BASEL II and its implications

Hazel Taylor Head of Regulatory Reporting David Robertson Head of Programme Delivery Alan Smith Head of Risk Strategy May 2008

Forward-looking statements
This presentation and subsequent discussion may contain certain forward-looking statements with respect to the financial condition, results of operations and business of the Group. These forward-looking statements represent the Group’s expectations or beliefs concerning future events and involve known and unknown risks and uncertainty that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Additional detailed information concerning important factors that could cause actual results to differ materially is available in our Annual Report.


Content • The journey to Basel II (David Robertson) • HSBC Basel II analysis and disclosure (Hazel Taylor) • Pillar 2 and stress testing in a Basel II environment (Alan Smith) 3 .

The journey to Basel II .

The journey to Basel II Major five-year infrastructure programme • Development of Group and local models for PD. LGD and EAD • Central system to capture granular data from 83 countries and generate RWA calculations • Contrast with relative simplicity of Basel I process • FSA approval given for majority IRBA approach for credit risk 5 .

collateral and other loss mitigation? Probability of Default (PD) Exposure at Default (EAD) Maturity (M) Loss Given Default (LGD) 6 . given seniority.Credit risk building blocks Credit risk Borrower characteristics Facility characteristics Who are you lending to? How much exposure do you expect to have should the borrower default? Time to repayment? What is the % you expect to lose.

06 (scaling factor) 7 .Basel II capital calculations Expected Loss (EL) • PD x LGD x EAD • Excess of EL over impairment allowances is a deduction from capital Unexpected Loss (UL) • Capital requirement (K) determined by regulatory formulae for each asset type • PD.5 x EAD x 1. LGD and Maturity are factors • RWA = K x 12.

0% Unexpected Loss PD = 10.Generic example 1 Corporate: Unexpected and Expected Loss 35 Unexpected Loss Expected Loss 30 PD = 0.0% R egulatory capital requirem ent and EL (%of EA ) D 25 20 Expected Loss 15 10 5 PD floor (0.03%) AAA AA+ AA AAA+ A ABB B + BBB B BB BB+ BB BBB+ B BCC C 0 Im plie d e x te rnal rating e quiv ale nt PDs M = 2.1% PD = 1.5 years. LGD = 45% 8 .

00 6.03 3.00 9.00 24.00 12.00 18.00 27.00 30.00 Probability of Default (% ) LGD = 10% 9 .00 15.00 21.Generic example 2 Residential mortgages: Unexpected and Expected Loss 8 Unexpected Loss Expected Loss R g la ryc p l re u m n a dE (%o E D e u to a ita q ire e t n L f A ) 6 Unexpected Loss Expected Loss 4 2 0 0.

1% 40 PD = 1.5 years 10 .0% PD = 10.0% R g la ryc p l a dE (%o E D e u to a ita n L f A ) 30 LGD = 65% 20 10 0 AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB Implied external rating equivalent PD LGD = 45% BBB+ B BCCC M = 2.Generic example 3 Corporate: impact of increasing LGDs 50 PD = 0.

00 12.00 18.00 15.00 6.00 27.00 30.Generic example 4 Residential mortgages: impact of increasing LGDs 25 20 R g lato c p l an E (%o E D e u ry a ita d L f A ) 15 LGD = 25% 10 LGD = 10% 5 0 0.03 3.00 9.00 Probability of Default (% ) 11 .00 21.00 24.

HSBC Basel II analysis and disclosure .

Disclosures Narrative disclosures: • Capital management and allocation • Capital measurement – What the FSA requires – Local requirements may differ – Not all on Basel II locally – But must do Basel II for Group reporting 13 .

Disclosures Narrative disclosures (cont’d) • IRBA for majority of businesses wef 1 January 2008 • IRBA is more risk-sensitive and relies on the bank’s own assessment of risk • There is no going back! (from IRBA to STDA) • Operational risk – using standardised approach for Group • Capital base impacts – Collective impairment allowances – Expected losses less impairment allowances • Pillar 2 – linked to capital management framework • Pillar 3 – first disclosures qualitative during 2008. quantitative during first half of 2009 as at 31 December 2008 14 .

