Hsbc Annual Report

The Hongkong and Shanghai Banking Corporation Limited Annual Report and Accounts 2012

THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Annual Report and Accounts 2012

Contents Financial Highlights ........................................................................................................................................... Report of the Directors ...................................................................................................................................... Financial Review ............................................................................................................................................... Statement of Directors’ Responsibilities ............................................................................................................ Auditor’s Report ................................................................................................................................................ Financial Statements .......................................................................................................................................... Consolidated income statement ......................................................................................................................... Consolidated statement of comprehensive income ............................................................................................ Consolidated balance sheet ................................................................................................................................ Consolidated statement of changes in equity ..................................................................................................... Consolidated statement of cash flows ................................................................................................................ Bank balance sheet ............................................................................................................................................ Bank statement of changes in equity .................................................................................................................. Notes on the Financial Statements ..................................................................................................................... Certain defined terms This document comprises the Annual Report and Accounts 2012 for The Hongkong and Shanghai Banking Corporation Limited (‘the Bank’) and its subsidiaries (together ‘the group’). References to ‘HSBC’, ‘the Group’ or ‘the HSBC Group’ within this document mean HSBC Holdings plc together with its subsidiaries. Within this document the Hong Kong Special Administrative Region of the People’s Republic of China is referred to as ‘Hong Kong’. The abbreviations ‘HK$m’ and ‘HK$bn’ represent millions and billions (thousands of millions) of Hong Kong dollars respectively. Cautionary statement regarding forward-looking statements This Annual Report and Accounts contains certain forward-looking statements with respect to the financial condition, results of operations and business of the group. Statements that are not historical facts, including statements about the Bank’s beliefs and expectations, are forwardlooking statements. Words such as ‘expects’, ‘anticipates’, ‘intends’, ‘plans’, ‘believes’, ‘seeks’, ‘estimates’, ‘potential’ and ‘reasonably possible’, variations of these words and similar expressions are intended to identify forward-looking statements. These statements are based on current plans, estimates and projections, and therefore undue reliance should not be placed on them. Forward-looking statements speak only as of the date they are made, and it should not be assumed that they have been revised or updated in the light of new information or future events. Forward-looking statements involve inherent risks and uncertainties. Readers are cautioned that a number of factors could cause actual results to differ, in some instances materially, from those anticipated or implied in any forwardlooking statement. Chinese translation A Chinese translation of the Annual Report and Accounts is available upon request from: Communications (Asia), Level 32, HSBC Main Building, 1 Queen’s Road Central, Hong Kong. The report is also available, in English and Chinese, on the Bank’s website at www.hsbc.com.hk .
本《年報及賬目》備有中譯本，如欲查閱可向下址索取：香港皇后大道中 1 號滙豐總行大廈 32 樓企業傳訊部（亞太區）。本年報之中英文本亦載於本行之網址 www.hsbc.com.hk。

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THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Financial Highlights

2012 HK$m For the year Net operating income before loan impairment charges .............................................. Profit before tax ......................................................................................................... Profit attributable to shareholders .............................................................................. At the year-end Shareholders’ equity .................................................................................................. Total equity ................................................................................................................ Total capital base ....................................................................................................... Customer accounts ..................................................................................................... Total assets ................................................................................................................ Ratios Return on average shareholders’ equity ..................................................................... Post-tax return on average total assets ....................................................................... Cost efficiency ratio ................................................................................................... Net interest margin .................................................................................................... Capital adequacy ratios – core capital ............................................................................................................. – total capital ............................................................................................................ 162,267 108,729 83,008

2011 HK$m 147,170 91,370 67,591

437,399 473,078 272,892 3,874,884 6,065,327 % 21.9 1.54 42.4 1.96 13.7 14.3

340,824 371,343 246,206 3,565,001 5,607,480 % 21.6 1.34 46.1 1.91 12.4 14.6

Established in Hong Kong and Shanghai in 1865, The Hongkong and Shanghai Banking Corporation Limited is the founding member of the HSBC Group – one of the world’s largest banking and financial services organisations – and its flagship in the Asia-Pacific region. It is the largest bank incorporated in Hong Kong and one of Hong Kong’s three note-issuing banks. Serving the financial and wealth management needs of an international customer base, the Bank and its subsidiaries provide a range of personal, commercial and corporate banking and related financial services in 20 countries and territories in Asia-Pacific – with the largest network of any international financial institution in the region – and in six other countries around the world. Employing some 65,600 people, of whom 34,000 work for the Bank itself, the Bank and its subsidiaries had consolidated assets at 31 December 2012 of HK$6,065bn. The Hongkong and Shanghai Banking Corporation Limited is a wholly owned subsidiary of HSBC Holdings plc, the holding company of the HSBC Group, which has an international network covering 81 countries and territories in six geographical regions: Europe, Hong Kong, Rest of Asia-Pacific, Middle East and North Africa, North America and Latin America.

The Hongkong and Shanghai Banking Corporation Limited Incorporated in the Hong Kong SAR with limited liability Registered Office and Head Office: HSBC Main Building, 1 Queen’s Road Central, Hong Kong Telephone: (852) 2822 1111 Facsimile: (852) 2810 1112 Web: www.hsbc.com.hk Telex:73201 HKBG HX

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THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Report of the Directors

Principal Activities The Bank and its subsidiaries and associates provide a comprehensive range of domestic and international banking and related financial services, principally in the Asia-Pacific region. Asia Strategy HSBC Group’s aim is to be acknowledged as the world’s leading international bank. As a subsidiary of the HSBC Group, the Bank applies a disciplined approach in managing its portfolio of businesses to focus on areas where it has a clear and competitive advantage. The Bank is simplifying its structures and processes to improve efficiency and achieve sustainable cost saves. The Bank’s strong presence across the Asia-Pacific region will help maintain its competitive advantage in connecting business opportunities within the region, as well as between Asia-Pacific and the rest of the world. Corporate Governance A corporate governance report is set out on pages 5 to 9. Financial Statements The state of affairs of the Bank and the group, and the consolidated profit of the group, are shown on pages 31 to 200. Share Capital To fund a capital injection into HSBC Bank (China) Company Limited (“HBCN”), a wholly-owned subsidiary, and to fund the redemption of preference shares, the Bank issued 780m ordinary shares at par value of HK$2.50 each to the existing shareholder, HSBC Asia Holdings BV (“HAHB”), on 29 March 2012. To fund the subscription of new Hshares in Bank of Communications Co., Ltd., the Bank issued 5,305.58m ordinary shares at par value of HK$2.50 each to HAHB on 2 May 2012. To fund a capital injection into HBCN, the Bank issued 775.76m ordinary shares at par value of HK$2.50 each to HAHB on 16 August 2012. The Bank also issued 4,650m ordinary shares at par value of HK$2.50 each to HAHB on 26 November 2012 to fund the redemption of preference shares. Reserves and Dividends Profits attributable to shareholders, before dividends, of HK$83,008m have been transferred to reserves. During the year, a surplus of HK$6,060m, net of the related deferred taxation effect, arising from professional valuations of premises held by the Bank and the group was credited to reserves. Details of the movements in reserves, including appropriations therefrom, are set out in the Consolidated Statement of Changes in Equity and the Bank Statement of Changes in Equity. The interim dividends paid in respect of 2012 are set out in note 9 to the financial statements. The Directors do not recommend the payment of a final dividend. Directors The names of the Directors at the date of this report are set out below: Stuart T Gulliver, Chairman Dr William Fung Kwok Lun*, SBS, OBE, Deputy Chairman Laura Cha May Lung*, GBS, Deputy Chairman Peter Wong Tung Shun, Chief Executive Graham John Bradley* Dr Raymond Ch’ien Kuo Fung*, GBS, CBE Naina L Kidwai Rose Lee Wai Mun Victor Li Tzar Kuoi*
* non-executive Director

Zia Mody* Christopher D Pratt* James Riley* Andreas Sohmen-Pao* T Brian Stevenson*, SBS Dr Rosanna Wong Yick-ming*, DBE Marjorie Yang Mun Tak* Tan Sri Dr Francis Yeoh Sock Ping*, CBE

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THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Report of the Directors (continued)

All the Directors served throughout the year save for Rose Lee Wai Mun, Francis Yeoh Sock Ping and Graham John Bradley who were appointed on 21 May, 1 July and 26 November 2012 respectively. Margaret Leung Ko May Yee and Dr Lo Ka Shui resigned on 11 May and 21 May 2012 respectively. Dr Patrick Wang Shui Chung and Paul Anthony Thurston resigned with effect from 31 December 2012. Directors’ Interests in Contracts No contracts of significance to which the Bank, its holding companies, its subsidiaries or any fellow subsidiary was a party and in which a Director had a material interest subsisted at the end of the year or at any time during the year. Directors’ Rights to Acquire Shares or Debentures To help align the interests of employees with shareholders, certain Directors have been granted options and conditional awards over HSBC Holdings plc ordinary shares by that company (being the ultimate holding company) pursuant to the HSBC Holdings Group Share Option Plan (‘GSOP’), the HSBC Holdings Savings-Related Share Option Plans (‘SRSOP’), the HSBC Share Plan or the HSBC Share Plan 2011. Under the GSOP, discretionary awards of share options, with vesting subject to the attainment of a pre-determined corporate performance condition, were made to employees at all levels of HSBC. The exercise price of options granted under the GSOP is the higher of the average market value on the five dealing days prior to the grant of the option and the middle market quotation of a share on the date of grant of the option or the nominal value of a share. No options have been granted under the GSOP since 26 May 2005. Under the SRSOPs, eligible employees, including Directors, may be granted options over HSBC Holdings plc shares at a price per share which is fixed at the average of the middle market quotations derived from the London Stock Exchange Daily Official List for the five dealing days preceding the date of the invitation to participate in the plan, discounted by 20%. The vesting of conditional awards of HSBC Holdings plc ordinary shares granted to Directors under the HSBC Share Plan and the HSBC Share Plan 2011 are generally subject to the individual remaining an employee on the vesting date. The Performance Share awards under the HSBC Share Plan, which are subject to the attainment of corporate performance conditions, have been replaced by the Group Performance Share Plan which is the long-term incentive plan under the HSBC Share Plan 2011. During the year, Stuart T Gulliver, Naina L Kidwai, Margaret Leung Ko May Yee, Rose Lee Wai Mun, Paul A Thurston and Peter Wong Tung Shun acquired or were awarded shares in HSBC Holdings plc under the terms of the HSBC Share Plan and/or the HSBC Share Plan 2011. Apart from these arrangements, at no time during the year was the Bank, its holding companies, its subsidiaries or any fellow subsidiary a party to any arrangements to enable the Directors to acquire benefits by means of the acquisition of shares in or debentures of the Bank or any other body corporate. Donations Donations made by the Bank and its subsidiaries during the year amounted to HK$208m (2011: HK$107m). Compliance with the Banking (Disclosure) Rules The Directors are of the view that the Accounts and Supplementary Notes for the year ended 31 December 2012, which will be published separately, fully comply with the Banking (Disclosure) Rules made under section 60A of the Banking Ordinance. Auditors The Accounts have been audited by KPMG. A resolution to reappoint KPMG as auditor of the Bank will be proposed at the forthcoming Annual General Meeting.

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Corporate Governance Report The Hongkong and Shanghai Banking Corporation Limited is committed to high standards of corporate governance. As an Authorised Institution, the Bank is subject to the Hong Kong Monetary Authority Supervisory Policy Manual CG-1 ‘Corporate Governance of Locally Incorporated Authorised Institutions’ (‘HKMA SPM CG-1’). The Bank has followed the HKMA SPM CG-1 during 2012. On 3 August 2012, a revised SPM CG-1 was issued. Authorised Institutions are expected to align their policies and practices as soon as practicable and within 12 months of the issue date. The Bank has undertaken a review and steps to bring relevant policies and practices into line with the revised module are progressing and will be completed within the implementation guidelines. Board of Directors The Board, led by the Chairman, provides entrepreneurial leadership of the Bank within a framework of prudent and effective controls which enables risks to be assessed and managed. It is collectively responsible for the long-term success of the Bank and delivery of sustainable value to shareholders. It sets the strategy and risk appetite for the Bank and its subsidiaries and approves capital and operating plans presented by management for the achievement of the strategic objectives it has set. Directors The Bank has a unitary Board. The authority of each Director is exercised in Board meetings where the Board acts collectively. As at 4 March, 2013, the Board comprised the Chairman, Chief Executive, two other Directors with executive responsibilities for the Bank’s or a subsidiary’s operations and thirteen non-executive Directors (including two Deputy Chairmen). Independence of non-executive Directors Non-executive Directors are not HSBC employees and do not participate in the daily business management of the Bank; they bring an external perspective, constructively challenge and help develop proposals on strategy, scrutinize the performance of management in meeting agreed goals and objectives, and monitor the risk profile and reporting of performance of the Bank. The non-executive Directors bring experience from a number of industries and business sectors, including the leadership of large complex multinational enterprises. The Board has considered the independence of each of the non-executive Directors and determined that each non-executive Director is independent in character and judgement and that there are no relationships or circumstances likely to affect their judgement, with any relationships or circumstances that could appear to do so not considered to be material. Chairman and Chief Executive The roles of Chairman and Chief Executive are separate and held by experienced full-time employees of the HSBC Group. There is a clear division of responsibilities between leading the Board and the executive responsibility for running the Bank’s business. The Chairman provides leadership to the Board and is responsible for the overall effective functioning of the Board. The Chairman is responsible for the development of strategy and the oversight of implementation of Board approved strategies and direction. The Chief Executive is responsible for ensuring implementation of the strategy and policy as established by the Board and the day-to-day running of operations. The Chief Executive is chairman of the Executive Committee and the Asset and Liability Management Committee. Each Asia-Pacific Global Business and Global Function head reports to the Chief Executive. Board Committees The Board has established various committees consisting of Directors and senior management. The Board and each Board committee have terms of reference to document their responsibilities and governance procedures. The key roles of the committees are described in the paragraphs below. The chairman of each Board committee reports to each subsequent Board meeting when presenting the meeting minutes of the relevant committee.

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THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Report of the Directors (continued)

Executive Committee The Executive Committee meets monthly and is responsible for the exercise of all of the powers, authorities and discretions of the Board in so far as they concern the management, operations and day-to-day running of the Bank and its subsidiaries, in accordance with such policies and directions as the Board may from time to time determine, with power to sub-delegate. A schedule of items that require the approval of the Board is maintained. The Bank’s Chief Executive, Peter Wong Tung Shun, is Chairman of the Committee. The current members of the Committee are: Louisa Cheang Wai Wan (Head of Retail Banking and Wealth Management Asia-Pacific), Raymond Cheng Siu Hong (Chief Operating Officer Asia-Pacific), Rhydian H Cox (Chief Risk Officer), Anita Fung Yuen Mei (Chief Executive Officer Hong Kong), Guy D Harvey-Samuel (Head of International), Alexander C Hungate (Chief Executive Officer Singapore), Mukhtar M Hussain (Deputy Chairman, HSBC Bank Malaysia Berhad), Sarah C Legg (Chief Financial Officer), Stuart P Milne (Chief Executive Officer India), Robin C Phillips (Head of Global Banking and Markets Asia-Pacific), Noel P Quinn (Regional Head of Commercial Banking Asia-Pacific), Donna Wong Ka Yuk (Head of Human Resources Asia-Pacific), Helen Wong Pik Kuen (President and Chief Executive Officer, HSBC Bank (China) Company Limited). P A Stafford (Corporation Secretary) is the Committee Secretary. In attendance are: P M Chan
(Chief Compliance Officer), G W French (Head of Global Markets Asia-Pacific), T Grimmer (Head of Communications Asia), K S Y Ng (General Counsel Asia-Pacific), B J Rennell (Chief Executive Officer, Private Bank North Asia and Global Head Private Wealth Solutions), J Rikhye (Head of Strategy & Planning Asia-Pacific) and W S M Tam (Deputy Secretary).

Asset and Liability Management Committee The Asset and Liability Management Committee is chaired by the Chief Executive and is responsible for providing direction on and monitoring the group’s balance sheet composition and capital, liquidity and funding structure, and structural exposures under normal and stressed conditions. The Committee consists of senior executives of the Bank, most of whom are members of the Executive Committee. Risk Management Committee The Risk Management Committee is chaired by the Chief Risk Officer and is responsible for the executive oversight of the risk management framework of the group. The Committee consists of senior executives of the Bank, most of whom are members of the Executive Committee. Audit and Risk Committee Until October 2012, a non-executive Audit and Risk Committee combined the oversight of audit and risk. The revised HKMA SPM CG-1 strongly encourages establishment of a non-executive risk committee and separate committees for different key control functions. Accordingly, the Board established a Risk Committee separate from the Audit Committee on 18 October 2012. The roles and memberships of the Audit Committee and Risk Committee are described below. Audit Committee The Audit Committee meets at least four times a year and has non-executive responsibility for oversight of and advice to the Board on matters relating to financial reporting. The current members of the Committee, all being independent non-executive directors, are James Riley (Chairman of the Committee), Graham John Bradley and T Brian Stevenson. Governance structure The Audit Committee monitors the integrity of the financial statements and oversees the internal control systems over financial reporting, including reviewing their effectiveness. The Committee reviews the financial statements before submission to the Board. It also monitors and reviews the effectiveness of the internal audit function and reviews the Bank’s financial and accounting policies and practices. The Committee advises the Board on the appointment of the external auditor and is responsible for oversight and remuneration of the external auditor. As part of the monitoring process, the Committee reviews the minutes of meetings of subsidiaries’ Audit Committees and the Asset and Liability Management Committee.

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Risk Committee The Risk Committee meets at least four times a year and has non-executive responsibility for oversight of and advice to the Board on high-level risk-related matters and risk governance. The current members of the Committee, all being independent non-executive directors, are T Brian Stevenson (Chairman of the Committee), Graham John Bradley, Zia Mody and James Riley. Risk governance and culture All of the Bank’s activities involve, to varying degrees, the measurement, evaluation, acceptance and management of risk or combination of risks. The Board, advised by the Risk Committee, requires and encourages a strong risk governance culture which shapes the Bank’s attitude to risk. The Bank’s risk governance is supported by a clear policy of risk ownership and accountability of all staff for identifying, assessing and managing risks within the scope of their assigned responsibilities. This personal accountability, reinforced by the governance structure, experience and mandatory learning, helps to foster a disciplined and constructive culture of risk management. Risk management The Risk Committee monitors the effectiveness of the Bank’s risk management and internal controls, other than controls over financial reporting, which are monitored by the Audit Committee. As part of the monitoring process, the Risk Committee requires risk management reports from management which enable the Risk Committee to assess the risks involved in the group’s business and how they are controlled and monitored by management. It also requires reports that give clear, explicit and dedicated focus to current and forward-looking aspects of risk exposure which may require a complex assessment of the group’s vulnerability to previously unknown or unidentified risks. Furthermore, it also reviews all meeting minutes of subsidiaries’ Risk Committees and the Risk Management Committee. The Risk Management Committee, which consists of senior executives, formulates high-level risk policies, exercises delegated risk management authority, oversees implementation of risk appetite and controls, monitors all categories of risk and determines appropriate mitigating action. The Executive Committee supports the Risk Management Committee and the Chief Risk Officer in providing strategic direction for the risk function, sets priorities and oversees their execution. It also oversees a consistent approach to accountability for, and mitigation of, risk across the risk function. Risk appetite The Board is responsible for approving risk appetite, strategy and performance targets for the Bank while approving the appointment of senior risk officers and delegating authority for risk management. The Risk Committee advises the Board on risk appetite and alignment with strategy, as well as risks associated with proposed strategic acquisitions and disposals. The Risk Management Committee, through their risk management oversight role, coordinates the process of aligning risk appetite and risk strategy with business strategy, oversees monitoring, reporting and governance around the risk appetite process, agrees remedial action should the risk profile fall outside agreed parameters and communicates risk appetite. The risk appetite is defined as an expression of the types and quantum of risks (both tangible and intangible) which the Bank is willing to accept in order to achieve its medium and long-term strategic goals. Across the Bank, each country and regional Global Business is required to prepare a Risk Appetite Statement (‘RAS’). The regional Risk function tracks the RAS development and performance across sites on a regular basis. Quantitative and qualitative metrics are assigned to primary categories including: earnings, capital, liquidity and funding, cost of risk, intra-group lending and risk categories. Measurement against these metrics serves to:     guide underlying business activity, ensuring it is aligned to RASs; determine risk-adjusted remuneration; enable the key underlying assumptions to be monitored and, where necessary, adjusted through subsequent business planning cycles; and promptly identify business decisions needed to mitigate risks.

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THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Report of the Directors (continued)

Stress testing The Bank uses an enterprise-wide approach to test the sensitivities of its capital plans against a number of scenarios. A range of stress testing scenarios is conducted including, but not limited to, severe global economic downturn, country, sector and counterparty failures and a variety of projected major operational risk events. The outcomes of the stress scenarios are used to assess the potential impact on demand for regulatory capital against its supply. The Bank also participates, where necessary, in scenario analyses requested by regulatory bodies. Top and emerging risks The Board and the Risk Committee oversee the maintenance and development of a strong risk management framework by the continual monitoring of the risk environment and top and emerging risks facing the Bank, and mitigating actions planned and taken. The Bank’s businesses are exposed to a variety of risk factors that could potentially affect the results of operations or financial condition. Certain risks are classified as ‘top’ or ‘emerging’. A ‘top risk’ is defined as a current, emerged risk which has arisen across any risk category, region or global business and has the potential to have a material impact on the Bank’s financial results or reputation and the sustainability of the long-term business model, and which may form and crystallise within a one year horizon. An ‘emerging risk’ is considered to be one which has large uncertain outcomes which may form and crystallise beyond a one-year horizon and, if it were to crystallise, could have a material effect on long term strategy. The Bank’s approach to identify and monitor top and emerging risks is informed by the risk factors. Top and emerging risks fall under the following three broad categories:    macro-economic and geopolitical risk; macro-prudential, regulatory and legal risks to the Bank’s business model; and risks related to business operations, governance and internal control systems.

Nomination Committee The Nomination Committee meets at least twice a year and is responsible for leading the process for Board appointments and for identifying and nominating, for the approval of the Board, candidates for appointment to the Board. Appointments to the Board are subject to the approval of the HKMA. The Committee considers plans for orderly succession to the Board and the appropriate balance of skills and experience on the Board. The current members of the Committee, being a majority of independent non-executive directors, are Stuart T Gulliver (Chairman of the Committee), Laura Cha May Lung and Dr William Fung Kwok Lun. Peter Wong Tung Shun attends each meeting of the Committee. Acquisitions and Disposals Committee The Acquisitions and Disposals Committee is responsible for the approval of acquisitions and disposals that arise between scheduled Board meetings where the transaction exceeds the authority delegated by the Board to the Chairman. All Directors are members of the Committee.

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Remuneration Committee The Board of the Bank’s ultimate parent company, HSBC Holdings plc, has established a Group Remuneration Committee comprising independent non-executive directors. The Committee is responsible for approving remuneration policy. The Committee also determines the remuneration of Directors, other senior Group employees, employees in positions of significant influence and employees whose activities have or could have an impact on the Bank’s risk profile and in doing so takes into account the pay and conditions across our Group. The establishment of a Group Remuneration Committee is consistent with the principles set out in the HKMA Supervisory Policy Manual CG-5 ‘Guideline on a Sound Remuneration System’. Remuneration Policy A global reward strategy for the HSBC Group, which is applicable to the Bank, has been approved by the Group Remuneration Committee. It aims to reward success, not failure, and to be properly aligned with the risk management framework and risk outcomes. In order to ensure alignment between remuneration and business strategy, individual remuneration is determined through assessment of performance, delivered against both annual and long-term objectives summarised in performance scorecards, as well as adherence to HSBC Values. Altogether, performance is judged not only on what is achieved over the short and long term, but also on how it is achieved, as the latter contributes to the sustainability of the organisation. The financial and non-financial measures incorporated in the annual and long-term scorecards are carefully considered to ensure alignment with the long-term strategy of the HSBC Group. An annual review of the Bank’s remuneration strategy and its operation is commissioned externally and carried out independently of management. The review confirms that the Bank’s remuneration policy is consistent with the principles set out in the ‘Guideline on a Sound Remuneration System’. In accordance with the HKMA Supervisory Policy Manual CG-5 ‘Guideline on a Sound Remuneration System’, details of the remuneration strategy are contained within the Annual Report and Accounts 2012 and Capital and Risk Management Pillar 3 Disclosures as at 31 December 2012 of HSBC Holdings plc.

On behalf of the Board Stuart T Gulliver, Chairman 4 March 2013

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THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Financial Review

Summary of Financial Performance
Results for 2012

Profit before tax
2012 HK$m Hong Kong ............................. Rest of Asia-Pacific ............... Total ....................................... 56,499 52,230 108,729 2011 HK$m 43,197 48,173 91,370

Profit attributable to shareholders for 2012 reported by The Hongkong and Shanghai Banking Corporation Limited (‘the Bank’) and its subsidiaries (together ‘the group’) increased by HK$15,417m, or 23%, to HK$83,008m in 2012. Profit before tax increased by HK$17,359m, or 19%, to HK$108,729m.

Geographical Regions

The group’s operating segments are organised into two geographical regions, Hong Kong and Rest of Asia-Pacific. Due to the nature of the group, the chief operating decision-maker regularly reviews operating activity on a number of bases, including by geographical region and by global business. Although the chief operating decision-maker reviews information on a number of bases, capital resources are allocated and performance assessed primarily by geographical region and the segmental analysis is presented on that basis. In addition, the economic conditions of each geographical region are influential in determining performance across the different types of business activity carried out in the region. Therefore, the provision of segmental performance on a geographical basis provides the most meaningful information with which to understand the performance of the business. Geographical information is classified by the location of the principal operations of the subsidiary or, in the case of the Bank, by the location of the branch responsible for reporting the results or advancing the funds. Information provided to the chief operating decision-maker of the group to make decisions about allocating resources and assessing performance of operating segments is measured in accordance with Hong Kong Financial Reporting Standards (‘HKFRSs’). Due to the nature of the group’s structure, the analysis of profits shown below includes intra-segment items between geographical regions with the elimination shown in a separate column. Such transactions are conducted on an arm’s length basis. Shared costs are included in segments on the basis of actual recharges made. Products and services The group provides a comprehensive range of banking and related financial services to its customers in its two geographical regions. The products and services

offered to customers are organised by global businesses.
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Retail Banking and Wealth Management (RBWM) serves personal customers. We take deposits and provide transactional banking services to enable customers to manage their day to day finances and save for the future. We selectively offer credit facilities to assist customers in their short or longerterm borrowing requirements; and we provide financial advisory, broking, insurance and investment services to help them manage and protect their financial futures. Commercial Banking (CMB) is segmented into Corporate, to serve both corporate and mid-market companies with more sophisticated financial needs, and Business Banking, to serve small and mediumsized enterprises (SMEs), enabling differentiated coverage of our target customers. This allows us to provide continuous support to companies as they grow both domestically and internationally, and ensures a clear focus on internationally aspirant customers. Global Banking and Markets (GB&M) provides tailored financial solutions to major government, corporate and institutional clients worldwide. GB&M operates a long-term relationship management approach to build a full understanding of clients’ financial requirements. Sector-focused client service teams comprising relationship managers and product specialists develop financial solutions to meet individual client needs. Global Private Banking (GPB) provides investment management and trustee solutions to high net worth individuals and their families. We aim to meet the needs of our clients by providing excellent customer service, leveraging our global footprint and offering a comprehensive suite of solutions.

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Geographical Regions (continued)

Profit before tax by geographical region
Hong Kong HK$m 2012 Net interest income ....................................................................... Net fee income .............................................................................. Net trading income ........................................................................ Net income from financial instruments designated at fair value .. Gains less losses from financial investments ................................ Dividend income ........................................................................... Net earned insurance premiums .................................................... Other operating income ................................................................. Total operating income ................................................................. Net insurance claims incurred and movement in liabilities to policyholders ............................................................................. Net operating income before loan impairment charges and other credit risk provisions ................................................ Loan impairment charges and other credit risk provisions .......... Net operating income .................................................................... Operating expenses ....................................................................... Operating profit ............................................................................. Share of profit in associates and joint ventures ............................ Profit before tax ............................................................................. 2011 Net interest income ....................................................................... Net fee income .............................................................................. Net trading income ........................................................................ Net expense from financial instruments designated at fair value . Gains less losses from financial investments ................................ Dividend income ........................................................................... Net earned insurance premiums .................................................... Other operating income ................................................................. Total operating income ................................................................. Net insurance claims incurred and movement in liabilities to policyholders ............................................................................. Net operating income before loan impairment charges and other credit risk provisions ................................................ Loan impairment charges and other credit risk provisions .......... Net operating income .................................................................... Operating expenses ....................................................................... Operating profit ............................................................................. Share of profit in associates and joint ventures ............................ Profit before tax ............................................................................. 40,155 24,670 9,892 3,799 2,510 489 46,304 14,991 142,810 (49,401) 93,409 (603) 92,806 (36,947) 55,859 640 56,499 Rest of Asia-Pacific HK$m 42,271 15,220 9,315 814 124 33 6,317 4,632 78,726 (5,582) 73,144 (2,975) 70,169 (36,109) 34,060 18,170 52,230 Intrasegment elimination HK$m (7) – 7 – – – – (4,286) (4,286) – (4,286) – (4,286) 4,286 – – –

Total HK$m 82,419 39,890 19,214 4,613 2,634 522 52,621 15,337 217,250 (54,983) 162,267 (3,578) 158,689 (68,770) 89,919 18,810 108,729

35,274 22,860 7,691 (4,230) 310 723 39,738 13,229 115,595 (35,778) 79,817 (938) 78,879 (36,106) 42,773 424 43,197

40,396 15,435 12,510 (293) (182) 6 5,932 2,674 76,478 (4,611) 71,867 (2,121) 69,746 (36,232) 33,514 14,659 48,173

2 – (2) – – – – (4,514) (4,514) – (4,514) – (4,514) 4,514 – – –

75,672 38,295 20,199 (4,523) 128 729 45,670 11,389 187,559 (40,389) 147,170 (3,059) 144,111 (67,824) 76,287 15,083 91,370

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THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Financial Review (continued)

Geographical Regions (continued) Hong Kong

Hong Kong reported pre-tax profits were HK$56,499m compared with HK$43,197m in 2011, an increase of 31%. Reported profits included gains on the sale of our shares in Global Payments AsiaPacific Ltd of HK$1,647m and both the HSBC and Hang Seng Bank general insurance businesses of HK$905m and HK$354m respectively. Excluding these gains, profit increased by 24% driven by higher net interest income in CMB and RBWM, the gain of HK$2,441m on the sale of our shares in four Indian banks, higher trading revenues in GB&M, increased fee income in both CMB and GB&M and a reduction in loan impairment charges. These favourable movements were partly offset by higher operating expenses. In RBWM, we continue to develop our wealth management services for our retail customers and launched new investment funds, including the Global High Yield Bond Fund. We completed the sale of both the HSBC and Hang Seng Bank general insurance businesses, enabling us to focus on life insurance manufacturing, where we maintained our market leadership position. We also led the market in deposits, mortgages, mandatory provident funds and credit cards. We maintained our prudent lending approach, with average loan to value ratios of 48% on new mortgage drawdowns and an estimated 32% on the portfolio as a whole. In CMB, we capitalised on our international connectivity and our standing as a leading trade finance bank to grow trade-related revenues by 10%. The collaboration between CMB and GB&M continued to strengthen, with revenue growth of 13%, most notably from the provision of foreign exchange products to our corporate customers. We won the FinanceAsia award for Best Commercial Bank 2012 and 10 AsiaMoney awards for Payments and Cash Management, including the “Best Local Cash Management Bank” for small, medium and large corporates. In GB&M we led the market in Hong Kong dollar bond issuance and were the leading bookrunner for corporate high yield bonds in Asia excluding Japan. We continued to lead the market in offshore renminbi bond issuance. We reinforced our position as a leading international bank for offshore renminbi products, winning the Asia Risk Renminbi House of the Year award and all seven product categories in Asiamoney’s Offshore Renminbi Survey.

