HSBC Bank Australia Ltd 31 st December 2008 Consolidated Basis
Contents 1. Introduction... 3 Purpose... 3 Background... 3 2. Scope of Application... 4 3. HBAU Context... 5 4. Frequency... 5 5. Enquiries... 5 Capital... 6 Tier 1... 6 Tier 2... 6 Capital adequacy... 6 Table 15 - Capital Structure (Consolidated)... 7 Risk Definitions... 8 Credit risk... 8 Market risk... 8 Operational risk... 8 Table 16 - Capital Adequacy (Consolidated)... 9 Credit Risk Management... 10 Table 17a Credit risk (Consolidated)... 11 Exposures... 12 Impairment of loans and advances... 12 Loan write-offs... 12 Reversals of impairment... 12 Provisions for liabilities and charges... 12 Table 17b Credit risk (Consolidated)... 13 General Reserve for Credit Losses... 13 Page 2
1. Introduction Purpose The Basel II regime is based around three complementary elements of Pillars. Pillar 3 recognises that market discipline has the potential to reinforce capital regulation and other supervisory efforts to promote safety and soundness in banks and financial systems. Market discipline imposes strong incentives on banks to conduct their business in a safe, sound and efficient manner. It can also provide a bank with an incentive to maintain a strong capital base as a cushion against potential future losses arising from its risk exposures. Background Capital is the cornerstone of an authorised deposit-taking institution's (ADI) strength. It provides a buffer to absorb unanticipated losses from an ADI s activities and, in the event of unforseen events, enables the ADI to continue operating while those issues are addressed or resolved. The new capital adequacy framework under the Basel II regime, implemented since 1 January 2008, seeks to promote regulatory capital requirements that are more comprehensive and sensitive to risk and therefore more aligned to the risk appetites of individual banks. The application of Pillar 3 aims to enhance transparency in Australian financial markets by setting minimum requirements for the public disclosure of information on the capital adequacy of locally incorporated authorised deposit-taking institutions. As outlined in APS 330, the Australian Prudential Regulation Authority (APRA) has adopted a proportional approach to Pillar 3 to ensure disclosure of information of banks is appropriate to the nature, scope and complexity of its activities, distinguishing clearly between banks adopting the Basel II Advanced Approaches and those adopting the Standardised Approach. Page 3
2. Scope of Application For regulatory (APRA) reporting purposes, (HBAU) establishes two levels of reporting, level one which comprises only, and for Level 2 purposes the Bank consolidates at level with all subsidiaries, except for HSBC Fiduciary (Australia) Pty Ltd and HSBC Corporate Finance (Australia) Pty Ltd. Level 1 Stand alone basis ( Solo ) Level 2 The consolidation of the Bank and all its subsidiary entities other than non-consolidated subsidiaries ( Consolidated ) The Pillar 3 disclosures are based on Level 2 - Consolidated basis. HSBC Bank Australia Limited HSBC Finance Holdings (Australia) Pty Limited HSBC Custody Nominees (Australia) Limited HSBC International Investments (Australia) Pty Limited Level 1 entities Level 2 entities Page 4
3. HBAU Context HSBC is a global bank and therefore deals with multiple regulators in multiple jurisdictions around the world. HSBC Holdings Plc operating under the Financial Services Authority (FSA) in the UK, with effect from 1 January 2008, adopted the Advanced Internal Ratings Based Approach (IRB-A) for Credit risk and the Standardised Approach to Operational risk. The Hongkong and Shanghai Banking Corporation Limited (HBAP), operating under the Hong Kong Monetary Authority (HKMA) in Hong Kong, has adopted the IRB-A for Credit risk and the Standardised Approach for Operational risk as of 1 January 2009. HBAU has adopted the Standardised Approach to Credit and Operational risk as of 1 January 2008. 2008 2009 2008 2009 Regulator Institution Credit risk Operational risk Financial Services Authority (FSA) HSBC Holdings Plc IRB- A IRB- A STD STD Hong Kong Monetary Authority (HKMA) HBAP IRB- F IRB- A STD STD Australian Prudential Regulation Authority (APRA) HBAU STD STD STD(asa) STD(asa) IRB-F = Internal Ratings Based Foundation for Credit risk IRB-A = Internal Ratings Based Advanced for Credit risk STD = Basel II Standardised Approach for either Credit or Operational risk STD (asa) = Standardised Approach (alternative standardised approach) for Operational risk 4. Frequency This report will be released on a quarterly basis, comprising the Capital Adequacy (Table 16) and the Credit risk exposures (Table 17a and b). The Capital Structure (Table 15) will be available annually and released once HSBC Holdings Plc results have been disclosed into the public domain. 5. Enquiries Kate Epworth +61 2 9006 5682 kateepworth@hsbc.com.au Page 5
