20-F 1 d307666d20f.htm FORM 20-F Form 20-F
Table of Contents

As filed with the Securities and Exchange Commission on March 7, 2012.

 

 

 

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 20-F

 

¨ REGISTRATION STATEMENT PURSUANT TO SECTION 12(b) OR 12(g) OF THE SECURITIES EXCHANGE ACT OF 1934

Or

 

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2011

 

Or

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Or

 

¨ SHELL COMPANY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Date of event requiring this shell company report                     

For the transition period from N/A to N/A

Commission file number: 1-14930

HSBC Holdings plc

(Exact name of Registrant as specified in its charter)

 

N/A   United Kingdom
(Translation of Registrant’s name into English)   (Jurisdiction of incorporation or organisation)

8 Canada Square

London E14 5HQ

United Kingdom

(Address of principal executive offices)

Russell C Picot

8 Canada Square

London E14 5HQ

United Kingdom

Tel +44 (0) 20 7991 8888

Fax +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:

 

Title of each class

  

Name of each exchange on which registered

Ordinary Shares, nominal value US$0.50 each.    London Stock Exchange
   Hong Kong Stock Exchange
   Euronext Paris
   Bermuda Stock Exchange
   New York Stock Exchange*

American Depository Shares, each representing 5

Ordinary Shares of nominal value US$0.50 each.

   New York Stock Exchange

6.20% Non-Cumulative Dollar Preference Shares,

Series A

   New York Stock Exchange*

American Depositary Shares, each representing one-

fortieth of a Share of 6.20% Non-Cumulative Dollar

Preference Shares, Series A

   New York Stock Exchange
5.25% Subordinated Notes 2012    New York Stock Exchange
5.10% Senior Unsecured Notes Due 2021    New York Stock Exchange
4.875% Senior Unsecured Notes Due 2022    New York Stock Exchange
7.625% Subordinated Notes due 2032    New York Stock Exchange
7.35% Subordinated Notes due 2032    New York Stock Exchange
6.5% Subordinated Notes 2036    New York Stock Exchange
6.5% Subordinated Notes 2037    New York Stock Exchange
6.8% Subordinated Notes Due 2038    New York Stock Exchange
6.100% Senior Unsecured Notes due 2042    New York Stock Exchange

8.125% Perpetual Subordinated Capital Securities

Exchangeable at the Issuer’s Option into Non-

Cumulative Dollar Preference Shares

   New York Stock Exchange

8.00% Perpetual Subordinated Capital Securities

Exchangeable at the Issuer’s Option into Non-

Cumulative Dollar Preference Shares, Series 2

   New York Stock Exchange

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 close of the period covered by the annual report:

Ordinary Shares, nominal value US$0.50 each                                              17,868,085,646

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

þ Yes ¨ No

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.

¨ Yes þ No.

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.

þ Yes ¨ No

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

¨ Yes ¨ No

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):

 

Large accelerated filer þ   Accelerated filer ¨   Non-accelerated filer ¨

Indicate by check mark which basis of accounting the registrant has used to prepare the financial statements included in this filing:

 

U.S. GAAP ¨   International Financial Reporting Standards as issued by the
International Accounting Standards Board þ
  Other ¨

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.

¨ Item 17 ¨ Item 18

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).

¨ Yes þ No

 

* Not for trading, but only in connection with the registration of American Depositary Shares.

 

 

 


Table of Contents

HSBC HOLDINGS PLC

 

Annual Report and Accounts 2011

  

 

Certain defined terms

Unless the context requires otherwise, ‘HSBC Holdings’ means HSBC Holdings plc and ‘HSBC’, the ‘Group’, ‘we’, ‘us’ and ‘our’ refers to HSBC Holdings together with its subsidiaries. Within this document the Hong Kong Special Administrative Region of the People’s Republic of China is referred to as ‘Hong Kong’. When used in the terms ‘shareholders’ equity’ and ‘total shareholders’ equity’, ‘shareholders’ means holders of HSBC Holdings ordinary shares and those preference shares classified as equity. The abbreviations ‘US$m’ and ‘US$bn’ represent millions and billions (thousands of millions) of US dollars, respectively.

Financial statements

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 issued by the International Accounting Standards Board (‘IASB’) and as endorsed by the European Union (‘EU’). EU-endorsed IFRSs may differ from IFRSs as issued by the IASB if, at any point in time, new or amended IFRSs have not been endorsed by the EU. At 31 December 2011, there were no unendorsed standards effective for the year ended 31 December 2011 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 2011 are prepared in accordance with IFRSs as issued by the IASB.

We use the US dollar as our presentation currency because the US dollar and currencies linked to it form the major currency bloc in which we transact and fund our 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 16), eliminating the impact of fair value movements in respect of credit spread changes on HSBC’s own debt and adjusting for the effects of acquisitions and disposals of subsidiaries and businesses. A reconciliation of reported and underlying profit before tax is presented on page 17.

Contents

 

 

Report of the Directors

  

Overview

  

Financial highlights

   2

Cautionary statement regarding forward-looking statements

   3a

Group Chairman’s Statement

   4

Group Chief Executive’s Business Review

   7

Principal activities

   10

Business and operating models

   10

Strategic direction

   11

Risk

   12

HSBC Values

   13

Key performance indicators

   13

Operating and Financial Review

  

Financial summary1

   16

Global businesses1

   43

Products and services

   44

Geographical regions1

   59

Disclosure controls

   93h

Management’s assessment of internal controls over financial reporting

   93h

Other information

   94

Legal proceedings and regulatory matters

   97b

Regulation and supervision

   97g

Risk1

   98

Capital

   211

Corporate Governance1

  

Corporate Governance Report

   218

Biographies of Directors and senior management

   218

Board of Directors

   225

Board committees

   230

Internal control

   240

Going concern basis

   243

Employees

   243

Directors’ Remuneration Report1

   256

Financial Statements and Other Information

  

Report of Independent Registered Public Accounting Firm

   276

Financial Statements1

  

Financial statements

   278

Notes on the financial statements

   291

Shareholder Information1

  

Shareholder information

   414

Glossary of accounting terms and US equivalents

   426

Glossary

   427

Index

   436

Exhibit 7.1

  

Exhibit 12.1

  

Exhibit 12.2

  

Exhibit 13.1

  

Exhibit 14.1

  

Exhibit 23.1

  

Exhibit 23.2

  

Exhibit 23.3

  

 

1 Detailed contents are provided on the referenced pages.
 


Table of Contents

HSBC HOLDINGS PLC

 

Annual Report and Accounts 2011

  

 

LOGO

Who we are and what we do

HSBC is one of the world’s largest banking and financial services organisations. With around 7,200 offices in both established and faster-growing markets, we aim to be where the growth is, connecting customers to opportunities, enabling businesses to thrive and economies to prosper, and ultimately helping people to fulfil their hopes and realise their ambitions.

We serve around 89 million customers through our four global businesses: Retail Banking and Wealth Management, Commercial Banking, Global Banking and Markets, and Global Private Banking. Our network covers 85 countries and territories in six geographical regions: Europe, Hong Kong, Rest of Asia-Pacific, Middle East and North Africa, North America and Latin America. Our aim is to be acknowledged as the world’s leading international bank.

Listed on the London, Hong Kong, New York, Paris and Bermuda stock exchanges, shares in HSBC Holdings plc are held by over 220,000 shareholders in 132 countries and territories.

Highlights

 

 

 

Profit before tax up 15% to US$21.9bn on a reported basis.

 

 

Underlying pre-tax profit down 6% to US$17.7bn.

 

 

Launched strategy to reshape the Group, improve returns and position for growth.

 

 

Strong performance in faster-growing regions, with revenue up 12% in Hong Kong, Rest of Asia-Pacific, Latin America and the Middle East and North Africa.

 

 

Record year in Commercial Banking with profit before tax of US$7.9bn, up 31%.

 

 

Achieved sustainable cost savings of US$0.9bn with a strong pipeline of further savings.

 

 

Dividends declared in respect of 2011 US$7.3bn or US$0.41 per ordinary share, up 14% on 2010.

 

 

Core tier 1 capital ratio 10.1%, down from 10.5% in 2010, largely reflecting the introduction of Basel 2.5.

Cover image

A Chinese ship in Brazil’s largest port, Santos, illustrates the growing trade links between the two countries. China is today Brazil’s largest trading partner, with HSBC financing an increasing share of that trade.

 

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HSBC HOLDINGS PLC

 

Report of the Directors: Overview

  

 

Financial highlights

 

 

Earnings per share   Dividends per ordinary share1   Net assets per share
US$0.92 – up 26%   US$0.39   US$8.48 – up 7%
2010: US$0.73   2010: US$0.34   2010: US$7.94
2009: US$0.34   2009: US$0.34   2009: US$7.17
         

For the year

   
Profit before taxation   Underlying profit before taxation   Total operating income
US$21,872m – up 15%   US$17,696m – down 6%   US$83,461m – up 4%
2010: US$19,037m   2010: US$18,925m   2010: US$80,014m
2009: US$7,079m     2009: US$78,631m

Net operating income before loan

impairment charges and other credit

risk provisions

 

Profit attributable to the ordinary

shareholders of the parent company

 
US$72,280m – up 6%   US$16,224m – up 27%  
2010: US$68,247m   2010: US$12,746m  
2009: US$66,181m   2009: US$5,565m  
         

At the year-end

   

Loans and advances to

customers

  Customer accounts  

Ratio of customer advances to

customer accounts

US$940bn – down 2%   US$1,254bn – up 2%   75.0%
2010: US$958bn   2010: US$1,228bn   2010: 78.1%
2009: US$896bn   2009: US$1,159bn   2009: 77.3%
Total equity  

Average total shareholders’ equity

to average total assets

  Risk-weighted assets
US$166bn – up 7%   5.6%   US$1,210bn – up 10%
2010: US$155bn   2010: 5.5%   2010: US$1,103bn
2009: US$136bn   2009: 4.7%   2009: US$1,133bn
         
Capital ratios    
Core tier 1 ratio   Tier 1 ratio   Total capital ratio
10.1%   11.5%   14.1%
2010: 10.5%   2010: 12.1%   2010: 15.2%
2009: 9.4%   2009: 10.8%   2009: 13.7%

 

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HSBC HOLDINGS PLC

 

Annual Report and Accounts 2011

  

 

Performance ratios

Credit coverage ratios

 

Loan impairment charges to

total operating income

 

Loan impairment charges to

average gross customer advances

 

Total impairment allowances to

impaired loans at year-end

13.8%   1.2%   42.3%
2010: 16.9%   2010: 1.5%   2010: 43.0% (restated for change in
2009: 31.7%   2009: 2.8%   disclosure policy – see page 105)

Return ratios

 

Return on average

invested capital2

  Return on average ordinary shareholders’ equity3  

Post-tax return on

average total assets

 

Pre-tax return on average

risk-weighted assets

10.2%   10.9%   0.6%   1.9%
2010: 8.7%   2010: 9.5%   2010: 0.6%   2010: 1.7%
2009: 4.1%   2009: 5.1%   2009: 0.3%   2009: 0.6%
Efficiency and revenue mix ratios    
Cost efficiency ratio4  

Net interest income to

total operating income

 

Net fee income to

total operating income

 

Net trading income to

total operating income

57.5%   48.7%   20.6%   7.8%
2010: 55.2%   2010: 49.3%   2010: 21.7%   2010: 9.0%
2009: 52.0%   2009: 51.8%   2009: 22.5%   2009: 12.5%

 

 

Share information at the year-end

 

       

Closing market price

US$0.50 ordinary

shares in issue

 

Market

capitalisation

  London   Hong Kong  

American

Depositary Share5

17,868m   US$136bn   £4.91   HK$59.00   US$38.10
2010: 17,686m   2010: US$180bn   2010: £6.51   2010: HK$79.70   2010: US$51.04
2009: 17,408m   2009: US$199bn   2009: £7.09   2009: HK$89.40   2009: US$57.09
       

Total shareholder return6

    Over 1 year   Over 3 years   Over 5 years
To 31 December 2011     79.1   96.8   78.2

Benchmarks:

       

– FTSE 1007

  97.8   140.3   107.9

– MSCI World7

  95.7   129.4   114.9

– MSCI Banks7

  82.7   107.5   60.5

For footnotes, see page 95.

 

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HSBC HOLDINGS PLC

 

Annual Report and Accounts 2011

  

 

Cautionary statement regarding forward-looking statements

 

The Annual Report and Accounts 2011 contains certain forward-looking statements with respect to HSBC’s financial condition, results of operations and business.

Statements that are not historical facts, including statements about HSBC’s beliefs and expectations, are forward-looking statements. Words such as ‘expects’, ‘anticipates’, ‘intends’, ‘plans’, ‘believes’, ‘seeks’, ‘estimates’, ‘potential’ and ‘reasonably possible’, variations of these words and similar expressions are intended to identify forward-looking statements. These statements are based on current plans, estimates and projections, and therefore undue reliance should not be placed on them. Forward-looking statements speak only as of the date they are made. HSBC makes no commitment to revise or update any forward-looking statements to reflect events or circumstances occurring or existing after the date of any forward-looking statements.

Written and/or oral forward-looking statements may also be made in the periodic reports to the US Securities and Exchange Commission, summary financial statements to shareholders, proxy statements, offering circulars and prospectuses, press releases and other written materials, and in oral statements made by HSBC’s Directors, officers or employees to third parties, including financial analysts.

Forward-looking statements involve inherent risks and uncertainties. Readers are cautioned that a number of factors could cause actual results to differ, in some instances materially, from those anticipated or implied in any forward-looking statement. These include, but are not limited to:

 

 

changes in general economic conditions in the markets in which we operate, such as continuing or deepening recessions and fluctuations in employment beyond those factored into consensus forecasts; changes in foreign exchange rates and interest rates; volatility in equity markets; lack of liquidity in wholesale funding markets; illiquidity and downward price pressure in national real estate markets; adverse changes in central banks’ policies with respect to the provision of liquidity support to financial markets; heightened market concerns over sovereign creditworthiness in over-indebted countries; adverse changes in the funding status

   

of public or private defined benefit pensions; and consumer perception as to the continuing availability of credit and price competition in the market segments we serve;

 

 

changes in government policy and regulation, including the monetary, interest rate and other policies of central banks and other regulatory authorities; initiatives to change the size, scope of activities and interconnectedness of financial institutions in connection with the implementation of stricter regulation of financial institutions in key markets worldwide; revised capital and liquidity benchmarks which could serve to deleverage bank balance sheets and lower returns available from the current business model and portfolio mix; imposition of levies or taxes designed to change business mix and risk appetite; the practices, pricing or responsibilities of financial institutions serving their consumer markets; expropriation, nationalisation, confiscation of assets and changes in legislation relating to foreign ownership; changes in bankruptcy legislation in the principal markets in which we operate and the consequences thereof; general changes in government policy that may significantly influence investor decisions; extraordinary government actions as a result of current market turmoil; other unfavourable political or diplomatic developments producing social instability or legal uncertainty which in turn may affect demand for our products and services; the costs, effects and outcomes of product regulatory reviews, actions or litigation, including any additional compliance requirements; and the effects of competition in the markets where we operate including increased competition from non-bank financial services companies, including securities firms; and

 

 

factors specific to HSBC, including our success in adequately identifying the risks we face, such as the incidence of loan losses or delinquency, and managing those risks (through account management, hedging and other techniques). Effective risk management depends on, among other things, our ability through stress testing and other techniques to prepare for events that cannot be captured by the statistical models it uses; and our success in addressing operational, legal and regulatory, and litigation challenges.

 

 

3a


Table of Contents

HSBC HOLDINGS PLC

 

Report of the Directors: Overview (continued)

  

 

Group Chairman’s Statement

 

 

LOGO

Throughout its history HSBC has sought to facilitate economic growth, as it is through such growth that businesses flourish and individuals fulfil the aspirations they have for themselves and those close to them. The cover of this year’s Annual Report and Accounts illustrates a core element of HSBC’s strategic direction – that is connecting markets by providing the financing and risk management products that facilitate trade and investment flows. In so doing, we help our customers to achieve their growth ambitions and generate economic returns for savers and investors.

The picture also illustrates the shift in emphasis towards the faster-growing markets that underpins HSBC’s investment priorities. The port is Santos in Brazil, which is the largest container port in South America; the ship is from China, delivering heavy machinery. The Brazil-China trade corridor has been one of the fastest growing over the last decade with a compound annual rate of growth of around 30%. China is now Brazil’s largest trade partner representing 18% of its total trade flows, versus 4% in 2000.

HSBC entered Brazil in 1997 and since then has built its operations to generate pre-tax profits of US$1.2 billion in 2011, an increase of 19% over the prior year. We estimate that we finance over 6% of Brazil’s total trade and some 9% of its trade with China. In 2011 we were recognised as ‘Financial institution of the year’ by the Brazil-China Chamber of Commerce for having contributed most to the growth and development of the Brazil-China trade corridor.

The purpose of the above introduction is to highlight the fact that, notwithstanding the major

uncertainties and risks concentrating minds in the advanced economies of Europe and the US, there are still attractive growth opportunities to pursue where our international network and strong balance sheet provide distinctive advantages.