Net interest income was 14% higher than in 2011, notably in CMB and RBWM, driven by increased customer loans and deposit balances and by growth in the insurance portfolio. In RBWM we continued to grow our average mortgage balances, reflecting continued strength in the property market. In CMB, average term and traderelated lending balances were higher as we capitalised on trade and capital flows. Asset spreads were marginally wider in CMB compared with 2011 on trade-related and other lending due to repricing, though they began to narrow towards the end of the year. Net interest income also rose due to higher average deposit balances, notably in RBWM, in part reflecting reduced net outflows from customer accounts in to investments. In addition, deposit spreads widened. Net fee income of HK$24,670m was 8% higher than in 2011. Fees rose from increased transaction volumes in trade services, remittances and account services as we continued to facilitate international trade and capital flows. Fee income also increased in both CMB and GB&M as we arranged debt issues for our customers to satisfy their funding requirements. In RBWM fees from unit trusts rose reflecting increased sales volumes, despite customers increasingly preferring lower risk products with lower fees. These increases were offset by a reduction in brokerage income from lower market turnover as a result of weaker investor sentiment.

12

Geographical Regions (continued)

Net trading income increased by 29%, from lower adverse fair value movements on derivatives relating to certain provident funds, following reductions in long term investment return assumptions in 2011. There was also a strong performance in GB&M, notably in Rates trading activities, which reflected increased client demand for risk management products, particularly in yen and renminbi, in part from increased cross-currency debt issuance by corporates. Credit trading revenues also rose in part due to increased client activity. This was partly offset by a net charge as a result of a change in estimation methodology in respect of the valuation adjustments on derivatives. Net income from financial instruments designated at fair value was HK$3,799m compared with an expense of HK$4,230m in 2011, due to net investment gains on assets held by the insurance business compared with net losses in the prior year, as a result of more favourable equity market conditions. To the extent that these investment gains were attributed to policyholders of unit-linked insurance policies and insurance contracts with discretionary participation features, there was a corresponding increase in ‘Net insurance claims incurred and movement in liabilities to policyholders’. Gains less losses from financial investments were HK$2,510m compared with HK$310m in 2011, largely from the gain of HK$2,694m on the sale of our shares in four non-strategic investments in banks in India. Net earned insurance premiums grew by 17% following increased new sales and renewals of life insurance products. The growth in premiums resulted in a corresponding increase in ‘Net insurance claims incurred and movement in liabilities to policyholders’.

Other operating income of HK$14,991m was HK$1,762m higher than in 2011. We completed the sales of Global Payments Asia-Pacific Ltd and both the HSBC and Hang Seng general insurance businesses, realising gains of HK$1,647m, HK$905m and HK$354m respectively. While the value of the present value of in-force long term insurance business (‘PVIF’) asset rose, this was not to the same extent as in 2011 as increased insurance sales in 2012 were more than offset by unfavourable assumption updates and the non-recurrence of the benefit from the refinement to the PVIF asset calculation in 2011. There was also a lower gain on the revaluation of investment properties compared with 2011. Loan impairment charges and other credit risk provisions reduced to HK$603m from HK$938m in 2011, largely due lower specific impairment charges in CMB. Operating expenses increased by 2%, primarily due to higher systems implementation and processing costs as we continued to invest in our technology infrastructure, as well as increased property rental and maintenance costs. Salaries and wages were broadly unchanged as wage inflation was largely offset by reduced average staff numbers as we continued to focus on efficiency.

13

THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Financial Review (continued)

Geographical Regions (continued)

Hong Kong profit before tax by global business
Retail Banking and Wealth Commercial Management Banking HK$m HK$m 2012 Net interest income/(expense) ..... Net fee income ............................. Net trading income ...................... Net income/(expense) from financial instruments designated at fair value .............................. Gains less losses from financial investments .............................. Dividend income .......................... Net earned insurance premiums .. Other operating income ............... Total operating income ................ Net insurance claims incurred and movement in liabilities to policyholders ........................... Net operating income before loan impairment charges and other credit risk provisions ............... Loan impairment (charges)/releases and other credit risk provisions Net operating income ................... Operating expenses ...................... Operating profit/(loss) ................. Share of profit in associates and joint ventures ........................... Profit/(loss) before tax ................. 2011 Net interest income/(expense) ..... Net fee income ............................. Net trading income/(expense) ...... Net expense from financial instruments designated at fair value ......................................... Gains less losses from financial investments .............................. Dividend income .......................... Net earned insurance premiums .. Other operating income ............... Total operating income ................ Net insurance claims incurred and movement in liabilities to policyholders ........................... Net operating income before loan impairment charges and other credit risk provisions ............... Loan impairment (charges)/releases and other credit risk provisions Net operating income ................... Operating expenses ...................... Operating profit/(loss) ................. Share of profit in associates and joint ventures ........................... Profit/(loss) before tax ................. 22,194 13,723 1,270 12,636 6,594 1,278 Global Banking & Markets HK$m 8,436 4,255 7,822 Global Private Banking HK$m – – – Intrasegment elimination HK$m 633 – (635)

Other HK$m (3,744) 98 157

Hong Kong Total HK$m 40,155 24,670 9,892

4,098 (8) 1 41,074 5,518 87,870

(412) – 7 5,132 1,965 27,200

177 18 36 98 738 21,580

– – – – – –

(66) 2,500 445 – 8,853 8,243

2 – – – (2,083) (2,083)

3,799 2,510 489 46,304 14,991 142,810

(44,650)

(4,676)

(75)

–

–

–

(49,401)

43,220 (754) 42,466 (14,127) 28,339 347 28,686 20,114 13,551 753

22,524 21 22,545 (5,621) 16,924 49 16,973 10,251 5,501 1,322

21,505 129 21,634 (9,952) 11,682 25 11,707 8,189 3,693 6,916

– – – – – – – – – –

8,243 1 8,244 (9,330) (1,086) 219 (867) (3,613) 115 (965)

(2,083) – (2,083) 2,083 – – – 333 – (335)

93,409 (603) 92,806 (36,947) 55,859 640 56,499 35,274 22,860 7,691

(3,612) 19 1 33,626 3,928 68,380

(565) 78 10 5,968 1,359 23,924

(39) 162 118 144 606 19,789

– – – – – –

(16) 51 594 – 9,212 5,378

2 – – – (1,876) (1,876)

(4,230) 310 723 39,738 13,229 115,595

(30,243)

(5,429)

(106)

–

–

–

(35,778)

38,137 (601) 37,536 (14,121) 23,415 47 23,462

18,495 (513) 17,982 (5,540) 12,442 69 12,511

19,683 176 19,859 (9,700) 10,159 32 10,191

– – – – – – –

5,378 – 5,378 (8,621) (3,243) 276 (2,967)

(1,876) – (1,876) 1,876 – – –

79,817 (938) 78,879 (36,106) 42,773 424 43,197

14

Geographical Regions (continued) Rest of Asia-Pacific

Rest of Asia-Pacific reported pre-tax profits of HK$52,230m compared with HK$48,173m in 2011, an increase of 8%. Reported profits included gains from the sale of our RBWM business in Thailand of HK$811m, our GPB business in Japan of HK$520m and our interest in a property company in the Philippines of HK$1,009m. Excluding the above gains, pre-tax profit increased by 4%. Net interest income increased, notably from Balance Sheet Management in GB&M in mainland China and strong growth in average lending balances across most of the region. We also benefited from increased profits from our associates in mainland China. These factors were partly offset by adverse fair value movements of HK$2,694m on the contingent forward sale contract related to the disposal of our shares in Ping An Insurance (Group) Company of China, Ltd. (‘Ping An’), the effect of which was offset in 2013 on completion of the transaction, and higher operating expenses, in part due to restructuring costs of HK$990m arising from the ongoing strategic review of our businesses and support functions in the region. Loan impairment charges also rose from a small number of specific corporate impairment charges, but remained low. We maintained our focus on our key priority growth markets in the region. In mainland China, we continued to invest in our branch network and at the end of the year had 141 HSBC China outlets, 20 HSBC rural bank outlets and 46 Hang Seng Bank outlets. We invested a further HK$13,264m in Bank of Communications Co., Ltd. (‘BoCom’) to maintain our interest of 19.03% in this strategically important associate and reinforce our position as the leading foreign bank in mainland China. Net interest income increased by 5%, notably in mainland China from Balance Sheet Management arising from growth in the debt securities portfolio and improved yields, as well as from increased traderelated and term lending in CMB and GB&M in mainland China and India. We grew deposit balances, notably in GB&M and CMB from new Payments and Cash Management mandates and deposit acquisition, as well as in RBWM. The benefit of this growth was partly offset by narrower liability spreads reflecting rate cuts and liquidity easing measures by central banks.

In RBWM, residential mortgage balances grew primarily in Singapore, Australia, Malaysia and mainland China, reflecting the continued strength of property markets and expansion of our distribution network. Net interest income was broadly unchanged, however, due to the effect of the sale of the RBWM business in Thailand and narrower asset spreads in a number of countries, attributable to competitive pricing pressures. Net fee income reduced by HK$215m. In GB&M, fee income increased from our participation in more debt capital markets transactions across the region, as well as from lower regulatory fee expenses on Foreign Exchange and Rates transactions in mainland China. In RBWM we reported higher income from cards in Australia from increased card issuance and wealth management fees in mainland China. This was more than offset by the discontinuation of our Premier business in Japan and the sale of our RBWM business in Thailand, as well as a fall in fund management fees as we saw a move in to lower yielding products reflecting investor’s lower risk appetite. Net trading income decreased by 26% compared with 2011, mainly from adverse fair value movements on the contingent forward sale contract relating to the sale of our shares in Ping An of HK$2,694m. Trading income was also lower, primarily in mainland China due to lower GB&M revenues in Foreign Exchange reflecting reduced volatility, and from growth in structured, deposits where the related income is recorded under ‘Net interest income’. These were partly offset by a net favourable movement as a result of a change in estimation methodology in respect of the valuation adjustments on derivatives. Net income from financial instruments designated at fair value was HK$814m in 2012 compared with a net expense of HK$293m in the prior year, driven by net investment gains on assets held by the insurance business, primarily in Singapore, due to positive equity market movements. To the extent that these investment gains were attributed to policyholders of unit-linked insurance policies and insurance contracts with discretionary participation features, there was a corresponding increase in ‘Net insurance claims incurred and movement in liabilities to policyholders’.

15

THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Financial Review (continued)

Geographical Regions (continued)

On 7 January 2013, Industrial Bank completed a private placement of additional share capital to a number of third parties, thereby diluting the group’s equity holding from 12.8% to 10.9%. The group ceased to account for the investment as an associate from that date. Gains less losses from financial investments were HK$124m compared with net losses of HK$182m in 2011, due to a disposal gain on investments managed by a private equity fund, and a gain on the sale of government debt securities in India. Net earned insurance premiums rose by 6% to HK$6,317m, as a result of increased renewals and new business volumes in mainland China, Singapore and Taiwan. The growth in premiums resulted in a corresponding increase in ‘Net insurance claims incurred and movement in liabilities to policyholders’. Other operating income increased by HK$1,958m, due to gains on the sale of our RBWM business in Thailand of HK$811m, our GPB business in Japan of HK$520m and our interest in a property company in the Philippines of HK$1,009m.

Loan impairment charges and other credit risk provisions increased by HK$854m as a result of individually assessed impairments on a single corporate exposure in Australia and a small number of corporate exposures in other countries in the region. These were partly offset by an impairment release in Singapore compared with a charge in 2011. Operating expenses were broadly unchanged. We incurred restructuring and other related costs of HK$990m in several countries as part of the ongoing strategic review of our businesses and support functions in the region. This resulted in a net reduction of more than 4,700 staff numbers, which was offset by inflationary pressures and business growth, including branch expansion in mainland China and Malaysia. Costs also increased from a litigation provision of HK$760m made in respect of a long-standing court case and the write down by HK$395m of our interest in a joint venture. Share of profit from associates and joint ventures increased by HK$3,511m, driven by higher profits from BoCom and Industrial Bank Co., Ltd. (‘Industrial Bank’) reflecting loan growth and higher fee income partly offset by increased operating expenses and loan impairment charges.

16

Geographical Regions (continued)

Rest of Asia-Pacific profit before tax by global business
Retail Banking and Wealth Commercial Management Banking HK$m HK$m 2012 Net interest income ...................... Net fee income/(expense) ............ Net trading income/(expense) ...... Net income/(expense) from financial instruments designated at fair value .............................. Gains less losses from financial investments .............................. Dividend income .......................... Net earned insurance premiums .. Other operating income ............... Total operating income ................ Net insurance claims incurred and movement in liabilities to policyholders ........................... Net operating income before loan impairment charges and other credit risk provisions ............... Loan impairment (charges)/releases and other credit risk provisions Net operating income ................... Operating expenses ...................... Operating profit/(loss) ................. Share of profit in associates and joint ventures ........................... Profit/(loss) before tax ................. 2011 Net interest income ...................... Net fee income/(expense) ............ Net trading income/(expense) ...... Net income/(expense) from financial instruments designated at fair value .............................. Gains less losses from financial investments .............................. Dividend income .......................... Net earned insurance premiums .. Other operating income ............... Total operating income ................ Net insurance claims incurred and movement in liabilities to policyholders ........................... Net operating income before loan impairment charges and other credit risk provisions ............... Loan impairment (charges)/releases and other credit risk provisions Net operating income ................... Operating expenses ...................... Operating profit/(loss) ................. Share of profit in associates and joint ventures ........................... Profit/(loss) before tax ................. 13,859 6,379 699 10,822 3,870 1,437 Global Banking & Markets HK$m 18,000 4,933 8,477 Global Private Banking HK$m 137 91 10 Intrasegment elimination HK$m (1,458) – 1,458 Rest of AsiaPacific Total HK$m 42,271 15,220 9,315

Other HK$m 911 (53) (2,766)

844 (6) 3 4,411 1,630 27,819

7 9 – 1,905 500 18,550

(24) (74) – – 580 31,892

– (1) – 1 499 737

(13) 196 30 – 1,985 290

– – – – (562) (562)

814 124 33 6,317 4,632 78,726

(4,057)

(1,524)

–

(1)

–

–

(5,582)

23,762 (1,815) 21,947 (17,133) 4,814 2,110 6,924 14,312 6,753 714

17,026 (1,133) 15,893 (7,702) 8,191 11,416 19,607 9,757 3,992 1,222

31,892 (24) 31,868 (9,695) 22,173 4,638 26,811 16,835 4,613 9,492

736 1 737 (256) 481 – 481 176 155 58

290 (4) 286 (1,885) (1,599) 6 (1,593) 831 (78) (491)

(562) – (562) 562 – – – (1,515) – 1,515

73,144 (2,975) 70,169 (36,109) 34,060 18,170 52,230 40,396 15,435 12,510

(295) (3) (1) 3,840 1,121 26,441

12 16 1 2,092 562 17,654

7 (190) – – 511 31,268

– – – – 10 399

(17) (5) 6 – 955 1,201

– – – – (485) (485)

(293) (182) 6 5,932 2,674 76,478

(2,727)

(1,884)

–

–

–

–

(4,611)

23,714 (1,731) 21,983 (18,504) 3,479 1,887 5,366

15,770 53 15,823 (7,367) 8,456 8,994 17,450

31,268 (443) 30,825 (9,594) 21,231 3,756 24,987

399 2 401 (470) (69) – (69)

1,201 (2) 1,199 (782) 417 22 439

(485) – (485) 485 – – –

71,867 (2,121) 69,746 (36,232) 33,514 14,659 48,173

17

THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Financial Review (continued)

Net interest income

Net interest income increased as a result of loan and deposit growth across key countries, as well as improved deposit spreads, notably in Hong Kong. The insurance business also contributed to increased net interest income as the portfolio grew from increased sales. Average interest-earning assets increased by HK$247,332m, or 6% compared with last year. Average customer lending increased by 8%, with notable growth in term lending and mortgages, while financial investments increased by 5%.
2012 HK$m Average interest-earning assets 4,199,329 2011 HK$m 3,951,997

Net interest margin (%)
2012 % Hong Kong: The Bank ............................ Hang Seng Bank ................. Rest of Asia-Pacific ................ 1.46 2.10 2.14 2011 % 1.35 1.97 2.10

In Hong Kong, the Bank recorded an increase in net interest margin of 11 basis points to 1.46% compared with 2011. The net interest spread increased by 10 basis points as asset spreads on mortgages remained broadly stable and deposit spreads improved. Asset spreads on other lending increased marginally, narrowing towards the end of the year. At Hang Seng Bank, the net interest margin increased by 13 basis points to 2.10% compared with last year. This was driven by improved loan pricing, increased deployment of funds towards customer lending and a wider range of investment opportunities for renminbi deposits. In the Rest of Asia-Pacific, the net interest margin was 2.14%, four basis points higher than 2011. Both loan and deposit spreads reduced in key markets across the region from competitive pressures and central bank rate cuts. This was more than offset by improved spreads in Balance Sheet Management in mainland China and deployment of more of the commercial surplus to customer lending.

Net interest margin increased by five basis points to 1.96% compared with last year. The net interest spread increased by four basis points, while the contribution from net free funds increased by one basis point. Net interest margin (%)
2012 % Spread ..................................... Contribution from net free funds ........................... Total ........................................ 1.85 0.11 1.96 2011 % 1.81 0.10 1.91

18

Net fee income

Net fee income increased by HK$1,595m, or 4% in 2012. Fees from unit trusts rose by 18%, notably in Hong Kong, as increased volumes more than offset the impact of customer preference shifting to lower risk, lower fee products. Fees from imports/exports and remittances increased by 7% and 8% respectively, driven by growing trade activities from both existing and newto-bank customers, with larger increases noted in Hong Kong, Singapore and Bangladesh. Underwriting fees were 39% higher than 2011, driven by the growth of debt capital market transactions in Hong Kong, Singapore and the Philippines, which included our participation in several high-profile deals during the year. Insurance fees increased by 46% in 2012, primarily due to fees received from external insurance providers from selling non-life products in Hong Kong, coupled with higher broking commissions earned in mainland China and Taiwan.

Fees from securities/stockbroking decreased by 17% as turnover reduced following stock market declines in the latter half of 2011. Fees from funds under management decreased by 8%, notably in Japan and Singapore as we saw customer preference moving towards lower risk products with lower fees and a reduction in client assets due to adverse movements in financial markets in the latter half of 2011.
2012 HK$m Account services .................... Credit facilities ....................... Import/export ......................... Remittances ............................ Securities/stockbroking .......... Cards ...................................... Insurance ................................ Unit trusts ............................... Funds under management ...... Underwriting ........................... Other ....................................... Fee income ............................. Fee expense ............................ Net fee income ....................... 2,772 2,797 5,115 3,066 6,824 6,858 1,042 4,523 4,089 1,689 7,446 46,221 (6,331) 39,890 2011 HK$m 2,686 2,812 4,793 2,839 8,234 6,709 712 3,832 4,442 1,219 6,888 45,166 (6,871) 38,295

Net trading income

Net trading income decreased by HK$985m, or 5% compared to 2011. Dealing profits increased, driven by favourable Rates and Foreign Exchange income, notably in Hong Kong, Australia, India and Indonesia, reflecting increased client activity. Trading income was lower in mainland China due to lower Foreign Exchange revenues reflecting reduced volatility.

Net interest income on trading assets and liabilities rose by 14% on the back of expanded debt securities portfolios in Hong Kong, India, mainland China and Singapore. This was offset by higher interest paid on structured deposits, primarily in mainland China, where the related income is recorded under ‘Net interest income’.
2012 HK$m Dealing profits ........................ Loss from hedging activities .. Net interest income ................ Dividend income from trading securities ................ Ping An contingent forward sale contract ........................ Net trading income ................. 16,633 (31) 4,520 786 (2,694) 19,214 2011 HK$m 15,590 (71) 3,958 722 – 20,199

19

THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Financial Review (continued)

Gains less losses from financial investments

Gains on disposal of available-for-sale securities include the gain of HK$2,441m on the sale of our shares in four non-strategic investments in banks in India.

2012 HK$m Gains on disposal of available-for-sale securities ............................ Impairment of available-forsale equity investments ...... Gains less losses from financial investments .........

2011 HK$m

2,809 (175) 2,634

470 (342) 128

Other operating income

The value of the present value of in-force insurance business (‘PVIF’) asset rose, though not to the same extent as in 2011 as increased insurance sales in 2012 were more than offset by unfavourable assumption updates and the non-recurrence of the benefit from the refinement to the PVIF asset calculation in 2011. Reflecting property market conditions in Hong Kong, the value of investment properties rose in 2012, though not to the same extent as 2011. The gains on disposal of business portfolios include the gains on sale of both the HSBC and Hang Seng Bank general insurance businesses of HK$905m and HK$354m respectively, our RBWM business in Thailand of HK$811m and our Global Private Banking business in Japan of HK$520m. The gain on disposal of associates includes the gains on sale of Global Payments Asia-Pacific Ltd of HK$1,647m and a property investment company in the Philippines of HK$1,009m.

2012 HK$m Rental income from investment properties ......... Movement in PVIF ................ Gains on investment properties ........................... Gain/(loss) on disposal of property, plant and equipment, and assets held for sale ........................ Gain/(loss) on disposal of subsidiaries, associates and business portfolios ...... Surplus arising on property revaluation ...... Other ....................................... Other operating income .......... 216 4,432 834

2011 HK$m 191 5,524 1,033

30

(3)

5,246 2 4,577 15,337

(9) 8 4,645 11,389

20

Insurance income

Net interest income increased by 16% as funds under management grew, reflecting net inflows from new and renewal insurance business. Net income from financial instruments designated at fair value was of HK$4,538m compared with a loss of HK$4,460m in 2011, from investment gains on assets held by the insurance business, mainly due to movements in equity markets. To the extent that revaluation is due to policyholders, there is an offsetting movement reported under ‘Net insurance claims incurred and movement in liabilities to policyholders’. Net insurance premiums rose by 15% as a result of higher premiums received from policy renewals and successful sales initiatives for annuity products. The growth in premiums resulted in a corresponding increase in ‘Net insurance claims incurred and movement in liabilities to policy holders’. The value of the PVIF asset rose, though not to the same extent as in 2011 as increased insurance sales in 2012 were more than offset by unfavourable assumption updates and the non-recurrence of the benefit from the refinement to the PVIF asset calculation in 2011.

Other operating income includes the gains on sale of both the HSBC and Hang Seng general insurance businesses of HK$905m and HK$354m respectively. Insurance income
2012 HK$m Net interest income ................ Net fee income ....................... Net trading income/(loss) ....... Net income/(expense) from financial instruments designated at fair value ...... Net earned insurance premiums ........................... Movement in PVIF ................ Other operating income .......... Net insurance claims incurred and movement in liabilities to policyholders ................. Net operating income ............. 7,864 1,216 56 2011 HK$m 6,779 692 (386)

4,538 52,621 4,432 1,308 72,035

(4,460) 45,670 5,524 237 54,056

(54,983) 17,052

(40,389) 13,667

21

THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Financial Review (continued)

Loan impairment charges and other credit risk provisions

Loan impairment charges and other credit risk provisions increased by HK$519m in 2012. The net charge for individually assessed impairment allowances increased by HK$40m in 2012, due to impairment of a corporate exposure in Australia, coupled with higher individual impairment charges in a number of countries including India, mainland China, New Zealand and Vietnam. These increases were offset by an impairment release in Singapore compared with a charge in 2011, coupled with lower new impairment charges in Hong Kong. The net charge for collectively assessed impairment allowances rose by HK$195m, or 8%, in 2012, reflecting the increase in loans and advances to customers. The net charge for other credit risk provisions was HK$284m higher, following charges against a corporate exposure in Australia, noted above.

Net charge for loan impairment by region
2012 HK$m Hong Kong ............................. Rest of Asia-Pacific ............... Total ....................................... 658 2,672 3,330 2011 HK$m 922 2,173 3,095

Net charge for loan impairment and other credit risk provisions
2012 HK$m Net charge for impairment of customer loans and advances – Individually assessed impairment allowances: New allowances ................. Releases ............................. Recoveries .......................... – Net charge for collectively assessed impairment allowances .......................... Net charge/(release) for other credit risk provisions ......... Net charge for loan impairment and other credit risk provisions ......... 2011 HK$m

2,201 (1,230) (237) 734

2,254 (1,204) (356) 694

2,596 3,330 248

2,401 3,095 (36)

3,578

3,059

22

Operating Expenses

Employee compensation and benefits were broadly unchanged compared with 2011. As part of the ongoing strategic review of our business and support functions, wages and salaries included termination benefits of HK$849m, incurred in several countries across the region, compared with HK$459m in 2011. This has resulted in a net reduction of more than 5,800 staff numbers since last year, or 8%. Excluding termination benefits, wages and salaries were 2% lower, as reduced staff numbers were partially offset by wage inflation. In mainland China, wages and salaries expenses rose as a result of branch expansion during 2012. Staff numbers by region (full time equivalent)
At 31 December 2012 2011 Hong Kong: The bank and wholly owned subsidiaries ........................ Hang Seng Bank Hong Kong ........................ Total Hong Kong ................... Rest of Asia-Pacific: Australia ................................. Mainland China ...................... Malaysia ................................. India ....................................... Indonesia ................................ Singapore ............................... Taiwan .................................... Sri Lanka ................................ Others ..................................... Total Rest of Asia-Pacific ...... Total .......................................

General and administrative expenses increased by HK$1,659m, or 7% in 2012. Premises and equipment costs increased by HK$321m, or 5%, with higher expenditure in Hong Kong from increased technology development and property rental and maintenance costs. Premises and equipment costs increased in both mainland China and Malaysia from branch expansion. Other administrative expenses rose by HK$1,729m, or 13%, in 2012. This included litigation expenses of HK$760m in Australia and Singapore in respect of a legacy case and the writedown of a joint venture of HK$395m. Higher costs were incurred in Hong Kong from intercompany expenses, compliance fees and higher corporate donations. Marketing and advertising expenses decreased by HK$391m, or 10%, following the implementation of cost control initiatives in a number of countries.
2012 % 42.4 2011 % 46.1

18,966 7,746 26,712

19,770 8,003 27,773

Cost efficiency ratio ...............

1,675 8,444 4,523 5,347 5,113 2,656 2,557 1,488 7,078 38,881 65,593

1,839 8,235 4,839 6,560 5,609 3,064 3,230 1,777 8,494 43,647 71,420

Operating expenses
2012 HK$m Employee compensation and benefits ........................ General and administrative expenses ............................. Depreciation of property plant and equipment ........... Amortisation of intangible assets .................................. Total ....................................... Of which: restructuring costs .. 37,021 26,011 4,014 1,724 68,770 1,166 2011 HK$m 37,834 24,352 3,878 1,760 67,824 864

Share of profit in associates and joint ventures

Share of profit in associates and joint ventures principally includes the group’s share of post-tax profits from Bank of Communications and Industrial Bank.

2012 HK$m Share of profit in associates and joint ventures ............... 18,810

2011 HK$m 15,083

23

THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Financial Review (continued)

Tax expense

The effective rate of tax for 2012 was 16.6% compared with 19.1% in 2011.

Effective tax rate ....................

2012 % 16.6

2011 % 19.1

Assets

Loans and advances to customers in Hong Kong increased by HK$113bn, or 10%, during 2012 largely through growth in corporate and commercial lending of HK$57bn, reflecting increased demand in international trade and commercial real estate. Residential mortgage lending increased by HK$41bn as the property market remained active. In the Rest of Asia-Pacific, loans and advances to customers increased by HK$105bn, or 11%, including foreign exchange translation effects of HK$16bn. The underlying increase of HK$89bn was mainly from growth in corporate and commercial lending of HK$48bn, supported by trade flows in mainland China, Indonesia, India and Australia. Residential mortgage lending increased by HK$28bn, notably in Singapore, mainland China, Australia and Malaysia.

Assets 20121
HK$m Cash and short term funds ..... Placings with banks maturing after one month and certificates of deposit ......... Trading assets ......................... Loans and advances to customers ........................... Financial investments ............. Other ....................................... Total ....................................... 1,111,199 % 18.9

277,796 419,697 2,349,043 626,042 1,105,286 5,889,063

4.7 7.1 39.9 10.6 18.8 100.0

Assets 20111
HK$m Cash and short term funds ..... Placings with banks maturing after one month and certificates of deposit ......... Trading assets ......................... Loans and advances to customers ........................... Financial investments ............. Other ....................................... Total ....................................... 919,906 % 16.9

286,978 447,968 2,130,871 722,433 936,800 5,444,956

5.2 8.2 39.2 13.3 17.2 100.0

1 Excluding Hong Kong Government certificates of indebtedness.

24

Customer accounts

Customer accounts increased by HK$310bn, or 9%, during 2012. In Hong Kong, customer accounts increased by HK$235bn, or 10%, and in the Rest of Asia-Pacific customer accounts increased by HK$75bn or 6% compared with 31 December 2011. Customer accounts by region
2012 HK$m Hong Kong excluding Hang Seng Bank .......................... Hang Seng Bank Hong Kong . Rest of Asia-Pacific ............... Total ....................................... 1,805,417 726,207 1,343,260 3,874,884 2011 HK$m 1,640,369 656,843 1,267,789 3,565,001

The group’s advances-to-deposits ratio increased to 60.6% at 31 December 2012, from 59.8% at 31 December 2011, as more of the commercial surplus was deployed to customer lending.
2012 % 60.6 2011 % 59.8

Advances-to-deposits ratio ....

Customer accounts by type
2012 HK$m Current accounts .................... Savings accounts .................... Other deposit accounts ........... Total ....................................... 831,256 2,063,565 980,063 3,874,884 2011 HK$m 696,435 1,826,893 1,041,673 3,565,001

Equity

Equity increased by HK$102bn, or 27%, to HK$473bn. The increase came from retained profits, the issue of additional share capital and an increase in the property revaluation reserve. In addition, the value of available-for-sale securities rose, largely from the group’s investment in Ping An Insurance.

Basel III

The Banking (Capital) (Amendment) Rules 2012 came into effect on 1 January 2013 to implement the first phase of the Basel III capital standards in Hong Kong (‘Basel III rules’). The group has estimated the pro-forma impact of the Basel III rules on the group’s capital position at 31 December 2012. The capital requirements that came in to effect on 1 January 2013 are estimated to result in capital ratios that are above the minimum requirements. The pro-forma capital position prepared in accordance with the Basel III rules would be higher than the 31 December 2012 position under the existing rules, for the following reasons:


 

the timing of the recognition of dividends; the removal of the cap on unrealised gains on own-use and investment properties; and the full recognition of unrealised gains on ‘available-for-sale’ and ‘designated at fair value’ securities.



