1. BASEL II
and its implications
Hazel Taylor David Robertson Alan Smith May 2008
Head of Regulatory Head of Programme Head of Risk
Reporting Delivery Strategy
2. Forward-looking statements
This presentation and subsequent discussion may contain certain forward-looking statements with respect
to the financial condition, results of operations and business of the Group.
These forward-looking statements represent the Group’s expectations or beliefs concerning future events
and involve known and unknown risks and uncertainty that could cause actual results, performance or
events to differ materially from those expressed or implied in such statements.
Additional detailed information concerning important factors that could cause actual results to differ
materially is available in our Annual Report.
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3. Content
• The journey to Basel II (David Robertson)
• HSBC Basel II analysis and disclosure (Hazel Taylor)
• Pillar 2 and stress testing in a Basel II environment (Alan Smith)
3
5. The journey to Basel II
Major five-year infrastructure programme
• Development of Group and local models for PD, LGD and EAD
• Central system to capture granular data from 83 countries and generate RWA calculations
• Contrast with relative simplicity of Basel I process
• FSA approval given for majority IRBA approach for credit risk
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6. Credit risk building blocks
Credit risk
Borrower
Facility characteristics
characteristics
Who are you How much exposure do Time to What is the % you
lending to? you expect to have repayment? expect to lose, given
should the borrower seniority, collateral and
default? other loss mitigation?
Probability of Default Exposure at Default Maturity Loss Given Default
(PD) (EAD) (M) (LGD)
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7. Basel II capital calculations
Expected Loss (EL)
• PD x LGD x EAD
• Excess of EL over impairment allowances is a deduction from capital
Unexpected Loss (UL)
• Capital requirement (K) determined by regulatory formulae for each asset type
• PD, LGD and Maturity are factors
• RWA = K x 12.5 x EAD x 1.06 (scaling factor)
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8. Generic example 1
Corporate: Unexpected and Expected Loss
35
Unexpected Loss PD =
PD = PD =
Expected Loss
0.1% 1.0% 10.0%
30
ent and EL (%of EA )
Unexpected
D
25 Loss
20
Expected Loss
egulatory capital requirem
15
10
R
5
PD floor
(0.03%)
0
AAA AA+ AA AA- A+ A A- BB B + BBB B BB - BB+ BB BB- B+ B B- CC C
Im plie d e x te rnal rating e quiv ale nt PDs M = 2.5 years;
LGD = 45%
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9. Generic example 2
Residential mortgages: Unexpected and Expected Loss
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Unexpected Loss
Expected Loss
f A )
R g la ryc p l re u m n a dE (%o E D
6
Unexpected Loss
e u to a ita q ire e t n L
Expected Loss
4
2
0
0.03 3.00 6.00 9.00 12.00 15.00 18.00 21.00 24.00 27.00 30.00
Probability of Default (% )
LGD = 10%
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10. Generic example 3
Corporate: impact of increasing LGDs
50
PD = PD = PD =
0.1% 1.0% 10.0%
40
f A )
R g la ryc p l a dE (%o E D
30
e u to a ita n L
LGD =
65%
20
10
LGD =
0 45%
AAA AA+ AA AA- A+ A A- BBB+ BBB BBB- BB+ BB BB- B+ B B- CCC
Implied external rating equivalent PD
M = 2.5
years
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11. Generic example 4
Residential mortgages: impact of increasing LGDs
25
20
f A )
R g lato c p l an E (%o E D
15
ry a ita d L
LGD = 25%
10
LGD = 10%
e u
5
0
0.03 3.00 6.00 9.00 12.00 15.00 18.00 21.00 24.00 27.00 30.00
Probability of Default (% )
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13. Disclosures
Narrative disclosures:
• Capital management and allocation
• Capital measurement
– What the FSA requires
– Local requirements may differ
– Not all on Basel II locally
– But must do Basel II for Group reporting
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14. Disclosures
Narrative disclosures (cont’d)
• IRBA for majority of businesses wef 1 January 2008
• IRBA is more risk-sensitive and relies on the bank’s own assessment of risk
• There is no going back! (from IRBA to STDA)
• Operational risk – using standardised approach for Group
• Capital base impacts
– Collective impairment allowances
– Expected losses less impairment allowances
• Pillar 2 – linked to capital management framework
• Pillar 3 – first disclosures qualitative during 2008, quantitative during first half of 2009 as at 31
December 2008
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15. Analysis
Basel I versus Basel II (as at 31Dec07)
• Capital base reduced by USD20 billion due to collective impairment allowances removed
and EL adjustment
• RWAs at a similar level to Basel I (less than 1% difference)
