the reconciliations of reported and underlying profit before tax, and the analyses of customer groups and global businesses on pages 16 to 35 and the geographical regions on pages 36 to 125.
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Introduction
The consolidated financial statements of HSBC and the separate financial statements of HSBC Holdings have been prepared in accordance with International Financial Reporting Standards (‘IFRSs’) as endorsed by the European Union (‘EU’). EU-endorsed IFRSs may differ temporarily from IFRSs as published by the International Accounting Standards Board (‘IASB’) if, at any point in time, new or amended IFRSs have not been endorsed by the EU. At 31 December 2007, there were no unendorsed standards effective for the year ended 31 December 2007 affecting these consolidated and separate financial statements, and there was no difference between IFRSs endorsed by the EU and IFRSs issued by the IASB in terms of their application to HSBC. Accordingly, HSBC’s financial statements for the year ended 31 December 2007 are prepared in accordance with IFRSs as issued by the IASB.
Certain information for 2003 has been prepared under UK Generally Accepted Accounting Principles (‘UK GAAP’), which are not comparable with IFRSs.
HSBC uses the US dollar as its presentation currency because the US dollar and currencies linked to it form the major currency bloc in which HSBC transacts its business. Unless otherwise stated, the accounting information presented in this document has been prepared in accordance with IFRSs.
Constant currency
Constant currency comparatives for 2006 and 2005 used in the 2007 and 2006 commentaries, respectively, are computed by retranslating into US dollars, for non-US dollar branches, subsidiaries, joint ventures and associates:
No adjustment has been made to the exchange rates used to translate foreign currency denominated assets and liabilities into the functional currencies of any HSBC branches, subsidiaries, joint ventures or associates. When reference is made to ‘constant currency’ in tables or commentaries, comparative data reported in the functional currencies of HSBC’s operations have been translated at the appropriate exchange rates applied in the current period on the basis described above.
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Critical accounting policies
The results of HSBC are sensitive to the accounting policies, assumptions and estimates that underlie the preparation of its consolidated financial statements. The accounting policies used in the preparation of the consolidated financial statements are described in Note 2 on the Financial Statements.
When preparing the financial statements, it is the directors’ responsibility under UK company law to select suitable accounting policies and to make judgements and estimates that are reasonable and prudent.
The accounting policies that are deemed critical to HSBC’s IFRSs results and financial position, in terms of the materiality of the items to which the policy is applied, and which involve a high degree of judgement including the use of assumptions and estimation, are discussed below.
Impairment of loans and advances
HSBC’s accounting policy for losses arising from the impairment of customer loans and advances is described in Note 2f on the Financial Statements. Loan impairment allowances represent management’s best estimate of losses incurred in the loan portfolios at balance sheet date.
Management is required to exercise judgement in making assumptions and estimations when calculating loan impairment allowances on both individually and collectively assessed loans and advances. Of the Group’s total loans and advances to customers before impairment allowances of US$1,000.8 billion (2006: US$881.7 billion), US$6.5 billion (2006: US$5.8 billion) or 1 per cent (2006: 1 per cent) were individually assessed for impairment, and US$994.3 billion (2006: US$875.9 billion) or 99 per cent (2006: 99 per cent) were collectively assessed for impairment.
The most significant judgemental area is the calculation of collective impairment allowances. HSBC’s most significant geographical area of exposure to collectively assessed loans and advances is North America, which comprised US$301.4 billion (2006: US$284.8 billion) or 30 per cent (2006: 33 per cent) of HSBC’s total collectively assessed loans and advances. Collective impairment allowances in North America were US$11.9 billion (2006: US$7.1 billion), representing 72 per cent (2006: 65 per cent) of the total collectively assessed loan impairment allowance.
HSBC uses two alternative methods to calculate collective impairment allowances on homogeneous groups of loans that are not considered individually significant:
When appropriate empirical information is available, HSBC utilises roll-rate methodology.
Both methodologies are subject to estimation uncertainty, in part because it is not practicable to identify losses on an individual loan basis because of the large number of individually insignificant loans in the portfolio.
In addition, the use of statistically assessed historical information is supplemented with significant management judgement to assess whether current economic and credit conditions are such that the actual level of inherent losses is likely to be greater or less than that suggested by historical experience. In normal circumstances, historical experience provides the most objective and relevant information from which to assess inherent loss within each portfolio. In certain circumstances, historical loss experience provides less relevant information about the inherent loss in a given portfolio at the balance sheet date, for example, where there have been changes in economic, regulatory or behavioural conditions such that the most recent trends in the portfolio risk factors are not fully reflected in the statistical models. In these circumstances, such risk factors are taken into account when calculating the appropriate levels of impairment allowances, by adjusting the impairment allowances derived solely from historical loss experience.
This key area of judgement is subject to uncertainty and is highly sensitive to factors such as loan portfolio growth, product mix, unemployment
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rates, bankruptcy trends, geographic concentrations, loan product features, economic conditions such as national and local trends in housing markets, the level of interest rates, portfolio seasoning, account management policies and practices, changes in laws and regulations, and other factors that can affect customer payment patterns. Different factors are applied in different regions and countries to reflect different economic conditions and laws and regulations. The assumptions underlying this judgement are highly subjective. The methodology and the assumptions used in calculating impairment losses are reviewed regularly in the light of differences between loss estimates and actual loss experience. For example, roll rates, loss rates and the expected timing of future recoveries are regularly benchmarked against actual outcomes to ensure they remain appropriate.
The total amount of the Group’s impairment allowances on homogeneous groups of loans is inherently uncertain because it is highly sensitive to changes in economic and credit conditions across a large number of geographical areas. Economic and credit conditions within geographical areas are influenced by many factors with a high degree of interdependency so that there is no one single factor to which the Group’s loan impairment allowances as a whole are particularly sensitive. However, HSBC’s loan impairment allowances are particularly sensitive to general economic and credit conditions in North America. For example, a 10 per cent increase in impairment allowances on collectively assessed loans and advances in North America would increase loan impairment allowances by US$1.2 billion at 31 December 2007 (2006: US$714 million). It is possible that the outcomes within the next financial year could be different from the assumptions built into the models, resulting in a material adjustment to the carrying amount of loans and advances.
Goodwill impairment
HSBC’s accounting policy for goodwill is described in Note 2o on the Financial Statements. Note 22 on the Financial Statements sets out the Group’s cash generating units (‘CGUs’) by geographical region and global business. The most significant amount of goodwill relates to the Personal Financial Services – North America CGU, which amounts to US$10.2 billion or 30 per cent of total goodwill. The process of identifying and evaluating goodwill impairment is inherently uncertain because it requires significant management judgement in making a series of estimations, the results of which are highly sensitive to the assumptions used. The
review of goodwill impairment represents management’s best estimate of the factors below.
Firstly, significant management judgement is required in estimating the future cash flows of the CGUs. These values are sensitive to the cash flows projected for the periods for which detailed forecasts are available, and to assumptions regarding the long-term pattern of sustainable cash flows thereafter. Forecasts are compared with actual performance and verifiable economic data in future years; however, the cash flow forecasts necessarily and appropriately reflect management’s view of future business prospects. Note 22 shows how the key assumptions used in estimating future cash flows for each CGU have changed from 2006 to 2007.
Secondly, the cost of capital assigned to an individual CGU and used to discount its future cash flows can have a significant effect on the CGU’s valuation. The cost of capital percentage is generally derived from a Capital Asset Pricing Model, which incorporates inputs reflecting a number of financial and economic variables, including the risk-free interest rate in the country concerned and a premium to reflect the inherent risk of the business being evaluated. These variables are established on the basis of significant management judgement and are subject to uncertainty.
When this exercise demonstrates that the expected cash flows of a CGU have declined and/or that its cost of capital has increased, the effect is to reduce the CGU’s estimated fair value. If this results in an estimated recoverable amount that is lower than the carrying value of the CGU, a charge for impairment of goodwill will be recorded, thereby reducing by a corresponding amount HSBC’s profit for the year.
Note 22 on the Financial Statements includes details of the CGUs with significant balances of goodwill, and states the key assumptions used to assess the goodwill in each CGU for impairment.
Goodwill impairment testing performed in 2007 and 2006 indicated that there was no impairment of goodwill. It is possible that the outcomes within the next financial year could be different from the assumptions used, resulting in a material adjustment to the carrying amount of goodwill. In particular, the deterioration in the economic and credit conditions in North America has resulted in a severe decline in the profitability of the North American consumer finance business during 2007, and as a result goodwill impairment in the Personal Financial Services – North America CGU was re-tested as at 31 December 2007. Notwithstanding these conditions, the recoverable amount based on
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Critical accounting policies > Financial summary / Income statement
expected cash flows continued to exceed the carrying amount including goodwill in the CGU, and therefore no goodwill impairment has occurred. However, in the event of further significant deterioration in the economic and credit conditions beyond the levels already reflected by management in the cash flow forecasts for the CGU, a further special review would be made, in addition to the annual review of the carrying value, including goodwill against the recoverable amount for the CGU. If this review indicated that the deterioration in current conditions and future outlook is sufficiently severe, this could result in a material adjustment to the carrying amount of goodwill.
Valuation of financial instruments
HSBC’s accounting policy for valuation of financial instruments is described in Note 2d on the Financial Statements.
The best evidence of fair value is a quoted price in an actively traded market. If the market for a financial instrument is not active, a valuation technique is used. The majority of valuation techniques employ only observable market data, and so the reliability of the fair value measurement is high. However, certain financial instruments are valued on the basis of valuation techniques that feature one or more significant market inputs that are not observable. Valuation techniques that rely to a greater extent on non-observable inputs require a higher level of management judgement to calculate a fair value than those based wholly on observable inputs.
Valuation techniques used to calculate fair values include comparisons with similar financial instruments for which market observable prices exist, discounted cash flow analysis, option pricing models and other valuation techniques commonly used by market participants. Valuation techniques incorporate assumptions that other market participants would use in their valuations, including assumptions about interest rate yield curves, exchange rates, volatilities, and prepayment and default rates. When valuing instruments by reference to comparable instruments, management takes into account the maturity, structure and rating of the instrument with which the position held is being compared.
The main assumptions and estimates which management considers when applying a model with valuation techniques are:
When applying a model with unobservable inputs, estimates are made to reflect uncertainties in fair values resulting from a lack of market data inputs, for example, as a result of illiquidity in the market. For these instruments, the fair value measurement is less reliable. Inputs into valuations based on non-observable data are inherently uncertain because there are little or no current market data available from which to determine the level at which an arm’s length transaction would occur under normal business conditions. However, in most cases there are some market data available on which to base a determination of fair value, for example historical data, and the fair values of most financial instruments will be based on some market observable inputs even where the non-observable inputs are significant.
Note 33 on the Financial Statements provides an analysis of the basis for valuation of financial instruments measured at fair value in the financial statements. The value of financial assets and liabilities that use a valuation technique are US$625.5 billion and US$400.7 billion or 66 per cent and 68 per cent of total assets and total liabilities measured at fair value respectively. Note 33 on the Financial Statements presents a sensitivity analysis of fair values for financial instruments with significant unobservable inputs to reasonably possible alternative assumptions. Given the uncertainty and subjective nature of valuing financial instruments at fair value, it is possible that the outcomes within the next financial year could be different from the assumptions used, and this would result in a material adjustment to the carrying amount of financial instruments measured at fair value.
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Income statement
The strength of HSBC’s diversified business model was demonstrated by profit growth in a year in which financial markets experienced significant dislocation and the credit environment, particularly in the US, deteriorated markedly. Pre-tax profits in 2007 increased by 10 per cent to US$24.2 billion and earnings per share rose by 18 per cent to US$1.65. Despite unprecedented market conditions, the return on shareholders’ equity exceeded 15 per
cent, capital ratios remained strong, revenue growth was in double digits and the cost efficiency ratio improved. For the first time in recent years, pre-tax profits from the Group’s emerging markets operations exceeded 60 per cent of total profits.
On an underlying basis, profit before tax was broadly in line with 2006. This was arrived at after excluding the effects of a US$1.1 billion gain from the dilution of holdings in associates in mainland China, restating comparative information using the average exchange rates applicable in 2007, and
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adjusting for acquisitions and disposals. The table on page 15 provides a more detailed reconciliation of reported and underlying profit before tax.
These results illustrated the benefit derived from the Group’s broad diversification, both geographically and by range of business. An excellent performance in Asia in all customer groups compensated for the effect of deteriorating conditions in the US and slower growth in other mature markets. Commercial Banking and Private Banking again delivered record results, as did many of the businesses within the newly designated Global Banking and Markets segment.
In Asia, the Group had a notably strong year. Vigorous economic activity across the region, strong trade flows and buoyant equity markets helped drive underlying profit growth of 42 per cent in Hong Kong and 34 per cent in Rest of Asia-Pacific. This growth was broadly based, with profits in all customer groups and in each of the main countries in which HSBC operates ahead of 2006. Results in Latin America were also better than in 2006, as an excellent performance in Brazil more than offset higher loan impairment charges in Mexico.
Pre-tax profits in North America fell significantly as loan impairment charges rose and trading income declined. What began in 2006 as a deterioration in credit quality in a particular portfolio of purchased mortgages in the US consumer finance business, widened in the second half of 2007 to affect the consumer lending business as a whole as economic conditions deteriorated in the US, the housing market contracted and market liquidity for asset-backed securities dried up. This lack of liquidity also adversely affected credit trading and asset-backed securities businesses within Global Banking and Markets where de-leveraging of traded markets contributed to volatility and lower valuations. The effect of these factors was partially offset by a gain on HSBC’s own debt designated at fair value.
Within Europe, underlying pre-tax profit performance was mixed, mainly as a consequence of ex gratia payments expensed in respect of overdraft fees applied in previous years and a provision for reimbursement of certain charges on historic will trusts and other related services. Offsetting this was a large fair value gain on the valuation of the portion of the Group’s own debt that is carried at fair value. Encouragingly, Personal Financial Services in the UK proved very successful in attracting deposit balances, which rose 15 per cent on 2006.
In 2007, notwithstanding the severe disruption in traded markets, Global Banking and Markets
delivered higher profits, which rose by 5 per cent to US$6.1 billion. This was driven by record results in its foreign exchange, payments and cash management, equities, HSBC Global Asset Management and securitie s services businesses; these more than offset the significant write-downs inthe Credit and Rates businesses, largely the consequence of the market-related factors discussed above.
HSBC made a profit before tax of US$22.1 billion, a rise of US$1.1 billion, or 5 per cent, compared with 2005. Incremental contributions to pre-tax profit from Metris in the US, the Argentine retail operations acquired from Banca Nazionale and Ping An Insurance in mainland China, less the profits of Cyprus Popular Bank, which was sold during the year, accounted for US$347 million of the increase in pre-tax profit in the period. These represented the bulk of changes in the constitution of the Group. On an underlying basis, which is described on page 131, profit before tax increased by 3 per cent.
Average invested capital increased by US$10.6 billion compared with 2005 and return on that capital fell slightly by 1.0 per cent to 14.9 per cent. Revenue growth was 13 per cent and the cost efficiency ratio was broadly unchanged at 51.3 per cent; the Group’s Tier 1 ratio strengthened to 9.4 per cent.
HSBC’s results in 2006 reflected the benefits of diversified earnings. There were a number of outstanding achievements, for example, exceeding US$1 billion pre-tax profits for the first time in Mexico and the Middle East, and in each of the Group Private Banking and Commercial Banking businesses in Rest of Asia-Pacific. HSBC added approximately US$1 billion in extra pre-tax profits in Rest of Asia-Pacific and globally in the Commercial Banking businesses.
However, results in 2006 also reflected a decline in pre-tax profits of around US$725 million in the Group’s personal businesses in the US as a portfolio of sub-prime mortgages purchased by a subsidiary of HSBC Finance, mortgage services, suffered much higher delinquency than had been built into pricing these products.
Earnings continued to be well diversified, both geographically and by customer group. Regionally, Asia including Hong Kong had record results as did the Group’s newly designated Latin America region, which combines Mexico and Central America with HSBC’s South American businesses. Within the
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Customer Groups, Commercial Banking again delivered a record performance, as did Private Banking and Global Banking and Markets, which made strong progress in the areas in which the Group has been investing in recent years. Personal Financial Services declined as growth in Asia and Latin America was masked by the problems in the US mortgage services business.
The economic backdrop in 2006 was favourable. Global equity markets enjoyed strong gains for much of the year, encouraging expanded investment flows and creating a receptive marketplace for the high level of mergers and acquisitions and IPO activity which followed. However, in these favourable conditions, the cumulative effect of rising short-term rates, benign credit conditions and strong liquidity put pressure on interest margins.
The credit environment for corporate and commercial lending continued to be exceptionally good. However, on the back of slowing housing markets and rising interest rates, a marked deterioration was experienced in the sub-prime mortgage market in the US. This more than outweighed the non-recurrence in 2006 of loan impairment costs associated with a surge in bankruptcy filings in the US in the fourth quarter of 2005, and the effect of hurricane Katrina.
Net operating income before loan impairment charges and other credit risk provisions of US$65.4 billion was US$7.7 billion or 13 per cent higher than in 2005, 11 per cent higher on an underlying basis. Commercial Banking, Global Banking and Markets and Private Banking operations all achieved strong double-digit growth.Operating income performance was well spread geographically, with the strongest growth in HSBC’s operations in Asia and in Latin America.
Loan impairment and other credit risk provisions, expressed as a percentage of gross average advances to customers, at 1.4 per cent, were 20 basis points higher in 2006 than the 1.2 per cent recorded in 2005. There was also a 20 basis point
rise in the ratio of new loan impairment charges to gross average advances to customers, from 1.4 per cent in 2005 to 1.6 per cent in 2006. The charge of US$10.6 billion was US$2.8 billion, or 36 per cent, higher than in 2005, 30 per cent higher on an underlying basis. Of this increase, approximately 60 per cent arose in the Group’s Personal Financial Services businesses in North America, with the major increase being in the US sub-prime mortgage portfolio acquired through mortgage services. Impairment charges in the UK were broadly stable as a percentage of lending to customers despite a rising trend of consumer recourse to debt mitigation arrangements. There was also some credit deterioration in a few emerging market countries, notably in the first half of 2006, as a consequence of regulatory changes.
Total operating expenses of US$33.6 billion were US$4.0 billion or 14 per cent higher than in 2005, 11 per cent higher on an underlying basis. Much of the growth reflected investment to expand the Group’s geographic presence and add product expertise and sales support. This expansion was most marked in Personal Financial Services in North America, and in Global Banking and Markets, where the cost efficiency ratio improved slightly as strong revenue growth offset the first full year effect of investment expenditure in previous years.
HSBC’s share of profit in associates and joint ventures increased by US$202 million, with improved contributions from The Saudi British Bank, Bank of Communications and Industrial Bank, supplemented by a first full year contribution from Ping An Insurance. HSBC’s share of profits from investments in associates in Rest of Asia-Pacific accounted for nearly a quarter of the profits from that region. For further detailed discussion and analysis by geographical segment of the Group’s results see Report of the Directors: Business Review from page 76.
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Net interest income of US$37.8 billion increased by 10 per cent, 4 per cent on an underlying basis. The commentary below is on an underlying basis.
The change in net interest income was influenced by the following factors:
In Europe, net interest income declined by 18 per cent. This was mainly driven by the expansion of trading activities in both the UK and France which resulted in higher funding costs, with the related revenues reported in the trading income line, as discussed above. This was partly offset by higher net interest income in the personal and commercial businesses.
In the UK, Personal Financial Services’ spreads widened in a rising interest rate environment and competitive pricing attracted higher balances. This was mitigated by lower spreads on mortgages as customers switched to fixed rate products. In Commercial Banking, higher net interest income was largely driven by growth in the UK, Turkey, Germany and Malta. The launch of a negotiated rate deposit product in previous years continued to prove successful in driving higher deposit balances. Strong growth in corporate and structured banking for micro customers, together with expansion in lending to small and mid-market customers, contributed to higher lending balances in the UK, although this
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benefit was partially constrained by spread compression in a competitive market.
Revenues from transactional balances held within the payments and cash management business increased by 13 per cent, as credit market dislocation in the second half of the year caused customers to hold higher cash balances. After several periods of decline, balance sheet management revenues in Europe increased.
In Turkey, higher net interest income was driven by new customer acquisition. In Switzerland, the Private Banking business earned higher net interest income from lending to existing clients as they further leveraged their portfolios.
In Hong Kong, net interest income rose by 17 per cent, driven by growth in asset and liability products in the personal, commercial and corporate businesses. Net interest income from Global Banking and Markets increased by 79 per cent as balance sheet management revenues recovered and deposits grew strongly with higher spreads. A rise in liabilities to fund trading activities reduced net interest income, with a corresponding rise in trading income.
Personal Financial Services’ net interest income grew by 16 per cent, driven by wider spreads on higher deposit balances. The relaunch of HSBC Premier contributed to the growth in deposit balances. Card balances were also higher, following a number of promotional programmes during the year. In Commercial Banking, strong economic growth helped generate demand for savings products and this, combined with strong customer acquisition, resulted in higher net interest earned from liability products.
In Rest of Asia-Pacific, HSBC continued to invest in expanding the branch network, particularly in the large markets of mainland China, Indonesia and India. This, combined with increased marketing and greater brand awareness, accelerated customer acquisition and consequently growth in loans and deposits. Net interest income across the region rose by 30 per cent.
In the Middle East, net interest income increased significantly, driven by balance sheet expansion across all customer groups, augmented by improved yields. Balance sheet growth was underpinned by a strong local economy, higher oil prices and demand for credit for infrastructure investment.
In Global Banking and Markets, higher net interest income was driven by the recovery in balance sheet management revenues. As trade and
investment flows increased, higher transactional balances in the payments and cash management businesses also delivered higher net interest income.
In Personal Financial Services, net interest income rose by 23 per cent, driven by higher personal lending, credit cards and deposit balances. Growth was broad-based across the region. Commercial Banking net interest income grew by 29 per cent. Expansion of the branch network, call centres and Business Internet Banking helped to drive an increase in customer numbers which, in turn, led to deposit and loan growth.
Net interest income in North America rose by 4 per cent, as higher revenues from payments and cash management, commercial lending and cards were offset by lower mo rtgage balances, spread compression and higher non-performing balances.
Overall average lending balances were 5 per cent higher, as growth in credit cards and vehicle finance offset lower mortgage balances. The benefits of higher volumes were largely offset as asset spreads narrowed due to higher funding costs. Also, although deposit balances rose, spreads reduced as the product mix shifted to higher yielding products. Business expansion and higher customer volumes drove growth in loans and deposits in Commercial Banking. A 43 per cent increase in revenue from payments and cash management was due to higher customer balances.
In Latin America, net interest income increased by 17 per cent. Growth was strong across the region, with net interest income rising by 22 and 11 per cent in Mexico and Brazil, respectively.
In Mexico, notwithstanding lower balance sheet management revenues, higher net interest income was due to both asset and liability growth. In particular, increased credit card balances were driven by marketing and portfolio management initiatives to improve customer retention and card usage. Net interest income in Brazil increased as the sound economic outlook and falling interest rates resulted in strong demand for credit.
Average interest-earning assets (‘AIEA’) of US$1,297 billion were US$121 billion, or 10 per cent, higher than 2006 on an underlying basis.
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Net interest income of US$34.5 billion was 10 per cent higher than in 2005 and 7 per cent higher on an underlying basis. The commentary that follows is on an underlying basis.
Movements in net interest income were particularly influenced by the following factors:
In Europe, net interest income increased by 1 per cent. The benefit of balance growth in Personal Financial Services and Commercial Banking was substantially offset by the increased deployment of liabilities to the fund trading activity referred to
above; there was a corresponding rise in trading income. This was most pronounced in the UK and France.
In the UK, growth in Personal Financial Services was strong in savings and packaged current accounts, but mortgage and credit card lending also increased. In Commercial Banking, customer recruitment boosted growth in deposit balances and spreads widened, particularly on US dollar denominated accounts. Commercial lending balances were higher, in part reflecting the strong growth throughout 2005. In France, revenues declined despite growth in lending, due to competitive pricing pressures and the impact of older, higher-yielding hedges of the network’s funding surplus maturing. Global Banking and Markets’ balance sheet management revenues declined as the rising trend in short-term interest rates continued to flatten yield curves.
In Hong Kong , net interest income rose by 15 per cent. Deposit spreads widened with progressive interest rate rises, and balances increased as customers took advantage of higher rates. HSBC supported this growth with a number of promotions and marketing campaigns during the year. In Personal Financial Services, average savings and deposit balances rose by 7 per cent. The launch of a simplified mortgage pricing structure helped boost mortgage balances and grow market share. A clear focus on sales and targeted marketing helped achieve strong growth in credit card balances, and the number of cards in issue rose by 17 per cent to 4.6 million. Average corporate lending balances rose as the economy gained momentum and investment was channelled into mainland China. The benefit of these developments, however, was substantially offset by spread compression through the rising cost of funds, and lower balance sheet management revenues as short-term interest rates continued to rise, and yield curves remained flat.
In Rest of Asia-Pacific , a 25 per cent rise in net interest income was fuelled by balance sheet growth in Personal Financial Services and Commercial Banking. This reflected HSBC’s continuing investment in growing the business through network expansion, customer recruitment and targeted marketing and promotions. In Personal Financial Services, the emphasis on the recruitment of HSBC Premier customers generated strong deposit growth throughout the region, which funded increased mortgage and credit card borrowing. Other unsecured lending balances also grew significantly, as HSBC expanded its consumer finance operations in India, Australia and Indonesia. In corporate and commercial banking, increased deposits raised
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through customer recruitment and through higher transactional balances in the payments and cash management and the custody businesses were significant to the growth in net interest income. On the asset side, growth reflected strong demand for credit as regional economies continued to expand and trade flows increased.
In North America, net interest income increased by 3 per cent. In the US Personal Financial Services business, strong growth in mortgages, cards, and other personal unsecured non-credit card lending was funded by a 21 per cent rise in average deposits to US$32.2 billion. This was led by the continued success of the online savings product which grew by US$6 billion to US$7 billion at 31 December 2006. Higher spreads in credit cards, reflecting a lower proportion of promotional balances and a degree of re-pricing, were in contrast with most other portfolios. Overall, asset spreads contracted, driven by the effect on funding costs of a succession of interest rate rises, while competitive pricing and customer migration to higher yielding products reduced spreads on deposits. Net interest income was boosted in Canada by strong lending to personal and commercial customers, supported by deposit raising initiatives. However, these benefits were partly offset by lower Global Banking and Markets’ balance sheet management income as spreads narrowed as a result of higher short-term rates coupled with a flat yield curve in the US. The increased deployment of liabilities to fund trading
activity also reduced growth in net interest income, with a corresponding increase in trading income.
In Latin America , net interest income increased by 17 per cent. In Mexico, deposit growth was boosted by the continuing success of the Tu Cuenta packaged account in Personal Financial Services. Credit card, unsecured lending and mortgage balances also grew strongly, though the benefit of the latter was offset by competitive pressure on spreads. In Brazil, where the domestic economy improved and inflation remained low, rising consumer demand for credit, together with increased sales activity and customer recruitment, drove strong lending growth. Deposits rose through current accounts linked to the growing payroll loan business. Growth in Commercial Banking was mainly in the small and middle market customer segments. HSBC increased focus on these businesses through network expansion and the recruitment of additional sales staff throughout the region. In Global Banking and Markets, improved balance sheet management revenues and growth in the payments and cash management business were the major contributors to interest income growth.
AIEA of US$1,113 billion were US$114 billion, or 11 per cent, higher than in 2005. On an underlying basis, growth was 10 per cent. HSBC’s net interest margin was 3.10 per cent in 2006, compared with 3.14 per cent in 2005.
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Net fee income increased by 28 per cent to US$22.0 billion, 23 per cent on an underlying basis. The commentary that follows is on an underlying basis.
In Europe, fee income rose by 11 per cent. Account services increased on higher customer balances and volumes of transactions, supported by
sales of fee-earning packaged accounts in the UK. In France, HSBC recorded an increase in transaction volumes while growth in client assets resulted in higher commission income in Private Banking. Card fees increased in the UK and Turkey, mainly on interchange and acquiring fees. This was partly offset by a reduction in default fees in the UK following regulatory intervention by the OFT in 2006. Broking income increased in the UK, Germany and Switzerland, mainly driven by growth in client assets and transaction volumes. Funds under management decreased on lower income from the Hermitage Fund due to the part sale of fund holdings.
In Hong Kong , buoyant stock market activity drove income on a number of commission lines. Broking and global custody income rose as larger trading volumes were registered on higher stock exchange daily turnover. This was enhanced by the launch of new investment schemes, awareness campaigns and the adoption of a new portfolio wealth management sales tool in the branch network. An increase in IPO activity through Hong Kong, mainly derived from mainland China, positively affected underwriting fees. Life insurance commission income increased, boosted by the launch of new products.
In Rest of Asia-Pacific , fee income increased by 34 per cent. Buoyant stock markets stimulated customer appetite for unit trusts and other investment products. Strong investment sales were recorded in India, Philippines, South Korea,
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Singapore and mainland China. Security services increased, driven by a sustained level of transaction volumes and investment flows. In the Middle East, increases were registered in cards, global custody, credit facilities and insurance. Increased trade services income in the region reflected higher intra-regional trade flows, which were driven by strong economic performance.
In North America, card fee income rose as a result of higher balances attracting late and over-limit fees. The Intellicheck service, which allows customers to pay their credit card balances over the telephone for a fee, proved popular with customers. Revenues from enhancement services on cards which offer services such as debt protection and identity protection, rose on higher sales. Payments and cash management fees also increased on higher volumes generated. Canada registered growth in investor administration fees and fees on the immigrant investor programme. Account services fees also increased.
In Latin America, card fee income rose, mainly due to increased volumes and balances in Mexico. The use of debit and credit cards grew, in part driven by the extended ATM network. Strong growth in customer accounts delivered higher transactional fees and the continuing success of the Tu Cuenta product led to increased take-up with higher product fees charged to customers. Lending-related fees increased in Brazil, aided by higher current account and payments and cash management fees.
Net fee income of US$17.2 billion was 19 per cent higher than in 2005, or 16 per cent higher on an underlying basis. The commentary that follows is on an underlying basis.
In Europe , account service fees increased as a result of customer acquisition, higher sales of packaged products and increased transaction volumes. Rising stock markets led to higher sales of investment products and growth in funds under management, while product mix improvements and service enhancements also contributed to a rise in investment fees. Higher performance fees in respect of the Hermitage Fund contributed an additional US$23 million in fee income, net of performance fees paid to the fund’s investment advisor. Offsetting these increases, HSBC’s decision to constrain unsecured lending growth in the UK resulted in lower creditor protection insurance fees.
In Hong Kong , a buoyant IPO market together with product launches and enhancements contributed to higher sales of investment products; this was augmented by increased transaction volumes following strong growth in local and regional equity markets. As global customers continued to seek investment opportunities in emerging markets, funds under management increased. Growth in cards in issue led to higher card fees.
In Rest of Asia-Pacific , higher trade and remittance flows led to increased payments and cash management income. Investment flows into emerging market funds triggered growth in custody and funds administration fees, while rising equity markets and product launches contributed to increased investor demand and higher income from custody, brokerage and the sale of investments.
In North America , card fees increased as a result of higher balances and improved interchange rates, while private label card fees benefited from renegotiations with a number of merchants.
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Increases in 2006 were partly offset by the effect of FFIEC guidance, which limits certain fee billings for non-prime credit card accounts. Following its launch in 2005, activity within HSBC’s mortgage-backed securities business increased rapidly during 2006. As a result, a greater proportion of loans originated by HSBC were sold to the secondary market and mortgage servicing fees grew accordingly, while income in the mortgage-backed securities business also rose. Tariff increases contributed to higher account service fees. Higher business volumes led to a rise in taxpayer services fees, while the WTAS
business progressed strongly, expanding its customer base and reporting significantly higher fee income.
In Latin America , increased cards in circulation and improvements in activation times led to higher card issuing fees, while growth in the merchant customer base led to a rise in card acquiring income. Account servicing fees benefited from higher packaged account sales, enhancements to other current account products, price increases and greater transaction volumes. The expansion of HSBC’s ATM network in Mexico drove higher ATM fees.
Net trading income increased by 20 per cent to US$9.8 billion, 13 per cent on an underlying basis. The following commentary is on an underlying basis.
In line with Global Banking and Markets’ focus on emerging markets, total income from trading in Asia and Latin America increased by 42 per cent, dominated by foreign exchange trading and reflecting the benefit of HSBC’s strong and diversified distribution network.
Net trading income was significantly affected by a total of US$2.1 billion of write-downs on credit trading, leveraged and acquisition financing positions, and monoline credit exposures resulting
from deterioration in the credit market in the second half of the year. The write-downs arose mainly in the US and, to a lesser extent, the UK.
Income from foreign exchange trading increased by 40 per cent, a record result. Revenues were driven by higher customer volumes, against the backdrop of a weakening US dollar and greater market volatility.
A trading loss of US$419 million in Credit and Rates compared with income of US$1.3 billion in 2006. US$1.1 billion of this arose in the second half of 2007. This was due to the write-downs discussed above.
Trading income from structured derivatives fell by 26 per cent. The structured credit business incurred losses in the second half of the year due to the difficult trading conditions described above.
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This was partly offset by higher trading income from other structured derivative products, following investment made in technical expertise and systems in previous years.
Record results were achieved in the equities business reflecting strong growth across all regions particularly in Europe, which benefited from effective product differentiation, notably in emerging market products.
In Europe, trading income increased by 41 per cent, driven by the equities business and foreign exchange trading, where income increased strongly, with volume and profitability driven by market volatility. This was partly offset by the write-downs in credit, structured derivatives and leveraged and acquisition finance.
Net trading income in Europe increased following the strategic decision to expand the collateralised lending and structured derivatives businesses, the funding costs of which are reported in ‘Net interest income’.
Income growth in Hong Kong was achieved throughout the Global Markets business, assisted by investments made in recent years to grow the product range and customer base. HSBC had only very limited exposure to asset-based securities and structured credit products in Hong Kong.
Strong growth was delivered in Rest of Asia-Pacific, led by foreign exchange trading, with higher volumes driven by increased volatility which, in turn, increased customer demand for risk management products.
HSBC’s operations in North America incurred a trading loss following write-downs in credit, structured derivatives, and leveraged and acquisition finance for the reasons noted above. This was compounded by trading losses on purchased loans in the mortgage services wholesale business in response to which, HSBC closed the business. By contrast, foreign exchange recorded a strong performance, supported by activity generated by the declining US dollar and volatile markets.
Net trading income increased significantly in comparison with 2005, reflecting the investment made in widening Global Markets’ product range and developing its sales and execution capabilities. Positive revenue trends were recorded in key product areas, although the rate of income growth slowed in the second half of the year, principally due to lower
market volatility and a decrease in deal volumes in the third quarter.
Income from structured derivatives grew by 74 per cent, as investments in technical expertise and systems enabled HSBC to address a broader spectrum of client needs. Increased market volatility, together with expansion in the provision of structured fund products, resulted in higher customer volumes. As the business matured and markets deepened and became more transparent, revenues were boosted by a rise of US$193 million in the recognition of income deferred in previous periods.
Foreign exchange income remained strong throughout 2006, principally driven by an increase in customer activity encouraged by US dollar weakness and volatility in emerging markets. In the metals trading business, revenues doubled, primarily due to the underlying strength in precious metals and increased price volatility.
Within the credit and rates business, higher gains from interest rate derivatives and emerging market bonds reflected increased volumes of new deals, a tightening of credit spreads and greater interest rate volatility.
In Europe, a significant increase in trading income was driven by higher foreign exchange flows and a greater focus on emerging market products. Overall, customer volumes rose, as increased hedging activity and a change in risk appetite among investors drove a general improvement in market sentiment towards developing economies.
On an underlying basis trading income in Rest of Asia-Pacific grew by 35 per cent, driven by HSBC’s strong distribution network and experience in developing markets activity, which contributed to particularly strong increases reported in India the Middle East and mainland China.
Performance in HSBC’s operations in the US remained robust benefiting, in part, from the first full year contribution from the US residential mortgage-backed securities business and successful product launches in structured derivatives.
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Net income from financial instruments designated at fair value
HSBC adopted ‘Amendment to IAS 39 Financial Instruments: Recognition and Measurement: the Fair Value Option’ with effect from 1 January 2005. HSBC may designate financial instruments at fair value under the option in order to remove or reduce accounting mismatches in measurement or recognition, or where financial instruments are managed, and their performance is evaluated, together on a fair value basis. All income and expense on financial instruments for which the fair value option was taken were included in this line
except for issued debt securities and related derivatives, where the interest components were shown in interest expense.
HSBC used the fair value designation principally in the following instances:
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Net income from financial assets designated at fair value which are held to support liabilities for both insurance and investment contracts, is presented as ‘Net income from financial instruments designated at fair value’. For investment contracts, where the liabilities to policyholders are designated at fair value, the movement in the value of the liabilities is presented in ‘Net income from financial instruments designated at fair value’ in the income statement. However, for insurance contracts, the movement in liabilities arising from the net income allocated to the policyholder is presented in ‘Net insurance
claims incurred and movement in liabilities to policyholders’.
Credit spreads widened significantly in the second half of 2007, leading to a substantial increase in net income from financial instruments designated at fair value compared with 2006. This was primarily driven by a widening in credit spreads on certain fixed-rate long-term debt, issued by HSBC Holdings and its subsidiaries. These cumulative gains will fully reverse over the life of the debt. The cumulative adjustment to reserves where the policy is applied for the first time and, subsequently, the income statement in terms of change in own credit spread since the fair value option was available, is US$1.6 billion after taking account of the US$3.1 billion credit in 2007.
Income from assets held to meet liabilities under insurance and investment contracts also rose by 32 per cent, mostly from premium growth and higher investment returns on the portfolios held by the insurance businesses in the UK and Hong Kong. The change in fair value of liabilities under investment contracts declined by 7 per cent.
Net income from financial instruments designated at fair value decreased compared with 2005. This was primarily driven by a narrowing (i.e. improvement) in credit spreads on certain fixed-rate long-term debt issued by HSBC Finance and lower net mark-to-market movements on this debt and the related interest rate swaps. During 2006, HSBC Finance’s debt received improved ratings from both Moody’s and S&P. Perversely, this improvement generated accounting losses of some US$388 million which will reverse over the residual maturity of the debt instruments.
Income from assets held to meet liabilities under insurance and investment contracts was some 12 per cent lower, reflecting movements in the market values of assets. The increase in the fair value of liabilities under investment contracts was 10 per cent lower than in 2005.
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Gains less losses from financial investments
Net gains of US$2.0 billion were reported by HSBC as a result of the disposal of financial investments during 2007, 102 per cent higher than in 2006, 93 per cent on an underlying basis. The following commentary is on an underlying basis.
In Europe, the sale of shareholdings and various equity investments in the UK and France, including the disposal of shares in Euronext (the European stock exchange), contributed to net gains of US$1.3 billion, an increase of 101 per cent from 2006. In Private Banking, gains of US$91 million arose from the sale of a further holding in the Hermitage Fund, compared with US$117 million in 2006.
In Hong Kong, gains were 42 per cent less than in 2006 as a result of the non-recurrence of a US$101 million gain on the partial sale of HSBC’s stake in UTI Bank Limited, an Indian retail bank, in that year.
Gains of US$245 million in North America were primarily attributable to the sale of shares in MasterCard and gains in Latin America largely arose from the sale of equity holdings in Brazil, including HSBC’s holding in a credit bureau.
HSBC reported net gains of US$969 million from the disposal of available-for-sale financial
investments during 2006, 40 per cent higher than in 2005. On an underlying basis, gains were 35 per cent greater than in 2005. Gains from financial investments were mainly attributable to the following transactions:
Gains arising from dilution of interests in associates
HSBC’s associates, Industrial Bank, Ping An Insurance and Bank of Communications in mainland China; Financiera Independencia in Mexico and Techombank in Vietnam, issued new shares for which HSBC did not subscribe. As a consequence of the new monies raised by the associates, HSBC’s share of their underlying assets increased by US$1.1 billion, notwithstanding the reduction in the Group’s interests. These gains are presented in the
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income statement as ‘Gains from dilution of the Group’s interests in associates’, and should be
regarded as exceptional. For further details see Note 4 on the Financial Statements.
Net earned insurance premiums of US$9.1 billion were 60 per cent higher than in 2006. This was boosted by HSBC’s acquisition in the first half of 2007 of the remaining shares in HSBC Assurances in France and the purchase of HSBC Bank Panama in Central America in late 2006. Underlying net insurance premiums grew by 21 per cent. The following commentary is on an underlying basis.
In Europe, net earned insurance premiums increased by 50 per cent to US$4.0 billion, including growth of the Guaranteed Income Bond and motor insurance, and the introduction of enhanced death benefits to pension contracts in the UK. Premiums also grew in the UK because of a higher retention of risk compared with 2006, when a greater proportion of risk and corresponding premiums were ceded to reinsurers. There were also significant contributions from increased reinsurance business in Ireland and from the life assurance business in Malta.
In Hong Kong, net earned insurance premiums increased by 7 per cent to US$2.8 billion, as the life assurance business expanded with the launch of new products.
In the Rest of Asia-Pacific region, net earned insurance premiums increased by 24 per cent to US$226 million. This growth was mainly generated in Malaysia by the HSBC Amanah Takaful business which was launched in late 2006, offering shariah-compliant insurance products.
In North America , net earned insurance premiums decreased by 9 per cent to US$449 million, as the decline in loan volumes led to a fall in credit insurance sales and HSBC stopped reinsuring credit insurance for other lenders.
In Latin America , net earned insurance premiums increased by 32 per cent to US$1.6 billion. There was good growth in all of HSBC’s insurance businesses in the region. Higher premiums in Brazil were driven by increased sales of pension products with linked-life policies. In Argentina, the growth was led by the motor insurance businesses and, in Mexico, the primary driver was life assurance.
Net earned insurance premiums of US$5.7 billion were 4 per cent higher than in 2005, 3 per cent on an underlying basis. The commentary that follows is on an underlying basis.
In Europe, net earned premium income decreased by 19 per cent to US$1.3 billion. This was largely in the UK, where lower sales of single premium insurance contracts, a lower market appreciation of investment assets and the effect of changes in reinsurance arrangements were the principal drivers of the decrease.
In Hong Kong , net earned premium income increased by 13 per cent, driven by the life insurance business. New products, many designed to meet financial needs identified in HSBC’s global study on the future of retirement, were supported by increased
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promotional and marketing activity, and the development of internet and telephone distribution channels. Sales rose in consequence.
In Rest of Asia-Pacific, net earned premium income rose by 5 per cent growth to US$174 million. This was concentrated in Singapore and reflected the success of new product launches, supported by increased marketing. Increased sales of individual life policies were the main driver of the growth. HSBC continued to expand its insurance business across Rest of Asia-Pacific with a number of initiatives including the establishment of HSBC’s first Islamic insurance company in Malaysia.
In North America, the modest rise in net premium income to US$492 million reflected growth from new life business underwritten in 2006, which
was substantially offset by a decline in the non-life business.
Improved cross-selling drove growth across Latin America, and income rose by 18 per cent to US$1.1 billion. In Mexico, growth in individual life, casualty and motor insurance was partly offset by increased reinsurance costs. In Brazil, growth was led by strong sales of both life and pension products. In Argentina, increased advertising partnerships with established local consumer brands and internal cross-selling initiatives led to a rise in motor, home and extended-warranty insurance premium income. This was, in part, offset by the effects of the disposal of the Brazilian general insurer HSBC Seguros during the latter half of 2005, which resulted in a significant reduction in non-life premium income.
Other operating income of US$1.4 billion was 43 per cent lower than in 2006, 51 per cent lower on an underlying basis. The commentary that follows is on an underlying basis.
In Europe, other operating income declined by 25 per cent. This largely resulted from a negative movement in the value of in-force business in the UK insurance business. The movement was driven by a change in the calculation methodology of the PVIF business in the first half of 2007 as HSBC
implemented regulatory changes to the rules governing the calculation of insurance liabilities. This had a marginally positive effect on profits as there was a corresponding reduction in policyholder liabilities.
Private equity income decreased significantly, due to the non-recurrence of asset disposals in 2006. Property gains included a gain on the disposal and leaseback of a London building in 2007.
Although HSBC sold its Canary Wharf headquarters building at 8 Canada Square in 2007, the gain remains unrecognised as HSBC continues to
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provide bridge finance for the debt portion of the transaction.
In Hong Kong, there was an increase of 2 per cent in other operating income, mainly due to increased cost recoveries from other HSBC sites. This was partially offset by the non-recurrence of income on the sale of the former head office building of Hang Seng Bank and transfer of credit card acquiring business into a joint venture with Global Payments Inc.
Other operating income in Rest of Asia-Pacific decreased by 2 per cent. The comparative figures included gains on disposals of certain businesses in Australia. No such gains on disposals were registered this year. Similarly, profits from disposal of assets held for sale decreased due to the non-recurrence of profits on sale of properties in Japan and India.
In North America, other operating income decreased significantly, driven by lower prices on sale of real estate due to the general decline in the property market. In addition, there were lower gains on the sale of investments, mainly due to a significant one-off gain in the latter part of 2006.
In Latin America, a 97 per cent increase in other operating income reflected the recognition of the embedded value calculation on the PVIF life assurance business in Mexico. The improvement on 2006 was also aided by the non-recurrence of a loss on sale of a portfolio of assets during that year and sundry gains on foreclosed assets in 2007.
Other operating income of US$2.5 billion was 7 per cent lower than in 2005, 9 per cent lower on an underlying basis. The commentary that follows is on an underlying basis.
In Europe, other operating income declined by 14 per cent. This largely resulted from the non-
recurrence of one-off gains from the restructuring and syndication of assets in Global Investment Banking in 2005. Gains on private equity were also lower. There was a 29 per cent fall in rental income, with a compensating effect on operating expenses, following the sale of the operational functions of HSBC’s vehicle financing and fleet management business in 2005, combined with the non-recurrence of gains made in that year on disposal of structured finance leases in the UK. This decline was partly offset by profit recognised on the sale of HSBC’s stake in Cyprus Popular Bank Limited of US$93 million, and income from UK branch sale and lease-back transactions.
In Hong Kong , the modest increase in other operating income reflected profits earned from the sale of the former head office building of Hang Seng Bank and income received from the transfer of the credit card acquiring business into a joint venture between HSBC and Global Payments Inc. These factors were partly offset by lower revaluation gains on Hang Seng Bank’s investment properties following a slowdown in the rate of property price appreciation and the non-recurrence of the disposal of a leasehold residential property.
Other operating income in Rest of Asia-Pacific more than doubled, reflecting profits earned from various business disposals in Australia and the sale of an office building in Japan. Higher levels of activity at the Group Service Centres resulted in rising income in the region and contributed further to the increase.
In North America , the 42 per cent increase largely resulted from gains on the disposal of various investments and real estate, and higher lease income from property investments by Amanah Finance.
The 73 per cent decline in Latin America was mainly driven by the non-recurrence of the receipt of coverage bonds issued as compensation for asymmetric pesification in Argentina last year. The non-recurrence of the gain on sale of the insurance underwriter, HSBC Seguros, in Brazil in 2005 (US$89 million) contributed further to the reduction.
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Net insurance claims incurred and movement in liabilities to policyholders of US$8.6 billion were 83 per cent higher than in 2006. In March 2007, HSBC acquired the remaining shares in HSBC Assurances in France and purchased HSBC Bank Panama in late 2006. Net insurance claims incurred and movement in liabilities to policyholders increased by 32 per cent on an underlying basis.
In Europe, net insurance claims incurred and movement in liabilities to policyholders grew by 121 per cent to US$3.5 billion. This growth was in parallel with the growth in net earned insurance premiums, including maintaining a higher level of risk, but it was offset by FSA rule changes which led to lower claims valuation on life policies. There was also a rise in flood-related claims in the UK after record rainfalls during the summer.
In Hong Kong, net insurance claims incurred and movement in liabilities to policyholders increased by 19 per cent to US$3.2 billion. The increase was more significant than premium growth because many of the liabilities were related to life policies. Policyholders participate in the investment performance of assets supporting these liabilities and
the investment return on these assets is shown in ‘Net income from financial instruments designated at fair value’.
In the Rest of Asia-Pacific region, net insurance claims incurred and movement in liabilities to policyholders rose by 25 per cent to US$253 million.