Following the implementation, capital ratios for the half-year ending 30 June 2013 will be calculated in accordance with the Basel III rules.

introduction of concessionary thresholds for deduction of capital investments in nonconsolidated financial institutions;

25

THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Financial Review (continued)

Capital Adequacy

The following tables show the components of the capital base, risk weighted assets and capital adequacy ratio as contained in the ‘Capital Adequacy Ratio’ return required to be submitted to the Hong Kong Monetary Authority (‘HKMA’) by The Hongkong and Shanghai Banking Corporation Limited on a consolidated basis that is specified by the HKMA under the requirements of section 98(2) of the Banking Ordinance. Capital structure at 31 December

The methods for calculating risk weighted assets for each type of risk are discussed in note 52(f) to the Financial Statements on page 197. There are no relevant capital shortfalls in any of the group’s subsidiaries as at 31 December 2012 which are not included in its consolidation group for regulatory purposes.

2012 HK$m Core capital: Share capital per balance sheet ............................................................................................................ Revaluation reserve capitalisation issue .............................................................................................. Paid-up ordinary share capital ................................................................................................................. Paid-up irredeemable non-cumulative preference shares ........................................................................ Reserves per balance sheet ................................................................................................................... Proposed dividend ................................................................................................................................ Unconsolidated subsidiaries ................................................................................................................. Cash flow hedging reserve ................................................................................................................... Regulatory reserve ................................................................................................................................ Reserves arising from revaluation of property and unrealised gains on available-for-sale equities and debt securities .................................................................................. Unrealised gains on equities and debt securities designated at fair value ........................................... Own credit spread ................................................................................................................................. Total reserves included in core capital ..................................................................................................... Non-controlling interests per balance sheet ......................................................................................... Non-controlling interests in unconsolidated subsidiaries .................................................................... Regulatory adjustments to non-controlling interests ........................................................................... Non-controlling interests ......................................................................................................................... Goodwill, intangible assets and valuation adjustments ........................................................................ 50% of unconsolidated investments ..................................................................................................... 50% of securitisation positions and other deductions .......................................................................... Deductions ............................................................................................................................................... Total core capital ................................................................................................................................... Supplementary capital: Paid-up irredeemable cumulative preference shares ........................................................................... Perpetual subordinated debt ................................................................................................................. Paid-up term preference shares ............................................................................................................ Term subordinated debt ........................................................................................................................ Property revaluation reserves1 .............................................................................................................. Unrealised gains on available-for-sale equities and debt securities2 ................................................... Unrealised gains on equities and debt securities designated at fair value ........................................... Regulatory reserve3 .............................................................................................................................. Collective impairment allowances3 ...................................................................................................... Excess impairment allowances over expected losses4 ......................................................................... Supplementary capital before deductions ................................................................................................ 50% of unconsolidated investments ..................................................................................................... 50% of securitisation positions and other deductions .......................................................................... Deductions ............................................................................................................................................... Total supplementary capital ................................................................................................................. Capital base ............................................................................................................................................. 58,969 (1,454) 57,515 51,570 378,430 (20,000) (40,088) (210) (19,426) (86,111) (20) (218) 212,357 35,679 (3,478) (3,291) 28,910 (21,191) (67,692) (16) (88,899) 261,453 16,510 9,355 15,115 16,418 7,977 2,534 9 2,333 496 8,400 79,147 (67,692) (16) (67,708) 11,439 272,892

2011 HK$m 30,190 (1,454) 28,736 51,681 310,634 (10,000) (32,672) (51) (17,108) (73,570) (77) (429) 176,727 30,519 (2,838) (2,976) 24,705 (19,663) (53,749) (140) (73,552) 208,297 16,546 9,386 28,742 16,327 7,977 2,318 35 2,267 545 7,655 91,798 (53,749) (140) (53,889) 37,909 246,206

26

Capital Adequacy (continued) Risk weighted assets at 31 December
2012 HK$m Risk weighted assets Credit risk ................................................................................................................................................. Counterparty credit risk ........................................................................................................................... Market risk ............................................................................................................................................... Operational risk ........................................................................................................................................ Total ......................................................................................................................................................... 1,455,675 81,409 116,911 250,139 1,904,134 2011 HK$m 1,350,467 71,270 38,585 221,429 1,681,751

The capital ratios on a consolidated basis calculated in accordance with the Banking (Capital) Rules are as follows:
2012 Core capital ratio ...................................................................................................................................... Capital adequacy ratio ............................................................................................................................. 13.7% 14.3% 2011 12.4% 14.6%

Reserves and deductible items
2012 HK$m Published reserves .................................................................................................................................... Profit and loss account ............................................................................................................................. Total reserves included in core capital ................................................................................................ 177,631 34,726 212,357 2012 HK$m Total of items deductible 50% from core capital and 50% from supplementary capital .............. 135,416 2011 HK$m 146,357 30,370 176,727 2011 HK$m 107,778

1 Includes the revaluation surplus on investment properties which is reported as part of retained profits and adjustments made in accordance with the Banking (Capital) Rules issued by the HKMA. 2 Includes adjustments made in accordance with the Banking (Capital) Rules issued by the HKMA. 3 Total regulatory reserve and collective impairment allowances are apportioned between the standardised approach and internal ratings-based approach in accordance with the Banking (Capital) Rules issued by the HKMA. Those apportioned to the standardised approach are included in supplementary capital. Those apportioned to the internal ratings-based approach are excluded from supplementary capital. 4 Excess impairment allowances over expected losses are applicable to non-securitisation exposures calculated by using the internal ratings based approach.

Risk Management All the group’s activities involve the analysis, evaluation, acceptance and management of some degree of risk or combination of risks. The principal types of risk faced by the group are credit risk (which includes country and cross-border risk), liquidity risk, market risk, insurance risk, operational risk and reputational risk. The HSBC Group Head Office formulates highlevel risk management policies for the HSBC Group worldwide. The group’s risk management policies and procedures are subject to a high degree of oversight and guidance to ensure that all types of risk are systematically identified, measured, analysed and actively managed. Credit risk, liquidity risk, market risk, operational risk, insurance risk and capital management are discussed in detail in Note 52 to the Financial Statements on pages 164 to 198.

27

THE HONGKONG AND SHANGHAI BANKING CORPORATION LIMITED

Financial Review (continued)

Market Risk Management

The nature of market risk and the principal tool used to monitor and limit market risk exposure (value at risk) are discussed in Note 52 on the Financial Statements on pages 181 to 184. The average daily revenue earned from market risk-related treasury activities in 2012, including accrual book net interest income and funding related to dealing positions, was HK$117m compared with HK$113m in 2011. The standard deviation of these daily revenues was HK$58m (HK$53m for 2011). Daily distribution of market risk revenues 2012
Number of days
50 45 40 35 30 25 20 15 10 5 0 -20 0 20 40 60 80 100 120 140 160 180 200 220 240 260 280 300 320 400 420 1 5 11 19 30 47 40 31 23 20 15 8 2 3 2 2 1 1

An analysis of the frequency distribution of daily revenues shows that negative revenues occurred on 1 day in 2012. The most frequent result was a daily revenue of between HK$80m and HK$100m with 47 occurrences. The highest daily revenue was HK$417m. The most frequent result in 2011 was a daily revenue of between HK$80m and HK$100m with 45 occurrences. The highest daily revenue in 2011 was HK$241m.

Daily distribution of market risk revenues 2011
Number of days
50 45 40 35 30 25 20 15 10 5 0 -20 0 20 40 60 80 1 4 11 27 35 25 19 11 10 9 1 0 0 0 0 45 34 26

100 120 140 160 180 200 220 240 260 280 300 320 340 420

Revenues (HK$m)
Profit and loss frequency

Revenues (HK$m)
Profit and loss frequency

Reputational Risk Management

Reputational risks can arise from social, ethical or environmental issues, or as a consequence of operational risk events. Reputational risks are considered and assessed by senior management. Standards on all major aspects of business are set by the HSBC Group Head Office. These policies, which form an integral part of the internal control systems, are communicated through manuals and statements of policy and are promulgated through internal communications and training. The policies set out operational procedures in all areas of reputational risk, including money laundering deterrence, environmental impact, anti-corruption measures and employee relations. Internal controls are an integral part of how the group conducts its business. HSBC’s manuals and

statements of policy are the foundation of these internal controls. There is a strong process in place to ensure controls operate effectively. Any significant failings are reported through control mechanisms, internal audit and compliance functions to the group’s Audit Committee and senior management. In addition, all businesses and major functions are required to review their control procedures and to make regular reports about any losses arising from operational risks. Management in all operating entities is required to establish a strong internal control structure to minimise the risk of operational and financial failure, and to ensure that a full appraisal of reputational implications is made before strategic decisions are taken. The HSBC Group’s internal audit function monitors compliance with policies and standards.

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T H E H O N G K O N G A N D S H A N G H A I B A N K I N G C O R P O R AT I O N L I M I T E D

Statement of Directors’ Responsibilities

The following statement, which should be read in conjunction with the Auditor’s statement of their responsibilities set out in their report on page 30, is made with a view to distinguishing for shareholders the respective responsibilities of the Directors and of the Auditor in relation to the financial statements. The Directors of The Hongkong and Shanghai Banking Corporation Limited (‘the Bank’) are responsible for the preparation of the Bank’s Annual Report and Accounts, which contains the consolidated financial statements of the Bank and its subsidiaries (together ‘the group’), in accordance with applicable law and regulations. The Hong Kong Companies Ordinance requires the Directors to prepare for each financial year the consolidated financial statements for the group, and the balance sheet and profit or loss for the Bank. The Directors are responsible for ensuring adequate accounting records are kept that are sufficient to show and explain the group’s transactions, such that the group’s financial statements give a true and fair view. The Directors are responsible for preparing the consolidated financial statements that give a true and fair view and are in accordance with Hong Kong Financial Reporting Standards (‘HKFRSs’) issued by the Hong Kong Institute of Certified Public Accountants. The Directors have elected to prepare the Bank’s balance sheet and profit or loss on the same basis. The Directors, the names of whom are set out in ‘Report of the Directors’ on page 3 of this Annual Report, confirm to the best of their knowledge:  the consolidated financial statements, which have been prepared in accordance with HKFRSs, have been prepared in accordance with the applicable set of accounting standards and give a true and fair view of the assets, liabilities, financial position and profit or loss of the group and the undertakings included in the consolidation taken as a whole; and the management report represented by the Financial Review has been prepared, and includes a fair review of the development and performance of the business and the position of the group and the undertakings included in the consolidation taken as a whole, together with a description of the principal risks and uncertainties that the group faces.



On behalf of the Board

Stuart T Gulliver Chairman

4 March 2013

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Independent auditor’s report to the shareholders of The Hongkong and Shanghai Banking Corporation Limited (incorporated in Hong Kong with limited liability)

We have audited the consolidated financial statements of The Hongkong and Shanghai Banking Corporation Limited (‘the Bank’) and its subsidiaries (together ‘the group’) set out on pages 31 to 200, which comprise the consolidated and the Bank’s balance sheets as at 31 December 2012, the consolidated income statement, the consolidated statement of comprehensive income, the consolidated and the Bank’s statement of changes in equity and the consolidated cash flow statement for the year then ended and a summary of significant accounting policies and other explanatory information. Directors’ responsibility for the consolidated financial statements The directors of the Bank are responsible for the preparation of consolidated financial statements that give a true and fair view in accordance with Hong Kong Financial Reporting Standards issued by the Hong Kong Institute of Certified Public Accountants and the Hong Kong Companies Ordinance, and for such internal control as the directors determine is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audit. This report is made solely to you, as a body, in accordance with section 141 of the Hong Kong Companies Ordinance, and for no other purpose. We do not assume responsibility towards or accept liability to any other person for the contents of this report. We conducted our audit in accordance with Hong Kong Standards on Auditing issued by the Hong Kong Institute of Certified Public Accountants. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance as to whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor’s judgement, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation of consolidated financial statements that give a true and fair view in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by the directors, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements give a true and fair view of the state of the affairs of the Bank and the group as at 31 December 2012 and of the group’s profit and cash flows for the year then ended in accordance with Hong Kong Financial Reporting Standards and have been properly prepared in accordance with the Hong Kong Companies Ordinance.

KPMG Certified Public Accountants 8th Floor, Prince’s Building 10 Chater Road Central Hong Kong 4 March 2013

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Financial Statements

Page

Page 25 26 27 28 29 30 31 32 33 Goodwill and intangible assets ............................. Property, plant and equipment ............................. Leasehold land and land use rights ...................... Other assets ........................................................... Customer accounts ................................................ Trading liabilities .................................................. Financial liabilities designated at fair value ......... Debt securities in issue ......................................... Other liabilities and provisions ............................. Liabilities under insurance contracts issued.......... Provisions for liabilities and charges .................... Subordinated liabilities ......................................... Preference shares .................................................. Share capital ......................................................... Reserves ................................................................ Maturity analysis of assets and liabilities ............ Analysis of cash flows payable under financial liabilities by remaining contractual maturities Reconciliation of operating profit to cash generated from/(used in) operations ................ Analysis of cash and cash equivalents ................. Contingent liabilities and commitments ............... Assets pledged as security for liabilities and collateral accepted as security for assets........... Capital commitments ............................................ Lease commitments .............................................. Segmental analysis ............................................... Related party transactions .................................... Share-based payments .......................................... Fair value of financial instruments ....................... Risk management ................................................. Special purpose entities ........................................ Legal proceedings ................................................. Ultimate holding company .................................... Nature of business ................................................. Events after the balance sheet date ....................... Approval of accounts ............................................ 105 109 112 113 114 114 114 114 115 115 118 118 119 120 121 122 130 132 133 134 136 136 136 137 142 147 151 164 198 199 200 200 200 200

Financial Statements
Consolidated income statement .................................... Consolidated statement of comprehensive income ...... Consolidated balance sheet ........................................... Consolidated statement of changes in equity ............... Consolidated statement of cash flows ........................... Bank balance sheet ........................................................ Bank statement of changes in equity ............................ 32 33 34 35 37 38 39

Notes on the Financial Statements
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 Basis of preparation .............................................. Critical accounting estimates and judgements in applying accounting policies ........................ Summary of significant accounting policies ........ Operating profit .................................................... Insurance income .................................................. Employee compensation and benefits .................. Tax expense .......................................................... Profit attributable to shareholders ........................ Dividends .............................................................. Analysis of financial assets and liabilities by measurement basis ...................................... Cash and short-term funds ................................... Placings with banks maturing after one month .... Certificates of deposit .......................................... Hong Kong currency notes in circulation ............ Trading assets ....................................................... Financial assets designated at fair value .............. Derivatives ........................................................... Loans and advances to customers ........................ Impairment allowances against loans and advances to customers ..................................... Impairment and rescheduled amounts relating to loans and advances to banks and other assets . Financial investments ........................................... Transfers of financial assets not qualifying for derecognition .............................................. Investments in subsidiaries .................................. Interests in associates and joint ventures ............. 41 43 45 63 66 69 72 76 76 77 81 81 81 81 82 83 84 88 92 97 98 100 101 102

34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58

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T H E H O N G K O N G A N D S H A N G H A I B A N K I N G C O R P O R AT I O N L I M I T E D

Financial Statements (continued)

Consolidated income statement for the year ended 31 December 2012
Note Interest income ....................................................................................................................... Interest expense ...................................................................................................................... Net interest income ................................................................................................................ Fee income ............................................................................................................................. Fee expense ............................................................................................................................ Net fee income ....................................................................................................................... Net trading income ................................................................................................................ Net income / (expense) from financial instruments designated at fair value ......................... Gains less losses from financial investments ........................................................................ Dividend income .................................................................................................................... Net earned insurance premiums ............................................................................................ Other operating income ......................................................................................................... Total operating income ....................................................................................................... Net insurance claims incurred and movement in liabilities to policyholders ....................... Net operating income before loan impairment charges and other credit risk provisions ..................................................................................... Loan impairment charges and other credit risk provisions ................................................... Net operating income ........................................................................................................... Employee compensation and benefits ................................................................................... General and administrative expenses .................................................................................... Depreciation of property, plant and equipment ..................................................................... Amortisation and impairment of intangible assets ................................................................ Total operating expenses ..................................................................................................... Operating profit ................................................................................................................... Share of profit in associates and joint ventures ..................................................................... Profit before tax ................................................................................................................... Tax expense ........................................................................................................................... Profit for the year ................................................................................................................ Profit attributable to shareholders ......................................................................................... Profit attributable to non-controlling interests ...................................................................... 7 4c 4d 4e 4f 4g 5b 4h 5c 4a 4b 2012 HK$m 115,511 (33,092) 82,419 46,221 (6,331) 39,890 19,214 4,613 2,634 522 52,621 15,337 217,250 (54,983) 162,267 (3,578) 158,689 (37,021) (26,011) (4,014) (1,724) (68,770) 89,919 18,810 108,729 (18,010) 90,719 83,008 7,711 2011 HK$m 107,458 (31,786) 75,672 45,166 (6,871) 38,295 20,199 (4,523) 128 729 45,670 11,389 187,559 (40,389) 147,170 (3,059) 144,111 (37,834) (24,352) (3,878) (1,760) (67,824) 76,287 15,083 91,370 (17,466) 73,904 67,591 6,313

4i 6a 4j 26 25c

32

Consolidated statement of comprehensive income for the year ended 31 December 2012
2012 HK$m Profit for the year ..................................................................................................................................... Other comprehensive income Available-for-sale investments: – fair value changes taken to equity ........................................................................................................ – fair value changes transferred to the income statement on disposal .................................................... – amounts transferred to the income statement on (impairment)/ reversal of impairment ..................... – fair value changes transferred to the income statement on hedged items due to hedged risk ............. – income taxes ......................................................................................................................................... Cash flow hedges: – fair value changes taken to equity ........................................................................................................ – fair value changes transferred to the income statement ....................................................................... – income taxes ......................................................................................................................................... Property revaluation: – fair value changes taken to equity ........................................................................................................ – income taxes ......................................................................................................................................... Share of other comprehensive income / (expense) of associates and joint ventures .............................. Exchange differences ............................................................................................................................... Actuarial gains / (losses) on post-employment benefits: – before income taxes .............................................................................................................................. – income taxes ......................................................................................................................................... Other comprehensive income / (expense) for the year, net of tax .......................................................... Total comprehensive income for the year, net of tax ......................................................................... Total comprehensive income for the year attributable to: – shareholders .......................................................................................................................................... – non-controlling interests ....................................................................................................................... 90,719 2011 HK$m 73,904

14,153 (2,753) 5 (287) (768)

(25,410) (231) (208) (1,124) 119

3,858 (3,662) (33)

303 (399) 15

7,221 (1,161) 638 925

12,940 (2,068) (1,259) (1,235)

1,080 (198) 19,018 109,737

(3,518) 575 (21,500) 52,404

100,814 8,923 109,737

45,428 6,976 52,404

33

T H E H O N G K O N G A N D S H A N G H A I B A N K I N G C O R P O R AT I O N L I M I T E D

Financial Statements (continued)

Consolidated balance sheet at 31 December 2012
Note ASSETS Cash and short-term funds ..................................................................................................... Items in the course of collection from other banks ............................................................... Placings with banks maturing after one month ..................................................................... Certificates of deposit ............................................................................................................ Hong Kong Government certificates of indebtedness .......................................................... Trading assets ........................................................................................................................ Financial assets designated at fair value ................................................................................ Derivatives ............................................................................................................................. Loans and advances to customers .......................................................................................... Financial investments ............................................................................................................ Amounts due from Group companies ................................................................................... Interests in associates and joint ventures ............................................................................... Goodwill and intangible assets .............................................................................................. Property, plant and equipment ............................................................................................... Deferred tax assets ................................................................................................................. Other assets ............................................................................................................................ Total assets ............................................................................................................................ LIABILITIES Hong Kong currency notes in circulation ............................................................................. Items in the course of transmission to other banks ............................................................... Deposits by banks .................................................................................................................. Customer accounts ................................................................................................................. Trading liabilities ................................................................................................................... Financial liabilities designated at fair value .......................................................................... Derivatives ............................................................................................................................. Debt securities in issue .......................................................................................................... Retirement benefit liabilities ................................................................................................. Amounts due to Group companies ........................................................................................ Other liabilities and provisions .............................................................................................. Liabilities under insurance contracts issued .......................................................................... Current tax liabilities ............................................................................................................. Deferred tax liabilities ........................................................................................................... Subordinated liabilities .......................................................................................................... Preference shares ................................................................................................................... Total liabilities ...................................................................................................................... EQUITY Share capital ........................................................................................................................... Other reserves ........................................................................................................................ Retained profits ...................................................................................................................... Proposed fourth interim dividend .......................................................................................... Total shareholders’ equity ..................................................................................................... Non-controlling interests ....................................................................................................... Total equity ............................................................................................................................ Total equity and liabilities .................................................................................................. 2012 HK$m 2011 HK$m

11 12 13 14 15 16 17 18 21 24 25 26 7 28

1,111,199 23,079 184,711 93,085 176,264 419,697 69,479 398,956 2,349,043 626,042 176,004 119,273 38,634 90,179 2,629 187,053 6,065,327

919,906 34,546 198,287 88,691 162,524 447,968 57,670 377,296 2,130,871 722,433 152,730 91,785 34,839 85,294 2,325 100,315 5,607,480

14

29 30 31 17 32 6 33 34 7 7 36 37

176,264 35,525 244,135 3,874,884 183,340 44,270 397,151 74,647 6,725 97,618 94,791 244,921 3,842 16,923 13,867 83,346 5,592,249

162,524 47,163 222,582 3,565,001 171,431 40,392 383,252 77,472 8,097 108,423 108,314 209,438 4,126 14,712 16,114 97,096 5,236,137

38

9

58,969 133,790 224,640 20,000 437,399 35,679 473,078 6,065,327

30,190 112,218 188,416 10,000 340,824 30,519 371,343 5,607,480

Directors Stuart T Gulliver Rose W M Lee Peter T S Wong

Secretary Paul A Stafford

34

Consolidated statement of changes in equity for the year ended 31 December 2012
2012 Other reserves

Share capital HK$m Other HK$m 29,177 – (110) – – – – (110) – (110) – – (277) – 5,566 15,193 34,356 638 926 100,814 28,779 (32,500) (523) 5 – 437,399 17,806 10,040 159 5,354 689 1,212 310 4 706 193 – (1) 8,923 – (3,766) 14 (11) – 35,679 340,824 83,008 30,519 7,711 198,416 83,008 519 – – (168) 689 (1) (1) – – 159 – – – – – 210 – – – – – 928 83,527 – (32,500) – – – (1,010) 43,451 40,580 – 8 (2) – (246) (3) (4,554) 244,640 – – 5,522 10,788 – – 749 (1) – 928 5,522 – – 5,522 – 10,788 10,040 – – – 159 – 159 – – 928 – – – – 38,939 – 29,786 – 51 – 14,265 – 371,343 90,719 19,018 10,350 163 6,060 882 638 925 109,737 28,779

Retained profits and proposed dividend HK$m Property revaluation reserve HK$m Total equity HK$m Cash flow hedge reserve HK$m Foreign exchange reserve HK$m Noncontrolling interests HK$m

Availablefor-sale investment reserve HK$m

Total shareholders’ equity HK$m

At 1 January ......................................................... Profit for the year ................................................. – – – – – – – –

30,190 –

Other comprehensive income (net of tax) ........... Available-for-sale investments ............................ Cash flow hedges ................................................. Property revaluation ............................................. Actuarial gains on defined benefit plans ............. Share of other comprehensive income of associates and joint ventures ........................... Exchange differences ...........................................

Total comprehensive income for the year ...........

35
– – – –

Shares issued .........................................................

28,779

Dividends paid ...................................................... Movement in respect of share-based payment arrangements ..................................... Other movements ................................................. Transfers ...............................................................

(36,266) (509) (6) – 473,078

At 31 December ...................................................

58,969

Consolidated statement of changes in equity for the year ended 31 December 2012 (continued)
2011 Other reserves

Share capital HK$m Other HK$m 20,954 – (74) – – – – (72) (2) (74) – – – – – 14,265 694 (205) 7,808 29,177 (1,259) (1,523) 45,428 7,696 (33,000) – 785 (215) – 340,824 (22,163) (26,579) (56) 9,691 (2,437) 320,130 67,591 27,305 6,313 663 (275) (25) 1,181 (506) – 288 6,976 – (3,764) 26 (24) – 30,519 173,254 67,591 (2,578) – – (137) (2,437) (6) 2 – 1 (55) – – – – – 51 – (1,524) 65,013 – (33,000) – – – (869) 38,939 29,786 – (7) – – 91 (3) (6,939) 198,416 – – 9,828 (27,760) – – (1,181) – – (1,524) 9,828 – – 9,828 – (27,760) (26,579) – – – (55) – (56) – – (1,524) – – – – 29,980 – 57,553 – 106 – 15,789 –

Retained profits and proposed dividend HK$m Property revaluation reserve HK$m Cash flow hedge reserve HK$m Foreign exchange reserve HK$m Noncontrolling interests HK$m Availablefor-sale investment reserve HK$m Total shareholders’ equity HK$m Total equity HK$m 347,435 73,904 (21,500) (26,854) (81) 10,872 (2,943) (1,259) (1,235) 52,404 7,696 (36,764) 811 (239) – 371,343

Financial Statements (continued)

At 1 January ......................................................... Profit for the year ................................................. – – – – – – – – 7,696 – – – –

22,494 –

Other comprehensive income (net of tax) ........... Available-for-sale investments ............................ Cash flow hedges ................................................. Property revaluation ............................................. Actuarial losses on defined benefit plans ............ Share of other comprehensive income of associates and joint ventures ........................... Exchange differences ...........................................

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36

Total comprehensive income for the year ...........

Shares issued .........................................................

Dividends paid ...................................................... Movement in respect of share-based payment arrangements ..................................... Other movements ................................................. Transfers ...............................................................

At 31 December ...................................................

30,190

Consolidated statement of cash flows for the year ended 31 December 2012
Note Operating activities Cash (used in)/generated from operations ................................................................................ Interest received on financial investments ............................................................................... Dividends received on financial investments ........................................................................... Dividends received from associates ......................................................................................... Taxation paid ............................................................................................................................ Net cash (outflow)/inflow from operating activities ............................................................ Investing activities Purchase of financial investments ............................................................................................ Proceeds from sale or redemption of financial investments .................................................... Purchase of property, plant and equipment .............................................................................. Proceeds from sale of property, plant and equipment and assets held for sale ........................ Purchase of other intangible assets ........................................................................................... Net cash outflow in respect of the acquisition of and increased shareholding in subsidiaries ................................................................................. Net cash inflow in respect of the sale of subsidiaries .............................................................. Net cash outflow in respect of the purchase of interests in associates and joint ventures ....... Net cash (outflow)/inflow from the sale of interests in business portfolios ............................ Proceeds from the sale of interests in associates ...................................................................... Net cash inflow from investing activities .............................................................................. Net cash inflow before financing ........................................................................................... Financing Issue of ordinary share capital .................................................................................................. Issue of preference shares ......................................................................................................... Redemption of preference shares .............................................................................................. Repayment of subordinated liabilities ...................................................................................... Issue of subordinated liabilities ................................................................................................ Ordinary dividends paid ........................................................................................................... Dividends paid to non-controlling interests ............................................................................. Interest paid on preference shares ............................................................................................ Interest paid on subordinated liabilities .................................................................................... Net cash outflow from financing ........................................................................................... Increase in cash and cash equivalents .................................................................................. 43 2012 HK$m (20,651) 14,349 464 2,297 (17,423) (20,964) 2011 HK$m 16,583 13,269 723 935 (15,790) 15,720

42

(262,280) 350,945 (1,990) 35 (1,303) 43 43 43 43 – 1,416 (13,521) (12,242) 3,970 65,030 44,066

(495,823) 588,409 (2,870) 215 (1,804) (143) 1 (263) 5,649 19 93,390 109,110

9

28,779 29 (13,566) (2,326) 2,328 (32,500) (3,766) (2,301) (884) (24,207) 19,859

7,696 – (4,280) (5,152) 3,502 (33,000) (3,764) (2,421) (793) (38,212) 70,898

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Financial Statements (continued)

Bank balance sheet at 31 December 2012
Note ASSETS Cash and short-term funds ..................................................................................................... Items in the course of collection from other banks ............................................................... Placings with banks maturing after one month ..................................................................... Certificates of deposit ............................................................................................................ Hong Kong Government certificates of indebtedness ........................................................... Trading assets ........................................................................................................................ Financial assets designated at fair value ................................................................................ Derivatives ............................................................................................................................. Loans and advances to customers .......................................................................................... Financial investments ............................................................................................................ Amounts due from Group companies .................................................................................... Investments in subsidiaries .................................................................................................... Interests in associates and joint ventures ............................................................................... Goodwill and intangible assets .............................................................................................. Property, plant and equipment ............................................................................................... Deferred tax assets ................................................................................................................. Other assets ............................................................................................................................ Total assets ............................................................................................................................ LIABILITIES Hong Kong currency notes in circulation .............................................................................. Items in the course of transmission to other banks ............................................................... Deposits by banks .................................................................................................................. Customer accounts ................................................................................................................. Trading liabilities ................................................................................................................... Financial liabilities designated at fair value .......................................................................... Derivatives ............................................................................................................................. Debt securities in issue .......................................................................................................... Retirement benefit liabilities ................................................................................................. Amounts due to Group companies ........................................................................................ Other liabilities and provisions .............................................................................................. Current tax liabilities ............................................................................................................. Deferred tax liabilities ........................................................................................................... Subordinated liabilities .......................................................................................................... Preference shares ................................................................................................................... Total liabilities ...................................................................................................................... EQUITY Share capital ........................................................................................................................... Other reserves ........................................................................................................................ Retained profits ...................................................................................................................... Proposed fourth interim dividend .......................................................................................... Total equity ............................................................................................................................ Total equity and liabilities .................................................................................................. 2012 HK$m 2011 HK$m

11 12 13 14 15 16 17 18 21 23 24 25 26 7 28

761,187 17,355 80,200 20,150 176,264 284,573 1,432 391,839 1,282,720 260,317 321,600 58,819 40,919 4,765 53,852 1,333 143,480 3,900,805

612,265 29,821 108,873 23,987 162,524 317,321 2,283 370,678 1,176,602 362,307 248,001 57,724 28,139 4,831 51,876 1,098 57,011 3,615,341

14

29 30 31 17 32 6 33 7 7 36 37

176,264 25,766 204,520 2,417,400 82,146 7,731 392,084 40,406 3,710 149,237 58,887 2,348 6,194 9,355 83,195 3,659,243

162,524 38,577 158,746 2,220,072 78,959 5,910 377,165 46,360 4,150 152,906 71,585 2,748 5,884 9,386 96,969 3,431,941

38

9

58,969 62,219 100,374 20,000 241,562 3,900,805

30,190 49,278 93,932 10,000 183,400 3,615,341

Directors Stuart T Gulliver Rose W M Lee Peter T S Wong

Secretary Paul A Stafford

38

Bank statement of changes in equity for the year ended 31 December 2012

Share capital HK$m Other HK$m 2,058 – – – – – – – 368 – – – – – 220 (2,784) – – – (269) – – 1,789 30,190 – – – – – – – – 28,779 – – – – 58,969 120,374 26,876 36,118 – (32,500) (221) – 562 – – – – (562) – – – – – – – – – – 48,601 3,142 10,105 157 224 – – (97) 321 – 3,142 – – 3,142 – – 10,105 10,106 – – – (1) 157 – 157 – – – 368 – – – – 368 48,377 – – – – 103,932 24,296 26,013 63 (3,152)

Retained profits and proposed dividend HK$m Property revaluation reserve HK$m Foreign exchange reserve HK$m

2012 Other reserves Availablefor-sale Cash flow investment hedge reserve reserve HK$m HK$m Total equity HK$m 183,400 48,377 13,996 10,106 157 3,045 321 367 62,373 28,779 (32,500) (490) – – 241,562

At 1 January ......................................................................................

