Brexit and other economic and political risks, passporting, customers, employees, banking

HSBC Holdings plc – Annual report – 31 December 2018

Industry: banking
Report of the Directors (extract)
Risk (extract)
Top and emerging risks (extract 1)
Our approach to identifying and monitoring top and emerging risks is described on page 76. During 2018, we made a number of changes to our top and emerging risks to reflect our assessment of the issues facing HSBC. Our current top and emerging risks are as follows.

Externally driven
Economic outlook and capital flows
Economic activity diverged across the global economy during 2018. The US benefited from a fiscal stimulus that helped to drive GDP growth above its long-term trend. The growth rate in trade-dependent regions like the European Union (‘EU’) declined on the back of a slowing Chinese economy, and trade and geopolitical tensions. Tightening global financial conditions alongside the tapering off of fiscal stimulus in the US is expected to lead to more moderate growth in global economic activity in 2019. Oil prices will likely remain volatile as contrasting supply and demand factors prevail in turn.

The stand-off between the US and China on a variety of economic and technological issues is likely to continue in 2019, although further liberalising initiatives in a vein similar to the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (‘CPTPP’) and the EU-Japan trade deal, as well as some re-organisation of global supply chains, could partly offset rising protectionism. Nevertheless, the net impact on trade flows could be negative, and may damage HSBC’s traditional lines of business.

Emerging markets are set to face challenging cross-currents. The reduction in global liquidity and consequent increase in the cost of external funding could expose vulnerabilities that spread more broadly. However, China has pledged to enact some stimulus to offset the effects of tariff hikes. This should help emerging markets achieve reasonable growth rates even in the face of headwinds, though downside risks abound.

US midterm elections brought in a divided Congress, while two of Latin America’s largest economies, Mexico and Brazil, elected new presidents. In Europe, populist parties have made political gains and could make further breakthroughs. In conjunction with continuing significant uncertainty around the ultimate shape of the UK’s exit from the EU, as well as developments in countries such as Italy, severe bouts of economic and financial turbulence could spread beyond Europe. We believe HSBC’s strong UK and European franchises are well placed to weather risks, but would nevertheless be affected by severe shocks.

Mitigating actions
• We actively assess the impact of economic developments in key markets on specific customer segments and portfolios and take appropriate mitigating actions. These actions include revising risk appetite and/or limits, as circumstances evolve.
• We use internal stress testing and scenario analysis, as well as regulatory stress test programmes, to evaluate the potential impact of macroeconomic shocks on our businesses and portfolios. Our approach to stress testing is described on page 76.
• We have carried out detailed reviews and stress tests of our wholesale credit, retail credit and trading portfolios to determine those sectors and customers most vulnerable to the UK’s exit from the EU, in order to proactively manage and mitigate this risk.

Geopolitical risk
Our operations and portfolios are exposed to risks associated with political instability, civil unrest and military conflict, which could lead to disruption to our operations, physical risk to our staff and/or physical damage to our assets. In addition, rising protectionism and the increasing trend of using trade and investment policies as diplomatic tools may also adversely affect global trade flows.

Geopolitical risk remained heightened throughout 2018. The growing presence of populist parties means political systems across Europe are increasingly fragmented, volatile and less predictable. Political uncertainty remains high in the UK as its departure from the EU continues to dominate the political agenda in 2019 (see ‘Process of UK withdrawal from the European Union’ on page 73).

In the Middle East, the US has reinstated components of its Iran sanctions regime that were previously lifted to implement the Iran Nuclear Deal. The US is also putting pressure to end the war in Yemen and the boycott of Qatar. In Turkey, which has local elections in March 2019, the president may face increasing pressure to solve economic challenges after the Turkish lira came under pressure in 2018.

In Asia, US-China competition and confrontation across multiple dimensions will likely continue, including concerning economic power and technology leadership. US investment and export restrictions on Chinese imports could disrupt investment decisions, leading to a slow decoupling of the US and Chinese technology sectors.