6% to 11.3% to 9.0% • And total capital ratio from 13.Analysis Basel I versus Basel II (as at 31Dec07) • Capital base reduced by USD20 billion due to collective impairment allowances removed and EL adjustment • RWAs at a similar level to Basel I (less than 1% difference) • Overall impact was to reduce the tier 1 ratio from 9.8% 15 .

8% 8 .1% 10 102 9.6% 14 • Composition of regulatory capital table – Core tier 1 USD91 billion.1% – After 50% of EL adjustment USD4.0% USDbn 100 94 8. ratio 9. ratio 11.Disclosures Numerical disclosures on a pro-forma Basel II basis (as at 31Dec07): 160 153 13. ratio 8.5 billion 140 133 11.4% 105 9.5% to 9.8% 12 120 • Total tier 1 USD102 billion.0 80 – After total EL adjustment of USD9 billion – After removal of collective impairment allowances of USD11 billion 6 60 • Target – Tier 1 target range: 7.0% 4 40 20 2 0 0 Core Tier 1 Total Tier 1 Total Capital Basel I Basel II 16 Ratio (%) • Total capital USD133 billion.3% 91 8.

021 billion (91%) – Trading book USD103 billion (9%) – Includes counterparty credit risk and market risk Credit risk Market risk Operational risk Banking book Trading book 17 .Analysis Basel II pro-forma RWAs of USD1.124 billion – Analysis by type of book: – Banking book USD1.129 billion (as at 31Dec07) • Analysis by risk type: – Credit risk USD976 billion (86%) – Market risk USD46 billion (4%) – Operational risk USD107 billion (10%) • Basel I RWAs of USD1.

Pillar 2 and stress testing in a Basel II environment .

and – Risks not included in Pillar 1 • Capital planning and stress testing is an important part of the assessment • • ICAAP Firm's own assessment of its capital needs Economic capital is an important part of the framework to supplement the Pillar 1 regulatory capital analysis Stress analysis is carried out for the ‘1 in 25’ scenario • 19 . HSBC ICAAP and Stress Testing Pillar 1 Minimum capital Minimum regulatory capital requirements for credit. Pillar 2 and the ICAAP Pillar 1 • • • Minimum capital requirement Calculated using prescribed parameters (advanced or standardised) Point-in-time assessment • Pillar 2 Supervisory assessment – via the Individual Capital Guidance (ICG) – of amount of regulatory capital considered necessary to cover: – Pillar 1 risks (including any uncertainties in their calculation).Basel Pillar 2. market and operational risk Pillar Pillar 2 Supervisory review Internal capital adequacy assessment process and supervisory review Pillar 3 Market discipline Regulatory requirements for external disclosure of risk information CAPITAL: Relationship between Pillar 1.

HSBC capital principles and stress testing • Embodied in HSBC Capital Management Principles approved by the Group Management Board • Capital – “the resources necessary to cover unexpected losses arising from the risk which HSBC accepts in the form of discretionary risk or runs in the form of non-discretionary risk” 20 .

allowing senior management to formulate proactive mitigating management action should actual conditions start to reflect the stress scenario conditions – Ensure that HSBC can meet its financial obligations across an economic cycle and it has sufficient capital to withstand a severe correction and/or a period of prolonged negative trading conditions • Stress testing scenarios consider the full range of risks within the HSBC risk framework 21 .HSBC stress testing framework and principles • Stress testing covers the techniques used to assess all facets of risk vulnerability facing the HSBC Group and its operations • HSBC stress testing approaches fall into two categories: – Sensitivity analysis (where the impact of a single factor is considered with all others being held unchanged). and – Scenario analysis (where the impact of changing multiple simultaneous factors are considered) • Stress testing allows HSBC senior management to: – Build an understanding of the sensitivities around the core assumptions in the strategic and capital plans.

Scenario stress testing process – critical features Scenario Definition Define macro stress scenario Translation Translate stress scenario into risk factors Feedback Get feedback on results and concerns for new scenario definition Stress scenario lifecycle Calculation Calculate Impact on drivers within risk categories Analysis and Reporting Analyse reports to highlight significant results Aggregation Aggregate results 22 .

Stress testing governance • Global stress testing oversight forum – group and regional level • Scenarios – mandatory and optional • Pillar 1 versus Pillar 2 • Mitigating actions and early warning indicators • Benchmarks/Tolerance 23 .

Question & Answer .

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