Performance in 2011

In 2011 in our heartland of Asia, throughout the Middle East and in Latin America we made good progress in developing customer business in line with the risk appetite endorsed by the Board. Largely driven by growth in lending in these faster-growing regions, our Commercial Banking business delivered a record performance. In Europe and the US we concentrated on supporting our core customer base, targeting trade services while constraining risk appetite within the financial sector. We also made significant further progress in working down our exit businesses in the US. The Group Chief Executive’s Review expands upon the execution of our strategy during 2011.

The strong progress made on strategy execution was all the more marked when contrasted with the fragile confidence that pervaded the advanced economies of the world. Continuing uncertainties arising from the eurozone debt crisis contributed to credit demand remaining muted in Europe, while US recovery lagged expectations held earlier in the year. As investors crowded into the safest asset classes, market activity levels dropped markedly and prices of securities outside the favoured asset classes weakened. These factors markedly reduced trading revenues in the second half of the year.

Against the backdrop of the economic and financial market conditions described above, the Board considered the Group’s performance in 2011 to be satisfactory in aggregate and strong in the faster growing markets. Earnings per share rose by 26% to US$0.92 and the Board approved a fourth interim dividend of US$0.14 per ordinary share taking total dividends in respect of 2011 to US$0.41 per share, an increase of US$0.05 per share or 14%. The Board confirmed its intention to continue to pay quarterly dividends during 2012 at the rate of US$0.09 per ordinary share in respect of each of the first three quarters, in line with 2011.

Notably, the capital strengthening required by regulatory reform is being successfully delivered while maintaining the strongest dividend paying record of any bank outside mainland China.

Total dividends declared during 2011 amounted to US$7.3 billion and in the last four years, that is since the financial crisis started, they have amounted

 

 

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HSBC HOLDINGS PLC

 

Report of the Directors: Overview (continued)

  

 

to US$27.2 billion, making HSBC the second largest dividend payer in the FTSE100 during this period.

Addressing a matter of public interest, the cost to shareholders of performance-related rewards made within our Global Banking and Markets business in 2011 and during the past four years amounted to some US$1 billion and US$4.7 billion, respectively. Pre-tax profit from Global Banking and Markets was, in aggregate, US$30 billion in the same four years, and represented the largest contribution, at 52%, of Group pre-tax profits during that period.

At the end of 2011, total shareholders’ equity stood at US$159 billion, up 24% from its pre-crisis level of US$128 billion at the end of 2007. Over the same period, our balance sheet grew by only 9%. The core tier 1 ratio at the end of 2011 stood at 10.1%, in line with our target range.

As foreshadowed in last year’s Statement, the UK government proceeded with its plan to raise £2.5 billion through a levy on the global balance sheets of UK domiciled banks. The cost to HSBC was US$570 million of which US$340 million related to non-UK banking activity. The levy, which is not tax deductible, is the equivalent of US$0.03 per ordinary share and, as indicated last year, would otherwise be available for distribution to shareholders.

Progress on regulatory reform

A number of important milestones were passed during 2011 on the regulatory reform agenda. In the UK the Independent Commission on Banking (‘ICB’) delivered its report in September and the Government published its response in December. In the US, greater clarity on the Dodd-Frank legislation was delivered through a multitude of notices of proposed new regulation and four US financial regulatory agencies issued proposed uniform regulations that would implement the Volcker Rule, which aims to constrain major financial institutions from engaging in proprietary trading and most hedge fund and proprietary investment activities. The Basel Committee, in conjunction with the Financial Stability Board, set out its proposals to identify and increase capital requirements for Global Systemically Important Banks and most major jurisdictions published their proposals around recovery and resolution planning for major institutions. Europe continued to embed the Basel III proposals within a new draft Capital Requirements Directive (‘CRD IV’), the European Banking Authority formally came into existence as the hub of financial regulatory bodies in Europe and, in the UK,

HM Treasury published its proposals for a new approach to financial regulation and the replacement of the FSA with a new supervisory structure, directed by the Bank of England.

Many topics remain subject to further debate including cross-border resolution protocols, the governance and operation of central counterparties, the prospective role of clearing systems and exchanges, the calibration of the proposed new liquidity framework, the definition and operation of proposed proprietary trading restrictions, the possible harmonisation and peer review of the calculation of the risk weights that drive capital requirements, a re-assessment of the risk free treatment of sovereign debt and some 22 follow-on workstreams are ongoing in the wake of the UK Government’s response to the ICB Report.

It is clear from the above that the industry will continue to bear a heavy burden of both time commitment and cost as it works with policymakers to finalise the regulatory reforms, including addressing the many inconsistencies within and extra-territorial dimensions of national rule-making. We are committed to all necessary constructive dialogue and support to speed the finalisation of these remaining issues. Our input will stress that it is critical that the reforms deliver a sustainable business model that can attract external economic capital. This is essential for the financial system to be able to contribute as fully as it should to the economic growth agenda which is being mandated by political leaders globally.

Board changes

We bid farewell at the upcoming AGM to two directors who have given huge service to HSBC over many years and who will not stand for re-election.

Sir Brian Williamson has served on the Board of HSBC Holdings since 2002 and brought great insight and wisdom to the Board from a distinguished career in financial services, most notably in the areas of money and bond markets, clearing, exchanges and electronic trading platforms where he was a pioneer in establishing The London International Financial Futures and Options Exchange.

Gwyn Morgan has served on the Board of HSBC Holdings since 2006 and before that on the Board of HSBC Canada for some nine years. His vast experience of leading large international companies in the engineering and energy sectors brought a balanced industrialist’s perspective to Board discussions and debate.

 

 

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HSBC HOLDINGS PLC

 

Report of the Directors: Overview (continued)

  

 

We shall miss them both and thank them sincerely for their contributions over many years.

We are delighted to welcome two new faces to the Board. Joachim Faber and John Lipsky will join the Board on 1 March.

Joachim Faber stepped down from the Management Board of Allianz at the end of 2011 where he served latterly as CEO of Allianz Global Investors one of the top five investment managers globally. He brings a wealth of experience from the perspective of the investor as well as in depth knowledge of banking, insurance, finance and capital markets from previous roles in a long and distinguished career.

John Lipsky is one of the world’s best known and respected economists who most recently served as First Deputy Managing Director at the IMF from which he retired in November 2011. Over the last five years John has been one of the key links between macroeconomic policymakers and the financial community and brings to the Board an exceptional depth of knowledge and understanding of the macroeconomic and geopolitical issues that will shape the future of the global economy.

Fuller details of their background and experience are set out in the Directors’ Report.

Brand and reputation

At HSBC we continue to think long-term as we build business platforms and relationships that will create options for value creation in generations to come.

Tactically there are necessary difficult decisions to take in today’s subdued economic environment but these are always weighed against what is right for the long-term health of the business. Similarly when things go wrong, as they will from time to time, we judge ourselves, inter alia, against how we respond and how quickly we learn from the experience. Nothing is more important than our reputation.

It was a moment of great pride within the organisation when we were judged to be the most valuable banking brand in the world in the recent Brand Finance® Banking 500 2012 report. This is the fourth time HSBC has headed the list in the last five years. This recognition is a testament to the work of all my colleagues in building value for customers that translates to shareholder value.

At the same time, however, we reflect that in 2011 we continued to deal with legacy regulatory, legal and reputational issues which remind us that our good work can be destroyed by lapses of judgement or control. The settlement of claims around the historical selling of Payment Protection Insurance in the UK, the fine and compensation arising from the now closed NHFA Limited business and ongoing regulatory and legal investigations in the US across a number of areas are all matters from which we need to learn to ensure they do not recur. The programme of values training which the Group Chief Executive is leading for all employees is but one measure to this end. We are truly sorry to all those who were adversely affected by our failings and to our shareholders for the reputational damage incurred.

Looking ahead

It is just over a year now since Stuart Gulliver and I took on our respective roles. During that time, the leadership team around Stuart has grown in stature and cohesion and is, I believe, among the best in our industry. That team is supported strongly by talented colleagues whose engagement and commitment to the strategic priorities laid out before them is evident and enthusiastic. On behalf of the Board I want to take this opportunity to thank them for their support and dedication. The uncertain economic and geopolitical backdrop will continue to raise challenges throughout 2012 and beyond. I am, however, confident that HSBC has the people, the financial strength and the right strategic focus and values to do well for those who place their trust in us, thereby meeting their expectations of us and contributing to the fulfilment of their aspirations and ambitions. That is what we exist to do.

 

LOGO

D J Flint, Group Chairman

27 February 2012

 

 

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Table of Contents

HSBC HOLDINGS PLC

 

Report of the Directors: Overview (continued)

  

 

Group Chief Executive’s

Business Review

 

 

LOGO

2011 was a year of change for HSBC as we articulated a clear strategy to become the world’s leading international bank. We made significant progress in executing this strategy to reshape the Group and improve returns. First, we conducted a Group-wide portfolio review to improve our capital deployment and have now announced the disposal or closure of 16 non-strategic businesses during the year, and a further three in 2012. Second, we took action to improve our cost efficiency, achieving sustainable cost saving of US$0.9bn. Third, and most importantly, we continued to position the business for growth, increasing revenues in each of the world’s faster-growing regions, particularly in mainland China, India, Malaysia, Brazil and Argentina. Commercial Banking achieved record revenue and profits, helped by loan growth as well as growth in cross-selling from Global Banking and Markets. In Wealth Management we made modest progress towards our target of US$4bn of incremental revenue over the medium term.

Executing our strategy is the primary lever to improve the Group’s performance. A substantial amount has been achieved during 2011 but this will be a long journey with significant headwinds, so we are increasing the intensity of execution in 2012.

Group performance headlines

 

 

HSBC’s financial performance was resilient.

 

 

Reported profit before tax was US$21.9bn, up US$2.8bn on 2010, including US$3.9bn of favourable fair value movements on our own debt attributable to credit spreads, compared with a negative movement of US$63m in 2010.

 

Underlying profit before tax was US$17.7bn, down US$1.2bn on 2010 due to higher costs which were partly offset by a significant improvement in loan impairment charges and other credit risk provisions.

 

 

We recorded a strong performance in each of the faster-growing regions. Underlying revenues grew in Rest of Asia-Pacific by 12%, in Hong Kong by 6% and in Latin America by 13%. The strong performance in these regions also led to record revenues in Commercial Banking.

 

 

We achieved strong revenue growth in key markets including mainland China, India, Malaysia, Brazil and Argentina, driving increases in profit before tax.

 

 

On an underlying basis, total revenues were broadly in line with 2010, despite the turmoil in the eurozone and its adverse effect on Credit and Rates revenue, combined with lower income in Balance Sheet Management and the continued reduction of our consumer finance portfolios in the US.

 

 

As the process of internationalising the renminbi continued, we strengthened our leadership position with a bond clearing licence in mainland China and as the market leader in the offshore ‘Dim Sum’ bond market. In addition, Commercial Banking and Global Banking and Markets successfully completed our first global US dollar-renminbi cross-currency swap and we extended our renminbi capability to over 50 markets in all regions.

 

 

Despite the eurozone sovereign debt concerns which dominated European market sentiment and depressed revenues in Global Banking and Markets, revenues grew strongly in over half of our business lines in Global Banking and Markets, including Equities and Foreign Exchange, and in Global Banking. This in part reflected the collaboration with Commercial Banking which has delivered more than US$500m in incremental revenues.

 

 

In Wealth Management we made modest progress towards our medium-term target of US$4bn incremental revenue, with revenue growth of some US$300m. Notably, we generated strong sales of insurance products in Hong Kong, Latin America and Rest of Asia-Pacific, while revenue from distribution of investment products to our clients and Global Asset Management was broadly unchanged, reflecting difficult market conditions, particularly in the second half of the year.

 

 

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Costs rose by 10%, reflecting wage inflation in key markets and higher average full-time equivalent employee numbers for the year (although numbers have fallen since the first quarter), as well as an increase in significant items. These included restructuring costs (including the impairment of certain intangible assets) of US$1.1bn, UK customer redress programmes of US$898m and a bank levy introduced by the UK Government of US$570m, partly offset by a UK pension credit of US$587m. The rise in costs was partially offset by US$0.9bn in sustainable cost savings achieved so far in executing our strategy.

 

 

As a result of these factors, the cost efficiency ratio worsened from 55.2% to 57.5% on a reported basis, and from 55.6% to 61.0% on an underlying basis.

 

 

Our results continue to be adversely affected by the losses in the US consumer finance business, which, on an underlying basis, were US$2.4bn and US$2.2bn in 2011 and 2010, respectively. We have agreed the sale of the profitable US Card and Retail Services portfolio with the remainder of the loss-making US consumer finance business being run down.

 

 

Return on average ordinary shareholders’ equity was 10.9%, up from 9.5% in 2010, reflecting the favourable movement on the fair value of our own debt.

 

 

The Group’s pre-tax return on risk-weighted assets (‘RoRWA’) for 2011 was 1.9%, or 1.5% on an underlying basis. Adjusting for negative returns on US consumer finance business and legacy credit in Global Banking and Markets, the remainder of the Group achieved a RoRWA of 2.2% in 2011 and 2.3% in 2010.

 

 

Dividends declared in respect of 2011 totalled US$7.3bn, or US$0.41 per ordinary share, an increase of 14%, with a fourth interim dividend for 2011 of US$0.14 per ordinary share.

 

 

The core tier 1 ratio was 10.1% at 31 December 2011, down from 10.5% at 31 December 2010, reflecting an increase in risk-weighted assets (‘RWA’s) due to the introduction of Basel 2.5 in Global Banking and Markets and growth in lending balances including those classified as held for sale. The growth in RWAs was notably in Commercial Banking, which included an increase in the RWAs of our mainland China associates.

 

Profit attributable to ordinary shareholders increased by 27% to US$16.2bn, of which US$7.3bn was declared in dividends in respect of the year. This compared with US$3.4bn of variable pay awarded (net of tax) to our employees for 2011.

Progress on strategy

There are two major trends which are key to HSBC’s future: the continuing growth of international trade and capital flows; and wealth creation, particularly in faster-growing markets. In May, we defined a new strategy for the Group to capitalise on these trends and connect customers to opportunities by building on our distinctive presence in the network of markets which generate the major trade and capital flows, capturing wealth creation in target markets and focusing on retail banking only where we can achieve profitable scale.

In a difficult operating environment this strategy is key to improving our performance and we remain focused on delivering our targets of a return on average shareholders’ equity of 12-15% and a cost efficiency ratio of 48-52% by the end of 2013. We are executing the strategy by deploying capital more effectively, implementing measures to improve our cost efficiency and positioning the business for growth. We have made significant progress in all of these three areas.

First, to ensure effective deployment of capital, we undertook a Group-wide review of our business, testing each part of the portfolio against our five filters framework. This looks at the strategic relevance of each country, and each business in each country, assessing their connectivity, economic development, profitability, cost efficiency and liquidity. As a result, we announced 16 disposals or closures in 2011 and a further three in 2012, including two large transactions in the US, the withdrawal from Georgia and the exit of Retail Banking and Wealth Management operations in Russia, Chile, Thailand and Poland. When completed, these disposals and closures should represent a reduction of around US$50bn of risk-weighted assets and the transfer to the acquirers of approximately 12,000 full-time equivalent employees. We are continuing this process in 2012 and have identified a number of further transactions.

Second, to improve cost efficiency we achieved US$0.9bn of sustainable savings. Our programmes to implement consistent business models and restructure global businesses and global functions progressed well. We are creating a leaner Group, removing layers of management to give staff greater

 

 

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responsibility, improve decision making and reduce bureaucracy. We have identified a strong pipeline of further sustainable cost savings which we believe will deliver at the upper end of our target of US$2.5-3.5bn of sustainable savings by 2013.

Third, we continued to position the business for growth, as outlined in the performance headlines.

We are increasing the intensity of strategy execution in 2012 and will provide a further update at our forthcoming Investor Strategy Day.

Our purpose and values

HSBC is one of the world’s largest banking and financial services organisations. We serve around 89 million customers and our network covers 85 countries and territories. With around 7,200 offices in both established and faster-growing markets, we aim to be where the growth is, connecting customers to opportunities, enabling businesses to thrive and economies to prosper, and ultimately helping people to realise their ambitions.

We are putting a new emphasis on values at HSBC, so that our employees are empowered to do the right thing and to act with courageous integrity. We recognise that we have not always got this right in the past. The inappropriate advice given to customers of NHFA Limited was completely unacceptable. We are profoundly sorry about what happened and are committed to standing fully behind our customers. This case has reinforced our determination to address legacy issues in HSBC.

Over the past year we have made our values more explicit to ensure we meet the expectations of society, customers, regulators and investors. Those values are that we are dependable, open to different ideas and cultures and connected to customers, communities, regulators and each other. We are ensuring that everyone who works for HSBC lives by these values and have made them a key part of every individual’s annual performance review. By

setting the highest standards of behaviour our aim is that all of our employees and customers can be proud of our business.