Key presidential votes in HSBC markets Mexico and Brazil have changed the political status quo. A major source of uncertainty for Mexico was removed with the negotiation of the United States-Mexico-Canada Agreement (‘USMCA’), which replaces NAFTA as a key driver of the Mexican economy, but still must be ratified. In Argentina, elections due in October 2019 will be shaped by economic factors and potential further market volatility. Corruption and security dynamics will continue to shape voter preferences.

Mitigating actions
We continually monitor the geopolitical outlook, in particular in countries where we have material exposures and/or a physical presence. We have also established dedicated forums to monitor geopolitical developments.
• We use internal stress tests and scenario analysis as well as regulatory stress test programmes, to adjust limits and exposures to reflect our risk appetite and mitigate risks as appropriate. Our internal credit risk ratings of sovereign counterparties take into account geopolitical developments that could potentially disrupt our portfolios and businesses.
• We continue to carry out contingency planning for the UK’s exit from the EU and we are assessing the potential impact on our portfolios, operations and staff. This includes the increased possibility of an exit with no transition agreement.
• We have taken steps to enhance physical security in those geographical areas deemed to be at high risk from terrorism and military conflicts.

Top and emerging risks (extract 2)
Regulatory developments including conduct, with adverse impact on business model and profitability
Financial service providers continue to face stringent regulatory and supervisory requirements, particularly in the areas of capital and liquidity management, conduct of business, financial crime, internal control frameworks, the use of models and the integrity of financial services delivery. The competitive landscape in which the Group operates may be significantly altered by future regulatory changes and government intervention. Regulatory changes, including any resulting from the UK’s exit from the EU, may affect the activities of the Group as a whole, or of some or all of its principal subsidiaries. This would include the loss of passporting rights and free movement of services, which are likely to arise in the event of the UK leaving the EU without an exit deal. Changes to business models and structures will be necessary to accommodate any such restrictions. For further details, see page 73.

Additionally, as described in Note 35 on the Financial Statements, we continue to be subject to a number of material legal proceedings, regulatory actions and investigations, including, for example, our January 2018 deferred prosecution agreement with the US DoJ arising from its investigation into HSBC’s historical foreign exchange activities (the ‘FX DPA’).

Mitigating actions
• We are fully engaged, wherever possible, with governments and regulators in the countries in which we operate, to help ensure that new requirements are considered properly by regulatory authorities and the financial sector and can be implemented effectively. Significant regulatory programmes are overseen by the Group Change Committee.
• We hold regular meetings with all relevant authorities to discuss strategic contingency plans covering a wide range of scenarios relating to the UK’s exit from the EU. In the absence of an agreement on the terms of the UK’s withdrawal from the EU, these discussions increasingly focus on no deal scenarios and our plans to navigate the restrictions that are likely to arise regarding our ability to access EU markets and customers from the UK if passporting rights are withdrawn.
• We have invested significant resources and have taken, and will continue to take, a number of steps to improve our compliance systems and controls relating to our activities in global markets. These included enhancements to trade, voice and audio surveillance and the implementation of algorithmic trading for benchmark orders. For further details, see ‘Regulatory compliance risk management’ on page 84.

Top and emerging risks (extract 3)
Risks associated with workforce capability, capacity and environmental factors with potential impact on growth
Our success in delivering our strategic priorities, as well as proactively managing the regulatory environment, depends on the development and retention of our leadership and high-performing employees. The ability to continue to attract, train, motivate and retain highly qualified professionals in an employment market where expertise is often mobile and in short supply is critical, particularly as our business lines execute their strategic business outlooks. This may be affected by external and environmental factors, such as the UK’s exit from the EU, changes to immigration policies and regulations and tax reforms in key markets that require active responses. Although potential people impacts related to the UK’s exit from the EU have not yet materialised, we continue to monitor retention trends and the recruitment of key roles.

Mitigating actions
• HSBC University is focused on developing opportunities and tools for current and future skills, personal skills and leaders to create an environment for success.
• We continue to develop succession plans for key management roles, with actions agreed and reviewed on a regular basis by the Group Management Board.
• We actively respond to immigration changes through the global immigration programme. Other political and regulatory challenges are being closely monitored to minimise the impact
on the attraction and retention of talent and key performers.
• HSBC is building the healthiest human system where colleagues can thrive. A number of initiatives have been launched to improve our ways of working and encourage an open and positive culture (e.g. simplifying processes and governance, and adopting new behaviours). We also promote a diverse and inclusive workforce and provide active support across a wide range of health and well-being activities.