Capital APRA adopts a risk-based capital assessment framework for Australian banks based on internationally accepted capital measurement standards. This risk-based approach requires eligible capital to be divided by total risk weighted assets, with the resultant ratio being used as a measure of a bank s capital adequacy. The local regulator sets and monitors the bank and consolidated entity s capital requirements under a tiered approach to the measurement of the entity s capital adequacy covering: Level 1 Bank Level 2 Consolidated Bank Tier 1 APRA has refined the definition of Tier 1 capital to coincide with the implementation of AIFRS for regulatory reporting on July 2006 and again with the implementation of Basel II regime on January 2008. A three component structure to Tier 1 reaffirms APRA s approach to de-couple the definition of capital from the Australian Accounting Standards. Fundamental capital comprised of ordinary share, retained earnings, general reserves, current year earnings net of tax expenses, declared dividends and minority interests. To constitute at least 75% of net Tier 1 capital. Residual capital comprised of all other items qualifying for Tier 1 status, including preference shares and innovative Tier 1 instruments. Limited to a maximum of 25% of net Tier 1 capital with innovative Tier 1 capital limited to 15% of net Tier capital. Any excesses to be transferred to upper Tier 2 capital. Innovative capital to include instruments that may contain an incentive for the issuer to call, such as a step up provision or an option to convert to ordinary shares. Any other Tier 1 instruments not in the form of shares. Tier 2 Tier 2 capital is divided into Upper and Lower Tier 2 capital; with Lower Tier 2 capital being dated subordinated debt. An eligible Tier 2 capital (net of deductions) is limited to a maximum of 100% of an ADI s net eligible Tier 1 capital and eligible Lower Tier 2 capital is limited to a maximum of 50% of an ADI s net eligible Tier 1 capital (APS 111 Capital Adequacy: Measurement of Capital). Capital adequacy The new capital adequacy framework under the Basel II regime, implemented since January 2008, seeks to promote regulatory capital requirements that are more comprehensive and sensitive to risk and therefore more aligned to the risk appetites of individual banks. It closely aligns regulatory capital with economic capital and introduces a spectrum of risk measurement approaches. Page 6
Table 15 - Capital Structure (Consolidated) All figures in AUD$m Tier 1 capital December December 2008 1 2007 2 Paid-up ordinary shares; 751.0 751.0 Reserves; - - Retained earnings, including current year earnings; 229.0 182.8 Minority interests arising from consolidation of Tier 1 capital of - - subsidiaries; Innovative instruments; - - Non-innovative residual instruments and other; 60.0 60.0 Gross Tier 1 1,040.0 993.8 Deductions from Tier 1 capital Deferred Tax assets (63.9) (51.9) Available for sale Reserve (19.9) (10.5) Capitalised expenses (15.5) (5.7) Goodwill (58.7) (58.7) Other deductions (3.3) - Total Tier 1 Capital 878.7 867.0 Tier 2 capital Upper 60.5 53.7 Lower 242.0 3 199.0 Gross Tier 2 302.5 252.7 Deductions from Tier 2 capital Upper and lower deductions (3.3) - Total Tier 2 Capital 299.2 252.7 Other deductions 1 - (5.1) Total Capital Base 1,177.9 1,114.6 Risk weighted assets Credit risk 9,806 10,651 Risk weighted assets Market risk 353 386 Risk weighted assets Operational risk 1,148 4-4 Total Risk weighted assets 11,307 11,037 Total Capital Ratio 10.4% 10.1% Tier 1 Ratio 7.8% 7.9% 1 Figures calculated under APRA Basel II Standardised. 2 Figures calculated under APRA Basel I. 3 Issued Tier 2 capital of AUD$42m in March 2008. 4 Operational risk is a new requirement under Basel II. Page 7
Risk Definitions Credit risk Credit risk is the risk of financial loss if a customer or counterparty fails to meet a payment obligation under a contract. It arises principally from direct lending, trade finance and leasing business, but also from off-balance sheet exposures such as market and non market related transactions, and from HBAU s holdings of debt securities. Among the risks HBAU engages in, credit risk generates the largest regulatory capital requirement. Market risk Market risk is the risk that movements in market risk factors, including foreign exchange rates, commodity prices, interest rates, credit spreads and equity prices, will reduce HBAU s income or the value of its portfolios. HBAU 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. Nontrading portfolios primarily arise from the interest rate management of HBAU s retail and commercial banking assets and liabilities, financial investments classified as available for sale and held to maturity. Operational risk Operational risk is the risk of loss arising through fraud, unauthorised activities, errors, omissions, inefficiencies, systems failures or from external events. It is inherent to every business organization and covers a wide spectrum of issues. The terms error, omission and inefficiency includes process failures, systems/machine failures and human error. Under Basel II this is a new requirement, and following the APRA alternative standardised approach this has added AUD$1,148m of risk weighted assets. Under the standardised approach used by HKMA and the FSA, the Operational risk charge is significantly lower. Page 8