Net insurance claims incurred and movement in liabilities to policyholders decreased by 7 per cent to US$241 million in North America, in line with the change in net earned insurance premiums.
In Latin America, net insurance claims incurred and movement in liabilities to policyholders grew by 26 per cent to US$1.4 billion. Most of this increase was in Brazil, driven by a rise in policyholders’ liabilities on the back of higher life insurance and pension volumes. Growth in the Mexico life business also contributed.
Net insurance claims incurred and movement in liabilities to policyholders of US$4.7 billion were 16 per cent higher than in 2005, 15 per cent on an underlying basis. The commentary that follows is on an underlying basis.
In Europe, net insurance claims incurred and movement in liabilities to policyholders decreased
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by 35 per cent to US$531 million, primarily driven by lower sales of critical illness and creditor protection products, along with the effect of adverse movements in fixed interest rate markets on the value of liabilities to policyholders.
Net insurance claims and movement in liabilities to policyholders in Hong Kongincreased by 31 per cent, predominantly in the life insurance business, in which reserves for liabilities to policyholders rose with business growth, together with the rising value of investments. Growth in the underwriting of accident and health business resulted in higher non-life insurance claims reserves.
Net insurance claims and movement in liabilities to policyholders in North America roseby 12 per cent to US$259 million, mainly reflecting an increase in reserves for new life insurance business underwritten in 2006.
In Latin America, higher sales of life and pension fund products led to an increase in net insurance claims incurred and movement in liabilities to policyholders of 24 per cent to US$1,023 million. Lower movements in the non-life insurance liabilities were due to the sale of the non-life insurance business, HSBC Seguros, in Brazil during the latter half of 2005.
Loan impairment charges and other credit risk provisions were US$17.2 billion, a 63 per cent increase over 2006. The analysis that follows is on an underlying basis.
Loan impairment charges increased by 58 per cent, reflecting:
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In Europe, loan impairment charges rose by 10 per cent to US$2.5 billion. Overall credit quality remained broadly stable. In the UK, loan impairment charges rose, primarily in consumer finance lending outside HSBC Bank; within HSBC Bank, steps taken in 2006 to tighten underwriting standards led to an improvement in loan impairment trends. Corporate loan impairment charges remained low in absolute terms although they were 23 per cent higher than the level incurred in 2006. In the UK, increased loan impairment charges principally reflected allowances on two large corporate accounts and the ongoing effect of IVAs on the micro business segment.
Loan impairment charges in Hong Kong continued at a low level and in line with 2006 at US$231 million, despite strong balance sheet growth. This reflected good credit quality and robust economic conditions.
In Rest of Asia-Pacific, loan impairment charges rose by 17 per cent to US$616 million. Loan impairment charges were significantly lower in Taiwan due to the non-recurrence of impairment charges in 2006 which resulted from regulatory intervention in the card market and the imposition of a government debt negotiation scheme. In Indonesia, performance improved on 2006 when loan impairment charges were affected by the introduction of minimum repayment terms. These factors were offset by an increase in corporate loan impairment charges in several countries, higher loan impairment charges in India due to balance sheet growth and higher loss rates on credit cards, and a deterioration in the Malaysian mortgage portfolio due to rising interest rates.
In North America, loan impairment charges posted a steep rise, increasing by 79 per cent to US$12.2 billion. The main factor driving this deterioration was the impact of the weaker housing
market on both economic activity and the ability of borrowers to extend or refinance debt. In addition, seasoning and mix change within the credit cards portfolio, and increases in bankruptcy filings after the exceptionally low levels seen in 2006 following changes in legislation, added to loan impairment charges.
The real estate secured portfolios experienced continuing deterioration in credit quality as a lack of demand for securitised sub-prime mortgages and falls in house prices severely restricted refinancing options for many customers. In the mortgage services business, loan impairment charges rose by 41 per cent to US$3.1 billion while, in consumer lending, loan impairment charges rose by 139 per cent to US$4.1 billion. Delinquency rates exceeded recent historical trends, particularly for those loans originated in 2005 and 2006. Performance was weakest in housing markets which had previously experienced the steepest home price appreciation and in respect of second lien products and stated income products.
US card services experienced a rise in loan impairment charges from a combination of growth in balances, higher losses in the final part of the year as the economy slowed, a rise in bankruptcy rates approaching historical levels, and a shift in portfolio mix to higher levels of non-prime loans. Further details are provided on page 220.
In Latin America, loan impairment charges rose sharply, by 53 per cent to US$1.7 billion, driven by portfolio growth, normal seasoning and higher delinquency rates on credit cards. Loan impairment charges for small and medium-sized businesses lending in Mexico also increased. Partly offsetting these was an improvement in personal and commercial delinquency rates in Brazil.
For the Group as a whole, the aggregate outstanding customer loan impairment allowances at 31 December 2007 of US$19.2 billion represented 2.0 per cent of gross customer advances (net of reverse repos and settlement accounts), compared with 1.6 per cent at year-end 2006. Impaired loans to customers were US$18.3 billion at 31 December 2007 compared with US$13.8 billion at 31 December 2006. On a constant currency basis, impaired loans to customers were 28 per cent higher than in 2006 compared with customer lending growth (excluding loans to the financial sector and settlement accounts) of 7 per cent .
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The charge for loan impairments and other credit risk provisions was US$10.6 billion, a 36 per cent increase over that reported in 2005. The analysis that follows is on an underlying basis.
In Europe, net loan impairment charges rose by 10 per cent to US$2.2 billion. In the UK, net charges rose by a modest 4 per cent as growth in the personal customer impairment charge, which was broadly in line with lending growth, was partially offset by favourable movements on the impairment charge for commercial loans in a robust corporate credit environment. The personal sector continued to experience higher levels of IVA and bankruptcy filings, following an easing of bankruptcy regulations in 2004, growth in consumer indebtedness and a rise in unemployment. This was mitigated by action taken on underwriting and collections. In France, the non-recurrence of several significant recoveries in 2005 resulted in an increase in net loan impairment charges in 2006.
Loan impairment charges in Hong Kong remained low at US$172 million, underpinned by robust personal and commercial credit quality in a strong economy with low unemployment.
In Rest of Asia-Pacific, loan impairment charges rose sharply to US$512 million. Taiwan and Indonesia experienced credit deterioration during 2006, although the problem peaked in the first half
of the year. Taiwan was affected by the imposition of a mandatory government debt renegotiation scheme which allowed customers to extend and heavily discount repayment terms, leading to market-wide credit losses. Indonesia was also affected by regulations, specifically with respect to minimum re-payment terms which compounded higher impairments brought about by a reduction in fuel subsidies. Elsewhere in Rest of Asia-Pacific, credit quality was stable.
In North America, the net loan impairment charge increased significantly, by 32 per cent to US$6.8 billion, largely in the second half of 2006, driven by the credit deterioration in US sub-prime mortgages described in the first bullet point above. The effects of the decline in US house price inflation and rising interest rates during 2006 were accentuated by the increased percentage of second lien loan originations to total loans originated in 2005 and the first half of 2006, and the underwriting of stated income (low documentation) products. The US net loan impairment charges increased by 37 per cent after taking into account the most recent trends in delinquency and loss severity, projecting the probable impact of re-pricing ARMs, and incorporating the effect of re-pricing on second lien loans. Further details are provided on page 217. Credit delinquency in other parts of the mortgage portfolio and in other US businesses rose modestly, driven by unusually low levels at the end of 2005, and growing loan maturity in 2006. Partially offsetting the effects of credit deterioration were a decline in bankruptcy filings following the surge at the end of 2005, relatively low unemployment and a fall in exposure estimated to result from hurricane Katrina.
In Latin America, the rise in impairment charges by 24 per cent to US$938 million was largely recorded in Mexico and, to a lesser extent, Brazil and Argentina. In Mexico, strong loan growth, particularly in 2006, led to increased loan impairment charges. In Brazil, the credit weaknesses seen in 2005 and the first half of 2006, particularly in the consumer market, were mitigated by changes to underwriting procedures. Net charges in Brazil increased by 7 per cent compared with 54 per cent in 2005 and declined in the second half of 2006 compared with the first half. In Argentina, net charges rose as a result of the non-recurrence of releases and recoveries in 2005.
The aggregate outstanding customer loan impairment allowances at 31 December 2006 of US$13.6 billion represented 1.6 per cent of gross customer advances (net of reverse repos and
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settlement accounts), compared with 1.5 per cent at the same time in 2005.
Impaired loans to customers were US$13.8 billion at 31 December 2006
compared with US$11.4 billion at 31 December 2005. On a constant currency basis, impaired loans were 14 per cent higher than in 2005 compared with lending growth (excluding loans to the financial sector and settlement accounts) of 10 per cent.
Operating expenses
Operating expenses increased by US$5.5 billion to US$39.0 billion. On an underlying basis, cost growth was 10 per cent, the main drivers being:
headcount in the region. A change in actuarial assumptions regarding the employees’ defined contribution pension scheme in the UK also contributed to the increase. General and administrative expenses were driven by ex gratia payments expensed in respect of overdraft fees applied in previous years and a provision for reimbursement of certain charges on historic will trusts and other rela ted services, both in the UK.
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In Europe, costs increased by 10 per cent, compared with an equivalent growth in net operating income before loan impairment charges. In the UK, a change in actuarial assumptions regarding the staff defined benefit pension scheme led to increased costs. Ex gratia payments were expensed in respect of overdraft fees applied in previous years and a provision for reimbursement of certain charges on historic will trusts and other related services was raised. Costs also increased on investments in technology, investing in straight-through processing and branch refurbishment. Costs rose in payments and cash management on higher transaction volumes. Operational costs rose in Global Markets, particularly structured derivatives, where the French business invested to support revenue growth. In France, the IT systems inherited with the acquisition of HSBC France were successfully replaced with HSBC’s universal banking platform. In Turkey, investment in physical and technical infrastructure and additional headcount in support of business growth also contributed to increased costs.
In Hong Kong, operating expenses increased by 16 per cent, compared with growth of 32 per cent in net operating income before loan impairment charges. Staff costs increased by 23 per cent on wage inflation and the recruitment of additional staff to
support business expansion, mainly in Commercial Banking and Global Banking and Markets. Performance-related bonuses increased in response to revenue growth. Increased marketing and IT costs reflected business growth and the launch of new initiatives. As commercial rents rose in Hong Kong’s dynamic economy, property rental costs increased, the effect magnified by a sale and leaseback agreement on a headquarters building in 2006.
Operating costs increased by 28 per cent in Rest of Asia-Pacific in line with the increase in net operating income before loan impairment charges. Business expansion continued throughout the region. Staff costs in India, mainland China and the Middle East rose on increases in headcount and performance-related bonuses due to higher revenue generation. Business expansion initiatives were taken in mainland China where an additional 27 new branches or sub-branches were opened. In India, branch network, consumer finance and credit card business were expanded. Marketing, technology and infrastructure costs were incurred in support of business expansion.
In North America, operating expenses increased by 3 per cent, compared with growth in net operating income before loan impairment charges of 5 per cent. The retail bank branch network was extended both within and beyond the Group’s traditional spheres of operation to support the expansion of retail and Commercial Bankingbusinesses. Premises and equipment expenses rose as a consequence. The business incurred US$70 million of one-off costs arising from the indemnification agreement with Visa ahead of Visa’s planned IPO. Communication expenses increased due to higher mailing volumes on cards and consumer lending. In the third quarter, expenditure on card marketing declined in line with a decision to slow lending growth in these portfolios. The consumer finance business incurred restructuring charges resulting from the discontinuation of the wholesale and correspondent channels in mortgage services and the closing of branch offices in consumer lending. There were corresponding benefits in origination costs. In Canada operating expenses rose due to the strategic growth of the bank branch network. Staff numbers and marketing costs increased as new branches were opened and new products were launched. The Canadian consumer finance business was also restructured in a similar fashion to the US.
Continuing investment and business expansion in Latin America resulted in an increase in costs of 15 per cent, compared with growth in net operating income before loan impairment charges of 20 per
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cent. Staff costs rose, mainly on higher salaries and bonuses in the region and one-off costs incurred to improve operational efficiencies in Brazil. These were partially offset by a curtailment and settlement gain from staff transferring from the bank’s defined benefit healthcare scheme to a new defined contribution scheme in Mexico. Increases in non-staff costs included higher marketing expenditure, costs relating to growth in credit card operations, higher telecommunication costs and transactional taxes. Four additional months of Banca Nazionale also increased total costs.
Operating expenses of US$33.6 billion were US$4.0 billion, or 14 per cent, higher than in 2005, and 11 per cent higher on an underlying basis.
The main drivers of cost growth were as follows:
online savings product in the US, strong growth in credit card acquisition across the Group, and an innovative new online mortgage product offered in Mexico.
The following points are also of note.
In Europe , the cost growth of 9 per cent was concentrated in Personal Financial Services and Global Banking and Markets. In Personal Financial Services, business expansion across the region drove the expenditure. In the UK, costs rose as the branch network refurbishment programme proceeded, additional staff were recruited to support longer opening hours in certain branches and IT costs increased. In France and Turkey, costs rose from the recruitment of additional sales staff and higher marketing expenditure. Costs in Global Banking and Markets increased, reflecting higher performance-related staff costs and the full year effect of the investment in 2005 in the business, especially in structured derivatives and Global Transaction Banking, where significant revenue growth was seen. These cost increases were partly offset by a reduction in Commercial Banking expenses following the sale of vehicle finance fleet management activities in the UK.
In Hong Kong , the increase in operating expenses of 14 per cent was mainly due to higher staff and marketing costs. Additional staff recruited to support longer opening hours in the branch network and the expansion of Commercial Banking, and an increase in revenue-driven performance-related awards drove staff costs higher. Marketing expenditure incurred on advertising and promotional activities rose in support of credit card and investment fund products in Personal Financial Services and the launch of Commercial Banking’s global campaign. The full year effect of the enhancement in the second half of 2005 of Global Banking and Markets’ business contributed further to the cost growth.
The 27 per cent rise in operating expenses in the Rest of Asia-Pacific region was primarily incurred in supporting retail business expansion. Staff costs rose from increased recruitment to support new business initiatives and incentive payments grew in response to improved revenues. Marketing expenses rose as advertising and promotional activity aimed at enlarging HSBC’s market share in cards, mortgages and other unsecured lending grew, and Commercial Banking marketing activity across several countries increased. In Global Banking and Markets, cost growth reflected higher revenue-driven performance-related costs and increased expenditure in Global
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Transaction Banking necessitated by business volumes.
In North America, costs rose by 13 per cent in 2006. In the US, the increase accompanied the expansion of both the core banking network (by 25 branches) and the geographical presence of Commercial Banking, and arose from incremental costs incurred in support of revenue growth in the consumer finance business. Marketing expenditure also rose, in line with increased levels of activity in the cards businesses in the US, continued promotion of the online savings product and airport branding initiatives. Cost growth in Canada followed higher revenues. The first full year effect of the expansion of various Global Banking and Markets businesses that commenced last year, together with higher
performance-linked pay contributed further to the expense growth.
In Latin America, operating expenses rose by 12 per cent. Staff costs grew as additional staff were recruited to support business expansion and pay rises were agreed with the unions. Marketing expenditure was higher as a consequence of advertising campaigns run by Personal Financial Services and Commercial Banking. The continued expansion of the branch network and ATM infrastructure in Mexico, in conjunction with construction of the new headquarters, also contributed to the overall cost growth in the region. Costs rose in Global Banking and Markets in line with higher transactional volumes, increased headcount and union-agreed pay rises.
Cost efficiency ratios
Share of profit in associates and joint ventures
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Share of profit in associates and joint ventures of US$1.5 billion was 78 per cent higher than in 2006, on both reported and underlying bases. The commentary that follows is on an underlying basis.
In Europe, increased profit resulted from a US$73 million adjustment to the embedded value of HSBC Assurances, an associate in France, prior to the acquisition of its remaining share capital, following which it was accounted for as a subsidiary.
Profit from associates and joint ventures in the Rest of Asia-Pacific region increased by 51 per cent, mainly due to increased contributions from HSBC’s strategic investments in mainland China. Profit from Bank of Communications, Ping An Insurance and Industrial Bank improved significantly, driven largely by a thriving local economy.
Income from associates and joint ventures was US$846 million, an increase of 31 per cent compared with 2005, and 7 per cent on an underlying basis. The commentary that follows is on an underlying basis.
Improved contributions from The Saudi British Bank, Bank of Communications and Industrial Bank were supplemented by a first full year contribution from Ping An Insurance. These strategic investments are of increasing significance to HSBC’s operations in the Rest of Asia-Pacific region. The profits were partly offset by a loss arising from an impairment charge on a private equity investment of an associate in Europe.
HSBC’s share of income from Bank ofCommunications rose by 44 per cent, driven bywider spreads and an improved product mix,with increased corporate and consumer lending.Fee income also rose as significant progress wasmade in expanding its investment bankingoperations.
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During the second half of 2006, HSBC and The Saudi British Bank jointly established HSBC Saudi Arabia Limited, the first full-service independent investment bank in Saudi Arabia licensed under the local new Capital Market law. HSBC, through a wholly owned subsidiary, holds 60 per cent of the equity in the new
company and The Saudi British Bank, in which HSBC has a 40 per cent shareholding, holds the remaining 40 per cent.
The share of profits from The Saudi British Bank grew by 21 per cent reflecting a strong performance in all core businesses.
Asset deployment
HSBC’s total assets at 31 December 2007 were US$2,354 billion, an increase of US$494 billion or 27 per cent since 31 December 2006. Over 75 per cent of the increase came from Global Banking and Markets, with the largest contributions from trading assets and derivatives following the strategic decision to expand the collateralised lending, equities and structured derivatives businesses in Europe.
Acquisitions added US$23 billion to total assets. On an underlying basis, total assets grew by 21 per cent.
At 31 December 2007, HSBC’s balance sheet was highly liquid. The proportion of assets deployed in loans and advances to customers declined to 42 per cent, while trading assets increased by 32 per cent to US$446 billion, representing 19 per cent of total assets. The increase in trading assets is discussed below.
Customer advances rose by 9 per cent, due to strong growth in corporate and commercial lending. The largest contribution came from Europe with strong growth in the UK and France.
Growth in residential mortgage lending was subdued, reflecting the decision to slow lending in the US in the light of a deterioration in credit conditions in the personal sector.
Trading assets, financial investments and derivatives
Trading assets principally consist of debt and equity instruments acquired for the purpose of market making or to benefit from short-term price movements. Securities classified as held for trading are carried in the balance sheet at fair value, with movements in fair value recognised in the income statement.
Trading assets of US$446 billion at 31 December 2007 were 32 per cent higher than at 31 December 2006. This increase was mainly due to the growth of the collateralised lending business in Europe. Holdings in debt securities rose as a result of higher trading activity, growth in the structured notes business and increased holdings of shorter maturity assets in the UK. The increase in equity securities resulted from an expansion in the equity swaps business in London, particularly with Asian products, and the growth in trading activity and structured derivatives transactions in France.
Financial investments include debt and equity instruments that are classified as available for sale or,
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to a small extent, held to maturity. The available for sale investments essentially represent a core element of the Group’s liquidity and may be disposed of either to manage that liquidity or in response to investment opportunities arising from favourable movements in economic indicators, such as interest rates, foreign exchange rates and equity prices. They are carried at fair value with unrealised gains and losses from movements thereon reported in equity until disposal. On disposal the accumulated unrealised gain or loss is recognised through the income statement and reported as ‘Gains less losses from financial investments’.
Financial investments were 29 per cent higher than reported at 31 December 2006, excluding the effect of acquisitions, chiefly HSBC Assurances. This was mainly due to the decision to consolidate Cullinan Finance Ltd (‘Cullinan’) and Asscher Finance Ltd (‘Asscher’), two structured investment vehicles managed by HSBC. The continued growth of HSBC’s operations in emerging markets also led to increased holdings of debt securities as surplus funds were invested and more assets were needed to meet regulatory requirements. Net unrealised gains in the valuation of equities amounted to US$4.2 billion.
Derivatives are financial instruments that derive their value from the price of an underlying item. HSBC transacts derivatives for three primary purposes: to create risk management solutions for clients, for proprietary trading purposes, and to manage and hedge HSBC’s own risks.
Derivative assets rose by 73 per cent, due to increases in interest rate swap balances, primarily in the UK and France. Credit derivative assets increased, particularly in the US in the first half of the year, followed by a significant slowdown in client trading in the second half of the year due to the deterioration in credit markets. Foreign exchange derivative balances increased, driven by heightened volatility in major currencies, particularly the US dollar.
Funds under management at 31 December 2007 were US$844 billion, an increase of US$149 billion, or 21 per cent, compared with 31 December 2006. Both HSBC Global Asset Management and Private Banking delivered good investment performance and continued to attract new funds with net new money of US$36 billion.
HSBC Global Asset Management funds reached US$380 billion, a rise of 16 per cent compared with 2006. This was attributable to US$12 billion of net new money, strong investment performance and favourable foreign exchange movements. Emerging markets contributed significantly to overall growth, with funds reaching US$93 billion, placing HSBC Global Asset Management as one of the world’s largest emerging market asset managers.
Private Banking’s funds increased by 19 per cent to US$275 billion, driven by client acquisition, partly due to greater brand awareness and an enhanced product range, strong investment performance and foreign exchange movements.
Client assets, which provide an indicator of overall Private Banking volumes and include fundsunder management, grew by 26 per cent, reaching US$421 billion.
Other funds under management, of which the main element is a corporate trust business in Asia, increased by 40 per cent to US$186 billion, driven by increases in the property trust business .
Assets held in custody and under administration
At 31 December 2007, assets held by HSBC as custodian amounted to US$6,094 billion, 33 per cent higher than the US$4,572 billion held at 31 December 2006. At constant exchange rates, growth was 30 per cent.
Complementing this was HSBC’s assets under administration business. At 31 December 2007, the value of assets held under administration by the Group amounted to US$1,422 billion, 24 per cent higher than the US$1,150 billion held at 31 December 2006. At constant exchange rates, growth was 19 per cent.
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Economic profit
HSBC’s internal performance measures include economic profit, a calculation which compares the return on financial capital invested in HSBC by its shareholders with the cost of that capital. HSBC prices its cost of capital internally and the difference between that cost and profit attributable to ordinary shareholders of the parent company, represents the amount of economic profit generated. Economic profit is used by management as a means of deciding where to allocate resources so that they will be most productive.
In order to concentrate on external factors rather than measurement bases, HSBC emphasises the trend in economic profit within business units rather than absolute amounts. In light of the current levels of world interest rates, and taking into account its geographical and customer group diversification, HSBC believes that its true cost of capital on a
consolidated basis remains 10 per cent. HSBC plans to continue using this rate until the end of the current five-year strategic plan in 2008 in order to ensure consistency and comparability.
Economic profit increased by US$1.4 billion, or 27 per cent compared with 2006. This increase compared favourably with the decrease recorded in 2006. Growth in Asia was partially offset by loan impairment charges, mainly in the US business. This led to a geographical realignment of profitability which had a positive effect on economic profit as, in general, Asia has lower tax rates than the US. Economic profit was also affected by significant fair value movements on HSBC’s own debt as a result of widening credit spreads and related derivatives. This resulted in a higher return on average invested capital and, in consequence, economic spread, which increased by 0.4 percentage points compared with 2006.
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Average balance sheet and net interest income
Average balances and related interest are shown for the domestic operations of HSBC’s principal commercial banks by geographic region. ‘Other operations’ comprise the operations of the principal commercial banking and consumer finance entities outside their domestic markets and all other banking operations, including investment banking balances and transactions.
Average balances are based on daily averages for the principal areas of HSBC’s banking activities with monthly or less frequent averages used elsewhere.
Balances and transactions with fellow subsidiaries are reported gross in the principal commercial banking and consumer finance entities within ‘Other interest-earning assets’ and ‘Other interest-bearing liabilities’ as appropriate and the elimination entries are included within ‘Other operations’ in those two categories.
Net interest margin numbers are calculated by dividing net interest income as reported in the income statement by the average interest-earning assets from which interest income is reported within the ‘Net interest income’ line of the income statement. Interest income and interest expense arising from trading assets and liabilities and the funding thereof is included within ‘Net trading income’ in the income statement.
Assets
For footnotes, see page 173.
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165
166
167
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Total equity and lia1bilities (continued)
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170
Analysis of changes in net interest income
The following table allocates changes in net interest income between volume and rate for 2007 compared with 2006, and for 2006 compared with 2005.
Interest income
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Interest income (continued)
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Interest expense (continued)
Footnotes to ‘Average balance sheet and net interest income’ and ‘Analysis of changes in net interest income’.
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Share capital and reserves
Authorised share capital
The authorised share capital of HSBC Holdings at 31 December 2007 was US$7,500,100,000 divided into 15,000 million ordinary shares of US$0.50 each and 10 million non-cumulative preference shares of US$0.01 each; £401,500 divided into 10 million non-cumulative preference shares of £0.01 each and 301,500 non-voting deferred shares of £1 each; and €100,000 divided into 10 million non-cumulative preference shares of €0.01 each.
The percentage of the total authorised share capital of HSBC Holdings at 31 December 2007 represented by the numbers of ordinary shares of US$0.50 each, non-cumulative preference shares of £0.01 each, non-cumulative preference shares of US$0.01 each, non-cumulative preference shares of €0.01 each and non-voting deferred shares of £1 each was approximately 99.9860, 0.0027, 0.0013, 0.0020 and 0.0081 per cent respectively.
Issued share capital
The issued share capital of HSBC Holdings at 31 December 2007 was US$5,915 million divided into 11,829,052,317 ordinary shares of US$0.50 each; 1,450,000 non-cumulative preference shares of US$0.01 each; and 301,500 non-voting deferred shares of £1 each.
Rights and obligations attaching to shares
The rights and obligations attaching to each class of share in the authorised share capital of HSBC Holdings are set out in the Articles of Association of HSBC Holdings. Set out below is a summary of the rights and obligations attaching to each class of shares with respect to voting, dividends, capital and, in the case of the preference shares, redemption.
Ordinary shares
Subject to the Companies Act 2006 and the Articles of Association of HSBC Holdings, in a general meeting of HSBC Holdings, every holder of ordinary shares who is present in person or by proxy shall on a show of hands have one vote and every holder of ordinary shares present in person or by proxy shall on a poll have one vote for every share he or she holds. Where any shareholder is, under the rules governing the listing of securities on any stock exchange on which all or any shares of HSBC Holdings are for the time being listed or traded, required to abstain from voting on any particular resolution or restricted to voting only for or only against any particular resolution, any votes cast by or
on behalf of such holder in contravention of such requirement or restriction will not be counted.
Subject to the Companies Act 2006 and the Articles of Association of HSBC Holdings, HSBC Holdings may, by ordinary resolution, declare dividends to be paid to the holders of ordinary shares, however, no dividend shall exceed the amount recommended by the Board. The Board may pay interim dividends as appears to the Board to be justified by the profits of HSBC Holdings available for distribution. All dividends shall be apportioned and paid proportionately to the percentage of the nominal amount paid up on the shares during any portion or portions of the period in respect of which the dividend is paid, but if any share is issued on terms providing that it shall rank for dividend as from a particular date, it shall rank for dividend accordingly. Subject to the Articles of Association of HSBC Holdings, the Board may, with the prior authority of an ordinary resolution of HSBC
Holdings and subject to such terms and conditions as the Board may determine, offer to any holders of ordinary shares the right to elect to receive ordinary shares of the same or a different currency, credited as fully paid, instead of cash in any currency in respect of the whole (or some part, to be determined by the Board) of any dividend specified by the ordinary resolution. At the 2007 Annual General Meeting shareholders gave authority to the Directors to offer a scrip dividend alternative until the conclusion of the Annual General Meeting in 2012.
Subject to the relevant insolvency laws and the Articles of Association of HSBC Holdings, if HSBC Holdings is wound up, the assets available for distribution among the holders of ordinary shares will be distributed among such holders in proportion to the number of ordinary shares held by them respectively, such distribution to be adjusted to take account of any amount remaining unpaid on a holder’s share. On a winding up, the liquidator may, with the sanction of a special resolution of HSBC Holdings and any other sanction required by law, divide among the shareholders in specie the whole or any part of the assets of HSBC Holdings and may, for that purpose, value any assets and determine how the division shall be carried out as between the shareholders or different classes of shareholders.
Preference shares
The non-cumulative preference shares of £0.01 each, the non-cumulative preference shares of US$0.01 each (the ‘Dollar Preference Shares’) and the non-cumulative preference shares of €0.01 each carry the same rights and obligations under the Articles of Association save in respect of the timing of and
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payment of proceeds from the redemption of each class of share, to the extent issued, and certain rights and obligations that attach to each class of preference share as determined by the Board prior to allotment of the relevant preference shares. The Dollar Preference Shares are the only class of the preference shares which have been issued and allotted to date.
Holders of the preference shares will only be entitled to attend and vote at general meetings of HSBC Holdings if any dividend payable on the relevant preference shares in respect of such period as the Board shall determine prior to allotment thereof (which, in the case of the Dollar Preference Shares in issue at 3 March 2008, is four consecutive dividend payment dates) is not paid in full or in such other circumstances, and upon and subject to such terms, as the Board may determine prior to allotment of the relevant preference shares. Whenever holders of the relevant preference shares are entitled to vote on a resolution at a general meeting, on a show of hands every such holder who is present in person or by proxy shall have one vote and on a poll every such holder who is present in person or by proxy shall have one vote per preference share held by him or her or such number of votes per share as the Board shall determine prior to allotment of such share.
Subject to the Articles of Association, holders of the relevant preference shares shall have the right to a non-cumulative preferential dividend at such rate, on such dates and on such other terms and conditions as may be determined by the Board prior to allotment thereof in priority to the payment of any dividend to the holders of ordinary shares and any other class of shares of HSBC Holdings in issue (other than (i) the other preference shares in issue and any other shares expressed to rank pari passu therewith as regards income; and (ii) any shares which by their terms rank in priority to the relevant preference shares as regards income). Dividends on the Dollar Preference Shares in issue at 3 March 2008 are paid quarterly at the sole and absolute discretion of the Board of Directors. The Board of Directors will not declare a dividend on the Dollar Preference Shares if payment of the dividend would cause HSBC Holdings not to meet the applicable capital adequacy requirements of the FSA or the profit of HSBC Holdings available for distribution as dividends is not sufficient to enable HSBC Holdings to pay in full both dividends on the relevant preference shares and dividends on any other shares that are scheduled to be paid on the same date and that have an equal right to dividends. HSBC Holdings may not declare or pay dividends on any
class of its shares ranking lower in the right to dividends than the preference shares nor redeem nor purchase in any manner any of its other shares ranking equal with or lower than the preference shares unless it has paid in full, or set aside an amount to provide for payment in full, the dividends on the preference shares for the then-current dividend period.
The preference shares carry no rights to participate in the profits or assets of HSBC Holdings other than as set out in the Articles of Association, subject to the Companies Act 1985, do not confer any right to participate in any offer or invitation by way of rights or otherwise to subscribe for additional shares in HSBC Holdings, do no not confer any right of conversion and do not confer any right to participate in any issue or bonus shares or shares issued by way of capitalisation of reserves.
Subject to the relevant insolvency laws and the Articles of Association of HSBC Holdings, holders of the relevant preference shares have the right in a winding up of HSBC Holdings to receive out of the assets of HSBC Holdings available for distribution to its shareholders, in priority to any payment to the holders of the ordinary shares and any other class of shares of HSBC Holdings in issue (other than (i) the other relevant preference shares and any other shares expressed to rank pari passu therewith as regards repayment of capital; and (ii) any shares which by their terms rank in priority to the relevant preference shares as regards repayment of capital), a sum equal to any unpaid dividend on the relevant preference shares which is payable as a dividend in accordance with or pursuant to the Articles of Association and the amount paid up or credited as paid up on the relevant preference shares together with such premium (if any) as may be determined by the Board prior to allotment thereof.
HSBC Holdings may redeem the relevant preference shares in accordance with the Articles of Association and the terms on which the relevant preference shares were issued and allotted. In the case of the Dollar Preference Shares in issue at 3 March 2008, HSBC Holdings may redeem such shares in whole at any time on or after 16 December 2010, with the consent of the FSA.
Non-voting deferred shares
The non-voting deferred shares are held by a subsidiary undertaking of HSBC Holdings. Holders of the non-voting deferred shares are not entitled to receive dividends on these shares. In addition, on winding up or other return of capital, holders are entitled to receive the amount paid up on their shares
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after distribution to ordinary shareholders of £10,000,000 in respect of each ordinary share held by them. The holders of the non-voting deferred shares are not entitled to receive notice of or to attend (either personally or by proxy) any general meeting of HSBC Holdings or to vote (either personally or by proxy) on any resolution to be proposed thereat.
To be registered, a transfer of shares must be in relation to a share which is fully paid up and on which the Company has no lien and to one class of shares denominated in the same currency. The transfer must be in favour of a single transferee or no more than four joint transferees and it must be duly stamped (if required). The transfer must be delivered to the registered office of the Company or to its Registrars accompanied by the certificate to which it relates or such other evidence that proves the title of the transferor.
If a shareholder or any person appearing to be interested in the Company’s shares has been sent a notice under section 793 of the Companies Act 2006 (which confers upon public companies the power to require information from any person whom the Company knows or has reasonable cause to believe to be interested in the shares) and has failed in relation to any shares (the ‘default shares’) to supply the information requested within the period set out in the notice, then the member is not entitled to be present at or to vote the default shares at any general meeting or to exercise any other right conferred by being a shareholder. If the default shares represent at least 0.25 per cent in nominal value of the issued shares of that class any dividend shall be withheld by the Company, without interest and no election for the scrip dividend alternative may be made. No transfer of any shares held by the member will be registered, except in limited circumstances.
The percentage of the total issued share capital of HSBC Holdings at 31 December 2007 representedby the ordinary shares of US$0.50 each, non-cumulative preference shares of US$0.01 each and non-voting deferred shares of £1 each was approximately 99.9895, 0.0002, and 0.0102 per cent respectively.
The following events occurred during the year in relation to the share capital of HSBC Holdings:
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Contractual obligations
The table below provides details of HSBC’s material contractual obligations as at 31 December 2007.
Ratios of earnings to combined fixed charges (and preference share dividends)
For the purpose of calculating the ratios, earnings consist of income from continuing operations before taxation and minority interests, plus fixed charges, and after deduction of the unremitted pre-tax income of associated undertakings. Fixed charges consist of total interest expense, including or excluding interest on deposits, as appropriate, preference share dividends, as applicable, and the proportion of rental expense deemed representative of the interest factor.
The above table contains ratios based on UK GAAP, HSBC’s previous primary GAAP, which is not comparable to financial information based upon IFRSs, as explained in HSBC’s 2004 IFRSs Comparative Financial Information published on 5 July 2004.
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Loan maturity and interest sensitivity analysis
At 31 December 2007, the geographical analysis of loan maturity and interest sensitivity by loan type on a contractual repayment basis was as follows:
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Deposits
The following tables analyse the average amount of bank deposits, customer deposits and certificates of deposit (‘CDs’) and other money market instruments (which are included within ‘Debt securities in issue’ in the balance sheet), together with the average
interest rates paid thereon for each of the past three years. The geographical analysis of average deposits is based on the location of the office in which the deposits are recorded and excludes balances with HSBC companies. The ‘Other’ category includes securities sold under agreements to repurchase.
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Certificates of deposit and other time deposits
At 31 December 2007, the maturity analysis of CDs and other wholesale time deposits, by remaining maturity, was as follows:
This section contains disclosures about off-balance sheet arrangements and special purpose entities (‘SPEs’) that have been included in HSBC’s consolidated balance sheet.
Special purpose entities (including on and off-balance sheet arrangements)
HSBC enters into certain transactions with customers in the ordinary course of business which involve the establishment of SPEs to facilitate customer transactions.
HSBC structures that utilise SPEs are authorised centrally upon establishment to ensure appropriate purpose and governance. The activities of SPEs administered by HSBC are closely monitored by senior management. The use of SPEs is not a significant part of HSBC’s activities and HSBC is not reliant on the use of SPEs for any material part of its business operations or profitability. HSBC’s involvements with SPE transactions are described below.
HSBC-sponsored vehicles
HSBC sponsors the formation of entities to accomplish certain narrow and well-defined objectives, such as securitisations of financial assets or to effect a lease. HSBC consolidates these SPEs when the substance of the relationship indicates that HSBC controls the SPE. In assessing control, all relevant factors need to be considered. Such factors may have qualitative and quantitative aspects. For example:
Qualitative factors. In substance:
In a number of cases, these SPEs are accounted for off-balance sheet under IFRSs where HSBC does not have the majority of the risks and rewards of ownership of the SPE. However in certain circumstances, after careful consideration of the facts, HSBC consolidates an SPE where, although it does not obtain the majority of risks and rewards of ownership, the qualitative features of HSBC’s involvement indicate that, in substance, the activities of the SPE are being conducted on behalf of HSBC.
HSBC reassesses the required consolidation accounting tests whenever there is a change in the substance of a relationship between HSBC and an SPE, for example, when there is a change in HSBC’s involvement or there is a change in the governing rules, contractual arrangements or capital structure of the SPE. The most significant categories of SPEs are discussed in more detail below.
Structured investment vehicles
Structured investment vehicles (‘SIVs’) are SPEs which are established to invest in diversified portfolios of interest-earning assets, generally comprising asset-backed debt securities and other debt securities issued by financial institutions or corporates. SIVs are typically funded through the issue of CP, medium-term notes or other senior debt (collectively referred to as ‘senior debt’), repo financing, and subordinated income or mezzanine notes (commonly referred to as ‘capital notes’). The sponsor of the SIV would typically provide only limited liquidity support to the senior debt investors through committed liquidity facilities.
SIVs are structured to provide investors with the opportunity to invest in a range of assets depending on their risk preference. Senior debt issued by SIVs is structured to be highly rated and the SIVs are managed within strict operating criteria. Liquidity in SIVs is primarily managed by rolling over debt at maturity or, if that is not possible, by the sale of assets to provide protection to senior debt holders. SIVs are typically subject to market value and net asset value triggers which underpin the external credit ratings of the senior debt. The liquidity risk in SIVs is managed by controlling the maximum cumulative cash outflow occurring in defined time periods.
HSBC sponsored the establishment of two SIVs, Cullinan and Asscher in August 2005 and May 2007, respectively, which were successful in obtaining funding from investors, who subscribed for senior
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debt and capital notes. These SIVs were not consolidated on inception because HSBC did not have the majority of risks and rewards of ownership and it was not anticipated that HSBC would provide significant funding to these SIVs. HSBC is the manager for both SIVs, and was committed from inception to provide limited support by way of contractually committed liquidity lines on normal commercial terms.
The maximum size of each SIV during 2007, as measured by the par value of the SIV’s total assets, together with the maximum exposure HSBC had under its committed liquidity facilities, was as follows:
From mid-August 2007, liquidity in the wholesale markets became severely disrupted, principally as a result of valuation concerns over securities linked to US sub-prime mortgage loans, resulting in funding difficulties for many SPEs, including SIVs. At the outset, bank-sponsored SIVs were less affected and, initially, Cullinan and Asscher continued to fund themselves in the CP market.
By the end of the third quarter of 2007, it became clear that the disruption in the supply of CP funding for the SIV market was not a temporary situation and, as a consequence, by the end of September 2007, HSBC provided US$16.7 billion of funding to Cullinan and Asscher in the form of repos, CP purchases and the acquisition of US$4.1 billion of assets at fair value from Cullinan.
During the same period, the market value of certain assets held by Cullinan and Asscher fell because the market liquidity position had weakened and credit spreads had widened.
From October 2007, all the capital note holders of Cullinan were given the option to switch their capital note holdings for a share of the assets of the SIV. As part of this offer, HSBC switched its entire holding in Cullinan capital notes for Cullinan assets. The par value and market value of the assets purchased amounted to US$709 million and US$684 million respectively. The consideration paid comprised HSBC’s capital note holding with an aggregate par value of US$50 million (fair value
US$25 million) and cash of US$659 million. In addition, in January 2008, HSBC purchased Cullinan capital notes from existing holders with a par value of US$171 million (fair value US$39 million), and then exchanged such Cullinan capital notes, together with cash of US$2,302 million, for Cullinan assets with a par value of US$2,473 million and a market value of US$2,341 million.
In November 2007, HSBC announced its intention to provide investors in Cullinan and Asscher with the option to exchange their capital notes for notes issued by one or more new SPEs, with term funding and liquidity to be provided by HSBC.
Based on a careful evaluation of all the facts and circumstances, HSBC concluded that this announcement had substantively changed the relationship HSBC had with these SIVs such that HSBC was required to consolidate these SIVs from November 2007.
After the announcement in November 2007, two new SPEs, an asset-backed commercial paper conduit and a term funding vehicle, were established in respect of Cullinan. Each SPE has been set up so that its continuing operation is not as sensitive as Cullinan to market value fluctuations in its underlying assets. These SPEs will be funded either by CP backed by a 100 per cent liquidity facility provided by HSBC, or by term funding provided by HSBC. This reorganisation addresses the two main challenges for the SIV sector which could force asset sales: the inability to fund in the CP markets, and the sensitivity of the continuing operation of SIVs to changes in the market value of their underlying assets.
The new SPEs have agreed to purchase Cullinan’s assets, over a time period that is anticipated to coincide with the maturity of Cullinan’s senior debt. The purchase price was based on the fair value of Cullinan’s assets as at 21 January 2008.
In January 2008, investors in the capital notes issued by Cullinan were given the option to exchange their existing capital notes for the capital notes in the new SPEs.
On 13 February 2008, the par value of the capital notes outstanding in Cullinan amounted to US$1.9 billion. On this date, all the holders of the remaining capital notes in Cullinan elected to exchange their existing holding for capital notes in the new SPEs. The holders of such capital notes will bear the risks of any losses arising in the new SPEs
up to the par value of their holding in the capital notes.
The holders of the capital notes in Asscher continue to bear the risk of any first losses in the assets held by the SIV. It is proposed to reorganise Asscher following the completion of the Cullinan exchange.
The effect of consolidating Cullinan and Asscher on HSBC’s balance sheet was to include US$42.5 billion of both assets and liabilities from November 2007. This included capital notes of US$38.1 million, holdings of CP of US$4.7 billion and repos of US$8.5 billion previously recognised on HSBC’s balance sheet.
An analysis of the assets held by Cullinan and Asscher at 31 December 2007 and 2006 is set out below.
Cullinan – Ratings analysis of assets
Cullinan – Composition of asset portfolio
These assets included US$2 billion (2006: US$2.7 billion) of exposure to US sub-prime mortgages, all of which are rated AAA.
Cullinan – Total assets by balance sheet classification
Cullinan – Weighted-average maturity of assets
The weighted average life of the portfolio at 31 December 2007 was 4 years (2006: 3.63 years).
Cullinan – Funding structure
The weighted average life of CP funding was 0.56 years (2006: 0.13 years) and the weighted average life of medium-term note funding was 1.13 years (2006: 0.64 years).
Asscher – Ratings analysis of assets
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Asscher – Composition of asset portfolio
These assets included US$42 million of exposure to US sub-prime mortgages, all of which are rated AAA.
Asscher – Total assets by balance sheet classification
Asscher – Weighted-average maturity of assets
The weighted average life of the portfolio at 31 December 2007 was 3.7 years.
The weighted average life of CP funding liabilities was 0.44 years and the weighted average life of medium-term note funding liabilities was 1.03 years.
Money market funds
HSBC has established and manages a number of money market funds which provide customers with tailored investment opportunities. These SPEs have narrow and well-defined objectives and typically HSBC does not have any holdings in the SPEs of sufficient size to represent the majority of the risks and rewards of ownership.
In aggregate, HSBC had established money market funds which had total assets of US$109 billion at 31 December 2007 (2006: US$93 billion).
These are the main sub-categories of money market funds:
These money market funds invest in a diverse portfolio of highly-rated debt instruments, including limited holdings in instruments issued by SIVs. At 31 December 2007, these funds’ exposure to SIVs was US$3.9 billion (2006: US$6.8 billion).
CNAV funds
CNAV funds price their assets on an amortised cost basis, subject to the amortised book value of the portfolio being within 50 basis points of its market value. This enables CNAV funds to create and liquidate shares in the fund at a constant price. If the amortised value of the portfolio were to vary by more than 50 basis points from its market value, the
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CNAV fund would be required to price its assets at market value, and consequently would no longer be able to create or liquidate shares at a constant price. This is commonly known as ‘breaking the buck’.
HSBC’s CNAV funds hold senior notes issued by a number of SIVs and, due to current market liquidity conditions and consequential actions of the rating agencies, the market value of this SIV paper has deteriorated. This has caused the CNAV funds to record unrealised losses on their SIV investments. While the majority of these SIVs are bank-sponsored, and are not judged to be impaired, there are holdings in three independent SIVs which have experienced greater difficulties; two of these, in which HSBC’s CNAV funds have invested US$0.3 billion, were placed in enforcement in early 2008; the process by which the winding down of the independent SIVs and repaying secured creditors begins.
The deterioration in the market value of holdings of SIV paper raised the possibility that certain CNAV funds would be forced to realise liquid assets to meet potential redemptions. To helpaddress this potential impact, on 24 December 2007, HSBC provided two letters of limited indemnity, capped at US$33 million and £4 million (US$8 million) respectively, in relation to certain holdings of SIV assets of two of its CNAV funds with total assets under management (‘AUM’) at 31 December 2007 of US$27.1 billion. These limited indemnities did not result in HSBC consolidating these funds because HSBC was not exposed to the majority of the risks and rewards of ownership and the investors of the funds continue to bear the first loss. Separately, in December 2007, HSBC acquired US$0.3 billion of SIV paper at fair value from these CNAV funds.
Since 31 December 2007, HSBC has provided two additional letters of limited indemnity capped at US$33 million and £2 million (US$4 million) respectively, in relation to certain holdings of SIV assets of a further two CNAV funds with AUM at 31 December 2007 of US$8.7 billion. HSBC is not exposed to the majority of risks and rewards of ownership of the funds.
HSBC has continued to create and liquidate shares in all its CNAV funds at a constant price.
Enhanced VNAV funds
Enhanced VNAV funds price their assets on a fair value basis and consequently prices may change from one day to the next. These funds pursue an ‘enhanced’ investment strategy, as part of which
investors accept greater credit and duration risk in the expectation of higher returns.
Money market activities are highly developed in France due to the historical restriction on the payment of interest on current accounts, and the search for enhanced yields has resulted in sophisticated money market funds which are essentially used as an alternative to cash. However, since July 2007, French dynamic money market funds have experienced unprecedented redemption requests caused by the market’s lack of confidence in funds containing exposure primarily to US sub-prime assets. In August 2007, the decision by two French institutions to suspend withdrawals from certain asset-backed securities funds caused a general acceleration of redemption requests on dynamic money market funds.
In the third quarter of 2007, HSBC acquired underlying assets and shares in two of its dynamic money market funds of €1.2 billion (US$1.8 billion) and €0.6 billion (US$0.9 billion) respectively to fund asset redemptions. No additional shares were acquired in the fourth quarter. HSBC’s aggregate holding in these funds at 31 December 2007 was €0.9 billion (US$1.3 billion). The total AUM of these two funds at 31 December 2007 was €2.1 billion (US$3.1 billion). These funds were not consolidated by HSBC at 31 December 2007 because the acquisition of additional shares in these funds did not expose HSBC to the majority of risks and rewards of ownership. However, post year end, one of the funds has been consolidated by HSBC as a result of continued redemptions by unit holders which caused HSBC’s percentage holding in the funds to increase to a level where HSBC would obtain the majority of risks and rewards of ownership.
A further Enhanced VNAV fund experienced high shareholder redemptions in the fourth quarter of 2007 which depleted its stock of liquid assets, reducing its ability to meet further redemption payments. During November 2007, HSBC made two purchases of shares in the fund for US$0.3 billion and US$0.1 billion, respectively, to fund asset redemptions. This resulted in HSBC consolidating the fund because its resultant holding of 52 per cent represents the majority of risks and rewards of ownership.
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Total assets of HSBC’s money market funds
Total assets of HSBC’s money market funds, which are off-balance sheet
HSBC’s financial investments in off-balance sheet money market funds at 31 December 2007 amounted to US$2.9 billion (2006: US$0.7 billion). These assets have been classified as available-for-sale securities and measured at fair value.
