HSBC 2011 Annual Report Download - page 218

HSBC HOLDINGS PLC
Report of the Directors: Operating and Financial Review (continued)
Capital > Appendix to Capital > Capital measurement and allocation
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Regulatory and accounting consolidations
The basis of consolidation for financial accounting purposes is described on page 292 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.
Basel II is structured around three ‘pillars’: minimum capital requirements, supervisory review process and market
discipline. The 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.
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 RWAs.
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 level, 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 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 PD, LGD, EAD 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 total accounting impairment allowances.
For credit risk we have adopted the IRB advanced approach for the majority of our business, with the remainder on
either IRB foundation or standardised approaches.
Under our Basel II rollout plans, a number of our Group companies and portfolios are in transition to advanced IRB
approaches. At end of 2011, portfolios in much of Europe, Hong Kong, Rest of Asia-Pacific and North America were
on advanced IRB approaches. Others remain on the standardised or foundation approaches under Basel II, pending
definition of local regulations or model approval, or under exemptions from IRB treatment.
• Counterparty credit risk
Counterparty credit risk arises for OTC derivatives and securities financing transactions. It is calculated in both
the trading and non-trading books and is the risk that the counterparty to a transaction may default before