Profit for the year ..............................................................................

Other comprehensive income (net of tax) ........................................ Available-for-sale investments ......................................................... Cash flow hedges .............................................................................. Property revaluation ......................................................................... Actuarial gains on defined benefit plans .......................................... Exchange differences ........................................................................

Total comprehensive income ............................................................

39

Shares issued ..................................................................................... Dividends paid .................................................................................. Movement in respect of share-based payment arrangements .......... Other movements .............................................................................. Transfers ...........................................................................................

At 31 December ................................................................................

Bank statement of changes in equity for the year ended 31 December 2012 (continued)

Share Capital HK$m Other HK$m 1,567 – – – – – – – (4,456) – – – – – 63 – – – – – (3,152) – – – 551 (60) – 2,058 22,494 – – – – – – – – 7,696 – – – – 30,190 103,932 24,296 26,013 – (33,000) 52 (4) 519 – – – – (519) – – – – – 36,279 6,378 (24,538) (7) (1,533) – – (79) (1,454) – 6,378 – – 6,378 – – (24,538) (24,538) – – – – (7) – (7) – – – (4,456) – – – – (4,456) 37,812 – – – – 100,086 18,437 50,551 70 1,304

Retained profits and proposed dividend HK$m Property revaluation reserve HK$m Foreign exchange reserve HK$m

2011 Other reserves AvailableCash flow for-sale hedge investment reserve reserve HK$m HK$m Total equity HK$m 194,509 37,812

At 1 January ......................................................................................

Financial Statements (continued)

Profit for the year ..............................................................................

Other comprehensive income (net of tax) ........................................ Available-for-sale investments ......................................................... Cash flow hedges .............................................................................. Property revaluation ......................................................................... Actuarial losses on defined benefit plans ......................................... Exchange differences ........................................................................

(24,156) (24,538) (7) 6,299 (1,454) (4,456) 13,656 7,696 (33,000) 603 (64) – 183,400

Total comprehensive income ............................................................

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Shares issued ..................................................................................... Dividends paid .................................................................................. Movement in respect of share-based payment arrangements .......... Other movements .............................................................................. Transfers ...........................................................................................

At 31 December ................................................................................

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Notes on the Financial Statements

1 Basis of preparation a The consolidated financial statements comprise the accounts of The Hongkong and Shanghai Banking Corporation Limited (‘the Bank’) and its subsidiaries (‘the group’) as of 31 December 2012. The consolidated financial statements have been prepared in accordance with Hong Kong Financial Reporting Standards (‘HKFRSs’), the provisions of the Hong Kong Companies Ordinance and accounting principles generally accepted in Hong Kong. HKFRSs is a collective term which includes all applicable individual Hong Kong Financial Reporting Standards, Hong Kong Accounting Standards (‘HKASs’) and Interpretations issued by the Hong Kong Institute of Certified Public Accountants (‘HKICPA’). The consolidated financial statements have been prepared under the historical cost convention as modified by the revaluation of certain financial assets and liabilities, premises, and certain assets and liabilities related to insurance contracts. During 2012 the group adopted a number of interpretations and amendments to standards, all of which had an insignificant effect on the consolidated financial statements of the group and the separate financial statements of the Bank. Following the amendment to HKAS 12 ‘Income Taxes’ issued by the HKICPA in December 2010, deferred taxes on investment property, carried under the fair value model in HKAS 40, are measured based on the rebuttable presumption that an investment property is recovered entirely through sale. The application of the amendment to HKAS 12 did not have a material effect on the group’s consolidated financial statements and, consequently, has been applied prospectively. b The consolidated financial statements include the attributable share of the results and reserves of associates and joint ventures based on accounts prepared at dates not earlier than three months prior to 31 December 2012. c Future Accounting Developments At 31 December 2012, a number of standards and interpretations, and amendments thereto, had been issued by the HKICPA, which are not effective for the group’s consolidated financial statements as at 31 December 2012. In addition to the projects to complete financial instrument accounting, there are other projects on insurance, revenue recognition and lease accounting which, together with the standards described below, will represent significant changes to accounting requirements from 2015 and later. Standards applicable in 2013 In June 2011, the HKICPA issued HKFRS 10 ‘Consolidated Financial Statements’ (‘HKFRS 10’), HKFRS 11 ‘Joint Arrangements’ (‘HKFRS 11’) and HKFRS 12 ‘Disclosure of Interests in Other Entities’ (‘HKFRS 12’). In July 2012, HKICPA issued amendments to HKFRS 10, HKFRS 11 and HKFRS 12 ‘Transition Guidance’. The standards are effective for annual periods beginning on or after 1 January 2013. HKFRSs 10 and 11 are to be applied retrospectively. Under HKFRS 10, there will be one approach for determining consolidation for all entities, based on the concept of power, variability of returns and their linkage. This will replace the current approach which emphasises legal control or exposure to risks and rewards, depending on the nature of the entity. HKFRS 11 places more focus on the investors’ rights and obligations than on the structure of an arrangement, and introduces the concept of a joint operation. HKFRS 12 includes the disclosure requirements for subsidiaries, joint arrangements and associates and introduces new requirements for unconsolidated structured entities. Based on our assessment to date, while the consolidation status of some entities may change because the group has control but not the majority of risks and rewards, or vice versa, we do not expect the overall impact of HKFRS 10 and HKFRS 11 on the financial statements to be material. In June 2011, the HKICPA issued HKFRS 13 ‘Fair Value Measurement’ (‘HKFRS 13’). This standard is effective for annual periods beginning on or after 1 January 2013 with early adoption permitted. HKFRS 13 is required to be applied prospectively from the beginning of the first annual period in which it is applied. The disclosure requirements of HKFRS 13 do not require comparative information to be provided for periods prior to initial application.

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Notes on the Financial Statements (continued)

1 Basis of preparation (continued) HKFRS 13 establishes a single source of guidance for all fair value measurements required or permitted by HKFRSs. The standard clarifies the definition of fair value as an exit price, which is defined as a price at which an orderly transaction to sell the asset or to transfer the liability would take place between market participants at the measurement date under current market conditions, and enhances disclosures about fair value measurement. Based on our current assessment, we do not expect the impact of HKFRS 13 on the financial statements to be material. In July 2011, the HKICPA issued amendments to HKAS 19 ‘Employee Benefits’ (‘HKAS 19 revised’). The revised standard is effective for annual periods beginning on or after 1 January 2013 with early adoption permitted. HKAS 19 revised is to be applied retrospectively. The most significant amendment for the group is the replacement of interest cost and expected return on plan assets by a finance cost component comprising the net interest on the net defined benefit liability or asset. This finance cost component is determined by applying the same discount rate used to measure the defined benefit obligation to the net defined benefit liability or asset. The difference between the actual return on plan assets and the return included in the finance cost component in the income statement will be presented in other comprehensive income. The effect of this change is to increase the pension expense by the difference between the current expected return on plan assets and the return calculated by applying the relevant discount rate. Based on our estimate of the impact of this particular amendment on the 2012 consolidated financial statements, the change would decrease pre-tax profit, with no effect on the pension liability. The effect on total operating expenses and pre-tax profit is not material. The effect at the date of adoption on 1 January 2013 was not material to the group. In December 2011, the HKICPA issued amendments to HKFRS 7 ‘Disclosures – Offsetting Financial Assets and Financial Liabilities’ which requires disclosures about the effect or potential effects of offsetting financial assets and financial liabilities and related arrangements on an entity’s financial position. The amendments are effective for annual periods beginning on or after 1 January 2013 and interim periods within those annual periods. The amendments are required to be applied retrospectively. Standards applicable in 2014 In December 2011, the HKICPA issued amendments to HKAS 32 ‘Financial Instruments: Presentation’ which clarified the requirements for offsetting financial instruments and addressed inconsistencies in current practice when applying the offsetting criteria in HKAS 32. The amendments are effective for annual periods beginning on or after 1 January 2014 with early adoption permitted and are required to be applied retrospectively. The group is currently assessing the impact of these clarifications but it is not practical to quantify their effect as at the date of publication of these consolidated financial statements. In December 2012, HKICPA issued amendments to HKFRS 10, HKFRS 12 and HKAS 27, which introduced an exception for investment entities to the principle that all subsidiaries shall be consolidated. We do not expect the amendments to have any material impact on the group’s financial statements. Standards applicable in 2015 In November 2009, the HKICPA issued HKFRS 9 ‘Financial Instruments’ (‘HKFRS 9’) which introduced new requirements for the classification and measurement of financial assets. In November 2010, the HKICPA issued an amendment to HKFRS 9 incorporating requirements for financial liabilities. Together, these changes represent the first phase in the planned replacement of HKAS 39 ‘Financial Instruments: Recognition and Measurement’ (‘HKAS 39’). Following the HKICPA’s decision in December 2011 to defer the effective date, the standard is effective for annual periods beginning on or after 1 January 2015. The second and third phases in the HKAS 39 replacement project will address the impairment of financial assets measured at amortised cost and hedge accounting.

42

1 Basis of preparation (continued) As a result of uncertainties with regard to the final HKFRS 9 requirements for classification and measurement and impairment, the group remains unable to provide a date by which it will apply HKFRS 9 as a whole and it remains impracticable to quantify the effect of HKFRS 9 as at the date of the publication of these financial statements. Enhanced Disclosure Task Force In accordance with the group’s policy to provide meaningful disclosures that help stakeholders understand the group’s performance, financial position and changes thereto, the group intends to implement the recommendations of the Enhanced Disclosure Task Force (‘EDTF’) report ‘Enhancing the Risk Disclosures of Banks’ (issued on 29 October 2012), which are relevant. The EDTF was established in May 2012 at the initiative of the Financial Stability Board. Its objective was to develop recommendations for enhancing risk and regulatory disclosures by banks. The report’s recommendations are voluntary and help financial institutions identify areas that need better and more transparent information about risks and how these relate to performance measurement and reporting. 2 Critical accounting estimates and judgements in applying accounting policies The results of the group are sensitive to the accounting policies, assumptions and estimates that underlie the preparation of our consolidated financial statements. The significant accounting policies are described in Note 3 on the financial statements. The accounting policies that are deemed critical to our results and financial position, in terms of the materiality of the items to which the policies are applied and the high degree of judgement involved, including the use of assumptions and estimation, are discussed below. Loan impairment Application of the group’s methodology for assessing loan impairment, as set out in note 3(d), involves considerable judgement and estimation. For individually significant loans, judgement is required in determining whether there are indications that an impairment loss may already have been incurred and then estimating the amount and timing of expected cash flows, which form the basis of the impairment loss that is recorded. For collectively assessed loans, judgement is involved in selecting and applying the criteria for grouping together loans with similar credit characteristics, as well as in selecting and applying the statistical and other models used to estimate the losses incurred for each group of loans in the reporting period. The benchmarking of loss rates, the assessment of the extent to which historical losses are representative of current conditions and the ongoing refinement of modelling methodologies provide a means of identifying changes that may be required, but the process is inherently one of estimation. Valuation of financial instruments The group’s accounting policy for valuation of financial instruments is included in note 3(h) and is discussed further within note 17 ‘Derivatives’ and note 51 ‘Fair value of financial instruments’. When fair values are determined by using valuation techniques which refer to observable market data because independent prices are not available, management will consider the following when applying a valuation model:  the likelihood and expected timing of future cash flows on the instrument. These cash flows are usually governed by the terms of the instrument, although management judgement may be required when the ability of the counterparty to service the instrument in accordance with the contractual terms is in doubt;  an appropriate discount rate for the instrument. Management uses all relevant market information in determining the appropriate spread over the risk-free/benchmark rate used by market participants for the particular instrument; and  judgement to determine what model to use to calculate fair value in areas where the choice of valuation model is particularly subjective, for example, when valuing complex derivatives.

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Notes on the Financial Statements (continued)

2

Critical accounting estimates and judgements in applying accounting policies (continued) When valuing instruments by reference to comparable instruments, management takes into account the maturity, structure, liquidity, credit rating and other market factors of the instrument with which the position held is being compared. When valuing instruments on a model basis using the fair value of underlying components, management also considers the need for adjustments to take account of factors such as bid-offer spread, credit profile, model uncertainty and any other factors market participants would consider in the valuation of that instrument. These adjustments are based on defined policies which are applied consistently across the group. When unobservable market data have a significant impact on the valuation of derivatives, the entire initial difference in fair value from the transaction price as indicated by the valuation model is recognised on one of the following bases: over the life of the transaction on an appropriate basis; in the income statement when the inputs become observable; or when the transaction matures or is closed out. Financial instruments measured at fair value through profit or loss comprises financial instruments held for trading and financial instruments designated at fair value. Changes in their fair value directly impact the group’s income statement in the period in which they occur. A change in the fair value of a financial asset which is classified as ‘available-for-sale’ is recorded directly in equity and other comprehensive income until the financial asset is sold, when the cumulative change in fair value is charged or credited to the income statement. When a decline in the fair value of an available-for-sale financial asset has been recognised directly in equity and other comprehensive income and there is objective evidence that the asset is impaired, the cumulative loss that had been recognised directly in equity is removed from equity and recognised in the income statement, reducing the group’s operating profit. Impairment of interests in associates The group’s accounting policy for impairment of interests in associates is set out in note 3m. When an investment in an associate is tested in accordance with HKAS 36 ‘Impairment of Assets’ to determine whether it is impaired, significant judgement is required in selecting and applying appropriate assumptions and estimates to determine the recoverable amount. Liabilities under investment contracts Estimating the liabilities for long-term investment contracts where the group has guaranteed a minimum return involves the use of statistical techniques. The selection of these techniques and the assumptions used about future interest rates and rates of return on equities, as well as behavioural and other future events, have a significant impact on the amount recognised as a liability. Insurance contracts Classification HKFRS 4 ‘Insurance Contracts’ requires the group to determine whether an insurance contract that transfers both insurance risk and financial risk is classified as an insurance contract, or as a financial instrument under HKAS 39, or whether the insurance and non-insurance elements of the contract should be accounted for separately. This process involves judgement and estimation of the amounts of different types of risks that are transferred or assumed under a contract. The estimation of such risks often involves the use of assumptions about future events and is thus subject to a degree of uncertainty. Present value of in-force long-term insurance business (‘PVIF’) The value of PVIF, which is recorded as an intangible asset, depends upon assumptions regarding future events. These are described in more detail in note 25(b). The assumptions are reassessed at each reporting date and changes in the estimates which affect the value of PVIF are reflected in the income statement. Insurance liabilities The estimation of insurance liabilities involves selecting statistical models and making assumptions about future events which need to be frequently calibrated against experience and forecasts. The sensitivity of insurance liabilities to potential changes in key assumptions is set out in note 52.

44

3

Summary of significant accounting policies a Interest income and expense Interest income and expense for all financial instruments, except those classified as held for trading or designated at fair value (other than debt securities issued by the group and derivatives managed in conjunction with such debt securities issued) are recognised in ‘Interest income’ and ‘Interest expense’ in the income statement using the effective interest method. The effective interest method is a way of calculating the amortised cost of a financial asset or a financial liability (or groups of financial assets or financial liabilities) and of allocating the interest income or interest expense over the relevant period. The effective interest rate is the rate that exactly discounts estimated future cash payments or receipts through the expected life of the financial instrument or, where appropriate, a shorter period, to the net carrying amount of the financial asset or financial liability. When calculating the effective interest rate, the group estimates cash flows considering all contractual terms of the financial instrument but excluding future credit losses. The calculation includes all amounts paid or received by the group that are an integral part of the effective interest rate of a financial instrument, including transaction costs and all other premiums or discounts. Interest on impaired financial assets is recognised using the rate of interest used to discount the future cash flows for the purpose of measuring the impairment loss. b Non interest income Fee income is earned from a diverse range of services provided by the group to its customers. Fee income is accounted for as follows:  income earned on the execution of a significant act is recognised as revenue when the act is completed (for example, fees arising from negotiating, or participating in the negotiation of, a transaction for a third-party, such as an arrangement for the acquisition of shares or other securities); income earned from the provision of services is recognised as revenue as the services are provided (for example, asset management, portfolio and other management advisory and service fees); and income which forms an integral part of the effective interest rate of a financial instrument is recognised as an adjustment to the effective interest rate (for example, certain loan commitment fees) and recorded in ‘Interest income’ (Note 3(a)).

 

Net trading income comprises all gains and losses from changes in the fair value of financial assets and financial liabilities held for trading, together with the related interest income, expense and dividends. Net income from financial instruments designated at fair value includes all gains and losses from changes in the fair value of financial assets and financial liabilities designated at fair value through profit or loss. Interest income and expense and dividend income arising on these financial instruments are also included, except for interest arising from debt securities issued, and derivatives managed in conjunction with those debt securities, which is recognised in ‘Interest expense’ (Note 3(a)). Dividend income is recognised when the right to receive payment is established. This is the ex-dividend date for listed equity securities, and usually the date when shareholders have approved the dividend for unlisted equity securities.

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Notes on the Financial Statements (continued)

3

Summary of significant accounting policies (continued) c Loans and advances to customers and placings with banks Loans and advances to customers and placings with banks include loans and advances originated by the group which are not classified as either held for trading or designated at fair value. Loans and advances are recognised when cash is advanced to a borrower. They are derecognised when either the borrower repays its obligations, or the loans are sold or written off, or substantially all the risks and rewards of ownership are transferred. They are initially recorded at fair value plus any directly attributable transaction costs and are subsequently measured at amortised cost using the effective interest method, less any reduction from impairment or uncollectibility. Where exposures are hedged by derivatives designated and qualifying as fair value hedges, the carrying value of the loans and advances so hedged includes a fair value adjustment for the hedged risk only. Loans and advances are reclassified to held for sale when their carrying amounts are to be recovered principally through sale, they are available for sale in their present condition and their sale is highly probable (Note 3ac); however, such loans and advances continue to be measured in accordance with the policy described above. The group may commit to underwrite loans on fixed contractual terms for specified periods of time, where the drawdown of the loan is contingent upon certain future events outside the control of the group. Where the loan arising from the lending commitment is expected to be held for trading, the commitment to lend is recorded as a trading derivative and measured at fair value through profit or loss. On drawdown, the loan is classified as held for trading and measured at fair value through profit or loss. Where it is not the group’s intention to trade but hold the loan, a provision on the loan commitment is only recorded where it is probable that the group will incur a loss. This may occur, for example, where a loss of principal is probable or the interest rate charged on the loan is lower than the cost of funding. On inception of the loan, the loan to be held is recorded at its fair value and subsequently measured at amortised cost using the effective interest method. For certain transactions, such as leveraged finance and syndicated lending activities, the cash advanced is not necessarily the best evidence of the fair value of the loan. For these loans, where the initial fair value is lower than the cash amount advanced (for example, due to the rate of interest charged on the loan being below the market rate of interest), the write-down is charged to the income statement. The write-down will be recovered over the life of the loan, through the recognition of interest income using the effective interest method, unless the loan becomes impaired. The write-down is recorded as a reduction to other operating income. Financial assets which have been reclassified into the loans and receivables category are initially recorded at the fair value at the date of reclassification and are subsequently measured at amortised cost, using the effective interest rate determined at the date of reclassification. d Impairment of loans and advances Losses for impaired loans are promptly recognised when there is objective evidence that impairment of a loan or portfolio of loans has occurred. Impairment allowances are calculated on individual loans and on groups of loans assessed collectively. Impairment losses are recorded as charges to the income statement. The carrying amount of impaired loans on the balance sheet is reduced through the use of impairment allowance accounts. Losses expected from future events are not recognised. Individually assessed loans and advances The factors considered in determining that a loan is individually significant for the purposes of assessing impairment include:     the size of the loan; the number of loans in the portfolio; the importance of the individual loan relationship, and how this is managed; and whether volumes of defaults and losses are sufficient to enable a collective assessment methodology to be applied.

Loans considered as individually significant are typically to corporate and commercial customers, are for larger amounts and are managed on an individual relationship basis. Retail lending portfolios are generally assessed for impairment on a collective basis as the portfolios generally consist of large pools of homogeneous loans.

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3

Summary of significant accounting policies (continued) For all loans that are considered individually significant, the group assesses on a case-by-case basis at each balance sheet date whether there is any objective evidence that a loan is impaired. The criteria used by the group to determine that there is such objective evidence include:     known cash flow difficulties experienced by the borrower; past due contractual payments of either principal or interest being past due for more than 90 days; the probability that the borrower will enter bankruptcy or other financial realisation; a concession granted to the borrower for economic or legal reasons relating to the borrower’s financial difficulty that results in the forgiveness or postponement of principal, interest or fees, where the concession is not insignificant; and deterioration in the financial condition or outlook of the borrower such that the ability to repay is considered doubtful.



For those loans where objective evidence of impairment exists, impairment losses are determined considering the following factors:     the group’s aggregate exposure to the customer; the viability of the customer’s business model and their capacity to trade successfully out of financial difficulties and generate sufficient cash flow to service debt obligations; the amount and timing of expected receipts and recoveries; the likely dividend available on liquidation or bankruptcy;

 the extent of other creditors’ commitments ranking ahead of, or pari passu with, the group and the likelihood of other creditors continuing to support the company;      the complexity of determining the aggregate amount and ranking of all creditor claims and the extent to which legal and insurance uncertainties are evident; the realisable value of security (or other credit mitigants) and likelihood of successful repossession; the likely deduction of any costs involved in recovery of amounts outstanding; the ability of the borrower to obtain, and make payments in, the currency of the loan if not denominated in local currency; and when available, the secondary market price of the debt.

The realisable value of security is determined based on the current market value when the impairment assessment is performed. The value is not adjusted for expected future changes in market prices; however, adjustments are made to reflect local conditions, such as forced sale discounts. Impairment losses are calculated by discounting the expected future cash flows of a loan at its original effective interest rate and comparing the resultant present value with the loan’s current carrying amount. The impairment allowances on individually significant accounts are reviewed at least quarterly and more regularly when circumstances require. This normally encompasses re-assessment of the enforceability of any collateral held and the timing and amount of actual and anticipated receipts. Individually assessed impairment allowances are only released when there is reasonable and objective evidence of a reduction in the established loss estimate. Collectively assessed loans and advances Impairment is assessed on a collective basis in two circumstances:   for homogeneous groups of loans that are not considered individually significant; and to cover losses which have been incurred but have not yet been identified on loans subject to individual assessment.

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Summary of significant accounting policies (continued) Homogeneous groups of loans and advances Statistical methods are used to determine impairment losses on a collective basis for homogeneous groups of loans that are not considered individually significant, because individual loan assessment is impracticable. Losses in these groups of loans are recorded on an individual basis when individual loans are written off, at which point they are removed from the group. Two alternative methods are used to calculate allowances on a collective basis:  when appropriate empirical information is available, the group uses a roll rate methodology. This methodology employs statistical analyses of historical data and experience of delinquency and default to estimate the amount of loans that will eventually be written off as a result of the events occurring before the balance sheet date which the group is not able to identify on an individual loan basis, and that can be reliably estimated. Under this methodology, loans are grouped into ranges according to the number of days past due and statistical analysis is used to estimate the likelihood that loans in each range will progress through the various stages of delinquency, and ultimately prove irrecoverable. In addition to the delinquency groupings, loans are segmented according to their credit characteristics as described below. Current economic conditions are also evaluated when calculating the appropriate level of allowance required to cover inherent loss. The estimated loss is the difference between the present value of expected future cash flows, discounted at the original effective interest rate of the portfolio, and the carrying amount of the portfolio. In certain highly developed markets, sophisticated models also take into account behavioural and account management trends as revealed in, for example, bankruptcy and rescheduling statistics. when the portfolio size is small or when information is insufficient or not reliable enough to adopt a roll rate methodology, the group adopts a basic formulaic approach based on historical loss rate experience.

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The inherent loss within each portfolio is assessed on the basis of statistical models using historical data observations, which are updated periodically to reflect recent portfolio and economic trends. When the most recent trends in portfolio risk factors arising from changes in economic, regulatory or behavioural conditions are not fully reflected in the statistical models, they are taken into account by adjusting the impairment allowances derived solely from historical loss experience to reflect these changes as at the balance sheet date. These additional portfolio risk factors may include recent loan portfolio growth and product mix, unemployment rates, bankruptcy trends, geographic concentrations, loan product features (such as the ability of borrowers to repay adjustable-rate loans where reset interest rates give rise to increases in interest charges), economic conditions such as national and local trends in housing markets and interest rates, portfolio seasoning, account management policies and practices, current levels of write-offs, changes in laws and regulations and other items which can affect customer payment patterns on outstanding loans, such as natural disasters. These risk factors, where relevant, are taken into account when calculating the appropriate level of impairment allowances by adjusting the impairment allowances derived solely from historical loss experience. Roll rates, loss rates and the expected timing of future recoveries are regularly benchmarked against actual outcomes to ensure they remain appropriate. Incurred but not yet identified impairment Individually assessed loans for which no evidence of loss has been specifically identified on an individual basis are grouped together according to their credit risk characteristics for the purpose of calculating an estimated collective impairment. The credit risk characteristics may include country of origination, type of business involved, type of products offered, security obtained or other relevant factors. This reflects impairment losses that the group has incurred as a result of events occurring before the balance sheet date, which the group is not able to identify on an individual loan basis, and that can be reliably estimated. These losses will only be individually identified in the future. As soon as information becomes available which identifies losses on individual loans within the group, those loans are removed from the group and assessed on an individual basis for impairment.

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Summary of significant accounting policies (continued) The collective impairment allowance is determined after taking into account:    historical loss experience in portfolios of similar credit risk characteristics (for example, by industry sector, loan grade or product); the estimated period between impairment occurring and the loss being identified and evidenced by the establishment of an appropriate allowance against the individual loan; and management’s experienced judgment as to whether current economic and credit conditions are such that the actual level of inherent losses at the balance sheet date is likely to be greater or less than that suggested by historical experience.

The period between a loss occurring and its identification is estimated by local management for each identified portfolio. The factors that may influence this estimation include economic and market conditions, customer behaviour, portfolio management information, credit management techniques and collection and recovery experiences in the market. As it is assessed empirically on a periodic basis the estimated period between a loss occurring and its identification may vary over time as these factors change. Write-off of loans and advances Loans (and the related impairment allowance accounts) are normally written off, either partially or in full, when there is no realistic prospect of recovery. Where loans are secured, this is generally after receipt of any proceeds from the realisation of security. In circumstances where the net realisable value of any collateral has been determined and there is no reasonable expectation of further recovery, write-off may be earlier. Reversals of impairment If the amount of an impairment loss decreases in a subsequent period, and the decrease can be related objectively to an event occurring after the impairment was recognised, the excess is written back by reducing the loan impairment allowance account accordingly. The write-back is recognised in the income statement. Assets acquired in exchange for loans Non-financial assets acquired in exchange for loans in order to achieve an orderly realisation are recorded as assets held for sale and reported in ‘Other assets’ if the carrying amounts of the assets are recovered principally through sale, the assets are available for sale in their present condition and their sale is highly probable. The asset acquired is recorded at the lower of its fair value less costs to sell and the carrying amount of the loan, net of impairment allowance amounts, at the date of exchange. No depreciation is charged in respect of assets held for sale. Any subsequent write-down of the acquired asset to fair value less costs to sell is recorded as an impairment loss and included within ‘Other operating income’ in the income statement. Any subsequent increase in the fair value less costs to sell, to the extent this does not exceed the cumulative impairment loss, is recognised as a gain in ‘Other operating income’ in the income statement, together with any realised gains or losses on disposal. Debt securities or equities acquired in debt-to-debt/equity swaps are included in ‘Financial investments’ and are classified as available-for-sale. Renegotiated loans Loans subject to collective impairment assessment whose terms have been renegotiated are no longer considered past due, but are treated as up to date loans for measurement purposes, once the minimum number of payments required under the new arrangements has been received. Loans subject to collective impairment assessment whose terms have been renegotiated are segregated from other parts of the loan portfolio for the purposes of collective impairment assessment, to reflect their risk profile. Loans subject to individual impairment assessment, whose terms have been renegotiated, are subject to ongoing review to determine whether they remain impaired or should be considered past due. The carrying amounts of loans that have been classified as renegotiated retain this classification until maturity or derecognition. A loan that is renegotiated is derecognised if the existing agreement is cancelled and a new agreement made on substantially different terms, or if the terms of an existing agreement are modified, such that the renegotiated loan is substantially a different financial instrument.

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Summary of significant accounting policies (continued) e Trading assets and trading liabilities Treasury bills, loans and advances to and from customers, loans and advances to and from banks, debt securities, structured deposits, equity shares, own debt issued and short positions in securities which have been acquired or incurred principally for the purpose of selling or repurchasing in the near term, or are part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking, are classified as held for trading. Financial assets and financial liabilities are recognised on trade date, when the group enters into contractual arrangements with counterparties to purchase or sell the financial instruments, and are normally derecognised when either sold (assets) or extinguished (liabilities). Measurement is initially at fair value, with transaction costs taken to the income statement. Subsequently, the fair values are remeasured and gains and losses from changes therein are recognised in the income statement within ‘Net trading income’. f Financial instruments designated at fair value Financial instruments, other than those held for trading, are classified in this category if they meet the criteria set out below and are so designated by management on initial recognition. The group may designate financial instruments at fair value when the designation:  eliminates or significantly reduces measurement or recognition inconsistencies that would otherwise arise from measuring financial assets or financial liabilities or recognising the gains and losses on them on different bases; examples include unit-linked investment contracts, and certain portfolios of securities and debt issuances that are managed in conjunction with financial assets or liabilities measured on a fair value basis; applies to a group of financial assets, financial liabilities, or both, that is managed and its performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy, and where information about that group of financial instruments is provided internally on that basis to key management personnel; examples include financial assets held to back certain insurance contracts, and certain asset-backed securities; or relates to financial instruments containing one or more embedded derivatives that significantly modify the cash flows resulting from those financial instruments, and which would otherwise be required to be accounted for separately; examples include certain debt issuances and debt securities held.





