BASEL II and its implications

Hazel Taylor Head of Regulatory Reporting David Robertson Head of Programme Delivery Alan Smith Head of Risk Strategy May 2008

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 Groups 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.

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)

The journey to Basel II

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

Credit risk building blocks

Credit risk

Borrower characteristics

Facility characteristics

Who are you lending to?

How much exposure do you expect to have should the borrower default?

Time to repayment?

What is the % you expect to lose, given seniority, collateral and other loss mitigation?

Probability of Default (PD)

Exposure at Default (EAD)

Maturity (M)

Loss Given Default (LGD)

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)

Generic example 1 Corporate: Unexpected and Expected Loss

35 Unexpected Loss Expected Loss 30

PD = 0.1%

PD = 1.0% Unexpected Loss

PD = 10.0%

R egulatory capital requirem ent and EL (%of EA ) D

25

20

Expected Loss
15

10

PD floor (0.03%)
AAA AA+ AA AAA+ A ABB B + BBB B BB BB+ BB BBB+ B BCC C

Im plie d e x te rnal rating e quiv ale nt PDs

M = 2.5 years; LGD = 45%

8

Generic example 2 Residential mortgages: Unexpected and Expected Loss

8

Unexpected Loss Expected Loss

R g la ryc p l re u m n a dE (%o E D e u to a ita q ire e t n L f A ) 6 Unexpected Loss Expected Loss

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%

Generic example 3 Corporate: impact of increasing LGDs

50

PD = 0.1%
40

PD = 1.0%

PD = 10.0%

R g la ryc p l a dE (%o E D e u to a ita n L f A )

30

LGD = 65%
20

10

0 AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB Implied external rating equivalent PD

LGD = 45%
BBB+ B BCCC

M = 2.5 years

10

Generic example 4 Residential mortgages: impact of increasing LGDs

25

20

R g lato c p l an E (%o E D e u ry a ita d L f A )

15

LGD = 25%
10

LGD = 10%

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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HSBC Basel II analysis and disclosure

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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Disclosures

Narrative disclosures (contd)

IRBA for majority of businesses wef 1 January 2008 IRBA is more risk-sensitive and relies on the banks 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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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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Disclosures

Numerical disclosures on a pro-forma Basel II basis (as at 31Dec07):

160

153 13.6%

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Composition of regulatory capital table

Core tier 1 USD91 billion, ratio 8.1%
After 50% of EL adjustment USD4.5 billion

140

133 11.8%

12

120

Total tier 1 USD102 billion, ratio 9.0%

USDbn

100

94 8.4%

105 9.3% 91 8.1%

10 102 9.0

80

After total EL adjustment of USD9 billion After removal of collective impairment allowances of USD11 billion

6
60

Target
Tier 1 target range: 7.5% to 9.0%

4
40

20

0 Core Tier 1 Total Tier 1 Total Capital

Basel I

Basel II

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Ratio (%)

Total capital USD133 billion, ratio 11.8%

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

Analysis by type of book: Banking book USD1,021 billion (91%) Trading book USD103 billion (9%)
Includes counterparty credit risk and market risk

Credit risk

Market risk

Operational risk

Banking book

Trading book

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Pillar 2 and stress testing in a Basel II environment

Basel Pillar 2, HSBC ICAAP and Stress Testing

Pillar 1
Minimum capital
Minimum regulatory capital requirements for credit, market and operational risk

Pillar Pillar 2
Supervisory review
Internal capital adequacy assessment process and supervisory review

Pillar 3
Market discipline
Regulatory requirements for external disclosure of risk information

CAPITAL: Relationship between Pillar 1, Pillar 2 and the ICAAP Pillar 1

Minimum capital requirement Calculated using prescribed parameters (advanced or standardised) Point-in-time assessment

Pillar 2
Supervisory assessment via the Individual Capital Guidance (ICG) of amount of regulatory capital considered necessary to cover: Pillar 1 risks (including any uncertainties in their calculation); and Risks not included in Pillar 1 Capital planning and stress testing is an important part of the assessment

ICAAP
Firm's own assessment of its capital needs Economic capital is an important part of the framework to supplement the Pillar 1 regulatory capital analysis Stress analysis is carried out for the 1 in 25 scenario

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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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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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Scenario stress testing process critical features

Scenario Definition
Define macro stress scenario

Translation
Translate stress scenario into risk factors

Feedback
Get feedback on results and concerns for new scenario definition

Stress scenario lifecycle

Calculation
Calculate Impact on drivers within risk categories

Analysis and Reporting

Analyse reports to highlight significant results

Aggregation
Aggregate results

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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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Question & Answer