Total assets of HSBC’s money market funds which are on-balance sheet at 31 December 2007 amounted to US$5.7 billion (2006: US$2.1 billion). These assets have been measured at fair value; US$0.7 billion (2006: nil) were classified as trading assets, and US$5 billion (2006: US$2.1 billion) were designated at fair value.
Non-money market investment funds
HSBC has also established a large number of non-money market funds to enable customers to invest in a range of assets, typically equities and debt securities. At the launch of a fund HSBC, as fund manager, typically provides a limited amount of initial capital known as ‘seed capital’ to enable the fund to start purchasing assets. These holdings are normally redeemed over time. The majority of these funds are off-balance sheet because in view of HSBC’s limited economic interest, HSBC does not have the majority of the risks and rewards of ownership.
Total assets of HSBC’s non-money market funds
Total assets of HSBC’s non-money market funds which are off-balance sheet
HSBC’s financial investments in off-balance sheet non-money market funds at 31 December 2007 amounted to US$2.7 billion (2006: US$2.0 billion). These assets have been classified as available-for-sale securities and measured at fair value.
Total assets of HSBC’s non-money market funds, which are on-balance sheet
Total assets of HSBC’s non-money market funds which are on-balance sheet, by balance sheet classification
Conduits
HSBC sponsors and manages two types of conduits which issue CP; multi-seller conduits and securities investment conduits. HSBC consolidated these conduits from inception because it is exposed to the majority of risks and rewards of ownership.
Multi-seller conduits have been established for the purpose of providing alternative sources of financing to HSBC’s clients, for example, in respect of discrete pools of vehicle finance loan receivables.
The multi-seller conduits purchase or fund interests in diversified pools of third party assets, which are financed by the issuance of CP. The cash flows received by the conduits are utilised to service payments to clients and to provide a commercial rate of return for HSBC. CP issued by the multi-seller
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conduits carries highly liquid short-term ratings, and benefits from liquidity facilities typically provided by HSBC. HSBC also provides secondary credit enhancements under the terms specified in the relevant programme documentation. HSBC’s multi-seller conduits are Regency Assets Limited (‘Regency’), Bryant Park Funding LLC (‘Bryant Park’), Abington Square Funding LLC (‘Abington Square’), and Performance Trust.
Due to lack of investor interest from the middle of 2007 in extendable CP, including that issued by Abington Square, HSBC provided finance to the conduit by purchasing the majority of its extendable CP from investors. In February 2008, the remaining assets within the conduit were refinanced and the CP repaid. The other multi-seller conduits are supported by liquidity facilities typically provided by HSBC. While these facilities do not provide for liquidity payments against defaulted assets they will in all cases provide for repayment of 100 per cent of CP that is covered by non-defaulted receivables.
Performance Trust was originally consolidated by HSBC, and later deconsolidated because HSBC retired the programme wide credit enhancement and the first loss note was sold to a third party during 2006. However, due to lack of liquidity in the market, Performance Trust experienced funding difficulties in the fourth quarter of 2007 and HSBC purchased Performance Trust’s CP as it became due. This resulted in HSBC consolidating the fund because its resultant holding of 83 per cent represents the majority of risks and rewards of ownership.
Securities investment conduits purchase highly rated asset-backed securities and facilitate tailored investment opportunities for HSBC’s investor clients. HSBC’s securities investment conduit is Solitaire Funding Limited (‘Solitaire’).
An analysis of the assets held by Solitaire at 31 December 2007 and 2006 is set out below.
Solitaire – Ratings analysis of assets
Solitaire – Composition of asset portfolio
These assets include US$1.1 billion (2006: US$1.8 billion) of exposure to US sub-prime mortgages, all of which are rated AAA.
Solitaire – Total assets by balance sheet classification
Solitaire – Funding structure
The consolidation of HSBC’s conduits resulted in HSBC consolidating assets of US$37.4 billion (2006: US$35.0 billion, excluding Performance Trust).
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Total assets of HSBC’s conduits by balance sheet classification, which are on-balance sheet
Securitisations
HSBC uses SPEs to securitise customer loans and advances it has originated mainly in order to diversify its sources of funding, and for capital efficiency. In such cases, the loans and advances are transferred by HSBC to the SPEs for cash, and the SPEs issue debt securities to investors. Credit enhancements are used to obtain investment grade ratings on the senior debt issued by the SPEs.
Except for one securitisation, with total assets of US$0.5 billion (2006: US$0.5 billion), where the SPE has not been consolidated because HSBC does not have the majority of risks and rewards of ownership, these SPEs are consolidated by HSBC. HSBC also established term securitisation programmes in the US and Germany where third party loans are securitised. The majority of these vehicles are not consolidated by HSBC as it is not exposed to majority of risks and rewards of ownership in the SPEs.
HSBC also uses SPEs for capital management purposes in respect of its originated customer loans and advances, where only the credit risk associated with the customer loans and advances is transferred by HSBC to the SPE using credit derivatives. These securitisations are commonly known as synthetic securitisations. These SPEs are consolidated where HSBC is exposed to the majority of risks and rewards of ownership.
Total assets of HSBC’s securitisations, by balance sheet classification, which are on-balance sheet
Total assets of HSBC’s securitisations, which are off-balance sheet
HSBC’s financial investments in off-balance sheet securitisations at 31 December 2007 amounted to US$0.7 billion (2006: US$0.7 billion). These assets include assets that have been securitised by HSBC under arrangements in which HSBC retains a continuing involvement in such assets which are classified as available-for-sale securities and measured at fair value. Further details are provided in Note 20 on the Financial Statements.
HSBC also establishes SPEs in the normal course of business for a number of purposes, for example, structured credit transactions for customers to provide finance to public and private sector infrastructure projects, and for asset and structured finance (‘ASF’) transactions.
Structured credit transactions
HSBC provides structured credit transactions to third party professional and institutional investors who wish to obtain exposure, sometimes on a leveraged basis, to a reference portfolio of debt instruments. The investors obtain the risks and rewards of the relevant reference portfolios by purchasing notes issued by the SPEs. The SPEs enter into contracts with HSBC, generally in the form of derivatives, in order to pass the risks and rewards of the reference portfolios to the SPEs. HSBC’s risk in relation to the derivative contracts with the SPEs is managed within HSBC’s trading market risk framework (see Market Risk Management on page 248).
The transactions are facilitated through SPEs in order that the notes issued to the investors can be rated. The SPEs are not consolidated by HSBC because the investors bear substantially all the risks and rewards of ownership through the notes. The exception would be in circumstances where HSBC itself holds a majority of the notes in particular SPEs.
The total fair value of liabilities (notes issued and derivatives) in structured credit transaction SPEs amounted to US$23.6 billion at 31 December 2007 (2006: US$7.9 billion). These amounts include
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US$0.1 billion (2006: US$0.7 billion) in SPEs that were consolidated by HSBC.
Other uses of SPEs
HSBC participates in ‘Public-Private Partnerships’ to provide financial support for infrastructure projects initiated by government authorities. The funding structure is commonly achieved through the use of SPEs. HSBC consolidates these SPEs where it is exposed to the majority of risks and rewards of the vehicles.
HSBC’s ASF business specialises in leasing and arranging finance for aircraft and other physical assets, which it is customary to ring-fence through the use of SPEs, and in structured loans and deposits where SPEs introduce cost efficiencies. HSBC consolidates these SPEs where the substance of the relationship indicates that HSBC controls the SPE.
HSBC’s risks and rewards of ownership in these SPEs are in respect of its on-balance sheet assets and liabilities.
Third party sponsored SPEs
HSBC’s exposure to third party sponsored SIVs, conduits and securitisations have arisen through normal banking arrangements on standard market terms. HSBC did not provide any credit enhancement to third party SIVs, conduits and securitisations.
HSBC’s commitments under liquidity facilities to third party SIVs, conduits and securitisations
Other exposures to third party SIVs, conduits and securitisations where a liquidity facility has been provided
Other off-balance sheet arrangements and commitments
Financial guarantees, letters of credit and similar undertakings
Note 41 on the Financial Statements describes various types of guarantees and discloses the maximum potential future payments under such arrangements. Credit risk associated with all forms of guarantees is assessed in the same manner as for on-balance sheet credit advances and, where necessary, provisions for assessed impairment are included in ‘Other provisions’.
Commitments to lend
Undrawn credit lines are disclosed in Note 41 on the Financial Statements. The majority by value of undrawn credit lines arise from ‘open to buy’ lines on personal credit cards, advised overdraft limits and other pre-approved loan products, and mortgage offers awaiting customer acceptance. HSBC generally has the right to change or terminate any conditions of a personal customer’s overdraft, credit card or other credit line upon notification to the customer. In respect of corporate commitments to lend, in most cases HSBC’s position will be protected through restrictions on access to funding in the event of material adverse change.
Leveraged finance transactions
Loan commitments in respect of leveraged finance transactions are accounted for as derivatives where it is HSBC’s intention to sell the loan after origination. As at 31 December 2007, HSBC’s commitments in respect of leveraged finance transactions were US$8.9 billion, of which US$6.0 billion were funded and US$2.9 billion were un-funded. During 2007, losses of US$195 million were recognised in trading income relating to transactions priced prior to the dislocation in the market. Transactions priced subsequent to the widening of credit spreads have not resulted in any material net write-downs.
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The Group Chairman and Group Finance Director, with the assistance of other members of management, carried out an evaluation of the effectiveness of the design and operation of HSBC Holdings’ disclosure controls and procedures as of 31 December 2007. Based upon that evaluation, the Group Chairman and Group Finance Director concluded that HSBC’s disclosure controls and procedures as of 31 December 2007 were effective to provide reasonable assurance that information required to be disclosed in the reports which the company files and submits under the US Securities Exchange Act of 1934, as amended, is recorded, processed, summarised and reported as and when required. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.
There has been no change in HSBC Holdings’ internal control over financial reporting during the year ended 31 December 2007 that has materially affected, or is reasonably likely to materially affect, HSBC Holdings’ internal control over financial reporting.
Management’s assessment of internal controls
Management is responsible for establishing and maintaining an adequate internal control structure and procedures for financial reporting, and has completed an assessment of the effectiveness of the Group’s internal control over financial reporting as of 31 December 2007. In making the assessment, management used the framework for Director’s internal control evaluation contained within the Combined Code (‘The Revised Turnbull Guidance’), as well as the criteria established by the Committee of Sponsoring Organisations of the Treadway Commission (COSO) in ‘Internal Control-Integrated Framework’.
Based on the assessment performed, management concluded that as at 31 December 2007, the Group’s internal control over financial reporting was effective.
KPMG Audit Plc, which has audited the consolidated financial statements of the Group for the year ended 31 December 2007, has also audited the effectiveness of the Group’s internal control over financial reporting under Auditing Standard No.5 of the Public Company Accounting Oversight Board (United States) as stated in their report on pages 334 and 335.
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With listings of its ordinary shares in London, Hong Kong, New York, Paris and Bermuda, HSBC Holdings complies with the relevant requirements for listing and trading on each of these exchanges. In the UK, these are the Listing Rules of the Financial Services Authority (‘FSA’); in Hong Kong, The Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited (‘HKSE’); in the US, where the shares are traded in the form of ADSs, HSBC Holdings’ shares are registered with the US Securities and Exchange Commission (‘SEC’). As a consequence of its US listing, HSBC Holdings is also subject to the reporting and other requirements of the US Securities Act of 1933, as amended, the Securities Exchange Act of 1934, as amended, and the New York Stock Exchange’s (‘NYSE’) Listed Company Manual, in each case as applied to foreign private issuers. In France and Bermuda, HSBC Holdings is subject to the listing rules of Euronext, Paris and the Bermuda Stock Exchange respectively, applicable to companies with secondary listings.
A statement of HSBC’s compliance with the code provisions of the Combined Code on Corporate Governance issued by the Financial Reporting Council and with the Code on Corporate Governance Practices in Appendix 14 to the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited is set out in the ‘Report of the Directors: Governance’ on page 289.
HSBC’s operations throughout the world are regulated and supervised by approximately 510 different central banks and regulatory authorities in those jurisdictions in which HSBC has offices, branches or subsidiaries. These authorities impose a variety of requirements and controls designed to improve financial stability and the transparency of financial markets and their contribution to economic growth. These regulations and controls cover, inter alia, capital adequacy, depositor protection, market liquidity, governance standards, customer protection (for example, fair lending practices, product design, and marketing and documentation standards), and social responsibility obligations (for example, anti-money laundering and anti-terrorist financing measures). In addition, a number of countries in which HSBC operates impose rules that affect, or place limitations on, foreign or foreign-owned or controlled banks and financial institutions. The rules include restrictions on the opening of local offices, branches or subsidiaries and the types of banking and non-banking activities that may be conducted by those local offices, branches or subsidiaries;
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restrictions on the acquisition of local banks or regulations requiring a specified percentage of local ownership; and restrictions on investment and other financial flows entering or leaving the country. The supervisory and regulatory regimes of the countries where HSBC operates will determine to some degree HSBC’s ability to expand into new markets, the services and products that HSBC will be able to offer in those markets and how HSBC structures specific operations.
The FSA supervises HSBC on a consolidated basis. In addition, each operating bank, finance company or insurance operation within HSBC is regulated by local supervisors. The primary regulatory authorities are those in the UK, Hong Kong and the US, the Group’s principal areas of operation.
In June 2004, the Basel Committee on Banking Supervision introduced a new capital adequacy framework to replace the 1988 Basel Capital Accord in the form of a final Accord (commonly known as ‘Basel II’). Details of the EU’s implementation of Basel II and how this will affect HSBC are set out on page 284.
UK regulation and supervision
UK banking and financial services institutions are subject to multiple regulations. The primary UK statute is the Financial Services and Markets Act 2000 (‘FSMA’). Additionally, data privacy is regulated by the Data Protection Act 1998. Other UK financial services legislation is derived from EU directives relating to banking, securities, insurance, investment and sales of personal financial services.
The FSA is responsible for authorising and supervising UK financial services institutions and regulates all HSBC’s businesses in the UK which require authorisation under the FSMA. These include deposit taking, retail banking, life and general insurance, pensions, investments, mortgages, custody and branch share-dealing businesses, and treasury and capital markets activity. HSBC Bank is HSBC’s principal authorised institution in the UK.
FSA rules establish the minimum criteria for authorisation for banks and financial services businesses in the UK. They also set out reporting (and, as applicable, consent) requirements with regard to large individual exposures and large exposures to related borrowers. In its capacity as supervisor of HSBC on a consolidated basis, the FSA receives information on the capital adequacy of, and sets requirements for, HSBC as a whole. Further details on capital measurement are included in ‘Capital management and allocation’ on pages 282 to
284. The FSA’s approach to capital requirements for UK insurers is to require minimum capital to be calculated on two bases. First, firms must calculate their liabilities on a prudent basis and add a statutory solvency margin (Pillar 1). Secondly, firms must calculate their liabilities on a realistic basis then add to this their own calculation of risk-based capital. The sum of realistic reserves and risk-based capital (Pillar 2) is agreed with the FSA. Insurers are required to maintain capital equal to the higher of Pillars 1 and 2. The FSA has the right to object, on prudential grounds, to persons who hold, or intend to hold, 10 per cent or more of the voting power of a financial institution.
The regulatory framework of the UK financial services system has traditionally been based on co-operation between the FSA and authorised institutions. The FSA monitors authorised institutions through ongoing supervision and the review of routine and ad hoc reports relating to financial and prudential matters. The FSA may periodically obtain independent reports, usually from the auditors of the authorised institution, as to the adequacy of internal control procedures and systems as well as procedures and systems governing records and accounting. The FSA meets regularly with HSBC’s senior executives to discuss HSBC’s adherence to the FSA’s prudential guidelines. They also regularly discuss fundamental matters relating to HSBC’s business in the UK and internationally, including areas such as strategic and operating plans, risk control, loan portfolio composition and organisational changes, including succession planning.
Consumers of UK financial services institutions are covered by the Financial Services Compensation Scheme (‘FSCS’), which is the UK’s statutory fund of last resort. It deals with claims against authorised institutions that are unable, or likely to be unable, to pay claims against them, for example if an institution has stopped trading or is in insolvency. FSCS protects deposits, investments, insurance and mortgage advice and arranging, and is funded by levies on institutions authorised by the FSA. The maximum levels of compensation are available on www.fscs.org.uk/consumer.
Hong Kong regulation and supervision
Banking in Hong Kong is subject to the provisions of the Banking Ordinance, and to the powers, functions and duties ascribed by the Banking Ordinance to the Hong Kong Monetary Authority (the ‘HKMA’). The principal function of the HKMA is to promote the general stability and effective working of the banking system in Hong Kong. The
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Report of the Directors: The Management of Risk (continued)
HKMA is responsible for supervising compliance with the provisions of the Banking Ordinance. The Banking Ordinance gives power to the Chief Executive of Hong Kong to give directions to the HKMA and the Financial Secretary with respect to the exercise of their respective functions under the Banking Ordinance.
The HKMA has responsibility for authorising banks, and has discretion to attach conditions to its authorisation. The HKMA requires that banks or their holding companies file regular prudential returns, and holds regular discussions with the management of the banks to review their operations. The HKMA may also conduct ‘on-site’ examinations of banks and, in the case of banks incorporated in Hong Kong, of any local and overseas branches and subsidiaries. The HKMA requires all authorised institutions to have adequate systems of internal control and requires the institutions’ external auditors, upon request, to report on those systems and other matters such as the accuracy of information provided to the HKMA. In addition, the HKMA may from time to time conduct tripartite discussions with banks and their external auditors.
The HKMA, which may deny the acquisition of voting power of over 10 per cent in a bank, and may attach conditions to its approval thereof, can effectively control changes in the ownership and control of Hong Kong-incorporated financial institutions. In addition, the HKMA has the power to divest controlling interests in a bank from persons if they are no longer deemed to be fit and proper, if they may otherwise threaten the interests of depositors or potential depositors, or if they have contravened any conditions specified by the HKMA. The HKMA may revoke authorisation in the event of an institution’s non-compliance with the provisions of the Banking Ordinance. These provisions require, among other things, the furnishing of accurate reports.
The Banking Ordinance requires that banks submit to the HKMA certain returns and other information and establishes certain minimum standards and ratios relating to capital adequacy (see below), liquidity, capitalisation, limitations on shareholdings, exposure to any one customer, unsecured advances to persons affiliated with the bank and holdings of interests in land, with which banks must comply.
The HKMA implemented Basel II with effect from 1 January 2007 for all Authorised Institutions incorporated in Hong Kong. As under Basel I, each Authorised Institution is required to maintain a capital adequacy ratio (calculated as the ratio of the
bank’s capital base to its risk-weighted exposure) of at least 8 per cent. For banks with subsidiaries, the HKMA is empowered to require that the ratio be calculated on a solo and consolidated basis. The HKMA is empowered to increase the minimum capital adequacy ratio (to up to 16 per cent), after consultation with the bank.
Hong Kong depositors are covered by the Deposit Protection Scheme, which covers deposits kept with licensed banks in Hong Kong. All such banks are scheme members unless specifically exempted, and are required to contribute to the funding of the scheme. In the event of the insolvency of a scheme member, each depositor is entitled to receive up to HK$100,000. Only traditional Hong Kong dollar or foreign currency deposits in Hong Kong are covered by the scheme and other deposit products like structured deposits, secured deposits, bearer instruments and offshore deposits are not protected.
The marketing of, dealing in and provision of advice and asset management services in relation to securities in Hong Kong are subject to the provisions of the Securities and Futures Ordinance of Hong Kong (‘Securities and Futures Ordinance’). Entities engaging in activities regulated by the Securities and Futures Ordinance are required to be licensed. The HKMA is the primary regulator for banks involved in the securities business, while the Securities and Futures Commission is the regulator for non-banking entities.
In Hong Kong, insurance business is regulated under the Insurance Companies Ordinance and by the Insurance Authority of Hong Kong. The IAHK is responsible for the licensing of insurers and insurance brokers, although insurance business can also be licensed by the Confederation of Insurance Brokers (‘CIB’). Separately , insurance agents are licensed by the Hong Kong Federation of Insurers (‘HKFI’). Both the HKFI and the CIB have enacted Codes of Conduct for insurance agents and brokers respectively and can impose sanctions for misbehaviour or breach.
HSBC Insurance (Asia-Pacific) Holdings Limited (‘INAH’) is licensed by the IA as an insurer. The Hongkong and Shanghai Banking Corporation, which is authorised by the HKFI, acts as an agent for INAH, and HSBC Insurance Brokers (Asia-Pacific) Limited acts as insurance brokers licensed by the CIB.
US regulation and supervision
HSBC is subject to extensive federal and state supervision and regulation in the US. Banking laws
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and regulations of the Federal Reserve Board, the Office of the Comptroller of the Currency (‘OCC’) and the Federal Deposit Insurance Corporation (‘FDIC’) govern many aspects of HSBC’s US business.
HSBC and its US operations are subject to supervision, regulation and examination by the Federal Reserve Board because HSBC is a ‘bank holding company’ under the US Bank Holding Company Act of 1956 (‘BHCA’). HSBC and HSBC North America Holdings Inc. (‘HNAH’), formed to hold HSBC’s US and Canadian operations, are ‘bank holding companies’ by virtue of their ownership and control of HSBC Bank USA, N.A. (‘HSBC Bank USA’), HSBC National Bank USA (‘HSBC Bank Maryland’), and HSBC Trust Company (Delaware), N.A. (‘HSBC Bank Delaware’). These three banks are nationally chartered FDIC-insured, full-service commercial banks and members of the Federal Reserve System. HSBC also owns HSBC Bank Nevada, N.A. (‘HSBC Bank Nevada’), a nationally chartered bank limited to credit card activities which is also a member of the Federal Reserve System. These four banks are subject to regulation, supervision and examination by the OCC and, as their deposits are insured by the FDIC, they are subject to relevant FDIC regulation. Both HSBC and HNAH are registered as financial holding companies (‘FHC’s) under the BHCA, enabling them to offer a broad range of financial products and services through their subsidiaries. HSBC’s and HNAH’s ability to engage in expanded financial activities as FHCs depends upon HSBC and HNAH continuing to meet certain criteria set forth in the BHCA, including requirements that their US depository institution subsidiaries, HSBC Bank USA, HSBC Bank Maryland, HSBC Bank Nevada and HSBC Bank Delaware, be ‘well capitalised’ and ‘well managed’, and that such institutions have achieved at least a satisfactory record in meeting community credit needs during their most recent examinations pursuant to the Community Reinvestment Act. These requirements also apply to Wells Fargo HSBC Trade Bank, N.A., in which HSBC and HNAH have a 20 per cent voting interest in equity capital and a 40 per cent economic interest. Each of these depository institutions achieved at least the required rating during their most recent examinations. At 31 December 2007, HSBC Bank USA, HSBC Bank Maryland, HSBC Bank Nevada, HSBC Bank Delaware and Wells Fargo HSBC Trade Bank, N.A. were each well capitalised and well managed under Federal Reserve Board regulations.
In general, under the BHCA, an FHC would be required, upon notice by the Federal Reserve Board,
to enter into an agreement with the Federal Reserve Board to correct any failure to comply with the requirements to maintain FHC status. Until such deficiencies are corrected, the Federal Reserve Board may impose limitations on the US activities of an FHC and depository institutions under its control. If such deficiencies are not corrected, the Federal Reserve Board may require an FHC to divest its control of any subsidiary depository institution or to desist from certain financial activities in the US.
HSBC and HNAH are generally prohibited under the BHCA from acquiring, directly or indirectly, ownership or control of more than 5 per cent of any class of voting shares of, or substantially all the assets of, or exercising control over, any US bank, bank holding company or many other types of depository institutions and/or their holding companies without the prior approval of the Federal Reserve Board and potentially other US banking regulatory agencies.
The Gramm-Leach-Bliley Act of 1999 (‘GLBA’) and the regulations issued thereunder contained a number of other provisions that affect HSBC’s operations and the operations of all financial institutions. One such provision contained detailed requirements relating to the financial privacy of consumers. In addition, the so-called ‘push-out’ provisions of GLBA removed the blanket exemption from registration for securities activities conducted in banks (including HSBC Bank USA) under the Exchange Act of 1934, as amended. New rules have been published to implement these changes and, when effective, will allow banks to continue to avoid registration as a broker or dealer only if they conduct securities activities that fall within a set of defined exceptions. A narrowed ‘dealer’ definition took effect in September 2003, and a narrowed ‘broker’ definition will take effect for each bank on the first day of its fiscal year following 30 September 2008. Pursuant to the new regulations, it is likely that certain securities activities currently conducted by HSBC Bank USA will need to be restructured or transferred to one or more US-registered broker-dealer affiliates effective from 1 January 2009.
The US is party to the 1988 Basel I Capital Accord, and US banking regulatory authorities have adopted capital requirements for US banks and bank holding companies that are generally consistent with the Accord.
The authorities have now published, on 7 December 2007, their final Basel II rules for credit and operational risk. These require mandated banking groups, which include HNAH, to have fully
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implemented Basel II by no later than 36 months after 1 April 2008, including the completion of a full 12-month parallel run. HSBC is analysing the rules to ensure that systems and processes, already largely developed and implemented, are aligned with the final requirements.
In addition, US banking authorities have adopted ‘leverage’ capital requirements that generally require US banks and bank holding companies to maintain a minimum amount of capital in relation to their balance sheet assets (measured on a non-risk-weighted basis).
The Federal Deposit Insurance Corporation Improvement Act of 1991 provides for extensive regulation of insured depository institutions (such as HSBC Bank USA, HSBC Bank Maryland, HSBC Bank Delaware, HSBC Bank Nevada and Wells Fargo HSBC Trade Bank, N.A.), including requiring federal banking regulators to take ‘prompt corrective action’ with respect to FDIC-insured banks that do not meet minimum capital requirements.
HSBC Bank USA, HSBC Bank Maryland, HSBC Bank Delaware, HSBC Bank Nevada and Wells Fargo HSBC Trade Bank, N.A., like other FDIC-insured banks, may be required to pay assessments to the FDIC for deposit insurance under the FDIC’s Bank Insurance Fund. Under the FDIC’s risk-based system for setting deposit insurance assessments, an institution’s assessments vary according to the level of capital an institution holds, its deposit levels and other factors.
The USA Patriot Act (‘Patriot Act’) imposes significant record keeping and customer identity requirements, expands the US federal government’s powers to freeze or confiscate assets and increases the available penalties that may be assessed against financial institutions for failure to comply with obligations imposed on such institutions to detect, prevent and report money laundering and terrorist financing. Pursuant to the Patriot Act, final regulations are in effect which impose anti-money laundering compliance obligations on financial institutions (a term which, for this purpose, includes insured US depository institutions, US branches and agencies of foreign banks, US broker-dealers and numerous other entities). Many of the anti-money laundering compliance requirements imposed by the Patriot Act and these implementing regulations are generally consistent with the anti-money laundering compliance obligations existing for banks prior to the Patriot Act. These include requirements to adopt and implement an anti-money laundering programme, report suspicious transactions and implement due diligence procedures for certain
correspondent and private banking accounts. Certain other specific requirements of the Patriot Act were new compliance obligations. The passage of the Patriot Act and other recent events have resulted in heightened scrutiny of the Bank Secrecy Act and anti-money laundering compliance by federal and state bank examiners.
The HSBC Group takes its obligations to prevent money laundering and terrorist financing very seriously. HSBC has policies, procedures and training intended to ensure that its employees know and understand HSBC’s criteria for when a client relationship or business should be evaluated as higher risk. As part of its continuing evaluation of risk, the HSBC Group monitors its activities in countries and entities subject to US economic sanctions programmes administered by the Office of Foreign Assets Control. HSBC’s business activities include correspondent banking services to banks located in some of these countries and private banking services for nationals of, and clients domiciled in, some of the countries. The Group has a small representative office in Tehran, Iran.
The US State Department has designated certain countries (Cuba, Iran, North Korea, Sudan and Syria) as state sponsors of terrorism, and US law generally prohibits US persons from doing business with such countries. HSBC is aware of initiatives by governmental entities and institutions in the US to adopt rules, regulations or policies prohibiting transactions with or investments in entities doing business with such countries. The HSBC Group does not believe its business activities with counterparties in, or directly relating to, such countries are material to its business, and such activities represented a very small part of total assets at 31 December 2007 and total revenues for the year ended 31 December 2007.
If HSBC were to fail to maintain and implement adequate programmes to combat money laundering and terrorist financing and to comply with economic sanctions, or was found to be in breach of relevant laws and regulations, including by failing to observe economic sanctions, serious legal and reputational consequences for the Group could arise.
HSBC’s US insurance agency and underwriting operations are subject to regulatory supervision under the laws of the states in which they operate. Insurance laws and regulations vary from state to state but generally require forms and rates to be filed with, and approved by, the state insurance departments, and cover licensing of insurance companies; corporate governance; premiums and loss rates; dividend restrictions; types of insurance that may be sold; underwriting processes;
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permissible investments; reserve requirements; and insurance advertising and marketing practices. Each HSBC US insurance subsidiary undergoes periodic market conduct and financial examinations by the relevant state insurance departments, and HSBC’s insurance agencies and agents are subject to state licensing and registration requirements.
Additionally, with respect to credit insurance, because it is sold in connection with a loan, state loan laws often contain requirements related to offering, cancelling and refunding credit insurance. Although insurance is not generally regulated by the federal government, certain federal regulations related to lending disclosures apply to the sale and cancellation of credit insurance.
HSBC’s US consumer finance operations are subject to extensive state-by-state regulation in the US, and to laws relating to consumer protection (both in general, and in respect of sub-prime lending operations, which have been subject to enhanced regulatory scrutiny); discrimination in extending credit; use of credit reports; privacy matters; disclosure of credit terms; and correction of billing errors. They also are subject to regulations and legislation that limit operations in certain jurisdictions. For example, limitations may be placed on the amount of interest or fees that a loan may bear, the amount that may be borrowed, the types of actions that may be taken to collect or foreclose upon delinquent loans or the information about a customer that may be shared. HSBC’s US consumer finance branch lending offices are generally licensed in those jurisdictions in which they operate. Such licences have limited terms but are renewable, and are revocable for cause. Failure to comply with applicable laws and regulations may limit the ability of these licensed lenders to collect or enforce loan agreements made with consumers and may cause the consumer finance lending subsidiary and/or its control person to be liable for damages and penalties.
HSBC’s US credit insurance operations are subject to regulatory supervision under the laws of the states in which they operate. Regulations vary from state to state but generally cover licensing of insurance companies; premiums and loss rates; dividend restrictions; types of insurance that may be sold; permissible investments; policy reserve requirements; and insurance marketing practices.
Certain US source payments to foreign persons may be subject to US withholding tax unless the foreign person is a ‘qualified intermediary’. A qualified intermediary is a financial intermediary which is qualified under the US Internal Revenue Code of 1986 and has completed the Qualified
Intermediary Withholding Agreement with the Internal Revenue Service. Various HSBC operations outside the US are qualified intermediaries.
All HSBC’s activities involve the measurement, evaluation, acceptance and management of some degree of risk, or combination of risks. The most important risk categories that the Group is exposed to are credit risk (including cross-border country risk), insurance risk, liquidity risk, market risk (including foreign exchange, interest rate and equity price risks), operational risks in various forms, pension risk, residual value risk, reputational risk and sustainability (environmental and social) risks.
The management of these various risk categories is discussed below. Given the distinct characteristics of the insurance business, the management of its credit, liquidity and market risksis described alongside insurance risk in the section ‘Risk management of insurance operations’.
The risk management framework established by the Group seeks to foster the continuous monitoring of the risk environment and an integrated evaluation of risks and their interdependencies.
Risk governance and ownership
A well-established risk governance and ownership structure ensures oversight of, and accountability for, the effective management of risk at Group, regional, customer group and operating entity levels.
The Board of Directors of HSBC Holdings approves plans and performance targets for the Group and its principal subsidiaries, the appointment of senior officers, the delegation of authorities for credit and other risks and the establishment of effective control procedures. Under authority delegated by the Board of Directors, Group Management Board (‘GMB’) formulates high-level Group risk management policy.
A separately convened Risk Management Meeting (‘RMM’) of GMB has the responsibility for exercising and delegating risk approval authorities, setting risk appetite and approving definitive risk policies and controls. It monitors all categories of risk, receives reports, determines action to be taken and reviews the efficacy of HSBC’s risk management framework.
GMB and RMM are supported by a dedicated Group Risk function headed by the Group Chief Risk
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Officer (‘GCRO’), who is a member of both GMB and RMM and reports to the Group Finance Director within an integrated Finance and Risk function. Similar structures involving the creation of local Chief Risk Officers are being extended to all major Group subsidiaries and customer groups during 2008. The Group Finance Director represents Finance and Risk on the HSBC Holdings Board.
Primary responsibility for managing risk at operating entity level lies with the respective boards and Chief Executive Officers, as custodians of the relevant balance sheets. In turn, Group Risk has functional responsibility for the principal financial risk types, namely: retail and wholesale credit, market, operational and security/fraud risks. Within this structure, it establishes Group policy, exercises Group-wide oversight and provides reporting and analysis of portfolio composition on a global and a regional basis to senior management. Group Risk co-ordinates the further development of the risk appetite, economic capital and stress-testing frameworks. In addition, the GCRO is a member of the Group Portfolio Oversight Committee, chaired by the Group Treasurer, which governs the Group’s portfolio management activities for the wholesale business sector.
HSBC’s risk management policies, encapsulated in the Group Standards Manual and cascaded in a hierarchy of policy manuals throughout the Group, are designed to support the formulation of risk appetite, guide employees and establish procedures for monitoring and controlling risks, with timely and reliable reporting to management. HSBC regularly reviews and updates its risk management policies and systems to reflect changes in markets, products and emerging best practice.
It is the responsibility of all Group officers to identify, assess and manage risk within the scope of their assigned responsibilities. Personal accountability, reinforced by the Group’s governance structure and instilled by training, helps to foster throughout the Group a disciplined and constructive culture of risk management and control.
Credit risk is the risk of financial loss if a customer or counterparty fails to meet an obligation under a contract. It arises principally from direct lending, trade finance and leasing business, but also from certain off-balance sheet products such as guarantees and credit derivatives, and from the Group’s holdings of assets in the form of debt securities.
HSBC has standards, policies and procedures dedicated to monitoring and managing risk from such activities.
Within Head Office, the Group Risk function provides high-level centralised oversight and management of credit risk for HSBC worldwide. Its responsibilities include:
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Each HSBC operating company is required to implement credit policies, procedures and lending guidelines that conform to Group standards, with credit approval authorities delegated from the Board of Directors of HSBC Holdings to the relevant Chief Executive Officer. In each major subsidiary, a Chief Risk Officer or Chief Credit Officer reports to the local Chief Executive Officer or Chief Operating Officer on credit-related issues, maintaining a strong functional reporting line to the GCRO.
Each operating company is responsible for the quality and performance of its credit portfolios and for monitoring and controlling all credit risks in its portfolios, including those subject to central approval by Group Risk. This includes managing its own risk concentrations by market sector, geography and product. Local systems are in place throughout the Group to enable operating companies to control and monitor exposures by customer and retail product segments.
Special attention is paid to problem exposures, which are subject to more frequent and intensive review and reporting, in order to accelerate remedialaction. Where appropriate, HSBC’s local operating companies maintain or establish specialist units to provide customers with support in order to help them avoid default wherever possible.
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Periodic risk-based audits of operating companies’ credit processes and portfolios are undertaken by HSBC’s Internal Audit function. Audits include consideration of the adequacy and clarity of credit policy/procedure manuals; an in-depth analysis of a representative sample of accounts; an overview of homogeneous portfolios of similar assets to assess the quality of the loan book and other exposures; consideration of any oversight or review work performed by credit risk management functions and the adequacy of impairment calculations; a review of analytical model governance and implementation; a review of management objectives and a check that Group and local standards and policies are adhered to in the approval and management of credit facilities.
Individually significant accounts are reviewed on a sample basis to ensure that risk ratings are appropriate, that credit and collection procedures have been properly followed and that, when an account or portfolio evidences deterioration, impairment allowances are raised in accordance with the Group’s established processes. Internal Audit discusses with management risk ratings it considers to be inappropriate; after discussion, its final recommendations for revised ratings must then be adopted.
Collateral and other credit enhancements(Audited)
Loans and advances
It is HSBC’s policy, when lending, to do so within the customer’s capacity to repay, rather than rely excessively on security. Depending on the customer’s standing and the type of product, facilities may be unsecured. Nevertheless, collateral can be an important mitigant of credit risk.
Operating companies are required to implement appropriate guidelines on the acceptability of specific classes of collateral or credit risk mitigation, and determine suitable valuation parameters. Such parameters, structures and legal covenants are required to be subject to regular review to ensure that they are supported by empirical evidence and continue to fulfil their intended purpose. The principal collateral types are as follows:
In addition, credit derivatives, including credit default swaps and structured credit notes, as well as securitisation structures, are used to manage credit risk in the Group’s loan portfolio.
HSBC does not disclose the fair value of collateral held as security or other credit enhancements on loans and advances past due but not impaired, or on individually assessed impaired loans and advances, as it is not practicable to do so.
Other financial assets
Collateral held as security for financial assets other than loans and advances is determined by the nature of the instrument. Debt securities, treasury and other eligible bills are generally unsecured, with the exception of asset-backed securities and similar instruments, which are secured by pools of financial assets.
The ISDA Master Agreement is HSBC’s preferred agreement for documenting derivatives activity. It provides the contractual framework within which dealing activity across a full range of over-the-counter products is conducted, and contractually binds both parties to apply close-out netting across all outstanding transactions covered by an agreement if either party defaults or other pre-agreed termination events occur. It is common, and HSBC’s preferred, practice for the parties to execute a Credit Support Annex (‘CSA’) in conjunction with the ISDA Master Agreement. Under a CSA, collateral is passed between the parties to mitigate the market-contingent counterparty risk inherent in the outstanding positions.
Settlement risk arises in any situation where a payment in cash, securities or equities is made in the expectation of a corresponding receipt in cash, securities or equities. Daily settlement limits are established for each counterparty to cover the aggregate of all settlement risk arising from HSBC’s transactions with them, on any single day. Settlement risk on many transactions, particularly those involving securities and equities, is substantially mitigated through being effected via assured payment systems, or on a delivery-versus-payment basis.
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Credit quality of loans and advances(Audited)
HSBC’s credit risk rating systems and processes differentiate exposures in order to highlight those with greater risk factors and higher potential severity of loss. For individually significant accounts, risk ratings are reviewed regularly and amendments, where necessary, are implemented promptly. Within the Group’s retail portfolios, risk is assessed and managed using a wide range of risk and pricing models.
For many years, HSBC has deployed a seven-grade rating system based on a ‘composite’ assessment of the likelihood and extent of delinquency and risk mitigation (for details, see page 224).
This legacy risk rating scale is being superseded by a more sophisticated and granular methodology, based on probability of default and loss estimates, compliant with an internal ratings-based (‘IRB’) approach required to support the Basel II framework for calculating the Group’s minimum capital requirement. The integration of this framework into reporting structures will enable Board and regulatory reporting on the new basis in accordance with the Group’s IRB obligations. The new framework is well embedded in the Group’s principal operating entities.
Impairment assessment(Audited)
When impairment losses occur, HSBC reduces the carrying amount of loans and advances and held-to-maturity financial investments through the use of an allowance account. When impairment of available-for-sale financial assets occurs, the carrying amount of the asset is reduced directly.
Two types of impairment allowance are in place: individually assessed and collectively assessed, as discussed below.
Impairment allowances may be assessed and created either for individually significant accounts or, on a collective basis, for groups of individually significant accounts for which no evidence of impairment has been individually identified or for high-volume groups of homogeneous loans that are not considered individually significant.
It is HSBC’s policy that each operating company creates allowances for impaired loans promptly and on a consistent basis.
Management regularly evaluates the adequacy of the established allowances for impaired loans by conducting a detailed review of the loan portfolio,
comparing performance and delinquency statistics with historical trends and assessing the impact of current economic conditions.
Individually assessed impairment allowances
These are determined by evaluating exposure to loss, case by case, on all individually significant accounts and all other accounts that do not qualify for the collective assessment approach outlined below. Loans are treated as impaired as soon as there is objective evidence that an impairment loss has been incurred. The criteria used by HSBC to determine that there is such objective evidence include, inter alia :
In determining the level of allowances on such accounts, the following factors are typically considered:
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The level of impairment allowances on individually significant accounts that are above defined materiality thresholds is reviewed at least semi-annually, and more regularly when circumstances require. This normally encompasses re-assessment of the enforceability of any collateral held and of actual and anticipated receipts. For significant commercial and corporate debts, specialised loan ‘work-out’ teams with experience in insolvency and specific market sectors are used to manage the lending and assess likely losses.
Individually assessed impairment allowances are only released when there is reasonable and objective evidence of a reduction in the established loss estimate.
Collectively assessed impairment allowances
Impairment is assessed on a collective basis in two circumstances:
Incurred but not yet identified impairment
Individually assessed loans for which no evidence of impairment has been specifically identified on an individual basis are grouped together according to their credit risk characteristics. A collective impairment allowance is calculated to reflect impairment losses incurred at the balance sheet date which will only be individually identified in the future.
The collective impairment allowance is determined having taken into account:
The period between a loss occurring and its identification is estimated by local management for each identified portfolio. In general, the periods used vary between four and twelve months although, in exceptional cases, longer periods are warranted.
The basis on which impairment allowances for incurred but not yet identified losses is established in each reporting entity is documented and reviewed by senior Finance and Credit Risk management to ensure conformity with Group policy.
Homogeneous groups of loans
Two methodologies are used to calculate impairment allowances where large numbers of relatively low-value assets are managed using a portfolio approach, typically:
When appropriate empirical information is available, the Group uses roll rate methodology. This employs a statistical analysis of historical trends of default and the amount of consequential loss, based on the delinquency of accounts within a portfolio of homogeneous accounts. Other historical data and current economic conditions are also evaluated when calculating the appropriate level of impairment allowance required to cover inherent loss. In certain highly developed markets, models also take into account behavioural and account management trends revealed in, for example, bankruptcy and rescheduling statistics.
When the portfolio size is small, or when information is insufficient or not reliable enough to adopt a roll rate methodology, a formulaic approach is used that allocates progressively higher percentage loss rates the longer a customer’s loan is overdue. Loss rates reflect the discounted expected future cash flows for a portfolio.
Generally, historical experience is the most objective and relevant information from which to begin to assess inherent loss within each portfolio. In circumstances where historical loss experience provides less relevant information about the inherent loss in a given portfolio at the balance sheet date – for example, where there have been changes in economic conditions or regulations – management considers the more recent trends in the portfolio risk
factors which may not be adequately reflected in its statistical models and, subject to guidance from Group Finance and Group Risk, adjusts impairment allowances accordingly.
Roll rates, loss rates and the expected timing of future recoveries are regularly benchmarked against actual outcomes to ensure they remain appropriate.
Write-off of loans and advances
Loans are normally written off, either partially or in full, when there is no realistic prospect of further recovery. Where loans are secured, this is generally after receipt of any proceeds from the realisation of security.
In the case of residential mortgages and second lien loans in HSBC Finance, loan carrying amounts in excess of net realisable value are written off at or before the time foreclosure is completed or when settlement is reached with the borrower. If foreclosure is not pursued, and there is no reasonable expectation of recovery, the loan is normally written off no later than the end of the month in which the loan becomes 240 days contractually past due.
Unsecured personal facilities, including credit cards, are generally written off at between 150 and 210 days past due, the standard period being the end of the month in which the account becomes 180 days contractually delinquent. This period may be extended, generally to 300 days past due but in no event exceeding 360 days past due, in the case of a small proportion of HSBC Finance’s cards business and unsecured personal facilities other than credit cards.
Cases of write-off periods exceeding 360 days past due are few but arise, for example, in a few countries where local regulation or legislation constrain earlier write-off, or where the realisation of collateral for secured real estate lending takes place at this time.
In the event of bankruptcy or analogous proceedings, write-off can occur earlier than at the periods stated above. Collections procedures may continue after write-off.
Cross-border exposures
Management assesses the vulnerability of countries to foreign currency payment restrictions when considering impairment allowances on cross-border exposures. This assessment includes an analysis of the economic and political factors existing at the time. Economic factors include the level of external indebtedness, the debt service burden and access to external sources of funds to meet the debtor
country’s financing requirements. Political factors taken into account include the stability of the country and its government, threats to security, and the quality and independence of the legal system.
Impairment allowances are assessed in respect of all qualifying exposures within these countries unless these exposures and the inherent risks are:
Credit exposure
Maximum exposure to credit risk(Audited)
HSBC’s exposure to credit risk is spread over several asset classes, including trading assets, loans to customers, loans to banks and financial investments. Recently, loss experience has mainly affected personal lending portfolios. Thus, in 2007, 94 per cent of loan impairment charges arose in Personal Financial Services, broadly in line with 2006.
The deterioration of credit conditions in the US mortgage market was the most significant factor affecting HSBC’s exposure to credit risk during 2007. A full discussion of this issue can be found in the commentary on Areas of Special Interest on page 216.
The following table presents the maximum exposure to credit risk of balance sheet and off-balance sheet financial instruments, before taking account of any collateral held or other credit enhancements unless such credit enhancements meet offsetting requirements as set out in Note 2m on the Financial Statements. For financial assets recognised on the balance sheet, the exposure to credit risk equals their carrying amount. For financial guarantees granted, the maximum exposure to credit risk is the maximum amount that HSBC would have to pay if the guarantees were called upon. For loan commitments and other credit-related commitments that are irrevocable over the life of the respective
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facilities, the maximum exposure to credit risk is the full amount of the committed facilities.
Note 18 on the Financial Statements gives more information on credit risk exposure to derivatives counterparties.
Maximum exposure to credit risk (Audited)
Concentration of exposure(Audited)
Concentrations of credit risk exist when a number of counterparties are engaged in similar activities, or operate in the same geographical areas or industry sectors and have comparable economic characteristics, so that their ability to meet contractual obligations is uniformly affected by changes in economic, political or other conditions.
Loans and advances(Unaudited)
Loans and advances were well diversified across industry sectors and jurisdictions.
At constant exchange rates, gross loans and advances to customers (excluding the financial sector and settlement accounts) grew by US$55 billion or 7 per cent during 2007. On the
same basis, personal lending comprised 56 per cent of HSBC’s loan portfolio and 23 per cent of the growth in loans in 2007.
Including the financial sector and settlement accounts, personal lending represented US$501 billion, or 50 per cent, of total loans and advances to customers at 31 December 2007. Within this total, residential mortgages were US$269 billion and, at 27 per cent of total advances to customers, comprised the Group’s largest single sectoral concentration.
Corporate, commercial and financial lending, including settlement accounts, amounted to 50 per cent of gross lending to customers at 31 December 2007. The largest industry concentrations were in non-bank financial institutions and commercial real estate lending at 10 per cent and 7 per cent, respectively, of total gross lending to customers.
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Lending to non-bank financial institutions principally comprises secured lending on trading accounts, primarily repo facilities.
Commercial, industrial and international trade lending grew strongly in 2007, rising by a percentage point to 20 per cent of total gross loans and advances to customers. Within this category, the largest concentration of lending was to the service sector, which amounted to 6 per cent of total gross lending to customers.
Advances to banks primarily represent amounts owing on trading account and HSBC’s placing of its own liquidity on short-term deposit. Such lending was widely distributed across major institutions, with no single exposure exceeding 5 per cent of total advances to banks.
Financial investments(Unaudited)
At US$270 billion, total financial investments, excluding equity securities, were 38 per cent higher at 31 December 2007 than at the end of 2006. Debt securities, at US$240 billion, represented the largest concentration of financial investments at 89 per cent of the total, compared with US$171 billion (87 per cent) at 31 December 2006. HSBC’s holdings of corporate debt, asset-backed securities and other securities were spread across a wide range of issuers and geographical regions, with 50 per cent invested in securities issued by banks and other financial institutions. The principal movement in financial investments in 2007 represented the consolidation of HSBC-sponsored SIVs together with certain debt securities purchased from the Group’s money market funds as noted on page 186
Investments in governments and government agencies of US$92 billion were 33 per cent of overall financial investments, 5 percentage points lower than in 2006. US$30 billion of these investments comprised treasury and other eligible bills.
A more detailed analysis of financial investments is set out in Note 19 on the Financial Statements and an analysis by Rating Agency designation is provided on page 215.
