HSBC 2010 Annual Report Download - page 180

HSBC HOLDINGS PLC
Report of the Directors: Operating and Financial Review (continued)
Capital > Capital measurement and allocation
178
Capital measurement and allocation
(Unaudited)
The FSA supervises HSBC on a consolidated basis
and therefore receives information on the capital
adequacy of, and sets capital requirements for, the
Group as a whole. Individual banking subsidiaries
are directly regulated by their local banking
supervisors, who set and monitor their capital
adequacy requirements.
We calculate capital at a Group level using the
Basel II framework of the Basel Committee on
Banking Supervision. However, local regulators are
at different stages of implementation and local
reporting may still be on a Basel I basis, notably in
the US. In most jurisdictions, non-banking financial
subsidiaries are also subject to the supervision and
capital requirements of local regulatory authorities.
Basel II is structured around three ‘pillars’:
minimum capital requirements, supervisory review
process and market discipline. The Capital
Requirements Directive (‘CRD’) implemented
Basel II in the EU and the FSA then gave effect
to the CRD by including the latter’s requirements
in its own rulebooks.
Regulatory capital
Our capital is divided into two tiers:
• tier 1 capital is divided into core tier 1 and other
tier 1 capital. Core tier 1 capital comprises
shareholders’ equity and related non-controlling
interests. The book values of goodwill and
intangible assets are deducted from core tier 1
capital and other regulatory adjustments are
made for items reflected in shareholders’ equity
which are treated differently for the purposes of
capital adequacy. Qualifying capital instruments
such as non-cumulative perpetual preference
shares and hybrid capital securities are included
in other tier 1 capital; and
• tier 2 capital comprises qualifying subordinated
loan capital, related non-controlling interests,
allowable collective impairment allowances and
unrealised gains arising on the fair valuation of
equity instruments held as available for sale.
Tier 2 capital also includes reserves arising from
the revaluation of properties.
To ensure the overall quality of the capital base,
the FSA’s rules set limits on the amount of hybrid
capital instruments that can be included in tier 1
capital relative to core tier 1 capital, and also limits
overall tier 2 capital to no more than tier 1 capital.
Regulatory and accounting consolidations
The basis of consolidation for financial accounting purposes
is described on page 251 and differs from that used for
regulatory purposes. Investments in banking associates are
equity accounted in the financial accounting consolidation,
whereas their exposures are proportionally consolidated for
regulatory purposes. Subsidiaries and associates engaged in
insurance and non-financial activities are excluded from the
regulatory consolidation and are deducted from regulatory
capital. The regulatory consolidation does not include SPEs
where significant risk has been transferred to third parties.
Exposures to these SPEs are risk-weighted as securitisation
positions for regulatory purposes.
Pillar 1 capital requirements
Pillar 1 covers the capital resources requirements
for credit risk, market risk and operational risk.
Credit risk includes counterparty credit risk and
securitisation requirements. These requirements are
expressed in terms of risk-weighted assets (‘RWA’s).
Credit risk capital requirements
Basel II applies three approaches of increasing
sophistication to the calculation of pillar 1 credit
risk capital requirements. The most basic, the
standardised approach, requires banks to use external
credit ratings to determine the risk weightings
applied to rated counterparties and group other
counterparties into broad categories and apply
standardised risk weightings to these categories.
The next level, the internal ratings-based (‘IRB’)
foundation approach, allows banks to calculate their
credit risk capital requirements on the basis of their
internal assessment of the probability that a
counterparty will default (‘PD’), but subjects their
quantified estimates of exposure at default (‘EAD’)
and loss given default (‘LGD’) to standard
supervisory parameters. Finally, the IRB advanced
approach allows banks to use their own internal
assessment in both determining PD and quantifying
EAD and LGD.
The capital resources requirement, which is
intended to cover unexpected losses, is derived from
a formula specified in the regulatory rules, which
incorporates these factors and other variables such as
maturity and correlation. Expected losses under the
IRB approaches are calculated by multiplying PD by
EAD and LGD. Expected losses are deducted from
capital to the extent that they exceed accounting
impairment allowances.
For credit risk, with the FSA’s approval, we
have adopted the IRB advanced approach for the
majority of our business, with the remainder on
either IRB foundation or standardised approaches.