This fair value designation, once made, is irrevocable. Financial assets and financial liabilities are recognised when the group enters the contractual provisions of the arrangements with counterparties, which is generally on trade date, and are normally derecognised when either sold (assets) or extinguished (liabilities). Measurement is initially at fair value, with transaction costs taken to the income statement. Subsequently, the fair values are remeasured and gains and losses from changes therein are recognised in the income statement within ‘Net income from financial instruments designated at fair value’. g Financial investments Treasury bills, debt securities and equity shares intended to be held on a continuing basis, other than those designated at fair value, are classified as available-for-sale or held-to-maturity. Financial investments are recognised on trade date, when the group enters into contractual arrangements with counterparties to purchase securities, and are normally derecognised when either the securities are sold or the borrowers repay their obligations.

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Summary of significant accounting policies (continued) Available-for-sale Available-for-sale financial assets are initially measured at fair value plus direct and incremental transaction costs. They are subsequently remeasured at fair value and changes therein are recognised in other comprehensive income in the ‘Available-for-sale investment reserve’ until the financial assets are either sold or become impaired. When available-for-sale financial assets are sold, cumulative gains or losses previously recognised in other comprehensive income are recognised in the income statement as ‘Gains less losses from financial investments’. Interest income is recognised on available-for-sale debt securities using the effective interest rate method, calculated over the asset’s expected life. Premiums and/or discounts arising on the purchase of dated investment securities are included in the calculation of their effective interest rates. Dividends are recognised in the income statement when the right to receive payment has been established. At each balance sheet date an assessment is made of whether there is any objective evidence of impairment in the value of a financial asset. Impairment losses are recognised if, and only if, there is objective evidence of impairment as a result of one or more events that occurred after the initial recognition of the financial asset (a ‘loss event’) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset and can be reliably estimated. If the available-for-sale financial asset is impaired, the difference between the financial asset’s acquisition cost (net of any principal repayments and amortisation) and the current fair value, less any previous impairment loss recognised in the income statement, is removed from other comprehensive income and recognised in the income statement. Impairment losses for available-for-sale debt securities are recognised within ‘Loan impairment charges and other credit risk provisions’ in the income statement and impairment losses for available-for-sale equity securities are recognised within ‘Gains less losses from financial investments’ in the income statement. The impairment methodologies for available-for-sale financial assets are set out in more detail below. Available-for-sale debt securities When assessing available-for-sale debt securities for objective evidence of impairment at the reporting date, the group considers all available evidence, including observable data or information about events specifically relating to the securities which may result in a shortfall in recovery of future cash flows. These events may include a significant financial difficulty of the issuer, a breach of contract such as a default, bankruptcy or other financial reorganisation, or the disappearance of an active market for the debt security because of financial difficulties relating to the issuer. These types of specific event and other factors such as information about the issuers’ liquidity, business and financial risk exposures, levels of and trends in default for similar financial assets, national and local economic trends and conditions, and the fair value of collateral and guarantees may be considered individually, or in combination, to determine if there is objective evidence of impairment of a debt security. Available-for-sale equity securities Objective evidence of impairment for available-for sale equity securities may include specific information about the issuer as detailed above, but may also include information about significant changes in technology, markets, economics or the law that provides evidence that the cost of the equity securities may not be recovered. A significant or prolonged decline in the fair value of the asset below its cost is also objective evidence of impairment. In assessing whether it is significant, the decline in fair value is evaluated against the original cost of the asset at initial recognition. In assessing whether it is prolonged, the decline is evaluated against the period in which the fair value of the asset has been below its original cost at initial recognition.

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Summary of significant accounting policies (continued) Once an impairment loss has been recognised on an available-for-sale financial asset, the subsequent accounting treatment for changes in the fair value of that asset differs depending on the nature of the available-for-sale financial asset concerned:  for an available-for-sale debt security, a subsequent decline in the fair value of the instrument is recognised in the income statement if, and only if, there is objective evidence of impairment as a result of further decreases in the estimated future cash flows of the financial asset. Where there is no further objective evidence of impairment, the decline in the fair value of the financial asset is recognised directly in other comprehensive income. If the fair value of a debt security increases in a subsequent period, and the increase can be objectively related to an event occurring after the impairment loss was recognised in the income statement, the impairment loss is reversed through the income statement to the extent of the increase in fair value; for an available-for-sale equity security, all subsequent increases in the fair value of the instrument are treated as a revaluation and are recognised directly in other comprehensive income. Impairment losses recognised on an equity security are not reversed through the income statement. Subsequent decreases in the fair value of the available-for-sale equity security are recognised in the income statement, to the extent that further cumulative impairment losses have been incurred in relation to the acquisition cost, less cumulative impairment to date, of the equity security.



Held-to-maturity investments Held-to-maturity investments are non-derivative financial assets with fixed or determinable payments and fixed maturities that the group has the positive intention and ability to hold until maturity. Held-to-maturity investments are initially recorded at fair value plus any directly attributable transaction costs, and are subsequently measured at amortised cost using the effective interest rate method, less any impairment losses. h Valuation of financial instruments All financial instruments are recognised initially at fair value. In the normal course of business, the fair value of a financial instrument on initial recognition is normally the transaction price, i.e. the fair value of the consideration given or received. In certain circumstances, however, the fair value may be based on other observable current market transactions in the same instrument, without modification or repackaging, or on a valuation technique whose variables include only data from observable markets, such as interest rate yield curves, option volatilities and currency rates. When such evidence exists, the group recognises a trading gain or loss on inception of the financial instrument, being the difference between the transaction price and the fair value. When unobservable market data have a significant impact on the valuation of financial instruments, the entire initial difference in fair value indicated by the valuation model from the transaction price is not recognised immediately in the income statement but is recognised over the life of the transaction on an appropriate basis, or when the inputs become observable, or the transaction matures or is closed out, or when the group enters into an offsetting transaction. Subsequent to initial recognition, the fair values of financial instruments measured at fair value are measured in accordance with the group’s valuation methodologies, which are described in Note 51. i Sale and repurchase agreements (including stock lending and borrowing) When securities are sold subject to a commitment to repurchase them at a predetermined price (‘repos’), they remain on the balance sheet and a liability is recorded in respect of the consideration received. Securities purchased under commitments to re-sell (‘reverse repos’) are not recognised on the balance sheet and the consideration paid is recorded in ‘Loans and advances to customers’ or ‘Placings with banks’ as appropriate. The difference between the sale and repurchase price is treated as interest income and recognised over the life of the agreement. Securities lending and borrowing transactions are generally secured, with collateral taking the form of securities or cash advanced or received. The transfer of securities to counterparties under these agreements is not normally reflected on the balance sheet. Cash collateral advanced or received is recorded as an asset or a liability respectively. Securities borrowed are not recognised on the balance sheet. If they are sold on to third parties, an obligation to return the securities is recorded as a trading liability and measured at fair value, and any gains or losses are included in ‘Net trading income’.

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Summary of significant accounting policies (continued) j Derivative financial instruments and hedge accounting Derivatives are recognised initially, and are subsequently remeasured, at fair value. Fair values of exchange-traded derivatives are obtained from quoted market prices. Fair values of over-the-counter derivatives are obtained using valuation techniques, including discounted cash flow models and option pricing models. Derivatives may be embedded in other financial instruments, for example, a convertible bond with an embedded conversion option. Embedded derivatives are treated as separate derivatives when their economic characteristics and risks are not clearly and closely related to those of the host contract; the terms of the embedded derivative would meet the definition of a stand-alone derivative if they were contained in a separate contract; and the combined contract is not held for trading or designated at fair value. These embedded derivatives are measured at fair value with changes therein recognised in the income statement. Derivatives are classified as assets when their fair value is positive, or as liabilities when their fair value is negative. Derivative assets and liabilities arising from different transactions are only offset if the transactions are with the same counterparty, a legal right of offset exists, and the parties intend to settle the cash flows on a net basis. The method of recognising fair value gains and losses depends on whether derivatives are held for trading or are designated as hedging instruments, and if the latter, the nature of the risks being hedged. All gains and losses from changes in the fair value of derivatives held for trading are recognised in the income statement. When derivatives are designated as hedges, the group classifies them as either: (i) hedges of the change in fair value of recognised assets or liabilities or firm commitments (‘fair value hedges’); (ii) hedges of the variability in highly probable future cash flows attributable to a recognised asset or liability, or a forecast transaction (‘cash flow hedges’); or (iii) a hedge of a net investment in a foreign operation (‘net investment hedges’). Hedge accounting is applied to derivatives designated as hedging instruments in a fair value, cash flow or net investment hedge provided certain criteria are met. Hedge accounting At the inception of a hedging relationship, the group documents the relationship between the hedging instruments and the hedged items, its risk management objective and its strategy for undertaking the hedge. The group also requires a documented assessment, both at hedge inception and on an ongoing basis, of whether or not the hedging instruments, primarily derivatives, that are used in hedging transactions are highly effective in offsetting the changes attributable to the hedged risks in the fair values or cash flows of the hedged items. Interest on designated qualifying hedges is included in ‘Net interest income’. Fair value hedge Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the income statement, along with changes in the fair value of the hedged assets, liabilities or group thereof that are attributable to the hedged risk. If the hedging relationship no longer meets the criteria for hedge accounting, the cumulative adjustment to the carrying amount of the hedged item is amortised to the income statement based on a recalculated effective interest rate over the residual period to maturity, unless the hedged item has been derecognised, in which case it is released to the income statement immediately.

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Summary of significant accounting policies (continued) Cash flow hedge The effective portion of changes in the fair value of derivatives that are designated and qualify as cash flow hedges is recognised in other comprehensive income. Any gain or loss in fair value relating to an ineffective portion is recognised immediately in the income statement. The accumulated gains and losses recognised in other comprehensive income are recycled to the income statement in the periods in which the hedged item will affect profit or loss. However, when the forecast transaction that is hedged results in the recognition of a non-financial asset or a non-financial liability, the gains and losses previously recognised in other comprehensive income are removed from equity and included in the initial measurement of the cost of the asset or liability. When a hedging instrument expires or is sold, or when a hedge no longer meets the criteria for hedge accounting, any cumulative gain or loss existing in other comprehensive income at that time remains in equity until the forecast transaction is eventually recognised in the income statement. When a forecast transaction is no longer expected to occur, the cumulative gain or loss that was recognised in other comprehensive income is immediately reclassified to the income statement. Net investment hedge Hedges of net investments in foreign operations are accounted for in a similar way to cash flow hedges. A gain or loss on the effective portion of the hedging instrument is recognised in other comprehensive income; a gain or loss on the ineffective portion is recognised immediately in the income statement. Gains and losses previously recognised in other comprehensive income are reclassified to the income statement on the disposal of the foreign operation. Hedge effectiveness testing To qualify for hedge accounting, the group requires that at the inception of the hedge and throughout its life, each hedge must be expected to be highly effective (prospective effectiveness), and demonstrate actual effectiveness (retrospective effectiveness) on an ongoing basis. The documentation of each hedging relationship sets out how the effectiveness of the hedge is assessed. The method adopted by an entity to assess hedge effectiveness will depend on the risk management strategy. For prospective effectiveness, the hedging instrument must be expected to be highly effective in offsetting changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designated. For actual effectiveness, the changes in fair value or cash flows must offset each other in the range of 80% to 125%. Hedge ineffectiveness is recognised in the income statement in “Net trading income’. Derivatives that do not qualify for hedge accounting All gains and losses from changes in the fair values of derivatives that do not qualify for hedge accounting are recognised immediately in the income statement. These gains and losses are reported in ‘Net trading income’, except where derivatives are managed in conjunction with financial instruments designated at fair value (other than derivatives managed in conjunction with debt securities issued by the group), in which case gains and losses are reported in ‘Net income from financial instruments designated at fair value’. The interest on derivatives managed in conjunction with debt securities issued by the group which are designated at fair value is recognised in ‘Interest expense’. All other gains and losses on these derivatives are reported in ‘Net income from financial instruments designated at fair value’.

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Summary of significant accounting policies (continued) k Derecognition of financial assets and liabilities Financial assets are derecognised when the rights to receive cash flows from the assets have expired; or where the group has transferred its contractual rights to receive the cash flows of the financial assets and has transferred substantially all the risks and rewards of ownership; or where both control and substantially all the risks and rewards are not retained. Financial liabilities are derecognised when they are extinguished, i.e. when the obligation is discharged or cancelled or expires. l Offsetting financial assets and financial liabilities Financial assets and liabilities are offset and the net amount reported in the balance sheet when there is a legally enforceable right to offset the recognised amounts and the group intends to settle on a net basis, or realise the asset and settle the liability simultaneously. m Subsidiaries, associates and joint ventures The group classifies investments in entities which it controls as subsidiaries. Where the group is a party to a contractual arrangement whereby, together with one or more parties, it undertakes an economic activity that is subject to joint control, the group classifies its interest in the venture as a joint venture. The group classifies investments in entities over which it has significant influence, and that are neither subsidiaries nor joint ventures, as associates. For the purpose of determining this classification, control is considered to be the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. Investments in associates and interests in joint ventures are recognised using the equity method. Under this method, such investments are initially stated at cost, including attributable goodwill, and are adjusted thereafter for the postacquisition change in the group’s share of net assets. Profits on transactions between the group and its associates and joint ventures are eliminated to the extent of the group’s interest in the respective associates or joint ventures. Losses are also eliminated to the extent of the group’s interest in the associates or joint ventures unless the transaction provides evidence of an impairment of the asset transferred. The Bank’s investments in subsidiaries, associates and joint ventures are stated at cost less any impairment losses. An impairment loss recognised in prior periods shall be reversed through the income statement if, and only if, there has been a change in the estimates used to determine the recoverable amount of the investment since the last impairment loss was recognised. In order to determine whether an impairment test under HKAS 36 ‘Impairment of Assets’ is required in respect of an interest in an associate or a joint venture, it is necessary to consider the indicators in HKAS 39 ‘Financial Instruments: Recognition and Measurement’. Where the review of the indicators suggests that the interest in an associate or joint venture may be impaired, the impairment testing requirements of HKAS 36 are applied. The group’s policy for impairment testing on goodwill arising on acquisition of subsidiaries is included under note 3(n). In the case of an interest in an associate or joint venture, the entire carrying amount in the consolidated balance sheet is compared to its recoverable amount. If the recoverable amount is less than its carrying amount, an impairment loss is recognised in the group’s consolidated financial statements.

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Notes on the Financial Statements (continued)

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Summary of significant accounting policies (continued) n Goodwill and intangible assets (i) Goodwill arises on business combinations, including the acquisition of subsidiaries and interests in joint ventures or associates, when the cost of acquisition exceeds the fair value of the group’s share of the identifiable assets, liabilities and contingent liabilities acquired. If the group’s interest in the fair value of the identifiable assets, liabilities and contingent liabilities of an acquired business is greater than the cost of acquisition, the excess is recognised immediately in the income statement. Intangible assets are recognised separately from goodwill when they are separable or arise from contractual or other legal rights, and their fair value can be measured reliably. Goodwill is allocated to cash-generating units (‘CGUs’) for the purpose of impairment testing, which is undertaken at the lowest level at which goodwill is monitored for internal management purposes. Impairment testing is performed at least annually, and whenever there is an indication that the CGU may be impaired, by comparing the recoverable amount of a CGU with the carrying amount of its net assets, including attributable goodwill. The recoverable amount of an asset is the higher of its fair value less cost to sell, and its value in use. Value in use is the present value of the expected future cash flows from a CGU. If the recoverable amount of the CGU is less than the carrying value, an impairment loss is charged to the income statement. Any write-off in excess of the carrying value of goodwill is limited to the fair value of the individual assets and liabilities of the CGU. Goodwill is stated at cost less accumulated impairment losses, if any. Goodwill on acquisitions of interests in joint ventures and associates is included in ‘Interests in associates and joint ventures’ and is not tested separately for impairment. At the date of disposal of a business, attributable goodwill is included in the group’s share of net assets in the calculation of the gain or loss on disposal. Goodwill is included in a disposal group if the disposal group is a CGU to which goodwill has been allocated or it is an operation within such a CGU. The amount of goodwill included in a disposal group is measured on the basis of the relative values of the operation disposed of and the portion of the CGU retained. (ii) Intangible assets include the present value of in-force long-term insurance business, operating rights, computer software and, when acquired in a business combination, trade names, customer relationships and core deposit relationships. Intangible assets that have an indefinite useful life, or are not yet ready for use, are tested for impairment annually. Intangible assets that have a finite useful life, except for the present value of in-force long-term insurance business, are stated at cost less amortisation and accumulated impairment losses and are amortised over their estimated useful lives. Estimated useful life is the lower of legal duration and expected economic life. Intangible assets are subject to impairment review if there are events or changes in circumstances that indicate that the carrying amount may not be recoverable. The accounting policy on the present value of in-force long-term insurance business is set out in note 3(w).

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Summary of significant accounting policies (continued) o Property, plant and equipment (i) Land and buildings Land and buildings held for own use are carried at their revalued amount, being the fair value at the date of the revaluation less any subsequent accumulated depreciation and impairment losses. Revaluations are performed by professional qualified valuers, on a market basis, with sufficient regularity to ensure that the net carrying amount does not differ materially from the fair value. Surpluses arising on revaluation are credited firstly to the income statement, to the extent of any deficits arising on revaluation previously charged to the income statement in respect of the same land and buildings, and are thereafter taken to the ‘Property revaluation reserve’. Deficits arising on revaluation are first set off against any previous revaluation surpluses included in the ‘Property revaluation reserve’ in respect of the same land and buildings, and are thereafter recognised in the income statement. Buildings held for own use which are situated on leasehold land where it is possible reliably to separate the value of the building from the value of the leasehold land at inception of the lease are revalued by professional qualified valuers, on a depreciated replacement cost basis or surrender value, with sufficient regularity to ensure that the net carrying amount does not differ materially from the fair value. Depreciation on land and buildings is calculated to write off the assets over their estimated useful lives as follows:    freehold land is not depreciated; leasehold land is depreciated over the unexpired terms of the leases; and buildings and improvements thereto are depreciated at the greater of 2% per annum on the straight line basis or over the unexpired terms of the leases or over the remaining useful lives of the buildings.

(ii) Investment properties The group holds certain properties as investments to earn rentals, or for capital appreciation, or both. Investment properties are stated at fair value with changes in fair value being recognised in ‘Other operating income’. Fair values are determined by independent professional valuers, primarily on the basis of capitalisation of net incomes with due allowance for outgoings and reversionary income potential. Property interests which are held under operating leases to earn rentals, or for capital appreciation, or both, are classified and accounted for as investment properties on a property-by-property basis. Such property interests are accounted for as if they were held under finance leases (see note 3(p)). (iii) Leasehold land and land use rights The Government of Hong Kong owns all the land in Hong Kong and permits its use under leasehold arrangements. Similar arrangements exist in mainland China. At inception of the lease, where the cost of land is known or can be reliably determined and the term of the lease is less than 50 years, the group records its interests in leasehold land and land use rights as operating leases. Where the cost of land is known or can be reliably determined and the term of the lease is not less than 50 years, the group records its interest in leasehold land and land use rights as land and buildings held for own use. Where the cost of the land is unknown or cannot be reliably determined, and the leasehold land and land use rights are not clearly held under an operating lease, they are accounted for as land and buildings held for own use. (iv) Other plant and equipment Equipment, fixtures and fittings (including equipment on operating leases where the group is the lessor) are stated at cost less any impairment losses. Depreciation is calculated on a straight-line basis to write-off the assets over their useful lives, which are generally between 5 and 20 years. Property, plant and equipment is subject to review for impairment if there are events or changes in circumstances that indicate that the carrying amount may not be recoverable.

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Notes on the Financial Statements (continued)

3

Summary of significant accounting policies (continued) p Finance and operating leases (i) Assets leased to customers under agreements which transfer substantially all the risks and rewards associated with ownership, other than legal title, are classified as finance leases. Where the group is a lessor under finance leases the amounts due under the leases, after deduction of unearned charges, are included in ‘Loans and advances to customers’ as appropriate. Finance income receivable is recognised over the periods of the leases so as to give a constant rate of return on the net investment in the leases. (ii) Where the group is a lessee under finance leases, the leased assets are capitalised and included in ‘Property, plant and equipment’ and the corresponding liability to the lessor is included in ‘Other liabilities’. The finance lease and corresponding liability are recognised initially at the fair value of the asset or, if lower, the present value of the minimum lease payments. Finance charges payable are recognised over the periods of the leases based on the interest rates implicit in the leases so as to give a constant rate of interest on the remaining balance of the liability. (iii) All other leases are classified as operating leases. Where the group is the lessor, the assets subject to the operating leases are included in ‘Property, plant and equipment’ and accounted for accordingly. Impairment losses are recognised to the extent that the carrying value of equipment is impaired through residual values not being fully recoverable. Where the group is the lessee, the leased assets are not recognised on the balance sheet. (iv) Rentals payable and receivable under operating leases are accounted for on a straight-line basis over the period of the leases and are included in ‘General and administrative expenses’ and ‘Other operating income’ respectively. (v) Leasehold land is included under ‘Other assets’ in the balance sheet if such land is considered to be held under operating leases and is stated at cost less amortisation and impairment losses. Amortisation is calculated to write off the cost of the land on a straight-line basis over the terms of the leases. q Income tax (i) Income tax for the year comprises current and deferred tax. Income tax is recognised in the income statement except to the extent that it relates to items recognised directly in the statement of comprehensive income, in which case it is recognised in the statement of comprehensive income. (ii) Current tax is the expected tax payable on the taxable income for the year, calculated using tax rates enacted or substantively enacted at the period end date, and any adjustment to tax payable in respect of previous years. The group provides for potential current tax liabilities that may arise on the basis of the amounts expected to be paid to the tax authorities. Current tax assets and liabilities are offset when the group intends to settle on a net basis and the legal right to offset exists. (iii) Deferred tax is recognised on temporary differences between the carrying amount of assets and liabilities in the balance sheet and the amount attributed to such assets and liabilities for tax purposes. Deferred tax liabilities are generally recognised for all taxable temporary differences and deferred tax assets are recognised to the extent it is probable that future taxable profits will be available against which deductible temporary differences can be used. Deferred tax is calculated using the tax rates that have been enacted or substantively enacted at the period end date and are expected to apply in the periods in which the assets will be realised or the liabilities settled. Deferred tax assets and liabilities are offset when they arise in the same tax reporting group, relate to income taxes levied by the same taxation authority, and a legal right to offset exists in the entity. Deferred tax relating to actuarial gains and losses arising from post-employment benefit plans which are recognised in the statement of comprehensive income is also credited or charged to the statement of comprehensive income. Deferred tax relating to share-based payment transactions is recognised directly in equity to the extent that the amount of the estimated future tax deduction exceeds the amount of the related cumulative remuneration expense. Deferred tax relating to changes in the fair value of available-for-sale investments and cash flow hedges, which are charged or credited directly to the statement of comprehensive income, is also credited or charged directly to the statement of comprehensive income and is recognised in the income statement when the fair value gain or loss is recognised in the income statement.

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Summary of significant accounting policies (continued) r Pension and other post-retirement benefits The group operates a number of pension plans which include both defined benefit and defined contribution plans. Payments to defined contribution plans and state-managed retirement benefit plans, where the group’s obligations under the plans are equivalent to a defined contribution plan, are charged as an expense as they fall due. The costs recognised for funding defined benefit plans are determined using the projected unit credit method, with annual actuarial valuations performed on each plan. Actuarial differences that arise are recognised in shareholders’ equity and presented in the statement of comprehensive income in the period they arise. Past service costs are recognised immediately to the extent the benefits are vested, and are otherwise recognised on a straight-line basis over the average period until the benefits are vested. The current service costs and any past service costs together with the expected return on plan assets less the unwinding of the discount on the plan liabilities are charged to ‘Employee compensation and benefits’. The net defined benefit asset or liability recognised in the balance sheet represents the difference between the fair value of plan assets and the present value of the defined benefit obligations adjusted for unrecognised past service costs. In the case of a defined benefit asset, it is limited to unrecognised past service costs plus the present value of available refunds and reductions in future contributions to the plan. s Share-based payments The cost of share-based payment arrangements with employees is measured by reference to the fair value of equity instruments on the date they are granted, and is recognised as an expense on a straight-line basis over the vesting period, with a corresponding credit to ‘Other reserves’. The fair value of equity instruments that are made available immediately, with no vesting period attached to the award, are expensed immediately. Fair value is determined by using market prices or appropriate valuation models, taking into account the terms and conditions upon which the equity instruments were granted. Market performance conditions are taken into account when estimating the fair value of equity instruments at the date of grant, so that an award is treated as vesting irrespective of whether the market performance condition is satisfied, provided all other conditions are satisfied. Vesting conditions, other than market performance conditions, are not taken into account in the initial estimate of the fair value at the grant date. They are taken into account by adjusting the number of equity instruments included in the measurement of the transaction, so that the amount recognised for services received as consideration for the equity instruments granted shall be based on the number of equity instruments that eventually vest. On a cumulative basis, no expense is recognised for equity instruments that do not vest because of a failure to satisfy non-market performance or service conditions. Where an award has been modified, as a minimum, the expense of the original award continues to be recognised as if it had not been modified. Where the effect of a modification is to increase the fair value of an award or increase the number of equity instruments, the incremental fair value of the award or incremental fair value of the extra equity instruments is recognised in addition to the expense of the original grant, measured at the date of modification, over the modified vesting period. A cancellation that occurs during the vesting period is treated as an acceleration of vesting and recognised immediately for the amount that would otherwise have been recognised for services over the remaining vesting period.

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Notes on the Financial Statements (continued)

3

Summary of significant accounting policies (continued) t Foreign currencies Items included in each of the group’s entities are measured using the currency of the primary economic environment in which the entity operates (the ‘functional currency’). The group’s financial statements are presented in Hong Kong dollars which is the Bank’s functional currency. Transactions in foreign currencies are recorded in the functional currency at the rate of exchange prevailing on the date of the transaction. Monetary assets and liabilities denominated in foreign currencies are translated into the functional currency at the rate of exchange ruling at the balance sheet date. Any resulting exchange differences are included in the income statement. Non-monetary assets and liabilities that are measured in terms of historical cost in a foreign currency are translated into the functional currency using the rate of exchange at the date of the initial transaction. Non-monetary assets and liabilities measured at fair value in a foreign currency are translated into the functional currency using the rate of exchange at the date the fair value was determined. The results of branches, subsidiaries and associates not reporting in Hong Kong dollars are translated into Hong Kong dollars at the average rates of exchange for the reporting period. Exchange differences arising from the retranslation of opening foreign currency net investments and exchange differences arising from retranslation of the result for the reporting period from the average rate to the exchange rate prevailing at the period-end are accounted for in a separate foreign exchange reserve in the consolidated financial statements. Exchange differences on a monetary item that is part of a net investment in a foreign operation are recognised in the income statement of the separate subsidiary’s financial statements. In the consolidated financial statements, these exchange differences are recognised in the foreign exchange reserve in shareholders’ equity. On disposal of a foreign operation, exchange differences relating thereto previously recognised in reserves are recognised in the income statement. u Provisions Provisions for liabilities and charges are recognised when it is probable that an outflow of economic benefits will be required to settle a present legal or constructive obligation arising from past events and a reliable estimate can be made of the amount of the obligation. Contingent liabilities, which include certain guarantees and letters of credit pledged as collateral security, are possible obligations that arise from past events whose existence will be confirmed only by the occurrence, or nonoccurrence, of one or more uncertain future events not wholly within the control of the group; or are present obligations that have arisen from past events but are not recognised because it is not probable that settlement will require the outflow of economic benefits, or because the amount of the obligations cannot be reliably measured. Contingent liabilities are not recognised in the financial statements but are disclosed unless the probability of settlement is remote. v Financial guarantee contracts Liabilities under financial guarantee contracts which are not classified as insurance contracts are recorded initially at their fair value, which is generally the fee received or receivable. Subsequently, financial guarantee liabilities are measured at the higher of the initial fair value, less cumulative amortisation, and the best estimate of the expenditure required to settle the obligations. w Insurance contracts Through its insurance subsidiaries, the group issues contracts to customers that contain insurance risk, financial risk or a combination thereof. A contract under which the group accepts significant insurance risk from another party, by agreeing to compensate that party on the occurrence of a specified uncertain future event, is classified as an insurance contract. An insurance contract may also transfer financial risk, but is accounted for as an insurance contract if the insurance risk is significant. Insurance contracts are accounted for as follows:

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Summary of significant accounting policies (continued) Premiums Premiums for life insurance contracts are accounted for when receivable, except in unit-linked insurance contracts where premiums are accounted for when liabilities are established. Gross insurance premiums for non-life insurance business are reported as income over the term of the insurance contracts based on the proportion of risks borne during the accounting period. The unearned premium (the proportion of the business underwritten in the accounting year relating to the period of risk after the balance sheet date) is calculated on a daily or monthly pro rata basis. Reinsurance premiums are accounted for in the same accounting period as the premiums for the direct insurance contracts to which they relate. Present value of in-force long-term insurance business The value placed on insurance contracts that are classified as long-term insurance business or long-term investment contracts with discretionary participating features (‘DPF’) and are in force at the balance sheet date is recognised as an asset. The asset represents the present value of the equity holders’ interest in the profits expected to emerge from those contracts written at the balance sheet date. The present value of in-force long-term insurance business and long-term investment contracts with DPF, referred to as ‘PVIF’, is determined by discounting the equity holders’ interest in future profits expected to emerge from business currently in force using appropriate assumptions in assessing factors such as future mortality, lapse rates and levels of expenses and a risk discount rate that reflects the risk premium attributable to the respective contracts. The PVIF incorporates allowances for both non-market risk and the value of financial options and guarantees. The PVIF asset is presented gross of attributable tax in the balance sheet and movements in the PVIF asset are included in ‘Other operating income’ on a gross of tax basis. Claims and reinsurance recoveries Gross insurance claims for life insurance contracts reflect the total cost of claims arising during the year, including claim handling costs and any policyholder bonuses allocated in anticipation of a bonus declaration. Claims arising during the year include maturities, surrenders and death claims. Maturity claims are recognised when due for payment. Surrenders are recognised when paid or at an earlier date on which, following notification, the policy ceases to be included within the calculation of the related insurance liabilities. Death claims are recognised when notified. Gross insurance claims for non-life insurance contracts include paid claims and movements in outstanding claims liabilities. Reinsurance recoveries are accounted for in the same period as the related claim. Liabilities under insurance contracts Liabilities under non-linked life insurance contracts are calculated by each life insurance operation based on local actuarial principles. Some insurance contracts may contain discretionary participation features whereby the policyholder is entitled to additional payments whose amount and/or timing is at the discretion of the issuer. The discretionary element of these contracts is included in ‘Liabilities under insurance contracts issued’. Liabilities under unit-linked life insurance contracts are at least equivalent to the surrender or transfer value which is calculated by reference to the value of the relevant underlying funds or indices. Outstanding claims liabilities for non-life insurance contracts are based on the estimated ultimate cost of all claims incurred but not settled at the balance sheet date, whether reported or not, together with related claim-handling costs and a reduction for the expected value of salvage and other recoveries. Liabilities for claims incurred but not reported are made on an estimated basis, using appropriate statistical techniques. A liability adequacy test is carried out on insurance liabilities to ensure that the carrying amount of the liabilities is sufficient in the light of current estimates of future cash flows. When performing the liability adequacy test, all contractual cash flows are discounted and compared with the carrying value of the liability. When a shortfall is identified it is charged immediately to the income statement.