The insurance businesses held diversified portfolios of debt and equity securities designated at fair value (2007: US$34 billion; 2006: US$18 billion) and debt securities classified as financial investments (2007: US$23 billion; 2006: US$10 billion). The increase was due to the acquisition of HSBC’s partner’s share in HSBC Assurances.
A more detailed analysis of securities held by the insurance businesses is set out on page 276.
Securities held for trading(Unaudited)
Total securities held for trading within trading assets were US$247 billion at 31 December 2007 (2006: US$204 billion). The largest concentration of these assets was government and government agency securities, which amounted to US$115 billion, or 46 per cent of overall trading securities (2006: US$94 billion, 46 per cent). This included US$16 billion (2006: US$22 billion) of treasury and other eligible bills. Corporate debt and other securities were US$60 billion or 24 per cent of overall trading securities, 9 percentage points lower than 2006’s level of 33 per cent at US$67 billion. Included within total securities held for trading were US$70 billion (2006: US$36 billion) of debt securities issued by banks and other financial institutions.
A more detailed analysis of securities held for trading is set out in Note 16 on the Financial Statements and an analysis by Rating Agency designation is provided on page 215.
Financial assets – net exposure to credit risk(Audited)
In respect of certain financial assets, HSBC has legally enforceable rights to offset them with financial liabilities. In normal circumstances, however, there would be no intention of settling net, or of realising the financial assets and settling the financial liabilities simultaneously. Consequently, the financial assets are not offset against the respective financial liabilities for financial reporting purposes. However, the exposure to credit risk relating to the respective financial assets is mitigated as follows:
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Gross loans and advances by industry sector (Unaudited)
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Year ended 31 December 2007 compared with year ended 31 December 2006(Unaudited)
The following commentary analyses, on a constant currency basis, the changes in lending noted in the table above compared with the position at 31 December 2006. Loans and advances to personal, corporate and commercial customers rose by 7 per cent, and total gross loans and advances grew by 12 per cent. There was a marked change in the distribution of net new lending in 2007 with personal lending growing significantly slower than corporate and commercial lending, primarily as a consequence of curtailing loan growth in US consumer finance.
Total lending to personal customers remained predominantly in North America (2007: US$231 billion; 2006: US$232 billion), the UK (2007: US$128 billion; 2006: US$131 billion) and Hong Kong (2007: US$43 billion; 2006: US$39 billion). These three regions comprised 80 per cent of total personal lending, a decline of 3 percentage points since 31 December 2006.
Residential mortgages fell marginally to US$269 billion at 31 December 2007, 27 per cent (2006: 30 per cent) of total loans and advances to customers (including the finance sector and settlement accounts). A reduction in the US mortgage loan portfolio was partly offset by increases in Europe, Hong Kong, Rest of Asia-Pacific and Latin America.
In Europe, residential mortgage balances rose by 1 per cent to US$96 billion. In France, mortgage lending grew by 11 per cent to US$6 billion, despite increasing competition, due to strong customer demand. In Turkey, strong growth of 13 per cent was driven by the expansion of the branch network. Mortgage lending in the UK was flat, with risk appetite restricted as margins on mortgage lending fell. There was also a shift in the portfolio towards fixed-rate mortgages.
In Hong Kong, residential mortgage balances rose by 3 per cent as a result of a buoyant economy.
In North America, residential mortgage balances decreased by 6 per cent. In the US, the level of mortgage lending stood at US$99 billion, a decline of 8 per cent since 31 December 2006. Balances in the mortgage services business fell by 27 per cent as the strategy to run down the book of business originated through correspondents was put into effect. The rundown was carried out through repayments in the normal course of business, as well as the sale of loans to third party investors and the cessation of all remaining origination following the closure of the wholesale activities of Decision One.
The write-off of impaired loans also contributed to the decline in residential mortgage balances. Balances elsewhere in the consumer lending business increased by 9 per cent. In the fourth quarter of 2007, management took a further series of actions to limit originations in the branch-based consumer lending business in respect of mortgage lending, which resulted in fewer new loans in the quarter and will markedly limit growth in this area for the foreseeable future. In Canada, mortgage balances rose by 7 per cent, driven by the buoyant Canadian residential property market and continued expansion of the branch network.
Mortgage lending balances rose by 10 per cent in Rest of Asia-Pacific, with increases in the Middle East and Singapore partly offset by the sale of the New Zealand mortgage loan portfolio in July 2007.
In Latin America, balances increased by 18 per cent, driven by rises of 23 per cent and 31 per cent in Mexico and Brazil, respectively.
Other personal lending increased by 7 per cent to US$232 billion at 31 December 2007, representing 23 per cent of total loans and advances to customers, including the financial sector and settlement accounts (2006: 24 per cent).
In Europe, other personal lending rose by 4 per cent to US$73 billion. Strong growth in lending to Private Banking clients in Switzerland, (rising by 50 per cent), a 42 per cent rise in Turkey and a 7 per cent rise in France were partly offset by a 7 per cent decline in the UK as HSBC curtailed growth through tightened underwriting criteria. Also in the UK, HSBC disposed of part of its non-core credit card portfolio, principally the Marbles brand, at the end of 2007.
In Hong Kong, other personal lending rose by 29 per cent to US$13 billion as HSBC launched a series of credit card campaigns that consolidated the Group’s position as market leader. Other unsecured lending rose by 46 per cent.
In Rest of Asia-Pacific, other personal lending increased by 19 per cent as branch expansion and enhanced marketing activity led to higher loan balances. Credit cards in circulation rose, with the Middle East and India, in particular, producing strong increases.
In North America, other personal lending balances rose by 2 per cent. In the US, asset levels remained broadly unchanged despite a significant decline in second lien mortgage balances. Unsecured personal lending in HSBC Finance fell, offset by a rise at HSBC’s US retail bank and strong growth in card balances from the momentum created by
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marketing initiatives in late 2006. In Canada, other personal lending balances rose by 23 per cent, with strong growth in both the consumer finance and retail bank lending portfolios.
In Latin America, other personal lending balances rose by 34 per cent to US$17 billion, due to growth in credit cards and payroll loans. In Mexico, where marketing campaigns added customers and portfolio management programmes were put in place to improve customer retention and card usage, the strong growth in credit card balances drove a 41 per cent rise in lending. In Brazil, other personal lending balances increased by 28 per cent.
Loans and advances to corporate and commercial customers increased by 12 per cent to US$401 billion (2006: US$358 billion), with strong growth in most regions.
In Europe, corporate and commercial advances rose by 10 per cent. In the UK, asset balances rose by 8 per cent as investment in direct sales channels and the recruitment of sales staff led to increased customer numbers. In France, lending balances increased by 12 per cent as HSBC continued to raise its brand profile.
In Hong Kong, HSBC achieved growth in corporate commercial lending of 3 per cent, due to increased demand for loans from manufacturers with operations in mainland China, and for other intra-Asian trading.
In Rest of Asia-Pacific, the corporate and commercial loan book increased by 29 per cent as expanded operations helped to gain new business. Strong growth was recorded in many countries, including South Korea (42 per cent), India (34 per cent) and mainland China (83 per cent). HSBC set up new International Banking Centres, increased its branch network and launched enhanced online banking services throughout the region. In the Middle East, new relationship managers were hired in the UAE, and HSBC entered the small business segment in Bahrain, Qatar and Jordan. In mainland China, local incorporation helped increase lending as the branch network expanded. HSBC was the first international bank to set up a rural branch, targeting businesses in the agricultural sector. In India, the addition of new staff in the branch network helped lift lending balances.
In North America, corporate and commercial lending rose by 15 per cent, led by Canada, where
balances increased by 24 per cent. In the US, loan growth in Commercial Banking resulted primarily from strong activity in middle market lending, despite a slowdown in commercial real estate activity. 2007 saw an extension of middle market activities in Chicago, Washington DC and the West Coast as HSBC continued its branch expansion programme. Global Banking and Markets funded a number of facilities in connection with its participation on leveraged and acquisition finance syndicates, which added to loan balance growth in the US. In Canada, lending balances rose against the backdrop of strong economic growth, particularly in Western Canada.
Corporate and commercial lending in Latin America rose by 6 per cent as HSBC expanded its network of International Banking Centres and launched new initiatives to gain customers in the small and micro-business segments. In Mexico, volumes grew in commercial real estate lending, trade and factoring. The loan portfolio in Brazil grew strongly, led by increases in volumes in the giro facil product, guaranteed account, rural loans and working capital financing.
Loans and advances to the financial sector rose by 53 per cent to US$99 billion. The increase was primarily due to Europe, up 45 per cent, in line with the strategy to expand the capital-efficient client-driven reverse repo business. In North America, lending to the financial sector rose by 65 per cent, due to substantial growth in balances with securities brokers and other financial institutions, as excess liquidity was invested in reverse repos rather than Fed funds.
Loans and advances to banks increased by 23 per cent to US$237 billion. Lending to banks in Hong Kong rose by 27 per cent and in Rest of Asia-Pacific by 39 per cent, due to growth in customer deposits across the region and increase in money market placements. In Europe, lending to banks rose by 28 per cent, due to project and money market loans in the UK and reverse repo lending in France.
The following tables analyse loans by industry sector and by the location of the principal operations of the lending subsidiary or, in the case of the operations of The Hongkong and Shanghai Banking Corporation, HSBC Bank, HSBC Bank Middle East and HSBC Bank USA, by the location of the lending branch.
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209
Loans and advances to customers by industry sector and by geographical region (Audited)
210
(Audited)
211
Loans and advances to customers by industry sector and by geographical region (continued)(Unaudited)
212
(Unaudited)
213
Gross loans and advances to customers by principal country within Rest of Asia-Pacific and Latin America(Audited)
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Debt securities and other bills by rating agency designation(Audited)
The following table presents an analysis by rating agency designation of debt and similar securities, other than loans, based on Standard & Poor’s ratings
or their equivalent. Debt securities with short-term ratings are reported against the long-term rating of the issuer of the short-term debt securities. If major rating agencies have different ratings for the same debt securities, the securities are reported against the lower rating.
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Areas of special interest
Personal lending(Unaudited)
HSBC provides a broad range of secured and unsecured personal lending products to meet customer needs. Given the diverse nature of the markets in which HSBC operates, the range is not standardised in all countries but, along with the distribution channels used, is tailored to meet the demands of individual markets, while using common global IT platforms wherever possible.
Personal lending includes advances to customers for asset purchase, including residential property and motor vehicles, where such lending is typically secured on the assets to be acquired. HSBC also offers loans secured on existing assets, such as first and second liens on residential property; unsecured lending products such as overdrafts, credit cards and payroll loans; and debt consolidation loans which may be secured or unsecured.
Various underwriting controls are applied before the loan is issued, and loss in the event of delinquency is managed through collection and customer management procedures. The expected occurrence and degree of delinquency varies according to the type of loan and the customer segment. Delinquency levels tend to increase in the course of normal portfolio ageing. As a result, loan impairment charges usually relate to lending originated in earlier accounting periods.
The commentary that follows is on a constant currency basis.
At 31 December 2007, total personal lending was US$501 billion, a rise of 3 per cent from 31 December 2006.
In 2007, loan impairment charges were primarily in personal lending, representing 94 per cent of the total charge. The three largest components were Personal Financial Services in North America (69 per cent), the UK (11 per cent) and Latin America (9 per cent).
HSBC recorded strong growth in Latin America, with gross loans and advances to personal customers rising by 31 per cent to US$22 billion. Residential mortgage lending in the region increased by 18 per cent, while other personal lending rose by 34 per cent.
In Mexico, HSBC’s other personal lending balances grew by 41 per cent in 2007 to US$5 billion, predominantly from growth in credit card balances. In the same period, loan impairment charges rose by US$574 million or 351 per cent, driven by strong growth in loan balances, a deterioration in credit quality and portfolio seasoning.
The credit quality of the US personal lending portfolio is discussed more fully below. In the UK, credit conditions were relatively benign, with loan impairment charges unchanged from 2006.
Total personal lending(Unaudited)
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US personal lending(Unaudited)
Total US personal lending fell by 4 per cent to US$199 billion at 31 December 2007. Residential mortgage balances were US$99 billion, a decline of 8 per cent, due to the continued run-down of the correspondent portfolio in mortgage services, the closure of the Decision One wholesale channel and tightened underwriting criteria in the branch-based consumer lending business, which curtailed growth.
Card balances rose by 8 per cent to US$50 billion, but underlying growth slowed in the latter part of the year following the decision to reduce marketing and promotional activity in line with reduced risk appetite, as the US economy weakened. Motor vehicle finance loans rose by 1 per cent to US$13 billion, driven by strong growth in the direct-to-consumer channel, partly offset by a flat performance from participating dealerships in the difficult economic environment.
Other personal lending fell by 9 per cent to US$38 million due to tightening of underwriting criteria and a reduction in direct mail campaigns.
Mortgage lending products(Unaudited)
The Group offers a wide range of mortgage products designed to meet customer needs. This includes capital or principal repayment mortgages subject to fixed or variable interest rates, and products designed to meet demand for housing loans with more flexible payment structures. HSBC underwrites first lien residential mortgages and loans secured by second lien mortgages; the latter are reported within ‘Other personal lending’ in the market sector analysis on page 216. The bulk of the mortgage lending products sold in the US consumer lending branch network are for refinancing and debt consolidation, rather than for house purchase.
Interest-only mortgages are those where customers make regular payments of interest during the life of the loan and repay the principal from the sale of their home or alternative sources of funds such as an endowment or other investment policy. Introductory interest-only mortgages are where the interest-only element is for a fixed term at the start of the loan, after which principal repayments commence. Affordability mortgages include all products where the customer’s monthly payments are set at a low initial rate, either variable or fixed,
before resetting to a higher rate once the introductory period is over. These include ARMs, loans in which the interest rate is periodically changed based on an index.
HSBC has not offered, and does not anticipate offering, ARMs with alternative payment options or other negative amortisation products.
Affordability mortgages are primarily offered in the US and the UK. Under the HFC and Beneficial brands, HSBC Finance offe rs a range of products and delivery channels designed for the needs of customers with non-standard or less favourable credit profiles. In the US, such mortgages experienced heightened levels of delinquency in late 2006 and 2007. As a result, HSBC Finance took a series of steps designed to curtail mortgage lending: the mortgage services business ceased acquiring new mortgages; the consumer lending business halted its small volume of ARM loan originations, tightened underwriting criteria and loan-to-income requirements, and reduced loan-to-value ratios for first and second lien loans. These measures reduced HSBC Finance’s mortgage balances to US$91 billion at 31 December 2007 (2006: US$99 billion) as set out in the table below.
In the UK, affordability mortgages stood at US$35 billion at 31 December 2007, compared with US$33 billion at 31 December 2006. Overall credit quality improved following measures taken in the recent past to tighten underwriting standards and improve the credit quality of new business. Delinquency rates on mortgages in the UK offered through HSBC Finance remained stable throughout 2007, with delinquency rates for loans offered in 2006 and 2007 lower than in the preceding two years.
In the rest of the UK business, loan impairment charges in the second half of 2007 were lower than in the first half of the year, as overall credit quality improved following recent measures to tighten underwriting standards and improve the credit quality of new business. Although losses from mortgage lending remained low, maximum loan-to-value ratios were reduced during the year to mitigate the effects of a possible housing marketdownturn.
The following table shows the levels of mortgage lending products in the various portfolios of HSBC Finance and the rest of the HSBC Group:
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HSBC Finance mortgage lending(Unaudited)
HSBC Finance held approximately US$91 billion of residential mortgage loans and advances to personal customers at 31 December 2007, 18 per cent of the Group’s gross loans and advances to personal customers.
At 31 December 2007, the balance outstanding of introductory interest-only loans in the US mortgage services business was US$4 billion, compared with US$6 billion in 2006, a decline of 36 per cent. No such loans were advanced in the consumer lending business.
The outstanding balance of ARMs in the US mortgage services business at 31 December 2007 was US$16 billion, a decrease of 41 per cent,
compared with the end of 2006. In the consumer lending business, adjustable-rate loans fell by 16 per cent to US$3 billion following the decision to cease the sale of these products in August 2007.
Second lien loans extended through the mortgage services business decreased by 33 per cent to US$7 billion, while the consumer lending business recorded a 6 per cent increase to US$7 billion.
The balance of HSBC Finance’s stated-income mortgages was approximately US$8.3 billion at the end of 2007 (2006: US$11.8 billion), all of which were held by mortgage services. The consumer lending business did not originate any stated-income mortgages in either period.
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HSBC Finance mortgage lending1(Unaudited)
US personal lending credit quality(Unaudited)
In 2007, a cycle of declining house prices, reduced availability of mortgage finance and growing customer delinquency and default caused a deterioration in credit quality of increasing intensity.
Housing markets in a large part of the US have been affected by a broad-based slowdown in the rate of appreciation in property values, with actual declines in many markets, including California, Florida and Arizona, where earlier price increases had been significant. The S&P/Case-Shiller 10-City Composite Index showed a record decline in house prices of 8.4 per cent in the year to November 2007.
There was a high degree of correlation between the increase in delinquency throughout 2007 and declining house prices. Two months or more delinquencies rose most rapidly in those states which, prior to 2007, demonstrated superior credit performance, the greatest rate of appreciation and the highest home values.
The rising level of delinquencies led investors to question the reliability of credit ratings, not only for residential mortgage-backed securities but for a wide range of structured credit products. Investors became increasingly unwilling to purchase securitised credit, leading to a sharp contraction in flows of credit through the affected channels. The exit of a number of participants in the sub-prime mortgage industry, together with a tightening of underwriting criteria by
remaining providers, led to fewer refinancing options for customers. This created particular problems for borrowers with affordability mortgages who faced a considerable increase in their monthly repayments at the end of their discounted introductory periods.
Within HSBC’s portfolio, the rise in delinquencies, first reported in 2006 in the sub-prime second lien mortgages within the mortgage services business, spread initially to other parts of mortgage services, then to the branch-based consumer lending business and, in the closing months of the year, to the credit card business as the US economy weakened and credit availability contracted.
Loans originated in 2005, 2006 and early 2007 experienced worse credit performance than earlier vintages. The highest delinquency rates were in second lien loans whose borrowers also had first lien loans that were ARMs.
In addition, a significant number of second lien customers had underlying ARMs that faced repricing in the near term. As the interest rate adjustments occurred in an environment of lower house prices and tightening credit, the probability of default was greater than generally experienced prior to 2007.
Second lien loans have a heightened risk profile, for the reasons no ted above. These loans often have higher loan-to-value ratios because, in many cases, the second lien loan was necessary to
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HSBC Finance: geographical concentration of US lending1 (Unaudited)
complete the purchase of the property. For second lien mortgages, the proportion of customers two months or more behind on contractual payments rose from 3.97 per cent at 31 December 2006 to 9.02 per cent at the end of 2007. Loss on default of second lien loans approaches 100 per cent of the amount owed as any collateral in the property is applied initially to the first lien loan.
Stated-income mortgages are also of above average risk as these were underwritten on the basis of borrowers’ representations of annual income, not verified by receipt of supporting documentation. In HSBC Finance mortgage services, two months or more delinquency rates on stated-income loans rose from 6.36 per cent at 31 December 2006 to 19.01 per cent at 31 December 2007. In part, the percentage rise is due to a decline in loan balances as the mortgage loan portfolio is run off.
In mortgage services, the deterioration in credit performance first reported in 2006 continued. In the second half of 2007, credit quality became progressively worse due to the market conditions discussed above. Two months or more delinquencies increased from US$2.3 billion, 4.64 per cent of loans and advances at the end of 2006, to US$4.1 billion, 11.24 per cent at 31 December 2007. The increase in the delinquency rate was partly due to the reduction in the size of the portfolio.
In response, HSBC took several management actions to reposition the US consumer business. In March 2007, it took the decision to cease purchasing mortgages from third party correspondents. In September 2007, the Group closed its wholesale business, Decision One, ending new originations for the mortgage services business.
The branch-based consumer lending business experienced relatively stable performance in its portfolio throughout 2006 and into the first half of
2007. Starting in the fourth quarter of 2006, delinquencies began to rise in loans of 2005 and later vintages, to levels above what had been previously experienced. This trend was also seen in the rest of the industry. It is clear that, for some time, equity withdrawal has been the principal source of credit available to sub-prime borrowers dealing with unforeseen financial needs. Declining house prices and an industry-wide tightening of underwriting criteria have significantly reduced the ability of consumers to refinance. Starting from the third quarter, these factors had a marked effect on consumer lending delinquency. Two months or more delinquencies rose from 2.22 per cent at 31 December 2006 to 4.18 per cent of loans and advances at the end of 2007. Delinquent balances doubled to US$2.1 billion. In this environment, HSBC took steps to tighten underwriting standards, including decreasing the loan to value ratio for residential mortgages and ceasing to underwrite certain products. To match the consequent reduction in demand and risk appetite, the network was reduced from nearly 1,400 branches to some 1,000.
HSBC also sold parts of the loan portfolio when opportunities arose at suitable valuations. In the first half of 2007, a total of US$2.7 billion of mortgage services’ loans that did not include any loans 30 days or more delinquent were sold.
Credit card delinquencies of two months or more rose from 4.48 per cent at the end of 2006 to 5.68 per cent of receivables at 31 December 2007. In part, this was due to a change in product mix, as originations in the sub-prime and near-prime parts of the portfolio grew at faster rates than the overall portfolio. There was also an increase in bankruptcy rates as levels moved closer to historical norms following the exceptionally low level of filings seen during 2006. Additionally, in the fourth quarter of 2007, delinquencies began to rise in all vintages, particularly in the markets experiencing
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the greatest home value depreciation, driven by rising unemployment rates in these markets and a weakening US economy.
In vehicle finance, two months or more delinquencies moved from 3.16 per cent at the end of 2006 to 3.68 per cent at 31 December 2007. The increased delinquency in the vehicle finance portfolio was not as severe as has been experienced elsewhere in the industry. In 2007, the vehicle finance business tightened underwriting criteria in both the dealer and direct-to-consumer channels, to convert the mix of new loans to a higher credit quality.
HSBC has been proactive in reaching out to customers to provide financial counselling and assist them in restructuring their debts to avoid foreclosure. As a consequence, HSBC restructured and modified loans that it believed could be serviced, in line with local policies. In particular, customers with ARM loans approaching the first reset were contacted in order to assess their ability to make the higher payments and, where appropriate, to refinance or modify their loans.
As a result, in 2007 HSBC has modified more than 8,500 loans with an aggregate balance of more than US$1.4 billion.
In 2007, approximately US$4.5 billion of ARM loans reached their first interest rate reset. In 2008, approximately US$6.5 billion of ARMs will reach their first interest rate reset, of which US$2.8 billion relates to HSBC Bank USA and US$3.7 billion to HSBC Finance. Within the latter, US$2.7 billion is in mortgage services, the remainder in consumer lending. ARMs in HSBC Bank USA are largely prime balances. Delinquency rates are expected to continue to rise in 2008, as the limiting of originations means that the portfolio will mostly be running off. A deterioration in economic conditions and the housing market would also increase delinquencies.
Loan delinquency in the US(Unaudited)
The following tables provide a detailed analysis of loan delinquency in the US.
Two months and over contractual delinquency in Personal Financial Services in the US(Unaudited)
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Two months and over contractual delinquency in mortgage services and consumer lending(Unaudited)
Country distribution of outstandings and cross-border exposures (Unaudited)
HSBC controls the risk associated with cross-border lending, essentially that foreign currency will not be made available to local residents to make payments, through a centralised structure of internal country limits which are determined by taking into account relevant economic and political factors. Exposures to individual countries and cross-border exposure in aggregate are kept under continual review.
The following table summarises the aggregate of in-country foreign currency and cross-border outstandings by type of borrower to countries which individually represent in excess of 1 per cent of
HSBC’s total assets. The classification is based on the country of residence of the borrower but also recognises the transfer of country risk in respect of third party guarantees, eligible collateral held and residence of the head office when the borrower is a branch. In accordance with the Bank of England Country Exposure Report (Form CE) guidelines, outstandings comprise loans and advances (excluding settlement accounts), amounts receivable under finance leases, acceptances, commercial bills, CDs and debt and equity securities (net of short positions), and exclude accrued interest and intra-HSBC exposures.
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In-country foreign currency and cross-border outstandings (Unaudited)
At 31 December 2007, HSBC had in-country foreign currency and cross-border outstandings to counterparties in Hong Kong, Belgium and Ireland of between 0.75 per cent and 1.0 per cent of total assets. The aggregate in-country foreign currency and cross-border outstandings were: Hong Kong, US$19.7 billion; Belgium, US$19.3 billion and Ireland, US$19.3 billion.
At 31 December 2006, HSBC had in-country foreign currency and cross-border outstandings to counterparties in Australia and Hong Kong of between 0.75 per cent and 1 per cent of total assets. The aggregate in-country foreign currency and cross-border outstandings were: Australia, US$17.5 billion; Hong Kong, US$15.5 billion.
At 31 December 2005, HSBC had in-country foreign currency and cross-border outstandings to counterparties in Hong Kong, Australia and Canada of between 0.75 per cent and 1 per cent of total assets. The aggregate in-country foreign currency and cross-border outstandings were: Hong Kong, US$14.6 billion; Australia, US$12.5 billion; Canada, US$11.7 billion.
Credit quality
The following tables reflect, with the principal exception of developments in US personal portfolios
that are extensively commented upon in ‘Areas of special interest’ above, broadly stable credit quality across the majority of the Group’s businesses.
Loans and advances that were neither past due nor impaired decreased marginally to 94.4 per cent (2006: 94.9 per cent) of total loans and advances. Among these, however, those classified as grades 1-3 (satisfactory risk) increased to 96.0 per cent (2006: 92.9 per cent).
The further deterioration in quality in, principally, US personal lending was reflected in an increase in the proportion of loans and advances to customers which were past due, though not impaired, to 5.1 per cent (2006: 4.6 per cent, following restatement). The great majority of such loans were in the band of past due up to 90 days.
The credit quality of loans and advances to banks remained broadly stable, showing overall a marginal improvement on its already favourable condition as at year-end 2006, and with a partial shift in the quality profile of neither past due nor impaired accounts being partly offset by a reduction in those that were past due.
Details of impaired loans and advances to customers, which increased from 1.56 per cent to 1.83 per cent of total loans and advances to customers, are commented on further below.
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Distribution of loans and advances by credit quality(Audited)
Distribution of loans and advances neither past due nor impaired(Audited)
Grades 1 and 2 include corporate facilities demonstrating financial condition, risk factors and capacity to repay that are good to excellent, residential mortgages with low to moderate loan to value ratios and other retail accounts which are maintained within generally applicable product parameters.
Grade 3 represents satisfactory risk, and includes corporate facilities that require closer monitoring, mortgages with higher loan to value ratios, credit card exposures and other retailexposures which operate outside generally applicable product parameters without being impaired.
Grades 4 and 5 include facilities that require varying degrees of special attention and all retail exposures that are progressively between 30 and 90 days past due (60 days for US motor loans).
Grades 6 or 7 represent impaired exposures.
Loans and advances which are individually assessed for impairment are identified on an individual basis and classified as grades 6 or 7 when they are impaired. It is not practicable to individually identify impaired loans and advances within portfolios of homogeneous loans which are assessed on a collective basis for impairment. In practice, such loans and advances are not individually identified as impaired until the time each impaired loan is written off. It is therefore necessary to estimate the carrying value of impaired loans and advances within these portfolios.
The approach adopted by HSBC to estimate the carrying value of impaired loans and advances within portfolios of homogeneous loans that are collectively assessed for impairment, is to classify these loans and advances as impaired when the
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balances are 90 days or more past due, except for US motor loans which are classified as impaired when 60 days or more past due. These loans and advances are classified as grades 6 and 7. All other collectively assessed loans and advances, including those which are less than 90 days past due (less than 60 days for US motor loans), are classified as not impaired and reported within grades 1 to 5. Collective impairment allowances are recognised in relation to losses that are likely to have been incurred at the balance sheet date on which they are collectively assessed for impairment and classified loans in grades 1 to 5, representing a small percentage of the total loans and advances in these grades.
Loans and advances which were past due but not impaired(Audited)
Examples of exposures designated past due but not considered impaired include loans that have missed the most recent payment date but on which there is no evidence of impairment; loans fully secured by cash collateral; residential mortgages in arrears more than 90 days, but where the value of collateral is sufficient to repay both the principal debt and all potential interest for at least one year; and short-term trade facilities past due more than 90 days for technical reasons such as delays in documentation, but where there is no concern over the creditworthiness of the counterparty.
Impaired loans and advances(Audited)
Customer loans and advances and impairment allowances by geographical region(Audited)
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Total impaired loans to customers were US$18.3 billion at 31 December 2007, an increase of 33 per cent since the end of 2006 (28 per cent at constant currency). Impaired loans were 2 per cent of gross customer loans and advances, broadly in
line with 31 December 2006.
The commentary that follows compares balances at 31 December 2007 with those at 31 December 2006, at constant exchange rates.
In Europe, impaired loans at US$6.3 billion were 2 per cent higher than at the end of 2006. Higher impaired loans in France and Turkey were
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partly offset by a decline in the UK, where changes in underwriting practices resulted in a fall in personal unsecured lending in 2007.
In Hong Kong, impaired loans declined by 4 per cent to US$433 million. Credit conditions were very favourable, reflecting the strong local economy and buoyant equity and property markets.
In Rest of Asia-Pacific, the decline in impaired loans of 11 per cent to US$1.1 billion was mainly driven by lower impaired loans in Taiwan following the non-recurrence of the effect of regulatory changes which, in 2006, led to a significant increase in impaired loans. This was partly offset by a rise in impaired loans in India due to strong growth in personal lending.
In North America, HSBC recorded a 73 per cent increase in impaired loans to US$8.4 billion at 31 December 2007. The consumer finance business in the US was responsible for the
bulk of the change. HSBC Finance experienced a deterioration in credit quality in most of its lending book, in particular for first and second lien mortgages originated in 2005 and 2006. In the final quarter of the year, in line with the market, delinquencies rose in the credit card portfolio, with a smaller rise in vehicle finance loans. A full discussion of these developments and their effect on credit quality is provided in the ‘Areas of special interest’ commentary on page 216. In Canada, although impaired loans rose from a low base, credit conditions remained strong.
In Latin America, impaired loans increased by 30 per cent to US$2.1 billion, primarily due to a rise of 76 per cent in impaired loans in Mexico. This was due to portfolio growth, seasoning and higher delinquency rates on credit cards. Revenues from this growth in credit card lending more than covered the rise in impairment charges.
Individually impaired loans and advances to customers(Audited)
Interest forgone on impaired loans(Audited)
Interest income that would have been recognised under the original terms of impaired and restructured loans amounted to approximately US$1.1 billion in 2007 (2006: US$0.7 billion). Interest income from such loans of approximately US$374 million was recorded in 2007.
Renegotiated loans(Audited)
Restructuring activity is designed to manage customer relationships, maximise collection
opportunities and, if possible, avoid foreclosure or repossession. Such activities include extended payment arrangements, approved external debt management plans, deferring foreclosure, modification, loan rewrites and/or deferral of payments pending a change in circumstances. Following restructuring, an overdue consumer account is normally reset from delinquent to current status. Restructuring policies and practices are based on indicators or criteria which, in the judgement of local management, indicate that repayment will probably continue. These policies are required to be kept under continual review and their application varies according to the nature of the market, the
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product, and the availability of empirically based data. Criteria vary between products, but typically include: receipt of one or more qualifying payments within a certain period, a minimum lapse of time from origination before restructuring may occur, and restrictions on the number and/or frequency of successive restructurings. When empirical evidence indicates an increased propensity to default on restructured accounts, the use of roll rate methodology ensures this factor is taken into account when calculating impairment allowances.
Renegotiated loans that would otherwise be past due or impaired totalled US$28 billion at 31 December 2007 (2006: US$21 billion). Restructuring is most commonly applied to consumer finance portfolios. The largest concentration was in the US and amounted to US$24 billion (2006: US$17 billion) or 86 per cent (2006: 81 per cent) of the Group’s total renegotiated loans. The increase was due to a significantdeterioration in credit quality in the US. Most restructurings in the US related to loans secured on real estate.
US loan modifications(Unaudited)
In October 2006, as part of its efforts to mitigate risk in the affected components of the mortgage services portfolio in the US, HSBC Finance established a new programme specifically designed to meet the needs of selected customers with ARMs. HSBC Finance is proactively calling and writing to customers who have ARM loans nearing their first reset that HSBC Finance expects will be the most affected by a rate adjustment. By a variety of means, HSBC Finance assesses the customer’s ability to make the adjusted payment and, as appropriate and in accordance with defined policies, HSBC Finance modifies the loans, allowing time for the customer to seek alternative financing or improve their individual situation. These loan modifications primarily provide for temporary interest rate relief for 12 months by either maintaining the current interest rate for the entire 12-month period or resetting the interest rate for the 12-month period to a rate lower than that originally required at the reset date. At the end of the 12-month period, the interest rate on the loan will reset in accordance with the original loan terms, unless the borrower qualifies for, and is granted, a further modification. In 2007, HSBC Finance made more than 33,000 outbound contacts and modified more than 8,500 loans with an aggregate balance of
US$1.4 billion. Since the inception of this programme, HSBC Finance has made more than 41,000 outbound contacts and modified more than 10,300 loans with an aggregate balance of US$1.6 billion. These loans are not included in the figures quoted above, because HSBC Finance has not reset delinquency on them as they were not contractually delinquent at the time of the modification. However, loans which have been restructured in the past for other reasons are included in the figures above. HSBC Finance also continues to manage a Foreclosure Avoidance Programme for delinquent consumer lending customers designed to provide relief to qualifying home owners by either loan restructuring or modification. HSBC Finance also supports a variety of national and local efforts in home ownership preservation and foreclosure avoidance.
Collateral and other credit enhancements obtained(Audited)
HSBC obtained assets by taking possession of collateral held as security, or calling upon other credit enhancements, as follows:
Repossessed properties are made available for sale in an orderly fashion, with the proceeds used to reduce or repay the outstanding indebtedness. Where excess funds are available after the debt has been repaid, they are available either for other secured lenders with lower priority or are returned to the customer. HSBC does not generally occupy repossessed properties for its business use. The majority of repossessed properties arose in the US in HSBC Finance, which experienced higher levels of foreclosure and higher losses on sale due to declining house prices. The average time taken to sell a foreclosed property in the US during 2007 was 184 days and the average loss on sale was 11 per cent. A quarterly breakdown is provided below:
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Impairment allowances and charges
Movement in allowance accounts for total loans and advances(Audited)
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Movement in impairment allowances by industry segment and by geographical region
The following tables show details of the movements in HSBC’s loan impairment allowances by location of lending office for each of the past five years.
A discussion of the material movements in the loan impairment charges by region follows these tables.
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Movement in impairment allowances by industry segment and by geographical region (continued)(Audited)
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Movement in provisions by industry segment and by geographical region(Unaudited)
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Movement in provisions by industry segment and by geographical region (continued) (Unaudited)
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Net loan impairment charge to the income statement by geographical region (Unaudited)
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Net loan impairment charge to the income statement by geographical region (continued)(Unaudited)
Net charge to the income statement for bad and doubtful debts by geographical region(Unaudited)
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Impairment allowances as a percentage of loans and advances to customers(Unaudited)
Year ended 31 December 2007 compared with year ended 31 December 2006 (Unaudited)
Loan impairment charges rose by 63 per cent to US$17.2 billion from US$10.5 billion in 2006. The commentary that follows is on a constant currency basis:
New allowances for loan impairment charges rose by 52 per cent, compared with 2006. Releases and recoveries of allowances increased by 1 per cent to US$1.6 billion.
In Europe, new loan impairment charges were US$3.5 billion, a rise of 8 per cent compared with 2006. This partly reflected growth in commercial lending, where charges remained low compared with historical amounts but rose from the exceptionally low levels experienced in 2005 and 2006. Increased charges also reflected growth in credit card lending in Turkey. In the UK, refinements to the methodology used to calculate roll rate percentages resulted in a higher charge in the consumer finance
operations in the first half of the year. Excluding this, loan impairment charges were marginally lower than in 2006.
Releases and recoveries in Europe were broadly in line with 2006.
In Hong Kong, new loan impairment charges of US$287 million were recorded, an increase of 19 per cent, due to the growth in credit card balances and new corporate loan charges.
Releases and recoveries in Hong Kong decreased to US$75 million, primarily in the corporate sector. This reflected the low level of allowances added in recent years.
In Rest of Asia-Pacific, new loan impairment charges rose by 10 per cent to US$834 million, with higher loan impairment charges arising in the commercial loan books in Thailand and Malaysia. This was offset by a decline in loan impairment charges for personal lending, particularly in Taiwan and Indonesia, where charges returned to more
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regular levels after an upsurge in 2006 due to regulatory changes which affected collection activity and minimum payments.
With corporate and commercial loan impairment charges low in recent years, releases and recoveries decreased by 6 per cent to US$220 million.
New loan impairment charges in North America rose by 76 per cent to US$12.2 billion, driven by the continued deterioration in credit quality in the US consumer finance loan portfolio.
US credit quality deteriorated as mortgage delinquencies rose, house prices declined, refinancing credit became less available in the market and the macroeconomic outlook worsened. The reasons behind the deterioration in US credit quality, the effects on the US personal lending portfolio and actions taken as a result are discussed in more detail on page 217.
Other factors affecting the rise in US loan impairment charges included normal seasoning of the portfolio, a higher proportion of unsecured personal lending and a return to historical norms from the unusually low levels of bankruptcy filings experienced in 2006, following changes enacted to US bankruptcy law in 2005.
Delinquency rates rose across all parts of the HSBC Finance personal lending portfolio, with mortgage services and consumer lending experiencing significant rises in delinquency which flowed through subsequent stages through to foreclosure. As the housing downturn began to have more effect on the broader economy, delinquency rates in credit cards and vehicle finance rose in the final quarter of 2007. A change in product mix in the cards portfolio towards higher yielding products also contributed to higher impairment charges as this segment of the portfolio seasoned.
Releases and recoveries in North America decreased to US$116 million. In the US consumer finance business, collection staff increased in all lending portfolios as part of the response to the deteriorating credit environment.
In Latin America, new loan impairment charges rose by 63 per cent to US$2.0 billion. The most significant increase was registered in Mexico, reflecting strong growth in balances, normal portfolio seasoning and a rise in delinquency rates in credit cards. Charges for commercial lending in Mexico fell as increased delinquency rates in the small and medium-sized business portfolios were offset by impairment allowance releases. Products with high credit losses were discontinued or restructured. Loan impairment charges in Brazil rose
marginally, due to growth in store loans and credit cards.
Releases and recoveries in Latin America increased to US$272 million. In Brazil, credit models were changed during 2007 to align with credit behaviour in underlying portfolios.
Year ended 31 December 2006 compared with year ended 31 December 2005(Unaudited)
Loan impairment charges increased by US$2.7 billion, or 34 per cent, compared with 2005. Acquisitions accounted for US$309 million of the rise, mainly Metris in the US. On an underlying basis, the increase was 30 per cent. Personal Financial Services continued to dominate loan impairments, representing 94 per cent of the Group’s charge. On a constant currency basis, the key trends were as follows.
New allowances for loan impairment charges of US$12.0 billion increased by 27 per cent compared with 2005. Releases and recoveries of allowances were broadly in line with 2005.
In Europe, new loan impairment charges rose by 9 per cent compared with 2005 to US$3.0 billion. A challenging credit environment in UK unsecured lending, which began to deteriorate in the middle of 2005, was the primary cause of the increase, although this was partly mitigated by continued benign corporate and commercial impairment experience. Personal bankruptcies and the use of IVAs have been on a rising trend since the introduction of legislation in 2004 that eased filing requirements, and this was further exacerbated by the recent active marketing of bankruptcy and IVA relief through the media by debt advisors. Additionally, a rise in unemployment, which began in the middle of 2005, and modest rises in interest rates added to the strain on some personal customers. In response, HSBC tightened underwriting controls in the second half of 2005, reduced its market share of unsecured personal lending and changed the product mix of new business towards lower-risk customers. In 2006, there were early signs of improvement in more recent unsecured lending. New loan impairment charges also rose in Turkey, by 30 per cent, mainly due to growth in unsecured credit card and personal lending as overall credit quality remained stable. In France, new charges fell, reflecting a stable credit environment and the reduction in charges following the sale of a consumer finance business in the second half of 2005.
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Releases and recoveries in Europe of US$860 million were 17 per cent higher than in 2005. Increases in the UK were partially offset by a decline in France. In the UK, increased resources deployed on collection activities, combined with a rise in sales of delinquent debt, were reflected in significantly higher recoveries. The non-recurrence of several significant recoveries in 2005 led to a large fall in France.
In Hong Kong, new loan impairment charges declined by 22 per cent to US$243 million, reflecting the non-recurrence of an individual charge in 2005 for a large commercial customer. This was partly offset by a rise in credit card impairments as a result of a rise in balances. Overall, credit quality remained stable as strong economic growth and low levels of unemployment continued.
Releases and recoveries fell by 49 per cent to US$86 million, again mainly as a result of fewer individual impairment releases in the corporate and commercial sector and the non-recurrence of mortgage lending recoveries in 2005, following improvement in the property market since 2004.
In Rest of Asia-Pacific, there was an 88 per cent rise in new impairment allowances toUS$737 million. This was an improvement on the situation in the first half of 2006, when new impairment charges were 111 per cent higher than in the first half of 2005. The year-on-year increase was largely due to Taiwan and, to a lesser extent, Indonesia. During the first half of 2006, new government regulations placing restrictions on collection activity, combined with the popularity of renegotiation schemes offering the opportunity to waive interest and postpone principal payments, led to a sharp rise in credit card defaults, for which a full-year charge of US$200 million was recorded. In the second half of 2006, this problem had begun to moderate and new impairment charges were 31 per cent lower than in the first half. In Indonesia, increased loan impairment charges in the personal sector reflected legislation which introduced higher minimum payment rules and a reduction in fuel subsidies. There were further rises in the Middle East, largely due to loan growth. Elsewhere in the region, credit quality was stable.
Releases and recoveries in the region fell by 11 per cent to US$225 million. The fall was mainly in Malaysia and was partly offset by a rise in commercial releases and recoveries in the Middle East.
In North America, new loan impairment charges rose by 36 per cent. Excluding Metris, new charges increased by 30 per cent. Credit
deterioration, mainly in second lien, some portions of first lien and adjustable-rate mortgages acquired from third party correspondents through HSBC’s mortgage services business, were the primary cause of the rise in new charges. As the housing market in the US slowed through 2006 and interest rates rose, delinquency trends on both second lien and portions of first lien mortgages originated in 2005 and 2006 were higher than for loans made in previous years. In addition, the extra payment obligations arising from the repricing of adjustable-rate mortgages to higher rates added to the assessed impairment of the correspondent portfolio, in particular in respect of second lien mortgages ranking behind adjustable-rate first lien mortgages.
As interest rate adjustments will be occurring in an environment of lower home value appreciation and tightening credit, it is estimated that the probability of default on adjustable-rate first mortgages subject to repricing, and on any second lien mortgage loans that are subordinate to an adjustable-rate first lien, will be greater than has been experienced in the past. As a result, loan impairment charges relating to the mortgage services portfolio have increased significantly.
In the second half of 2006, HSBC took action to tighten credit criteria in the mortgage services operation as detailed on page 217. As a consequence, balances in mortgage services declined compared with 30 June 2006.
Notwithstanding the credit weakness witnessed in the mortgage services business, credit delinquency in the majority of the other portfolios, including mortgage balances originated through the branch-based consumer lending business, rose modestly, driven by portfolio ageing and an increased proportion of credit card loans following the Metris acquisition. Partially offsetting factors included the effects of a decline in bankruptcy filings, especially in the first half of 2006 following the spike in the fourth quarter of 2005, low unemployment and the non-recurrence of charges relating to hurricane Katrina.
HSBC in the US closely monitors the two-month-and-over contractual delinquency ratio (being the ratio of two or more months delinquent accounts to gross loans and advances), as management views this as an important indicator of future write-offs. Details are disclosed below. The rise in the total ratio was chiefly as a result of the mortgage services business.
The increase in the US was partly offset by a small decline in new loan impairment charges in
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Canada, as the strong economy continued to underpin good credit quality.
Releases and recoveries in North America decreased by 23 per cent to US$146 million due to the non-recurrence of recoveries in the US.
In Latin America, new impairment charges rose by 24 per cent to US$1.1 billion in 2006. This increase was chiefly attributable to Mexico and, to a lesser extent, Brazil. Strong growth in personal and
commercial lending in Mexico resulted in higher new charges. In Brazil, new charges rose by 11 per cent, a significant reduction from the 52 per cent rise reported in 2005, as credit quality improved following enhancements made to underwriting procedures during 2005 and 2006.
Latin American releases and recoveries went up by 7 per cent, largely in Mexico as a result of more stable political and economic conditions.
Charge for impairment losses as a percentage of average gross loans and advances to customers(Unaudited)
HSBC Holdings (Audited)
Credit risk arises in HSBC Holdings primarily as a result of transactions with Group subsidiaries as well as guarantees issued in support of obligations incurred by some Group businesses in the normal conduct of their business.
These risks are reviewed and managed, within regulatory and internal limits for exposures, by the HSBC Group Risk function, which provides high-level, centralised oversight and management ofHSBC’s credit risks world-wide, reporting to the Group Chief Risk Officer.
No collateral or other credit enhancements were held by HSBC Holdings in respect of its transactions with subsidiary undertakings.
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HSBC Holdings’ maximum exposure to credit risk at 31 December 2007 is shown below. HSBC Holdings’ financial assets represent claims on Group
subsidiaries, principally located in Europe and North America.
All of the derivative transactions are with HSBC undertakings which are banking counterparties (2006: 100 per cent).
The credit quality of loans and advances to HSBC undertakings is assessed as satisfactory risk, with 100 per cent of the exposure being neither past due nor impaired (2006: 100 per cent).
The long-term debt rating of issuers of financial investments is within the Standard & Poor’s ratings range of AA– to AA+ (2006: AA– to AA+).
Risk elements in the loan portfolio(This section all unaudited)
The disclosure of credit risk elements under the following headings reflects US accounting practice and classifications for publicly traded bank holding companies:
Troubled debt restructurings
The SEC requires separate disclosure of any loans whose terms have been modified because of problems with the borrower to grant concessions other than are warranted by market conditions. These are classified as ‘troubled debt restructurings’ and are distinct from the normal restructure activities in personal loan portfolios described in ‘Renegotiated loans’ on page 227. Disclosure of troubled debt restructurings may be discontinued after the first year if the debt performs in accordance with the new terms.
Troubled debt restructurings increased by 54 per cent in 2007, reflecting measures taken to mitigate risk in the US consumer finance business in response to the deterioration in mortgage loans.
Unimpaired loans past due 90 days or more
Unimpaired loans contractually past due 90 days or more increased by 11 per cent. The rise was largely attributable to the US consumer finance business, where credit quality deteriorated throughout the year. The rise in overdue balances on credit cards in Mexico also contributed.
Impaired loans
In accordance with IFRSs, HSBC recognises interest income on assets after they have been written down as a result of an impairment loss. In the following tables, HSBC represents information on its impaired loans and advances which are designated in accordance with the policy described above.
Potential problem loans
Credit risk elements also cover potential problem loans. These are loans where information on possible credit problems among borrowers causes management to seriously doubt their ability to comply with the loan repayment terms. There are no potential problem loans other than those identified in the table of risk elements set out below, and as discussed in ‘Areas of special interest’ above, including ARMs and stated-income products.
Risk elements
The following table provides an analysis of risk elements in the loan portfolios at 31 December for the past five years:
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Credit risk > Risk elements / Liquidity and funding > Policies / Primary sources of funding
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Liquidity risk is the risk that HSBC does not have sufficient financial resources to meet its obligations as they fall due, or will have to do so at an excessive cost. This risk arises from mismatches in the timing of cash flows. Funding risk (a form of liquidity risk) arises when the necessary liquidity to fund illiquid asset positions cannot be obtained at the expected terms and when required.
The objective of HSBC’s liquidity and funding management is to ensure that all foreseeable funding commitments, including deposit withdrawals, can be met when due, and that access to the wholesale markets is co-ordinated and cost-effective. It is HSBC’s objective to maintain a diversified and stable funding base comprising core retail and corporate customer deposits and institutional balances. This is augmented by wholesale funding and maintaining portfolios of highly liquid assets which are diversified by currency and maturity, with the objective of enabling HSBC to respond quickly and smoothly to unforeseen liquidity requirements.