Outlook

In 2012, notwithstanding the macroeconomic, regulatory and political uncertainties which we believe will persist, we expect continued strong growth in the dynamic markets of Asia, Latin America and the Middle East, although at a more moderate pace than in 2011, and that mainland China will achieve a soft landing. We believe that trade and capital flows between emerging areas of the world will also continue to grow, and could increase tenfold in the next 40 years.

As these results demonstrate, HSBC is well-positioned in the faster-growing markets and across international trade flows to benefit from these engines of global growth.

In 2011 we generated a return on average ordinary shareholders’ equity of 10.9% compared with 9.5% in 2010. The strength of our position gives us confidence that by the end of 2012 we will have developed a clear trajectory towards meeting our target of 12-15% by the end of 2013.

Finally, I am pleased to report we had good results in January.

 

LOGO

S T Gulliver, Group Chief Executive

27 February 2012

 

 

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Principal activities

 

HSBC is one of the largest banking and financial services organisations in the world, with a market capitalisation of US$136bn at 31 December 2011. We are headquartered in London.

Our products and services are delivered to clients through four global businesses, Retail Banking and Wealth Management (‘RBWM’), Commercial Banking (‘CMB’), Global Banking and Markets (‘GB&M’), and Global Private Banking (‘GPB’).

We operate through long-established businesses and have an international network of some 7,200 offices in 85 countries and territories in six geographical regions; Europe, Hong Kong, Rest of Asia-Pacific, Middle East and North Africa (‘MENA’), North America and Latin America.

Taken together, our five largest customers do not account for more than 1% of our income. We have contractual and other arrangements with numerous third parties in support of our business activities. None of the arrangements is individually considered to be essential to the business of the Group.

Following a Group-wide review of our businesses, 16 disposals or closures were announced in 2011, and a further three in 2012. The most significant of these were the sales of 195 retail branches, primarily in upstate New York, our US Card and Retail Services portfolio and our businesses in Costa Rica, El Salvador and Honduras. For further information on these disposals, see page 379.

There were no significant acquisitions during the year.

Business and operating models

 

Business model

We accept deposits and channel these deposits into lending activities, either directly or through the capital markets. We also offer a range of products and financial services including broking, underwriting and credit facilities, trade finance, credit cards, sales of insurance and investment products and funds under management. These banking and financial services are provided to a wide range of clients including governments, large and mid-market corporates, small and medium-sized enterprises (‘SMEs’), high net worth individuals, and mass affluent and retail customers.

Our operating income is primarily derived from:

 

 

net interest income – interest income on customer loans and advances, less interest expense on interest bearing customer accounts and debt securities in issue;

 

 

net fee income – fee income earned from the provision of financial services and products to customers of our global businesses; and

 

 

net trading income – income from trading activities primarily conducted in Global Markets, including Foreign Exchange, Credit, Rates and Equities trading.

Operating model

HSBC has a matrix management structure which includes global businesses, geographical regions and global functions.

Holding company

HSBC Holdings plc, the holding company of the Group, has listings in London, Hong Kong, New York, Paris and Bermuda. HSBC Holdings is the primary provider of equity capital to its subsidiaries and provides non-equity capital to them where necessary.

Under authority delegated by the Board of HSBC Holdings, the Group Management Board (‘GMB’) is responsible for management and day-to-day running of the Group. The Board, together with GMB, ensures that there are sufficient cash resources to pay dividends to shareholders, interest to bondholders, expenses and taxes.

HSBC Holdings does not provide core funding to any subsidiary, is not a lender of last resort and does not carry out any banking business in its own right. HSBC has a legal entity-based Group structure, sometimes referred to as subsidiarisation, which underpins our strong balance sheet and helps generate a resilient stream of earnings.

Global businesses

Our four global businesses are responsible for developing, implementing and managing their business propositions consistently across the Group, focusing on profitability and efficiency. They set their strategies within the confines of the Group strategy in liaison with the geographical regions, are responsible for issuing planning guidance regarding their businesses, are accountable for their profit and loss performance and manage their headcount.

 

 

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Geographical regions

The geographical regions share responsibility for executing the strategies set by the global businesses. They represent the Group to clients, regulators, employee groups and other stakeholders, allocate capital, manage risk appetite, liquidity and funding by legal entity and are accountable for profit and loss performance in line with the global business plans.

Within the geographical regions, the Group is structured as a network of regional banks and locally incorporated regulated banking entities. Each bank is separately capitalised in accordance with applicable prudential reporting requirements and maintains a capital buffer consistent with the Group’s appetite for risk in its country or region. Each bank manages its own funding and liquidity within parameters set centrally, and is required to consider its risk appetite, consistent with the Group’s risk appetite for the relevant country or region.

Global functions

Our global functions are Communications, Company Secretaries, Corporate Sustainability, Finance, Human Resources, Internal Audit, Legal, Marketing, Risk (including Compliance) and Strategy and Planning. They establish and manage all policies, processes and delivery platforms relevant to their activities, are fully accountable for their costs globally and are responsible for managing their headcount.

Strategic direction

 

Our strategy is aligned to two long-term trends:

 

 

Financial flows – the world economy is becoming ever-more connected. Growth in world trade and cross-border capital flows continues to outstrip growth of gross domestic product. Financial flows between countries and regions are highly concentrated. Over the next decade we expect 35 markets to represent 90% of world trade growth and a similar degree of concentration in cross-border capital flows.

 

 

Economic development – by 2050, we expect economies currently deemed ‘emerging’ to have increased five-fold in size, benefiting from demographics and urbanisation, and they will be larger than the developed world. By then, we expect 19 of the 30 largest economies will be markets that are currently described as emerging.

HSBC is one of the few truly international banks and our advantages lie in our network of markets relevant for international financial flows, our access and exposure to high growth markets and businesses, and our strong balance sheet generating a resilient stream of earnings.

Based on these long-term trends and our competitive position, our strategy has two parts:

 

 

Network of businesses connecting the world – HSBC is ideally positioned to capture the growing international financial flows. Our franchise puts us in a privileged position to serve corporate clients as they grow from small enterprises into large and international corporates, and personal clients as they become more affluent. Access to local retail funding and our international product capabilities allows us to offer distinctive solutions to these clients in a profitable manner.

 

 

Wealth management and retail with local scale – we will leverage our position in faster-growing markets to capture social mobility and wealth creation through our Wealth Management and Private Banking businesses. We will only invest in retail businesses in markets where we can achieve profitable scale.

Implementing this strategy relies on actions across three areas:

 

 

Capital deployment (five filters) – we are improving the way we deploy capital as part of our efforts to achieve our targeted return on equity of between 12% and 15% over the business cycle. We have introduced a strategic and financial framework assessing each of our businesses on a set of five strategic evaluation criteria, namely international connectivity, economic development, profitability, cost efficiency and liquidity. The results of this review determine whether we invest in, turn around, continue with or exit businesses.

 

 

Cost efficiency (four programmes) – we have launched four programmes which we believe will achieve sustainable savings of between US$2.5bn and US$3.5bn by the end of 2013, resulting in a leaner and more values-driven organisation. These are: (i) implement consistent business models, (ii) re-engineer operational processes, (iii) streamline IT, and (iv) re-engineer global functions. Sustainable cost savings are intended to facilitate self-funded growth in key markets and investment in new products, processes and technology, and provide a buffer against regulatory and inflationary headwinds.

 

 

Growth – we continue to position ourselves for growth. We are increasing our relevance in fast-growing markets and in wealth management,

 

 

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and are improving the collaboration between our international network of businesses, particularly between CMB and GB&M.

If we are successful in executing this strategy, we will be regarded as ‘The world’s leading international bank’. We have defined financial targets to achieve a return on equity of between 12% and 15% with a core tier 1 ratio of between 9.5% and 10.5%, and achieve a cost efficiency ratio of between 48% and 52%. We have also defined Key Performance Indicators to monitor the outcomes of actions across the three areas of capital deployment, cost efficiency and growth.

Risk

 

As a provider of banking and financial services, risk is at the core of our day-to-day activities.

We have identified a comprehensive suite of risk factors which informs our assessment of our top and emerging risks. This assessment may result in our risk appetite being revised.

Risk factors

Our businesses are exposed to a variety of risk factors that could potentially affect our results of operations or financial condition. These are:

 

 

 

Macroeconomic and geopolitical risk

 

 

Current economic and market conditions may adversely affect our results.

 

 

We have exposure to the ongoing economic crisis in the eurozone.

 

 

We are subject to political and economic risks in the countries in which we operate.

 

 

Changes in foreign currency exchange rates may affect our results.

Macroprudential, regulatory and legal risks to our business model

 

 

Our businesses are subject to wide-ranging legislation and regulation and to regulatory and governmental oversight. Unfavourable legislative or regulatory developments, or changes in the policy of regulators or governments, could have a significant adverse effect on our operations, financial condition and prospects.

 

 

The Independent Commission on Banking has published its final report on competition and possible structural reforms in the UK banking industry. The implementation of the recommendations included in the final report could have a material adverse effect on us.

 

 

We are subject to a number of legal and regulatory actions and investigations, the outcomes of which are inherently difficult to predict, but unfavourable outcomes could have a material adverse effect on our operating results and brand.

 

 

We are subject to tax-related risks in the countries in which we operate which could have a material adverse effect on our operating results.

Risks related to our business operations, governance and internal control systems

 

 

Our risk management measures may not be successful.

 

 

Operational risks are inherent in our business.

 

 

Our operations are highly dependent on our information technology systems.

 

 

Our operations have inherent reputational risk.

 

 

We may suffer losses due to employee misconduct.

 

 

We rely on recruiting, retaining and developing appropriate senior management and skilled personnel.

 

 

Our financial statements are based in part on assumptions and estimates which, if inaccurate, could cause material misstatement of the results and financial position of the Group.

 

 

Third parties may use us as a conduit for illegal activities without our knowledge, which could have a material adverse effect on us.

 

 

We may not achieve all the expected benefits of our strategic initiatives.

Risks related to our business

 

 

We have significant exposure to counterparty risk within the financial sector and to other risk concentrations.

 

 

Market fluctuations may reduce our income or the value of our portfolios.

 

 

Liquidity, or ready access to funds, is essential to our businesses.

 

 

Any reduction in the credit rating assigned to HSBC Holdings, any subsidiaries of HSBC Holdings or any of their respective debt securities could increase our cost or availability of funding and adversely affect our liquidity position and interest margins.

 

 

Risks concerning borrower credit quality are inherent in our businesses.

 

 

Our insurance businesses are subject to risks relating to insurance claim rates and changes in insurance customer behaviour.

 

 

HSBC Holdings is a holding company and, as a result, is dependent on dividends from its subsidiaries to meet its obligations including its obligations with respect to its debt securities, and to provide profits for payment of future dividends to shareholders.

 

 

We may be required to make substantial contributions to our pension plans.

 

 

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Macroeconomic and geopolitical risk

Current economic and market conditions may adversely affect our results

Our earnings are affected by global and local economic and market conditions. Following the global financial crisis in 2007, a difficult economic climate remains with continued pressures on household and corporate finances. The peripheral eurozone economies, such as Greece, Ireland, Italy, Portugal and Spain, came under increasing pressure in 2011, the dominant concern being over the high levels of their sovereign debt. The large budget deficit and growing government indebtedness of the US and the recent downgrade of its sovereign debt by a major ratings agency are generating concerns regarding the financial position and economic prospects of the US, the global economy and the financial services sector. In addition, mainland China experienced a slowdown in economic growth in 2011 and faces uncertainty over future growth.

With unemployment remaining high and consumer confidence weak in developed markets, and amid signs of inflationary pressures in emerging markets, economic conditions are fragile and volatile and markets are weak. These adverse economic conditions continue to create a challenging operating environment for financial services companies such as HSBC. In particular, we may face the following challenges to our operations and operating model in connection with these factors:

 

 

the demand for borrowing from creditworthy customers may diminish if economic activity slows or remains subdued;

 

 

the heightened risk of overheating economies in emerging markets in recent years is giving rise to concerns that asset and credit bubbles may be created, leading to volatility and losses;

 

 

European banks may come under stress as a result of the sovereign debt crisis in the eurozone;

 

 

trade and capital flows may contract as a result of protectionist measures being introduced in certain markets or on the emergence of geopolitical risks;

 

 

a prolonged period of modest interest rates will constrain, for example, through margin compression and low returns on assets, the interest income we earn from investing our excess deposits;

 

 

our ability to borrow from other financial institutions or to engage in funding transactions may be adversely affected by market disruption,

   

for example, in the event of contagion from stress in the eurozone sovereign and financial sectors; and

 

 

market developments may depress consumer and business confidence. If growth in the UK or the US remains subdued, for example, asset prices and payment patterns may be adversely affected, leading to increases in delinquencies, default rates, write-offs and loan impairment charges beyond our expectations.

We have exposure to the ongoing economic crisis in the eurozone

The sovereign debt crisis that erupted in 2010 extended through 2011. Concern regarding the financial position of several economies which spread from those of peripheral eurozone countries such as Greece, Ireland, Italy, Portugal and Spain to include certain core eurozone countries, became increasingly widespread and severe. These negative trends caused considerable turbulence on the global financial markets.

The risk of contagion throughout and beyond the eurozone remains noteworthy. A significant number of financial institutions throughout Europe, including in core eurozone countries, have substantial exposure to sovereign debt issued by states which have come under considerable financial pressure, such as Greece. Should any of those nations default on their debt or experience a significant widening of credit spreads, major financial institutions and banking systems throughout Europe could be destabilised, intensifying the economic crisis. Although our direct exposure to peripheral eurozone economies is limited, we have substantial exposure to financial institutions and central banks in core European countries which may be affected by the ongoing crisis. For a further description of our exposures to selected eurozone countries, eurozone banks and other financial institutions and corporates see ‘Areas of special interest’ on page 112.

While the authorities throughout Europe continue to work on agreeing a political solution which will encompass economic plans designed to address the fiscal instability of the eurozone, the ongoing economic crisis has increased the risk of its break-up. This would have a dramatic impact on the whole financial sector, creating new challenges in sovereign and corporate lending and resulting in significant disruption to financial activities at both the wholesale and retail levels.

 

 

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We are subject to political and economic risks in the countries in which we operate

We operate through an international network of subsidiaries and affiliates in 85 countries and territories around the world. Our results are, therefore, subject to the risk of loss from unfavourable political developments, currency fluctuations, social instability and changes in government policies on such matters as expropriation, authorisations, international ownership, interest-rate caps, limits on dividend flows and tax in the jurisdictions in which we operate. For example, in the Middle East, the ‘Arab Spring’ has led to political instability across the region. In Asia, tensions persist in certain areas following leadership/regime changes which pose the threat of instability and potential conflict. A break-up of the eurozone or continued social unrest triggered by the ongoing economic crisis and related austerity programmes may result in political and social disruption throughout Europe. The occurrence of any of these events or circumstances could have a material adverse effect on our business, financial condition and/or results of operations.

Changes in foreign currency exchange rates may affect our results

We prepare our accounts in US dollars, but because a substantial portion of our assets, liabilities, assets under management, revenues and expenses are denominated in other currencies, changes in foreign exchange rates have an effect on our reported income, cash flows and shareholders’ equity and may have a material adverse effect on our business, financial condition and/or results of operations.

Macroprudential, regulatory and legal risks to our business model

Our businesses are subject to wide-ranging legislation and regulation and to regulatory and governmental oversight. Unfavourable legislative or regulatory developments, or changes in the policy of regulators or governments, could have a significant adverse effect on our operations, financial condition and prospects

Our businesses are subject to ongoing regulation and associated regulatory risks, including the effects of changes in the laws, regulations, policies, voluntary codes of practice and interpretations in the UK, the US, Hong Kong, the European Union (‘EU’) and the other markets where we operate. This is particularly the case in the current market environment, where

we are witnessing increased levels of government and regulatory intervention in the banking sector, which we expect to continue for the foreseeable future. Since 2008, regulators and governments have focused on the reform of the financial services industry, including enhanced capital, liquidity and leverage requirements, changes in compensation practices, tax levies and measures to address systemic risk. The US government, the UK government, the Financial Services Authority (‘FSA’) and other regulators in the UK, Hong Kong, the EU or elsewhere may intervene further in relation to areas of industry risk already identified, or in new areas, which could adversely affect us. Future changes are difficult to predict but could materially and unfavourably affect our business.

Areas where changes could have an adverse impact include, but are not limited to:

 

 

general changes in government, central bank or regulatory policy, or changes in regulatory regimes that may influence investor decisions in particular markets in which we operate, which may change the structure of those markets and the products offered or may increase the costs of doing business in those markets;

 

 

external bodies applying or interpreting standards or laws differently to us;

 

 

changes in competitive and pricing environments;

 

 

further requirements relating to financial reporting, corporate governance, conduct of business and employee compensation; and

 

 

expropriation, nationalisation, confiscation of assets and changes in legislation relating to foreign ownership.

