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

HSBC Holdings plc – Annual report – 31 December 2019

Industry: banking

Report of the Directors (extract)
Risk (extract)
Top and emerging risks (extract 1)
We use a top and emerging risks process to provide a forward-looking view of issues with the potential to threaten the execution of our strategy or operations over the medium to long term.

We proactively assess the internal and external risk environment, as well as review the themes identified across our regions and global businesses, for any risks that may require global escalation, updating our top and emerging risks as necessary.

We define a ‘top risk’ as a thematic issue that may form and crystallise within one year, and which has the potential to materially affect the Group’s financial results, reputation or business model. It may arise across any combination of risk types, regions or global businesses. The impact may be well understood by senior management and some mitigating actions may already be in place. Stress tests of varying granularity may also have been carried out to assess the impact.

An ‘emerging risk’ is a thematic issue with large unknown components that may form and crystallise beyond a one-year time horizon. If it were to materialise, it could have a material effect on our long-term strategy, profitability and/or reputation. Existing mitigation plans are likely to be minimal, reflecting the uncertain nature of these risks at this stage. Some high-level analysis and/or stress testing may have been carried out to assess the potential impact.

Our current top and emerging risks are as follows.

Externally driven
Economic outlook and capital flows
Global manufacturing was in recession in 2019 as the Chinese economy slowed, trade and geopolitical tensions continued, and key sectors like automotive and information technology suffered from idiosyncratic issues. This had an impact on trade-reliant regions including the European Union (‘EU’), while the US benefited from a resilient consumer. Early in 2019, global central banks abandoned their previous intentions to tighten monetary policy gradually in order to underpin economic activity.

These and other factors contributed to an increase in market optimism towards the end of 2019 that global economic activity may be bottoming out.

However, a significant degree of caution is warranted. US-China relations are likely to remain tense as negotiations move to a second phase, covering aspects like intellectual property. Changing global consumption patterns and the introduction of stricter environmental standards may continue to hamper the automotive and other traditional industries. The net impact on trade flows could be negative, and may damage HSBC’s traditional lines of business.

The coronavirus outbreak is a new emerging risk. In a baseline scenario, the outbreak should be contained but may lead to a slowdown in China’s economic activity during the first quarter of 2020, followed by a rebound in the remainder of the year, helped by an increased policy stimulus in response to the outbreak. However, there is a risk that containment proves more challenging, and the resulting socio-economic disruption is more extensive and prolonged, extending beyond China. Since the beginning of January, the coronavirus outbreak has caused disruption to our staff, suppliers and customers, particularly in mainland China and Hong Kong. Should the coronavirus continue to cause disruption to economic activity in Hong Kong and mainland China through 2020, there could be adverse impacts on income due to lower lending and transaction volumes, and insurance manufacturing revenue, which may impact our RWAs and capital position. We have invoked our business continuity plans to help ensure the safety and well-being of our staff, as well as our capability to support our customers and maintain our business operations.

Elsewhere, there could also be other downside idiosyncratic risks in emerging markets, which could include a disorderly sovereign debt restructuring in Argentina.
It is anticipated that oil prices are likely to remain range-bound in 2020, with occasional spikes in volatility.

The run-up to the US Presidential Election in November may be a key factor in causing market volatility. Persistent social tensions in Hong Kong may disrupt local economy and business sentiment further. In Europe, political uncertainty around the ultimate shape of UK-EU relations may lead to occasional periods of market volatility and economic uncertainty. We believe our businesses 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 75.
• 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 manage and mitigate this risk proactively.
• In Hong Kong we are actively monitoring our credit and trading portfolios. We have also performed internal stress tests and scenario analysis. We continue to support our customers and manage risk and exposures as appropriate.

Geopolitical risk
Our operations and portfolios are exposed to risks associated with political instability, civil unrest and military conflict, which could lead to disruption of our operations, physical risk to our staff and/or physical damage to our assets.

Global tensions over trade, technology and ideology can manifest themselves in divergent regulatory, standards and compliance regimes, presenting long-term strategic challenges for multinational businesses.

In 2019, societies in nearly all the markets in which we operate were affected by a series of common issues, which are likely to continue in 2020. Migration, income inequality, corruption, climate change and terrorism are examples of those issues, which have led to discontent in the markets in which we operate. This discontent is reflected in increased protest activity and challenging traditional political structures. This level of geopolitical risk is expected to remain heightened throughout 2020.

The UK formally left the EU on 31 January 2020 and entered a transition period until 31 December 2020. The top risk is that the UK fails to agree a trade deal with the EU and commits to its pledge to not extend the 11-month transition period. This scenario would likely renew economic and financial uncertainty.

In 2019, Hong Kong experienced heightened levels of domestic social unrest and, if prolonged, there could be broader economic ramifications, affecting several of the Group’s portfolios.

In the US, there will be political uncertainty and increased partisanship, as the US Presidential election campaign was preceded by a presidential impeachment trial.

More broadly, intensified US-China competition and occasional confrontation are expected to feature prominently in 2020, despite the ‘phase one’ trade deal, as negotiations move to phase two, which covers aspects such as intellectual property.

The impact of US-China competition may also be felt in our other markets, particularly in Europe. New regulations from both the US and China will likely increase scrutiny of companies involved in cross-border data transfers and limit the use of foreign technology in private and national infrastructure. Combined, these regulations could drive the bifurcation of US and Chinese technology sectors, standards and supply chain ecosystems, which may limit innovation and drive up production and compliance costs for firms operating in both markets.