HSBC requires its operating entities to maintain a strong liquidity position and to manage the liquidity profile of their assets, liabilities and commitments with the objective of ensuring that cash flows are appropriately balanced and all obligations can be met when due.
Policies and procedures(Audited)
The management of liquidity and funding is primarily carried out locally in the operating entities of HSBC in accordance with practices and limits set by the Group Management Board. These limits vary by entity to take account of the depth and liquidity of the market in which the entity operates. It is HSBC’s general policy that each banking entity should be self-sufficient with regards to funding its own operations. Exceptions are permitted to facilitate the efficient funding of certain short-term treasury requirements and start-up operations or branches which do not have access to local deposit markets, all of which are funded under clearly defined internal and regulatory guidelines and limits from HSBC’s largest banking operations. These internal and regulatory limits and guidelines serve to place formal limitations on the transfer of resources between HSBC entities and are necessary to reflect the broad range of currencies, markets and time zones within which HSBC operates.
The Group’s liquidity and funding management process includes:
Primary sources of funding (Audited)
Current accounts and savings deposits payable on demand or at short notice form a significant part of HSBC’s funding. HSBC places considerable importance on maintaining the stability of these deposits.
The stability of deposits, which are a primary source of funding, depends upon preserving depositor confidence in HSBC’s capital strength and liquidity, and on competitive and transparent deposit-pricing strategies.
HSBC also accesses professional markets in order to provide funding for non-banking subsidiaries that do not accept deposits, to maintain a presence in local money markets and to optimise the funding of asset maturities not naturally matched by core deposit funding. In aggregate, HSBC’s banking entities are liquidity providers to the inter-bank market, placing significantly more funds with other banks than they themselves borrow.
The main operating subsidiary that does not accept deposits is HSBC Finance, which funds itself principally by taking term funding in the professional markets and by securitising assets.
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At 31 December 2007, US$142 billion (2006: US$150 billion) of HSBC Finance’s liabilities were drawn from professional markets, utilising a
range of products, maturities and currencies to avoid undue reliance on any particular funding source.
Cash flows payable by HSBC under financial liabilities by remaining contractual maturities(Audited)
The balances in the above table will not agree directly to the balances in the consolidated balance sheet as the table incorporates all cash flows, on an undiscounted basis, relating to both principal and those associated with all future coupon payments (except for trading liabilities and trading derivatives). Furthermore, loan commitments are generally not recognised on the balance sheet. Trading liabilities and trading derivatives have been included in the ‘On demand’ time bucket, and not by contractual maturity, because trading liabilities are typically held for short periods of time. The undiscounted cash flows on hedging derivative liabilities are classified according to their contractual maturity.
Cash flows payable in respect of customer accounts are primarily contractually repayable on demand or at short notice. However, in practice, short-term deposit balances remain stable as inflows and outflows broadly match.
Advances to deposits ratio(Audited)
HSBC emphasises the importance of current accounts and savings accounts as a source of funds to finance lending to customers, and discourages reliance on short-term professional funding. To achieve this goal, limits are placed on Group banking entities which restrict their ability to grow loans to customers without corresponding growth in core current accounts and savings accounts. This measure is referred to as the ‘advances to deposits’ ratio.
Advances to deposits ratio limits are set by the RMM and monitored by Group Finance. The ratio compares loans and advances to customers as a percentage of core customer current and savings accounts together with term funding with a remaining term to maturity in excess of one year. Loans to customers which are part of reverse repurchase arrangements, and where the Group
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receives securities which are deemed to be liquid, are excluded from the advances to deposits ratio. Current accounts and savings accounts from customers deemed to be ‘professional’ are excluded. The definition of a professional customer takes account of the size of the customer’s total deposit balances by applying a tiering classification. Generally, any customer with total funds deposited in excess of US$2 million is regarded as professional. Due to the distinction between core and professional depositors, the Group’s measure of advances to deposits will be more restrictive than that which could be inferred from the published financial statements.
The advances to deposits ratios of the Group’s principal banking entities(Audited)
The three major Group banking entities shown
separately in the table above represented 71 per cent of the Group’s total core deposits at 31 December 2007 (2006: 73 per cent). The table demonstrates that loans to customers in the Group’s principal banking entities are broadly financed by reliable and stable sources of funding.
HSBC would meet any unexpected net cash outflows by selling securities and accessing additional funding sources such as interbank or collateralised lending markets. In addition to the advances to deposits ratio, the Group uses a range of other measures for managing liquidity risk. These other measures include the ratio of net liquid assets to customer liabilities and projected cash flow scenario analyses.
Ratio of net liquid assets to customer liabilities(Audited)
Net liquid assets are liquid assets less all funds maturing in the next 30 days from wholesale market sources and from customers who are deemed to be professional. The Group defines liquid assets for the purposes of the liquidity ratio as cash balances, short-term interbank deposits and highly rated debt securities available for immediate sale and for which a deep and liquid market exists. As noted above, the definition of a professional customer takes account of the size of the customer’s total deposits. Contingent liquidity risk associated with committed loan facilities is not reflected in the ratios. The Group’s framework for monitoring this risk is outlined below.
Limits for the ratio of net liquid assets to customer liabilities are set for each bank operating entity. As HSBC Finance does not accept customer deposits, it is not appropriate to manage their liquidity using the standard liquidity ratios. The liquidity and funding risk framework of HSBC Finance is discussed below.
Ratios of net liquid assets to customer liabilities are provided in the following table. For additional information, the US dollar equivalents of net liquid assets are also provided.
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Ratio of net liquid assets to customer liabilities and net liquid assets(Audited)
The ‘Total of Group’s other principal banking entities’ reflects the other main banking subsidiaries and, as such, includes businesses spread across a range of locations, in many of which the Group may require a higher ratio of net liquid assets to customer liabilities to reflect local market conditions.
Projected cash flow scenario analysis(Audited)
The Group uses a number of standard projected cash flow scenarios which are designed to model both Group-specific and market-wide liquidity crises. The scenarios vary the rate and timing of deposit withdrawals and drawdowns on committed lending facilities, and restrict access to interbank funding, term debt markets and the ability to generate funds from asset portfolios. The scenarios are modelled by all Group banking entities and by HSBC Finance. The assumptions for each scenario are regularly reviewed for appropriateness. In addition to the Group’s standard projected cash flow scenarios, individual entities are required to design their own scenarios tailored to reflect specific local market conditions, products and funding bases.
Limits for cumulative net cash flows under stress scenarios are set for each banking entity and for HSBC Finance.
Both ratio and cash flow limits reflect the local market place, the diversity of funding sources
available and the concentration risk from large depositors. Compliance with entity level limits is monitored centrally by Group Finance and reported regularly to the RMM.
HSBC Finance
As HSBC Finance does not accept customer deposits, it takes funding from the professional markets. HSBC Finance uses a range of measures to monitor funding risk, including projected cash flow scenario analysis and placing caps on the amount of unsecured term funding that can mature in any rolling three-month and rolling 12-month periods. HSBC Finance also maintains access to committed sources of secured funding and has in place committed backstop lines for short-term refinancing CP programmes. At 31 December 2007, the maximum amounts of unsecured term funding maturing in any rolling three-month and rolling 12-month periods were US$6.2 billion and US$17.7 billion, respectively (2006: US$6.1 billion and US$16.0 billion). At 31 December 2007, HSBC Finance also had in place unused committed sources of secured funding, for which eligible assets were held, of US$6.2 billion (2006: US$9.0 billion) and committed backstop lines from non-Group entities in support of CP programmes totalling US$9.3 billion (2006: US$9.3 billion).
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The deterioration of the US sub-prime credit market has reduced the willingness of financial institutions to provide committed financing to entities with exposures to the US sub-prime market, such as HSBC Finance. HSBC Finance continues to have access to term funding markets, although the price of this funding has increased to reflect the downturn in credit markets. Funding plans are in place to enable HSBC Finance to deal with continued stress in the credit markets.
Contingent liquidity risk(Audited)
In the normal course of its business, the Group provides committed facilities to customers; these
facilities include committed backstop lines to conduit vehicles sponsored by the Group. The liquidity risk consequences of drawdowns on these committed loan facilities provided by Group entities are reflected in projected cash flow scenario analyses, in which the level of drawdown is varied under different stress scenarios. The Group also sets total notional limits by Group entity for non-cancellable contingent funding commitments. The limits are set by the RMM after due consideration of the entity’s ability to fund the commitments. The limits are split according to the borrower, the liquidity of the underlying assets and the size of the committed line.
The Group’s contractual exposures as at 31 December monitored under the contingent liquidity risk limit structure(Audited)
The Group recognises that, in times of market stress, it may choose to provide non-contractual liquidity support to certain HSBC-sponsored vehicles or HSBC-promoted products. Such potential support would not be included in the Group’s liquidity risk measures until such time as the support becomes legally binding, and would only be provided after careful consideration of the potential funding requirement and the impact on the entity’s overall levels of liquidity.
In the second half of 2007, HSBC provided additional funding to two SIVs sponsored by the Group (Cullinan and Asscher) in the form of repos, CP purchases and the acquisition of assets at fair value from Cullinan. In November 2007, HSBC announced its intention to provide investors in Cullinan and Asscher with the option to exchange their capital notes for notes issued by one or more new SPEs, with term funding and liquidity to be
provided by HSBC. For further information on these SIVs, see ‘Off-balance sheet arrangements and special purpose entities’ on page 183.
HSBC Holdings’ primary sources of cash are interest and capital receipts from its subsidiaries, which it deploys in short-term bank deposits or liquidity funds. HSBC Holdings’ primary uses of cash are investments in subsidiaries, interest payments to debt holders and dividend payments to shareholders. On an ongoing basis, HSBC Holdings replenishes its liquid resources through the receipt of interest on, and repayment of, intra-group loans, from dividends paid by subsidiaries and from interest earned on its own liquid funds. The ability of its subsidiaries to pay dividends or advance monies to HSBC Holdings depends, among other things, on their respective
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regulatory capital requirements, statutory reserves, and financial and operating performance.
HSBC actively manages the cash flows from its subsidiaries to optimise the amount of cash held at the holding company level, and expects to continue doing so in the future. The wide range of HSBC’s activities means that HSBC Holdings is not dependent on a single source of profits to fund its dividends. HSBC Holdings is also subject to contingent liquidity risk by virtue of loan
commitments and guarantees given. Such commitments are only provided after due consideration of HSBC Holdings’ ability to finance these commitments and the likelihood of the need arising. Together with its accumulated liquid assets, HSBC Holdings believes that planned dividends and interest from subsidiaries will enable it to meet anticipated cash obligations. Also, in usual circumstances, HSBC Holdings has full access to capital markets on normal terms.
Cash flows payable by HSBC Holdings under financial liabilities by remaining contractual maturities(Audited)
At 31 December 2007, the short-term liabilities of HSBC Holdings totalled US$3.3 billion (2006: US$1.8 billion), including US$1.4 billion in respect of the third interim dividend for 2007 (2006: US$1.5 billion) which was paid on 16 January 2008. Short-term assets of US$8.1 billion (2006: US$7.6 billion) consisted mainly of cash at bank of US$360 million (2006: US$729 million) and loans and advances to HSBC undertakings of US$7.4 billion (2006: US$6.9 billion). Derivatives have been included in the ‘On demand’ time bucket, and not by contractual maturity. The undiscounted cash flows on hedging derivative liabilities are classified according to their contractual maturity.
Market risk management(Audited)
The objective of HSBC’s market risk management is to manage and control market risk exposures in order to optimise return on risk while maintaining a market profile consistent with the Group’s status as one of the world’s largest banking and financial services organisations.
Market risk is the risk that movements in market risk factors, including foreign exchange rates and commodity prices, interest rates, credit spreads and equity prices will reduce HSBC’s income or the value of its portfolios.
HSBC separates exposures to market risk into trading and non-trading portfolios. Trading portfolios include those positions arising from market-making, proprietary position-taking and other marked-to-market positions so designated.
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Non-trading portfolios include positions that arise from the interest rate management of HSBC’s retail and commercial banking assets and liabilities, financial investments designated as available for sale and held to maturity, and exposures arising from HSBC’s insurance operations.
Market risk arising in HSBC’s insurance businesses is discussed in ‘Risk management of insurance operations’ on pages 272 to 275.
The management of market risk is principally undertaken in Global Markets using risk limits approved by the Group Management Board. Limits are set for portfolios, products and risk types, with market liquidity being a principal factor in determining the level of limits set. Traded Credit and Market Risk, an independent unit within the Group Management Office, develops the Group’s market risk management policies and measurement techniques. Each major operating entity has an independent market risk management and control function which is responsible for measuring market risk exposures in accordance with the policies defined by Traded Credit and Market Risk, and monitoring and reporting these exposures against the prescribed limits on a daily basis.
Each operating entity is required to assess the market risks which arise on each product in its business and to transfer these risks to either its local Global Markets unit for management, or to separate books managed under the supervision of the local Asset and Liability Management Committee (‘ALCO’). The aim is to ensure that all market risks are consolidated within operations which have the necessary skills, tools, management and governance to manage such risks professionally. In certain cases where the market risks cannot be adequately captured by the transfer process, simulation modelling is used to identify the impact of varying scenarios on valuations and net interest income.
HSBC uses a range of tools to monitor and limit market risk exposures. These include value at risk (‘VAR’), sensitivity analysis and stress testing. The following table provides an overview of the reporting of risks within this section:
Value at risk(Audited)
VAR is a technique that estimates the potential losses that could occur on risk positions as a result of movements in market rates and prices over a specified time horizon and to a given level of confidence.
The VAR models used by HSBC are predominantly based on historical simulation. These models derive plausible future scenarios from past series of recorded market rates and prices, taking account of inter-relationships between different markets and rates such as interest rates and foreign exchange rates. The models also incorporate the effect of option features on the underlying exposures.
The historical simulation models used by HSBC incorporate the following features:
HSBC routinely validates the accuracy of its VAR models by backtesting the actual daily profit and loss results, adjusted to remove non-modelled items such as fees and commissions, against thecorresponding VAR numbers. Statistically, HSBC would expect to see losses in excess of VAR only 1 per cent of the time over a one-year period. The actual number of excesses over this period can therefore be used to gauge how well the models are performing.
Although a valuable guide to risk, VAR should always be viewed in the context of its limitations. For example:
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HSBC recognises these limitations by augmenting its VAR limits with other position and sensitivity limit structures. HSBC also applies a wide range of stress testing, both on individual portfolios and on the Group’s consolidated positions.
The VAR, both trading and non-trading, for the Group was as follows:
Total VAR at 31 December 2007 increased, compared with 31 December 2006. The major cause of this was an increase in volatility in market rates during the latter half of 2007.
The daily VAR, both trading and non-trading, for the Group was as follows:
Daily VAR (trading and non-trading) (US$m)(Unaudited)
The major contributor to the trading and non-trading VAR for the Group was Global Markets.
The histograms below illustrate the frequency of daily revenue arising from Global Markets’ trading, balance sheet management and other trading activities.
The average daily revenue earned therefrom in 2007 was US$18.7 million, compared with US$21.3 million in 2006. The standard deviation of these daily revenues was US$25.3 million, compared with US$11.4 million in 2006. The standard deviation measures the variation of daily revenues about the mean value of those revenues. An analysis of the frequency distribution of daily revenue shows that there were 35 days with negative revenue during 2007, compared with two days in 2006.
Daily distribution of Global Markets’ trading, balance sheet management and other trading revenues(Unaudited)
For a description of HSBC’s fair value and price verification controls, see Note 33 on the Financial Statements.
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Trading portfolios(Audited)
HSBC’s control of market risk is based on a policy of restricting individual operations to trading within a list of permissible instruments authorised for each site by Traded Credit and Market Risk, of enforcing rigorous new product approval procedures, and of restricting trading in the more complex derivative products only to offices with appropriate levels of product expertise and robust control systems.
In addition, at both portfolio and position levels, market risk in trading portfolios is monitored and
controlled using a complementary set of techniques. These include VAR and, for interest rate risk, present value of a basis point movement in interest rates, together with stress and sensitivity testing and concentration limits. These techniques quantify the impact on capital of defined market movements.
Market making and proprietary position taking is undertaken within Global Markets. The VAR for such trading activity at 31 December 2007 was US$48.3 million (2006: US$30.2 million). This is analysed below by risk type:
VAR by risk type for the trading activities(Audited)
The risk associated with movements in credit spreads is primarily managed through sensitivity limits, stress testing and VAR on those portfolios where VAR is calculated.
The Group is introducing credit spread as a separate risk type within the VAR models and, at 31 December 2007, credit spread VAR was calculated for the London trading and New York credit derivatives portfolios. At that date, the total VAR for the trading activities, including credit spread VAR for the above portfolios, was US$60.1 million.
The effect of movements in credit spreads on the Group’s trading portfolio became more significant in 2007 as volatility in these spreads increased in the latter half of 2007. The sensitivity of trading income to the effect of movements in credit spreads on the total trading activities of the Group was US$95.4 million at 31 December 2007 (2006: US$27.3 million). This sensitivity was calculated using simplified assumptions based on one-day movements in average market credit spreads over a two-year period at a confidence level of 99 per cent.
The increase in the sensitivity at 31 December
2007, compared with 31 December 2006, was due to the effect of higher volatility in credit spreads observed in the latter half of 2007. The credit spread positions within the trading portfolios were at a similar level on 31 December 2007 compared with 31 December 2006.
Credit spread risk also arises on credit derivative transactions entered into by Global Banking. The purpose of these transactions is to manage the risk concentrations within the corporate loan portfolio and so enhance capital efficiency. The mark-to-market of these transactions is taken through the profit and loss account.
At 31 December 2007, the credit spread VAR on the credit derivatives transactions entered into by Global Banking was US$19.7 million (2006: US$8.2 million). The VAR shows the effect on trading income from a one-day movement in credit spreads over a two-year period, calculated to a 99 per cent confidence level.
HSBC augments its VAR measures with a series of stress scenarios to determine the potential loss arising from market moves that are outside the 99 per cent confidence level measured by VAR.
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The stress scenarios cover a range of potential market events, such as the hypothetical breaking of a currency peg or the historical observation of market moves during previous periods of stress which would not be captured within VAR. The scenarios provide senior management with an assessment of the financial impact such events would have on the profit and loss of HSBC. The daily losses experienced during 2007 were within the stress loss scenarios reported to senior management.
Certain transactions are structured such that the risk to HSBC is negligible under a wide range of market conditions or events, but in which there exists a remote probability that a significant gap event could lead to loss. A gap event could be seen as a change in market price from one level to another with no trading opportunity in between, and where the price change breaches the threshold beyond which the risk profile changes from having no open risk to having full exposure to the underlying structure. Such movements may occur, for example, when there are adverse news announcements and the market for a specific investment becomes illiquid, making hedging impossible.
Given the characteristics of these transactions, they will make little or no contribution to VAR or to traditional market risk sensitivity measures. HSBC captures the risks for such transactions within the stress testing scenarios. Gap risk arising is monitored on an ongoing basis, and HSBC incurred no gap losses on such transactions in 2007.
Non-trading portfolios(Audited)
The principal objective of market risk management of non-trading portfolios is to optimise net interest income.
Market risk in non-trading portfolios arises principally from mismatches between the future yield on assets and their funding cost, as a result of interest rate changes. Analysis of this risk is complicated by having to make assumptions on embedded optionality within certain product areas such as the incidence of mortgage prepayments, and from behavioural assumptions regarding the economic duration of liabilities which are contractually repayable on demand such as current accounts. The prospective change in future net
interest income from non-trading portfolios will be reflected in the current realisable value of these positions, should they be sold or closed prior to maturity. In order to manage this risk optimally, market risk in non-trading portfolios is transferred to Global Markets or to separate books managed under the supervision of the local ALCO.
The transfer of market risk to books managed by Global Markets or supervised by ALCO is usually achieved by a series of internal deals between the business units and these books. When thebehavioural characteristics of a product differ from its contractual characteristics, the behavioural characteristics are assessed to determine the true underlying interest rate risk. Local ALCOs are required to regularly monitor all such behavioural assumptions and interest rate risk positions to ensure they comply with interest rate risk limits established by the Group Management Board.
In certain cases, the non-linear characteristics of products cannot be adequately captured by the risk transfer process. For example, both the flow from customer deposit accounts to alternative investment products and the precise prepayment speeds of mortgages will vary at different interest rate levels, and where expectations about future moves in interest rates change. In such circumstances, simulation modelling is used to identify the impact of varying scenarios on valuations and net interest income.
Once market risk has been consolidated in Global Markets or ALCO-managed books, the net exposure is typically managed through the use of interest rate swaps within agreed limits. The VAR for these portfolios is included within the Group VAR (see ‘Value at risk’ above).
Fixed-rate securities(Audited)
Market risk also arises on fixed-rate securities issued by HSBC Holdings. These securities are managed as capital instruments and include non-cumulative preference shares, non-cumulative perpetual preferred securities and fixed-rate subordinated debt. The interest rate VAR for these capital instruments, which is not included within Group VAR, was as follows:
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Capital instruments VAR(Audited)
At 31 December 2007, the sensitivity of equity to the effect of movements in credit spreads on the Group’s available-for-sale debt securities was US$206.5 million (2006: US$52.0 million). The sensitivity was calculated on the same basis as applied to the trading portfolio. Including the gross exposure for the SIVs consolidated within HSBC’s balance sheet at 31 December 2007, the sensitivity increased to US$279.8 million. This sensitivity is struck, however, before taking account of any losses which would be absorbed by the income note holders. At 31 December 2007, the income note holders would have absorbed the first US$1.3 billion of any losses incurred by the SIVs prior to HSBC incurring any equity losses.
The increase in this sensitivity at 31 December 2007, compared with 31 December 2006, was due to the effect of higher volatility in credit spreads observed in the latter half of 2007.
Equity securities classified as available for sale(Audited)
Market risk arises on equity securities held as available for sale. The fair value of these securities at 31 December 2007 was US$12.6 billion (2006: US$8.3 billion) and included private equity holdings of US$3.2 billion (2006: US$0.9 billion). Investments in private equity are primarily made through managed funds that are subject to limits on the amount of investment. Potential new commitments are subject to risk appraisal to ensure that industry and geographical concentrations remain within acceptable levels for the portfolio as a whole. Regular reviews are performed to substantiate the valuation of the investments within the portfolio and Group Finance is responsible for reviewing the carrying value of the investments. Funds typically invested for short-term cash management represented US$3.1 billion (2006: US$2.6 billion),
Investments held to facilitate ongoing business, such as holdings in government-sponsored enterprises and local stock exchanges, represented US$1.7 billion (2006: US$1.3 billion). Other strategic investments represented US$4.6 billion (2006: US$3.5 billion). The fair value of the constituents of equity securities classified as available for sale can fluctuate considerably. A 10 per cent reduction in the value of the available-for-sale equities at 31 December 2007 would have reduced equity by US$1.3 billion (2006: US$0.8 billion).
Defined benefit pension scheme(Audited)
Market risk also arises within HSBC’s defined benefit pension schemes to the extent that the obligations of the schemes are not fully matched by assets with determinable cash flows. Pension scheme obligations are subject to change due to fluctuations in long-term interest rates as well as factors such as changes in inflation, salary increases and scheme members living longer. The pension scheme assets will include equities and debt securities, the cash flows of which will change as equity prices and interest rates vary. The risks are that market movements in equity prices and interest rates could result in assets which are insufficient over time to cover the level of projected obligations. In addition, increases in inflation and members living longer could increase the pension scheme obligations. Management, together with the trustees who act on behalf of the pension scheme beneficiaries, assess the level of this risk using reports prepared by independent external actuaries and take action, where appropriate, in terms of setting investment strategy and agreeing contribution levels. For example, in order to mitigate the risk of adverse movements in investments, interest rates and inflation, the Trustee of the HSBC Bank (UK) Pension Scheme has continued to implement a programme of initiatives proposed by HSBC, including reducing the equity content of the investment strategy and increasing the diversification of the investments, and entering into long-term interest rate and inflation swaps.
The present value of HSBC’s defined benefit pension plans’ liabilities was US$32.4 billion at 31 December 2007, compared with US$32.2 billion at 31 December 2006. Assets of the defined benefit schemes at 31 December 2007 comprised equity investments, 26 per cent (2006: 30 per cent); debt securities, 62 per cent (2006: 56 per cent); and other (including property), 12 per cent (2006: 14 per cent) (see Note 8 on the Financial Statements).
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Increased corporate bond yields in the UK over the period have resulted in an increase of 40 basis points in the real discount rate (net of the increase in expected inflation) used to value the net present value of the benefits payable of the HSBC Bank (UK) Pension Scheme, the Group’s largest plan. In addition, the plan assets of the scheme have increased due to a special contribution to the scheme of US$0.6 billion. Primarily as a result of these factors, the deficit on HSBC’s defined benefit plans has decreased to US$2 billion from US$4.6 billion.
Sensitivity of net interest income (Unaudited)
A principal part of HSBC’s management of market risk in non-trading portfolios is to monitor the sensitivity of projected net interest income under varying interest rate scenarios (simulation modelling). HSBC aims, through its management of market risk in non-trading portfolios, to mitigate the effect of prospective interest rate movements which could reduce future net interest income, while balancing the cost of such hedging activities on the current net revenue stream.
For simulation modelling, businesses use a
combination of scenarios relevant to local businesses and local markets and standard scenarios which are required throughout HSBC. The standard scenarios are consolidated to illustrate the combined pro forma effect on HSBC’s consolidated portfolio valuations and net interest income.
The table below sets out the effect on future net interest income of an incremental 25 basis points parallel fall or rise in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 January 2008. Assuming no management actions, a series of such rises would decrease planned net interest income for 2008 by US$503 million (2007: US$578 million), while a series of such falls would increase planned net interest income by US$525 million (2007: US$511 million). These figures incorporate the effect of any option features in the underlying exposures.
Instead of assuming that all interest rates move together, HSBC groups its interest rate exposures into currency blocs whose rates are considered likely to move together. The sensitivity of projected net interest income, on this basis, is as follows:
Sensitivity of projected net interest income (Unaudited)
The interest rate sensitivities set out in the table above are illustrative only and are based on simplified scenarios. The figures represent the effect of the pro-forma movements in net interest income based on the projected yield curve scenarios and the Group’s current interest rate risk profile. This effect, however, does not incorporate actions that would be taken by Global Markets or in the business units to mitigate the impact of this interest rate risk. In
reality, Global Markets seeks proactively to change the interest rate risk profile to minimise losses and optimise net revenues. The projections above also assume that interest rates of all maturities move by the same amount and, therefore, do not reflect the potential impact on net interest income of some rates changing while others remain unchanged. The projections take account of the anticipated net interest income impact of rate change differences
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between interbank interest rates and interest rates linked to other bases (such as Central Bank rates or product rates over which the entity has discretion in terms of the timing and extent of rate changes). The projections make other simplifying assumptions too, including that all positions run to maturity.
HSBC’s exposure to the effect of movements in interest rates on its net interest income arise in three main areas: core deposit franchises, HSBC Finance and Global Markets.
The main drivers of change in the sensitivity of the Group’s net interest income to the changes in interest rates tabulated above were:
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.
HSBC monitors the sensitivity of reported reserves to interest rate movements on a monthly basis by assessing the expected reduction in valuation of available-for-sale portfolios and cash flow hedges due to parallel movements of plus or minus 100 basis points in all yield curves. The table below describes the sensitivity of HSBC’s reported reserves to these movements at the end of 2007 and 2006 and the maximum and minimum month-end figures during these years:
Sensitivity of reported reserves to interest rate movements (Unaudited)
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The sensitivities are illustrative only and are based on simplified scenarios. The table shows interest rate risk exposures arising in available-for-sale portfolios and from cash flow hedges which are marked-to-market through reserves. These particular exposures form only a part of the Group’s overall interest rate exposures. The accounting treatment under IFRSs of the Group’s remaining interest rate exposures, while economically largely offsetting the exposures shown in the above table, does not require revaluation movements to go to reserves.
Structural foreign exchange exposures(Unaudited)
Structural foreign exchange exposures represent net investments in subsidiaries, branches or associated undertakings, the functional currencies of which are currencies other than the US dollar.
Exchange differences on structural exposures are recorded in the consolidated statement of recognised income and expense. The main operating (or functional) currencies in which HSBC’s business is transacted are the US dollar, the Hong Kong dollar, pound 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 exchange differences between the US dollar and all the non-US dollar functional currencies of underlying subsidiaries.
HSBC hedges structural foreign exchange exposures only in limited circumstances. HSBC’s structural foreign exchange exposures are managed with the primary objective of ensuring, where practical, that HSBC’s consolidated capital ratios and the capital 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 capital ratio of the subsidiary in question.
Selective hedges were in place during 2006 and 2007. Hedging is undertaken using forward foreign exchange contracts which are accounted for under IFRSs as hedges of a net investment in a foreign operation, or by financing with borrowings in the same currencies as the functional currencies involved. There was no ineffectiveness arising from these hedges in the year ended 31 December 2007.
There was no material effect from exchange differences on HSBC’s capital ratios during the year.
HSBC Holdings(Audited)
As a financial services holding company, HSBC Holdings has limited market risk activity. Its activities predominantly involve maintaining sufficient capital resources to support the Group’s diverse activities; allocating these capital resources across the Group’s businesses; earning dividend and interest income on its investments in the Group’s businesses; providing dividend payments to HSBC Holding’s equity shareholders and interest payments to providers of debt capital; and maintaining a supply of short-term cash resources. It does not take proprietary trading positions.
The main market risks to which HSBC Holdings is exposed are interest rate risk and foreign currency risk. Exposure to these risks arises from short-term cash balances, funding positions held, loans to subsidiaries, investments in long-term financial assets and financial liabilities including debt capital issued. The objective of HSBC Holding’s market risk management strategy is to reduce exposure to these risks and minimise volatility in reported income, cash flows and distributable reserves. Market risk for HSBC Holdings is monitored by its Structural Positions Review Group.
Certain loans to subsidiaries of a capital nature that are not denominated in the functional currency of either the provider or the recipient are accounted for as financial assets. Changes in the carrying amount of these assets due to exchange differences are taken directly to the income statement. These loans, and the associated foreign exchange exposures, are eliminated on a Group consolidated basis.
Total VAR arising within HSBC Holdings in 2007 and 2006 was as follows:
Value at risk – HSBC Holdings (Audited)
The increase in total VAR during 2007 was mainly due to the increase in volatility of interest rates and new debt capital issues made in the year.
A principal tool in the management of market risk is the projected sensitivity of HSBC Holdings’ net interest income to future changes in yield curves.
The table below sets out the effect on HSBC Holdings’ future net interest income of an incremental 25 basis point parallel fall or rise in all yield curves worldwide at the beginning of each quarter during the 12 months from 1 January 2008.
Assuming no management action, a series of such rises would decrease HSBC Holdings’ planned net interest income for 2008 by US$23 million (2007: increase of US$8 million) while a series of such falls would increase planned net interest income by US$23 million (2007: decrease of US$8 million). These figures incorporate the impact of any option features in the underlying exposures.
Instead of assuming that all interest rates move together, HSBC groups its interest rate exposures into currency blocs whose interest rates are considered likely to move together. The sensitivity of projected net interest income, on this basis, is described as follows:
Sensitivity of HSBC Holdings’ net interest income to interest rate movements (Unaudited)
HSBC Holdings’ principal exposure to changes in its net interest income from movements in interest rates arises on short-term cash balances, floating rate loans advanced to subsidiaries and fixed rate debt capital securities in issue which have been swapped to floating rate.
The interest rate sensitivities tabulated above are illustrative only and are based on simplified scenarios. The figures represent the effect of pro forma movements in net interest income based on the projected yield curve scenarios and HSBC Holdings’ current interest rate risk profile. They do not take into account the effect of actions that could be taken to mitigate this interest rate risk, however.
The projected increase in HSBC Holdings’ sensitivity to moves in interest rates is mainly due to new interest-bearing capital issues, the funds from which have been largely invested in non-interest bearing equity investments in subsidiaries.
Areas of special interest – market risk (Audited)
In the second half of 2007, credit risk concerns emanating from the US sub-prime mortgage market led to a deterioration in the fair value of assets supported by sub-prime mortgages. However, there was a consequential impact beyond sub-prime related assets and, to a lesser degree, fair value
deterioration occurred in US mortgage-related financial instruments generally, with financial instruments issued by non-US government sponsored entities more significantly affected than sponsored financial instruments.
The following table shows the net market risk arising from HSBC’s exposure to US mortgage loans held at fair value through profit or loss, and US mortgage-backed securities (‘MBSs’) including those represented by collateralised debt obligations (‘CDOs’). HSBC’s exposures arise from the following activities:
Unrealised and realised gains and losses arising from securitisation and secondary market trading activity are recognised in the income statement, while changes in fair value of the investment portfolio and the SIV and conduit portfolios are recognised in equity. US MBSs are primarily measured at fair value; a small proportion of high grade securities are classified as held-to-maturity and measured at amortised cost. There are no significant differences between fair value and carrying amount for these US MBSs measured at amortised cost.
HSBC’s principal exposure to the US mortgage market is via credit risk from loans and advances to customers, details of which are set out from page 216.
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In addition to the exposure detailed above, HSBC also holds long positions in MBSs with a carrying value of US$1,633 million (2006: US$963 million) and MBS CDOs with a carrying value of US$349 million (2006: US$608 million) where the exposure has been matched by specific credit derivatives with monolines and other financial institutions. The counterparty credit risk arising from the derivative transactions undertaken with monolines is included in the monoline exposure analysis detailed on page 260.
HSBC’s exposure to derivative transactions entered into directly with monoline insurers(Audited)
HSBC’s principal exposure to monoline insurers is through a number of OTC derivative transactions, primarily credit default swaps (‘CDSs’). HSBC has entered into CDSs to purchase credit protection against securities held within the trading portfolio.
During the second half of 2007, the market value of the securities declined, with offsetting increases in the mark-to-market value of the CDS transactions, thereby increasing OTC counterparty credit risk to the monoline insurers. The table below sets out the mark-to-market value of the derivative contracts at 31 December 2007, and hence the amount at risk, based on 31 December 2007 security prices, if the CDS protection purchased were to be wholly ineffective because, for example, the monoline insurer was unable to meet its obligations. In order to assess that risk, protection purchased is sub-divided between those monoline insurers that had external investment grade ratings at 25 February 2008, and those that did not. The ‘Credit Risk Adjustment’ column indicates the valuation adjustment taken against the mark-to-market exposures, and reflects the deterioration in creditworthiness of the monoline insurers during 2007. These adjustments have been charged to the income statement.
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HSBC’s exposure to debt securities which benefit from guarantees provided by monoline insurers(Audited)
Within both the trading and available-for-sale portfolios, HSBC holds bonds that are ‘wrapped’ with a credit enhancement from a monoline insurer. Any deterioration in the credit profile of the monoline insurer is reflected in market prices and therefore in the carrying value of these securities in HSBC’s balance sheet at 31 December 2007. For wrapped bonds held in the trading portfolio, the mark-to-market loss has been reflected through the income statement. For wrapped bonds held in the available-for-sale portfolio, the mark-to-market deterioration is reflected in equity unless the impairment is regarded as permanent, in which case it is reflected in the income statement. There was no permanent impairment recognised in respect of these assets at 31 December 2007.
HSBC’s exposure to direct lending and irrevocable commitments to lend to monoline insurers(Audited)
HSBC has extended liquidity facilities totalling US$158 million to monoline insurers, none of which was drawn at 31 December 2007 (31 December 2006: US$145 million, none of which was drawn).
A significant part of a lessor’s return from operating leases is dependent upon its management of residual value risk. This arises from operating lease transactions to the extent that the values recovered from disposing of leased assets or re-letting them at the end of the lease terms (the ‘residual values’) differ from those projected at the inception of the
leases. The business regularly monitors residual value exposure by reviewing the recoverability of the residual value projected at lease inception. This entails considering the potential of re-letting of operating lease assets and their projected disposal proceeds at the end of their lease terms. Provision is made to the extent that the carrying values of leased assets are impaired through residual values not being fully recoverable.
The net book value of equipment leased to customers on operating leases by the Group includes projected residual values at the end of current lease terms, to be recovered through re-letting or disposal in the following periods:
Residual values(Unaudited)
Operational risk is the risk of loss arising from fraud, unauthorised activities, error, omission, inefficiency, systems failure or external events. It is inherent in every business organisation and covers a wide spectrum of issues.
HSBC manages this risk through a controls-based environment in which processes are documented, authorisation is independent and transactions are reconciled and monitored. In each of HSBC’s subsidiaries, local management is responsible for the review and supervision of the operation of these controls. The control environment
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in each subsidiary is subject to an independent programme of periodic reviews undertaken by Internal Audit. This is supported by the monitoring of external operational risk events, which ensures that HSBC stays in line with industry best practice and takes account of lessons learned from publicised operational failures within the financial services industry.
HSBC has codified its operational risk management framework by issuing a high level standard, supplemented by more detailed formal policies. The detailed policies explain HSBC’s approach to identifying, assessing, monitoring and controlling operational risk, give guidance on remedial action to be taken when rectifying operational risk events and set out responsibilities for meeting local regulatory requirements. Processes undertaken to manage operational risk are determined by reference to the scale and nature of each HSBC operation. The HSBC standard covers the following:
In each of HSBC’s subsidiaries, local management is responsible for implementing HSBC standards on operational risk throughout their operations and, where deficiencies are evident, rectifying them within a reasonable timeframe. Subsidiaries acquired by HSBC are required to assess, plan and implement the standard’s requirements within an agreed timescale.
HSBC maintains and tests contingency facilities to support operations in the event of disasters. Additional reviews and tests are conducted in the event that any HSBC office is affected by a business disruption event to incorporate lessons learned in the operational recovery from those circumstances. As part of HSBC’s contingency planning, all country managers have prepared plans for the operation of their businesses with reduced staffing levels, should a flu pandemic occur. Country managers are required to update these plans as circumstances change.
Legal risk(Unaudited)
Each operating company is required to implement policies, procedures and guidelines in respect of the management and control of legal risk which conform to HSBC standards. Legal risk falls within the definition of operational risk and includes contractual risk, legislative risk, intellectual property risk and litigation risk. Legal risk is the risk of:
HSBC has a dedicated global legal function which is responsible for managing legal risk. This comprises the provision of legal advice and support in resisting claims and legal proceedings against HSBC companies, including analysis of legal issues and the management of any litigation, as well as in respect of non-routine debt recoveries or other litigation against third parties.
The Head Office legal department oversees the global legal function and is headed by a Group General Manager who reports to the Group Chairman. There are legal departments in 56 of thecountries in which HSBC operates which have primary responsibility for identifying and assessing legal risk and advising local management in their respective jurisdictions on these matters. There is also a regional-level legal function in each of Europe, North America, Latin America, the Middle East, and Asia-Pacific.
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HSBC policy requires operating companies to notify the appropriate in-house legal department immediately any litigation is either threatened or commenced against the Group or an employee. Claims which exceed US$1.5 million must be advised immediately to the appropriate regional legal department. Claims where the amount exceeds US$5 million, where the action is by a regulatory authority, where the proceedings are criminal, or where the claim might materially affect the Group’s reputation must immediately be advised to the Head Office legal department. Such matters are then advised to the Risk Management Meeting of the Group Management Board in a monthly paper.
HSBC policy also requires that an exception report must be made to the local compliance function and escalated to the Head of Group Compliance in respect of any breach which has given rise to a fine and/or costs levied by a court of law or regulatory body where the amount is US$1,500 or more, and material or significant issues are reported to the Risk Management Meeting of the Group Management Board and/or the Group Audit Committee.
In addition, operating companies are required to submit quarterly returns detailing outstanding claims where the claim (or group of similar claims) exceeds US$10 million, where the action is by a regulatory authority, where the proceedings are criminal, where the claim might materially affect the Group’s reputation, or, where the Head Office legal department has requested returns be completed for a particular claim. These returns are used for reporting to the Group Audit Committee and the Board of HSBC Holdings, and disclosure in the Interim Report and Annual Report and Accounts if appropriate.
Global security and fraud risk (Unaudited)
Security and fraud risk issues are managed at Group level by Global Security and Fraud Risk. This unit, which has responsibility for physical, fraud, information and contingency risk, and security and business intelligence, is now fully integrated within the central Group Risk function. This will facilitate synergies between it and other risk functions, such as with Global Retail Risk Management in the selection, design and implementation of systems and processes to protect the Group against fraud by deterring fraudulent activity, detecting it where it does occur and mitigating its effects.
HSBC operates a number of pension plans throughout the world, as described in Note 8 on the Financial Statements. Some of these pension plans are defined benefit plans, of which the largest is the HSBC Bank (UK) Pension Scheme.
In order to fund these benefits, sponsoring group companies (and in some instances, employees) make regular contributions in accordance with advice from actuaries and in consultation with the scheme’s Trustees (where relevant). The defined benefit plans invest these contributions in a range of investments designed to meet their long-term liabilities.
The level of these contributions has a direct impact on the cash flow of the Group and would normally be set to ensure that there are sufficient funds to meet the cost of the accruing benefits for the future service of active members. However, higher contributions will be required when plan assets are considered insufficient to cover the existing pension liabilities as a deficit exists. Contribution rates are typically revised annually or triennially, depending on the plan. The agreed contributions to the HSBC Bank (UK) Pension Scheme are revised triennially.
A deficit in a defined benefit plan may arise from a number of factors, including:
The plan’s investment strategy is determined in the light of the market risk inherent in the investments and the consequential impact on potential future contributions.
Ultimate responsibility for investment strategy rests with either the Trustees or, in certain circumstances, a Management Committee. The degree of independence of the Trustees from HSBC differs in different jurisdictions. For example, the HSBC Bank (UK) Pension Scheme, which accounts for over 40 per cent of the net liability of the Group’s pension plans, is overseen by a corporate Trustee. This scheme’s Trustee regularly monitors the market risks inherent in the scheme.
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The safeguarding of HSBC’s reputation is of paramount importance to its continued prosperity and is the responsibility of every member of staff, and HSBC regularly reviews its policies and procedures for safeguarding against reputational and operational risks. This is an evolutionary process which takes account of relevant developments and industry guidance such as The Association of British Insurers’ guidance on best practice when responding to environmental, social and governance (‘ESG’) risks.
HSBC has always aspired to the highest standards of conduct and, as a matter of routine, takes account of reputational risks to its business. Reputational risks can arise from a wide variety of causes, including ESG issues and operational risk events. As a banking group, HSBC’s good reputation depends upon the way in which it conducts its business, but it can also be affected by the way in which clients, to whom it provides financial services, conduct themselves. The training of Directors on appointment includes reputational matters.
A Reputational Risk Committee (‘RRC’) has been established at which relevant Group functions with responsibility for activities and functions which attract reputational risk are represented. The primary role of the RRC is to consider areas and activities presenting significant reputational risk and, where appropriate, to make recommendations to the Risk Management Meeting and the Group Management Board for policy or procedural changes to mitigate such risk.
Standards on all major aspects of business are set for HSBC and for individual subsidiaries, businesses and functions. Reputational risks, including ESG matters, are considered and assessed by the Board, the Group Management Board, the Risk Management Meeting, subsidiary company boards, board committees and senior management during the formulation of policy and the establishment of HSBC standards. These policies, which form an integral part of the internal control system (see page 304), are communicated through manuals and statements of policy and are promulgated through internal communications and training. The policies cover ESG issues and set out operational procedures in all areas of reputational risk, including money laundering deterrence, environmental impact, anti-corruption measures and employee relations. The policy manuals address risk issues in detail and co-operation between Head Office departments and businesses is required to
ensure a strong adherence to HSBC’s risk management system and its corporate responsibility practices.
Sustainability risks arise from the provision of financial services to companies or projects which run counter to the needs of sustainable development; in effect this risk arises when the environmental and social effects outweigh economic benefits. Within Group Head Office, a separate function, Group Corporate Sustainability, is mandated to manage these risks globally. Its risk management responsibilities include:
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HSBC operates a bancassurance model which provides insurance products for customers with whom the Group has a banking relationship. Many of these products are manufactured by HSBC subsidiaries, but where the Group considers it operationally more effective, third parties are engaged to manufacture and provide insurance products which HSBC sells through its banking network. The Group works with a limited number of market-leading partners to provide these products. When manufacturing products, the Group underwrites the insurance risk and retains the risks and rewards associated with writing insurance contracts. HSBC’s exposure to risks associated with manufacturing insurance contracts in its subsidiaries and its management of these risks are discussed below.
One advantage of the bancassurance model to HSBC is that, where the Group manufactures products to sell to customers, the underwriting profit is retained within the Group as is the commission paid by the manufacturer to the bank distribution channel. When HSBC sells products provided by third parties, it earns a commission. HSBC sells insurance products across all its customer groups, mainly utilising its retail branches, the internet and phone centres. Personal Financial Services customers attract the majority of sales and comprise the majority of policyholders. HSBC offers its customers a wide range of insurance and investment products, many of which complement other bank and consumer finance products.
HSBC’s bancassurance business operates in all five of the Group’s geographical regions with over 35 legal entities manufacturing insurance products. The majority of these insurance operations are subsidiaries of banking legal entities and comply with their management control procedures. In addition to local management requirements, the insurance operations follow guidelines issued by the Group Insurance Head Office. The Group Insurance Head Office is headed by the Group’s Managing Director of Insurance, supported by a Chief Operating Officer and Chief Finance Officer. The role of Group Insurance Head Office includes setting the control framework for monitoring and measuring insurance risk in line with existing Group practices, and defining insurance-specific policies and guidelines for inclusion in the Group Instruction Manuals. The control framework for monitoring risk includes the Group Insurance Risk Committee, to which four Group Insurance sub-committees report,
focusing on operational risk, insurance risk, market and liquidity risk, and credit risk. The sub-committees of the Group Insurance Risk Committee were introduced during 2007. The processes and controls employed to monitor individual risks are described under their respective headings below. The main contracts manufactured by HSBC are described below.
Life insurance business(Audited)
Life insurance contracts with discretionary participation features (‘DPF’) allow policyholders to participate in the profits generated from such business, which may take the form of annual bonuses and a final bonus, in addition to providing cover on death. The largest portfolio, which is in Hong Kong, is a book of endowment and whole-life policies, with annual bonuses awarded to policyholders. In addition, certain minimum return levels are guaranteed.
Credit life insurance business is written to underpin banking and finance products. The policy pays a claim if the holder of the loan is unable to make repayments due to early death or unemployment.
Annuities are contracts providing regular payments of income from capital investment for either a fixed period or during the annuitant’s lifetime. Payments to the annuitant either begin on inception of the policy (immediate annuities) or at a designated future date (deferred annuities).
Term assurance and critical illness policies provide cover in the event of death (term assurance) and serious illness.
Linked life insurance contracts pay benefits to policyholders which are typically determined by reference to the value of the investments supportingthe policies.
Investment contracts with DPF allow policyholders to participate in the profits generated by such business. The largest portfolio is written inFrance. Policyholders are guaranteed to receive a return on their investment plus any discretionary bonuses. In addition, certain minimum return levels are guaranteed.
Unit-linked investment contracts are those where the principal benefit payable is the value of assigned assets.
Other investment contracts include pension contracts written in Hong Kong.
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Non-life insurance business(Audited)
Non-life insurance contracts include motor, fire and other damage to property, accident and health, repayment protection and commercial insurances.
Motor insurance business covers vehicle damage and liability for personal injury. For fire and other damage to property, the predominant focus in most markets is insurance for home and contents for individuals, with cover for selected commercial customers largely written in Asia and Latin America.
A very limited portfolio of liability business is written (other than that which is included in the motor book).
Credit non-life insurance is concentrated in North America and Europe. This business is originated in conjunction with the provision of loans.
Given the nature of the contracts written by the Group, the risk to which the Group insurance operations are exposed falls into two principal categories: insurance risk and financial risk.
The following section describes the nature and extent of the risks that arise in the Group’s insurance subsidiaries and the principal approach that HSBC adopts to managing them. The majority of the risk in the insurance business resides in the manufacturing activities.