Beginning in April 2011, the FSA commenced an internal reorganisation as a first step in a process towards the formal transition of regulatory and supervisory powers from it to the new Financial Conduct Authority (‘FCA’) for the conduct of business supervision and to the Prudential Regulatory Authority (‘PRA’) for capital and liquidity supervision in 2012. Until this time, the responsibility for regulating and supervising the activities of HSBC will remain with the FSA. In addition, new European supervisory authorities, the European Banking Authority (‘EBA’), the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority are likely to exert greater influence on regulatory issues across the EU. These could change the way in which we are regulated and supervised.

 

 

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The Basel Committee has approved significant changes to the regulation of banking institutions’ capital and liquidity, involving a substantial strengthening of the minimum requirements. Implementation at the national level remains ongoing.

HSBC has been classified by the Financial Stability Board (‘FSB’) as a Global Systemically Important Financial Institution (‘G-SIFI’) under proposals that would place an additional capital buffer on the Group and may place us under additional regulatory scrutiny. As proposed, the capital surcharge will apply at a Group level and have implications for capital management for all our locally incorporated banks and branch operations which hold capital. The Basel committee issued in November 2011 its rules for Global Systemically Important Banks (‘G-SIBs’). These provide a framework for more intensive supervision of G-SIBs and assessment methodology to determine additional requirements for loss absorbing capacity. See ‘Capital’ on pages 211 to 217.

The implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (‘Dodd-Frank’) and related final regulations could result in additional costs or limit or restrict the way we conduct our business. Uncertainty remains about many of the details, impact and timing of these reforms and the effect they will ultimately have on HSBC. While we do not have segregated proprietary trading desks, the Volcker Rule could affect our businesses in North America and elsewhere in the world. In addition, the Federal Reserve Board stated in December 2011 that it expects to issue ‘shortly’ a proposal to apply enhanced supervisory standards to large foreign banking organisations such as HSBC.

There are also a number of ongoing regulatory initiatives at the EU and at national level in various stages of development which could result in additional costs or limit or restrict the way we conduct business. These include the EU’s proposed Crisis Management Directive and its ongoing review of the existing Markets in Financial Instruments Directive. At a national level they include the FSA’s Retail Distribution and Mortgage Market Reviews. Uncertainty remains about the details, impact and timing of some of these reforms and the effect they will ultimately have on HSBC.

Notwithstanding our efforts to comply with applicable regulations, we may fail, particularly in areas where applicable regulations may be unclear or where regulators revise existing guidance or courts overturn previous rulings. Authorities in many jurisdictions have the power to bring administrative

or judicial proceedings against us which could result in, among other things, suspension or revocation of our licenses, cease and desist orders, fines, civil penalties, criminal penalties or other disciplinary action which could materially adversely affect our results of operations and seriously harm our reputation.

Changes in laws, rules or regulations, or in their interpretation or enforcement, or the implementation of new laws, rules or regulations, may adversely affect our business, financial condition and/or results of operations. Further, uncertainty and lack of international regulatory coordination as enhanced supervisory standards are developed and implemented may adversely affect our ability to engage in effective business, capital and risk management planning.

The Independent Commission on Banking has published its final report on competition and possible structural reforms in the UK banking industry. The implementation of the recommendations included in the final report could have a material adverse effect on us

The UK Independent Commission on Banking (‘ICB’) published its Final Report on 12 September 2011. The Commission’s reform proposals, if adopted as legislation in substantially the form prescribed, would have wide-ranging implications for the structure and costs of large UK-headquartered banks and the UK banking industry.

In respect of large banks, including HSBC, the ICB proposes that there should be primary loss-absorbing capacity equal to at least 17% of risk-weighted assets (‘RWA’s) calculated under Basel III. This capacity should be satisfied by complying with the Basel III capital requirements and issuing additional equity and/or long-term, unsecured bonds that are loss-absorbing at the point of non-viability. The UK supervisor would retain the power to increase this minimum loss-absorbing capacity to 20% of RWAs if it had concerns about the ability of the bank to restructure or liquidate at the point of failure.

In addition, in respect of UK universal banks, including HSBC’s major UK banking subsidiary, HSBC Bank plc, the ICB has proposed a separation of the UK retail and wholesale banking operations through the creation of a ring-fenced retail bank. The ICB recommends that a large ring-fenced bank should be required to maintain an equity ‘ring-fence buffer’ of at least 3% of RWAs above the Basel III base requirement of 7% of RWAs.

 

 

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Report of the Directors: Overview (continued)

  

 

The Chancellor of the Exchequer expressed broad approval of the ICB’s Final Report and indicated that the UK Government endorses in principle the proposals to establish a ring-fenced bank and greater primary loss absorbing capacity. The Government is not, however, bound to adopt the Commission’s recommendations and are proposing to undertake extensive consultation in two stages during 2012.

If the proposals described above are adopted, major changes to our corporate structure and business activities conducted in the UK through HSBC Bank plc might be required. The changes may include separating the ring-fenced bank from the existing UK incorporated universal bank. The proposals, if adopted, would take an extended period of time to implement and would significantly increase our costs, both to implement and to run the ongoing operations as restructured.

We are subject to a number of legal and regulatory actions and investigations, the outcomes of which are inherently difficult to predict, but unfavourable outcomes could have a material adverse effect on our operating results and brand

We face significant legal risks in our business and the volume and amount of damages claimed in litigation, regulatory proceedings and other adversarial proceedings against financial institutions are increasing.

We are subject to a number of material legal proceedings, regulatory actions and investigations as described in Note 44 on the Financial Statements on pages 405 to 409. It is inherently difficult to predict the outcome of many of the legal, regulatory and other adversarial proceedings involving our businesses, particularly those cases in which the matters are brought on behalf of various classes of claimants, seek damages of unspecified or indeterminate amounts or involve novel legal claims. An unfavourable result in one or more of these proceedings could have a material adverse effect on our results of operations.

We are subject to tax-related risks in the countries in which we operate which could have a material adverse effect on our operating results

HSBC is subject to the substance and interpretation of tax laws in all countries in which we operate and is subject to routine review and audit by tax authorities in relation thereto. We provide for

potential tax liabilities that may arise on the basis of the amounts expected to be paid to the tax authorities. The amounts ultimately paid may differ materially from the amounts provided depending on the ultimate resolution of such matters. Changes to tax law, tax rates and penalties for failure to comply could have a material adverse effect on our business, financial condition and/or results of operations.

For example, HM Treasury introduced a new bank levy in the Finance Act 2011. The bank levy is imposed on (among other entities) UK banking groups and subsidiaries, and therefore applies to HSBC. A charge of US$570m has been recognised in 2011 in respect of this levy, based on the consolidated balance sheet at the year end. A reduced rate is applied to longer-term liabilities. Other countries, including France, Germany and South Korea, have also introduced bank levies. These do not have the same global basis as the UK bank levy and do not have a material effect on the Group at present. It is possible that we will become subject to higher levies in the future, to similar taxes in other jurisdictions and/or to financial activity or transaction taxes which are currently under consideration.

Risks related to our business operations, governance and internal control systems

Our risk management measures may not be successful

The management of risk is an integral part of all our activities. Risk constitutes our exposure to uncertainty and the consequent variability of return. Specifically, risk equates to the adverse effect on profitability or financial condition arising from different sources of uncertainty including retail and wholesale credit risk, market risk, operational risk, non-traded market risk, insurance risk, concentration risk, liquidity and funding risk, reputational risk, strategic risk, pension obligation risk and regulatory risk. We seek to monitor and manage our risk exposure through a variety of separate but complementary control and reporting systems such as financial, credit, market, operational, compliance and legal. While we employ a broad and diversified set of risk monitoring and risk mitigation techniques, such techniques, and the judgements that accompany their application, cannot anticipate every unfavourable event or the specifics and timing of every outcome. Failure to manage risks appropriately could have a significant effect on our business, financial condition and/or results of operations.

 

 

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Report of the Directors: Overview (continued)

  

 

Operational risks are inherent in our business

We are exposed to many types of operational risk, including fraudulent and other criminal activities (both internal and external), breakdowns in processes or procedures and systems failure or non-availability. For example, failure to protect our operations from internet crime or cyber attacks could result in the loss of customer data or other sensitive information which could impact our reputation and our ability to attract and keep customers. The threat of external fraud may increase during adverse economic conditions especially in retail and commercial banking. We are also subject to the risk of disruption of our business arising from events that are wholly or partially beyond our control (for example, natural disasters, acts of terrorism, epidemics and transport or utility failures) which may give rise to losses in service to customers and/or economic loss to us. All of these risks are also applicable when we rely on outside suppliers or vendors to provide services to us and our customers.

Our operations are highly dependent on our information technology systems

The reliability and security of our information and technology infrastructure and our customer databases are crucial to maintaining the service availability of banking applications and processes and to protecting the HSBC brand. The proper functioning of our payment systems, financial control, risk management, credit analysis and reporting, accounting, customer service and other information technology systems, as well as the communication networks between our branches and main data processing centres, are critical to our operations. Critical system failure, any prolonged loss of service availability or any material breach of data security, particularly involving confidential customer data, could cause serious damage to our ability to service our clients, could breach regulations under which we operate and could cause long-term damage to our business and brand. For example, in 2010 HSBC Private Bank (Suisse) SA was the victim of a significant data theft resulting in reputational harm, intervention by regulators and remediation costs.

Our operations have inherent reputational risk

Reputational risk, meaning the risk to earnings and capital from negative public opinion, is inherent in our business. Negative public opinion can result from the actual or perceived manner in which we conduct our business activities, from our financial

performance, or from actual or perceived practices in the banking and financial industry. Modern technologies, in particular online social networks and other broadcast tools which facilitate communication with large audiences in short time frames and with minimal costs, may significantly enhance and accelerate the impact of damaging information and allegations. Negative public opinion may adversely affect our ability to keep and attract customers and, in particular, corporate and retail depositors.

We may suffer losses due to employee misconduct

Our businesses are exposed to risk from potential non-compliance with policies, employee misconduct or negligence and fraud, which could result in regulatory sanctions and serious reputational or financial harm. In recent years, a number of multinational financial institutions have suffered material losses due to the actions of ‘rogue traders’ or other employees. It is not always possible to deter employee misconduct and the precautions we take to prevent and detect this activity may not always be effective.

We rely on recruiting, retaining and developing appropriate senior management and skilled personnel

Our continued success depends in part on the continued service of key members of our management team. The ability to continue to attract, train, motivate and retain highly qualified professionals is a key element of our strategy. The successful implementation of our growth strategy depends on the availability of skilled management, both at our head office and at each of our business units. If one of our business units or other functions fails to staff its operations appropriately or loses one or more of its key senior executives, and fails to replace them in a satisfactory and timely manner, our business, financial condition and/or results of operations, including control and operational risks, may be adversely affected. Likewise, if we fail to attract and appropriately train, motivate and retain qualified professionals, our business may be adversely affected.

Our financial statements are based in part on assumptions and estimates which, if inaccurate, could cause material misstatement of the results and financial position of the Group

The preparation of financial statements requires management to make judgements, estimates and

 

 

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Report of the Directors: Overview (continued)

  

 

assumptions that affect the reported amounts of assets, liabilities, income and expenses. Due to the inherent uncertainty in making estimates, actual results reported in future periods may be based upon amounts which differ from those estimates. Estimates, judgements and assumptions are continually evaluated and are based on historical experience and other factors, including expectations of future events that are believed to be reasonable under the circumstances. Revisions to accounting estimates are recognised in the period in which the estimate is revised and in any future periods affected. The accounting policies deemed critical to our results and financial position, based upon materiality and significant judgements and estimates, include impairment of loans and advances, goodwill impairment, valuation of financial instruments, impairment of available-for-sale financial assets, deferred tax assets and provision for liabilities, which are discussed in detail in ‘Critical accounting policies’ on page 38.

The valuation of financial instruments measured at fair value can be subjective, in particular where models are used which include unobservable inputs. Given the uncertainty and subjectivity associated with valuing such instruments it is possible that the results of operations and financial position of the Group could be materially misstated if the estimates and assumptions used prove to be inaccurate. For further details, see ‘Critical accounting policies’ on page 38.

If the judgement, estimates and assumptions we use in preparing our consolidated financial statements are subsequently found to be incorrect, there could be a material effect on our results of operations and a corresponding effect on our funding requirements and capital ratios.

Third parties may use us as a conduit for illegal activities without our knowledge, which could have a material adverse effect on us

We are required to comply with applicable anti-money laundering laws and regulations and have adopted various policies and procedures, including internal control and ‘know-your-customer’ procedures, aimed at preventing use of HSBC for money laundering. A major focus of US governmental policy relating to financial institutions in recent years has been combating money laundering and enforcing compliance with US economic sanctions. For example, subsidiaries of HSBC Holdings have entered into a consent cease and desist order with the OCC and a similar consent order with the Federal Reserve Board which requires

the implementation of improvements to compliance procedures regarding obligations under the US Bank Secrecy Act (the ‘BSA’) and anti-money laundering (‘AML’) rules. These consent orders do not preclude additional enforcement actions by bank regulatory, governmental or law enforcement agencies. Investigations by various authorities pertaining to, among other things, alleged violations of AML laws, the BSA and regulations issued by the Office of Foreign Asset Control are ongoing. See Note 44 on the Financial Statements on page 405.

In relevant situations and where permitted by regulation, we may rely upon certain counterparties to maintain and properly apply their own appropriate anti-money laundering procedures. While permitted by regulation, such reliance may not be completely effective in preventing third parties from using us (and our relevant counterparties) as a conduit for money laundering including illegal cash operations without our (and our relevant counterparties’) knowledge. If we are associated with, or even accused of being associated with, or become a party to, money laundering, our reputation could suffer and we could become subject to fines, sanctions and/or legal enforcement (including being added to any ‘blacklists’ that would prohibit certain parties from engaging in transactions with us), any one of which could have a material adverse effect on our business, financial condition and/or results of operations.

We may not achieve all the expected benefits of our strategic initiatives

In 2011 we developed and presented a new strategy for the Group. See further discussion in ‘Strategic direction’ on page 11. Our strategy is built around two trends, continued growth of international trade and capital flows, and wealth creation, particularly in faster growing markets. Based on our analysis of those trends, we have developed criteria to help us better deploy capital. We have also launched an initiative to reduce costs, part of which includes the disposal of non-core businesses. The development and implementation of our strategy requires difficult, subjective and complex judgements, including forecasts of economic conditions in various parts of the world. We may fail to correctly identify the trends we seek to exploit and the relevant factors in making decisions as to capital deployment and cost reduction. Our ability to execute our strategy may also be limited by our operational capacity and the increasing complexity of the regulatory environment in which we operate. For example, the complexities of separating disposed assets from continuing operations, including transitional

 

 

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Report of the Directors: Overview (continued)

  

 

arrangements, could increase operational and reputational risks and threaten successful execution of an announced disposal. In addition, factors beyond our control, including but not limited to the market and economic conditions and other challenges discussed in detail above, could limit our ability to achieve all of the expected benefits of these initiatives.

Risks related to our business

We have significant exposure to counterparty risk within the financial sector and to other risk concentrations

We have exposure to virtually all major industries and counterparties, and we routinely execute transactions with counterparties in financial services, including brokers and dealers, commercial banks, investment banks, mutual and hedge funds, and other institutional clients. Many of these transactions expose us to credit risk in the event of default by our counterparty or client. Our ability to engage in routine transactions to fund our operations and manage our risks could be adversely affected by the actions and commercial soundness of other financial services institutions. Financial institutions are necessarily interdependent because of trading, clearing, counterparty or other relationships. As a consequence, a default by, or decline in market confidence in, individual institutions, or anxiety about the financial services industry generally, can lead to further individual and/or systemic difficulties, defaults and losses. Where counterparty risk has been mitigated by taking collateral, our credit risk may remain high if the collateral we hold cannot be realised or has to be liquidated at prices which are insufficient to recover the full amount of our loan or derivative exposure.

Market fluctuations may reduce our income or the value of our portfolios

Our businesses are inherently subject to risks in financial markets and in the wider economy, including changes in, and increased volatility of, interest rates, inflation rates, credit spreads, foreign exchange rates, commodity, equity, bond and property prices and the risk that our customers act in a manner inconsistent with our business, pricing and hedging assumptions.

Market movements will continue to have a significant impact on us in a number of key areas. For example, our pension scheme assets include equity and debt securities, the cash flows of which change as equity prices and interest rates vary. Banking and trading activities are subject to interest

rate risk, foreign exchange risk, inflation risk and credit spread risk. Changes in interest rate levels, interbank spreads over official rates, yield curves and spreads affect the interest rate spread realised between lending and borrowing costs. The potential for future volatility and margin changes remains. Competitive pressures on fixed rates or product terms in existing loans and deposits sometimes restrict our ability to change interest rates applying to customers in response to changes in official and wholesale market rates.

Our insurance businesses are exposed to the risk that market fluctuations will cause mismatches to occur between product liabilities and the investment assets which back them. Market risks can affect our insurance products in a number of ways depending upon the product and associated contract. For example, mismatches between assets and liability yields and maturities give rise to interest rate risk. Some of these risks are borne directly by the customer and some are borne by the insurance businesses. Some insurance contracts involve guarantees and options that increase in value in adverse investment markets. There is a risk that the insurance businesses will bear some of the cost of such guarantees and options. The insurance businesses also have capital directly invested in the markets that are exposed to market risk. The performance of the investment markets will thus have a direct impact upon the value embedded in the insurance and investment contracts and our operating results, financial condition and prospects.

