HSBC 2012 Annual Report Download - page 297

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Overview Operating & Financial Review Corporate Governance Financial Statements Shareholder Information
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, the standardised approach, requires banks to use external credit ratings to determine
the risk weightings applied to rated counterparties. Other counterparties are grouped into broad categories and
standardised risk weightings are applied 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 a counterparty’s probability of default (‘PD’), but their estimates of exposure at default (‘EAD’) and
loss given default (‘LGD’) are subject 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 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 portfolios, 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 the end of 2012, portfolios in most 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
CCR 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 completing the satisfactory
settlement of the transaction. Three approaches to calculating CCR and determining exposure values are defined
by Basel II: standardised, mark-to-market and internal model method. These exposure values are used to
determine capital requirements under one of the credit risk approaches: standardised, IRB foundation and IRB
advanced.
We use the mark-to-market and internal model method approaches for CCR. Our longer-term aim is to migrate
more positions from the mark-to-market to the internal model method approach.
• Securitisation
Securitisation positions are held in both the trading and non-trading books. For non-trading book securitisation
positions, Basel II specifies two methods for calculating credit risk requirements, the standardised and the IRB
approaches. Both rely on the mapping of rating agency credit ratings to risk weights, which range from 7% to
1,250%. Positions that would otherwise be weighted at 1,250% are deducted from capital.
Within the IRB approach, we use the ratings-based method for the majority of our non-trading book
securitisation positions, and the internal assessment approach for unrated liquidity facilities and programme-wide
enhancements for asset-backed securitisations.
The majority of securitisation positions in the trading book are treated for capital purposes as if they are held in
the non-trading book under the standardised or IRB approaches. Other traded securitisation positions, known as
correlation trading, are treated under an internal model approach approved by the FSA.
Market risk capital requirement
The market risk capital requirement is measured using internal market risk models where approved by the FSA, or
the FSA’s standard rules. Our internal market risk models comprise VAR, stressed VAR, incremental risk charge and
correlation trading under the comprehensive risk measure.