Insurance risk(Audited)
Insurance risk is a risk, other than financial risk, transferred from the holder of a contract to the issuer, in this case HSBC. The principal insurance risk faced by HSBC is that the combined cost of claims, administration and acquisition of the contract may exceed the aggregate amount of premiums received and investment income. The cost of a claim can be influenced by many factors, including mortality and morbidity experience, lapse and surrender rates and, where the policy has a savings element, the performance of the assets held to support the liabilities.
HSBC manages its exposure to insurance risk by applying formal underwriting, reinsurance and claims-handling procedures designed to ensure compliance with regulations and insurance riskappetite, the latter proposed by local businesses and authorised centrally. This is supplemented by undertaking stress testing.
The insurance contracts sold by the Group relate, in the main, to core underlying banking activities such as savings or investment products and
credit life products. The Group’s manufacturing focuses on personal lines, i.e. contracts written for individuals. Personal lines tend to be of higher volume and lower individual value than commercial lines, and this diversifies the insurance risk.
Life and non-life business insurance risks are controlled by high level procedures set centrally, supplemented as appropriate with locally-imposed measures which take account of specific local market conditions and regulatory requirements. For example, manufacturing entities are required to obtain authorisation from Group Insurance Head Office to write certain classes of business, with restrictions applying particularly to commercial and liability non-life insurance. Local ALCOs are required to monitor certain risk exposures, in particular for life business.
Reinsurance is also used as a means of mitigating exposure, in particular to aggregations of catastrophe risk. Specific examples are as follows:
The following tables provide an analysis of the insurance risk exposures by geography and by type of business. By definition, HSBC is not exposed to insurance risk on investment contracts, so they have not been included in the insurance risk management analysis.
Life business tends to be longer-term in nature than non-life business and frequently involves an element of savings and investment in the contract. Separate tables are therefore provided for life and non-life businesses, reflecting their distinctive risk characteristics. The life insurance risk table provides an analysis of insurance liabilities as the best available overall measure of insurance exposure, because provisions for life contracts are typically set by reference to expected future cash outflows relating to the underlying policies. The table for non-life business uses written premiums as the best available measure of risk exposure.
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Analysis of life insurance risk – liabilities to policyholders(Audited)
The liabilities for long-term contracts are set by reference to a range of assumptions which include lapse and surrender rates, mortality and expense levels. These assumptions are typically set by reference to the entity’s own experience. Economic assumptions, such as investment returns and interest rates, are typically set by reference to market observable data.
The above table of liabilities to life insurance policyholders provides an overall summary of HSBC’s life insurance activity. In particular, the table highlights that the most significant products are investment contracts with DPF issued in France, insurance contracts with DPF issued in Hong Kong, annuities issued in North America and Latin America and unit-linked contracts issued in Europe, Hong Kong and Latin America.
Insurance risk arising from life insurance depends on the type of business, and varies considerably. The principal risks are mortality, morbidity, lapse, surrender and expense levels.
The main contracts which generate exposure to mortality and morbidity risks are term assurance contracts and annuities. These risks are monitored on a regular basis, and are primarily mitigated by medical underwriting and by retaining the ability in certain cases to amend premiums in the light of experience. The risk associated with lapses and surrenders is generally mitigated by the application of surrender charges. Expense risk can generally be managed through pricing. The level of expenses in the contract will be one of the items considered when setting premiums rates.
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Analysis of non-life insurance risk – net written insurance premiums 1(Audited)
The above table of non-life net written insurance premiums provides an overall summary of the non-life insurance activity of the Group. Motor business is written predominantly in Europe and Latin America and represents the largest class of non-life business in 2007. Fire and other damage to property business is written in all major markets, most significantly in Europe. Credit non-life insurance, which is originated in conjunction with the provision of loans, is concentrated in the US and Europe.
The main risks associated with non-life business are underwriting risk and claims experience risk. Underwriting risk is the risk that HSBC does not charge premiums appropriate to the cover provided and claims experience risk is the risk that portfolio experience is worse than expected. HSBC manages these risks through pricing (for example, imposing restrictions and deductibles in the policy terms and conditions), product design, risk selection, claims handling, investment strategy and reinsurance policy. The majority of non-life insurance contracts are renewable annually and the underwriters have the right to refuse renewal or to change the terms and conditions of the contract at the time.
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Balance sheet of insurance manufacturing subsidiaries by type of contract
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A principal tool used to manage the Group’s exposure to insurance risk, in particular for life insurance contracts, is asset and liability matching. Models are used to assess the effect of a range of future scenarios on the values of financial assets and associated liabilities, and ALCOs employ the outcomes in determining how the assets and liabilities should be matched. The stresses applied include factors which impact on insurance risk such as mortality and lapse rates. Of particular importance is the need to match the expected pattern of cash
inflows with the benefits payable on the underlying contracts which, in some cases, can extend for many years. The table above shows the composition of assets and liabilities and demonstrates that there was an appropriate level of matching at the end of 2007. It may not always be possible to achieve a complete matching of asset and liability durations, partly because there is uncertainty over the receipt of all future premiums and partly because the duration of liabilities may exceed the duration of the longest available dated fixed interest investments.
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Balance sheet of insurance manufacturing subsidiaries by geographical region (Audited)
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Financial risks(Audited)
HSBC’s insurance businesses are exposed to a range of financial risks, including market risk, credit risk and liquidity risk. Market risk includes interest rate risk, equity risk and foreign exchange risk. The nature and management of these risks is described below.
Manufacturing subsidiaries are exposed to financial risk, for example, when the proceeds from financial assets are not sufficient to fund the obligations arising from non-linked insurance and investment contracts. Certain insurance-related activities undertaken by HSBC subsidiaries such as insurance broking, insurance management (including captive management) and insurance, pensions and annuities administration and intermediation, are exposed to financial risk, but not to a significant extent.
In addition to policies provided for Group-wide application through the Group Instruction Manuals,
insurance manufacturing subsidiaries may implement additional risk management procedures which reflect local market conditions and regulatory requirements.
In many jurisdictions, local regulatory requirements prescribe the type, quality and concentration of assets that HSBC’s insurance manufacturing subsidiaries must maintain to meet insurance liabilities. Within each subsidiary, ALCOs are responsible for ensuring that exposures to financial risks remain within local requirements and risk mandates (as agreed with Group Insurance Head Office), and ensure compliance with the control framework established centrally through the Group Instruction Manuals.
The following table analyses the assets held in HSBC’s insurance manufacturing subsidiaries at 31 December 2007 by type of liability, and provides a view of the exposure to financial risk:
Financial assets held by insurance manufacturing subsidiaries (Audited)
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The table demonstrates that for linked contracts, HSBC typically designates assets at fair value. For non-linked contracts, the classification of the assets is driven by the nature of the underlying contract.
The table also shows that approximately 55.4 per cent of financial assets was invested in debt securities at 31 December 2007 (2006: 51.9 per cent) with 30.3 per cent (2006: 31.8 per cent) invested in equity securities.
In life linked insurance, premium income less charges levied is invested in a portfolio of assets. HSBC manages the financial risk of this product on behalf of the policyholders by holding appropriate assets in segregated funds or portfolios to which the liabilities are linked. HSBC typically retains some exposure to market risk as the market value of the linked assets influences the fees charged by HSBC and thereby affects the recoverability of expenses incurred by the Group in managing the product. The assets held to support life linked liabilities represented 29.7 per cent of the total financial assets of HSBC’s insurance manufacturing subsidiaries at the end of 2007 (2006: 41.7 per cent).
Market risk (Audited)
Insurance and investment products manufactured by HSBC’s insurance manufacturing subsidiaries typically comprise features or combinations of features which may not be easily or exactly replicated by investments. Market risk arises from the mismatch between product liabilities and the investment assets which back them. For example, interest rate risk arises from the mismatch between asset and liability yields and maturities.
Description of market risks (Audited)
The main features of products manufactured by HSBC’s insurance manufacturing subsidiaries which generate market risks, and the market risks to which these features expose the subsidiaries, are discussed in the sections which follow.
Long-term insurance or investment products may incorporate investment return guarantees, divided into the following categories:
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within a prescribed range of average investment returns earned by predetermined market participants on the specified product.
Subsidiaries manufacturing products with guarantees are usually exposed to falls in market interest rates as these result in lower yields on the assets supporting guaranteed investment returns payable to policyholders.
The table below shows, in respect of each category of guarantee, the total policyholders’ liabilities established for guaranteed products, the range of investment returns (net of operating costs) implied by the guarantees, and the range of current yields of the investment portfolios supporting the guarantees.
Liabilities to policyholders(Audited)
A certain number of these products have been discontinued, including the US$609 million deferred annuity portfolio in HSBC Finance where, as highlighted in the above table, the current portfolio yield is less than the guarantee. On acquisition of this block of business by HSBC Finance, a provision was established to mitigate the shortfall in yields. There has been no further deterioration in the shortfall since acquisition. There are a limited number of additional contracts where the current portfolio yield is less than the guarantee implied by the contract.
Long-term insurance and investment products typically permit the policyholder to surrender the policy or let it lapse at any time. When the surrender value is not linked to the value realised from the sale of the associated supporting assets, the subsidiary is exposed to market risk. In particular, when asset values fall and customers seek to surrender their
policies, assets may have to be sold at a loss to fund redemptions.
Insurance and investment products with DPF are primarily invested in bonds, but a proportion of their investment portfolios is allocated to equity securities in order to provide customers with potentially enhanced returns. Subsidiaries with portfolios of such products are exposed to falls in the market price of equity securities when the risk cannot be managed through the discretionary bonus policy.
A subsidiary holding a portfolio of long-term insurance and investment products, especially with DPF, may attempt to reduce exposure to one particular market by investing in assets in countries other than the country in which it is based. These assets may be denominated in currencies other than the subsidiary’s local currency. It is often not cost effective to hedge the foreign exchange exposure of
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these assets and the subsidiary will be exposed to a strengthening of its local currency against the currency of the related assets.
For unit-linked contracts, market risk is substantially borne by the policyholder. HSBC typically retains an exposure to market risk as the market value of the linked assets influences the fees HSBC earns for managing them.
How the risks are managed(Audited)
HSBC’s insurance manufacturing subsidiaries manage market risk by using some or all of the techniques relevant to the contracts being written by the subsidiary. The techniques applied may include:
Each insurance manufacturing subsidiary is required to have a market risk mandate which specifies the investment instruments in which it is permitted to invest and the maximum quantum of market risk which it is permitted to retain. It is the responsibility of the local ALCO to ensure that its mandate is consistent with local regulations. All mandates must be reviewed and agreed annually with Group Insurance Head Office, and aggregate limits are approved by the Risk Management Meeting of the Group Management Board.
How the exposures to risks are measured(Audited)
HSBC’s insurance manufacturing subsidiaries monitor exposures against mandated limits regularly and report these quarterly to Group Insurance Head Office. Exposures are aggregated and reported to senior risk management forums in the Group, including the Group Insurance Market and Liquidity Risk Meeting, Group Insurance Risk Committee and the Group Stress Test Review Group.
The standard measures used to quantify the market risks are as follows:
Although these measures are relatively straightforward to calculate and aggregate, there are limitations. The most significant limitation is that the one basis point parallel shift in yield curves measure does not capture the non-linear relationships between the value of certain assets and liabilities and interest rates which arise, for example, from investment return guarantees, and certain product features such as the ability of policyholders to surrender their policies. If the yields on investments held to support contracts with guarantees are below the investment return implied by the guarantee, shortfalls will fall to the account of HSBC.
HSBC recognises these limitations and augments its standard measures with stress tests which examine the effect of a range of market rate scenarios on the aggregated profits of the insurance manufacturing subsidiaries for the year and their net assets. A quarterly process was introduced for HSBC’s insurance manufacturing subsidiaries during 2007 to report stress tests to Group Insurance Head Office, where the reports are consolidated and reviewed by the Group Insurance Market and Liquidity Risk Meeting and the Group Stress Test Review Group.
HSBC’s insurance manufacturing subsidiaries identify those assets and lia bilities whose values in the financial statements are sensitive to each category of market risk and revalue them assuming different market rates. The outcome of the exercise
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is measured in terms of the change in profit after tax and net assets under the stress-tested assumptions, after taking into consideration tax and accounting treatments where material and relevant.
The following table illustrates the effect on the aggregated profit for the year and net assets under various interest rate, equity price, foreign exchange rate and credit spread scenarios. Where appropriate, the impact of the stress on the PVIF is included in
the results of the stress tests. The relationship between the value of certain assets and liabilities and the risk factors may be non-linear and, therefore, the results disclosed cannot be extrapolated to measure sensitivities to different levels of stress. The sensitivities are stated before allowance for the effect of management actions which may mitigate changes in market rates, and for any factors such as policyholder behaviour that may change in response to changes in market risk.
Sensitivity of HSBC’s insurance subsidiaries to risk factors(Audited)
The sensitivity of the net profit of HSBC’s insurance subsidiaries to the effects of increases in credit spreads is a fall of US$15 million (2006: US$7 million fall). The sensitivity is expressed on an after tax basis consistent with the other sensitivities noted above and has been calculated using simplified assumptions based on one-day movement in credit spreads over a two-year period. A confidence level of 99 per cent, consistent with the Group’s VAR, has been applied. The impact of movements in credit spreads has become more significant in 2007 due to increased volatility in credit spreads.
Credit risk(Audited)
Credit risk can give rise to losses through default and can lead to volatility in income statement and balance sheet figures through movements in credit spreads, principally on the US$29.8 billion (2006: US$14.1 billion) non-linked bond portfolio. The exposure of the income statement to the effect of changes in credit spreads is small (see the table above). 36 per cent of the financial assets held by insurance subsidiaries are classified as either held to maturity or available for sale, and consequently any changes in the fair value of these financial investments would have no impact on the profit after tax.
HSBC’s exposure to credit risk in its insurance manufacturing subsidiaries primarily arises from their portfolios of invested assets held, their reinsurance transactions and any credit protection products they write.
HSBC sells certain unit-linked life insurance contracts via a co-insurance agreement with a third party. The insurance contracts issued under the co-insurance agreement include market return guarantees, which are underwritten by the third party. HSBC has a credit risk exposure arising on the guarantees were the counterparty unable to meet the terms of the guarantees. At 31 December 2007, the exposure to the counterparty was small.
The exposure to credit risk products and the management of the risks associated with credit protection products are included in the analyses of life and non-life insurance risk from page 266 to 267.
Management of HSBC’s insurance manufacturing subsidiaries is responsible for the credit risk, quality and performance of their investment portfolios. Investment credit mandates and limits are set locally by the insurance manufacturing subsidiaries and approved by their local insurance ALCO and Credit Risk function before receiving concurrence centrally from Group Credit Risk. The form and content of the mandates
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accord with centrally set investment credit risk guidance regarding credit quality, industry sector concentration and liquidity restrictions, but allow for local regulatory and country-specific conditions. The assessment of creditworthiness of issuers and counterparties is based primarily upon internationally recognised credit ratings and other publicly available information.
Investment credit exposures are monitored against limits by the local insurance manufacturing subsidiaries, and are aggregated and reported to HSBC’s Group Credit Risk function, the Group Insurance Credit Risk Meeting and the Group Insurance Risk Committee.
Stress testing is performed by Group Insurance Head Office on the investment credit exposures using credit spread sensitivities and default
probabilities. The stresses are reported to the Group Insurance Credit Risk Committee.
Credit quality(Audited)
The following table presents the analysis of treasury bills, other eligible bills and debt securities within HSBC’s insurance business by rating agency designation based on Standard & Poor’s ratings or equivalent. Only assets supporting non-linked liabilities are included in the table since financial risk on assets supporting linked liabilities is predominantly borne by the policyholder.
The table indicates that 72.3 per cent (2006: 74.5 per cent) of the assets included in the table are invested in AA or AAA rated investments.
Treasury bills, other eligible bills and debt securities in HSBC’s insurance subsidiaries (Audited)
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Credit risk also arises when part of the insurance risk incurred by HSBC is assumed by reinsurers. The credit risk exposure for reinsurers is monitored by Group Insurance Head Office and is reported quarterly to the Group Insurance Risk Committee and the Group Insurance Credit Risk Committee.
The split of liabilities ceded to reinsurers and outstanding reinsurance recoveries, analysed by Standard & Poor’s reinsurance credit rating data or their equivalent, was as follows:
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Reinsurance(Audited)
Liquidity risk (Audited)
It is an inherent characteristic of almost all insurance contracts that there is uncertainty over the amount and the timing of settlement of claims liabilities that may arise, and this leads to liquidity risk.
To fund the cash outflows arising from claims liabilities, HSBC’s insurance manufacturing subsidiaries utilise liquidity primarily from the following sources:
HSBC’s insurance manufacturing subsidiaries manage liquidity risk by utilising some or all of the following techniques:
During 2007, a quarterly process has been introduced whereby HSBC’s insurance manufacturing subsidiaries are required to complete and submit liquidity risk reports to Group Insurance Head Office for collation and review by the Group Insurance Market and Liquidity Risk Meeting. Liquidity risk is assessed in these reports by measuring changes in expected cumulative net cash flows under a series of stress scenarios designed to determine the effect of reducing expected available liquidity and accelerating cash outflows. This is achieved by, for example, assuming new business or renewals are lower, and surrenders or lapses are greater than expected.
As indicated in the table headed ‘Expected maturity of insurance contract liabilities’ below and in the analyses of life and non-life insurance risks on pages 266 to 267, a significant proportion of the Group’s non-life insurance business is viewed as short term, with the settlement of liabilities expected to occur within one year of the period of risk. There is a greater spread of expected maturities for the life business where, in a large proportion of cases, the
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liquidity risk is borne in conjunction with policyholders (wholly in the case of unit-linked business).
The following tables show the expected undiscounted cash flows for insurance contract liabilities and the remaining contractual maturity of investment contract liabilities, respectively, at 31 December 2007.
The profile of the expected maturity of the insurance contracts as at 31 December 2007 has remained stable compared with 2006. The increase in the undated investment contract liabilities arises principally from the incorporation of HSBC Assurances’ balance sheet as a subsidiary at 31 December 2007.
Expected maturity of insurance contract liabilities(Audited)
Remaining contractual maturity of investment contract liabilities(Audited)
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Present value of in-force long-term insurance business(Audited)
The HSBC life insurance business is accounted for using the embedded value approach, which, inter alia, provides a comprehensive framework for the evaluation of insurance and related risks. The present value of the in-force long-term (‘PVIF’) asset at 31 December 2007 was US$2.0 billion (2006: US$1.5 billion). The present value of the shareholders’ interest in the profits expected to emerge from the book of in-force policies at 31 December can be stress-tested to assess the ability of the life business book to withstand adverse developments. A key feature of the life insurance business is the importance of managing the assets, liabilities and risks in a coordinated fashion rather than individually. This reflects the greater interdependence of these three elements for life insurance than is generally the case for non-life insurance.
The following table shows the effect on the PVIF of reasonably possible changes in the main economic assumptions, changes in the risk-free and risk discount rates, across all insurance manufacturing subsidiaries.
It should be noted that, due to certain conditions that may exist within the contracts, the effects may be non-linear and so the results of the stress-testing
Sensitivity of PVIF to changes in economic assumptions (Audited)
disclosed may not be extrapolated to higher levels of stress. In calculating the various scenarios, all other assumptions are held stable except for testing the effect of the shift in the risk-free rate, when consequential changes to investment returns, risk discount rates and bonus rates are also incorporated. The sensitivities shown are before actions that could be taken by management to mitigate effects and before consequential changes in policyholder behaviour.
The following table shows the movements recorded during the year in respect of PVIF and the net assets of insurance operations:
Movements in PVIF and net assets of insurance operations (Audited)
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Non-economic assumptions (Audited)
The policyholder liabilities and PVIF are determined by reference to non-economic assumptions which include, for non-life manufacturers, claims costs and expense rates and, for life manufacturers, mortality and/or morbidity, lapse rates and expense rates. The table below shows the sensitivity of profit for the year to, and net assets at, 31 December 2007 to reasonably possible changes in these non-economic assumptions at 31 December 2007 across all insurance manufacturing subsidiaries, with comparatives for 2006.
Claims costs is a risk associated with non-life insurance business. If the cost of claims increases, a negative impact on profit would occur.
Mortality and morbidity risk is typically associated with life insurance contracts. The impact of an increase in mortality or morbidity on profit depends on the type of business being written. For a portfolio of term assurance contracts, an increase in mortality would have a negative impact on profit since the instances of claims would increase. For a portfolio of annuity contracts, an increase in
mortality rates typically has a positive impact on profit as the period over which the benefit is being paid to the policyholder is shortened. However, where an annuity contract includes life cover, the positive impact of reduced future annuity payments observed through an increase in mortality can be offset by the benefits payable under the life cover.
Sensitivity to lapse rates is dependent on the type of contracts being written. For insurance contracts, the cost of claims is funded by premiums received and income earned on the investment portfolio supporting the liabilities. For a portfolio of term assurance, an increase in lapses typically leads to a negative impact on profit due to the loss of future premium income on the lapsed policies. For a portfolio of annuity contracts, an increase in lapse rates results in a positive impact on profit as the period over which the Group is obliged to pay benefits to the policyholder is shortened.
Expense rate risk is the exposure to a change in expense rates. To the extent that increased expenses cannot be passed on to the policyholder, an increase in expense rates will have a negative impact on profits.
Sensitivity analysis (Audited)
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Capital management and allocation > Capital measurement
Capital management and allocation
Capital management (Audited)
HSBC’s capital management approach is driven by its strategy and organisational requirements, taking into account the regulatory and commercial environment in which it operates. The Group’s strategy underpins HSBC’s Capital Management Framework which has been approved by the Group Management Board. It is HSBC’s policy to maintain a strong capital base to support the development of its business and to meet regulatory capital requirements at all times. It also maintains a strong discipline over its investment decisions and where it allocates its capital, seeking to ensure that returns on investment are appropriate after taking account of capital costs. In addition, the level of capital held by HSBC Holdings and other major subsidiaries, particularly HSBC Finance, is determined by its rating targets.
HSBC’s strategic intention is to allocate capital to businesses based on their economic profit generation and, within this process, regulatory and economic capital requirements and the cost of capital are key factors. The responsibility for global capital allocation principles and decisions rests with the Group Management Board. Stress testing is used as an important mechanism in understanding the sensitivities of the core assumptions in the capital plans to the adverse impact of extreme, but plausible, events. Stress testing allows senior management to formulate management action in advance of conditions starting to reflect the stress scenarios identified. The Group has identified the following as being the material risks faced and managed through the Capital Management Framework; credit, market, operational, asset and liability management, pension, and insurance risks.
In 2007, HSBC continued to manage its capital against its benchmark minimum tier 1 capital ratio of 8.25 per cent, which it has used under the current Basel Capital Accord (‘Basel I’) for the purposes of its long-term capital planning. In 2008, as the Group operates under the new framework for calculating minimum capital requirements known as ‘Basel II’, it will target a tier 1 capital ratio within the range 7.5 to 9.0 per cent, based on core tier 1 capital plus innovative tier 1 capital, less deductions from tier 1 capital under the FSA’s Basel II disclosure rules.
HSBC recognises the effect on shareholder returns of the level of equity capital employed within the Group and seeks to maintain a prudent balance between the advantages and flexibility afforded by a strong capital position and the higher returns on
equity that are possible with greater leverage.
The Capital Management Framework covers the different capital measures within which HSBC manages its capital in a consistent and aligned manner. These include the market capitalisation, invested capital, economic capital and regulatory capital. HSBC defines invested capital as the equity capital invested in HSBC by its shareholders. Economic capital is the capital requirement calculated internally by HSBC to support the risks to which it is exposed and is set at a confidence level consistent with a ‘AA’ target credit rating. Regulatory capital is the capital which HSBC is required to hold as determined by the rules established by the FSA for the consolidated Group and by HSBC’s local regulators for individual Group companies.
An annual Group capital plan is prepared and approved by the Board with the objective of maintaining both the optimal amount of capital and the mix between the different components of capital. The Group’s policy is to hold capital in a range of different forms and from diverse sources and all capital raising is agreed with major subsidiaries as part of their individual and the Group’s capital management processes. HSBC Holdings and its major subsidiaries raise non-equity tier 1 capital and subordinated debt in accordance with the Group’s guidelines on market and investor concentration, cost, market conditions, timing, effect on composition and maturity profile. The subordinated debt requirements of other HSBC companies are met internally.
Each subsidiary manages its own capital required to support planned business growth and meet local regulatory requirements, within the context of the approved annual Group capital plan. As part of HSBC’s Capital Management Framework, capital generated in excess of planned requirements is returned to HSBC Holdings, normally by way of dividends.
HSBC Holdings is primarily a provider of equity capital to its subsidiaries. These investments are substantially funded by HSBC Holdings’ own capital issuance and profit retentions. HSBC Holdings seeks to maintain a prudent balance between the composition of its capital and that of its investment in subsidiaries.
Capital measurement and allocation (Audited)
The FSA supervises HSBC on a consolidated basis and, as such, receives information on the capital adequacy of, and sets capital requirements for,
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HSBC as a whole. Individual banking subsidiaries are directly regulated by their local banking supervisors, who set and monitor their capital adequacy requirements. In most jurisdictions, non-banking financial subsidiaries are also subject to the supervision and capital requirements of local regulatory authorities. Since 1988, when the governors of the Group of Ten central banks agreed to guidelines for the international convergence of capital measurement and standards, known as Basel I, the banking supervisors of HSBC’s major banking subsidiaries have exercised capital adequacy supervision within a broadly similar framework.
The FSA implements the capital adequacy requirements issued by the Basel Committee on Banking Supervision (‘the Basel Committee’) as implemented by the relevant EU Directives. In June 2006, the EU Capital Requirements Directive (‘CRD’) was formally adopted by the Council and European Parliament and it required EU Member States to bring implementing provisions into force on 1 January 2007. The CRD recast the Banking Consolidation Directive and the Capital Adequacy Directive, which had previously applied.
In October 2006, the FSA published the General Prudential Sourcebook (‘GENPRU’) and the Prudential Sourcebook for Banks, Building Societies and Investment Firms (‘BIPRU’), which took effect from 1 January 2007 and implemented the CRD in the UK. GENPRU introduced changes to the definition of capital and the methodology for calculating a firm’s capital resources requirements. BIPRU sets out the FSA’s rules implementing the other CRD requirements for banks, building societies and investment firms and groups containing such firms. Transitional provisions regarding the implementation of capital requirements calculations meant that, in general, unless firms notified the FSA to the contrary, they continued to apply the existing capital requirements calculations until 1 January 2008; changes that took effect on that date are described below in the section ‘Basel II’.
In implementing these EU Directives, the FSA requires each bank and banking group to maintain an individually prescribed ratio of total capital to risk-weighted assets, taking into account both balance sheet assets and off-balance sheet transactions.
Various limits are applied to elements of the capital base. The amount of innovative tier 1 securities cannot exceed 15 per cent of overall tier 1 capital, qualifying tier 2 capital cannot exceed tier 1 capital, and qualifying term subordinated loan capital may not exceed 50 per cent of tier 1 capital. There are also limitations on the amount of collective impairment allowances which may be included as part of tier 2 capital. From the total of tier 1 and tier 2 capital are deducted the carrying amounts of unconsolidated investments, investments in the capital of banks, and certain regulatory items.
Changes to the definition of capital came into force on 1 January 2007. They include the introduction of proportional consolidation of banking associates, which previously were either fully consolidated or deducted from capital, the relaxation of rules covering the deduction of investments in other banks’ capital, and a change for disclosure purposes only to make certain deductions, previously from total capital, now 50 per cent from each of tier 1 and tier 2 capital in the published disclosures. This applies to deductions of investments in insurance subsidiaries and associates, but the FSA has granted a transitional provision, until 31 December 2012, under which any of these 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.
Banking operations are categorised as either trading book or banking book and risk-weighted assets are determined accordingly. Banking book risk-weighted assets are measured by means of a hierarchy of risk weightings classified according to the nature of each asset and counterparty, taking into account any eligible collateral or guarantees. Banking book off-balance sheet items giving rise to credit, foreign exchange or interest rate risk are assigned weights appropriate to the category of the counterparty, taking into account any eligible collateral or guarantees. Trading book risk-weighted assets are determined by taking into account market-
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related risks such as foreign exchange, interest rate and equity position risks, and counterparty risk.
Basel II(Audited)
The Basel Committee on Banking Supervision (‘the Basel Committee’) has published Basel II which replaces the 1988 Basel Capital Accord. The supervisory objectives for Basel II are to promote safety and soundness in the financial system and maintain at least the current overall level of capital in the system; enhance competitive equality; constitute a more comprehensive approach to addressing risks; and focus on internationally active banks. Basel II is structured around three ‘pillars’: minimum capital requirements, supervisory review process and market discipline. The CRD is the means by which Basel II is implemented in the EU. The FSA gives effect to the CRD through GENPRU and BIPRU, as described above.
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. In the next level, the internal ratings-based (‘IRB’) foundation approach allows banks to calculate their credit risk regulatory capital requirement on the basis of their internal assessment of the probability that a counterparty will default, but with quantification of exposure and loss estimates being subject to standard supervisory parameters. Finally, the IRB advanced approach, will allow banks to use their own internal assessment of not only the probability of default but also the quantification of exposure at default and loss given default. Expected losses are calculated by multiplying the probability of default by the loss given default multiplied by the exposure at default. 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 to Basel II for the majority of its business with effect from 1 January 2008, with the remainder on either IRB foundation or standardised approaches. A rollout plan is in place to extend coverage of the advanced approach over the next three years, leaving a small residue of exposures on the standardised approach.
Basel II also introduces capital requirements for operational risk and, again, contains three levels of sophistication. The capital required under the basic indicator approach is a simple percentage of gross revenues, whereas under the standardised approach it is one of three different percentages of gross revenues allocated to each of eight defined business lines. Finally, the advanced measurement approach uses banks’ own statistical analysis and modelling of operational risk data to determine capital requirements. HSBC has adopted the standardised approach to the determination of Group operational risk capital requirements.
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, ‘Impact of Basel II’. 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 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 impact on 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 through reflecting a downturn scenario. For rapidly revolving consumer credit portfolios such as credit cards, therefore, impairment allowances only capture some of the expected losses predicted over the next 12 months. These portfolios turn over three to four times per year, and therefore a large proportion of expected losses relate to credit advances not made at the measurement date.
The effect of the deduction of the difference between expected losses and total impairment allowances is to set the total effect on capital to be equal to the regulatory definition of expected losses. Because expected losses are based on long-term estimates and incorporate through-the-cycle considerations, it is not anticipated that they will be very volatile. The impact of this deduction, however,
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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 second pillar of Basel II (Supervisory Review and Evaluation Process) involves both firms and regulators taking a view on whether a firm should hold additional capital against risks not covered in pillar 1. Part of the pillar 2 process is the Internal Capital Adequacy Assessment Process which is the firm’s self assessment of risks not captured by pillar 1. The pillar 2 process culminates with the FSA providing firms with Individual Capital Guidance. The ICG replaces the current trigger ratio and is set as a capital resources requirement higher than that required under pillar 1, generally by a specified percentage.
Pillar 3 of Basel II is related to market discipline and aims to make firms more transparent by requiring them to publish specific, prescribed details of their risks, capital and risk management under the
Basel II framework. HSBC will provide qualitative pillar 3 disclosures during 2008, with the first full set of pillar 3 disclosures including quantitative tables, being made during the first half of 2009 as of 31 December 2008.
For individual banking subsidiaries, the timing and manner of implementing Basel II varies by jurisdiction according to requirements set by local banking supervisors. Applying Basel II across HSBC’s geographically diverse businesses, which operate in a large number of different regulatory environments, presents a significant logistical and technological challenge, involving an extensive programme of implementation.
Basel II allows local regulators to exercise discretion in a number of areas. The extent to which their requirements diverge, coupled with how the FSA and the local regulators in the other countries in which HSBC operates interact, are key factors in completing implementation of Basel II locally.
Source and application of tier 1 capital – Basel I (Audited)
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Capital structure at 31 December – Basel I
HSBC complied with the FSA’s capital adequacy requirements throughout 2007 and 2006. Tier 1 capital increased by US$17.1 billion. Retained profits contributed US$8.9 billion, shares issued, including shares issued in lieu of dividends, contributed US$4.8 billion and exchange differences added US$5.5 billion. These increases were partly offset by an increase in goodwill and intangible assets, which are deducted from capital, of US$2.4 billion, and are mainly due to the weakening of the US dollar against the pound sterling and the euro.
Total risk-weighted assets increased by US$185 billion, or 19.7 per cent. Of this increase,
US$95 billion reflects balance sheet growth, mainly in the loan book. A further US$39 billion arose from the proportional consolidation of banking associates, mainly Bank of Communications and Industrial Bank. The weakening US dollar gave rise to an increase of US$32 billion while increased trading book activity contributed US$19 billion.
Risk-weighted assets by principal subsidiary (Unaudited)
In order to give an indication of how HSBC’s capital is deployed, the table below analyses the disposition of risk-weighted assets by principal subsidiary. The risk-weighted assets are calculated using FSA rules and exclude intra-HSBC items.
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Risk-weighted assets – Basel I (Unaudited)
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Impact of Basel II (Unaudited)
As reflected in the table below, the Group’s capital base under Basel II is US$19.7 billion lower than under Basel I. This reduction in the capital base does not reflect a change in the risk profile of the underlying portfolios and the Group remains strongly capitalised.
The Group’s risk-weighted assets under Basel II are broadly similar to the Basel I position. A reduction in the credit risk capital requirement has been more than offset by the new capital requirement for operational risk.
The Group’s pro-forma capital position if it had been reporting on a Basel II basis at 31 December 2007 is as follows:
Capital position under Basel II
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Biographies > Directors
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Biographies > Senior Management
A A Flockhart , CBE
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A Hungate
Age 41. Global Head of Personal Financial Services and Marketing. Joined HSBC as a Group Managing Director on 3 September 2007. Formerly Managing Director, Asia Pacific at Reuters. Worldwide Chief Marketing Officer of Reuters between 2002 and 2005.
D D J John
Age 57. Chief Executive, HSBC Bank plc. A Group Managing Director since March 2006. Joined HSBC Bank plc in 1971. Appointed a Group General Manager in 2000. Deputy Chairman and Chief Executive Officer, HSBC Bank Malaysia Berhad from 1999 to 2002. Chief Operating Officer of HSBC Bank plc from 2003 to 2005 and Deputy Chief Executive from 2005 to March 2006.
B P McDonagh
Age 49. Chief Executive Officer, HSBC North America Holdings Inc. A Group Managing Director since 21 February 2008. Joined HSBC in 1979. Appointed a Group General Manager in 2005. Chief Executive Officer, HSBC Finance Corporation and Chief Operating Officer, HSBC North America Holdings Inc. from 2007 to 21 February 2008. Chief Operating Officer, HSBC Bank USA from 2004 to 2006.
Y A Nasr
Age 53. Deputy Chairman and Chief Executive of HSBC Bank Middle East Limited since 22 May 2007. A Group Managing Director since 2004. Joined HSBC in 1976. Deputy Chairman of HSBC Bank Egypt S.A.E. since 31 May 2007. A Director of HSBC Private Banking Holdings (Suisse) SA since September 2006. Appointed a Group General Manager in 1998. President and Chief Executive Officer of HSBC Bank Canada from 1997 to 1999. President and Chief Executive Officer of HSBC USA Inc. and HSBC Bank USA from 1999 to 2003. President, HSBC Bank Brasil S.A.-Banco Múltiplo from 2003 to October 2006.
B Robertson
Age 53. Group Chief Risk Officer. A Group Managing Director since 25 February 2008. Joined HSBC in 1975. A Group General Manager since 2003. Head of Global Banking and Markets for North America from 2003 to 2005. Group General Manager, Group Credit and Risk from 2005 to September 2007.
P Y Antika
Age 47. Chief Executive Officer, HSBC Turkey. Joined HSBC in 1990. Appointed a Group General Manager in 2005.
R E T Bennett
Age 56. Group General Manager, Legal and Compliance. Joined HSBC in 1979. Appointed a Group General Manager in 1998.
N S K Booker
Age 49. Chief Operating Officer, HSBC Finance Corporation and Chief Operating Officer, HSBC North America. Joined HSBC in 1981. Appointed a Group General Manager in 2004.
P W Boyles
Age 52. Chief Executive Officer, HSBC France. Joined HSBC in 1975. Appointed a Group General Manager in January 2006.
D C Budd
Age 54. Director, International, HSBC Bank plc. Joined HSBC in 1972. Appointed a Group General Manager in 2005.
Z J Cama
Age 60. Group General Manager, International HSBC Holdings plc. Joined HSBC in 1968. Appointed a Group General Manager in 2001.
T M Detelich
Age 51. President, Consumer and Mortgage Lending, HSBC Finance Corporation. Joined HSBC Finance Corporation in 1976. Appointed a Group General Manager in October 2006.
I M Dorner
Age 53. Deputy Chairman and Chief Executive Officer, HSBC Bank Malaysia Berhad. Joined HSBC in 1986. Appointed a Group General Manager in June 2007.
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J D Garner
Age 38. Group General Manager, Personal Financial Services and Direct Businesses, HSBC Bank plc. Joined HSBC in 2004. Appointed a Group General Manager in October 2006.
J L Gordon
Age 55. President and Chief Executive Officer, HSBC Bank Canada. Joined HSBC in 1987. Appointed a Group General Manager in 2005.
K M Harvey
Age 47. Group General Manager and Group Chief Information Officer. Joined HSBC Finance Corporation in 1989. Appointed a Group General Manager in 2004.
A M Keir
Age 49. Global Co-Head Commercial Banking. Joined HSBC in 1981. Appointed a Group General Manager in October 2006.
N L Kidwai
Age 50. Chief Executive Officer, HSBC India. Joined HSBC in 2002. Appointed a Group General Manager in October 2006.
M J W King
Age 51. Group General Manager, Internal Audit. Joined HSBC in 1986. Appointed a Group General Manager in 2002.
P J Lawrence
Age 46. Head of Global Banking and Markets, USA. President and Chief Executive Officer, HSBC Bank USA, N.A. and HSBC USA Inc. Joined HSBC in 1982. Appointed a Group General Manager in 2005.
M Leung
Age 55. Global Co-Head Commercial Banking. Joined HSBC in 1978. Appointed a Group General Manager in 2005.
A M Mahoney
Age 45. Group General Manager and Head of PFS Distribution. Joined HSBC in 1983. Appointed a Group General Manager in November 2006.
C M Meares
Age 50. Chief Executive Officer, Group Private Banking. Joined HSBC in 1980. Appointed a Group General Manager in November 2006.
W G Menezes
Age 62. Group Executive, Card Services, HSBC Finance Corporation. Joined HSBC in 1996. Appointed a Group General Manager in October 2006.
K Newman
Age 50. Senior Executive Vice President, Personal Financial Services, HSBC Bank USA, N.A. Joined HSBC in 1989. Appointed a Group General Manager in October 2006.
R C F Or
Age 58. Vice-Chairman and Chief Executive, Hang Seng Bank Limited and Director, The Hongkong and Shanghai Banking Corporation Limited. Joined HSBC in 1972. Appointed a Group General Manager in 2000.
K Patel
Age 59. Group General Manager, Chief Executive Officer, Africa. Joined HSBC in 1984. Appointed a Group General Manager in 2000.
R C Picot
Age 50. Group Chief Accounting Officer. Joined HSBC in 1993. Appointed a Group General Manager in 2003.
C D Spooner
Age 57. Head of Group Financial Planning & Tax. Joined HSBC in 1994. Appointed a Group General Manager in June 2007.
P A Thurston
Age 54. Co-Head of Latin America and President of HSBC Mexico and Central America. Joined HSBC in 1975. Appointed a Group General Manager in 2003.
P T S Wong
Age 56. Executive Director, Hong Kong and Mainland China, The Hongkong and Shanghai Banking Corporation Limited. Joined HSBC in 2005. Appointed a Group General Manager in 2005.
The objective of the management structures within HSBC, headed by the Board of Directors of HSBC Holdings and led by the Group Chairman, is to deliver sustainable value to shareholders. Implementation of the strategy set by the Board is delegated to the Group Management Board under the leadership of the Group Chief Executive.
HSBC Holdings has a unitary Board of Directors. The authority of each Director is exercised in Board Meetings where the Board acts collectively as a unit. At 3 March 2008, the Board comprises the Group Chairman, Group Chief Executive, two other executive Directors and 14 non-executive Directors. The names and brief biographical particulars of the Directors are listed on pages 289 to 292. The Group Chairman, Group Chief Executive and two other executive Directors are employees who carry out executive functions in HSBC in addition to their duties as Directors. Non-executive Directors are not HSBC employees and do not participate in the daily business management of HSBC. Non-executive Directors bring an external perspective, constructively challenge and help develop proposals on strategy, scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. The non-executive Directors have a wealth of experience across a number of industries and business sectors, including the leadership of large, complex multinational enterprises. The roles of non-executive Directors as members of Board committees are set out on pages 300 to 304. It is estimated that non-executive Directors spend 24 days per annum on HSBC business after an induction phase, with Committee members devoting significant additional time.
The Board is responsible for managing the business of HSBC Holdings and, in doing so, may exercise all of the powers of HSBC Holdings, subject to any relevant laws and regulations and to the Memorandum and Articles of Association. In particular, the Board may exercise all the powers of the Company to borrow money and to mortgage or charge all or any part of the undertaking, property or assets (present and future) of HSBC Holdings and may also exercise any of the powers conferred on it by the Companies Act 1985 and Companies Act 2006 (as appropriate) and/or by shareholders. The Board is able to delegate and confer on certain Directors holding executive office any of its powers, authorities and discretions (including the power to sub-delegate) for such time and on such terms as it
thinks fit. In addition, the Board may establish any local or divisional boards or agencies for managing the business of HSBC Holdings in any specified locality and delegate and confer on any local or divisional board, manager or agent so appointed any of its powers, authorities and discretions (including the power to sub-delegate) for such time and on such terms as it thinks fit. The Board may also, by power of attorney or otherwise, appoint any person or persons to be the agent of HSBC Holdings and may delegate to any such person or persons any of its powers, authorities and discretions (including the power to sub-delegate) for such time and on such terms as it thinks fit.
The Board sets the strategy for HSBC through the five-year strategic plan and approves the operating plans presented by management for the achievement of the strategic objectives. The operating plans ensure the efficient disposition of HSBC’s resources for the achievement of these objectives. The Board delegates the management and day-to-day running of HSBC to the Group Management Board but retains to itself approval of certain matters including operating plans and performance targets, procedures for monitoring and control of operations, the authority or the delegation of authority to approve credit, market risk limits, acquisitions, disposals, investments, capital expenditure or realisation or creation of a new venture, specified senior appointments, and any substantial change in balance sheet management policy.
The Directors who served during the year were, Lord Butler, R K F Ch’ien, J D Coombe, Baroness Dunn, R A Fairhead, D J Flint, W K L Fung, M F Geoghegan, S K Green, S Hintze, J W J Hughes-Hallett, Sir Brian Moffat, Sir Mark Moody-Stuart, G Morgan, S W Newton, S M Robertson, H Sohmen and Sir Brian Williamson. J F Gil Díaz was appointed a Director on 2 January 2007 and resigned on 5 March 2007.
The Board of Directors meets regularly and Directors receive information between meetings about the activities of committees and developments in HSBC’s business.
Eight Board meetings were held during 2007. The table that follows gives details of Directors’ attendance at meetings of the Board, Group Audit Committee, Nomination Committee and Remuneration Committee during 2007.
During 2007, the non-executive Directors and the Group Chairman met twice without the presence of the Group Chief Executive and Group Finance Director. In addition, the non-executive Directors
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met four times without the Group Chairman including a meeting to appraise the Group Chairman’s performance.
In addition to the meetings of the principal Committees referred to in the following pages,
sixteen other meetings of Committees of the Board were held during the year to discharge business delegated by the Board.
All Directors attended the 2007 Annual General Meeting.
Group Chairman and Group Chief Executive
The roles of Group Chairman and Group Chief Executive are separated and held by experienced full-time Directors.
There is a clear division of responsibilities at the head of the Company between the running of the Board and the executive responsibility for running HSBC’s business. The Group Chairman’s responsibilities include the long-term strategic development of HSBC, the development of relationships with governments and other significant external parties and performance appraisal of the Group Chief Executive. The Group Chairman also monitors the performance of the Group Finance Director and, subject to the Group Chief Executive’s recommendation, approves risk, capital allocation and capital investment decisions within authorities delegated by the Board. The Group Chief Executive has responsibility for developing business plans and delivering performance against these.
S K Green became Group Chairman at the conclusion of the Annual General Meeting on 26 May 2006 and M F Geoghegan succeeded
S K Green as Group Chief Executive. The appointments were made after consulting with representatives of major institutional investors and explaining the succession planning and independent external search process undertaken. S K Green and M F Geoghegan stood for re-election at the 2006 Annual General Meeting and were both re-elected ahead of taking up their new roles from the conclusion of that Meeting.
Board balance and independence of Directors
The balance of the Board includes a strong presence of both executive and non-executive Directors such that no individual or small group can dominate the Board’s decision making. Following the 2008 Annual General Meeting, the Board will comprise 19 Directors, 12 of whom are independent non-executive Directors. The size of the Board is appropriate given the complexity and geographical spread of HSBC’s business and the significant time demands placed on the non-executive Directors, particularly those who serve as members of Board committees.
The Board has appointed S M Robertson as the senior independent non-executive Director. The principal role of the senior independent non-executive Director is to support the Group Chairman in his role, to lead the non-executive Directors in the oversight of the Group Chairman and to ensure there is a clear division of responsibility between the Group Chairman and Group Chief Executive. The senior independent non-executive Director is also available to shareholders for concerns which the normal channels have failed to resolve or are inappropriate.
The Board considers all of the non-executive Directors to be independent in character and judgement. Baroness Dunn, Sir Brian Moffat, Lord Butler and W K L Fung have served on the Board for more than nine years, however, and in that respect only, do not meet the usual criteria for independence set out in the UK Combined Code on corporate governance. The Board has therefore determined S A Catz, J D Coombe, J L Durán, R A Fairhead, J W J Hughes-Hallett, W S H Laidlaw, Sir Mark Moody-Stuart, G Morgan, N R N Murthy, S W Newton, S M Robertson, and Sir Brian Williamson to be independent. In reaching its determination of each non-executive Director’s independence the Board has concluded that there are no relationships or circumstances which are likely to affect a Director’s judgement and any relationships or circumstances which could appear to do so were considered not to be material.
When determining independence the Board considers that calculation of the length of service of a non-executive Director begins on the date of his or her first election by shareholders as a Director of HSBC Holdings. Given the complexity and geographical spread of HSBC’s business, the experience of previous service on a subsidiary company Board can be a considerable benefit to HSBC and does not detract from a Director’s independence.
In accordance with the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited, each non-executive Director determined by the Board to be independent has provided an annual confirmation of his or her independence to HSBC Holdings.
Information, induction and ongoing development
The Board regularly reviews reports on progress against financial objectives, on business developments and on investor and external relations and receives reports from the Chairmen of Board Committees and from the Group Chief Executive.
The Board receives regular reports and presentations on strategy and developments in the customer groups and principal geographical areas. Regular reports are also provided to the Board, the Group Audit Committee and the Group Management Board on credit exposures and the loan portfolio, asset and liability management, liquidity, litigation and compliance and reputational issues. The agenda and supporting papers are distributed in advance of all Board and Committee meetings to allow time for appropriate review and to facilitate full discussion at the meetings. All Directors have full and timely access to all relevant information and may take independent professional advice if necessary.
The Directors have free and open contact with management at all levels. Group Managing Directors and Group General Managers meet informally with Directors after Board meetings. Board offsite visits are made each year to enable Directors to see at first hand the operations of subsidiary companies in local environments and to meet management, employees and customers. In 2007 the Board visited New York and Curitiba.
Full, formal and tailored induction programmes, with particular emphasis on internal controls, are arranged for newly appointed Directors. The programmes consist of a series of meetings with other Directors and senior executives to enable new Directors to receive information and familiarise themselves with HSBC’s strategy, operations and internal controls. Prior to their appointment, each Director receives comprehensive guidance on the duties and liabilities of a Director of HSBC Holdings. Opportunities to update and develop skills and knowledge, through externally run seminars and through briefings by senior executives, are provided to all Directors.