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Notes on the Financial Statements (continued)

3

Summary of significant accounting policies (continued) x Investment contracts Customer liabilities under linked and certain non-linked investment contracts without discretionary participation features and the corresponding financial assets are designated at fair value. Movements in fair value are recognised in ‘Net income from financial instruments designated at fair value’. Deposits receivable and amounts withdrawn are accounted for as increases or decreases in the liability recorded in respect of investment contracts. Liabilities under linked investment contracts are at least equivalent to the surrender or transfer value which is calculated by reference to the value of the relevant underlying funds or indices. Investment management fees receivable are recognised in the income statement over the period of the provision of the investment management services, in ‘Net fee income’. y Dividends Dividends proposed, or declared after the balance sheet date, are disclosed as a separate component of shareholders’ equity. z Debt securities in issue and subordinated liabilities Debt securities issued for trading purposes or designated at fair value are reported under the appropriate balance sheet captions. Other debt securities in issue and subordinated liabilities are measured at amortised cost using the effective interest method and are reported under ‘Debt securities in issue’ or ‘Subordinated liabilities’. aa Cash and cash equivalents For the purpose of the cash flow statement, cash and cash equivalents include highly liquid investments that are readily convertible to known amounts of cash and which are subject to an insignificant risk of change in value. Such investments comprise cash and balances with banks maturing within one month, and treasury bills and certificates of deposit with less than three months’ maturity from the date of acquisition. ab Share capital Shares are classified as equity when the group has the unconditional right to avoid transferring cash or other financial assets to the holder. ac Assets held for sale Non-current assets held for sale and disposal groups (including both assets and liabilities of the disposal groups) are classified as held for sale when their carrying amounts will be recovered principally through sale, they are available for sale in their present condition and their sale is highly probable. Non-current assets held for sale and disposal groups are measured at the lower of their carrying amount and fair value less costs to sell, except for deferred tax assets, financial assets, investment properties, insurance contracts and assets arising from employee benefits, which are measured in accordance with the accounting policies described above. Immediately before the initial classification as held for sale, the carrying amounts of the asset (or assets and liabilities in the disposal group) are measured in accordance with applicable HKFRSs. On subsequent remeasurement of a disposal group, the carrying amounts of the assets and liabilities that are not within the scope of the measurement requirements of HKFRS 5 ‘Non-current Assets Held for Sale and Discontinued Operations’ are measured in accordance with applicable HKFRSs before the fair value less costs to sell of the disposal group is determined. Income earned and expenses incurred on assets and liabilities of disposal groups held for sale continue to be recognised in the appropriate line items in the income statement until the transaction is complete.

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4

Operating profit The operating profit for the year is stated after taking account of: a Interest Income
2012 HK$m Interest income on listed securities ................................................................................................ Interest income on unlisted securities ............................................................................................ Other interest income ..................................................................................................................... Less: interest income classified as ‘Net trading income’ (note 4(d)) ............................................ Less: interest income classified as ‘Net income from financial instruments designated at fair value’(note 4(e)) ....................................................................................... 7,708 19,458 97,465 124,631 (9,064) (56) 115,511 2011 HK$m 8,004 17,989 89,699 115,692 (8,183) (51) 107,458

Included in the above is interest income accrued on impaired financial assets of HK$174m (2011: HK$308m), including the unwinding of discounts on loan impairment losses of HK$152m (2011: HK$294m). b Interest expense
2012 HK$m Interest expense on subordinated liabilities, other debt securities in issue, customer accounts and deposits by banks maturing after five years ......................................... Interest expense on preference shares ............................................................................................ Other interest expense .................................................................................................................... Less: interest expense classified as ‘Net trading income’ (note 4(d)) ........................................... Less: interest expense classified as ‘Net income from financial instruments designated at fair value’ (note 4(e)) ...................................................................................... 726 2,386 34,547 37,659 (4,544) (23) 33,092 2011 HK$m 831 2,337 32,867 36,035 (4,225) (24) 31,786

c

Net fee income
2012 HK$m Net fee income includes the following: Net fee income, other than amounts included in determining the effective interest rate, arising from financial assets or financial liabilities that are not held for trading or designated at fair value – fee income .............................................................................................................................. – fee expense ............................................................................................................................. 2011 HK$m

15,315 (1,542) 13,773

15,081 (1,415) 13,666

Net fee income on trust and other fiduciary activities where the group holds or invests assets on behalf of its customers – fee income .............................................................................................................................. – fee expense .............................................................................................................................

8,287 (1,069) 7,218

8,862 (1,213) 7,649

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Notes on the Financial Statements (continued)

4

Operating profit (continued) d Net trading income
2012 HK$m Dealing profits ................................................................................................................................ – Foreign exchange ........................................................................................................................ – Interest rate derivatives .............................................................................................................. – Debt securities ............................................................................................................................ – Equities and other trading ........................................................................................................... Loss from hedging activities .......................................................................................................... Fair value hedges – Net gain on hedged items attributable to the hedged risk ...................................................... – Net loss on hedging instruments ............................................................................................ – Other ....................................................................................................................................... Interest on trading assets and liabilities ......................................................................................... – Interest income (note 4(a)) ......................................................................................................... – Interest expense (note 4(b)) ........................................................................................................ Dividend income from trading securities ....................................................................................... – Listed investments ...................................................................................................................... – Unlisted investments .................................................................................................................. Ping An contingent forward sale contract (note 28) ....................................................................... 16,633 14,002 2,145 2,322 (1,836) (31) 345 (376) – 4,520 9,064 (4,544) 786 653 133 (2,694) 19,214 2011 HK$m 15,590 15,313 400 1,300 (1,423) (71) 1,050 (1,147) 26 3,958 8,183 (4,225) 722 608 114 – 20,199

e

Net income/(expense) from financial instruments designated at fair value
2012 HK$m Income/(expense) on assets designated at fair value which back insurance and investment contracts ........................................................................................... Change in fair value of liabilities to customers under investment contracts ................................. 2011 HK$m

6,670 (2,209) 4,461

(4,542) 30 (4,512) (38)

Net change in fair value of other financial assets/liabilities designated at fair value1 .................. Interest on financial assets and liabilities designated at fair value – Interest income (note 4(a)) ......................................................................................................... – Interest expense (note 4(b)) ........................................................................................................

119

56 (23) 4,613

51 (24) (4,523)

1 Gains and losses from changes in the fair value of the group’s issued debt securities include those arising from changes in the group’s own credit risk. In 2012 the group recognised a HK$22m loss on changes in the fair value of these instruments arising from changes in own credit risk (2011:HK$15m gain).

f

Gains less losses from financial investments
2012 HK$m Gains on disposal of available-for-sale securities .......................................................................... Impairment of available-for-sale equity investments ..................................................................... 2,809 (175) 2,634 2011 HK$m 470 (342) 128

There are no gains or losses on the disposal of held-to-maturity investments in the year (2011: nil).

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Operating profit (continued) g Dividend income
2012 HK$m Listed investments .......................................................................................................................... Unlisted investments ...................................................................................................................... 325 197 522 2011 HK$m 431 298 729

h Other operating income
2012 HK$m Rental income from investment properties .................................................................................... Movement in present value of in-force insurance business ........................................................... Gains on investment properties ...................................................................................................... Gain/(loss) on disposal of property, plant and equipment, and assets held for sale ...................... Gain/(loss) on disposal of subsidiaries, associates and business portfolios .................................. Surplus arising on property revaluation ......................................................................................... Other ............................................................................................................................................... 216 4,432 834 30 5,246 2 4,577 15,337 2011 HK$m 191 5,524 1,033 (3) (9) 8 4,645 11,389

Other largely comprises recoveries of IT and other operating costs from shared services activities incurred on behalf of fellow Group companies. Other also includes recoveries against initial fair value on acquired loan portfolios of HK$650m (2011: HK$558m). There are no gains or losses on the disposal of financial liabilities measured at amortised cost during the year (2011: nil). i Loan impairment charges and other credit risk provisions
2012 HK$m Net charge for impairment of loans and advances to customers – Individually assessed impairment allowances: New allowances .......................................................................................................................... Releases ...................................................................................................................................... Recoveries .................................................................................................................................. 2011 HK$m

2,201 (1,230) (237) 734

2,254 (1,204) (356) 694 2,401 (36) 3,059

– Net charge for collectively assessed impairment allowances .................................................... Net charge/(release) for other credit risk provisions ...................................................................... Net charge for loan impairment and other credit risk provisions ..................................................

2,596 248 3,578

Included in the net charge for other credit risk provisions is an impairment release of HK$82m against availablefor-sale debt securities (2011: impairment release of HK$4m). There are no impairment losses or provisions relating to held-to-maturity investments (2011: nil).

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Notes on the Financial Statements (continued)

4

Operating profit (continued) j General and administrative expenses
2012 HK$m Premises and equipment – Rental expenses .......................................................................................................................... – Amortisation of prepaid operating lease payments .................................................................... – Other premises and equipment expenses .................................................................................... 2011 HK$m

3,292 18 3,941 7,251

3,102 18 3,810 6,930 3,969 13,453 24,352

Marketing and advertising expenses .............................................................................................. Other administrative expenses ........................................................................................................

3,578 15,182 26,011

Included in operating expenses are direct operating expenses of HK$23m (2011: HK$19m) arising from investment properties that generated rental income during the year. Direct operating expenses arising from investment properties that did not generate rental income amounted to HK$1m (2011: HK$2m). Included in operating expenses are minimum lease payments under operating leases of HK$3,361m (2011: HK$3,170m). k Auditors’ remuneration Auditors’ remuneration amounted to HK$77m (2011: HK$77m), of which HK$29m (2011: HK$29m) related to the Bank. 5 Insurance income Included in the consolidated income statement are the following revenues earned by the insurance business: a Insurance income
2012 HK$m Net interest income ......................................................................................................................... Net fee income ................................................................................................................................ Net trading income/(loss) ............................................................................................................... Net income/(expense) from financial instruments designated at fair value .................................. Net earned insurance premiums (note 5(b)) .................................................................................... Movement in present value of in-force business ........................................................................... Other operating income .................................................................................................................. 7,864 1,216 56 4,538 52,621 4,432 1,308 72,035 Net insurance claims incurred and movement in liabilities to policyholders (note 5(c)) .............. Net operating income ..................................................................................................................... (54,983) 17,052 2011 HK$m 6,779 692 (386) (4,460) 45,670 5,524 237 54,056 (40,389) 13,667

66

5 Insurance income b Net earned insurance premiums
Investment contracts with discretionary participation features HK$m – – – – – – –

Non-life insurance HK$m 2012 Gross written premiums ...................... Movement in unearned premiums ....... Gross earned premiums ....................... Gross written premiums ceded to reinsurers ..................................... Reinsurers’ share of movement in unearned premiums ..................... Reinsurers’ share of gross earned premiums ............................. Net earned premiums ............................ 2011 Gross written premiums ...................... Movement in unearned premiums ....... Gross earned premiums ....................... Gross written premiums ceded to reinsurers ..................................... Reinsurers’ share of movement in unearned premiums ..................... Reinsurers’ share of gross earned premiums ............................. Net earned premiums ............................ 2,935 (385) 2,550 (365) 24 (341) 2,209

Life insurance (non-linked) HK$m 41,405 – 41,405 (1,587) – (1,587) 39,818

Life insurance (linked) HK$m 10,605 – 10,605 (11) – (11) 10,594

Total HK$m 54,945 (385) 54,560 (1,963) 24 (1,939) 52,621

3,318 (183) 3,135 (455) (1) (456) 2,679

36,000 – 36,000 (311) – (311) 35,689

7,312 – 7,312 (10) – (10) 7,302

– – – – – – –

46,630 (183) 46,447 (776) (1) (777) 45,670

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Notes on the Financial Statements (continued)

5 Insurance income (continued) c Net insurance claims incurred and movement in liabilities to policyholders
Investment contracts with discretionary participation features HK$m 62 (61) 1 – –

Non-life insurance HK$m 2012 Claims, benefits and surrenders paid ... Movement in provision ........................ Gross claims incurred and movement in liabilities to policyholders ........... Reinsurers’ share of claims, benefits and surrenders paid .......................... Reinsurers’ share of movement in provision ...................................... Reinsurers’ share of claims incurred and movement in liabilities to policyholders .................................... Net insurance claims incurred and movement in liabilities to policyholders ................................... 2011 Claims, benefits and surrenders paid ... Movement in provision ........................ Gross claims incurred and movement in liabilities to policyholders ........... Reinsurers’ share of claims, benefits and surrenders paid .......................... Reinsurers’ share of movement in provision ...................................... Reinsurers’ share of claims incurred and movement in liabilities to policyholders ................................... Net insurance claims incurred and movement in liabilities to policyholders ................................... 1,135 71 1,206 (98) (1)

Life insurance (non-linked) HK$m 6,931 35,445 42,376 (143) (1,172)

Life insurance (linked) HK$m 7,286 3,686 10,972 (5,233) 7,075

Total HK$m 15,414 39,141 54,555 (5,474) 5,902

(99)

(1,315)

1,842

–

428

1,107

41,061

12,814

1

54,983

1,420 (33) 1,387 (147) (14)

6,399 30,598 36,997 (178) (5)

1,958 1,192 3,150 (385) (417)

85 (84) 1 – –

9,862 31,673 41,535 (710) (436)

(161)

(183)

(802)

–

(1,146)

1,226

36,814

2,348

1

40,389

68

6

Employee compensation and benefits a Employee compensation and benefits
2012 HK$m Wages and salaries .......................................................................................................................... Social security costs ........................................................................................................................ Retirement benefit costs – Defined contribution plans ......................................................................................................... – Defined benefit plans (note 6(c)(v)) ............................................................................................ 34,233 935 1,063 790 37,021 2011 HK$m 35,020 912 1,043 859 37,834

b Directors’ emoluments The aggregate emoluments of the Directors of the Bank, calculated in accordance with section 161 of the Hong Kong Companies Ordinance, were HK$74m (2011: HK$71m). This comprises fees of HK$8m (2011: HK$6m) and other emoluments of HK$66m (2011: HK$66m) which includes pension benefits of HK$1m (2011: HK$1m). c Retirement benefit pension plans The group operates 85 (2011: 80) retirement benefit plans, with a total cost of HK$1,853m (2011: HK$1,902m), of which HK$658m (2011: HK$587m) relates to overseas plans and HK$19m (2011: HK$30m) to a plan sponsored by HSBC Asia Holdings BV. Progressively the HSBC Group has been moving to defined contribution plans for all new employees. The group’s defined benefit plans, which cover 26% (2011: 35%) of employees, are predominantly funded plans with assets which, in the case of the larger plans, are held either under insurance policies or in trust funds separate from the group. The cost relating to the funded plans was HK$722m (2011: HK$804m) which was assessed in accordance with the advice of qualified actuaries; the plans are reviewed at least on a triennial basis or in accordance with local practice and regulations. The actuarial assumptions used to calculate the projected benefit obligations of the group’s retirement benefit plans vary according to the economic conditions of the countries in which they are situated. (i) Defined benefit plan principal actuarial assumptions The principal actuarial assumptions used to calculate the assets and liabilities of the major defined benefit pension plans were:
2012 % p.a. Discount rate ............................................................................................................................. Expected rates of return on plan assets1 – equities .................................................................................................................................. – bonds .................................................................................................................................... – other ...................................................................................................................................... Rate of pay increase – long term .............................................................................................................................. Mortality table .......................................................................................................................... 0.60 8.4 2.8 4.5 4.0 HKLT20112 2011 % p.a. 1.47 7.5 3.9 3.9 5.0 HKLT20013

1 The expected rates of return in 2011 were used to measure the expected return on plan assets in the subsequent year, i.e. 2012. The rates under 2012, however, are for reference only as starting from 2013, the interest cost and the expected return on plan assets will be replaced by the net interest component on the net defined benefit liability or asset under HKAS 19 (revised) ‘Employee Benefits’. Details are included under note 1c ‘Future Accounting Developments’. The expected rates of return as shown above are weighted on the basis of the fair value of the plan assets. 2 HKLT2011 – Hong Kong Life Tables 2011. 3 HKLT2001 – Hong Kong Life Tables 2001.

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Notes on the Financial Statements (continued)

6

Employee compensation and benefits (continued) The overall expected long-term rate of return on assets as at 31 December 2012 was 4.6% (2011: 4.7%). The expected long-term rate of return is based on the portfolio as a whole and not on the sum of the returns on individual asset categories. The return is based on historical market returns adjusted for additional factors such as the current rate of inflation and interest rates. In Hong Kong, the HSBC Group Hong Kong Local Staff Retirement Benefit Scheme covers employees of the Bank and certain other local employees of HSBC Group. The scheme comprises a funded defined benefit scheme (which provides a lump sum on retirement but is now closed to new members) and a defined contribution scheme. The latter was established on 1 January 1999 for new employees. The latest valuation of the defined benefit scheme was made at 31 December 2010 and was performed by Wing Lui, Fellow of the Society of Actuaries of the United States of America, of Towers Watson Hong Kong Limited, an external consultant. At that valuation date, the market value of the defined benefit scheme’s assets was HK$8,611m. On an ongoing basis, the actuarial value of the scheme’s assets represented 104% of the actuarial present value of the benefits accrued to members, after allowing for expected future increases in salaries, and the resulting surplus amounted to HK$319m. On a wind-up basis, the scheme’s assets represents 110% of the members’ vested benefits, based on current salaries, and the resulting surplus amounted to HK$808m. The attained age method has been adopted for the valuation and the major assumptions used in this valuation were a discount rate of 6% per annum and long-term salary increases of 5% per annum. (ii) Value recognised in the balance sheet
The group 2012 HK$m Equities ...................................................... Bonds ......................................................... Other .......................................................... Fair value of plan assets ............................ Present value of funded obligations .......... Present value of unfunded obligations ...... Defined benefit obligations ....................... Past service (credit)/ cost not recognised .. Effect of limit on plan surpluses ............... Net defined benefit liability ....................... Reported as ‘Assets’ .................................. Reported as ‘Liabilities’ ............................ Net defined benefit liability ....................... 3,977 9,050 1,549 14,576 20,835 402 21,237 (2) 1 (6,664) 61 (6,725) (6,664) 2011 HK$m 3,162 9,357 1,594 14,113 21,699 402 22,101 3 1 (7,986) 111 (8,097) (7,986) The Bank 2012 HK$m 2,176 6,106 1,047 9,329 12,772 243 13,015 – 1 (3,687) 23 (3,710) (3,687) 2011 HK$m 1,483 6,600 1,269 9,352 13,186 247 13,433 5 1 (4,077) 73 (4,150) (4,077)

(iii) Changes in the present value of the defined benefit obligations
The group 2012 HK$m At 1 January ............................................... Current service cost ................................... Interest cost ................................................ Contributions by employees ...................... Actuarial (gains)/losses ............................. Benefits paid .............................................. Past service cost – vested immediately ..... Liabilities extinguished on settlements ...... Exchange and other movements ................ At 31 December ......................................... 22,101 1,126 398 2 (385) (1,694) 1 (186) (126) 21,237 2011 HK$m 19,308 1,024 591 2 2,641 (1,203) 28 (195) (95) 22,101 The Bank 2012 HK$m 13,433 706 265 – (92) (1,167) – – (130) 13,015 2011 HK$m 12,156 658 390 – 1,263 (848) 27 (128) (85) 13,433

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6

Employee compensation and benefits (continued) (iv) Changes in the fair value of plan assets
The group 2012 HK$m At 1 January ............................................... Expected return .......................................... Contributions by the group/the Bank ........ Contributions by employees ...................... Actuarial gains/(losses) .............................. Benefits paid .............................................. Assets distributed on settlement ................ Exchange and other movements ................ At 31 December ......................................... 14,113 674 876 2 694 (1,541) (113) (129) 14,576 2011 HK$m 14,887 754 718 2 (880) (1,140) (153) (75) 14,113 The Bank 2012 HK$m 9,352 460 394 – 323 (1,065) – (135) 9,329 2011 HK$m 9,859 510 436 – (471) (808) (101) (73) 9,352

The plan assets above included assets issued by entities within HSBC Group:
The group 2012 HK$m Equities ...................................................... Others ......................................................... 155 65 220 2011 HK$m 341 179 520 The Bank 2012 HK$m 80 14 94 2011 HK$m 284 132 416

The group’s actual gain on plan assets for the year ended 31 December 2012 was HK$1,369m (2011: HK$157m loss). The Bank’s actual gain on plan assets for the year ended 31 December 2012 was HK$783m (2011: HK$8m). The group expects to make HK$669m of contributions to defined benefit pension plans during 2013. Contributions to be made by the Bank are expected to be HK$378m. (v) Total expense recognised in the income statement in ‘Defined benefit plans’
2012 HK$m Current service cost .................................................................................................................. Interest cost ............................................................................................................................... Expected return on plan assets ................................................................................................. Past service costs ...................................................................................................................... Gains on settlements/curtailments ............................................................................................. Total net expense ...................................................................................................................... 1,126 398 (674) 5 (65) 790 2011 HK$m 1,024 591 (754) 37 (39) 859

The total net actuarial gains recognised in total equity during 2012 in respect of defined benefit pension plans was HK$1,079m (2011: HK$3,518m loss). After deduction of non-controlling interests, a gain of HK$850m (2011: HK$2,912m loss) was recognised in total shareholders’ equity. Total net actuarial losses recognised outside of the income statement to date are HK$9,219m (2011: HK$10,298m). After deduction of noncontrolling interests, the total net actuarial losses recognised in total shareholders’ equity to date are HK$7,979m (2011: HK$8,829m). The total net actuarial gain recognised in the Bank’s retained profits during 2012 in respect of defined benefit pension plans was HK$415m (2011: HK$1,727m loss). Total net actuarial losses recognised outside of the income statement to date are HK$5,573m (2011: HK$5,988m). The total effect of the limit on plan surpluses recognised within actuarial losses in equity for both the group and the Bank during 2012 was nil (2011: nil).

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Notes on the Financial Statements (continued)

6

Employee compensation and benefits (continued) (vi) Amounts for the current and previous years
2012 HK$m Defined benefit obligations ................ Plan assets ..................... Net deficit ..................... Experience gains/(losses) on plan liabilities ...... Experience gains/(losses) on plan assets ............ 21,237 14,576 (6,661) 374 694 2011 HK$m 22,101 14,113 (7,988) (344) (911) The group 2010 2009 HK$m HK$m 19,308 14,887 (4,421) (214) 2 17,948 14,318 (3,630) 408 368 2008 HK$m 20,954 13,588 (7,366) (132) (3,591) 2012 HK$m 13,015 9,329 (3,686) 154 323 2011 HK$m 13,433 9,353 (4,080) (230) (502) The Bank 2010 2009 HK$m HK$m 12,156 9,859 (2,297) (175) (59) 11,437 9,627 (1,810) 60 (47) 2008 HK$m 12,841 9,379 (3,462) (363) (1,400)

7 Tax expense a The Bank and its subsidiaries in Hong Kong have provided for Hong Kong profits tax at the rate of 16.5% (2011: 16.5%) on the profits for the year assessable in Hong Kong. Overseas branches and subsidiaries have similarly provided for tax in the countries in which they operate at the appropriate rates of tax ruling in 2012. Deferred taxation is provided for in accordance with the group’s accounting policy in note 3(q). The charge for taxation in the income statement comprises:
2012 HK$m Current income tax – Hong Kong profits tax – on current year profit ......................................................................... – Hong Kong profits tax – adjustments in respect of prior years ................................................. – Overseas taxation – on current year profit ................................................................................. – Overseas taxation – adjustments in respect of prior years ......................................................... Deferred tax – Origination and reversal of temporary differences .................................................................... – Effect of changes in tax rates ..................................................................................................... – Adjustments in respect of prior years ........................................................................................ 2011 HK$m

7,810 (20) 10,631 (203) 18,218 35 65 (308) (208) 18,010

6,395 145 9,593 (219) 15,914 1,494 8 50 1,552 17,466

72

7 Tax expense (continued) b The components of deferred tax assets and liabilities recognised in the balance sheet and the movements during the year are as follows: (i) Deferred tax assets The group
Accelerated capital allowances and short term timing differences HK$m 2012 At 1 January .................. Exchange and other adjustments ............... Credit to income statement ................... Credit/(charge) to reserves ..................... At 31 December ............ 2011 At 1 January .................. Exchange and other adjustments ............... Credit/(charge) to income statement ...... Credit to reserves .......... At 31 December ............ 1,154 415 98 – 1,667

Leasing transactions HK$m – – – – –

Impairment allowances on financial assets HK$m 782 (404) 516 – 894

Revaluation of properties HK$m (740) (65) 4 1 (800)

Other HK$m 1,129 (225) 197 (233) 868

Total HK$m 2,325 (279) 815 (232) 2,629

1,669 (611) 96 – 1,154

– – – – –

896 98 (212) – 782

(852) 102 (1) 11 (740)

802 170 134 23 1,129

2,515 (241) 17 34 2,325

The Bank
Accelerated capital allowances and short term timing differences HK$m 2012 At 1 January .................. Exchange and other adjustments ............... Credit to income statement ................... Credit/(charge) to reserves ..................... At 31 December ............ 2011 At 1 January .................. Exchange and other adjustments ............... Credit/(charge) to income statement ...... Credit to reserves .......... At 31 December ............ 522 120 72 – 714

Leasing transactions HK$m – – – – –

Impairment allowances on financial assets HK$m 544 (83) 125 – 586

Revaluation of properties HK$m (723) (21) 2 12 (730)

Other HK$m 755 (95) 273 (170) 763

Total HK$m 1,098 (79) 472 (158) 1,333

616 (289) 195 – 522

– – – – –

846 (67) (235) – 544

(797) 59 (2) 17 (723)

439 109 169 38 755

1,104 (188) 127 55 1,098

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Notes on the Financial Statements (continued)

7 Tax expense (continued) (ii) Deferred tax liabilities The group
Accelerated capital allowances and short term timing differences HK$m 2012 At 1 January .................. Exchange and other adjustments ............... Charge/(credit) to income statement ...... Charge to reserves ........ At 31 December ............ 2011 At 1 January .................. Exchange and other adjustments ............... Charge/(credit) to income statement ...... Charge/(credit) to reserves ..................... At 31 December ............ 5,734 (654) 1,700 – 6,780

Leasing transactions HK$m (30) – – – (30)

Impairment allowances on financial assets HK$m 5 (293) 26 – (262)

Revaluation of properties HK$m 9,608 (99) (867) 1,162 9,804

Other HK$m (605) 797 (252) 691 631

Total HK$m 14,712 (249) 607 1,853 16,923

4,680 (278) 1,332 – 5,734

(31) (1) 2 – (30)

(295) (56) 356 – 5

7,456 57 16 2,079 9,608

103 74 (137) (645) (605)

11,913 (204) 1,569 1,434 14,712

The Bank
Accelerated capital allowances and short term timing differences HK$m 2012 At 1 January .................. Exchange and other adjustments ............... Charge/(credit) to income statement ...... Charge to reserves ........ At 31 December ............ 2011 At 1 January .................. Exchange and other adjustments ............... (Credit)/charge to income statement ...... Charge/(credit) to reserves ..................... At 31 December ............ 962 (625) (36) – 301

Leasing transactions HK$m (30) – – – (30)

Impairment allowances on financial assets HK$m (236) (12) 18 – (230)

Revaluation of properties HK$m 5,359 (57) (98) 601 5,805

Other HK$m (171) 631 (353) 241 348

Total HK$m 5,884 (63) (469) 842 6,194

1,124 (140) (22) – 962

(31) – 1 – (30)

(211) (5) (20) – (236)

4,230 15 (76) 1,190 5,359

413 14 (184) (414) (171)

5,525 (116) (301) 776 5,884

74

7 Tax expense (continued) (iii) Net deferred tax liabilities
The group 2012 HK$m Deferred tax liabilities recognised on the balance sheet ......................................... Deferred tax assets recognised on the balance sheet ......................................... 16,923 (2,629) 14,294 2011 HK$m 14,712 (2,325) 12,387 The Bank 2012 HK$m 6,194 (1,333) 4,861 2011 HK$m 5,884 (1,098) 4,786

The amount of unused tax losses for which no deferred tax asset is recognised in the balance sheet is HK$3,891m (2011: HK$3,777m). Of this amount, HK$2,041m (2011: HK$2,062m) has no expiry date and the remaining will expire within 10 years. Deferred tax of HK$2,084m (2011: HK$1,164m) has been provided in respect of distributable reserves or postacquisition reserves of associates that, on distribution or sale, would attract withholding tax. Deferred tax is not recognised in respect of the group's investments in subsidiaries and branches where remittance or other realisation is not probable, and for those associates and interests in joint ventures where it has been determined that no additional tax will arise. c Provisions for taxation
The group 2012 HK$m Hong Kong profits tax ................................................ Overseas taxation ........................................................ Current tax liabilities .................................................. Deferred tax liabilities ................................................ 1,168 2,674 3,842 16,923 20,765 2011 HK$m 658 3,468 4,126 14,712 18,838 The Bank 2012 HK$m 215 2,133 2,348 6,194 8,542 2011 HK$m 251 2,497 2,748 5,884 8,632

d Reconciliation between taxation charge and accounting profit at applicable tax rates:
2012 HK$m Profit before tax ............................................................................................................................. Notional tax on profit before tax, calculated at the rates applicable to profits in the countries concerned ....................................................................... Adjustments in respect of prior years ............................................................................................ Deferred tax temporary differences (previously not recognised) / not recognised ...................... Effects of profits in associates and joint ventures .......................................................................... Non taxable income and gains ....................................................................................................... Permanent disallowables ............................................................................................................... Change in tax rates ........................................................................................................................ Local taxes and overseas withholding taxes ................................................................................. Others ............................................................................................................................................. 108,729 2011 HK$m 91,370

21,376 (531) (17) (3,104) (2,381) 1,609 65 970 23 18,010

18,633 (24) 58 (2,489) (1,654) 928 8 632 1,374 17,466

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Notes on the Financial Statements (continued)

8

Profit attributable to shareholders The consolidated profit attributable to shareholders includes a profit of HK$48,377m (2011: HK$37,812m) which has been dealt with in the accounts of the Bank.

9

Dividends
2012 HK$ per share Ordinary dividends paid – fourth interim dividend in respect of the previous financial year approved and paid during the year ....................................................... – first interim dividend paid ............................................. – second interim dividend paid ........................................ – third interim dividend paid ............................................ HK$m HK$ per share 2011 HK$m

0.83 0.58 0.41 0.40 2.22

10,000 7,500 7,500 7,500 32,500

1.33 0.78 0.78 0.68 3.57

12,000 7,000 7,000 7,000 33,000

The Directors have declared a fourth interim dividend in respect of the financial year ending 31 December 2012 of HK$20,000m (HK$0.85 per ordinary share).