It is difficult to predict with any accuracy changes in market conditions, and such changes may have a material adverse effect on our operating results, financial condition and prospects.

Liquidity, or ready access to funds, is essential to our businesses

Our ability to borrow on a secured or unsecured basis and the cost of so doing can be affected by increases in interest rates or credit spreads, the availability of credit, regulatory requirements relating to liquidity or the market perceptions of risk relating to us or the banking sector, including our perceived or actual creditworthiness.

Current accounts and savings deposits payable on demand or at short notice form a significant part of our funding, and we place considerable importance on maintaining their stability. For deposits, stability depends upon preserving investor confidence in our capital strength and liquidity, and on comparable and transparent pricing. Although

 

 

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deposits have been, over time, a stable source of funding, this may not continue.

We also access professional markets in order to provide funding for non-banking subsidiaries that do not accept deposits, to align asset and liability maturities and currencies and to maintain a presence in local money markets. While we continued to have good access to debt capital markets in 2011, market disruption continued to have adverse effects on the liquidity and funding risk profile of the banking system in the year. An inability to obtain financing in the unsecured long-term or short-term debt capital markets, or to access the secured lending markets, could have a substantial adverse effect on our liquidity. In challenging credit markets, our funding costs may increase or we may be unable to raise funds to support or expand our businesses, adversely affecting our results of operations. Even though we continued to have good access to debt capital markets during 2011 at competitive prices, the costs of liquidity have risen, and we expect to incur additional costs as a result of regulatory requirements for increased liquidity and the challenging economic environment in Europe, the US and elsewhere.

If we are unable to raise funds through deposits and/or in the capital markets, our liquidity position could be adversely affected and we might be unable to meet deposit withdrawals on demand or at their contractual maturity, to repay borrowings as they mature, to meet our obligations under committed financing facilities and insurance contracts, or to fund new loans, investments and businesses. We may need to liquidate unencumbered assets to meet our liabilities. In a time of reduced liquidity, we may be unable to sell some of our assets, or we may need to sell assets at depressed prices, which in either case could adversely affect our results of operations and financial condition.

Any reduction in the credit rating assigned to HSBC Holdings, any subsidiaries of HSBC Holdings or any of their respective debt securities could increase our cost or availability of funding and adversely affect our liquidity position and interest margins

Credit ratings affect the cost and other terms upon which we are able to obtain funding. Rating agencies regularly evaluate HSBC Holdings and certain of its subsidiaries, as well as their respective debt securities. Their ratings are based on a number of factors, including their assessment of the relative

financial strength of HSBC or of the relevant entity, as well as conditions affecting the financial services industry generally. There can be no assurance that the rating agencies will maintain HSBC’s or the relevant entity’s current ratings or outlook, especially in light of the difficulties in the financial services industry and the financial markets. HSBC Holdings’ long-term credit rating was recently downgraded by Standard & Poor’s, after the rating agency applied its new rating methodology to banks globally. HSBC experienced no change in market demand or the cost of issuing liabilities and negligible changes in its collateral requirements arising from this change in rating. Further reductions in those ratings and outlook could increase the cost of our funding, limit access to capital markets and require additional collateral to be placed and, consequently, adversely affect our interest margins and/or our liquidity position.

Risks concerning borrower credit quality are inherent in our businesses

Risks arising from changes in credit quality and the recoverability of loans and amounts due from borrowers and counterparties (e.g. reinsurers and counterparties in derivative transactions) are inherent in a wide range of our businesses. Adverse changes in the credit quality of our borrowers and counterparties as a consequence of a general deterioration in economic conditions, or arising from systemic risks in the financial systems, could reduce the recoverability and value of our assets and require an increase in our loan impairment charges.

We estimate and recognise impairment allowances for credit losses inherent in our credit exposure. This process, which is critical to our results and financial condition, requires difficult, subjective and complex judgements, including forecasts of how these economic conditions might impair the ability of our borrowers to repay their loans and the ability of other counterparties to meet their obligations. As is the case with any such assessments, we may fail to estimate accurately the effect of factors that we identify or fail to identify relevant factors. Further, the information we use to assess the creditworthiness of our counterparties may be inaccurate or incorrect. Any failure by us to accurately estimate the ability of our counterparties to meet their obligations may have a material adverse impact on our business, financial condition and/or results of operations. For further information on the nature of our credit risk, see ‘Credit risk’ on page 104.

 

 

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Our insurance businesses are subject to risks relating to insurance claim rates and changes in insurance customer behaviour

We provide various insurance products for customers with whom we have a banking relationship, including several types of life insurance products. The cost of claims and benefits can be influenced by many factors, including mortality and morbidity rates, lapse and surrender rates and, if the policy has a savings element, the performance of assets to support the liabilities. Adverse developments in any of these factors may adversely affect our financial condition and results of operations.

Our general insurance businesses are exposed to the risk of uncertain insurance claim rates. For example, extreme weather conditions can result in high property damage claims, higher levels of theft can increase claims on home insurance and changes to unemployment levels can increase claims on loan protection insurance. These claims rates may differ from business assumptions and negative developments may adversely affect our financial condition and results of operations.

 

HSBC Holdings is a holding company and as a result, is dependent on dividends from its subsidiaries to meet its obligations including its obligations with respect to its debt securities, and to provide profits for payment of future dividends to shareholders.

HSBC Holdings is a non-operating holding company and as such the principal sources of its income are from operating subsidiaries which hold the principal assets of HSBC. As a separate legal entity, HSBC Holdings relies on remittance of its subsidiaries’ profits and other funds in order to be able to pay obligations to shareholders and debt holders as they fall due. The ability of HSBC’s subsidiaries and affiliates to pay dividends could be restricted by changes in official banking measures, exchange controls and other requirements.

We may be required to make substantial contributions to our pension plans.

We operate a number of pension plans throughout the world, including defined benefit plans. Pension scheme obligations fluctuate with changes in long-term interest rates, inflation, salary levels and the longevity of scheme members. The level of contributions we make to our pension plans has a direct impact on our cash flow. To the extent plan assets are insufficient to cover existing liabilities higher levels of contributions will be required. As a result, deficits in those pension plans may have a material adverse impact on our business, financial condition and/or results of operations.

 

 

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Report of the Directors: Overview (continued)

  

 

Top and emerging risks

We classify certain risks as ‘top’ or ‘emerging’. We define a ‘top risk’ as being a current, emerged risk which has arisen across any of our risk categories, regions or global businesses and has the potential to have a material impact on our financial results or our reputation and the sustainability of our long-term business model, and which may form and crystallise within a one year horizon. We consider an ‘emerging risk’ to be one which has large uncertain outcomes which may form and crystallise beyond a one year horizon and, if it were to crystallise, could have a material effect on our long term strategy.

Our approach to identifying and monitoring top and emerging risks is informed by the risk factors.

All of our activities involve, to varying degrees, the measurement, evaluation, acceptance and management of risk or combinations of risks which we assess on a Group-wide basis. Top and emerging risks fall under the following three broad categories:

 

 

macro-economic and geopolitical risk;

 

 

macro-prudential, regulatory and legal risks to our business model;

 

 

risks related to our business operations, governance and internal control systems.

During 2011 our senior management paid particular attention to a number of top and emerging risks which are summarised below:

 

 

Macro-economic and geopolitical risk

 

 

Eurozone – risk of sovereign defaults

 

 

Eurozone member departing from the currency union

 

 

Increased geopolitical risk in certain regions

Macro-prudential, regulatory and legal risks to our business model

 

 

Regulatory developments affecting our business model and Group profitability

 

 

Regulatory investigations and requirements relating to conduct of business and financial crime negatively affecting our results and brand

 

 

Dispute risk

Risks related to our business operations, governance and internal control systems

 

 

Challenges to achieving our strategy in a downturn

 

 

Internet crime and fraud

 

 

Social media risk

 

 

Level of change creating operational complexity and heightened operational risk

 

 

Information security risk

 

All of the above risks are regarded as top risks with the exception of social media risk which is an emerging risk.

A detailed account of these risks is provided on page 99. Further comments on expected risks and uncertainties are made throughout the Annual Report and Accounts 2011, particularly in the section on Risk, pages 98 to 210.

Risk appetite

Risk appetite is a key component of our management of risk and describes the types and level of risk we are prepared to accept in delivering our strategy. It is discussed further on page 234.

Our risk appetite may be revised in response to the top and emerging risks we have identified.

HSBC Values

 

The role of HSBC Values in daily operating practice is significant in the context of the financial services sector and the wider economy, particularly in the light of developments and changes in regulatory policy, investor confidence and society’s view of the role of banks. We expect our executives and employees to act with courageous integrity in the execution of their duties by being:

 

 

dependable and doing the right thing;

 

 

open to different ideas and cultures; and

 

 

connected with our customers, communities, regulators and each other.

We continue to enhance our values-led culture by embedding HSBC Values into how we conduct our business and through the personal sponsorship of the Group Chief Executive and senior executives. These initiatives will continue in 2012 and beyond.

Key performance indicators

 

The Board of Directors and the GMB monitor HSBC’s progress against its strategic objectives. Progress is assessed by comparison with our strategy, our operating plan and our historical performance using both financial and non-financial measures.

Following a review of our high-level key performance indicators (‘KPI’s) and reflecting the increased focus on the quality of the capital base, the GMB decided to adopt a core tier 1 capital ratio instead of a tier 1 capital ratio as the primary indicator of the strength of our capital base and its ability to support the growth of the business and meet regulatory requirements.

The GMB remains focused on improving our capital deployment to support the achievement of our medium term target for return on equity of between 12% and 15%, utilising the five filter analysis across the portfolio of businesses. We will continue to evaluate our businesses in 2012 using this methodology.

 

 

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Report of the Directors: Overview (continued)

  

 

Strategy  

Capital deployment – improving the way we deploy capital

   

Return on average ordinary

shareholders’ equity3

  Core tier 1 capital8   Advances to core funding  ratio9
LOGO   LOGO   LOGO   LOGO
  Measure: (percentage) profit attributable to shareholders divided by average ordinary shareholders’ equity.   Measure: (percentage) core tier 1 capital comprising shareholders’ equity and related non-controlling interests less regulatory deductions and adjustments.  

Measure: loans and advances to customers as a percentage of the total of core customer deposits and term funding with a remaining term to maturity in excess of one year.

 

  Target: to maintain a return in the medium term of between 12% and 15%.  

Target: to maintain a strong capital base to support the development of the business and meet regulatory capital requirements at all times.

 

  Target: to maintain an advances to core funding ratio below limits set for each entity.
  Outcome: return on average ordinary shareholders’ equity was below the target range, but 1.4 percentage points higher than 2010.   Outcome: the decrease in core tier 1 capital to 10.1% reflected an increase in RWAs due to a growth in lending balances, including those held for sale and an increase in the RWAs of our mainland China associates, as well as the introduction of Basel 2.5.   Outcome: the strong funding position of HBAP has allowed us to take advantage of loan growth opportunities during the year, while reduced lending in the US resulted in further strengthening of our funding position.

 

Strategy  

Cost efficiency – a lean and values-driven organisation

   

Cost efficiency

(2011: underlying cost efficiency 61%)

  Employee engagement
LOGO   LOGO   LOGO
  Measure: (percentage) total operating expenses divided by net operating income before loan impairment and other credit risk provisions.  

Measure: (percentage) measure of employee’s emotional and rational attachment to HSBC, a combination of advocacy, satisfaction, commitment and pride.

 

 

Target: to be between 48% and 52%, a range within which business is expected to remain to accommodate both returns to shareholders and the need for continued investment in support of future business growth.

 

  Target: to achieve a 72% global rating in 2011, with progressive improvement to best in class.
  Outcome: on a reported and underlying basis the ratio was outside the target range, in part due to notable items including restructuring costs, customer redress programmes and a bank levy introduced by the UK government, but also due to an increase in staff costs reflecting wage inflation in key markets and higher average staff numbers.   Outcome: employee engagement behind global best in class. Improvement in 2011 despite a challenging environment.

 

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Report of the Directors: Overview (continued)

  

 

Growth – continue to position ourselves for growth

  Strategy

Risk-adjusted revenue growth

(2011: underlying growth 2%)

 

Basic earnings

per ordinary share

 

Dividends per ordinary

share growth

   
LOGO   LOGO   LOGO  

LOGO

 

Measure: (percentage) increase in reported net operating income after loan impairment and other credit risk charges since last year.   Measure: (US$) level of basic earnings generated per ordinary share.  

Measure: (percentage) increase in dividends per share since last year, based on dividends paid in respect of the year to which the dividend relates.

 

 
Target: to deliver consistent growth in risk adjusted revenues.   Target: to deliver consistent growth in basic earnings per share.  

Target: to deliver sustained dividend per share growth.

 

 
Outcome: reported risk-adjusted revenue increased primarily due to favourable movements on the fair value of own debt due to credit spreads and on an underlying basis due to lower loan impairment charges.  

Outcome: Earnings per share (‘EPS’) increased in 2011 reflecting significant favourable movements on the fair value of own debt due to credit spreads which resulted in an increase in reported profits.

 

  Outcome: dividends per share increased by 14%.  

 

Customer recommendation   Brand value    
LOGO   LOGO  

LOGO

 

Measure: we measure our customer satisfaction through an independent market research survey of retail banking and business banking customers in selected countries, using a specific metric of customer recommendation (the ‘CRI’) to score performance. We benchmark our performance against key competitors in each market and set targets for performance based on our peer group of banks.  

Measure: in 2011, we moved our brand measure to the Brand Finance valuation method as reported in The Banker Magazine. Our previous measure only gave us a score derived from a survey of our personal and small business customers. The Brand Finance methodology gives us a more complete measure of the strength of the brand and its impact across all business lines and customer groups. It is a wholly independent measure and is publicly reported.

 

 

Target: the Group target is for 75% of all the selected markets (based on their weighted revenue) to meet their CRI targets.

 

  Target: a top 3 position in the banking peer group.  
Outcome: CMB Business Banking exceeded its target. RBWM experienced a challenging environment in many of its large retail markets, with strong local competition and negative reaction to some strategic portfolio management activity, and only met its target in 35% of the markets by weighted revenue. It got to within 2 percentage points of its target in a further 44% of markets. See page 46 for further details. RBWM had a strong fourth quarter, with 77% of the markets meeting target and it finished the year ranked first in five of the six markets surveyed in Asia.   Outcome: HSBC’s brand value in 2009 followed a sharp drop in industry brand values in 2008/9 which coincided with the financial crisis. The subsequent increase reflected a general rise in values, with HSBC’s brand remaining one of the strongest in the sector.  

For footnotes, see page 95.

 

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Report of the Directors: Operating and Financial Review

  

 

Financial summary

 

Reconciliation of reported and underlying profit before tax

   16

Consolidated income statement

   18

Group performance by income and expense item

   20

Net interest income

   20

Net fee income

   22

Net trading income

   23

Net income/(expense) from financial instruments designated at fair value

   24

Gains less losses from financial investments

   25

Net earned insurance premiums

   26

Other operating income

   26

Net insurance claims incurred and movement in liabilities to policyholders

   27

Loan impairment charges and other credit risk provisions

   27

Operating expenses

   29

Share of profit in associates and joint ventures

   31

Tax expense

   31

2010 compared with 2009

   31a

Recent events

   31j

Consolidated balance sheet

   32

Movement in 2011

   33

Average balance sheet

   36a

Average balance sheet and net interest income

   36a

Analysis of changes in net interest income and net interest expense

   36h

Short-term borrowings

   36k

Contractual obligations

   36k

Loan maturity and interest sensitivity analysis

   36l

Deposits

   36m

Certificates of deposit and other time deposits

   36o

Economic profit/(loss)

   37

Reconciliation of RoRWA measures

   37

Ratio of earnings to fixed charges

   37a

Critical accounting policies

   38

The management commentary included in the Report of the Directors: ‘Overview’ and ‘Operating and Financial Review’, together with the ‘Employees’ and ‘Corporate sustainability’ sections of ‘Corporate Governance’ and the ‘Directors’ Remuneration Report’ is presented in compliance with the IFRS Practice Statement ‘Management Commentary’ issued by the IASB.

Reconciliation of reported and

underlying profit before tax

 

In addition to results reported on an IFRSs basis, we measure our performance internally on a like-for-like basis by eliminating the effects of foreign currency translation differences, acquisitions and disposals of subsidiaries and businesses, and fair value movements on own debt attributable to credit spread where the net result of such movements will be zero upon maturity of the debt; all of which distort year-on-year comparisons. We refer to this as our underlying performance.

Reported results include the effects of the above items. They are excluded when monitoring progress against operating plans and past results because management believes that the underlying basis more accurately reflects operating performance.