Performance evaluation
In November 2007, ICSA Corporate Services Limited was commissioned to undertake an evaluation of the effectiveness of the Board. This was to investigate the performance of the Board as a whole and, in that context, the main Board committees and individual Directors. The evaluation examined whether eight key areas met the Board’s needs and expectations: Board responsibilities; oversight; Board meetings; information received; support for the Board; Board composition; working together; and outcome and achievements. The report on the evaluation has been reviewed by the Board and has been used by the non-executive Directors, led by the senior independent non-executive Director, in their evaluation of the performance of
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the Group Chairman. The review concluded that the Board and its committees were functioning effectively. It is the intention of the Board of HSBC Holdings to continue to review its performance and that of its Directors annually.
Appointment, retirement and re-election of Directors
The Board may at any time appoint any person who is willing to act as a Director, either to fill a vacancy or as an addition to the existing Board, but the total number of Directors shall not exceed twenty-five. Any Director so appointed by the Board shall retire at the Annual General Meeting following their appointment and shall be eligible for re-election but is not taken into account in determining the number of Directors who are to retire by rotation at such meeting. The Board may appoint any Director to hold any employment or executive office and may revoke or terminate any such appointment. Shareholders may, by ordinary resolution, appoint a person as a Director or remove any Director before the expiration of his period of office. At each Annual General Meeting, one third of the Directors who are subject to retirement by rotation are required to retire and may offer themselves for re-election by shareholders. In addition to those required to retire by rotation, any Director who was not elected or reelected at either of the preceding two Annual General Meetings and any non-executive Director who has served in office for a continuous period of nine years or more at the date of the Annual General Meeting is required to retire and may offer him or herself for re-election by shareholders.
R K F Ch’ien, S Hintze and H Sohmen retired as Directors at the conclusion of the Annual General Meeting held on 25 May 2007. J L Durán and W S H Laidlaw were appointed non-executive Directors on 1 January 2008. V H C Cheng was appointed an executive Director on 1 February 2008. A A Flockhart and S T Gulliver have been appointed executive Directors, and S A Catz and N R N Murthy have been appointed non-executive Directors with effect from 1 May 2008.
S A Catz, V H C Cheng, J L Durán, A A Flockhart, S T Gulliver, W S H Laidlaw and N R N Murthy, having been appointed since the Annual General Meeting in 2007, will retire at the forthcoming Annual General Meeting and offer themselves for re-election.
Lord Butler, J D Coombe, Baroness Dunn, D J Flint, W K L Fung, J W J Hughes-Hallett, Sir Brian Moffat and S W Newton will retire by rotation at the forthcoming Annual General Meeting. With
the exception of Lord Butler, Baroness Dunn and Sir Brian Moffat, who are to retire, they offer themselves for re-election.
None of the non-executive Directors seeking re-election at the forthcoming Annual General Meeting has a service contract. Of the executive Directors who are seeking re-election, D J Flint is employed on a rolling contract dated 29 September 1995 which requires 12 months’ notice to be given by the Company and nine months’ notice to be given by Mr Flint. V H C Cheng and A A Flockhart are employed on rolling contracts dated 1 October 1978 and 6 July 1974 respectively, which require three months’ notice to be given by either party. S T Gulliver is employed on a rolling contract dated 8 December 2005 which requires twelve months’ notice to be given by either party.
Following the performance evaluation of the Board, the Group Chairman has confirmed that the non-executive Directors standing for re-election at the Annual General Meeting continue to perform effectively and to demonstrate commitment to their roles.
Brief biographical particulars of all Directors including those seeking re-election at the Annual General Meeting, are given on pages 289 to 292.
Relations with shareholders
The Board ensures all Directors, including non-executive Directors, develop an understanding of the views of major shareholders through attendance at analyst presentations and other meetings with institutional investors and their representative bodies. The Board also met with representatives of institutional shareholders in 2007 to discuss corporate governance matters.
The Group Chairman, Group Chief Executive, Group Finance Director and other senior executives hold regular meetings with institutional investors and report to the Board on those meetings.
As described in the Directors’ Remuneration Report, a consultation with institutional shareholders on the framework of Directors’ remuneration and proposed changes to The HSBC Share Plan began in January 2008.
S M Robertson, senior independent non-executive Director since the conclusion of the 2007 Annual General Meeting, and other non-executive Directors met and corresponded with institutional investors and their representatives to discuss strategy, remuneration policy and governance. The senior independent non-executive Director is also available to shareholders should they have concerns
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which contact through the normal channels of Group Chairman, Group Chief Executive, Group Finance Director or other executives has failed to resolve or for which such contact would be inappropriate. Invitations to meet S M Robertson prior to his appointment as senior independent non-executive Director were extended to the Group’s largest shareholders. The senior independent non-executive Director may be contacted through the Group Company Secretary at 8 Canada Square, London E14 5HQ.
Indemnification of Directors, relevant audit information and contracts of significance
The Articles of Association of HSBC Holdings provide that Directors are entitled to be indemnified out of the assets of the Company against claims from third parties in respect of certain liabilities arising in connection with the performance of their functions, in accordance with the provisions of the UK Companies Act 1985. Such indemnity provisions have been in place during the financial year but have not been utilised by the Directors.
Each person who is a Director at the date of approval of this report confirms that so far as the Director is aware, there is no relevant audit information of which the Company’s auditor is unaware; and the Director has taken all the steps that he or she ought to have taken as a Director in order to make himself or herself aware of any relevant audit information and to establish that the Company’s auditor is aware of that information. This confirmation is given pursuant to section 234ZA of the UK Companies Act 1985 and should be interpreted in accordance therewith and subject to the provisions thereof.
None of the Directors had, during the year or at the end of the year, a material interest, directly or indirectly, in any contract of significance with HSBC Holdings or any of its subsidiary undertakings.
Corporate governance codes
HSBC is committed to high standards of corporate governance. HSBC Holdings has complied throughout the year with the applicable code provisions of the Combined Code on Corporate Governance issued by the Financial Reporting Council and the Code on Corporate Governance Practices in Appendix 14 to the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited.
The Board of HSBC Holdings has adopted a code of conduct for transactions in HSBC Group securities by Directors that complies with The Model
Code in the Listing Rules of the Financial Services Authority and with The Model Code for Securities Transactions by Directors of Listed Issuers (‘Hong Kong Model Code’) set out in the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited, save that The Stock Exchange of Hong Kong Limited has granted certain waivers from strict compliance with the Hong Kong Model Code, primarily to take into account accepted practices in the UK, particularly in respect of employee share plans. Following a specific enquiry, each Director has confirmed he or she has complied with the code of conduct for transactions in HSBC Group securities throughout the year.
Differences in HSBC Holdings/New York Stock Exchange corporate governance practices
Under the NYSE’s corporate governance rules for listed companies, as a NYSE-listed foreign private issuer, HSBC Holdings must disclose any significant ways in which its corporate governance practices differ from those followed by US companies subject to NYSE listing standards. HSBC Holdings believes the following to be the significant differences between its corporate governance practices and NYSE corporate governance rules applicable to US companies.
US companies listed on the NYSE are required to adopt and disclose corporate governance guidelines. The Listing Rules of the UK Financial Services Authority require each listed company incorporated in the UK to include in its Annual Report and Accounts a narrative statement of how it has applied the principles of the Combined Code and a statement as to whether or not it has complied with the code provisions of the Combined Code throughout the accounting period covered by the Annual Report and Accounts. A company that has not complied with the Code provisions, or complied with only some of the Code provisions or (in the case of provisions whose requirements are of a continuing nature) complied for only part of an accounting period covered by the report, must specify the Code provisions with which it has not complied, and (where relevant) for what part of the reporting period such non-compliance continued, and give reasons for any non-compliance. As stated above, HSBC Holdings complied throughout 2007 with the applicable code provisions of the Combined Code. The Combined Code does not require HSBC Holdings to disclose the full range of corporate governance guidelines with which it complies.
Under NYSE standards, companies are required to have a nominating/corporate governance
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committee, composed entirely of independent directors. In addition to identifying individuals qualified to become Board members, this committee must develop and recommend to the Board a set of corporate governance principles. HSBC’s Nomination Committee, which follows the requirements of the Combined Code, includes a majority of members who are independent. All members of the Committee are non-executive Directors and three of the five members, including the Committee chairman, are independent non-executive Directors. The Committee’s terms of reference do not require the Committee to develop and recommend corporate governance principles for HSBC Holdings. As stated above, HSBC Holdings is subject to the corporate governance principles of the Combined Code.
Pursuant to NYSE listing standards, non-management directors must meet on a regular basis without management present and independent directors must meet separately at least once per year. During 2007, HSBC Holdings’ non-executive Directors met twice as a group with the Group Chairman, but without the Group Chief Executive or Group Finance Director present, and met four times as a group without the Group Chairman, Group Chief Executive or Group Finance Director present. HSBC Holdings’ practice, in this regard, complies with the Combined Code.
In accordance with the requirements of the Combined Code, HSBC Holdings discloses in its annual report how the Board, its committees and the Directors are evaluated (on page 297) and it provides extensive information regarding Directors’ compensation in the Directors’ Remuneration Report (on pages 322 to 332). The terms of reference of HSBC Holdings’ Audit, Nomination and Remuneration Committees are available at www.hsbc.com/boardcommittees.
NYSE listing standards require US companies to adopt a code of business conduct and ethics for directors, officers and employees, and promptly disclose any waivers of the code for directors orexecutive officers. In addition to the Group Business Principles and Values, which apply to the employees of all HSBC companies, pursuant to the requirements of the Sarbanes-Oxley Act the Board of HSBC Holdings has adopted a Code of Ethics applicable to the Group Chairman and the Group Chief Executive, as the principal executive officers, and to the Group Finance Director and Group Chief Accounting Officer. HSBC Holdings’ Code of Ethics is available on www.hsbc.com/codeofethics or from the Group Company Secretary at 8 Canada Square, London E14 5HQ. If the Board amends or waives
the provisions of the Code of Ethics, details of the amendment or waiver will appear at the same website address. During 2007, HSBC Holdings made no amendments to its Code of Ethics and granted no waivers from its provisions. The Group Business Principles and Values are available on www.hsbc.com/businessprinciplesandvalues.
Under NYSE listing rules applicable to US companies, independent directors must comprise a majority of the Board of directors. Currently, over half of HSBC Holdings’ Directors are independent.
Under the Combined Code the HSBC Holdings Board determines whether a Director is independent in character and judgement and whether there are relationships or circumstances which are likely to affect, or could appear to affect, the Director’s judgement. Under the NYSE rules a director cannot qualify as independent unless the Board affirmatively determines that the director has no material relationship with the listed company; in addition the NYSE rules prescribe a list of circumstances in which a director cannot be independent. The Combined Code requires a company’s Board to assess director independence by affirmatively concluding that the director is independent of management and free from any business or other relationship that could materially interfere with the exercise of independent judgement.
Lastly, a chief executive officer of a US company listed on the NYSE must annually certify that he or she is not aware of any violation by the company of NYSE corporate governance standards. In accordance with NYSE listing rules applicable to foreign private issuers, HSBC Holdings’ Group Chief Executive is not required to provide the NYSE with this annual compliance certification. However, in accordance with rules applicable to both US companies and foreign private issuers, the Group Chief Executive is required promptly to notify the NYSE in writing after any executive officer becomes aware of any material non-compliance with the NYSE corporate governance standards applicable to HSBC Holdings.
HSBC Holdings is required to submit annual and interim written affirmations of compliance with applicable NYSE corporate governance standards, similar to the affirmations required of NYSE-listed US companies.
Board committees
The Board has appointed a number of committees consisting of certain Directors, Group Managing Directors and, in the case of the Corporate
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Sustainability Committee, certain co-opted non-director members. The following are the principal committees:
The Group Management Board meets regularly and operates as a general management committee under the direct authority of the Board. The objective of the Group Management Board is to maintain a reporting and control structure whereby all of the line operations of HSBC are accountable to individual members of the Group Management Board who report to the Group Chief Executive who in turn reports to the Group Chairman. The Board has set objectives and measures for the Group Management Board. These will align senior executives’ objectives and measures with the strategy and operating plans throughout HSBC. The members of the Group Management Board are M F Geoghegan (Chairman), V H C Cheng and D J Flint, who are executive Directors, and A Almeida, C C R Bannister, A A Flockhart, S T Gulliver, D H Hodgkinson, A Hungate, D D J John, B P McDonagh, Y A Nasr and B Robertson, all of whom are Group Managing Directors.
The Group Management Board exercises the powers, authorities and discretions of the Board in so far as they concern the management and day-to-day running of HSBC Holdings in accordance with such policies and directions as the Board may from time to time determine. Matters reserved for approval by the Board are described on page 295.
Following each meeting the Group Chief Executive reports to the Board on the Group Management Board’s activities.
The Group Audit Committee meets regularly with HSBC’s senior financial, internal audit, credit, legal and compliance management and the external auditor to consider HSBC Holdings’ financial reporting, the nature and scope of audit reviews and the effectiveness of the systems of internal control, compliance and risk management. The members of the Group Audit Committee throughout 2007 were, R A Fairhead (appointed Chairman on 25 May 2007), J D Coombe and J W J Hughes-Hallett. S W Newton was appointed a member of the Committee on 25 May 2007. Sir Brian Moffat ceased to be Chairman and a member of the Committee on 25 May 2007. R K F Ch’ien retired as a Director of HSBC Holdings and ceased to be a member of the Committee on 25 May 2007. All
members of the Committee are independent non-executive Directors.
The Board has determined that R A Fairhead, J D Coombe, J W J Hughes-Hallett and S W Newton are independent according to SEC criteria, and that R A Fairhead, J D Coombe, and J W J Hughes-Hallett may be regarded as audit committee financial experts for the purposes of section 407 of the Sarbanes-Oxley Act and as having recent and relevant financial experience.
Appointments to the Committee are made for periods of up to three years, extendable by no more than two additional three-year periods, so long as members continue to be independent.
Formal and tailored induction programmes are held for newly-appointed Committee members and appropriate training is provided on an ongoing and timely basis.
There were seven meetings of the Group Audit Committee during 2007. The table on page 296 gives details of Directors’ attendance at these meetings. Following each meeting the Committee reports to the Board on its activities.
At each meeting, the Committee has the opportunity to meet with the external auditor, without management present, to facilitate the discussion of any matter relating to its remit and any issue arising from the audit. Similar arrangements have been adopted for the Committee to meet with the internal auditor.
The terms of reference of the Committee, which are reviewed annually, are available at www.hsbc.com/boardcommittees. To ensure consistency of scope and approach by subsidiary company audit committees, the Group Audit Committee has established core terms of reference to guide subsidiary company Boards when adopting terms of reference for their audit committees. Subsidiary company audit committees are required to provide bi-annual certificates to the Committee relating to the financial statements and internal control procedures of those subsidiaries.
The Group Audit Committee is accountable to the Board and assists it in meeting its responsibilities for maintaining an effective system of internal control and compliance and for meeting its external financial reporting obligations. The Committee undertakes an annual review of the effectiveness of HSBC’s system of internal control, which is described on page 304, and reviews the Company’s financial statements before they are considered by the Board.
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Regular reports are received on the risks involved in HSBC’s business and how they are controlled and monitored by management which enable the Committee to review the effectiveness of HSBC’s risk management framework. Each year the Committee agrees a schedule of presentations to be made to it by management during the ensuing year on the operation of the risk control framework within the Group. The presentations specifically address risk indicators and performance measures such as indicators of credit, liquidity and interest rate risk. During 2007 the Committee also received frequent reports on the US mortgage services business, credit performance in the US and the impact of the tightening of liquidity in the money markets. Comprehensive reports are received at each meeting from the Group Chief Risk Officer, the Head of Group Compliance, the Group General Manager, Legal and Compliance and the Group General Manager Internal Audit. Periodic presentations are made by other functional heads and line management.
The reports from the Group General Manager Internal Audit include information on frauds and special investigations and weakness in internal controls identified through internal audit reports or reviews of regulatory reports and external auditors’reports. The Committee monitors and reviews the effectiveness of the internal audit function and receives summaries of periodic peer reviews of HSBC’s principal internal audit functions. HSBC has adopted the Principles of the International Institute of Internal Auditors, which include a periodic external quality assurance review of the internal audit function. The first such review was undertaken by Independent Audit Limited during 2007.
The Committee receives regular updates on changes in law, regulations and accounting standards and practices and the preparations being made to respond to those requirements. During 2007, the Committee received regular updates on the review of internal financial reporting controls required by section 404 of the Sarbanes-Oxley Act and the implementation of the Basel II capital adequacy requirements. The Committee also considered a report on HSBC’s compliance with the recommendations of the Institute of International Finance’s Special Committee on Liquidity Risk.
The Committee has approved procedures for the receipt, retention and handling of complaints regarding accounting, internal accounting controls and auditing matters. The Committee receives regular reports regarding the nature, investigation
and resolution of material complaints and concerns from the Head of Group Compliance.
The Committee is directly responsible on behalf of the Board for the selection, oversight and remuneration of the external auditor. The Committee reviews and monitors the external auditor’s independence and objectivity and the effectiveness of the audit process, taking into consideration relevant professional and regulatory requirements.
The Committee reviews the strategy and approves the terms for the engagement of the external auditor for the audit of the Annual Report and Accounts. Regular reports on the progress of the audit facilitate the Committee’s assessment of the effectiveness of the audit.
The Committee receives reports from the external auditor on its own policies and procedures regarding independence and quality control and oversees the appropriate rotation of audit partners within the external auditor. The external auditor provides the Committee with an annual confirmation of its independence in accordance with industry standards.
On the recommendation of the Committee the Board has approved a policy for the employment by HSBC of former employees of the external auditor or its affiliates. The Committee monitors this policy through the receipt of an annual report of those former employees of the external auditor employed by HSBC and the number of former employees of the external auditor currently employed in senior positions in HSBC. The reports enable the Committee to consider whether there has been any impairment, or appearance of impairment, of the auditor’s judgement or independence in respect of the audit.
The Group Audit Committee has established policies for the pre-approval of specific services that may be provided by the principal auditor, KPMG Audit Plc and its affiliates (‘KPMG’). These policies are kept under review and amended as necessary to meet the dual objectives of ensuring that HSBC benefits in a cost effective manner from the cumulative knowledge and experience of its auditor, while also ensuring that the auditor maintains the necessary degree of independence and objectivity. These pre-approval policies apply to all services where HSBC Holdings or any of its subsidiaries pays for the service, or is a beneficiary or addressee of the service and has selected or influenced the choice of KPMG. All services entered into with KPMG during 2007 were pre-approved by the Committee or were entered into under pre-approval policies established by the Committee. A quarterly update on non-audit
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services provided by KPMG is presented to the Committee.
The pre-approved services relate to regulatory reviews, agreed-upon procedures reports, other types of attestation reports, the provision of advice and other non-audit services allowed under SEC independence rules. They fall into the categories of audit services, audit-related services, tax services and other services.
All services provided by KPMG relating to the implementation of section 404 of the Sarbanes-Oxley Act were specifically pre-approved by the Group Audit Committee.
An analysis of the remuneration paid in respect of audit and non-audit services provided by KPMG for each of the last three years is disclosed in Note 9 on the Financial Statements.
The Committee has recommended to the Board that KPMG Audit Plc be reappointed auditor at the forthcoming Annual General Meeting.
The role of the Remuneration Committee and its membership are set out in the Directors’ Remuneration Report on page 322.
The Nomination Committee is responsible for leading the process for Board appointments and for identifying and nominating, for approval by the Board, candidates for appointment to the Board. Before recommending an appointment to the Board, the Committee evaluates the balance of skills, knowledge and experience on the Board and, in the light of this, identifies the role and capabilities required for a particular appointment. Candidates are considered on merit against these criteria. Care is taken to ensure that appointees have enough time to devote to HSBC. Prospective Directors are asked to identify any significant other commitments and confirm they have sufficient time to discharge what is expected of them. In accordance with the Articles of Association all Directors are subject to election by shareholders at the Annual General Meeting following their appointment by the Board and to re-election at least every three years. The members of the Nomination Committee throughout 2007 were Sir Brian Williamson (appointed Chairman on 25 May 2007), Baroness Dunn and Sir Brian Moffat. J W J Hughes-Hallett and S M Robertson were appointed members of the Committee on 25 May 2007. Lord Butler ceased to be a member on 25 May 2007.
There were two Nomination Committee meetings during 2007. The table on page 296 gives details of Directors’ attendance at these meetings.
Following each meeting the Committee reports to the Board on its activities.
The terms of reference of the Committee are available at www.hsbc.com/boardcommittees.
The appointments of J F Gil Díaz, J L Durán and W S H Laidlaw as non-executive Directors and V H C Cheng as an executive Director were made on the advice and recommendation of the Nomination Committee. J F Gil Díaz, former Secretary of Finance and Public Credit in Mexico, was identified by the Nomination Committee and so neither an external consultancy nor open advertising was used in connection with his appointment. An external consultancy was used in connection with the appointments of J L Durán and W S H Laidlaw.
The terms and conditions of appointment of non-executive Directors are available for inspection at 8 Canada Square, London E14 5HQ and will be made available for 15 minutes before the AnnualGeneral Meeting and during the Meeting itself.
The Committee makes recommendations to the Board concerning: plans for succession for both executive and non-executive Directors; the appointment of any Director to executive or other office; suitable candidates for the role of senior independent non-executive Director; the re-election by shareholders of Directors retiring by rotation; the renewal of the terms of office of non-executive Directors; membership of Board Committees, in consultation with the Group Chairman and the chairman of such committees as appropriate; any matters relating to the continuation in office of any Director at any time; Directors’ fees and committee fees for the Company; and appointments and reappointments to the Boards of Directors of major subsidiary companies as appropriate.
The Committee regularly reviews the structure, size and composition (including the skills, knowledge and experience required) of the Board and makes recommendations to the Board as appropriate. It keeps under review the leadership needs of HSBC, with a view to ensuring the continued ability of HSBC to compete effectively in the marketplace. The Board has satisfied itself that the Nomination Committee has in place appropriate plans for orderly succession to the Board and senior management positions as well as procedures to ensure an appropriate balance of skills and experience within HSBC and on the Board.
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Corporate Sustainability Committee
The Corporate Sustainability Committee is responsible for overseeing corporate responsibility and sustainability policies, principally environmental, social and ethical matters and for advising the Board, committees of the Board and executive management on such matters. The terms of reference of the Committee are available at www.hsbc.com/boardcommittees. The members of the Committee throughout 2007 were Lord Butler (Chairman), W K L Fung and Sir Mark Moody-Stuart (each of whom is a non-executive Director) and G V I Davis and Lord May, who are non-director members of the Committee. S Hintze was a member of the Committee until her retirement as a Director at the conclusion of the 2007 Annual General Meeting.
There were five meetings of the Corporate Sustainability Committee during 2007. Following each meeting the Committee reports to the Board on its activities.
Further information will be in HSBC’s Sustainability Report 2007, available in May 2008.
The Directors are responsible for internal control in HSBC and for reviewing its effectiveness. Procedures have been designed for safeguarding assets against unauthorised use or disposition; for maintaining proper accounting records; and for the reliability of financial information used within the business or for publication. Such procedures are designed to manage rather than eliminate the risk of failure to achieve business objectives and can only provide reasonable and not absolute assurance against material misstatement, errors, losses or fraud. The procedures also enable HSBC Holdings to discharge its obligations under the Handbook of Rules and Guidance issued by the Financial Services Authority, HSBC’s lead regulator.
The key procedures that the Directors have established are designed to provide effective internal control within HSBC and accord with the Internal Control: Revised Guidance for Directors on the Combined Code issued by the Financial Reporting Council. Such procedures for the ongoing identification, evaluation and management of the significant risks faced by HSBC have been in place throughout the year and up to 3 March 2008, the date of approval of the Annual Report and Accounts 2007. In the case of companies acquired during the year, the internal controls in place are being reviewed against HSBC’s benchmarks and integrated into HSBC’s processes.
HSBC’s key internal control procedures include the following:
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from the principal regions, customer groups and global businesses.
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The Directors, through the Group Audit Committee, have conducted an annual review of the effectiveness of HSBC’s system of internal control covering all material controls, including financial, operational and compliance controls and risk management systems. The Group Audit Committee has received confirmation that management has taken or is taking the necessary action to remedy any failings or weaknesses identified through the operation of HSBC’s framework of controls.
Directors’ interests
Pursuant to the requirements of the UK Listing Rules and according to the register maintained by HSBC Holdings pursuant to section 352 of the Securities and Futures Ordinance of Hong Kong, the Directors of HSBC Holdings at the year-end had the following interests, all beneficial unless otherwise stated, in the shares and loan capital of HSBC and its associated corporations:
HSBC Holdings ordinary shares of US$0.50
M F Geoghegan has an interest as beneficial owner in 280,000 ordinary shares of HK$5.00 each in Hang Seng Bank (representing less than 0.02 per cent of the shares in issue), which he acquired during the year.
S K Green has an interest as beneficial owner in €75,000 of HSBC Holdings plc 5½ per cent Subordinated Notes 2009 which he held throughout the year.
As a Director of HSBC Private Banking Holdings (Suisse), S K Green has an interest as beneficial owner in one share of CHF1,000 in that company (representing less than 0.01 per cent of the shares in issue), which he held throughout the year. S K Green has waived his rights to receive dividends on the share and has undertaken to transfer the share to HSBC on ceasing to be a Director of HSBC Private Banking Holdings (Suisse).
As Directors of HSBC France, S K Green and M F Geoghegan each have an interest as beneficial owner in one share of €5 in that company (representing less than 0.01 per cent of the shares in issue), which they held throughout the year. The Directors have waived their rights to receive dividends on these shares and have undertaken to transfer these shares to HSBC on ceasing to be Directors of HSBC France.
No Directors held any short positions as defined in the Securities and Futures Ordinance of Hong Kong in the shares and loan capital of HSBC and itsassociated corporations. Save as stated above and in the Directors’ Remuneration Report, none of the Directors had an interest in any shares or debentures of HSBC or any associated corporation at the beginning or at the end of the year, and none of the Directors or members of th eir immediate family was
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awarded or exercised any right to subscribe for any shares or debentures in any HSBC corporation during the year.
Since the end of the year, the interests of each of the following Directors have increased by the number of HSBC Holdings ordinary shares shown against their name:
W S H Laidlaw had beneficial and non-beneficial interests in 20,000 and 4,500 HSBC Holdings ordinary shares respectively, on 1 January 2008, the date he was appointed a Director of HSBC Holdings.
V H C Cheng had beneficial interests in 244,539 HSBC Holdings ordinary shares and 408,022 conditional long-term incentive awards of Performance Shares on 1 February 2008, the date he was appointed a Director of HSBC Holdings.
There have been no other changes in the share and loan capital interests of the Directors until the date of this Report. Any subsequent changes up to the last practicable date before the publication of the Notice of Annual General Meeting will be set out in the notes to that Notice.
At 31 December 2007, Directors and Senior Management held, in aggregate, beneficial interests in 12,849,034 HSBC Holdings ordinary shares (0.1 per cent of the issued ordinary shares).
At 31 December 2007, executive Directors and Senior Management held, in aggregate, options to subscribe for 58,795 HSBC Holdings ordinary shares under the HSBC Holdings Executive Share Option Scheme and HSBC Holdings savings-related share option plans. These options are exercisable between 2008 and 2013 at prices ranging from £5.3496 to £7.6736 per share.
At 31 December 2007, HSBC’s customers were served by 330,000 full and part-time employees worldwide, compared with 312,000 at 31 December 2006 and 284,000 at 31 December 2005. The main centres of employment are the UK with approximately 56,700 employees; the US 43,000; India 33,000; Hong Kong 29,000; Brazil 27,000; Mexico 23,000 and France 15,000. HSBC negotiates with recognised unions. The highest concentrations of union membership are in Argentina, Brazil, Colombia, Egypt, France, Germany, Jordan, Lebanon, Malaysia, Malta, Mexico, the Philippines, Singapore and the UK. It is HSBC’s policy to maintain well-developed communications and consultation programmes and there have been no material disruptions to its operations from labour disputes during the past five years.
HSBC continues to develop the capabilities of its people. Formal policies and structures are in place to provide career development and training for all employees, with particular emphasis on increasing international mobility to enrich the diversity of the employees’ experience. HSBC’s talent strategy, which focuses on the development of leadership capability and smooth succession planning, continues. This is being achieved through mutual and open dialogue and planned development from graduate through to senior management levels.
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HSBC continues to be committed to creating a diverse and inclusive work environment reflective of its customer base, international workforce, and communities in which it operates. It has a Group-wide strategy that aims to improve gender, ethnicity and age diversity to ensure the long-term sustainability of the organisation. There is particular focus on increasing gender and ethnic diversity at senior management levels. Diversity initiatives are implemented at a country level taking local and national laws into account. Employee network groups and mentoring programmes are promoted and established where possible to facilitate open discussion of workplace issues for employees belonging to minority groups, and to foster an environment that celebrates diversity.
HSBC recognises its role as an employer in a wider context and is committed to employee health issues, promoting employee involvement in community and not-for-profit organisations andproviding flexible working opportunities. As a responsible employer and corporate citizen, HSBC recognises the need to address the issues raised by HIV/AIDS in the workplace and, in 2007, launched a HIV/AIDS policy. The policy defines the approach and minimum standards to be achieved by HSBC entities around the world. Key principles include non-discrimination and confidentiality, voluntary testing, commitment to prevention, education, awareness, care and support. To coincide with the launch of the Group policy an e-learning module and a dedicated intranet site was established to provide education on the important issues surrounding HIV/AIDS.
HSBC considers its people to be fundamental to its past and future success. In its pursuit of making HSBC the best place to work, HSBC maintains an ongoing dialogue with employees, and looks to understand how they are motivated and engaged. In 2007, HSBC conducted its first Global People Survey which comprised questions designed to measure employee engagement levels consistently across the Group. The survey covered HSBC’s permanent global workforce, and responses were received from almost 290,000 employees, a significant response rate of 88 per cent. Questions were summarised under 12 dimensions. On all of the dimensions, employees rated HSBC above external global norms. Particular areas of strength were HSBC’s brand reputation, its commitment to corporate sustainability and the quality of its direct managers. HSBC has communicated the results and key action plans are being developed to improve engagement. Following the success of the first
survey, plans are underway for the second survey in 2008.
HSBC values open communication with its employees. Employees are encouraged to discuss operational and strategic issues, and ways of improving performance, with their line managers. Open communication throughout the organisation is encouraged and opportunities to share individual perspectives are created through networking events, management blogs, international assignments and learning and development programmes. Information is regularly given to employees about employment matters and the financial and economic factors affecting HSBC’s performance. This is communicated via management channels, internal seminars, training programmes, in-house magazines and an intranet site accessible to the majority of HSBC’s employees worldwide.
Employment of disabled persons
HSBC believes in providing equal opportunities to all employees. The employment of disabled persons is included in this commitment and the recruitment, training, career development and promotion of disabled persons is based on the aptitudes and abilities of the individual. Should employees become disabled during employment, every effort is made to continue their employment and, if necessary, appropriate training is provided.
As the quality and commitment of its human capital is deemed fundamental to HSBC’s success, the Board’s stated strategy is to attract, retain and motivate the very best people.
In a business that is based on trust and relationships, HSBC’s broad policy is to recruit those who are committed to making a long-term career with the organisation since trust and relationships are built over time.
Remuneration is an important component in people’s decisions on which company to join and to stay with, but it is not the overriding one; it is HSBC’s experience that people are attracted to, an organisation with strong values, one which is meritocratic and competitive and which offers transparent and interesting career development.
In line with the overall principles applied by the Remuneration Committee as described on page 322 in the Directors’ Remuneration Report:
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Employee share plans
To help align the interests of employees with those of shareholders, share options are granted under all-employee share plans and discretionary awards of Performance Shares and Restricted Shares are made under The HSBC Share Plan. There have been no awards of discretionary share options since 30 September 2005.
Set out on pages 309 to 317 are particulars of outstanding employee share options, including those held by employees working under employment contracts that are regarded as ‘continuous contracts’ for the purposes of the Hong Kong Employment Ordinance. The options were granted at nil consideration. No options have been granted to substantial shareholders, suppliers of goods or services, or in excess of the individual limit for each share plan. No options were cancelled during the year.
Employee share plans are subject to the following limits on the number of HSBC Holdings ordinary shares that may be subscribed for. In any 10-year period not more than 10 per cent of the HSBC Holdings ordinary shares in issue from time to time (approximately 1,187 million HSBC Holdings ordinary shares at 3 March 2008) may in aggregate become issuable pursuant to the grant of options or be issued other than pursuant to options under all-employee share plans. In any 10-year period not more than 5 per cent of the HSBC Holdings ordinary shares in issue from time to time (approximately 593 million HSBC Holdings ordinary shares on 3 March 2008) may in aggregate be put under option under The HSBC Share Plan or be issuable pursuant to the HSBC Holdings Group Share Option Plan, the HSBC Executive Share Option Scheme, the HSBC Holdings Restricted Share Plan 2000 or The HSBC Share Plan. The number of HSBC Holdings ordinary shares that may be issued on exercise of all options granted on or after 27 May 2005 under The HSBC Share Plan and any other plans must not exceed 1,119,000,000 HSBC Holdings ordinary shares. Under the HSBC Holdings savings-related share option plans, The HSBC Share Plan, HSBC Holdings Group Share Option Plan and the HSBC Holdings Executive Share Option Scheme there were options outstanding over 260,714,579 HSBC Holdings ordinary shares at 31 December 2007. Particulars of options over HSBC Holdings shares held by Directors of HSBC Holdings are set out on page 331 of the Directors’ Remuneration Report.
The effect on earnings per share of granting share options and share awards is shown in diluted earnings per share on the face of the consolidated income statement, with further details disclosed in Note 13 on the Financial Statements. The effect on basic earnings per share of dilutive share options and share awards would be to dilute it by 1.2 per cent.
All-employee share option plans
The HSBC Holdings Savings-Related Share Option Plan and the HSBC Holdings Savings-Related Share Option Plan: International are all-employee share plans under which eligible HSBC employees (those employed within the Group on the first working day of the year of grant) may be granted options to acquire HSBC Holdings ordinary shares. Employees may make contributions of up to £250 (or equivalent) each month over a period of one, three or five years which may be used on the first, third or fifth anniversary of the commencement of the relevant savings contract, at the employee’s election, to exercise the options. Alternatively, the employee
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may elect to have the savings, plus (where applicable) any interest or bonus, repaid in cash. Options granted over a one-year period will be exercisable within three months following the first anniversary of the commencement of the savings contract. Options granted over three or five-year periods will be exercisable within six months following the third or fifth anniversary of the commencement of the relevant savings contract. In the case of redundancy, retirement on grounds of injury or ill health, retirement at or after normal retirement age, the transfer of the employing business to another party, or a change of control of the employing company, options may be exercised before completion of the relevant savings contract.
Under the HSBC Holdings Savings-Related Share Option Plan and the HSBC Holdings Savings-Related Share Option Plan: International the option exercise price is determined by reference to the average market value of the ordinary shares on the
five business days immediately preceding the invitation date, then applying a discount of 20 per cent (except for the one-year options awarded under the US sub-plan where a 15 per cent discount is applied). The exercise period of the options awarded under all-employee share plans may be advanced to an earlier date in certain circumstances, for example on retirement, and may be extended in certain circumstances, for example on the death of a participant, the executors may exercise the option up to six months beyond the normal exercise period. The closing price per HSBC Holdings ordinary share on 24 April 2007, the day before options were awarded in 2007 under the HSBC Holdings Savings-Related Share Option Plan and the HSBC Holdings Savings-Related Share Option Plan: International, was £9.21. The all-employee share option plans will terminate on 27 May 2015 unless the Directors resolve to terminate the plans at an earlier date.
HSBC Holdings Savings-Related Share Option PlanHSBC Holdings ordinary shares of US$0.50
HSBC Holdings Savings-Related Share Option Plan: International
To encourage greater participation in the HSBC Holdings Savings-Related Share Option Plan: International, two amendments were approved at the 2005 Annual General Meeting. The first was the introduction of the facility to save and have option
prices expressed in US dollars, Hong Kong dollars and euros as well as in pounds sterling. Where applicable, the US dollars, Hong Kong dollars and euro exercise prices are converted from the sterling exercise price at the applicable exchange rate on the working day preceding the relevant invitation date. The second amendment was to provide the choice of options over one year in addition to three and five year terms.
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Discretionary Share Plans
Note 10 on the Financial Statements gives detail on share-based payments, including awards of Performance Shares and Restricted Shares made in 2007.
The HSBC Share Plan was approved at the 2005 Annual General Meeting. Awards of Performance Shares are made under this Plan to executive Directors and other senior executives. The performance conditions for awards of Performance Shares are described under ‘Long-term incentive plan’ on page 324.
Awards of Performance Shares are directed to those senior executives who can influence corporate performance such as members of the Group Management Board.
Awards of Restricted Shares are typically made to other employees based on individual performance, business performance and competitive market practice.
Restricted Share awards define the number of shares to which the employee will become entitled, generally between one and three years from the date of the award, subject to the individual remaining in employment. All awards of Performance Shares and Restricted Shares will be satisfied by the transfer of existing shares.
Since 2005, awards of share options under The HSBC Share Plan have only been granted in very limited circumstances. There may be particular circumstances in the future where option grants could be appropriate. No options were awarded under The HSBC Share Plan in 2007.
Prior to 2005, discretionary awards of share options, with vesting subject to the attainment of a predetermined TSR performance condition, were made to employees at all levels of HSBC.
The vesting of these options was subject to the attainment of pre-determined relative TSR performance criteria, except in HSBC France (which was acquired in 2000) where performance criteria were phased in. Under the HSBC Holdings Group Share Option Plan, the maximum grant of options which could be granted to an employee in any one
year (together with the Performance Share awards under the HSBC Holdings Restricted Share Plan 2000) was 150 per cent (or in exceptional circumstances 225 per cent) of the employee’s annual salary at the date of grant plus any bonus paid in the previous year.
Under the HSBC Executive Share Option scheme the maximum value of options which could be granted to an employee in any one year was four times the employee’s relevant earnings. Subject to the attainment of the relative TSR performance condition where applicable, options are generally exercisable between the third and the tenth anniversary of the date of grant. Employees of a subsidiary that is sold or transferred out of HSBC may exercise options awarded under the HSBC Group Share Option Plan or the HSBC Holdings Executive Share Option Scheme within six or twelve months respectively of the sale or transfer, regardless of whether the performance condition is met.
The maximum value of options that may be granted to an employee in any one year under The HSBC Plan (when taken together with any Performance Share award made under The HSBC Share Plan) is 700 per cent of the employee’s annual salary at the date of grant.
The exercise price of options granted under The HSBC Share Plan, and previously under the HSBC Holdings Group Share Option Plan, is the higher of the average market value of the ordinary shares on the five business days prior to the grant of the option or the market value of the ordinary shares on the date of grant of the option. The exercise price of options granted under the HSBC Holdings Executive Share Option Scheme was the market value of the ordinary shares on the business day prior to the grant of the option. The HSBC Share Plan will terminate on 27 May 2015 unless the Directors resolve to terminate the Plan at an earlier date.
The exercise period of the options awarded under discretionary share incentive plans may be advanced to an earlier date in certain circumstances, for example on retirement, or on the death of a participant, options may be exercised up to 12 months beyond the normal exercise period.
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Subsidiary company share plans
HSBC France and subsidiary company
When it was acquired in 2000, HSBC France and one of its subsidiary companies, HSBC Private Bank France, operated employee share option plans under
which options could be granted over their respective shares. No further options will be granted under either of these companies’ plans. The following are details of options to acquire shares in HSBC France and HSBC Private Bank France.
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HSBC Franceshares of €5
HSBC Private Bank Franceshares of €2
HSBC Finance and its subsidiaries
Following the acquisition of HSBC Finance in 2003, all outstanding options and equity-based awards over HSBC Finance common shares were converted into rights to receive HSBC Holdings ordinary shares in the same ratio as the share exchange offer for the acquisition of HSBC Finance (2.675 HSBC Holdings ordinary shares for each HSBC Finance common share) and the exercise prices per share were adjusted accordingly. No further options will be granted under any of these plans.
All outstanding options and other equity-based awards over HSBC Finance common shares granted before 14 November 2002, being the date the
transaction was announced, vested on completion of the acquisition. Options and equity-based awards granted on or after 14 November 2002 are exercisable on their original terms, save that they have been adjusted to reflect the exchange ratio.
The following are details of options and equity-based awards to acquire shares in HSBC Holdings.
At 31 December 2007, the HSBC (Household) Employee Benefit Trust 2003 held 1,856,417 HSBC Holdings ordinary shares and 196,455 American Depositary Shares, each of which represents fiveHSBC Holdings ordinary shares, which may be used to satisfy the exercise of employee share options.
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HSBC Finance: 1996 Long-Term Executive Incentive Compensation PlanHSBC Holdings ordinary shares of US$0.50
HSBC Finance: 1996 Long-Term Executive Incentive Compensation Plan 1HSBC Holdings ordinary shares of US$0.50
Beneficial Corporation: 1990 Non-Qualified Stock Option PlanHSBC Holdings ordinary shares of US$0.50
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Beneficial Corporation: BenShares Equity Participation PlanHSBC Holdings ordinary shares of US$0.50
Renaissance Holdings, Inc: Amended and Restated 1997 Incentive PlanHSBC Holdings ordinary shares of US$0.50
Bank of Bermuda
Following the acquisition of Bank of Bermuda in 2004, all outstanding options over Bank of Bermuda shares were converted into rights to receive HSBC Holdings ordinary shares based on the consideration of US$40 for each Bank of Bermuda share and the average closing price of HSBC Holdings ordinary shares, derived from the London Stock Exchange Daily Official List, for the five business days preceding the closing date of the acquisition. No
further options will be granted under any of these plans.
All outstanding options over Bank of Bermuda shares vested on completion of the acquisition. The following are details of options to acquire shares in HSBC Holdings. At 31 December 2007, the HSBC (Bank of Bermuda) Employee Benefit Trust 2004 held 1,889,903 HSBC Holdings ordinary shares which may be used to satisfy the exercise of these options.
Bank of Bermuda: Executive Share Option Plan 1997HSBC Holdings ordinary shares of US$0.50
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Bank of Bermuda: Share Option Plan 2000HSBC Holdings ordinary shares of US$0.50
Bank of Bermuda: Directors’ Share Option PlanHSBC Holdings ordinary shares of US$0.50
Employee compensation and benefits
Note 9 on the Financial Statements gives details about employee compensation and benefits including pension plans.
Set out below is information in respect of the five individuals (including a Director of HSBC Holdings) whose emoluments were the highest in HSBC for the year ended 31 December 2007.
Their emoluments are within the following bands:
The aggregate remuneration of Directors and Senior Management for the year ended 31 December 2007 was US$92,586,000.
The aggregate amount set aside or accrued to provide pension, retirement or similar benefits for Directors and Senior Management for the year ended 31 December 2007 was US$2,027,455.
Executive Directors and members of Senior Management are generally subject to notice periods of up to 12 months and a normal retirement age of 65.
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Corporate sustainability is the term used at HSBC to describe the Group’s approach to meeting a wide range of non-financial responsibilities which, although not generally enshrined as legal or regulatory requirements, constitute business practices expected of the Group by its stakeholders, including shareholders, customers and employees. Insofar as these expectations concern HSBC’s impact on the long-term environmental, social and economic well-being of the world at large, corporate sustainability influences the Group’s response to encouraging sustainable development. Previously, HSBC described these activities under the heading, ‘Corporate responsibility’.
HSBC seeks to meet society’s expectations by managing all aspects of its business ethically, responsibly and in an increasingly sustainable way. The Group’s key business values include a commitment to the highest personal standards of integrity at all levels, including honesty, transparency and fair dealing in all its business activities. In recent years HSBC has intensified its efforts to embed sustainability into the way it manages risk and business development opportunities. This acknowledges that HSBC’s continuing financial success depends, in part, on its ability to identify and address non-financial considerations which are material to the business.
Recognising that HSBC’s core financial services businesses have the potential to exert the most influence over sustainability issues, a Group Corporate Sustainability unit was formed in 2007 to work closely with individuals and businesses in all customer groups to help them to manage sustainability risks and to pursue opportunities in environmental markets worldwide.
Group Corporate Sustainability acts as a focal point for the management of HSBC’s environmental and social initiatives. Environmental initiatives are directed primarily to issues arising from climate change, including its effect on energy production and usage, water management and biodiversity. Social initiatives are centred on community action to promote education as a lasting way of alleviating poverty. The Group Corporate Sustainability unit allows HSBC to join up its business development, risk management, business operations, community investment and reporting activities. The unit also works closely with Group Marketing to further embed sustainability into the brand; with Group Communications to ensure that sustainability
initiatives are communicated to internal and external audiences; and with Group Human Resources to integrate this area into employee engagement and talent management strategies. The unit reports directly to the Group Chairman.
HSBC aims for consistency in the implementation of its sustainability strategy across all Group businesses, and has identified four themes as relevant to its response to the United NationsMillennium Development Goals of resisting climate change, achieving water availability, protecting biodiversity and alleviating poverty. These themes are risk management (policies and processes); business development; operations (buildings, travel, suppliers and IT); and community investment (education and environment).
The Group’s Sustainable Risk Management Unit has published policies laying down minimum standards for lending and investment covering relationships with clients in energy, forest land and products, freshwater infrastructure, mining and metals and the chemicals industry. Each policy focuses on how HSBC’s involvement in these environmentally sensitive industries can contribute to sustainable development.
In recognition of its leadership in building responsible practices into the way it does business, HSBC moved from 7th to 4th in the Accountability Rating prepared by Accountability. HSBC continued to earn a high score of 95 and a triple-A rating in the Carbon Disclosure Project, a climate change index ranking FT500 corporations.
In 2005, HSBC was the first major banking organisation in the world to become carbon neutral. HSBC remains committed to reducing its own carbon emissions and helping to bring about alow-carbon economy.
HSBC created a Climate Change Centre of Excellence in 2007. The Centre’s goal is to evaluate the implications of climate change for the HSBC Group, its Global Research division and relevant businesses. The Centre is HSBC’s central source of climate knowledge, translating a wide range of expertise – from academic studies, think tanks and government regulations – into business opportunities for the bank and its clients. The Centre works closely with HSBC’s Global Research sector heads and analysts on integrating the financial implications of climate change and relevant government regulations into their sectoral research. It also supports the implementation of HSBC’s Carbon Finance Strategy, announced in June 2006, and advises a range of HSBC businesses for which climate change is increasingly important.
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In 2007, HSBC appointed Lord Stern, the renowned academic and former World Bank Chief Economist, as Special Adviser to the Chairman on Economic Development and Climate Change. Lord Stern is responsible for advising HSBC on economic development issues and the implications of climate change on the Group and its clients. His role includes:
Community involvement
HSBC has a longstanding commitment to supporting the communities in which it operates. In 2006, for example, the HSBC Global Education Trust launched ‘Future First’, a five-year programme designed to help street children, children in care and orphans. HSBC’s operations around the world collaborate with local charitable organisations to make a lasting and beneficial difference by supporting projects that bring these children into the mainstream of society. The programme complements HSBC’s sustainable business development focus on poverty, for which a microfinance strategy was developed during 2006. To date, US$2 million has been allocated to 80 projects in 30 countries. These projects will benefit 37,000 children.
In May 2007, the Group Chairman launched the HSBC Climate Partnership, committing US$100 million over five years to fund the work of The Climate Group, Earthwatch Institute,Smithsonian Tropical Research Institute and WWF to inspire action by individuals, businesses and governments around the world on the challenge of climate change. The HSBC Climate Partnership, which will strengthen the Group’s leadership position and help HSBC employees to use their business skills and climate change knowledge to build a more sustainable future, represents one of the largest single corporate donations to each of the charity partners and one of the largest employee engagement programmes by any organisation on climate change.
HSBC participated in the Prince of Wales’ Accounting for Sustainability Project, which seeks to develop systems to help public and private sector organisations account more accurately for the wider social and environmental costs of their activities.
The maintenance of appropriate health and safety standards throughout HSBC remains a key responsibility of all managers and HSBC is committed to managing actively all health and safety risks associated with its business. HSBC’s objectives are to identify, remove, reduce or control material risks of fires and of accidents or injuries to employees and visitors.
Health and Safety Policies, Group standards and procedures are set by Group Corporate Real Estate and are implemented by Health, Safety and Fire Co-ordinators based in each country in which HSBC operates.