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10 Analysis of financial assets and liabilities by measurement basis

The group
At 31 December 2012

Held for trading HK$m – – – – – – – – – 8,426 – 184,711 – – – 84,659 23,079 – – – – – – – 362,197 534,898 214,104 – – – – –

Designated at fair value HK$m

Held-tomaturity securities HK$m Loans and receivables HK$m

Availablefor-sale securities HK$m

Financial assets and liabilities at amortised cost HK$m Total HK$m 1,111,199 23,079 184,711 93,085

Derivatives designated as fair value hedging instruments HK$m

Derivatives designated as cash flow hedging instruments HK$m

77
821,194 74,645 163,819 2,895,951 1,136,124 – – – – 183,340 – 393,264 – 27,112 – – – 603,716 44,447 – – – – – – 44,270 – – 2 175 – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –

Assets Cash and short-term funds ................................... Items in the course of collection from other banks ....................................................... Placings with banks maturing after one month ... Certificates of deposit .......................................... Hong Kong Government certificates of indebtedness ................................................ Trading assets ....................................................... Financial assets designated at fair value .............. Derivatives ........................................................... Loans and advances to customers ........................ Financial investments .......................................... Amounts due from Group companies .................. Other assets .......................................................... – 419,697 – 394,787 – – 6,710 – 657,207 – – 69,479 – – – 4,966 200 – – – – – 155,393 – – – – – – 2,349,043 – – – – – – – – 470,649 – 45,918 176,264 – – – – – 164,328 79,432 – – – 359 – – – – 359

– – – 3,810 – – – – 3,810

176,264 419,697 69,479 398,956 2,349,043 626,042 176,004 125,550 5,753,109

Total financial assets ..........................................

Liabilities Hong Kong currency notes in circulation ............ Items in the course of transmission to other banks ....................................................... Deposits by banks ................................................ Customer accounts ............................................... Trading liabilities ................................................. Financial liabilities designated at fair value ........ Derivatives ........................................................... Debt securities in issue ........................................ Amounts due to Group companies ...................... Other liabilities .................................................... Subordinated liabilities ........................................ Preference shares .................................................

176,264 35,525 244,135 3,874,884 – – – 74,647 70,504 84,549 13,867 83,346 4,657,721

– – – – – – 3,626 – – – – – 3,626

– – – – – – 261 – – – – – 261

176,264 35,525 244,135 3,874,884 183,340 44,270 397,151 74,647 97,618 84,724 13,867 83,346 5,309,771

Total financial liabilities ....................................

10 Analysis of financial assets and liabilities by measurement basis (continued)

The group
At 31 December 2011

Held for trading HK$m – – – – – – – – – 8,342 – 198,287 – – – 80,349 34,546 – – – – – – – 456,294 353,505 110,107 – – – – –

Designated at fair value HK$m

Held-tomaturity securities HK$m Loans and receivables HK$m

Availablefor-sale securities HK$m

Financial assets and liabilities at amortised cost HK$m Total HK$m 919,906 34,546 198,287 88,691

Derivatives designated as fair value hedging instruments HK$m

Derivatives designated as cash flow hedging instruments HK$m

Notes on the Financial Statements (continued)

T H E H O N G K O N G A N D S H A N G H A I B A N K I N G C O R P O R AT I O N L I M I T E D

78
835,725 63,060 143,062 2,785,452 1,021,567 – – – – 171,431 – 379,989 – 37,675 – – – 589,095 40,397 – – – – – – 40,392 – – 5 – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –

Assets Cash and short-term funds ................................... Items in the course of collection from other banks ....................................................... Placings with banks maturing after one month ... Certificates of deposit .......................................... Hong Kong Government certificates of indebtedness ................................................ Trading assets ....................................................... Financial assets designated at fair value .............. Derivatives ........................................................... Loans and advances to customers ........................ Financial investments .......................................... Amounts due from Group companies .................. Other assets .......................................................... – 447,968 – 376,636 – – 11,121 – 520,917 – – 57,670 – – – 5,390 – – – – – – 134,720 – – – – – – 2,130,871 – – – – – – – – 587,713 – – 162,524 – – – – – 136,219 77,521 – – – 389 – – – – 389 – – – 271 – – – – 271

162,524 447,968 57,670 377,296 2,130,871 722,433 152,730 77,521 5,370,443

Total financial assets ............................................

Liabilities Hong Kong currency notes in circulation ............ Items in the course of transmission to other banks ....................................................... Deposits by banks ................................................ Customer accounts ............................................... Trading liabilities ................................................. Financial liabilities designated at fair value ........ Derivatives ........................................................... Debt securities in issue ........................................ Amounts due to Group companies ...................... Other liabilities .................................................... Subordinated liabilities ........................................ Preference shares .................................................

162,524 47,163 222,582 3,565,001 – – – 77,472 70,743 102,321 16,114 97,096 4,361,016

– – – – – – 3,045 – – – – – 3,045

– – – – – – 218 – – – – – 218

162,524 47,163 222,582 3,565,001 171,431 40,392 383,252 77,472 108,423 102,321 16,114 97,096 4,993,771

Total financial liabilities ......................................

10 Analysis of financial assets and liabilities by measurement basis (continued)
At 31 December 2012

The Bank

Held for trading HK$m – – – – – – – – – – – 80,200 – – – 20,150 17,355 – – – – – – – 165,904 419,345 175,938 – – – – –

Designated at fair value HK$m

Held-tomaturity securities HK$m Loans and receivables HK$m

Availablefor-sale securities HK$m

Financial assets and liabilities at amortised cost HK$m Total HK$m 761,187 17,355 80,200 20,150

Derivatives designated as fair value hedging instruments HK$m

Derivatives designated as cash flow hedging instruments HK$m

79
685,997 1,432 – 1,528,824 743,503 – – – – 82,146 – 390,282 – 18,969 – – – 491,397 7,731 – – – – – – 7,731 – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –

Assets Cash and short-term funds ................................... Items in the course of collection from other banks ....................................................... Placings with banks maturing after one month ... Certificates of deposit .......................................... Hong Kong Government certificates of indebtedness ................................................ Trading assets ....................................................... Financial assets designated at fair value .............. Derivatives ........................................................... Loans and advances to customers ........................ Financial investments .......................................... Amounts due from Group companies .................. Other assets .......................................................... – 284,573 – 388,298 – – 13,126 – 723,263 – – 1,432 – – – – – – – – – – – – – – – – – 1,282,720 – – – – – – – – 260,317 – 43,691 176,264 – – – – – 308,474 45,232 – – – 65 – – – – 65 – – – 3,476 – – – – 3,476

176,264 284,573 1,432 391,839 1,282,720 260,317 321,600 88,923 3,686,560

Total financial assets ..........................................

Liabilities Hong Kong currency notes in circulation ............ Items in the course of transmission to other banks ....................................................... Deposits by banks ................................................ Customer accounts ............................................... Trading liabilities ................................................. Financial liabilities designated at fair value ........ Derivatives ........................................................... Debt securities in issue ........................................ Amounts due to Group companies ...................... Other liabilities .................................................... Subordinated liabilities ........................................ Preference shares .................................................

176,264 25,766 204,520 2,417,400 – – – 40,406 130,268 53,011 9,355 83,195 3,140,185

– – – – – – 1,632 – – – – – 1,632

– – – – – – 170 – – – – – 170

176,264 25,766 204,520 2,417,400 82,146 7,731 392,084 40,406 149,237 53,011 9,355 83,195 3,641,115

Total financial liabilities ....................................

10 Analysis of financial assets and liabilities by measurement basis (continued)
At 31 December 2011

The Bank

Held for trading HK$m – – – – – – – – – – – 108,873 – – – 23,987 29,821 – – – – – – – 232,654 299,701 79,910 – – – – –

Designated at fair value HK$m

Held-tomaturity securities HK$m Loans and receivables HK$m

Availablefor-sale securities HK$m

Financial assets and liabilities at amortised cost HK$m Total HK$m 612,265 29,821 108,873 23,987

Derivatives designated as fair value hedging instruments HK$m

Derivatives designated as cash flow hedging instruments HK$m

Notes on the Financial Statements (continued)

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80
702,137 2,283 – 1,518,129 685,995 – – – – 78,959 – 375,712 – 33,258 – – – 487,929 5,910 – – – – – – 5,910 – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – – –

Assets Cash and short-term funds ................................... Items in the course of collection from other banks ....................................................... Placings with banks maturing after one month ... Certificates of deposit .......................................... Hong Kong Government certificates of indebtedness ................................................ Trading assets ....................................................... Financial assets designated at fair value .............. Derivatives ........................................................... Loans and advances to customers ........................ Financial investments .......................................... Amounts due from Group companies .................. Other assets .......................................................... – 317,321 – 370,361 – – 14,455 – 548,860 – – 2,283 – – – – – – – – – – – – – – – – – 1,176,602 – – – – – – – – 362,307 – – 162,524 – – – – – 233,546 43,059 – – – 150 – – – – 150 – – – 167 – – – – 167

162,524 317,321 2,283 370,678 1,176,602 362,307 248,001 43,059 3,457,721

Total financial assets ............................................

Liabilities Hong Kong currency notes in circulation ............ Items in the course of transmission to other banks ....................................................... Deposits by banks ................................................ Customer accounts ............................................... Trading liabilities ................................................. Financial liabilities designated at fair value ........ Derivatives ........................................................... Debt securities in issue ........................................ Amounts due to Group companies ...................... Other liabilities .................................................... Subordinated liabilities ........................................ Preference shares .................................................

162,524 38,577 158,746 2,220,072 – – – 46,360 119,648 67,758 9,386 96,969 2,920,040

– – – – – – 1,343 – – – – – 1,343

– – – – – – 110 – – – – – 110

162,524 38,577 158,746 2,220,072 78,959 5,910 377,165 46,360 152,906 67,758 9,386 96,969 3,415,332

Total financial liabilities ......................................

11 Cash and short-term funds
The group 2012 HK$m Cash in hand ........................................................................ Sight balances with central banks ....................................... Placings with banks with remaining maturity of one month or less ....................................................... Treasury bills and other eligible bills ................................. 17,925 196,179 362,197 534,898 1,111,199 2011 HK$m 15,204 94,903 456,294 353,505 919,906 The Bank 2012 HK$m 11,139 164,799 165,904 419,345 761,187 2011 HK$m 7,888 72,022 232,654 299,701 612,265

As at 31 December 2012, included within notes 11 and 12, the total amount placed with central banks by the group, including sight balances, amounted to HK$356,880m (2011: HK$350,823m). Placings with central banks made by the Bank amounted to HK$230,427m (2011: HK$211,307m). Treasury bills and other eligible bills are analysed as follows:
The group 2012 HK$m Treasury bills and other eligible bills – available-for-sale – subject to repledge or resale by counterparties ............... – not subject to repledge or resale by counterparties ........ 512 534,386 534,898 2011 HK$m 498 353,007 353,505 The Bank 2012 HK$m 512 418,833 419,345 2011 HK$m 498 299,203 299,701

Treasury bills and other eligible bills held for trading are included under ‘Trading assets’ (note 15). Treasury bills and other eligible bills are largely unlisted. 12 Placings with banks maturing after one month
The group 2012 HK$m Gross placings with banks maturing after one month but not more than one year ............................................. Gross placings with banks maturing after one year ........... Total placings with banks ................................................... 150,504 34,207 184,711 2011 HK$m 173,498 24,789 198,287 The Bank 2012 HK$m 58,846 21,354 80,200 2011 HK$m 93,098 15,775 108,873

There were no rescheduled placings included in the above table. Details of overdue placings are included in note 52. 13 Certificates of deposit
The group 2012 HK$m Held-to-maturity ................................................................. Available-for-sale ............................................................... 8,426 84,659 93,085 2011 HK$m 8,342 80,349 88,691 The Bank 2012 HK$m – 20,150 20,150 2011 HK$m – 23,987 23,987

Certificates of deposit held are largely unlisted. There were no disposals of held-to-maturity certificates of deposit during the year (2011: nil). 14 Hong Kong currency notes in circulation Hong Kong currency notes in circulation are secured by the deposit of funds in respect of which the Hong Kong Government certificates of indebtedness are held.

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15 Trading assets
The group 2012 HK$m Debt securities ...................................................................... Equity shares ........................................................................ Treasury bills and other eligible bills .................................. Other .................................................................................... Trading assets – which may be repledged or resold by counterparties ...... – not subject to repledge or resale by counterparties ......... 176,757 30,401 155,464 57,075 419,697 651 419,046 419,697 2011 HK$m 168,849 15,060 230,959 33,100 447,968 281 447,687 447,968 The Bank 2012 HK$m 125,372 30,250 116,214 12,737 284,573 651 283,922 284,573 2011 HK$m 120,575 14,978 160,911 20,857 317,321 281 317,040 317,321

The amount of listed treasury bills and other eligible bills amounted to HK$2,838m at both group and Bank level as at 31 December 2012 (2011: HK$4,427m). ‘Other’ trading assets primarily includes reverse repos, settlement accounts and stock borrowing transactions with banks and customers. a Debt securities
The group 2012 HK$m Listed – listed in Hong Kong ................................................. – listed outside Hong Kong ......................................... 11,377 62,102 73,479 Unlisted ......................................................................... 103,278 176,757 Issued by public bodies – central governments and central banks .................... – other public sector entities ....................................... 128,866 7,160 136,026 Issued by – banks ......................................................................... – corporate entities ...................................................... 16,870 23,861 176,757 2011 HK$m 17,880 54,897 72,777 96,072 168,849 114,322 6,651 120,973 23,984 23,892 168,849 The Bank 2012 HK$m 8,330 61,791 70,121 55,251 125,372 89,724 6,760 96,484 12,922 15,966 125,372 2011 HK$m 13,329 54,180 67,509 53,066 120,575 77,477 6,544 84,021 19,811 16,743 120,575

b Equity shares
The group 2012 HK$m Listed – listed in Hong Kong ................................................. – listed outside Hong Kong ......................................... 10,543 13,884 24,427 Unlisted ......................................................................... 5,974 30,401 Issued by – banks ......................................................................... – corporate entities ...................................................... 2,986 27,415 30,401 2011 HK$m 4,494 7,211 11,705 3,355 15,060 2,192 12,868 15,060 The Bank 2012 HK$m 10,513 13,884 24,397 5,853 30,250 2,986 27,264 30,250 2011 HK$m 4,487 7,211 11,698 3,280 14,978 2,192 12,786 14,978

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16 Financial assets designated at fair value
The group 2012 HK$m Debt securities ................................................................... Equity shares ..................................................................... Other ................................................................................. 17,001 52,058 420 69,479 2011 HK$m 16,762 40,268 640 57,670 The Bank 2012 HK$m 1,432 – – 1,432 2011 HK$m 2,283 – – 2,283

a Debt securities
The group 2012 HK$m Listed – listed in Hong Kong ................................................. – listed outside Hong Kong ......................................... 1,884 4,365 6,249 Unlisted ......................................................................... 10,752 17,001 Issued by public bodies – central governments and central banks .................... – other public sector entities ....................................... 2,135 1,586 3,721 Issued by other bodies – banks ......................................................................... – corporate entities ...................................................... 5,330 7,950 17,001 2011 HK$m 1,780 4,578 6,358 10,404 16,762 2,298 1,992 4,290 5,153 7,319 16,762 The Bank 2012 HK$m 576 856 1,432 – 1,432 576 – 576 – 856 1,432 2011 HK$m 587 1,696 2,283 – 2,283 587 – 587 – 1,696 2,283

b Equity shares
The group 2012 HK$m Listed – listed in Hong Kong ................................................. – listed outside Hong Kong ......................................... 5,790 19,682 25,472 Unlisted ......................................................................... 26,586 52,058 Issued by – banks ......................................................................... – corporate entities ...................................................... 2011 HK$m 3,354 14,732 18,086 22,182 40,268 The Bank 2012 HK$m – – – – – 2011 HK$m – – – – –

2,365 49,693 52,058

1,386 38,882 40,268

– – –

– – –

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Notes on the Financial Statements (continued)

17 Derivatives Derivatives are financial instruments that derive their value from the price of an underlying item such as equities, bonds, interest rates, foreign exchange rates, credit spreads, commodities and equity or other indices. Derivatives enable users to increase, reduce or alter exposures to credit or market risks. The group makes markets in derivatives for its customers and uses derivatives to manage its exposures to credit and market risks. Derivatives are carried at fair value and shown in the balance sheet as separate totals of assets and liabilities. A description of how the fair value of derivatives is derived is set out in note 51. Derivative assets and liabilities on different transactions are only offset if the transactions are with the same counterparty, a legal right of offset exists and the cash flows are intended to be settled on a net basis. Changes in the values of derivatives are recognised in accordance with the group’s accounting policy as described in note 3(j). Use of derivatives The group transacts derivatives for three primary purposes: to create risk management solutions for clients, to manage the portfolio risk arising from client business, and to manage and hedge the group’s own risks. For accounting purposes, derivative instruments are classified as held either for trading or hedging. Derivatives that are held as hedging instruments are formally designated as hedges as defined in HKAS 39. All other derivative instruments are classified as held for trading. The held for trading classification includes two types of derivative instruments. The first type are those used in sales and trading activities, including those instruments that are used for risk management purposes but which for various reasons do not meet the qualifying criteria for hedge accounting. The second type of held for trading category includes derivatives managed in conjunction with financial instruments designated at fair value. These activities are described more fully below. The group’s derivative activities give rise to significant open positions in portfolios of derivatives. These positions are managed constantly to ensure that they remain within acceptable risk levels, with offsetting deals being used to achieve this where necessary. When entering into derivative transactions, the group employs the same credit risk management procedures to assess and approve potential credit exposures as are used for traditional lending. a Trading derivatives Most of the group’s derivative transactions relate to sales and trading activities. Sales activities include the structuring and marketing of derivative products to customers to enable them to take, transfer, modify or reduce current or expected risks. Trading activities in derivatives are entered into principally for the purpose of generating profits from short-term fluctuations in price or margin. Positions may be traded actively or be held over a period of time to benefit from expected changes in currency rates, interest rates, equity prices or other market parameters. Trading includes market-making, positioning and arbitrage activities. Market-making entails quoting bid and offer prices to other market participants for the purpose of generating revenues based on spread and volume; positioning means managing market risk positions in the expectation of benefiting from favourable movements in prices, rates or indices; arbitrage involves identifying and profiting from price differentials between markets and products. As mentioned above, other derivatives classified as held for trading include non-qualifying hedging derivatives, ineffective hedging derivatives and the components of hedging derivatives that are excluded from assessing hedge effectiveness. Non-qualifying hedging derivatives are entered into for risk management purposes but do not meet the criteria for hedge accounting. These include derivatives managed in conjunction with financial instruments designated at fair value. Ineffective hedging derivatives were previously designated as hedges, but no longer meet the criteria for hedge accounting.

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17 Derivatives (continued) Contract amounts and fair values of assets and liabilities by class of derivatives The notional contract amounts of derivatives held indicate the nominal value of transactions outstanding at the balance sheet date; they do not represent amounts at risk. The group
2012 Contract Amounts HK$m Trading derivatives Exchange rate contracts ........... – spot and forward .................. – swaps ................................... – options purchased ................ – options written ..................... – other ..................................... Interest rate contracts ............... – forward and future ................ – swaps ................................... – options purchased ................ – options written ..................... – other ..................................... Equity derivatives .................... Credit derivatives ..................... Commodity and other .............. Total held for trading ............... Trading derivatives managed in conjunction with financial instruments designated at fair value Exchange rate contracts ........... Interest rate contracts ............... 12,166,808 8,062,408 3,219,733 394,957 429,401 60,309 18,115,892 639,265 16,919,103 222,359 282,512 52,653 818,543 335,214 114,226 31,550,683 Assets HK$m 182,941 80,839 98,168 3,205 372 357 200,790 311 195,781 2,468 3 2,227 29,824 2,631 1,173 417,359 Liabilities HK$m 185,274 75,494 106,514 119 2,861 286 193,208 92 189,097 28 2,988 1,003 33,607 2,655 1,175 415,919 Contract amounts HK$m 10,996,534 7,347,246 2,983,663 250,711 285,008 129,906 17,283,126 898,955 15,544,934 378,709 423,074 37,454 785,433 465,174 87,764 29,618,031 2011 Assets HK$m 172,868 81,683 82,852 7,862 368 103 174,078 143 168,767 3,707 – 1,461 29,729 5,000 2,713 384,388 Liabilities HK$m 181,560 74,197 100,711 360 6,064 228 169,313 173 164,062 80 3,865 1,133 31,066 4,784 1,054 387,777

546 6,573 7,119

5 123 128

– 45 45

546 4,835 5,381

3 128 131

– 95 95

Cash flow hedging derivatives Exchange rate contracts ........... Interest rate contracts ...............

40,044 40,216 80,260

3,740 70 3,810

151 110 261

2,679 101,069 103,748

– 271 271

79 139 218

Fair value hedging derivatives Interest rate contracts ............... Gross total derivatives ............. Netting ...................................... Total .........................................

114,887 31,752,949 – 31,752,949

359 421,656 (22,700) 398,956

3,626 419,851 (22,700) 397,151

109,477 29,836,637 – 29,836,637

389 385,179 (7,883) 377,296

3,045 391,135 (7,883) 383,252

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Notes on the Financial Statements (continued)

17 Derivatives (continued) The Bank
2012 Contract amounts HK$m Trading derivatives Exchange rate contracts ........... – spot and forward .................. – swaps ................................... – options purchased ................ – options written ..................... – other ..................................... Interest rate contracts ............... – forward and future ................ – swaps ................................... – options purchased ................ – options written ..................... – other ..................................... Equity derivatives .................... Credit derivatives ..................... Commodity and other .............. Total held for trading ............... Trading derivatives managed in conjunction with financial instruments designated at fair value Exchange rate contracts ........... Interest rate contracts ............... 10,989,189 7,181,287 3,190,866 270,035 301,789 45,212 17,697,104 635,628 16,488,092 221,674 280,675 71,035 827,109 339,873 82,557 29,935,832 Assets HK$m 177,543 76,898 97,084 2,926 307 328 199,813 311 194,643 2,426 – 2,433 29,844 2,675 999 410,874 Liabilities HK$m 182,472 73,425 106,156 119 2,504 268 192,287 90 188,302 15 2,874 1,006 33,752 2,655 1,771 412,937 Contract Amounts HK$m 10,080,072 6,643,385 2,964,442 152,018 189,536 130,691 16,979,848 889,170 15,244,353 377,556 421,639 47,130 791,046 465,174 68,406 28,384,546 2011 Assets HK$m 168,229 78,232 82,177 7,352 369 99 172,438 142 166,827 3,707 – 1,762 30,013 5,024 2,409 378,113 Liabilities HK$m 178,375 71,804 100,445 376 5,529 221 167,860 169 162,635 80 3,844 1,132 30,959 4,797 1,512 383,503

546 6,573 7,119

5 119 124

– 45 45

546 4,695 5,241

3 128 131

– 92 92

Cash flow hedging derivatives Exchange rate contracts ........... Interest rate contracts ...............

35,781 19,587 55,368

3,461 15 3,476

148 22 170

2,679 41,253 43,932

– 167 167

79 31 110

Fair value hedging derivatives Interest rate contracts ............... Gross total derivatives ............. Netting ...................................... Total .........................................

51,689 30,050,008 – 30,050,008

65 414,539 (22,700) 391,839

1,632 414,784 (22,700) 392,084

53,767 28,487,486 – 28,487,486

150 378,561 (7,883) 370,678

1,343 385,048 (7,883) 377,165

b Hedging derivatives The group uses derivatives (principally interest rate and currency swaps) for hedging purposes in the management of its own asset and liability portfolios and structural positions. This enables the group to optimise the overall costs to the group of accessing debt capital markets, and mitigate the market risk which would otherwise arise from structural imbalances in the maturity and other profiles of its assets and liabilities. The accounting treatment of hedging transactions varies according to the nature of the instrument hedged and the type of hedging transaction. Derivatives may qualify as hedges for accounting purposes if they are fair value hedges, cash flow hedges, or hedges of net investments in foreign operations. The cash flows of the above hedging derivatives are expected to affect the income statement in 2013 and beyond.

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17 Derivatives (continued) Fair value hedges The group’s fair value hedges principally consist of interest rate swaps that are used to protect against changes in the fair value of fixed-rate long-term financial instruments due to movements in market interest rates. For qualifying fair value hedges, all changes in the fair value of the derivative and in the fair value of the item in relation to the risk being hedged are recognised in the income statement. If the hedge relationship is terminated, the fair value adjustment to the hedged item continues to be reported as part of the basis of the item and is amortised to the income statement as a yield adjustment over the remainder of the hedging period. Gains or losses arising from fair value hedges
2012 HK$m Gains/(losses): On hedging instruments ............................................................................................................. On the hedged items attributable to hedged risk ....................................................................... (376) 345 (31) 2011 HK$m (1,147) 1,050 (97)

Cash flow hedges The group’s cash flow hedges consist principally of interest rate and currency swaps that are used to protect against exposures to variability in future interest and principal cash flows on non-trading assets and liabilities which bear interest at variable rates or which are expected to be re-funded or reinvested in the future. The amounts and timing of future cash flows, representing both principal and interest flows, are projected for each portfolio of financial assets and liabilities on the basis of their own contractual terms and other relevant factors, including estimates of prepayments and defaults. The aggregate principal balances and interest cash flows across all portfolios over time form the basis for identifying gains and losses on the effective portions of derivatives designated as cash flow hedges of forecast transactions. Gains and losses are initially recognised directly in equity, in the cash flow hedging reserve, and are transferred to the income statement when the forecast cash flows affect the income statement. During the year to 31 December 2012, the amount transferred to the income statement comprised HK$352m (2011: HK$324m) included in net interest income. The gains and losses on ineffective portions of such derivatives are recognised immediately in the income statement. During the year to 31 December 2012, an insignificant amount was recognised due to hedge ineffectiveness and termination of forecast transactions (2011: insignificant amount). The schedule of forecast principal balances on which the expected interest cash flows arise as at 31 December 2012 is as follows:
3 months or less HK$m At 31 December 2012 Cash inflows from assets ......................................................... Cash outflows from liabilities ................................................. Net cash inflows ...................................................................... At 31 December 2011 Cash inflows from assets ......................................................... Cash outflows from liabilities ................................................. Net cash inflows ...................................................................... 43,626 (3,661) 39,965 More than 3 months but less than 1 year HK$m 50,643 (2,896) 47,747 5 years or less but more than 1 year HK$m 37,167 (2,640) 34,527

80,782 (1,022) 79,760

68,488 (1,656) 66,832

22,613 (2,406) 20,207

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Notes on the Financial Statements (continued)

17 Derivatives (continued) c Unobservable inception profits Any initial gain or loss on financial instruments where the valuation is dependent on unobservable parameters is deferred over the life of the contract or until the instrument is redeemed, transferred or sold or the fair value becomes observable. All derivatives that are part of qualifying hedging relationships have valuations based on observable market parameters. The table below sets out the aggregate unobservable inception profit yet to be recognised in the income statement at the beginning and end of the year with a reconciliation of the changes during the year. The group
2012 HK$m Balance at 1 January ...................................................................................................................... Deferrals on new transactions ....................................................................................................... Reduction due to amortisation ....................................................................................................... Reduction due to redemption/sale/transfer/improved observability/risk hedged ......................... Exchange differences and others ................................................................................................... Balance at 31 December ................................................................................................................ 137 169 (96) (89) 3 124 2011 HK$m 101 225 (86) (101) (2) 137

The Bank
2012 HK$m Balance at 1 January ...................................................................................................................... Deferrals on new transactions ....................................................................................................... Reduction due to amortisation ....................................................................................................... Reduction due to redemption/sale/transfer/improved observability/risk hedged ......................... Exchange differences and others ................................................................................................... Balance at 31 December ................................................................................................................ 124 117 (75) (58) 2 110 2011 HK$m 91 195 (71) (89) (2) 124

18 Loans and advances to customers a Loans and advances to customers
The group 2012 HK$m Gross loans and advances to customers ..................... Impairment allowances (note 19(a)) ........................... 2,358,814 (9,771) 2,349,043 2011 HK$m 2,142,172 (11,301) 2,130,871 The Bank 2012 HK$m 1,288,269 (5,549) 1,282,720 2011 HK$m 1,184,316 (7,714) 1,176,602

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18 Loans and advances to customers (continued) b Analysis of loans and advances to customers based on categories used by the HSBC Group The following analysis of loans and advances to customers is based on the categories used by the HSBC Group, including the group, to manage associated risks. The group
Hong Kong HK$m 401,855 45,961 51,721 499,537 342,463 177,339 127,099 21,995 96,055 764,951 31,545 3,031 34,576 1,299,064 (1,418) (2,167) 1,295,479 Rest of Asia-Pacific HK$m 284,317 33,489 42,337 360,143 402,735 71,925 51,448 8,804 133,921 668,833 30,263 511 30,774 1,059,750 (3,827) (2,359) 1,053,564 Total HK$m 686,172 79,450 94,058 859,680 745,198 249,264 178,547 30,799 229,976 1,433,784 61,808 3,542 65,350 2,358,814 (5,245) (4,526) 2,349,043

2012 Residential mortgages¹ ................................................................................. Credit card advances ..................................................................................... Other personal ............................................................................................... Total personal ............................................................................................... Commercial, industrial and international trade ............................................ Commercial real estate ................................................................................. Other property-related lending ..................................................................... Government .................................................................................................. Other commercial ......................................................................................... Total corporate and commercial ................................................................... Non-bank financial institutions .................................................................... Settlement accounts ...................................................................................... Total financial ............................................................................................... Gross loans and advances to customers ....................................................... Individually assessed impairment allowances ............................................. Collectively assessed impairment allowances ............................................. Net loans and advances to customers ........................................................... 2011 Residential mortgages¹ ................................................................................. Credit card advances ..................................................................................... Other personal ............................................................................................... Total personal ............................................................................................... Commercial, industrial and international trade ............................................ Commercial real estate ................................................................................. Other property-related lending ..................................................................... Government .................................................................................................. Other commercial ......................................................................................... Total corporate and commercial ................................................................... Non-bank financial institutions .................................................................... Settlement accounts ...................................................................................... Total financial ............................................................................................... Gross loans and advances to customers ....................................................... Individually assessed impairment allowances ............................................. Collectively assessed impairment allowances ............................................. Net loans and advances to customers ...........................................................

360,368 41,200 51,339 452,907 295,729 158,222 134,910 22,669 96,398 707,928 24,799 1,236 26,035 1,186,870 (2,174) (2,254) 1,182,442

247,767 31,849 38,093 317,709 365,579 74,041 49,659 7,471 117,205 613,955 23,300 338 23,638 955,302 (4,720) (2,153) 948,429

608,135 73,049 89,432 770,616 661,308 232,263 184,569 30,140 213,603 1,321,883 48,099 1,574 49,673 2,142,172 (6,894) (4,407) 2,130,871

1 Residential mortgages include Hong Kong Government Home Ownership Scheme loans of HK$24,426m (2011: HK$25,640m).

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Notes on the Financial Statements (continued)

18 Loans and advances to customers (continued) The Bank
Hong Kong HK$m 244,780 25,557 32,314 302,651 235,972 113,958 45,402 21,814 66,809 483,955 28,771 – 28,771 815,377 (903) (1,579) 812,895 Rest of Asia-Pacific HK$m 111,721 12,198 21,468 145,387 171,735 33,314 21,682 2,786 81,040 310,557 16,814 134 16,948 472,892 (1,994) (1,073) 469,825 Total HK$m 356,501 37,755 53,782 448,038 407,707 147,272 67,084 24,600 147,849 794,512 45,585 134 45,719 1,288,269 (2,897) (2,652) 1,282,720

2012 Residential mortgages¹ .................................................................................. Credit card advances ...................................................................................... Other personal ................................................................................................ Total personal ................................................................................................ Commercial, industrial and international trade ............................................. Commercial real estate .................................................................................. Other property-related lending ...................................................................... Government ................................................................................................... Other commercial .......................................................................................... Total corporate and commercial .................................................................... Non-bank financial institutions ..................................................................... Settlement accounts ....................................................................................... Total financial ................................................................................................ Gross loans and advances to customers ........................................................ Individually assessed impairment allowances .............................................. Collectively assessed impairment allowances .............................................. Net loans and advances to customers ............................................................ 2011 Residential mortgages¹ .................................................................................. Credit card advances ...................................................................................... Other personal ................................................................................................ Total personal ................................................................................................ Commercial, industrial and international trade ............................................. Commercial real estate .................................................................................. Other property-related lending ...................................................................... Government ................................................................................................... Other commercial .......................................................................................... Total corporate and commercial .................................................................... Non-bank financial institutions ..................................................................... Settlement accounts ....................................................................................... Total financial ................................................................................................ Gross loans and advances to customers ........................................................ Individually assessed impairment allowances .............................................. Collectively assessed impairment allowances .............................................. Net loans and advances to customers ............................................................