Top and emerging risks (extract 4)
Areas of special interest
During 2018, a number of areas have been identified and considered as part of our top and emerging risks because of the effect they may have on the Group. We have placed particular focus on the UK withdrawal from the European Union (‘EU’) in this section.

Process of UK withdrawal from the European Union
The UK is due to formally leave the EU in March 2019. Before then, the UK and the EU have to finalise the Article 50 Withdrawal Agreement, which will need to be approved by their respective parliaments. A comprehensive trade deal will not be concluded within this time frame. A period of transition until 31 December 2020 has been agreed between the UK and the EU. However, there will be no legal certainty until this is enshrined in the Withdrawal Agreement. To ensure continuity of service, independent of the outcome of negotiations, our contingency plan is based on the assumption of a scenario whereby the UK exits the EU without the existing passporting or regulatory equivalence framework that supports cross-border business.

Our programme to manage the impact of the UK leaving the EU was set up in 2017 and now has in excess of 1,000 employees covering all businesses and functions. It focuses on four main components: legal entity restructuring; product offering; customer migrations; and employees.

Legal entity restructuring
The Group currently has branches in seven European Economic Area (‘EEA’) countries (Belgium, the Netherlands, Luxembourg, Spain, Italy, Ireland and Czech Republic), which rely on passporting out of the UK. Assuming a UK departure from the EU without the existing passporting or regulatory equivalence framework that supports cross-border business, this will no longer be possible. As a result, we have now completed the establishment of new branches of HSBC France (‘HBFR’), our primary banking entity authorised in the EU, after receiving regulatory approval in 2018. We are on track to complete the business transfer in the first quarter of 2019, and are making good progress on the operational integration of our EEA branch network into HBFR.

Product offering
To accommodate for customer migrations and new business after the UK’s departure from the EU, we are expanding and enhancing our existing product offering in France, the Netherlands and Ireland. HBFR’s euro clearing capabilities are now available and further product launches are planned during the first quarter of 2019.

Customer migrations
The UK’s departure from the EU is likely to have an impact on our clients’ operating models, including their working capital requirements, investment decisions and financial markets infrastructure access. Our priority is to provide continuity of service, and while our intention is to minimise the level of change for our customers, we will be required to migrate some EEA-incorporated clients from the UK to HBFR, or another EEA entity. We are in active dialogue with affected clients to make the transition as smooth as possible. We are organising client events and communications to provide clients with a better understanding of these implications.

Employees
The migration of EEA-incorporated clients will require us to strengthen our local teams in the EU, and France in particular. We expect the majority of roles to be filled through hires and we have started a recruitment process. Throughout, our objective is to minimise the level of change for our people and ensure any transition is as smooth as possible.

Given the scale and capabilities of our existing business in France, we are well prepared to take on additional roles and activities.

Looking beyond the transfer of roles to the EU, we are also providing support to our UK employees resident in EEA countries and EEA employees resident in the UK (e.g. on settlement applications).

Nevertheless, London will continue to be an important global financial centre and the best location for our global headquarters. As at 31 December 2018, HSBC employed approximately 39,000 people in the UK.

Across the programme, we have made good progress in terms of ensuring we are prepared for the UK leaving the EU in the first quarter of 2019 under the terms described above. However, there remain execution risks, many of them linked to the uncertain outcome of negotiations and potentially tight timelines to implement significant changes to our UK and European operating models. If these risks materialise, HSBC’s clients and employees are likely to be affected. The exact impact on our clients will depend on their individual circumstances and, in a worst case scenario, could include disruption to the provision of products and services.

We have carried out detailed reviews of our credit portfolios to determine those sectors and customers most vulnerable to the UK’s exit from the EU. For further details, please see ‘Impact of UK economic uncertainty on ECL’ on page 98.

 

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