Despite the considerable international pressure on terrorist networks over the past few years, the global threat from terrorism persists. HSBC remains committed to maintaining its preparedness and to ensuring the highest standards of health and safety wherever in the world it operates.
Group Security provides regular risk assessments in areas of increased risk to assist management in judging the level of terrorist threat. In addition, Regional Security functions conduct regular security reviews to ensure measures to protect HSBC staff, buildings, assets and information are appropriate for the level of threat.
Supplier payment policy
HSBC Holdings subscribes to the Better Payment Practice Code for all suppliers, the four principles of which are: to agree payment terms at the outset and stick to them; to explain payment procedures to suppliers; to pay bills in accordance with any contract agreed with the supplier or as required by law; and to tell suppliers without delay when an invoice is contested and settle disputes quickly.
Copies of, and information about, the Code are available from: BERR Publications Orderline, Admail 528, London SW1W 8YT; and the internet at www.payontime.co.uk/downloads/DTI_BPP_ brochure.pdf
It is HSBC Holdings’ practice to organise payment to its suppliers through a central accounts function operated by its subsidiary, HSBC Bank. Included in the balance with HSBC Bank is the amount due to trade creditors which, at 31 December
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2007, represented 22 days’ average daily purchases of goods and services received from such creditors, calculated in accordance with the Companies Act 1985, as amended by Statutory Instrument 1997/571.
Donations
During the year, HSBC made charitable donations totalling US$101 million (2006: US$86.3 million). Of this amount, US$36.8 million (2006: US$32.8 million) was given for charitable purposes in the UK. No political donations were made during the year.
At the Annual General Meeting in 2007, shareholders renewed the authorities for HSBC Holdings and HSBC Bank to make EU political donations and incur EU political expenditure up to a maximum aggregate sum of £250,000 and £50,000 respectively as a precautionary measure in light of the wide definitions in The Political Parties, Elections and Referendums Act 2000. These authorities have not been used and will expire on the conclusion of the Annual General Meeting to be held in 2008.
Sustainability reporting
HSBC reports on its progress towards meeting the Group’s environmental reduction targets and provides information for stakeholders in the annual HSBC Sustainability Report (previously called the Corporate Responsibility Report). The contents of the report are informed by feedback from stakeholder engagement forums, and are prepared using the Global Reporting Initiative guidelines. The report is verified by an external assurance provider to demonstrate to stakeholders that the information disclosed in the report is complete and covers material aspects of HSBC’s business. The HSBC Sustainability Report 2007 will be available at www.hsbc.com/sustainabilityreport from June 2008.
Dividends for 2007
First, second and third interim dividends for 2007, each of US$0.17 per ordinary share, were paid on 5 July 2007, 4 October 2007 and 16 January 2008 respectively. Note 12 on the Financial Statements gives more information on the dividends declared in 2007. On 3 March 2008, the Directors declared a fourth interim dividend for 2007 of US$0.39 per ordinary share in lieu of a final dividend, which will be payable on 7 May 2008 in cash in US dollars, or in sterling or Hong Kong dollars at exchange rates to be determined on 28 April 2008, with a scrip dividend alternative. As the fourth interim dividend
for 2007 was declared after the balance sheet date it has not been included as a creditor at 31 December 2007. The reserves available for distribution at 31 December 2007 are US$15,551 million.
A quarterly dividend of US$15.50 per 6.20 per cent non-cumulative US dollar preference share, Series A (‘Series A dollar preference share’), equivalent to a dividend of US$0.3875 per Series A American Depositary Share, each of which represents one-fortieth of a Series A dollar preference share, was paid on 15 March, 15 June, 17 September and 17 December 2007.
Dividends for 2008
The proposed timetable for interim dividends in respect of 2008 on the ordinary shares of US$0.50 is set out in the Shareholder Information section on page 454.
A quarterly dividend of US$15.50 per Series A dollar preference share (equivalent to a dividend of US$0.3875 per Series A American Depositary Share, each of which represents one -fortieth of a Series A dollar preference share) was declared on 13 February 2008 for payment on 17 March 2008.
Communication with shareholders
Communication with shareholders is given high priority. Extensive information about HSBC’s activities is provided in the Annual Report and Accounts , Annual Review and the Interim Report which are sent to shareholders and are available on www.hsbc.com. There is regular dialogue with institutional investors and enquiries from individuals on matters relating to their shareholdings and the business of HSBC are welcomed and are dealt with in an informative and timely manner. All shareholders are encouraged to attend the Annual General Meeting or the informal meeting of shareholders held in Hong Kong to discuss the progress of HSBC.
Notifiable interests in share capital
As at 3 March 2008, the following disclosures of major holdings of voting rights have been made to the Company pursuant to the requirements of the Financial Services Authority Disclosure and Transparency Rule 5:
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There are no notifiable interests in the equity share capital recorded in the register maintained under section 336 of the Securities and Futures Ordinance of Hong Kong.
In compliance with the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited at least 25 per cent of the total issued share capital of HSBC Holdings has been held by the public at all times during 2007 and up to the date of this Report.
Dealings in HSBC Holdings shares
Except for dealings as intermediaries by HSBC Bank, HSBC Financial Products (France) and The Hongkong and Shanghai Banking Corporation, which are members of a European Economic Area exchange, neither HSBC Holdings nor any subsidiary has bought, sold or redeemed any securities of HSBC Holdings during the year ended 31 December 2007.
The Annual General Meeting of HSBC Holdings will be held at the Barbican Hall, Barbican Centre, London EC2 on 30 May 2008 at 11.00am.
An informal meeting of shareholders will be held at Level 28, 1 Queen’s Road Central, Hong Kong on Tuesday 27 May 2008 at 4.30pm.
Resolutions to receive the Annual Report and Accounts , approve the Directors’ Remuneration Report, re-elect Directors and reappoint KPMG Audit Plc as Auditor will be submitted to the Annual General Meeting. KPMG Audit Plc has expressed its willingness to continue in office and the Group Audit Committee and the Board have recommended that KPMG Audit Plc be reappointed. Resolutions will also be submitted to the Annual General Meeting to renew the authorities for the allotment of shares, the disapplication of pre-emption rights and the purchase of ordinary shares. In addition, resolutions will be proposed to amend The HSBC Share Plan and to seek approval for changes to the Articles of Association.
A live webcast of the Annual General Meeting will be available on www.hsbc.com. From shortly after the conclusion of the Meeting until 30 June 2008 a recording of the proceedings will be available on www.hsbc.com.
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The Remuneration Committee meets regularly to consider human resource issues, particularly terms and conditions of employment, remuneration and retirement benefits. Within the authority delegated by the Board, the Committee is responsible for approving the remuneration policy of HSBC including the terms of bonus plans, share plans and other long-term incentive plans and for agreeing the individual remuneration packages of executive Directors and other senior Group employees. No Directors are involved in deciding their own remuneration.
Following each meeting the Committee reports to the Board on its activities. The terms of reference of the Committee are available at www.hsbc.com/boardcommittees.
The members of the Remuneration Committee throughout 2007 were Sir Mark Moody-Stuart (Chairman) and J D Coombe. At the conclusion of the Annual General Meeting on 25 May 2007 W K L Fung and S Hintze retired as members of the Committee and G Morgan became a member of the Committee.
There were eight meetings of the Remuneration Committee during 2007. The table on page 296 gives details of Directors’ attendance at these meetings.
In July 2007, following a competitive tender process, Mercer Limited, a firm of specialist human resources consultants, was appointed by the
Committee to provide independent advice on executive remuneration issues. As a global firm, Mercer also provides other remuneration consulting services to various parts of HSBC. Towers Perrin continues to provide remuneration data to the Remuneration Committee. Other consultants are used from time to time to advise on specific issues. During the year the Group Chief Executive provided regular briefings to the Remuneration Committee. The Committee received advice from the Group General Manager, Human Resources, being P Boyles until June 2007 and thereafter A Almeida, and the Head of Group Performance and Reward, J Beadle.
In carrying out its responsibilities, the Remuneration Committee applies the following key principles:
The Committee also considers corporate performance on environmental, social and governance factors when determining the executive Directors’ remuneration. In addition, the Remuneration Committee has oversight that the incentive structure for senior management does not raise environmental, social and governance risks by inadvertently motivating irresponsible behaviour.
Proposed changes to remuneration arrangements from 2008
In July 2007, the Remuneration Committee requested that Mercer conduct a comprehensive assessment of the remuneration arrangements of the executive Directors and other senior executives. The objective was to ensure close alignment with HSBC’s business strategy, taking into account competitive market practice.
As part of this review, the Committee updated the remuneration comparator group to reflect more accurately the market in which the Company
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competes for executive talent. This group will comprise nine global financial services companies, namely Banco Santander, Bank of America, Barclays, BNP Paribas, Citigroup, Deutsche Bank, Royal Bank of Scotland, Standard Chartered and UBS. These companies were selected on the basis of their broadly similar business coverage, size and international scope.
While in general HSBC salaries for executive Directors were in the upper quartile of this comparator group, total cash (base salary and bonus) and total compensation (base salary, cash bonus and the expected value of long-term incentive awards) were generally at the lower quartile.
The Committee concluded that while the overall remuneration principles described above remain appropriate, the remuneration strategy should be refined by targeting base salary at the market median of the comparator group, while providing an opportunity for top quartile total compensation for higher levels of performance. At the same time, a greater proportion of total compensation will be share based, and shareholding requirements will be increased.
This proposed policy would generally apply to all executive Directors from 2008 onwards. Under
the proposed arrangements, the performance-related proportion of the remuneration package will increase with the performance-related elements making up around 80 per cent of the remuneration package. Under the current arrangements, the performance-related proportion of the remuneration package is typically around 70 per cent of total compensation.
The arrangements for S T Gulliver, who has been appointed a Director with effect from 1 May 2008, will reflect the market practice in the Global Banking and Markets sector where a greater performance-related element is typical.
The net effect of these changes would mean, for example, that the Group Chief Executive’s total compensation, on an expected value basis, would be at market median of the comparator group, but with a significantly higher proportion of share-based compensation than the group.
As part of the Company’s on-going commitment to shareholder engagement, the largest institutional shareholders, representing approximately 50 per cent of the share capital of HSBC Holdings, the Association of British Insurers and the National Association of Pension Funds, are being consulted on these proposals. The planned implementation of these changes will be as follows:
As stated above, in 2008, in view of the current competitive positioning of base salaries, the Remuneration Committee will not increase base salaries for the executive Directors in place at the end of 2007.
The base salaries for executive Directors appointed to the Board after the 2007 financial year will be set in light of the overall remuneration principles set out above.
Any future salary increases will be considered in the light of the remuneration strategy, which targets base salary at market median, and the market data from the remuneration comparator group.
A similar approach has been adopted for other senior executives across the Group.
From the 2008 performance year, objectives will be set and assessed using a ‘balanced scorecard’. This will include financial and non-financial performance measures, with an emphasis on tangible, measurable targets to ensure the appropriate alignment with HSBC’s strategy in the assessment of annual bonus
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awards. Example measures for the Group Chief Executive are set out below:
The Committee intends to provide significantly greater transparency in subsequent Reports regarding both the performance measures and the achievement against performance targets, together with a commentary on the resulting levels of bonus awards.
Long-term incentive plan
The long-term incentive plan (‘LTIP’) was last reviewed in 2005 when, with the adoption of The HSBC Share Plan, a growth in earnings per share measure (‘EPS’) was introduced alongside Total Shareholder Return (‘TSR’) relative to a peer group of 28 banks.
The Committee is proposing changes to the performance measures and vesting conditions of the long-term incentive awards of Performance Shares under The HSBC Share Plan, the details of which will be described in the circular containing the Notice of the 2008 Annual General Meeting, which is expected to be sent to shareholders in April 2008, and submitted to shareholder vote at that Meeting.
Awards will be granted to executive Directors and other senior executives shortly after the Meeting. These will be made under the amended Plan subject to the proposed changes to the Plan receiving shareholder approval.
Current arrangements
Salary
The Committee reviews salary levels for executive Directors each year.
As described above, the Remuneration Committee will not increase base salaries for current executive Directors in 2008.
Annual cash bonus
The annual cash bonus for executive Directors is based upon individual performance as well as performance measured against a number of key financial targets for the Group, including financial (e.g. revenue growth, economic profit and cost efficiency). Annual bonus payments are not pensionable.
The Committee took into account the Group’s absolute performance and relative performance compared to its peers in a challenging operating environment, in setting the overall bonus payment levels.
There were significant increases in profit before tax, earnings per share and improvements in cost efficiencies during 2007. During that year management moved effectively to resolve the issues identified in late 2006 in the United States in relation to consumer lending, and to anticipate and respond to the sector-wide liquidity crisis.
On this basis, the Remuneration Committee approved annual bonus payments for the following executive Directors in 2008 in respect of 2007 performance (payments made in 2007 in respect of 2006 performance are shown for reference):
Chairman’s variable compensation
The Committee has determined, at the request of the Chairman, that future variable compensation payments to the Chairman will be delivered exclusively through Performance Share awards given the key focus of the role of the Chairman in the formation and management of Group strategy.
The Remuneration Committee approved an annual bonus payment for the Chairman for 2008, in respect of 2007 performance, that was unchanged from the prior performance year as indicated in the table below (the payment made in 2007 in respect of 2006 performance is shown for reference):
Under The HSBC Share Plan, executive Directors, as with other participants in the Plan, are eligible to receive awards of Performance Shares with a face value at grant of up to a maximum of seven times
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salary. The individual awards received in any one year are based on market competitive information and individual performance. The face and expected
values of individual awards made in 2007 are set out in the table below (awards made in 2006 are shown for reference).
Vesting of the awards is subject to the performance conditions described in the next section being met. Shares released will include additional shares equivalent to the value of thedividends payable on the vested shares over the performance period.
Arrangements from 2005 to 2007
Vesting of the awards of Performance Shares under The HSBC Share Plan is based on two independent measures, relative TSR and growth in EPS. The performance conditions are measured over a three-year performance period and awards forfeited to the extent that they have not been met. The vesting of 50 per cent of the awards is based on TSR and the remaining 50 per cent on growth in EPS.
The comparator group of 28 banks for the TSR award comprises the largest banks in the world, on the basis of their market capitalisation, their geographic spread and the nature of their activities:
The extent to which the TSR award will vest will be determined on a sliding scale based on
HSBC’s relative TSR ranking, measured over the three years, against the comparator group as shown below:
The method for calculating EPS growth has been summarised in narrative form in the 2005 and 2006 Directors’ Remuneration Reports, as well as in the circular containing the Notice of Annual General Meeting for 2005.
This year’s Report sets out more information (including a graph and an example) on the method of calculation of EPS growth in light of some questions from shareholders on the operation of this element. The Committee regrets if there has been any misunderstanding, but wishes to reassure shareholders that the method of calculation, which is set out in the rules of The HSBC Share Plan, has remained unchanged since the Plan was adopted. Further, before introducing the Plan in 2005, the Committee consulted extensively with major shareholders and their representative bodies in line with best practice, and the rules of the Plan including worked examples of the EPS calculation were available for inspection at the time.
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The percentage of the conditional award vesting will depend upon the absolute growth in EPS achieved over the three years (‘the performance period’). 30 per cent of the conditional shares will vest if the incremental EPS over the performance period is 24 per cent or more of EPS in the base year. The percentage of shares vesting will rise on a straight line proportionate basis to 100 per cent if HSBC’s incremental EPS over the performance period is 52 per cent or more of EPS in the base year. In the interests of clarity, this has been set out in graphical form in the chart below.
For the EPS element of the award, the base measure shall be EPS for the financial year preceding that in which the award is made (‘the base year’). Absolute growth in EPS will then be compared with the base year over three consecutive financial years commencing with the year in which the award is made. Incremental EPS will be calculated by expressing as a percentage of the EPS of the base year the difference each year of the three-year performance period between the EPS of that year and the EPS of the base year. These percentages will then be aggregated to arrive at the total incremental EPS for the performance period. As illustrated in the table below, an incremental EPS of 51 per cent over three years would equate to a compound annual growth rate of 8 per cent.
Illustration of incremental EPS of 51 per cent over three years.
If EPS in any of the Years 1, 2 or 3 is below the base year, then the percentage difference between that particular year and the base year is negative.
For this purpose, EPS means the profit attributable to the Shareholders (expressed in US dollars), excluding goodwill amortisation, divided by the weighted average number of Ordinary Shares in issue and held outside the Group during
the year in question. In the event that the published EPS for the base year is restated during the performance period to adjust for changes in accounting standards, that restated EPS will be used for the purposes of the EPS performance condition.
In addition, awards will not vest unless the Remuneration Committee is satisfied that HSBC Holdings’ financial performance has shown a sustained improvement in the period since the award date. In determining whether HSBC Holdings has achieved a sustained improvement in performance the Remuneration Committee will take account of all relevant factors but in particular comparisons against the comparator group in areas such as revenue growth and mix, cost efficiency, credit performance, cash return on cash invested, dividend performance and TSR.
If events occur which cause the Remuneration Committee to consider that a performance condition has become unfair or impractical in either direction, the right is reserved to the Remuneration Committee, if it considers it appropriate to do so, to amend, relax or waive the condition.
Awards will vest in full immediately in cases of death. In the event of redundancy, retirement on grounds of injury or ill health, early retirement by agreement, normal retirement and where a participant ceases to be employed by HSBC due to a company ceasing to be part of HSBC, awards will normally vest at the end of the vesting period on a time-apportioned basis to the extent that the TSR and EPS performance conditions have been satisfied. In the event of a change of control, awards will normally vest immediately and on a time-apportioned basis to the extent that the TSR performance condition has been satisfied. Awards will normally be forfeited if the participant is dismissed for cause or resigns from HSBC. In all these circumstances the Committee retains discretion to ensure fair and reasonable treatment.
Arrangements from 2002 to 2004
Between 2002 and 2004, awards of Performance Shares were made under the HSBC Holdings Restricted Share Plan 2000. Vesting was based on HSBC’s relative TSR performance over a three-year period from the date of the award, with full vesting of awards and transfer of shares to participants being no earlier than the fifth anniversary of the date of award.
The initial performance period was three years from the date of award. Prior to 2004, awards were subject to re-testing on the fourth
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and fifth anniversaries of the date of award if the performance target was not met at the third anniversary. The awards made in 2004 had a three-year performance period with no re-testing.
The table below describes the outcome of the performance tests for the 2002, 2003 and 2004 awards:
In addition to these performance conditions, none of the outstanding awards will vest unless the Remuneration Committee is satisfied that, during the performance period, HSBC Holdings has achieved sustained growth. The Remuneration Committee retains discretion to recommend early release of shares awarded in certain circumstances, for example, retirement, redundancy or ill health. When events occur which cause the Remuneration Committee to consider that the performance conditions have become unfair or impractical, the right is reserved for the Committee to amend or substitute the performance conditions.
The Company’s policy is to fund long-term incentive awards of Performance Shares and Restricted Shares under The HSBC Share Plan through employee benefit trusts which undertake market purchases of HSBC Holdings’ shares. The dilution limits set out in the HSBC share plans comply with the Association of British Insurers’ guidelines.
The graphs below show how HSBC has performed against the benchmark TSR used to determine vesting for the 2004 Performance Share awards and the FTSE 100 Index.
Graph 1: HSBC TSR and Benchmark TSR
Graph 2: HSBC TSR and FTSE 100 Index
Pursuant to the Directors’ Remuneration Report Regulations 2002, Graph 2 shows HSBC’s TSR performance against the FTSE 100 Index, for the five-year period ended 31 December 2007. The FTSE 100 has been chosen as this is a recognised broad equity market index of which HSBC Holdings is a member.
The normal retirement age for executive Directors is 65. The pension entitlements earned by the executive Directors during the year are set out on page 330.
In line with a focus on highly leveraged variable pay, HSBC operates a formal share ownership policy, expressed as a number of shares, for the executive Directors and the Group Managing Directors. The Committee believes that material levels of share ownership by executives create a community of interest between the leadership team and shareholder. The executive Directors and Group Managing Directors are therefore required to build and retain the following shareholdings:
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Under the guidelines, the shareholding is expected to be achieved within five years of the executive’s appointment or three years from the date of approval of the guidelines (May 2007), whichever is the later. All executive Directors and the majority of Group Managing Directors exceed the required shareholding. The Remuneration Committee will monitor compliance annually prior to approving any awards or vesting of Performance Shares. The Remuneration Committee will have full discretion in determining any penalties in case of non-compliance, which could include: a reduction of future awards of long-term incentives and/or an increase in the proportion of the annual bonus that is deferred into shares. Increases in the expected level of share ownership will be introduced as part of the refinements to reward strategy and structure from 2008 discussed above.
Service contracts
HSBC’s policy is to employ executive Directors on one-year rolling contracts although longer initial terms may be approved by the Remuneration Committee if considered appropriate. The Remuneration Committee will, consistent with the best interests of the Group, seek to minimise termination payments.
S K Green, M F Geoghegan and D J Flint have rolling service contracts with a notice period of 12 months for either party save that D J Flint’s contract provides for nine months’ notice to be given by Mr Flint.
In the event of early termination of employment of S K Green, M F Geoghegan, or D J Flint, other than for cause, HSBC is entitled to make a payment in lieu of notice equal in the case of D J Flint, to base salary and pension entitlement and in the case of S K Green and M F Geoghegan to base salary, pension entitlements and other benefits.
In addition, on termination of employment by HSBC, other than for cause (or termination by either party within 12 months following a change of control), S K Green and M F Geoghegan will be eligible for a bonus calculated as not less than the
average of the previous two years of bonus payments received, pro-rated for any part year worked to termination.
The dates of executive Directors’ service contracts are as follows:
Other directorships
Executive Directors, if so authorised by either the Nomination Committee or the Board, may accept appointments as non-executive directors of suitable companies which are not part of HSBC. Approval will not be given for executive Directors to accept a non-executive directorship of more than one FTSE 100 company. When considering a non-executive appointment, the Nomination Committee or Board will take into account the expected time commitment of such appointment. The time commitment for executive Directors’ external appointments will be reviewed as part of the annual Board review. Any remuneration receivable in respect of an external appointment is normally paid to HSBC, unless otherwise approved by the Remuneration Committee. D J Flint does not retain his fees as a non-executive Director of BP p.l.c.
Non-executive Directors are appointed for fixed terms not exceeding three years, subject to their re-election by shareholders at Annual General Meetings. Non-executive directors have no service contract and are not eligible to participate in HSBC’s share plans. Current non-executive Directors’ terms of appointment will expire as follows: in 2008, Lord Butler, Baroness Dunn and Sir Brian Moffat; in 2009, W K L Fung, S W Newton, S M Robertson and Sir Brian Williamson; in 2010, R A Fairhead, Sir Mark Moody-Stuart and G Morgan; and in 2011, J D Coombe, J L Dúran, J W J Hughes-Hallett and W S H Laidlaw. S A Catz and N R N Murthy were appointed non-executive Directors with effect from 1 May 2008. Subject to their re-election by shareholders at the Annual General Meeting in 2008, their terms of appointment will expire in 2011.
Fees
Non-executive Directors’ fees are regularly reviewed and compared with other large international companies. The current fee, which was approved by shareholders in 2006, is £65,000 per annum.
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A fee of £30,000 per annum is payable to the senior independent non-executive Director. In addition, non-executive Directors receive the following fees for service on Board Committees:
During 2007, seven meetings of the Group Audit Committee were held.
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S K Green is entitled to receive benefits from an Employer-Funded Retirement Benefits Scheme (EFRBS). The benefits to which he is entitled from the HSBC Bank (UK) Pension Scheme but in respect of which he ceased membership on 5 April 2006, will be calculated based on completed service to the date of opting out and on pensionable salary calculated at the date employment with HSBC Holdings ceases. The intention of this arrangement is to provide benefits to Mr Green that would be broadly comparable to an accrual rate of one-
thirtieth of pensionable salary for each year of pensionable service.
For M F Geoghegan an employer contribution was made to the HSBC Asia Holdings Pension Plan in respect of 2007 of £225,000 (2006: £215,000) arising entirely from a bonus sacrifice. There were no other employer contributions made to this plan. Mr Geoghegan receives an executive allowance of 50 per cent of annual basic salary to fund personal pension arrangements.
D J Flint receives an executive allowance of 55 per cent of annual basic salary to fund personal pension arrangements.
The following unfunded pension payments, in respect of which provision has been made, were made during 2007 to five former Directors of HSBC Holdings:
The payments in respect of R Delbridge and Sir Brian Pearse were made by HSBC Bank plc as former Directors of that bank. The payment in respect of C F W de Croisset was made by HSBC France as a former Director of that bank.
At 31 December 2007, the undernamed Directors held Performance Share awards and options to acquire the number of HSBC Holdings ordinary shares set against their respective names.
The options under the HSBC Holdings Savings-Related Share Option Plan were awarded for nil consideration and are exercisable at a 20 per cent discount to the average market value of the ordinary shares on the five business days immediately preceding the invitation date. Under the Securities and Futures Ordinance of Hong Kong the options are categorised as ‘unlisted physically settled equity derivatives’. No options lapsed during the year and except as otherwise indicated, no options were awarded or exercised during the year. There are no performance criteria conditional upon which the outstanding options are exercisable.
The market value of the ordinary shares at 31 December 2007 was £8.42. The highest and lowest market values during the year were £9.64 and £8.03. Market value is the mid-market price derived from the London Stock Exchange Daily Official List on the relevant date.
Under the Securities and Futures Ordinance of Hong Kong, Performance Share awards under The HSBC Share Plan and the HSBC Holdings Restricted Share Plan 2000 are categorised as ‘the interests of a beneficiary of a Trust’.
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Vesting of these Performance Share awards is subject to the attainment of predetermined TSR targets over a three-year period from the date of the award. Full vesting and transfer of the shares will not generally occur until the fifth anniversary of the date of award. A benchmark for HSBC Holdings’ TSR, weighted by market capitalisation, was established which takes account of the TSR performance of: (1) a peer group of nine banks weighted by market capitalisation which were considered most relevant to HSBC in terms of size and internationalscope. For performance periods up to and including the one beginning in 2003, this group comprised ABN AMRO Holding N.V., The Bank of East Asia, Limited, Citigroup Inc., Deutsche Bank AG, JPMorgan Chase & Co., Lloyds TSB Group plc, Mitsubishi Tokyo Financial Group Inc., Oversea-Chinese Banking Corporation Limited and Standard Chartered PLC. To be more relevant to HSBC in terms of size and international scope, this peer group was amended for conditional awards made in 2004 by the replacement of Lloyds TSB Group plc,
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The following statement, which should be read in conjunction with the Auditors’ statement of their responsibilities set out in their report on pages 334 and 335, is made with a view to distinguishing for shareholders the respective responsibilities of the Directors and of the Auditors in relation to the financial statements.
The Directors are responsible for preparing the Annual Report, the consolidated financial statements of HSBC Holdings and its subsidiaries (the ‘Group’) and holding company financial statements for HSBC Holdings (the ‘parent company’) in accordance with applicable law and regulations.
Company law requires the Directors to prepare Group and parent company financial statements for each financial year. The Directors are required to prepare the Group financial statements in accordance with IFRSs as adopted by the EU and have elected to prepare the parent company financial statements on the same basis.
The Directors are also required to present additional information for US Shareholders. Accordingly these financial statements are framed to meet both UK and US requirements to give a consistent view to all shareholders.
The Group and parent company financial statements are required by law and IFRSs as adopted by the EU to present fairly the financial position of the Group and the parent company and the performance for that period; the Companies Act 1985 provides in relation to such financial statements that references in the relevant part of that Act to financial statements giving a true and fair view are references to their achieving a fair presentation. In addition, in order to meet certain US requirements, we are required to present our financial statements in accordance with IFRSs as adopted by the International Accounting Standards Board (‘IASB’). Currently, there are no differences in application to HSBC between IFRS endorsed by the EU and IFRS issued by the IASB.
In preparing each of the Group and parent company financial statements, the Directors are required to:
The Directors are required to prepare the financial statements on the going concern basis unless it is not appropriate. Since the Directors are satisfied that the Group has the resources to continue in business for the foreseeable future, the financial statements continue to be prepared on the going concern basis.
The Directors have responsibility for ensuring that sufficient accounting records are kept that disclose with reasonable accuracy at any time the financial position of the parent company and enable them to ensure that its financial statements comply with the Companies Act 1985.
The Directors have general responsibility for taking such steps as are reasonably open to them to safeguard the assets of the Group and to prevent and detect fraud and other irregularities.
Under applicable law and regulations, the Directors also have responsibility for preparing a Directors’ Report, Directors’ Remuneration Report and the Corporate Governance statement on pages 289 to 332 that comply with that law and those regulations.
The Directors have responsibility for the maintenance and integrity of the Annual Report and Accounts as they appear on the company’s website. Legislation in the UK governing the preparation and dissemination of financial statements may differ from legislation in other jurisdictions.
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We have audited the accompanying consolidated financial statements of HSBC Holdings plc and its subsidiary undertakings (together HSBC) on pages 337 to 452 which comprise the consolidated balance sheets as of 31 December 2007 and 2006, and the related consolidated income statements, consolidated cash flow statements and consolidated statements of recognized income and expense, for each of the years in the three-year period ended 31 December 2007, including the disclosures marked ‘audited’ within the critical accounting policies on pages 132 to 134, th e ‘Report of the Directors: The Management of Risk’ section on pages 192 to 288 and the ‘Off-balance sheet arrangements and special purpose entities’ section on pages 183 to 191. We have also audited HSBC’s internal control over financial reporting as of 31 December 2007, based on the framework for Directors’ internal control evaluation contained within the Combined Code (The Revised Turnbull Guidance), and the criteria established in Internal Control—Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). HSBC’s management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Assessment of Internal Controls. Our responsibility is to express an opinion on these consolidated financial statements and an opinion on the effectiveness of HSBC's internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the consolidated financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on assessed risk. Our audits also included performing other such procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of HSBC as of 31 December 2007 and 2006, and the results of their operations and their cash flows for each of the years in the three-year period ended 31 December 2007, in conformity with International Financial Reporting Standards (IFRSs) as adopted by the European Union (EU) and IFRSs as issued by the International Accounting Standards Board (IASB). Also in our opinion, HSBC maintained, in all material respects, effective internal control over financial reporting as of 31 December 2007, based on the framework for Directors’ internal control evaluation contained within the Combined Code (The Revised Turnbull Guidance) and the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
KPMG Audit PlcLondon, England3 March 2008
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For an explanation of the IFRSs transition adjustment at 1 January 2005, see Note 46 on the Financial Statements in the Annual Report and Accounts 2005.
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Adjustment to bring changes between opening and closing balance sheet amounts to average rates. This is not done on a line-by- line basis, as details cannot be determined without unreasonable expense.
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The accompanying notes on pages 344 to 452, the audited sections of the ‘Report of the Directors: The Management of Risk’ on pages 192 to 288, ‘Critical accounting policies’ on pages 132 to 134 and ‘Off-balance sheet arrangements and special purpose entities ’ on pages 183 to 191 form an integral part of these financial statements.
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HSBC Holdings statement of changes in total equity for the year ended 31 December 2007
The accompanying notes on pages 344 to 452, the audited sections of the ‘Report of the Directors: The Management of Risk’ on pa ges 192 to 288, ‘Critical accounting policies’ on pages 132 to 134 and ‘Off-balance sheet arrangements and special purpose entities ’ on pages 183 to 191 form an integral part of these financial statements.
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HSBC Holdings cash flow statement for the year ended 31 December 2007
The accompanying notes on pages 344 to 452, the audited sections of the ‘Report of the Directors: The Management of Risk’ on pages 192 to 288, ‘Critical accounting policies’ on pages 132 to 134 and ‘Off-balance sheet arrangements and special purpose entities’ on pages 183 to 191 form an integral part of these financial statements.
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For the purpose of the cash flow statement, cash and cash equivalents include highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of change in value. Such investments are normally those with less than three months’ maturity from the date of acquisition, and include cash and balances at central banks, treasury bills and other eligible bills, loans and advances to banks, items in the course of collection from or in transmission to other banks, and certificates of deposit.
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HSBC pension plans
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Restricted share awards under the Restricted Share plan were granted to eligible employees from 2000 to 2005, after taking into account the employees’ performance in the previous year, their potential and retention requirements. Restricted shares were also awarded as part-deferral of annual bonuses or for recruitment purposes. Shares were awarded without corporate performance conditions and generally vest between one and three years from the date of award, providing the employees have remained continuously employed by HSBC for the period.
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Options over HSBC France shares granted between 1994 and 1999 vested upon announcement of HSBC’s agreement to acquire HSBC France and were therefore included in the valuation of HSBC France.
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Derivatives are carried at fair value and shown in the balance sheet as separate totals of assets and liabilities. Asset values represent the cost to HSBC of replacing all transactions with a fair value in HSBC’s favour assuming that all HSBC’s relevant counterparties default at the same time, and that transactions can be replaced instantaneously. Liability values represent the cost to HSBC’s counterparties of replacing all their transactions with HSBC with a fair value in their favour if HSBC were to default. Derivative assets and liabilities on different transactions are only set off if the transactions are with the same counterparty, a legal right of set-off exists and the cash flows are intended to be settled on a net basis.
HSBC transacts derivatives for three primary purposes: to create risk management solutions for clients, for proprietary trading purposes, and to manage and hedge HSBC’s own risks. Derivatives (except for derivatives which are designated as effective hedging instruments as defined in IAS 39) are held for trading. The held for trading classification includes two types of derivatives: those used in sales and trading activities, and those used for risk
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management purposes but which for various reasons do not meet the qualifying criteria for hedge accounting. The second category includes derivatives managed in conjunction with financial instruments designated at fair value. These activities are described more fully below.
HSBC’s derivative activities give rise to significant open positions in portfolios of derivatives. These positions are managed constantly to ensure that they remain within acceptable risk levels, with matching deals being utilised to achieve this where necessary. When entering into derivative transactions, HSBC employs the same credit risk management procedures to assess and approve potential credit exposures that are used for traditional lending.
Derivative assets with a carrying amount of US$123,041 million or 65.5 per cent of the total carrying amount (2006: US$67,628 million; 65.2 per cent) are held with banking counterparties, and US$46,789 million or 24.9 per cent of the total carrying amount (2006: US$26,811 million; 25.9 per cent) with other financial institutions. The remainder are held with government and other counterparties.
Most of HSBC’s derivative transactions relate to sales and trading activities. Sales activities include the structuring and marketing of derivative products to customers to enable them to take, transfer, modify or reduce current or expected risks. Trading activities in derivatives are entered into principally for the purpose of generating profits from short-term fluctuations in price or margin. Positions may be traded actively or be held over a period of time to benefit from expected changes in exchange rates, interest rates, equity prices or other market parameters. Trading includes market-making, positioning and arbitrage activities. Market-making entails quoting bid and offer prices to other market participants for the purpose of generating revenues based on spread and volume; positioning means managing market risk positions in the expectation of benefiting from favourable movements in prices, rates or indices; arbitrage involves identifying and profiting from price differentials between markets and products.
As mentioned above, other derivatives classified as held for trading include non-qualifying hedging derivatives, ineffective hedging derivatives and the components of hedging derivatives that are excluded from assessing hedge effectiveness. Non-qualifying hedging derivatives are entered into for risk management purposes but do not meet the criteria for hedge accounting. These include derivatives managed in conjunction with financial instruments designated at fair value.
Gains and losses from changes in the fair value of derivatives that do not qualify for hedge accounting are reported in ‘Net trading income’, except for derivatives managed in conjunction with financial instruments designated at fair value, where gains and losses are reported in ‘Net income from financial instruments designated at fair value’, together with the gains and losses on the hedged items. Changes in the fair values of trading derivatives are inclusive of contractual interest. Changes in the fair value of derivatives managed in conjunction with financial instruments designated at fair value are included in ‘Net income from financial instruments designated at fair value’ inclusive of contractual interest unless the derivatives are managed with debt securities in issue, in which case the contractual interest is shown in interest payable with the interest payable on the issued debt. Substantially all of HSBC Holdings’ derivatives entered into with HSBC undertakings are managed in conjunction with financial liabilities designated at fair value.
HSBC trades credit derivatives through its principal dealing operations and acts as a principal counterparty to a broad range of users, structuring deals to produce risk management products for its customers, or making markets in certain
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products. Risk is typically controlled through entering into offsetting credit derivative contracts with other counterparties.
HSBC manages the credit risk arising on buying and selling credit derivative protection by including the related credit exposures within its overall credit limit structure for the relevant counterparty. Trading of credit derivatives is restricted to a small number of offices within the major centres which have the control infrastructure and market skills to manage effectively the credit risk inherent in the products.
Credit derivatives are also deployed to a limited extent for the risk management of the Group’s loan portfolios.
The contract amount of credit derivatives of US$1,893,802 million (2006: US$1,109,828 million) consisted of protection bought of US$926,794 million (2006: US$540,229 million) and protection sold of US$967,008 million (2006: US$569,599 million).
The difference between these notional amounts is attributable to HSBC selling protection on large, diversified, predominantly investment grade portfolios (including the most senior tranches) and then hedging these positions by buying protection on the more subordinated tranches of the same portfolios. In addition, HSBC uses securities to hedge certain derivative positions. Consequently, while there is a mismatch in notional amounts of credit derivatives bought and sold this should not be interpreted as representing the open risk position. The credit derivative business operates within the market risk management framework described from page 248.
Derivatives valued using models with unobservable inputs
The amount that has yet to be recognised in the consolidated income statement relating to the difference between the fair value at initial recognition (the transaction price) and the amount that would have arisen had valuation techniques used for subsequent measurement been applied at initial recognition, less subsequent releases, is as follows:
The accounting treatment of hedge transactions varies according to the nature of the instrument hedged and the type of hedge transactions. Derivatives may qualify as hedges for accounting purposes if they are fair value hedges, cash flow hedges, or investment hedges. These are described under the relevant headings below:
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The following table provides an analysis of the basis for valuing financial assets and financial liabilities measured at fair value in the consolidated financial statements:
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The above table discloses the nominal principal amounts of contingent liabilities, commitments and guarantees. They are mainly credit-related instruments which include both financial and non-financial guarantees and commitments to extend credit. Nominal principal amounts represent the amounts at risk should contracts be fully drawn upon and clients default. The amount of the loan commitments shown above reflects, where relevant, the expected level of take-up of pre-approved loan offers made by mailshots to personal customers. Since a significant portion of guarantees and commitments are expected to expire without being drawn upon, the total of the nominal principal amounts is not representative of future liquidity requirements.
HSBC provides guarantees and similar undertakings on behalf of both third party customers and other entities within the HSBC Group. These guarantees are generally provided in the normal course of HSBC’s banking business. The principal types of guarantees provided, and the maximum potential amount of future payments which HSBC could be required to make at 31 December 2007, were as follows:
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further terms. Lessees may participate in any sales proceeds achieved. Lease rentals arising during the lease terms will either be fixed in quantum or be varied to reflect changes in, for example, tax or interest rates. Rentals are calculated to recover the cost of assets less their residual value, and earn finance income.
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In addition, awards of punitive damages in actions brought in the US or elsewhere may be unenforceable in the UK. The enforceability of any judgement in the UK will depend on the particular facts of the case as well as the laws and treaties in effect at the time.
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US Investors may read and copy the reports, statements or information that HSBC Holdings files with the Securities and Exchange Commission at its public reference room in Washington, DC, which is located at 100 F Street, Room 1580, Washington, DC 20549. These documents will also be available at the Commission’s regional offices located at the Woolworth Building, 233 Broadway, New York, NY 10279 and at Citicorp Center, 500 West Madison Street, Suite 1400, Chicago, IL 60661. Investors should call the Commission at 1-800-SEC-0330 for further information on the operation of the public reference rooms. Investors can request copies of these documents upon payment of a duplicating fee, by writing to the Commission at 100 F Street, Mail Stop 5100, Washington, DC 50549. The Commission maintains an internet site (www.sec.gov) at which investors may view reports, proxy and information statements, and other information regarding issuers that file electronically with the Commission,
including HSBC Holdings. Investors may also obtain the reports and other information HSBC Holdings files at the offices of the New York Stock Exchange, Inc., 20 Broad Street, New York, NY 10005.
The following is a summary, under current law, of the principal UK tax considerations that are likely to be material to the ownership and disposition of shares. The summary does not purport to be a comprehensive description of all the tax considerations that may be relevant to a holder of shares. In particular, the summary deals principally with shareholders who are resident in the UK for UK tax purposes and only with holders who hold the shares as investments and who are the beneficial owners of the shares, and does not address the tax treatment of certain classes of holders such as dealers in securities. Holders and prospective purchasers should consult their own advisers regarding the tax consequences of an investment in shares in light of their particular circumstances, including the effect of any national, state or local laws.
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Currently no tax is withheld from dividends paid by HSBC Holdings. However, dividends are paid with an associated tax credit which is available for set-off by certain shareholders against any liability they may have to UK income tax. Currently, the associated tax credit is equivalent to 10 per cent of the combined cash dividend and tax credit, i.e. one-ninth of the cash dividend.
For individual shareholders who are resident in the UK for taxation purposes and liable to UK income tax at the basic rate, no further UK income tax liability arises on the receipt of a dividend from HSBC Holdings. Individual shareholders who are liable to UK income tax at the higher rate on UK dividend income (currently 32.5 per cent) are taxed on the combined amount of the dividend and the tax credit. The tax credit is available for set-off against the higher rate liability, leaving net higher rate tax to pay equal to 25 per cent of the cash dividend. Individual UK resident shareholders are not entitled to any tax credit repayment.
Although non-UK resident shareholders are generally not entitled to any repayment of the tax credit in respect of any UK dividend received, some such shareholders may be so entitled under the provisions of a double taxation agreement between their country of residence and the UK. However, in most cases no amount of the tax credit is, in practice, repayable.
Information on the taxation consequences of the HSBC Holdings scrip dividends offered in lieu of the 2006 fourth interim dividend and the first, second and third interim dividends for 2007 was set out in the Secretary’s letters to shareholders of 3 April, 30 May, 29 August and 5 December 2007. In each case, the difference between the cash dividend foregone and the market value of the scrip dividend did not equal or exceed 15 per cent of the market value and accordingly, the price of HSBC Holdings US$0.50 ordinary shares (the ‘shares’) for UK tax purposes for the dividends was the cash dividend foregone.
The computation of the capital gains tax liability arising on disposals of shares in HSBC Holdings by shareholders subject to UK capital gains tax can be complex, partly depending on whether, for example, the shares were purchased since April 1991, acquired in 1991 in exchange for shares in The Hongkong and Shanghai Banking Corporation Limited, or acquired subsequent to 1991 in exchange for shares in other companies.
For capital gains tax purposes, the acquisition cost for ordinary shares is adjusted to take account of subsequent rights and capitalisation issues. Further adjustments apply where an individual shareholder has chosen to receive shares instead of cash dividends, subject to scrip issues made since 6 April 1998 being treated for tax as separate holdings. Any capital gain arising on a disposal may also be adjusted to take account of indexation allowance and, in the case of individuals, taper relief. Except for gains made by a company chargeable to UK corporation tax, any such indexation allowance is calculated up to 5 April 1998 only.
Changes to capital gains tax have been announced that will apply to disposals of shares with effect from 6 April 2008. The proposals are expected to be confirmed by the Chancellor of the Exchequer in his budget due on 12 March 2008. The proposals include:
If in doubt, shareholders are recommended to consult their professional advisers.
Shares or ADSs held by an individual whose domicile is determined to be the US for the purposes of the United States-United Kingdom Double Taxation Convention relating to estate and gift taxes (the ‘Estate Tax Treaty’) and who is not for such purposes a national of the UK will not, provided any US Federal estate or gift tax chargeable has been paid, be subject to UK inheritance tax on the individual’s death or on a lifetime transfer of shares or ADSs except in certain cases where the shares or ADSs (i) are comprised in a settlement (unless, at the time of the settlement, the settlor was domiciled in the US and was not a national of the UK), (ii) is part of the business property of a UK permanent establishment of an enterprise, or (iii) pertains to a UK fixed base of an individual used for the performance of independent personal services. In such cases, the Estate Tax Treaty generally provides a credit against US Federal tax liability for the amount of any tax paid in the UK in a case where the shares or ADSs are subject to both UK inheritance tax and to US Federal estate or gift tax.
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Stamp duty and stamp duty reserve tax
Transfers of shares by a written instrument of transfer generally will be subject to UK stamp duty at the rate of 0.5 per cent of the consideration paid for the transfer, and such stamp duty is generally payable by the transferee.
An agreement to transfer shares, or any interest therein, normally will give rise to a charge to stamp duty reserve tax at the rate of 0.5 per cent of the consideration. However, provided an instrument of transfer of the shares is executed pursuant to the agreement and duly stamped before the date on which the stamp duty reserve tax becomes payable, under the current practice of UK HM Revenue and Customs it will not be necessary to pay the stamp duty reserve tax, nor to apply for such tax to be cancelled. Stamp duty reserve tax is generally payable by the transferee.
Paperless transfers of shares within CREST, the UK’s paperless share transfer system, are liable to stamp duty reserve tax at the rate of 0.5 per cent of the consideration. In CREST transactions, the tax is calculated and payment made automatically. Deposits of shares into CREST generally will not be subject to stamp duty reserve tax, unless the transfer into CREST is itself for consideration.
Taxation – US residents
The following is a summary, under current law, of the principal UK tax and US federal income tax considerations that are likely to be material to the ownership and disposition of shares or ADSs by a holder that is a resident of the US for the purposes of the income tax convention between the US and the UK (the ‘Treaty’), and is fully eligible for benefits under the Treaty (an ‘eligible US holder’). The summary does not purport to be a comprehensive description of all of the tax considerations that may be relevant to a holder of shares or ADSs. In particular, the summary deals only with eligible US holders that hold shares or ADSs as capital assets, and does not address the tax treatment of holders that are subject to special tax rules, such as banks, tax- exempt entities, insurance companies, dealers in securities or currencies, persons that hold shares or ADSs as part of an integrated investment (including a ‘straddle’) comprised of a share or ADS and one or more other positions, and persons that own, directly or indirectly, 10 per cent or more of the voting stock of HSBC Holdings. This discussion is based on laws, treaties, judicial decisions and regulatory interpretations in effect on the date hereof, all of which are subject to change. Under the current income tax treaty between the UK and the US,
Holders and prospective purchasers should consult their own advisers regarding the tax consequences of an investment in shares or ADSs in light of their particular circumstances, including the effect of any national, state or local laws.
In general, the beneficial owner of a share or ADS will be entitled to benefits under the Treaty (and, therefore, will be an eligible US holder) if it is (i) an individual resident of the US, a US corporation meeting ownership criteria specified in the Treaty or other entity meeting criteria specified in the Treaty; and (ii) not also resident in the UK for UK tax purposes. Special rules, including a limitation of benefits provision, may apply. The Treaty benefits discussed below generally are not available to US holders that hold shares or ADSs in connection with the conduct of a business through a permanent establishment, or the performance of personal services through a fixed base, in the UK.
Taxation of dividends
An eligible US holder must include cash dividends paid on the shares or ADSs in ordinary income on the date that such holder or the ADS depositary receives them, translating dividends paid in UK pounds sterling into US dollars using the exchange rate in effect on the date of receipt. Subject to certain exceptions for positions that are held for less than 61 days or are hedged, and subject to a foreign corporation being considered a ‘qualified foreign corporation’ (which includes not being classified for US federal income tax purposes as a passive foreign investment company), certain dividends (‘qualified dividends’) received by an individual eligible US holder before 2009 generally will be subject to US taxation at a maximum rate of 15 per cent. Based on the company’s audited financial statements and relevant market and shareholder data, HSBC Holdings believes that it was not treated as a passive foreign investment company for US federal income tax purposes with respect to its 2005 or 2006 taxable year. In addition, based on the company’s audited financial statements and current expectations regarding the value and nature of its assets, and the sources and nature of its income, HSBC Holdings does not anticipate being classified as a passive foreign investment company for its 2007 taxable year. Accordingly, dividends paid on the shares or ADSs generally should be treated as qualified dividends.
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© Copyright HSBC Holdings plc 2008All rights reserved
Item 19. Exhibits
Documents filed as exhibits to this Form 20-F:
SIGNATURES
The registrant hereby certifies that it meets all of the requirements for filing on Form 20-F and that it has duly caused and authorized the undersigned to sign this annual report on its behalf
Douglas J Flint
Dated: 10 March 2008