 

 

Constant currency

Constant currency comparatives for 2010 referred to in the commentaries are computed by retranslating into US dollars for non-US dollar branches, subsidiaries, joint ventures and associates:

 

 

the income statements for 2010 at the average rates of exchange for 2011; and

 

 

the balance sheet at 31 December 2010 at the prevailing rates of exchange on 31 December 2011.

Constant currency comparatives for 2009 referred to in the 2010 commentaries are computed on the same basis, by applying average rates of exchange for 2010 to the 2009 income and rates of exchange on 31 December 2010 to the balance sheet at 31 December 2009.

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.

 

Underlying performance

The following tables compare our underlying performance in 2011 and 2010 with reported profits in those years. Equivalent tables are provided for each of HSBC’s global businesses and geographical segments in the Form 20-F filed with the SEC, which is available on www.hsbc.com.

The foreign currency translation differences reflect the relative weakening of the US dollar against most major currencies during 2011.

The following acquisitions and disposals affected both comparisons:

 

 

the gain of US$62m on reclassification of Bao Viet Holdings (‘Bao Viet’) from an available-for-sale asset to an associate in January 2010;

 

 

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Report of the Directors: Operating and Financial Review (continued)

  

 

 

the gain of US$66m on sale of our stake in Wells Fargo HSBC Trade Bank in March 2010;

 

 

the gain of US$107m on disposal of HSBC Insurance Brokers Limited in April 2010;

 

 

the dilution gains which arose on our holding in Ping An Insurance (Group) Company of China, Limited (‘Ping An’) following the issue of share capital to third parties in May 2010 and June 2011 of US$188m and US$181m, respectively;

 

 

the loss of US$42m on the sale of our investment in British Arab Commercial Bank plc in October 2010;

 

 

the gain of US$74m on the deconsolidation of private equity funds following the management buy-out of Headland Capital Partners Ltd (formerly known as HSBC Private Equity (Asia) Ltd) in November 2010;

 

the gain of US$255m on the sale of Eversholt Rail Group in December 2010;

 

 

the gain of US$83m on the sale of HSBC Afore S.A. de C.V. (‘HSBC Afore’) in August 2011;

 

 

a loss of US$48m being our share of the loss recorded by Ping An on remeasurement of its previously held equity interest in Shenzen Development Bank (‘SDB’) when Ping An took control and fully consolidated SDB in July 2011; and

 

 

the dilution gain of US$27m in December 2011 as a result of the merger between HSBC Saudi Arabia Limited and SABB Securities Limited.

 

 

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HSBC HOLDINGS PLC

 

Report of the Directors: Operating and Financial Review (continued)

  

 

Reconciliation of reported and underlying profit before tax

 

     2011 compared with 2010  
HSBC   

2010

as

reported
US$m

        

2010
adjust-

ments10

US$m

        

Currency

translation11

US$m

        

2010
at 2011
exchange

rates12

US$m

        

2011

as

reported

US$m

        

2011

adjust-

ments10

US$m

        

2011
under-

lying
US$m

    

Re-
ported

change13

%

    

Under-
lying

change13

%

 

Net interest income

     39,441           48           781           40,270           40,662                     40,662         3         1   

Net fee income

     17,355           (55        349           17,649           17,160                     17,160         (1      (3

Changes in fair value14

     (63        63                               3,933           (3,933                

Other income15

     11,514           (847        284           10,951           10,525           (291        10,234         (9      (7

Net operating income16

     68,247           (791        1,414           68,870           72,280           (4,224        68,056         6         (1

Loan impairment charges and other credit risk provisions

     (14,039                  (206        (14,245        (12,127                  (12,127      14         15   

Net operating income

     54,208           (791        1,208           54,625           60,153           (4,224        55,929         11         2   

Operating expenses

     (37,688        220           (842        (38,310        (41,545                  (41,545      (10      (8

Operating profit

     16,520           (571        366           16,315           18,608           (4,224        14,384         13         (12

Income from associates

     2,517                     93           2,610           3,264           48           3,312         30         27   

Profit before tax

     19,037           (571        459           18,925           21,872           (4,176        17,696         15         (6

By geographical region

                                      

Europe

     4,302           (88        167           4,381           4,671           (2,947        1,724         9         (61

Hong Kong

     5,692           (130        (10        5,552           5,823                     5,823         2         5   

Rest of Asia-Pacific

     5,902           (187        227           5,942           7,471           (135        7,336         27         23   

Middle East and North Africa

     892           42           (10        924           1,492           (41        1,451         67         57   

North America

     454           (208        39           285           100           (970        (870      (78   

Latin America

     1,795                     46           1,841           2,315           (83        2,232         29         21   

Profit before tax

     19,037           (571        459           18,925           21,872           (4,176        17,696         15         (6

By global business

                                      

Retail Banking and Wealth Management17

     3,839           (3        126           3,962           4,270           (83        4,187         11         6   

Commercial Banking

     6,090           (119        126           6,097           7,947                     7,947         30         30   

Global Banking and Markets17

     9,215           (262        198           9,151           7,049                     7,049         (24      (23

Global Private Banking

     1,054                     6           1,060           944                     944         (10      (11

Other

     (1,161        (187        3           (1,345        1,662           (4,093        (2,431         (81

Profit before tax

     19,037           (571        459           18,925           21,872           (4,176        17,696         15         (6

For footnotes, see page 95.

Additional information is available on the HSBC website www.hsbc.com.

 

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Report of the Directors: Operating and Financial Review (continued)

  

 

Consolidated income statement

 

Five-year summary consolidated income statement

 

    

2011

US$m

        

2010

US$m

        

2009

US$m

        

2008

US$m

        

2007

US$m

 

Net interest income

     40,662           39,441           40,730           42,563           37,795   

Net fee income

     17,160           17,355           17,664           20,024           22,002   

Net trading income

     6,506           7,210           9,863           6,560           9,834   

Net income/(expense) from financial instruments designated at fair value

     3,439           1,220           (3,531        3,852           4,083   

Gains less losses from financial investments

     907           968           520           197           1,956   

Dividend income

     149           112           126           272           324   

Net earned insurance premiums

     12,872           11,146           10,471           10,850           9,076   

Gains on disposal of French regional banks

                                   2,445             

Other operating income

     1,766           2,562           2,788           1,808           2,531   

Gains arising from dilution of interests in associates and joint ventures

     208           188                               1,092   

 

Other

  

 

 

 

1,558

 

  

    

 

 

 

2,374

 

  

    

 

 

 

2,788

 

  

    

 

 

 

1,808

 

  

    

 

 

 

1,439

 

  

Total operating income

     83,461           80,014           78,631           88,571           87,601   

Net insurance claims incurred and movement in liabilities to policyholders

     (11,181        (11,767        (12,450        (6,889        (8,608

Net operating income before loan impairment charges and other credit risk provisions

     72,280           68,247           66,181           81,682           78,993   

Loan impairment charges and other credit risk provisions

     (12,127        (14,039        (26,488        (24,937        (17,242

Net operating income

     60,153           54,208           39,693           56,745           61,751   

Total operating expenses19

     (41,545        (37,688        (34,395        (49,099        (39,042

Operating profit

     18,608           16,520           5,298           7,646           22,709   

Share of profit in associates and joint ventures

     3,264           2,517           1,781           1,661           1,503   

Profit before tax

     21,872           19,037           7,079           9,307           24,212   

Tax expense

     (3,928        (4,846        (385        (2,809        (3,757
Profit for the year    17,944          14,191          6,694          6,498          20,455  

Profit attributable to shareholders of the parent company

     16,797           13,159           5,834           5,728           19,133   

Profit attributable to non-controlling interests

     1,147           1,032           860           770           1,322   
Five-year financial information                       
     US$          US$          US$          US$          US$  

Basic earnings per share20

     0.92           0.73           0.34           0.41           1.44   

Diluted earnings per share20

     0.91           0.72           0.34           0.41           1.42   

Dividends per ordinary share1

     0.39           0.34           0.34           0.93           0.87   
     %           %           %           %           %   

Dividend payout ratio21

     42.4           46.6           100.0           226.8           60.4   

Post-tax return on average total assets

     0.65           0.57           0.27           0.26           0.97   

Return on average ordinary shareholders’ equity

     10.9           9.5           5.1           4.7           15.9   

Average foreign exchange translation rates to US$:

                      

US$1: £

     0.624           0.648           0.641           0.545           0.500   

US$1: €

     0.719           0.755           0.719           0.684           0.731   

For footnotes, see page 95.

 

Reported profit before tax of US$21.9bn in 2011 was US$2.8bn higher than in 2010, primarily due to US$3.9bn of favourable fair value movements on own debt attributable to credit spreads compared with a negative movement of US$63m in 2010. On an underlying basis, profit before tax was 6% lower than

in 2010 due to increased operating expenses which were partly offset by lower loan impairment charges and other credit risk provisions.

The results of the Group continued to be adversely affected by the losses in the US consumer

 

 

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HSBC HOLDINGS PLC

 

Report of the Directors: Operating and Financial Review (continued)

  

 

finance business, which were US$2.4bn in 2011 and US$2.2bn in 2010. We have agreed to sell the profitable US Card and Retail Services portfolio, with the remainder of the loss-making US consumer finance business being run down. We expect the sale of this business to have a significant impact on both revenue and profitability in North America for the foreseeable future.

The difference between reported and underlying results is explained on page 16. Except where stated otherwise, the commentaries in the Financial Summary are on an underlying basis and references to HSBC Finance Corporation (‘HSBC Finance’) and HSBC Bank USA N.A. (‘HSBC Bank USA’) are on a management basis, rather than a legal entity basis.

Net operating income before loan impairment charges and other credit risk provisions (‘revenue’) was broadly in line with 2010, due to the adverse effect on GB&M revenue in Europe of the turmoil in the eurozone sovereign debt market and a decline in lending balances in RBWM in North America being offset by revenue growth in faster-growing regions. The eurozone turmoil resulted in lower trading income from our Credit and Rates businesses as problems escalated, particularly in the second half of 2011. Our GB&M performance was also affected by lower revenues in Balance Sheet Management, as higher yielding positions matured and interest rates remained low, and in our legacy credit portfolio (see page 23). In North America, we continued to reposition our business and we remained focused on managing down our run-off portfolios. As a consequence, revenue fell, reflecting declining customer loan balances in the run-off portfolios and in the Card and Retail Services businesses.

These factors were broadly offset by increased net interest income in CMB as a result of strong balance sheet growth in 2010 which continued into 2011, albeit at a slower pace during the latter part of the year. Revenue also benefited from balance sheet growth in RBWM in Rest of Asia-Pacific and Latin America. There were also strong performances in over half of our business lines in GB&M, including Global Banking, Foreign Exchange and Equities, particularly in the faster growing regions of Rest of Asia-Pacific and Latin America.

Loan impairment charges and other credit risk provisions were considerably lower than in 2010, with decreases across all regions except Latin America and Hong Kong. The most significant decline in loan impairment charges was in RBWM in North America, reflecting lower balances in our

consumer finance portfolios and lower lending balances and improved credit quality in Card and Retail Services. There was also a notable decline in loan impairment charges in Europe, due to successful initiatives taken to mitigate risk within RBWM which resulted in a reduction in delinquency rates in personal lending in the UK. Loan impairment charges and other credit risk provisions fell in the Middle East in GB&M due to the non-recurrence of restructuring activity for a small number of large customers. In Latin America, loan impairment charges and other credit risk provisions increased as a result of strong lending growth in RBWM and CMB, along with a rise in delinquency rates in Brazil during the second half of 2011.

Operating expenses were higher than in 2010, reflecting an increase in notable items and higher staff costs in faster-growing regions. Notable items included restructuring costs of US$1.1bn, a bank levy introduced by the UK government of US$570m, higher provisions relating to customer redress programmes of US$898m and US mortgage servicing costs of US$257m. The restructuring costs were incurred as a result of actions taken following the review of our capital deployment and operational effectiveness. This led to a reduction of more than 7,600 FTEs during the second half of 2011 and sustainable savings of US$0.9bn. These notable items were partially offset by a credit of US$587m resulting from a change in the inflation measure used to calculate the defined benefit obligation of the HSBC Bank plc (‘HSBC Bank’) UK defined benefit plan for deferred pensions.

Income from associates increased, mainly driven by strong results in our mainland China associates. The contribution from Bank of Communications Co., Limited (‘BoCom’) rose due to loan growth, wider deposit spreads and higher fee income. Our share of profits from Industrial Bank Co. Limited (‘Industrial Bank’) rose due to strong growth in customer lending and an increase in fee-based revenue.

The reported profit after tax was US$3.8bn or 26% higher, due to the increase in taxable profits, primarily from movements on the fair value of own debt and a lower tax expense. This reflected the inclusion in 2011 of a deferred tax benefit now eligible to be recognised in respect of foreign tax credits. In addition, the tax charge in 2010 included US$1.2bn attributable to a taxable gain from an internal reorganisation in North America. As a result of these factors, the effective tax rate for 2011 was 18% compared with 25.5% in 2010.

 

 

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Table of Contents

HSBC HOLDINGS PLC

 

Report of the Directors: Operating and Financial Review (continued)

  

 

Group performance by income and expense item

 

Net interest income

 

    

2011

US$m

         

2010

US$m

         

2009

US$m

 

Interest income

     63,005            58,345            62,096   

Interest expense

     (22,343         (18,904         (21,366

Net interest income22

     40,662            39,441            40,730   

Average interest-earning assets

     1,622,658            1,472,294            1,384,705   

Gross interest yield23

     3.88%            3.96%            4.48%   

Less: cost of funds

     (1.56%         (1.41%         (1.58%

Net interest spread24

     2.32%            2.55%            2.90%   

Net interest margin25

     2.51%            2.68%            2.94%   

Summary of interest income by type of asset

 

    2011         2010         2009  
   

Average

balance
US$m

       

Interest

income
US$m

        Yield
%
       

Average

balance
US$m

       

Interest

income
US$m

        Yield
%
       

Average

balance
US$m

       

Interest

income
US$m

        Yield
%
 

Short-term funds and loans and advances to banks

    261,749          5,860          2.24          236,742          4,555          1.92          192,578          4,199          2.18   

Loans and advances to customers

    945,288          45,250          4.79          858,499          44,186          5.15          870,057          48,301          5.55   

Financial investments

    384,059          10,229          2.66          378,971          9,375          2.47          322,880          9,425          2.92   

Other interest-earning assets26

    31,562          1,666          5.28          (1,918       229          (11.94       (810       171          (21.11

Total interest-earning assets

    1,622,658          63,005          3.88          1,472,294          58,345          3.96          1,384,705          62,096          4.48   

Trading assets and financial assets designated at fair value 27, 28

    410,038          8,671          2.11          385,203          7,060          1.83          419,647          8,646          2.06   

Impairment provisions

    (18,738               (22,905               (26,308        

Non-interest-earning assets

    752,965                        664,308                        667,942                 

Total assets and interest income

    2,766,923          71,676          2.59          2,498,900          65,405          2.62          2,445,986          70,742          2.89   

Summary of interest expense by type of liability and equity

 

 
    2011         2010         2009  
   

Average

balance
US$m

       

Interest

expense
US$m

        Cost
%
       

Average

balance
US$m

       

Interest

expense
US$m

        Cost
%
       

Average

balance
US$m

       

Interest

expense
US$m

        Cost
%
 

Deposits by banks29

    106,099          1,591          1.50          111,443          1,136          1.02          117,847          1,659          1.41   

Financial liabilities designated at fair value – own debt issued30

    73,635          1,313          1.78          66,706          1,271          1.91          60,221          1,558          2.59   

Customer accounts31

    1,058,326          13,456          1.27          962,613          10,778          1.12          940,918          11,346          1.21   

Debt securities in issue

    181,482          5,260          2.90          189,898          4,931          2.60          225,657          5,901          2.62   

Other interest-bearing liabilities

    14,024          723          5.16          8,730          788          9.03          8,640          902          10.44   

Total interest-bearing liabilities

    1,433,566          22,343          1.56          1,339,390          18,904          1.41          1,353,283          21,366          1.58   

Trading liabilities and financial liabilities designated at fair value (excluding own debt issued)

    355,345          4,564          1.28          275,804          3,780          1.37          221,358          4,280          1.93   

Non-interest bearing current accounts

    162,369                  142,579                  123,271           

Total equity and other non-interest bearing liabilities

    815,643                        741,127                        748,074                 

Total equity and liabilities

    2,766,923          26,907          0.97          2,498,900          22,684          0.91          2,445,986          25,646          1.05   

For footnotes, see page 95.

 

Net interest income was US$40.7bn, 3% higher than in 2010. On an underlying basis, net interest income was broadly in line with the previous year, as the benefit to income from continued strong growth in

average interest-earning balances was largely offset by a decline in spreads.

Average loans and advances to customers grew strongly in 2011, reflecting targeted lending growth during 2010 and the first half of 2011 in CMB and

 

 

20


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HSBC HOLDINGS PLC

 

Report of the Directors: Operating and Financial Review (continued)

  

 

GB&M, as well as strong mortgage lending growth in our RBWM businesses in the UK, Hong Kong and Rest of Asia-Pacific throughout both years. During the year, we announced the sale of 195 non-strategic branches and our Cards and Retail Services business in the US, and reclassified the related loans and advances to customers to other assets held for sale, reported within ‘Other interest-earning assets’. This, together with the continued decline in the consumer finance portfolios in run-off, partly offset the rise in average lending balances in other regions.