Table 16 - Capital Adequacy (Consolidated) All figures in AUD$m Credit risk weighted assets 1 $M Corporate 6,094 Government - Bank 611 Residential Mortgage 1,883 Other retail 1,073 All Other 143 Credit risk weighted assets excluding securitisation 9,804 Securitisation 2 Total Credit risk weighted assets 9,806 Risk weighted assets Market risk 353 Risk weighted assets Operational risk 1,148 Risk weighted assets Interest rate risk in the Banking Book N/A Total Risk weighted assets 11,307 1 Excludes securitisation Capital Ratios Total Capital Ratio 10.4% Tier 1 Ratio 7.8% Page 9
Credit Risk Management Within Group Head Office, a specialised function, Group Credit and Risk, is mandated to provide high-level centralised management of Credit risk for HSBC worldwide, including to the consolidated entity. Group Credit and Risk is headed by a Group General Manager who reports to the Group Chief Executive. Its responsibilities include the following: Formulating Group credit policies and monitoring compliance with them. These policies are embodied in the HSBC standards; Issuing policy guidelines to the consolidated entity on the Group's attitude toward, and appetite for, credit risk exposure to specified market sectors, activities and banking products; Undertaking an independent review and objective assessment of risk. Group Credit and Risk assesses all commercial non-bank credit facilities and exposures including those embedded in derivatives; Monitoring the performance and management of retail portfolios across the Group and reviewing whether any adverse trends are being managed appropriately by Group businesses; Controlling centrally exposures to sovereign entities, banks and other financial institutions. HSBC's credit and settlement risk limits to counterparties in these sectors are approved centrally and globally managed by a dedicated unit within Group Credit and Risk, to optimise the use of credit availability and avoid excessive risk concentration; Maintaining HSBC's policy on large credit exposures, controlling these to ensure that exposure to any individual counterparty or group of closely related counterparties, or to individual geographic areas or industry sectors, does not become excessive in relation to the Group's capital base and is kept within internal and regulatory limits. The approach is designed to be more conservative than intentionally accepted regulatory standards. A dedicated unit within Group Credit and Risk manages this process, and also monitors HSBC's intra-group exposures to ensure that they are maintained within regulatory limited; Controlling cross-border exposures, through the imposition of country limits with sub-limits by maturity and type of business. Country limits are determined by taking into account economic and political factors, and applying local business knowledge. Transactions with countries deemed to be high risk are considered case by case; Maintaining and developing HSBC's risk ratings in order to categorise exposures meaningfully and facilitate focused management of the attendant risks; Reviewing the performance and effectiveness of operating companies' credit approval processes; Reporting to senior executives on aspects of the HSBC credit risk portfolio; Managing and directing credit risk management systems initiatives. HSBC has a centralised database of large corporate, sovereign and bank facilities and is constructing a database covering all the Group's credit assets. A systems-based credit application process for bank lending is operational throughout the Group and an electronic corporate credit application system is deployed in all the Group's major businesses; Providing advice and guidance to HSBC's operating companies in order to promote best practice throughout the Group on credit-related matters such as: regulatory developments; implementing environmental and social responsibility policies; risk modelling; collective impairment allowances; new products; training courses; and credit risk reporting. The consolidated entity is required to implement credit policies, procedures and lending guidelines which conform to HSBC Group standards, with credit approval authorities delegated from the Board of Directors of the consolidated entity to the Chief Executive Officer. The management of the consolidated entity includes a Chief Risk Officer who reports to the local Chief Executive Officer on credit-related issues and has a functional reporting line to the HSBC Group General Manager, Group Credit and Risk. The consolidated entity 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 Credit and Risk. This includes managing its own risk concentrations by market sector, geography and product. Local systems are in place to enable the consolidated entity to control and monitor exposures by customer and retail product segments. Page 10