• Overall impact was to reduce the tier 1 ratio from 9.3% to 9.0%
• And total capital ratio from 13.6% to 11.8%
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16. Disclosures
153
Numerical disclosures on a pro-forma Basel II basis 160
13.6%
14
(as at 31Dec07):
133
• Composition of regulatory capital table
140
11.8% 12
– Core tier 1 USD91 billion, ratio 8.1% 120
– After 50% of EL adjustment USD4.5 billion 105 10
9.3% 102
94 9.0
• Total tier 1 USD102 billion, ratio 9.0% 100 8.4% 91
8.1%
8
• Total capital USD133 billion, ratio 11.8%
Ratio (%)
USDbn
80
– After total EL adjustment of USD9 billion 6
– After removal of collective impairment allowances of 60
USD11 billion
4
• Target 40
– Tier 1 target range: 7.5% to 9.0% 2
20
0 0
Core Tier 1 Total Tier 1 Total Capital
Basel I Basel II
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17. Analysis
Basel II pro-forma RWAs of USD1,129 billion
(as at 31Dec07)
• Analysis by risk type:
– Credit risk USD976 billion (86%)
– Market risk USD46 billion (4%)
– Operational risk USD107 billion (10%)
• Basel I RWAs of USD1,124 billion Credit risk Market risk Operational risk
– Analysis by type of book:
– Banking book USD1,021 billion (91%)
– Trading book USD103 billion (9%)
– Includes counterparty credit risk and market risk
Banking book Trading book
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18. Pillar 2 and stress testing in a
Basel II environment
19. Basel Pillar 2, HSBC ICAAP and Stress Testing
Pillar 1 Pillar 2
Pillar Pillar 3
Minimum capital Supervisory review Market discipline
Minimum regulatory capital Internal capital adequacy Regulatory requirements for
requirements for credit, market and assessment process and external disclosure of risk
operational risk supervisory review information
CAPITAL: Relationship between Pillar 1, Pillar 2 and the ICAAP
Pillar 1 Pillar 2 ICAAP
• Minimum capital requirement • Supervisory assessment – via the • Firm's own assessment of its capital needs
Individual Capital Guidance (ICG) – of
• Calculated using prescribed parameters • Economic capital is an important part of the
amount of regulatory capital considered
(advanced or standardised) framework to supplement the Pillar 1
necessary to cover:
regulatory capital analysis
• Point-in-time assessment
– Pillar 1 risks (including any
• Stress analysis is carried out for the ‘1 in
uncertainties in their calculation); and
25’ scenario
– Risks not included in Pillar 1
• Capital planning and stress testing is an
important part of the assessment
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20. HSBC capital principles and stress testing
• Embodied in HSBC Capital Management Principles approved by the Group Management Board
• Capital – “the resources necessary to cover unexpected losses arising from the risk which HSBC
accepts in the form of discretionary risk or runs in the form of non-discretionary risk”
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21. HSBC stress testing framework and principles
• Stress testing covers the techniques used to assess all facets of risk vulnerability facing the HSBC
Group and its operations
• HSBC stress testing approaches fall into two categories:
– Sensitivity analysis (where the impact of a single factor is considered with all others being held unchanged); and
– Scenario analysis (where the impact of changing multiple simultaneous factors are considered)
• Stress testing allows HSBC senior management to:
– Build an understanding of the sensitivities around the core assumptions in the strategic and capital plans, allowing
senior management to formulate proactive mitigating management action should actual conditions start to reflect the
stress scenario conditions
– Ensure that HSBC can meet its financial obligations across an economic cycle and it has sufficient capital to
withstand a severe correction and/or a period of prolonged negative trading conditions
• Stress testing scenarios consider the full range of risks within the HSBC risk framework
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22. Scenario stress testing process – critical features
Scenario Translation
Definition Translate stress scenario into
Define macro stress scenario risk factors
Feedback
Get feedback on results and Stress scenario Calculation
concerns for new scenario Calculate Impact on drivers
definition lifecycle within risk categories
Analysis and
Reporting
Analyse reports to
Aggregation
highlight significant Aggregate results
results
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23. Stress testing governance
• Global stress testing oversight forum – group and regional level
• Scenarios – mandatory and optional
• Pillar 1 versus Pillar 2
• Mitigating actions and early warning indicators
• Benchmarks/Tolerance
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