The benefit to interest income of the strong customer lending volume growth was offset in part by a reduction in gross yields from loans and advances to customers. This reflected the transfer of balances to assets held for sale, including higher yielding unsecured lending, the continued decline within the US consumer finance portfolios and the repositioning of RBWM towards higher quality secured lending, particularly mortgages, together with intense competition in certain markets.

Interest income from short-term funds and loans and advances to banks also increased, attributable to higher average balances with central banks. This reflected higher deposit requirements by central banks in certain markets, together with the placement of excess liquidity in Asia with central banks. Interest income from short-term funds and loans and advances to banks, as well as financial investments, also benefited from higher yields as interest rates rose, particularly in mainland China, India and Brazil.

Interest income from other interest earning assets rose as a result of the reclassification of assets held for sale and the related income.

The rise in interest income was largely offset by higher interest expense. This was driven by a

significant increase in average customer account balances in Hong Kong, Rest of Asia-Pacific and Europe as a result of targeted deposit campaigns. The cost of funds also rose as a result of base rate increases, notably in mainland China, India and Brazil, and competitive pricing to attract and retain deposits in many markets.

The increase in interest expense on deposits by banks was driven by a rise in the cost of funds in Europe, reflecting the maturity of derivatives used to hedge interest rate risk and their replacement at lower prevailing interest rates.

The interest expense on own debt designated at fair value also rose, reflecting the volume of new issuances during the year. Although the average balance of debt securities in issue declined due to maturities not being replaced in North America and Europe, the related interest expense increased as a result of a general widening of credit spreads in the financial sector.

‘Net interest income’ includes the expense of internally funding trading assets, while related revenue is reported in ‘Net trading income’. The internal cost of funding these assets rose due to the increase in average trading assets during the year. In reporting our global business results, this cost is included within ‘Net trading income’.

The decrease in the net interest spread compared with 2010 was attributable to lower yields on loans and advances to customers as we continued to target higher quality assets, coupled with a rising cost of funds on customer accounts. Our net interest margin also fell, but by a lesser amount, due to the benefit from net free funds. This benefit rose as a result of the increase in the Group’s cost of funds, coupled with higher third party funding of our trading book, in line with the growth of trading assets.

 

 

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Net fee income

 

    

2011

US$m

        

2010

US$m

        

2009

US$m

 

Cards

     3,955           3,801           4,625   

Account services

     3,670           3,632           3,592   

Funds under management

     2,753           2,511           2,172   

Credit facilities

     1,749           1,635           1,479   

Broking income

     1,711           1,789           1,617   

Imports/exports

     1,103           991           897   

Insurance

     1,052           1,147           1,421   

Remittances

     770           680           613   

Global custody

     751           700           988   

Unit trusts

     657           560           363   

Underwriting

     578           623           746   

Corporate finance

     441           440           396   

Trust income

     294           291           278   

Investment contracts

     136           109           97   

Mortgage servicing

     109           118           124   

Taxpayer financial services

     2           73           87   

Maintenance income on operating leases

               99           111   

Other

     1,766           1,918           1,797   

Fee income

     21,497           21,117           21,403   

Less: fee expense

     (4,337        (3,762        (3,739

Net fee income

     17,160           17,355           17,664   

 

Reported net fee income was broadly in line with 2010. Reported results in 2010 included revenue from Eversholt Rail Group and HSBC Insurance Brokers Ltd. These items are excluded from our underlying results which declined by 3%. This was mainly due to increased fee expenses in North America and the impact of discontinuing certain business operations.

Fee expenses increased in North America, reflecting higher ‘revenue-share’ payments to our credit card partners as improved portfolio performance resulted in increased cash flows. Fee expenses also rose in Latin America, reflecting increased transaction volumes, and in Europe, notably in GB&M, which benefited from higher recoveries from the securities investment conduits in 2010.

Card-related income was higher, led by growth in Hong Kong due to higher transaction volumes, driven by increased retail spending and customer promotions, and in Europe due to increased interchange commissions from higher volumes and rates.

Fee income from unit trusts increased due to higher transaction volumes, notably in Hong Kong, reflecting increased product offerings, competitive pricing and successful sales activity as clients sought to maximise returns in the low interest rate environment. However, broking income was lower, primarily in Hong Kong due to increased competition in the territory during the second half of the year.

Remittances and trade-related fee income increased, notably in the Rest of Asia-Pacific region, due to higher trade and transaction volumes as we targeted asset growth and trade activity in the region, supported by marketing activities, customer acquisition and a rise in transactions from existing customers.

The negligible income from Taxpayer Financial Services in the US during 2011 resulted from the decision to exit the business.

We expect the sale of the Card and Retail Services business to have a significant impact on both fee income related to cards and insurance, and fee expenses.

 

 

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Net trading income

 

    

2011

US$m

        

2010

US$m

        

2009

US$m

 

Trading activities

     4,873           5,708           5,312   

Net interest income on trading activities

     3,223           2,530           3,627   

Other trading income – hedge ineffectiveness:

            

– on cash flow hedges

     26           (9        90   

– on fair value hedges

     (224        38           (45

Non-qualifying hedges

     (1,392        (1,057        951   

Losses on Bernard L Madoff Investment Securities LLC fraud

                         (72

Net trading income32,33

     6,506           7,210           9,863   

For footnotes, see page 95.

 

Reported net trading income was US$6.5bn, 10% lower than in 2010. On an underlying basis, net trading income declined by 15%, driven by significantly lower net income from trading activities in GB&M as turmoil in eurozone sovereign debt markets escalated, particularly in the second half of 2011. Increased risk aversion and limited client activity led to a significant widening of spreads on certain eurozone sovereign and corporate bonds, resulting in trading losses in our European Credit and Rates businesses.

Net trading income also declined from our legacy credit portfolio, a separately identifiable, discretely managed business comprising Solitaire Funding Limited, the securities investment conduits, the asset-backed securities trading portfolios and credit correlation portfolios, derivative transactions entered into directly with monoline insurers, and certain other structured credit transactions. This reflected the non-recurrence of the price appreciation during the previous year and lower holdings as a result of maturities and disposals aimed at reducing capital consumption, coupled with the non-recurrence of an US$89m gain from a 2010 legal settlement relating to certain loans previously purchased for resale from a third party.

In addition, lower favourable foreign exchange movements were reported on trading assets held as economic hedges of foreign currency debt designated at fair value. These offset lower adverse foreign exchange movements on the foreign currency debt which are reported in ‘Net expense from financial instruments designated at fair value’.

Notwithstanding the difficult trading conditions, there were strong performances across other parts of GB&M. Rates trading revenues in Hong Kong, North America and Latin America remained resilient as client flows increased. Fair value gains on structured liabilities also increased, mainly in Rates, as credit spreads widened more significantly than in 2010, resulting in a gain of US$458m compared with US$23m in 2010.

Our Foreign Exchange business benefited from increased activity from both Global Banking and CMB customers, particularly in Hong Kong, Rest of Asia-Pacific, North America and Latin America, coupled with an improved trading environment compared with 2010. The latter reflected market volatility caused by geopolitical tensions, ongoing eurozone sovereign debt concerns and interventions by central banks. Equities revenues also rose as investment in platforms improved our competitive positioning and helped capture increased client flows, notably in the first half of the year in Europe and Hong Kong.

In addition to the decline in net income from trading activities in GB&M, we reported adverse fair value movements on derivatives relating to certain legacy provident funds in Hong Kong as long-term investment returns fell. This was offset in part by a reduction in the loss provisions for mortgage loan repurchase obligations associated with loans previously sold in RBWM in North America, which decreased by US$341m to US$92m.

There were adverse fair value movements on non-qualifying hedges. These are derivatives entered into as part of a documented interest rate management strategy for which hedge accounting was not, or could not be, applied. They are principally cross-currency and interest rate swaps used to economically hedge fixed rate debt issued by HSBC Holdings and floating rate debt issued by HSBC Finance. The size and direction of the changes in fair value of non-qualifying hedges that are recognised in the income statement can be volatile from year to year, but do not alter the cash flows expected as part of the documented interest rate management strategy for both the instruments and the underlying economically hedged assets and liabilities. The adverse fair value movement on non-qualifying hedges in North America was higher in 2011 as long-term US interest rates declined to a greater extent than in 2010. This was partly offset by lower adverse fair value movements on these

 

 

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instruments in Europe.

Ineffectiveness in the hedging of available-for-sale investment portfolios resulted in adverse movements on fair value hedges. This was due to growth in the underlying investment portfolio in Europe as a result of new purchases and a more pronounced decline in yield curves in North America than in 2010.

Net interest income earned on trading activities rose by 23%, driven by an increase in average holdings and higher yields on our trading portfolio. This was partly offset by higher interest expense on trading liabilities reflecting an increase in funding requirements in line with the growth in average trading assets. The cost of internally funding these assets also rose, but this interest expense is reported within ‘Net interest income’.

 

 

Net income/(expense) from financial instruments designated at fair value

 

     2011 US$m          2010 US$m          2009 US$m  

Net income/(expense) arising from:

            

– financial assets held to meet liabilities under insurance and investment contracts

     (933        2,349           3,793   

– liabilities to customers under investment contracts

     231           (946        (1,329

– HSBC’s long-term debt issued and related derivatives

     4,161           (258        (6,247

Change in own credit spread on long-term debt

     3,933           (63        (6,533

Other changes in fair value34

     228           (195        286   

– other instruments designated at fair value and related derivatives

     (20        75           252   

Net income/(expense) from financial instruments designated at fair value

     3,439           1,220           (3,531

Assets and liabilities from which net income/(expense) from financial instruments designated at fair value arose

 

     2011 US$m      2010 US$m      2009 US$m  

Financial assets designated at fair value at 31 December

     30,856         37,011         37,181   

Financial liabilities designated at fair value at 31 December

     85,724         88,133         80,092   

Including:

        

Financial assets held to meet liabilities under:

        

– insurance contracts and investment contracts with DPF35

     7,221         7,167         6,097   

– unit-linked insurance and other insurance and investment contracts

     20,033         19,725         16,982   

Long-term debt issues designated at fair value

     73,808         69,906         62,641   

For footnotes, see page 95.

 

The accounting policies for the designation of financial instruments at fair value and the treatment of the associated income and expenses are described in Notes 2i and 2b on the Financial Statements, respectively.

The majority of the financial liabilities designated at fair value relate to certain fixed-rate long-term debt issues whose rate profile has been changed to floating through interest rate swaps as part of a documented interest rate management strategy. The movement in fair value of these long-term debt issues includes the effect of our credit spread changes and any ineffectiveness in the economic relationship between the related swaps and own debt. As credit spreads widen or narrow, accounting profits or losses, respectively, are booked. The size and direction of the changes in the credit spread on our debt and ineffectiveness, which are recognised in the income statement, can be volatile from year to year, but do not alter the cash flows envisaged as part

of the documented interest rate management strategy. As a consequence, fair value movements arising from changes in our own credit spread on long-term debt and other fair value movements on the debt and related derivatives are not regarded internally as part of managed performance and are therefore not allocated to customer groups, but are reported in ‘Other’. Credit spread movements on own debt are excluded from underlying results, and related fair value movements are not included in the calculation of regulatory capital.

We reported net income from financial instruments designated at fair value of US$3.4bn in 2011 compared with US$1.2bn in 2010. This included the credit spread-related movements in the fair value of our own long-term debt, on which we reported favourable fair value movements of US$3.9bn in 2011 and adverse movements of US$63m in 2010. These favourable fair value movements arose in 2011 as credit spreads widened,

 

 

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in comparison with smaller favourable fair value movements in North America and adverse fair value movements in Europe, both in 2010.

On an underlying basis, which excludes credit spread-related movements in the fair value of our own long-term debt, the equivalent figures were net expense of US$494m in 2011 and net income of US$1.3bn in 2010. Net expense arising from financial assets held to meet liabilities under insurance and investment contracts reflected net investment losses in 2011 as a result of adverse movements in equity markets, primarily in Europe and Hong Kong, compared with net investment gains experienced during 2010. This predominantly affected the value of assets held to support unit-linked contracts in the UK and Hong Kong, insurance contracts with discretionary participation features (‘DPF’) in Hong Kong, and investment contracts with DPF in France.

The investment gains or losses arising from equity markets resulted in a corresponding

movement in liabilities to customers, reflecting the extent to which unit-linked policyholders, in particular, participate in the investment performance of the associated asset portfolio. Where these relate to assets held to back investment contracts, the corresponding movement in liabilities to customers is also recorded under ‘Net income from financial instruments designated at fair value’. This is in contrast to gains or losses related to assets held to back insurance contracts or investment contracts with DPF, where the corresponding movement in liabilities to customers is recorded under ‘Net insurance claims incurred and movement in liabilities to policyholders’.

Within net income from financial instruments designated at fair value were lower adverse foreign exchange movements than in 2010 on foreign currency debt designated at fair value issued as part of our overall funding strategy, with an offset from trading assets held as economic hedges reported in ‘Net trading income’.

 

 

Gains less losses from financial investments

 

     2011
US$m
         2010
US$m
         2009
US$m
 

Net gains/(losses) from disposal of:

            

– debt securities

     712           564           463   

– equity securities

     360           516           407   

– other financial investments

     12           (7        8   
     1,084           1,073           878   

Impairment of available-for-sale equity securities

     (177        (105        (358

Gains less losses from financial investments

     907           968           520   

 

Reported gains less losses from financial investments decreased by US$61m to US$907m. On an underlying basis, excluding an accounting gain of US$62m arising from the reclassification of Bao Viet as an associate in 2010, they declined by 4%.

The reduction was principally driven by lower net gains from the disposal of available-for-sale equity securities, as deterioration in market confidence resulted in fewer disposal opportunities and lower gains from the sale of private equity investments, notably in Europe. We also recognised a gain on disposal in 2010 of an equity investment in a Singaporean property company which did not recur. This was partly offset by a gain on sale of shares in a Mexican listed company.

Impairments of available-for-sale equity securities rose, due to write downs of our equity investments in real estate companies, reflecting a decline in property values in 2011.

Net gains from the disposal of available-for-sale debt securities increased in Europe and North America following sales of government bonds and mortgage-backed securities by Balance Sheet Management as part of normal portfolio management activities. However, this was offset in part by lower net gains in Hong Kong and Rest of Asia-Pacific on the disposal of government debt securities in 2011.

 

 

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Net earned insurance premiums

 

    

2011

US$m

        

2010

US$m

        

2009

US$m

 

Gross insurance premium income

     13,338           11,609           10,991   

Reinsurance premiums

     (466        (463        (520

Net earned insurance premiums

     12,872           11,146           10,471   

 

Net earned insurance premiums which relate to insurance and investment contracts with DPF increased by 15% on a reported basis and by 13% on an underlying basis, primarily driven by strong sales in the Hong Kong life insurance business and also in Latin America. This reflected the strategic focus of the Group on wealth management, of which insurance is a key part.

In Hong Kong, sales of deferred annuities, unit-linked products and a universal life product targeted at high net worth individuals all rose, coupled with higher levels of renewals from a larger in-force book of business due to an increased demand for wealth products. Sales of a universal life insurance product targeted at high net worth individuals were also higher in Rest of Asia-Pacific, notably in Singapore, driven by successful sales initiatives.

In Latin America, net earned premiums also grew strongly due to a rise in contributions from unit-linked, life and credit protection products in Brazil, reflecting investment in the distribution network. This was supported by higher premiums from the motor insurance business in Argentina as a result of volume growth and repricing initiatives.

In Europe, net earned premiums decreased resulting from the non-renewal and transfer to third parties of certain contracts in our Irish business as well as the continued run-off and subsequent disposal of the motor business in the UK during 2011.

This was partly offset by premium growth in both France, on investment contracts with DPF as a result of targeted sales campaigns aimed at high net worth clients, and the UK, on unit-linked products due to increased distribution channels.

 

 

Other operating income

 

     2011
US$m
          2010
US$m
         2009
US$m
 

Rent received

     217            535           547   

Gains/(losses) recognised on assets held for sale

     55            (263        (115

Valuation gains/(losses) on investment properties

     118            93           (24

Gain on disposal of property, plant and equipment, intangible assets and non-financial investments

     57            701           1,033   

Gains arising from dilution of interests in associates and joint ventures

     208            188             

Change in present value of in-force long-term insurance business

     726            705           605   

Other

     385            603           742   

Other operating income

     1,766            2,562           2,788   

 

Reported other operating income of US$1.8bn decreased by US$796m in 2011. Reported results in 2011 included a gain of US$181m arising from a dilution of our holding in Ping An following its issue of share capital to a third party and a gain of US$83m from the sale of HSBC Afore, our Mexican pension administration business. We also reported a dilution gain of US$27m as a result of the reduction in our holding in HSBC Saudi Arabia Limited following its merger with SABB Securities Limited. Income in 2010 included a gain of US$188m following the dilution of our holding in Ping An along with gains from the sale of HSBC Insurance Brokers (US$107m), the Wells Fargo HSBC Trade Bank (US$66m), Eversholt Rail Group (US$255m) and HSBC Private Equity (Asia) Ltd (US$74m), partly offset by a loss of US$42m on the disposal

of our shareholding in British Arab Commercial Bank plc.

