HSBC 2008 Annual Report Download - page 64

HSBC HOLDINGS PLC
Report of the Directors: Operating and Financial Review (continued)
Critical accounting policies
62
Impairment of loans and advances
HSBC’s accounting policy for losses arising from
the impairment of customer loans and advances is
described in Note 2g on the Financial Statements.
Loan impairment allowances represent
management’s best estimate of losses incurred
in the loan portfolios at the balance sheet date.
Management is required to exercise judgement
in making assumptions and estimations when
calculating loan impairment allowances on both
individually and collectively assessed loans and
advances. Of the Group’s total loans and advances
to customers before impairment allowances of
US$957 billion (2007: US$1,001 billion),
US$6.9 billion or 1 per cent (2007: US$6.5 billion;
1 per cent) were individually assessed for
impairment, and US$950 billion or 99 per cent
(2007: US$994 billion; 99 per cent) were
collectively assessed for impairment.
The most significant judgemental area is the
calculation of collective impairment allowances.
HSBC’s most significant geographical area of
exposure to collectively assessed loans and
advances is North America, which comprised
US$271 billion or 29 per cent (2007:
US$301 billion; 30 per cent) of HSBC’s
total collectively assessed loans and advances.
Collective impairment allowances in North America
were US$15.9 billion, representing 77 per cent
(2007: US$11.9 billion; 72 per cent) of the total
collectively assessed loan impairment allowance.
HSBC uses two alternative methods to calculate
collective impairment allowances on homogeneous
groups of loans that are not considered individually
significant:
• when appropriate empirical information is
available, HSBC utilises roll-rate methodology.
This methodology employs statistical analysis
of historical data and experience of delinquency
and default to estimate the likelihood that loans
will progress through the various stages of
delinquency and ultimately prove irrecoverable.
The estimated loss is the difference between the
present value of expected future cash flows,
discounted at the original effective interest rate
of the portfolio, and the carrying amount of the
portfolio; and
• in other cases, when the portfolio size is small
or when information is insufficient or not
reliable enough to adopt a roll-rate
methodology, HSBC adopts a formulaic
approach which allocates progressively higher
percentage loss rates the longer a customer’s
loan is overdue. Loss rates are based on
historical experience.
Both methodologies are subject to estimation
uncertainty, in part because it is not practicable to
identify losses on an individual loan basis because
of the large number of individually insignificant
loans in the portfolio.
In addition, the use of statistically assessed
historical information is supplemented with
significant management judgement to assess whether
current economic and credit conditions are such that
the actual level of inherent losses is likely to be
greater or less than that suggested by historical
experience. In normal circumstances, historical
experience provides the most objective and relevant
information from which to assess inherent loss
within each portfolio. In certain circumstances,
historical loss experience provides less relevant
information about the inherent loss in a given
portfolio at the balance sheet date, for example,
where there have been changes in economic,
regulatory or behavioural conditions such that the
most recent trends in the portfolio risk factors are not
fully reflected in the statistical models. In these
circumstances, such risk factors are taken into
account when calculating the appropriate levels of
impairment allowances, by adjusting the impairment
allowances derived solely from historical loss
experience.
This key area of judgement is subject to
uncertainty and is highly sensitive to factors such as
loan portfolio growth, product mix, unemployment
rates, bankruptcy trends, geographic concentrations,
loan product features, economic conditions such as
national and local trends in housing markets, the
level of interest rates, portfolio seasoning, account
management policies and practices, changes in laws
and regulations, and other factors that can affect
customer payment patterns. Different factors are
applied in different regions and countries to reflect
different economic conditions and laws and
regulations. The assumptions underlying this
judgement are highly subjective. The methodology
and the assumptions used in calculating impairment
losses are reviewed regularly in the light of
differences between loss estimates and actual loss
experience. For example, roll rates, loss rates and the
expected timing of future recoveries are regularly
benchmarked against actual outcomes to ensure they
remain appropriate.
The total amount of the Group’s impairment
allowances on homogeneous groups of loans is
inherently uncertain because it is highly sensitive to
changes in economic and credit conditions across a