In the Middle East, Iran is expected to remain central to regional security in 2020. The risk of escalation remains high, and any mismanaged incidents would have significant regional security and global market repercussions. Continued geopolitical risks have negative implications for economic growth. Central banks in key markets are likely to see little need to raise their policy interest rates above current levels and may even resort to lowering rates to accommodate the risks to growth.

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 following 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 without a comprehensive trade agreement.
• We have taken steps to enhance physical security in those geographical areas deemed to be at high risk from terrorism and military conflicts.
• In Hong Kong, we are actively monitoring our credit portfolio. We have performed internal stress tests and scenario analysis. We continue to support our customers and manage risk and exposures as appropriate.

Top and emerging risks (extract 2)
Regulatory developments including conduct, with adverse impact on business model and profitability
Financial service providers continue to face demanding 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, digital, cyber, sustainability and the integrity of financial services delivery. HSBC is particularly affected by regulatory change, given the geographic scope of the Group’s operations.

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 could include the loss of passporting rights and free movement of services, depending on the final terms of the future relationship between the UK and the EU. Changes to business models and structures will be necessary to accommodate any such restrictions.

As described in Note 34 on the financial statements, we continue to be subject to a number of material legal proceedings, regulatory actions and investigations, including our January 2018 deferred prosecution agreement with the US Department of Justice (‘DoJ’) arising from its investigation into HSBC’s historical foreign exchange activities (the ‘FX DPA’).

Mitigating actions
• We continue to enhance our horizon scanning capabilities to identify new developments and regulatory publications. We are investing in – and rolling out – a new system that collects regulatory change information from multiple sources, to drive clear accountability and responsibility for the implementation and oversight of regulatory development.
• Relevant governance forums within the Group oversee change programmes. Significant regulatory programmes are overseen by the Group Change Committee.
• We are fully engaged, wherever appropriate, with governments and regulators in the countries in which we operate, to help ensure that new proposals achieve their policy objectives and can be implemented effectively. We hold regular meetings with all relevant authorities to discuss strategic contingency plans across the range of regulatory priorities.
• We have invested in 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 include enhancements to pricing and disclosure, order management and trade execution; trade, voice and audio surveillance; front office supervision; and improvements to our enforcement and discipline framework for employee misconduct. For further details, see ‘Regulatory compliance risk management’ on page 144.

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 and proactively managing the regulatory environment depends on the development and retention of our leadership and high-performing employees. The ability to continue to attract, develop and retain competent individuals in alignment with our strategy 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, internal and environmental factors, such as the UK’s exit from the EU, changes to immigration policies and regulations, organisational restructuring and tax reforms in key markets that require active responses.

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 closely monitored to minimise the impact on the attraction and retention of talent and key performers.
• We promote a diverse and inclusive workforce and provide active support across a wide range of health and well-being activities.
• We have robust plans in place, driven by senior management, to mitigate the effect of external factors that may impact our employment practices. We will also be monitoring the impact on people linked to organisational changes announced in 2020.

Top and emerging risks (extract 4)
Areas of special interest (extract)
During 2019, a number of areas were identified and considered as part of our top and emerging risks because of the effect they may have on the Group. While considered under the themes captured under top and emerging risks, in this section we have placed a particular focus on the UK withdrawal from the EU, Ibor transition and the risks to our operations and portfolios in Asia-Pacific.

UK withdrawal from the European Union
The UK left the EU on 31 January 2020 and entered a transition period until 31 December 2020, during which negotiations will take place on the future relationship between the UK and the EU. At this stage it remains unclear what that relationship will look like, potentially leaving firms with little time to adapt to changes, which may enter into force on 1 January 2021. Our programme to manage the impact of the UK leaving the EU has now been largely completed. It is based on the assumption of a scenario whereby the UK exits the transition period without the existing passporting or regulatory equivalence framework that supports cross-border business. Our focus has been on four main components: legal entity restructuring; product offering; customer migrations; and employees.

Legal entity restructuring
Our branches in seven European Economic Area (‘EEA’) countries (Belgium, the Netherlands, Luxembourg, Spain, Italy, Ireland and Czech Republic) relied on passporting out of the UK. We had worked on the assumption that passporting will no longer be possible following the UK’s departure from the EU and therefore transferred our branch business to newly established branches of HSBC France, our primary banking entity authorised in the EU. This was completed in the first quarter of 2019.

Product offering
To accommodate for customer migrations and new business after the UK’s departure from the EU, we expanded and enhanced our existing product offering in France, the Netherlands and Ireland. We also opened a new branch in Stockholm to service our customers in the Nordic region.

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 are required to migrate some EEA-incorporated clients from the UK to HSBC France, or another EEA entity. We have now migrated most clients who we expect can no
longer be serviced out of the UK. We are working in close collaboration with any remaining clients to make the transition as smooth as possible.

Employees
The migration of EEA-incorporated clients will require us to strengthen our local teams in the EU, and France in particular. 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 employees who are UK citizens resident in EEA countries, and employees who are citizens of an EU member state resident in the UK (e.g. on settlement applications).

At December 2019, HSBC employed approximately 40,000 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 under the terms described above. However, there remain execution risks, many of them linked to the uncertain outcome of negotiations. 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, see ‘Impact of alternative/additional scenarios’ on page 95.