On an underlying basis, excluding the items referred to above, other operating income decreased by US$71m compared with 2010. Lower losses on assets held for sale driven by the non-recurrence of the US$207m loss on the sale of the US vehicle finance servicing operation in 2010 and associated loan portfolio were more than offset by the non-recurrence of gains of US$250m on the sale and leaseback of our Paris and New York headquarters in 2010, which exceeded gains recorded in 2011 on the sale of buildings including US$61m from the sale and leaseback of branches in Mexico.

Favourable net movements in the present value of in-force (‘PVIF’) long-term insurance business

 

 

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compared with 2010 were driven by a one-off gain of US$243m recognised upon the refinement of the calculation of the PVIF asset to bring greater comparability and consistency across our insurance operations, and strong sales of life insurance

products, notably in Hong Kong and Singapore. Largely offsetting this was a net decrease from experience and assumption updates and a higher unwind of cash flows from the growing in-force book.

 

 

Net insurance claims incurred and movement in liabilities to policyholders

 

    

2011

US$m

        

2010

US$m

        

2009

US$m

 

Insurance claims incurred and movement in liabilities to policyholders:

            

– gross

     11,631           11,969           12,560   

– reinsurers’ share

     (450        (202        (110

– net36

     11,181           11,767           12,450   

For footnote, see page 95.

 

Net insurance claims incurred and movement in liabilities to policyholders decreased by 5% on a reported basis and by 7% on an underlying basis, driven by investment losses on insurance assets, notably in Europe and Hong Kong.

In France, the UK and Hong Kong we experienced a reduction in the movement in liabilities to policyholders resulting from a fall in fair value of the assets held to support policyholder funds, particularly in relation to unit-linked insurance contracts and investment and insurance contracts with DPF, as a result of equity market falls.

The gains or losses experienced on the financial assets designated at fair value held to support insurance contract liabilities and investment contracts

with DPF are reported in ‘Net income from financial instruments designated at fair value’.

Further declines in the movement in liabilities to policyholders resulted from the non-renewal and transfer to third parties of certain contracts in our Irish businesses as well as the continued run-off and subsequent sale of the motor business in the UK during 2011.

Reductions in the movement in liabilities to policyholders were partly offset by additional liabilities established for new business premiums written, notably in Hong Kong, Brazil, France, the UK and Singapore, which are consistent with increases in net earned premiums.

 

 

Loan impairment charges and other credit risk provisions

 

    

2011

US$m

        

2010

US$m

        

2009

US$m

 

Loan impairment charges

            

New allowances net of allowance releases

     12,931           14,568           25,832   

Recoveries of amounts previously written off

     (1,426        (1,020        (890
     11,505           13,548           24,942   

Individually assessed allowances

     1,915           2,625           4,458   

Collectively assessed allowances

     9,590           10,923           20,484   

Impairment of available-for-sale debt securities

     631           472           1,474   

Other credit risk provisions/(recoveries)

     (9        19           72   

Loan impairment charges and other credit risk provisions

     12,127           14,039           26,488   
     %           %           %   

– as a percentage of net operating income excluding the effect of fair value movements in respect of credit spread on own debt and before loan impairment charges and other credit risk provisions

     17.7           20.6           36.4   

Impairment charges on loans and advances to customers as a percentage of gross average loans and advances to customers

     1.2           1.5           2.8   

 

Loan impairment charges and other credit risk provisions were US$12.1bn, a decline of 14% compared with 2010 on a reported basis and 15% on an underlying basis.

At 31 December 2011, the aggregate balance of customer loan impairment allowances was US$17.5bn, representing 1.9% of gross loans and advances to customers (net of reverse repos and

 

 

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settlement accounts) compared with 2.2% at 31 December 2010.

In 2011, loan impairment charges and other credit risk provisions declined in all regions except Latin America and Hong Kong. The reduction was most significant in our consumer finance portfolios in HSBC Finance in North America, which contributed 66% of the reduction, reflecting lower lending balances in the run-off portfolio along with a reduction in lending balances and lower delinquency rates as our Card and Retail Services customers focused on repayments. In Latin America, principally Brazil, and also in Hong Kong, collective loan impairment allowances rose as we grew our lending book on the back of strong economic growth and increased customer demand.

During 2011, we reported US$631m of impairments related to available-for-sale debt securities, compared with US$472m in 2010. In 2011, we recognised a charge of US$212m to write down to market value available-for-sale Greek sovereign debt now judged to be impaired following the deterioration in Greece’s fiscal position. This was partly offset as losses arising in underlying collateral pools generated lower charges on asset-backed securities.

In our US run-off portfolios, loan impairment charges of US$5.0bn were 14% lower than in 2010. The decline was mainly in our Consumer and Mortgage Lending (‘CML’) portfolio, driven by the reduction in customer lending balances, in part offset by higher loan impairment allowances reflecting a rise in the estimated cost to obtain collateral as well as delays in the timing of expected cash flows, both the result of the industry-wide delays in foreclosure processing.

In the third quarter of 2011, loan impairment charges in the CML portfolio increased markedly as delinquency worsened compared with the first half of 2011. In addition, we increased our loan impairment allowances to reflect a rise in the expected cost to obtain and realise collateral following delays in foreclosure processing. Despite a decline in loan impairment charges in the fourth quarter, these factors contributed significantly to a rise in the Group’s loan impairment charges in the second half of 2011 compared with the first half of the year.

In Card and Retail Services, loan impairment charges fell by 26% to US$1.6bn reflecting lower lending balances and improved delinquency rates as customer repayment rates remained strong during 2011.

In CMB, loan impairment charges and other credit risk provisions in North America declined in both Canada and the US reflecting improved credit quality, and in Canada this was also due to lower lending balances. These declines were partly offset by a loan impairment charge on a commercial real estate lending exposure.

The reduction in loan impairment charges and other credit risk provisions in North America was partly offset by an increase in GB&M, reflecting lower releases of collective loan impairment allowances compared with 2010. In addition, 2011 included a loan impairment charge associated with a corporate lending relationship.

Loan impairment charges and other credit risk provisions in Europe fell by 20% to US$2.5bn, notably in the UK. The reduction was mainly in our RBWM business where loan impairment charges declined by 53% to US$596m despite the difficult economic climate and continued pressures on households’ finances. Delinquency rates declined across both the secured and unsecured lending portfolios, reflecting improvement in portfolio quality and the continued low interest rate environment as well as successful actions taken to mitigate credit risk and proactive account management. In CMB, loan impairment charges and other credit risk provisions were 7% lower, mainly in the UK. This was partly offset by an increase in individually assessed loan impairment charges in Greece as economic conditions worsened.

In GB&M in Europe, loan impairment charges and other credit risk provisions increased by 8% as we recorded an impairment of US$145m to write down to market value available-for-sale Greek sovereign debt now judged to be impaired following the deterioration in Greece’s fiscal position. Further information on our exposures to countries in the eurozone is provided in ‘Areas of special interest – wholesale lending’ on page 112.

In the Middle East and North Africa, loan impairment charges and other credit risk provisions fell by 53% to US$293m, primarily due to a marked decline in loan impairment charges and other credit risk provisions in our GB&M business. This reflected the non-recurrence of individually assessed loan impairment charges recorded in the first half of 2010 related to restructuring activity for a small number of large corporate customers in the United Arab Emirates (‘UAE’). In RBWM, loan impairment charges declined by 45%, due to significantly improved delinquency rates reflecting a repositioning of the loan book towards higher quality lending as

 

 

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we continued to manage down unsecured lending, together with impaired collections practices.

In Rest of Asia-Pacific, loan impairment charges and other credit risk provisions declined by 42% to US$267m, driven by reductions in India and Singapore. The marked decline in India reflected an improvement in delinquency, particularly in the unsecured portfolios as lending balances were managed down. In GB&M, loan impairment charges and other credit risk provisions declined by 58%, mainly in Singapore, due to a reduction in individually assessed loan impairment charges.

In Latin America, loan impairment charges increased by 17% to US$1.9bn. In Brazil, loan impairment charges and other credit risk provisions rose by 43% to US$1.4bn due to a rise in collective loan impairment allowances in both RBWM and CMB following the strong growth in our customer lending balances

and a rise in delinquency rates in the second half of 2011. In addition, we recognised a significant individually assessed loan impairment charge related to a commercial customer. The increase in Brazil was partly offset by a 28% decline in loan impairment charges and other credit risk provisions in Mexico. This was mainly in our RBWM business due to lower balances in our credit card portfolio as certain higher risk portfolios were run-down and both credit quality and collections improved.

In Hong Kong, loan impairment charges and other credit risk provisions increased by 36% to US$156m. In CMB, higher loan impairment charges included a specific impairment charge related to a single customer, as well as higher collectively assessed charges reflecting growth in lending balances. In GPB, loan impairment charges and other credit risk provisions also increased, reflecting an impairment of available-for-sale Greek sovereign debt.

 

 

Operating expenses

 

     2011          2010          2009  
     US$m          US$m          US$m  

By expense category

            

Employee compensation and benefits

     21,166           19,836           18,468   

Premises and equipment (excluding depreciation and impairment)

     4,503           4,348           4,099   

General and administrative expenses

     12,956           10,808           9,293   

Administrative expenses

     38,625           34,992           31,860   

Depreciation and impairment of property, plant and equipment

     1,570           1,713           1,725   

Amortisation and impairment of intangible assets

     1,350           983           810   

Operating expenses

     41,545           37,688           34,395   

Included in the above are the following notable cost items:

            

Restructuring costs (including impairment of assets)

     1,122           154           301   

UK customer redress programmes

     898           78             

UK bank levy

     570                       

Payroll tax

     (13        324             

US mortgage foreclosure and servicing costs

     257                       

UK pension credit

     (587                  (499

US accounting gain on change in staff benefits

               (148          

Deferred variable compensation awards – accelerated amortisation

     163                       

Staff numbers (full-time equivalents)

 

     At 31 December                            
     2011           2010           2009  

Europe

     74,892            75,698            76,703   

Hong Kong

     28,984            29,171            27,614   

Rest of Asia-Pacific

     91,051            91,607            87,141   

Middle East and North Africa

     8,373            8,676            8,281   

North America

     30,981            33,865            35,458   

Latin America

     54,035            56,044            54,288   

Staff numbers

     288,316            295,061            289,485   

 

Operating expenses increased by 10% to US$41.5bn on a reported basis. On an underlying basis, costs increased by 8% compared with 2010, driven by a

higher amount of notable items in 2011 as listed in the table above and a rise in staff costs, primarily in faster growing regions. Notable items included

 

 

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Report of the Directors: Operating and Financial Review (continued)

  

 

restructuring costs, provisions relating to customer redress programmes in the UK, including a charge in respect of the possible mis-selling of Payment Protection Insurance (‘PPI’) in previous years, the UK bank levy and a new provision for US mortgage foreclosure and servicing costs. These were partially offset by a credit resulting from a change in the inflation measure used to calculate the defined benefit obligation in the UK for deferred pensions and the non-recurrence of the 2010 payroll and bonus taxes in the UK and France.

Salaries and wages rose, primarily driven by wage inflation in Rest of Asia-Pacific and Hong Kong and union-agreed salary increases in Latin America.

The growth in business volumes, primarily in Hong Kong, Rest of Asia-Pacific and Latin America, was supported by a small rise in average staff numbers (expressed as FTEs) which grew marginally in 2011. Staff costs also rose due to higher amortisation charges for previous years’ restricted and performance share awards and an acceleration in the expense recognition for deferred bonus awards of US$163m, in line with regulatory and best practice guidance (see page 95). Otherwise, performance-related costs were lower than in 2010, primarily in GB&M where net operating income declined.

During the year, we incurred US$1.1bn of restructuring costs including US$542m which were staff related and US$325m of impairment of certain software projects now deferred or cancelled.

During 2011, we began a Group-wide review of our organisational effectiveness. We achieved US$0.9bn of sustainable savings in 2011, approximately one third of our objective of US$2.5bn to US$3.5bn over three years. We started implementing consistent business models in RBWM and CMB and undertook a detailed review of our head offices. In addition, we began the re-engineering of our global functions, we commenced the streamlining of our IT function including the consolidation of some data centres and other services, and we re-engineered a number of customer-facing and back-office processes leading to a more efficient use of our corporate real estate.

This resulted in a net reduction of staff numbers of more than 7,600 during the second half of 2011 despite continuing to recruit selectively in our target growth areas.

The savings achieved by delivering on these programmes enabled the funding of investment in strategic initiatives, including the development of Prime Services and equity market capabilities and the expansion of the Rates and Foreign Exchange e-commerce platforms in Europe, and the recruitment of additional front office staff in selected markets.

Costs increased due to a rise in compliance costs in GB&M and litigation expenses in RBWM, both predominantly in the US. However, marketing costs fell in North America and Latin America as discretionary costs were tightly controlled.

 

 

Cost efficiency ratios4

 

    

2011

%

         

2010

%

         

2009

%

 

HSBC

     57.5            55.2            52.0   

Geographical regions

              

Europe

     70.4            67.9            59.4   

Hong Kong

     44.5            43.4            41.7   

Rest of Asia-Pacific

     54.2            55.7            55.6   

Middle East and North Africa

     44.5            44.7            38.6   

North America

     55.7            48.8            51.5   

Latin America

     63.3            65.7            59.6   

Global businesses

              

Retail Banking and Wealth Management17

     63.2            58.1            52.3   

Commercial Banking

     46.3            49.4            46.4   

Global Banking and Markets17

     57.0            48.8            37.5   

Global Private Banking

     68.8            65.8            60.5   

For footnote, see page 95.

 

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Report of the Directors: Operating and Financial Review (continued)

  

 

Share of profit in associates and joint ventures

 

     2011 US$m           2010 US$m           2009 US$m  

Associates

              

Bank of Communications Co., Limited

     1,370            987            754   

Ping An Insurance (Group) Company of China, Limited

     946            848            551   

Industrial Bank Co., Limited

     471            327            216   

The Saudi British Bank

     308            161            172   

Other

     126            156            42   

Share of profit in associates

     3,221            2,479            1,735   

Share of profit in joint ventures

     43            38            46   

Share of profit in associates and joint ventures

     3,264            2,517            1,781   

 

The reported share of profit in associates and joint ventures was US$3.3bn, an increase of 30% compared with 2010. On an underlying basis, which excludes the re-measurement loss relating to Ping An’s acquisition of Shenzhen Development Bank, the share of profits from associates increased by 27%. This was driven mainly by higher contributions from our mainland China associates.

Our share of profits from BoCom rose, driven by strong loan growth, wider spreads following benchmark interest rate rises by the People’s Bank of China and effective re-pricing. Fee-based income also increased due to the continued development of investment banking services as well as increased

credit card spending. The contribution from Industrial Bank rose as a result of continued growth in customer lending, higher fee income and a fall in loan impairment charges.

Profits from Saudi British Bank increased, driven by a decline in loan impairment charges as the credit environment improved in Saudi Arabia and due to good cost control.

Higher profits from Ping An resulted from strong growth in sales in the insurance business and higher income from the banking business following the acquisition of Shenzhen Development Bank in July 2011.

 

 

Tax expense

 

    

2011

US$m

        

2010

US$m

        

2009

US$m

 

Profit before tax

     21,872           19,037           7,079   

Tax expense

     (3,928        (4,846        (385

Profit after tax

     17,944           14,191           6,694   

Effective tax rate

     18.0%           25.5%           5.4%   

 

Our reported tax expense decreased by US$0.9bn compared with 2010. The lower tax charge reflected the benefit of a deferred tax credit of US$0.9bn now eligible to be recognised in respect of foreign tax credits in the US. In addition, the tax charge in

2010 included US$1.2bn attributable to a taxable gain from an internal reorganisation in our North American operations. The resulting reported effective tax rate for 2011 was 18% compared with 25.5% in 2010.

 

 

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Report of the Directors: Operating and Financial Review (continued)

  

 

2010 compared with 2009

Reconciliation of reported and underlying profit before tax

 

    2010 compared with 2009  
HSBC  

2009

as
reported
US$m

       

2009
adjust-

ments10

US$m

       

Currency

translation11

US$m

       

2009

at 2010
exchange

rates18

US$m

       

2010

as

reported

US$m

       

2010

adjust-

ments10

US$m

       

2010
under-

lying
US$m

       

Re-
ported

change13

%

       

Under-
lying

change13

%

 

Net interest income

    40,730          (1       642          41,371          39,441          (31       39,410          (3       (5

Net fee income

    17,664          (210       182          17,636          17,355          (3       17,352          (2       (2

Changes in fair value14

    (6,533       6,533                            (63       63                   99       

Other income15

    14,320