Table 17a Credit risk (Consolidated) All figures in AUD$m Gross Credit risk Exposure Exposure Type Total Average Cash and Liquid Assets 31 50 Trading Securities 1,650 2,015 Investment Securities 3,604 4,049 Due from other Financial Institutions 206 1,250 Loans and Advances 9,886 10,237 Derivatives 319 272 Contingent Liabilities, Commitments and other Off Balance 4,578 3,574 sheet Exposures Other Assets 326 308 Total Exposures 20,600 21,755 Gross Credit risk Exposure Portfolios subject to Standardised approach Total Average Corporate 6,686 7,275 Government 811 885 Bank 6,858 7,458 Residential Mortgage 4,981 4,929 Other retail 1,102 1,091 All Other 162 117 Total Exposures 20,600 21,755 Note: Total exposures are based on local APRA definitions. Page 11
Exposures Impairment of loans and advances It is the consolidated entity s policy that each operating company will recognise losses for impaired loans promptly where there is objective evidence that impairment of a loan or portfolio of loans has occurred. This is done on a consistent basis in accordance with the established Bank Group guidelines. There are two basic methods of calculating impairment losses: those calculated on individual loans and those losses assessed on a collective basis. Losses expected as a result of future events, no matter how likely, are not recognised. Individually assessed loans Impairment losses on individually assessed accounts are determined by an evaluation of the exposures on a case-by-case basis. The consolidated entity assesses at each balance sheet date whether there is any objective evidence that a loan is impaired. This procedure is applied to all accounts that are considered individually significant Collectively assessed loans in respect of losses which have been incurred but have not yet been identified on loans subject to individual assessment for impairment; and for homogeneous groups of loans that are not considered individually significant. Loan write-offs Loans (and the related impairment allowance accounts) are normally written off, either partially or in full, when there is no realistic prospect of recovery of these amounts and, for collateralised loans, when the proceeds from the realisation of security have been received. Reversals of impairment If, in a subsequent period, the amount of an impairment loss decreases and the decrease can be related objectively to an event occurring after the impairment was recognised, the previously recognised impairment loss is reversed to the extent it is now excessive by reducing the loan impairment allowance account. The amount of any reversal is recognised in the income statement. Provisions for liabilities and charges A provision is recognised in the balance sheet when the consolidated entity has a present legal or constructive obligation as a result of a past event, and it is probable that an outflow of economic benefits will be required to settle the obligation. Provisions are determined by discounting the expected future cash flows at a pre-tax rate that reflects current market assessments of the time value of money and, where appropriate, the risks specific to the liability. A provision for restructuring is recognised when the consolidated entity has approved a detailed and formal restructuring plan, and the restructuring has either commenced or has been announced publicly. Future operating costs are not provided for. Page 12
Table 17b Credit risk (Consolidated) All figures in AUD$m Portfolios subject to Standardised approach Impaired Loans Past due loans >90 days 1 Specific Provisions 1 Charges for Specific Provisions 2 Write offs 3 Recoveries 4 Corporate 31.2-7.5 3.2 - (4.0) Government - - - - - - Bank 2.5 - - - 47.5 5 - Residential Mortgage - 42.0 - - - - Other retail 26.2 18.6 30.4 12.2 61.8 - All Other - - - - - (0.4) Total Exposures 59.9 60.6 37.9 15.4 109.3 (4.4) Collective provision not included 6.7 1.1 Total Provisions 44.6 16.5 109.3 (4.4) Total loan impairment charges and other credit risk provisions 121.4 1 Includes Individually and Portfolio Managed Facilities, both on and off balance sheet. 2 Includes year to date (YTD) funding charges and benefits from recoveries/release to specific and portfolio provisions, and excludes collective provisions. 3 Includes YTD write-off to provision and directly to income statement. 4 Includes YTD recoveries directly to income statement. 5 Icelandic Bank debt security impairment charge. General Reserve for Credit Losses APRA requires an allocation of the collective provision determined in accordance with Australian Accounting Standards between a portfolio that is considered specific and a portion that is considered general. Should the level of eligible provisioning fall below a provisional benchmark of 0.5% of total risk weighted assets, the shortfall is taken out from retained earnings to a reserve for credit loss. The General reserve for credit losses represents both the general collective provision and the reserve for credit loss. All figures in AUD$m Balance General reserve for credit losses 70.6 Page 13