222,219 22,653 32,651 277,523 207,990 113,104 43,206 22,124 66,345 452,769 21,256 – 21,256 751,548 (1,377) (1,633) 748,538

95,004 11,966 18,684 125,654 166,072 36,160 23,190 2,166 66,804 294,392 12,607 115 12,722 432,768 (3,608) (1,096) 428,064

317,223 34,619 51,335 403,177 374,062 149,264 66,396 24,290 133,149 747,161 33,863 115 33,978 1,184,316 (4,985) (2,729) 1,176,602

The geographical information shown above has been classified by the location of the principal operations of the subsidiary or, in the case of the Bank, by the location of the branch responsible for advancing the funds.
1 Residential mortgages include Hong Kong Government Home Ownership Scheme loans of HK$10,540m (2011: HK$11,235m).

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18 Loans and advances to customers (continued) c Loans and advances to customers include equipment leased to customers under finance leases and hire purchase contracts having the characteristics of finance leases The group
2012 Present value of the minimum lease payments HK$m Amounts receivable – Within one year .......................... – After one year but within five years .................................... – After five years ........................... Impairment allowances ................... Net investment in finance leases and hire purchase contracts ........ 2,965 7,667 14,506 25,138 (47) 25,091 Present value of the minimum lease payments HK$m 3,022 7,241 13,198 23,461 (54) 23,407 2011

Unearned future finance income HK$m 684 2,005 2,042 4,731

Total minimum lease payments HK$m 3,649 9,672 16,548 29,869

Unearned future finance income HK$m 686 1,701 1,661 4,048

Total minimum lease payments HK$m 3,708 8,942 14,859 27,509

The Bank
2012 Present value of the minimum lease payments HK$m Amounts receivable – Within one year .......................... – After one year but within five years .................................... – After five years ........................... Impairment allowances ................... Net investment in finance leases and hire purchase contracts ........ 1,590 4,058 10,217 15,865 (9) 15,856 Present value of the minimum lease payments HK$m 1,640 3,938 8,871 14,449 (10) 14,439 2011

Unearned future finance income HK$m 321 924 1,586 2,831

Total minimum lease payments HK$m 1,911 4,982 11,803 18,696

Unearned future finance income HK$m 272 764 1,207 2,243

Total minimum lease payments HK$m 1,912 4,702 10,078 16,692

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Notes on the Financial Statements (continued)

19 Impairment allowances against loans and advances to customers a Impairment allowances against loans and advances to customers The group
Individually assessed allowances HK$m 6,894 (2,730) 237 734 (57) 167 5,245 Collectively assessed allowances HK$m 4,407 (3,597) 1,166 2,596 (94) 48 4,526

2012 At 1 January .................................................................................................. Amounts written off ...................................................................................... Recoveries of loans and advances written off in previous years ................. Net charge to income statement (note 4(i)) .................................................. Unwinding of discount of loan impairment .................................................. Exchange and other adjustments .................................................................. At 31 December (note 18(a)) ........................................................................ 2011 At 1 January .................................................................................................. Amounts written off ...................................................................................... Recoveries of loans and advances written off in previous years ................. Net charge to income statement (note 4(i)) .................................................. Unwinding of discount of loan impairment .................................................. Exchange and other adjustments .................................................................. At 31 December (note 18(a)) ........................................................................

Total HK$m 11,301 (6,327) 1,403 3,330 (151) 215 9,771

8,259 (2,150) 356 694 (78) (187) 6,894

4,735 (3,792) 1,448 2,401 (216) (169) 4,407

12,994 (5,942) 1,804 3,095 (294) (356) 11,301

The Bank
Individually assessed allowances HK$m 4,985 (2,236) 71 162 (42) (43) 2,897 Collectively assessed allowances HK$m 2,729 (1,833) 542 1,223 (41) 32 2,652

2012 At 1 January .................................................................................................. Amounts written off ...................................................................................... Recoveries of loans and advances written off in previous years ................. Net charge to income statement .................................................................... Unwinding of discount of loan impairment .................................................. Exchange and other adjustments .................................................................. At 31 December (note 18(a)) ........................................................................ 2011 At 1 January .................................................................................................. Amounts written off ...................................................................................... Recoveries of loans and advances written off in previous years ................. Net charge to income statement .................................................................... Unwinding of discount of loan impairment .................................................. Exchange and other adjustments .................................................................. At 31 December (note 18(a)) ........................................................................

Total HK$m 7,714 (4,069) 613 1,385 (83) (11) 5,549

5,946 (1,545) 198 612 (53) (173) 4,985

3,027 (2,216) 845 1,358 (149) (136) 2,729

8,973 (3,761) 1,043 1,970 (202) (309) 7,714

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19 Impairment allowances against loans and advances to customers (continued) b Impairment allowances on loans and advances to customers Impaired loans and advances to customers are those loans and advances where objective evidence exists that full repayment of principal or interest is considered unlikely. Individually assessed allowances are made after taking into account the value of collateral in respect of such loans and advances. The geographical information shown below has been classified by the location of the principal operations of the subsidiary or, in the case of the Bank, by the location of the branch responsible for advancing the funds. The group
Hong Kong HK$m At 31 December 2012 Gross loans and advances to customers Individually assessed impaired gross loans and advances ......................... Collectively assessed .................................................................................. – Impaired loans and advances .................................................................. – Non-impaired loans and advances .......................................................... Total gross loans and advances to customers ............................................. Impairment allowances ............................................................................ – Individually assessed .............................................................................. – Collectively assessed .............................................................................. Net loans and advances ............................................................................... Fair value of collateral which has been taken into account in respect of individually assessed impaired loans and advances to customers ..... Individually assessed impaired gross loans and advances as a percentage of gross loans and advances to customers ........................... Total allowances as a percentage of total gross loans and advances .......... At 31 December 2011 Gross loans and advances to customers Individually assessed impaired gross loans and advances ......................... Collectively assessed .................................................................................. – Impaired loans and advances .................................................................. – Non-impaired loans and advances .......................................................... Total gross loans and advances to customers ............................................. Impairment allowances ............................................................................... – Individually assessed .............................................................................. – Collectively assessed .............................................................................. Net loans and advances ............................................................................... Fair value of collateral which has been taken into account in respect of individually assessed impaired loans and advances to customers ..... Individually assessed impaired gross loans and advances as a percentage of gross loans and advances to customers ........................... Total allowances as a percentage of total gross loans and advances ......... 2,927 1,296,137 621 1,295,516 1,299,064 (3,585) (1,418) (2,167) 1,295,479 Rest of Asia-Pacific HK$m 8,467 1,051,283 999 1,050,284 1,059,750 (6,186) (3,827) (2,359) 1,053,564 Total HK$m 11,394 2,347,420 1,620 2,345,800 2,358,814 (9,771) (5,245) (4,526) 2,349,043

1,264 0.2% 0.3%

3,790 0.8% 0.6%

5,054 0.5% 0.4%

3,881 1,182,989 657 1,182,332 1,186,870 (4,428) (2,174) (2,254) 1,182,442

8,490 946,812 823 945,989 955,302 (6,873) (4,720) (2,153) 948,429

12,371 2,129,801 1,480 2,128,321 2,142,172 (11,301) (6,894) (4,407) 2,130,871

1,403 0.3% 0.4%

3,252 0.9% 0.7%

4,655 0.6% 0.5%

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Notes on the Financial Statements (continued)

19 Impairment allowances against loans and advances to customers (continued) The Bank
Hong Kong HK$m At 31 December 2012 Gross loans and advances to customers Individually assessed impaired gross loans and advances ......................... Collectively assessed .................................................................................. – Impaired loans and advances .................................................................. – Non-impaired loans and advances .......................................................... Total gross loans and advances to customers ............................................. Impairment allowances ............................................................................ – Individually assessed .............................................................................. – Collectively assessed .............................................................................. Net loans and advances ............................................................................... Fair value of collateral which has been taken into account in respect of individually assessed impaired loans and advances to customers ..... Individually assessed impaired gross loans and advances as a percentage of gross loans and advances to customers ........................... Total allowances as a percentage of total gross loans and advances ......... At 31 December 2011 Gross loans and advances to customers Individually assessed impaired gross loans and advances ......................... Collectively assessed .................................................................................. – Impaired loans and advances .................................................................. – Non-impaired loans and advances .......................................................... Total gross loans and advances to customers ............................................. Impairment allowances ............................................................................... – Individually assessed .............................................................................. – Collectively assessed .............................................................................. Net loans and advances ............................................................................... Fair value of collateral which has been taken into account in respect of individually assessed impaired loans and advances to customers ..... Individually assessed impaired gross loans and advances as a percentage of gross loans and advances to customers ........................... Total allowances as a percentage of total gross loans and advances ......... 1,963 813,414 471 812,943 815,377 (2,482) (903) (1,579) 812,895 Rest of Asia-Pacific HK$m 3,754 469,138 360 468,778 472,892 (3,067) (1,994) (1,073) 469,825 Total HK$m 5,717 1,282,552 831 1,281,721 1,288,269 (5,549) (2,897) (2,652) 1,282,720

925 0.2% 0.3%

1,032 0.8% 0.6%

1,957 0.4% 0.4%

2,520 749,028 566 748,462 751,548 (3,010) (1,377) (1,633) 748,538

5,472 427,296 393 426,903 432,768 (4,704) (3,608) (1,096) 428,064

7,992 1,176,324 959 1,175,365 1,184,316 (7,714) (4,985) (2,729) 1,176,602

1,032 0.3% 0.4%

1,167 1.3% 1.1%

2,199 0.7% 0.7%

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19 Impairment allowances against loans and advances to customers (continued) For individually assessed customer loans and advances where the industry sector comprises not less than 10% of the group’s total gross loans and advances to customers, the analysis of gross impaired loans and advances and allowances by major industry sectors based on categories and definitions used by the HSBC Group is as follows: The group
Total gross loans and advances HK$m At 31 December 2012 Residential mortgages ..................... Commercial, industrial and international trade ....................... Commercial real estate ................... At 31 December 2011 Residential mortgages ..................... Commercial, industrial and international trade ....................... Commercial real estate ................... 608,135 661,308 232,263 2,369 6,970 580 (372) (5,184) (268) (166) (2,049) (69) 29 919 134 47 1,435 47 686,172 745,198 249,264 2,485 5,117 533 (428) (2,897) (413) (122) (2,060) (107) 67 140 226 59 2,410 59 Gross impaired advances HK$m Individually assessed allowances HK$m Collectively assessed allowances HK$m Net new impairment allowances HK$m Advances written-off in year HK$m

The Bank
Total gross loans and advances HK$m At 31 December 2012 Residential mortgages ..................... Commercial, industrial and international trade ....................... Commercial real estate ................... At 31 December 2011 Residential mortgages ..................... Commercial, industrial and international trade ....................... Commercial real estate ................... 317,223 374,062 149,264 598 5,115 357 (98) (3,897) (117) (72) (1,256) (32) 7 703 84 8 999 4 356,501 407,707 147,272 620 2,932 335 (101) (1,694) (281) (38) (1,292) (68) (1) (91) 223 23 2,063 1 Gross impaired advances HK$m Individually assessed allowances HK$m Collectively assessed allowances HK$m Net new impairment allowances HK$m Advances written-off in year HK$m

Collectively assessed allowances refer to impairment allowances which are assessed on a collective basis for those individually assessed loans and advances where an individual impairment has not yet been identified.

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Notes on the Financial Statements (continued)

19 Impairment allowances against loans and advances to customers (continued) c Overdue and rescheduled loans and advances to customers The group
Hong Kong HK$m At 31 December 2012 Gross amounts which have been overdue with respect to either principal or interest for periods of – more than three months but less than six months ................ – more than six months but less than one year ................... – more than one year ................. % Rest of Asia-Pacific HK$m % Total HK$m %

288 166 1,856 2,310

0.0 0.0 0.1 0.1

1,733 1,283 2,828 5,844

0.2 0.1 0.3 0.6

2,021 1,449 4,684 8,154

0.1 0.1 0.2 0.4

Individually assessed impairment allowances made in respect of amounts overdue ......................... Fair value of collateral held in respect of amounts overdue ....... Rescheduled loans and advances to customers .................................... At 31 December 2011 Gross amounts which have been overdue with respect to either principal or interest for periods of – more than three months but less than six months ................ – more than six months but less than one year ................... – more than one year .................

(895) 769 565 0.0

(3,008) 2,285 2,781 0.3

(3,903) 3,054 3,346 0.1

616 234 1,807 2,657

0.1 0.0 0.2 0.3

3,446 720 2,880 7,046

0.4 0.1 0.3 0.8

4,062 954 4,687 9,703

0.2 0.0 0.2 0.4

Individually assessed impairment allowances made in respect of amounts overdue ......................... Fair value of collateral held in respect of amounts overdue ........ Rescheduled loans and advances to customers ....................................

(1,614) 825 1,257 0.1

(4,106) 2,030 1,938 0.2

(5,720) 2,855 3,195 0.1

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19 Impairment allowances against loans and advances to customers (continued) The Bank
Hong Kong HK$m At 31 December 2012 Gross amounts which have been overdue with respect to either principal or interest for periods of – more than three months but less than six months ................ – more than six months but less than one year ................... – more than one year ................. % Rest of Asia-Pacific HK$m % Total HK$m %

189 109 1,272 1,570

0.0 0.0 0.2 0.2

427 303 1,489 2,219

0.1 0.1 0.3 0.5

616 412 2,761 3,789

0.1 0.0 0.2 0.3

Individually assessed impairment allowances made in respect of amounts overdue ......................... Fair value of collateral held in respect of amounts overdue ........ Rescheduled loans and advances to customers .................................... At 31 December 2011 Gross amounts which have been overdue with respect to either principal or interest for periods of – more than three months but less than six months ................ – more than six months but less than one year ................... – more than one year .................

(551) 681 427 0.1

(1,357) 501 1,234 0.3

(1,908) 1,182 1,661 0.1

390 181 1,131 1,702

0.1 0.0 0.2 0.3

2,315 270 1,780 4,365

0.5 0.1 0.4 1.0

2,705 451 2,911 6,067

0.2 0.0 0.3 0.5

Individually assessed impairment allowances made in respect of amounts overdue ......................... Fair value of collateral held in respect of amounts overdue ........ Rescheduled loans and advances to customers ....................................

(871) 675 1,149 0.2

(3,090) 643 543 0.1

(3,961) 1,318 1,692 0.1

Rescheduled loans and advances to customers are those loans and advances which have been restructured or renegotiated because of deterioration in the financial position of the borrower or because of the inability of the borrower to meet the original repayment schedule. Rescheduled loans and advances to customers are stated net of any loans and advances which have subsequently become overdue for more than three months and which are included in ‘Overdue and rescheduled loans and advances to customers’. 20 Impairment and rescheduled amounts relating to loans and advances to banks and other assets There are no significant impaired or rescheduled loans and advances to banks or overdue or rescheduled other assets as at 31 December 2012 and 31 December 2011. Information relating to overdue balances can be found in note 52.

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Notes on the Financial Statements (continued)

21 Financial investments
The group 2012 HK$m Debt securities – held-to-maturity .............................................................. – available-for-sale ............................................................ Equity shares – available-for-sale ............................................................ Financial investments – which may be repledged or resold by counterparties ..... – not subject to repledge or resale by counterparties ........ 155,393 463,278 2011 HK$m 134,720 542,536 The Bank 2012 HK$m – 257,804 2011 HK$m – 325,136

7,371 626,042 985 625,057 626,042

45,177 722,433 847 721,586 722,433

2,513 260,317 897 259,420 260,317

37,171 362,307 325 361,982 362,307

a Held-to-maturity debt securities The group
Book value 2012 HK$m Listed – listed in Hong Kong ............................................... – listed outside Hong Kong ...................................... Unlisted ...................................................................... 4,174 39,217 43,391 112,002 155,393 Issued by public bodies – central governments and central banks ................. – other public sector entities ..................................... Issued by – banks ...................................................................... – corporate entities .................................................... 3,538 20,660 24,198 75,744 55,451 155,393 2011 HK$m 2,932 31,017 33,949 100,771 134,720 2,551 20,703 23,254 72,303 39,163 134,720 Fair value 2012 HK$m 4,644 42,814 47,458 119,873 167,331 4,189 22,646 26,835 80,819 59,677 167,331 2011 HK$m 3,209 32,847 36,056 106,618 142,674 3,049 22,347 25,396 75,309 41,969 142,674

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21 Financial Investments (continued) b Available-for-sale debt securities
The group 2012 HK$m Listed – listed in Hong Kong ............................................... – listed outside Hong Kong ...................................... Unlisted ...................................................................... 21,587 166,320 187,907 275,371 463,278 Issued by public bodies – central governments and central banks ................. – other public sector entities ..................................... Issued by – banks ...................................................................... – corporate entities .................................................... 263,466 70,715 334,181 94,758 34,339 463,278 2011 HK$m 23,333 169,312 192,645 349,891 542,536 295,436 78,901 374,337 136,388 31,811 542,536 The Bank 2012 HK$m 5,235 126,066 131,301 126,503 257,804 158,035 41,214 199,249 46,467 12,088 257,804 2011 HK$m 2,872 131,216 134,088 191,048 325,136 182,580 51,118 233,698 74,434 17,004 325,136

c

Available-for-sale equity shares
The group 2012 HK$m Listed – listed in Hong Kong ............................................... – listed outside Hong Kong ...................................... Unlisted ...................................................................... 663 26 689 6,682 7,371 Issued by – banks ...................................................................... – corporate entities .................................................... 2011 HK$m 31,794 129 31,923 13,254 45,177 The Bank 2012 HK$m – 15 15 2,498 2,513 2011 HK$m 31,372 89 31,461 5,710 37,171

42 7,329 7,371

7,140 38,037 45,177

31 2,482 2,513

3,716 33,455 37,171

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Notes on the Financial Statements (continued)

22 Transfers of financial assets not qualifying for derecognition The group enters into transactions in the normal course of business by which it transfers recognised financial assets directly to third parties or to special purpose entities. These transfers may give rise to full or partial derecognition of the financial assets concerned.  Full derecognition occurs when the group transfers its contractual right to receive cash flows from the financial assets, or retains the right but assumes an obligation to pass on the cash flows from the asset, and transfers substantially all the risks and rewards of ownership. The risks include credit, interest rate, currency, prepayment and other price risks. Partial derecognition occurs when the group sells or otherwise transfers financial assets in such a way that some but not substantially all of the risks and rewards of ownership are transferred but control is retained. These financial assets are recognised in the balance sheet to the extent of the group’s continuing involvement.



The majority of transferred financial assets that do not qualify for derecognition are (i) debt securities held by counterparties as collateral under repurchase agreements or (ii) securities lent under securities lending agreements. As the substance of these transactions is secured borrowings the asset collateral continues to be recognised in full and the related liability reflecting the group’s obligation to repurchase the transferred assets for a fixed price at a future date is recognised in deposits by banks or customer accounts as appropriate. As a result of these transactions, the group is unable to use, sell or pledge the transferred assets for the duration of the transaction. The group remains exposed to interest rate risk and credit risk on these pledged instruments. The counterparty’s recourse is not limited to the transferred assets. The following table analyses the carrying amount of financial assets that did not qualify for derecognition and their associated liabilities. Financial assets and associated financial liabilities not qualifying for full derecognition The group
2012 Carrying amount of transferred assets HK$m Repurchase agreements .............................................. Securities lending agreements .................................... 15,223 2,090 17,313 Carrying amount of associated liabilities HK$m 15,202 2,085 17,287 Carrying amount of transferred assets HK$m 33,961 4,269 38,230 2011 Carrying amount of associated liabilities HK$m 33,675 3,793 37,468

The Bank
2012 Carrying amount of transferred assets HK$m Repurchase agreements .............................................. Securities lending agreements .................................... 26,415 2,002 28,417 Carrying amount of associated liabilities HK$m 26,451 2,085 28,536 Carrying amount of transferred assets HK$m 19,281 4,113 23,394 2011 Carrying amount of associated liabilities HK$m 19,350 3,793 23,143

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23 Investments in subsidiaries
The Bank 2012 HK$m Investments in subsidiaries: Unlisted investments ................................................................................................................................ Listed investment ..................................................................................................................................... 57,954 865 58,819 2011 HK$m 56,859 865 57,724

The principal subsidiaries of the Bank are:
Nominal value of issued share capital / registered capital HK$9,559m RMB12,400m RM$115m A$751m A$60m TWD30,000m HK$2,798m HK$2,778m The group’s interest in issued share capital / registered capital 62.14% 100% 100% 100% 100% 100% 100% 100%

Place of incorporation Hang Seng Bank Limited ......................... HSBC Bank (China) Company Limited .. HSBC Bank Malaysia Berhad ................. HSBC Bank Australia Limited2 ............... HSBC Bank (Taiwan) Limited2 ............... HSBC Insurance (Asia) Limited2 ............ HSBC Life (International) Limited2 ........ Hong Kong PRC1 Malaysia Australia Taiwan Hong Kong Bermuda

Principal activity Banking Banking Banking Banking Banking Insurance Retirement benefits and life insurance

Class of share / registered capital Ordinary Ordinary Ordinary Ordinary Preference Ordinary Ordinary Ordinary

1 People’s Republic of China 2 Held indirectly

The principal countries of operation are the same as the countries of incorporation except for HSBC Life (International) Limited which operates mainly in Hong Kong. All of the above companies are controlled subsidiaries and have been consolidated in the financial statements. The principal subsidiaries are regulated banking and insurance entities and, as such, are required to maintain certain minimum levels of capital and liquid assets to support their operations. The effect of these regulatory requirements is to limit the extent to which the subsidiaries may transfer funds to the Bank in the form of repayment of shareholder loans or cash dividends.

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Notes on the Financial Statements (continued)

24 Interests in associates and joint ventures
The group 2012 HK$m Share of net assets .................................................................................................................................... Goodwill .................................................................................................................................................. Intangible assets ....................................................................................................................................... Deferred tax on intangible assets ............................................................................................................. Impairment ............................................................................................................................................... 113,415 5,191 1,409 (347) (395) 119,273 2011 HK$m 84,493 5,544 2,216 (468) – 91,785

At 31 December 2012, the group’s interests in associates amounted to HK$117,946m (2011: HK$90,130m).
The Bank 2012 HK$m Listed investments ................................................................................................................................... Unlisted investments ................................................................................................................................ 39,824 1,095 40,919 2011 HK$m 26,561 1,578 28,139

Shareholdings in associates held by the Bank include listed investments of HK$39,824m (2011: HK$26,561m). As at the balance sheet date, the fair value of these investments held by the group, based on quoted market prices, was HK$110,820m (2011: HK$87,107m). a Principal associates The principal associates of the group are:
At 31 December 2012 Carrying value Fair value HK$m HK$m Listed Bank of Communications Co., Ltd. .......................... Industrial Bank Co., Ltd.3 ......................................... Bao Viet Holdings3 .................................................... 91,840 22,099 – 113,939 82,411 28,409 – 110,820 At 31 December 2011 Carrying value Fair value HK$m HK$m 66,704 17,199 1,409 85,312 63,964 21,307 1,836 87,107

Place of incorporation Listed Bank of Communications Co., Ltd. .. Industrial Bank Co., Ltd.3 ................. Unlisted Barrowgate Limited3 ......................... Vietnam Technological and Commercial Joint Stock Bank ...... Yantai Bank Co., Limited3 ................ PRC1 PRC1

Principal activity Banking Banking

Nominal value of issued share capital / registered capital RMB74,263m RMB10,786m

Class of share / registered capital Ordinary Ordinary

The group’s interest in issued share capital / registered capital 19.03% 12.80%

Hong Kong Vietnam PRC1

Property investment Banking Banking

–2 VND8,848bn RMB2,000m

Ordinary Ordinary Ordinary

24.64% 19.48% 20.00%

1 People’s Republic of China 2 Nominal value of issued share capital is less than HK$1m 3 Held indirectly

The principal countries of operation are the same as the countries of incorporation.

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24 Interests in associates and joint ventures (continued) The group’s interests in Bank of Communications Co., Ltd. (‘BoCom’) and Vietnam Technological and Commercial Joint Stock Bank (‘TechCom Bank’) are accounted for as associates as the group has representation on the Board of Directors of each, whilst for BoCom, the Bank also has representation on the strategy committee. The group has entered into Technical Support and Assistance Agreements with BoCom, TechCom Bank, Hana HSBC Life Insurance and Canara HSBC Oriental Bank of Commerce Life Insurance to provide technical support and assistance in relation to their banking and insurance business. Until 20 December 2012, the group’s interest in Bao Viet Holdings (‘Bao Viet’) was accounted for as an associate as the group had representation on the Board of Directors. On 20 December 2012, the group announced that it had entered into an agreement to sell its entire 18% shareholding in Bao Viet to Sumitomo Life Insurance Company, a transaction which is expected to complete during the first quarter of 2013. At 31 December 2012, the group’s interest in Bao Viet was classified as ‘Held For Sale’. For the year ended 31 December 2012, Hang Seng Bank Limited’s (‘Hang Seng’) interest in Industrial Bank Co., Ltd. (‘Industrial Bank’) was accounted for as an associate as Hang Seng had representation on the Board of Directors and the executive committee. On 7 January 2013, Industrial Bank completed a private placement of additional share capital to a number of third parties, thereby diluting the group’s equity holding from 12.8% to 10.9%. As a result of this and other factors, the group considers it is no longer in a position to exercise significant influence over Industrial Bank and ceased to account for the investment as an associate from that date. Thereafter, the holding is recognised as an available-for-sale financial investment. In respect of the year ended 31 December 2012, BoCom, Industrial Bank, TechCom Bank and Bao Viet were included in these financial statements based on financial statements drawn up to 30 September 2012, but taking into account the financial effect of significant transactions or events in the subsequent period from 1 October 2012 to 31 December 2012. The group has taken advantage of the provision contained in HKAS 28 ‘Investments in Associates’ whereby it is permitted to include the attributable share of associates’ results based on accounts drawn up to a non-coterminous period end where the difference is no greater than three months. Interests in associates include intangible assets recognised on acquisition with respect to customer relationships and brand names which are amortised over a period of 10 years. During 2012, the market value of the investment in BoCom had been below the carrying amount in the group’s consolidated balance sheet for a period of approximately ten months. An impairment test was performed as at 31 December 2012 on the carrying amount of the investment in BoCom. The result confirmed that there was no impairment. The impairment test was performed by comparing the recoverable amount of BoCom, determined by a value in use (‘VIU’) calculation, with its carrying amount. The calculation of VIU used discounted cash flow projections based on management’s estimates. Cash flows beyond the next five years were then extrapolated in perpetuity using a long-term growth rate. The discount rate used was based on a cost of capital used to evaluate investments in mainland China. Management judgement is required in estimating the future cash flows of BoCom. These values are sensitive to the cash flows projected in the short and medium term, and also to the key assumptions regarding the long term sustainable cash flows thereafter. The key assumptions are consistent with external sources of information.

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Notes on the Financial Statements (continued)

24 Interests in associates and joint ventures (continued) b Summarised aggregate financial information on associates and joint ventures

Assets HK$m 2012 100% ................................................ The group’s effective interest1 ......... 2011 100% ................................................ The group’s effective interest1 ......... 10,184,199 1,537,471 8,127,975 1,265,356

Liabilities HK$m 9,539,491 1,433,597 7,647,933 1,188,011

Equity HK$m 644,708 103,874 480,042 77,345

Revenue HK$m 290,621 44,579 223,952 36,318

Expenses HK$m 176,997 27,476 133,979 22,342

Profit HK$m 113,624 17,103 89,973 13,976

1 The group’s effective interest is stated net of non-controlling interests.

At 31 December 2012, the group’s share of associates and joint ventures’ contingent liabilities was HK$357,664m (2011: HK$266,530m). c The principal joint ventures of the group are:
Nominal value of issued share capital The group’s interest in issued share capital

Place of incorporation Listed Canara HSBC Oriental Bank of Commerce Life Insurance Company Limited ................................. Hana HSBC Life Insurance Co., Ltd ........

Principal activity

Class of share

India South Korea

Insurance manufacturing Insurance manufacturing

INR9,500m KRW110,201m

Ordinary Ordinary

26.00% 49.99%

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25 Goodwill and intangible assets Goodwill and intangible assets includes goodwill arising on business combinations, the present value of in-force longterm insurance business, and other intangible assets.
The group 2012 HK$m Goodwill ............................................................................ Present value of in-force long-term insurance business ..... Other intangible assets ....................................................... 7,237 24,425 6,972 38,634 2011 HK$m 7,629 20,232 6,978 34,839 The Bank 2012 HK$m 1,180 – 3,585 4,765 2011 HK$m 1,177 – 3,654 4,831

a Goodwill
The group 2012 HK$m Cost at 1 January .......................................................... Disposals ...................................................................... Exchange and other movements .................................. Net book value at 31 December .................................. 7,629 (67) (325) 7,237 2011 HK$m 7,891 – (262) 7,629 The Bank 2012 HK$m 1,177 (2) 5 1,180 2011 HK$m 1,167 – 10 1,177

Segmental analysis of goodwill
The group 2012 HK$m Hong Kong – Retail Banking and Wealth Management ................................................................. Hong Kong – Commercial Banking ............................... Hong Kong – Global Banking and Markets ................... Rest of Asia-Pacific – Retail Banking and Wealth Management ................................................................ Rest of Asia-Pacific – Commercial Banking ................. Rest of Asia-Pacific – Global Banking and Markets ..... Total goodwill in the CGUs listed ................................ – 24 750 1,192 4,184 1,087 7,237 2011 HK$m 12 36 755 1,430 4,275 1,121 7,629 The Bank 2012 HK$m – 24 498 80 – 578 1,180 2011 HK$m – 24 498 78 – 577 1,177

During 2012 there was no impairment of goodwill (2011: nil). Impairment testing in respect of goodwill is performed annually by comparing the recoverable amount of cash generating units (‘CGUs’), determined at 1 July 2012 based on a value in use calculation, with the carrying amount of the CGUs. That calculation uses cash flow estimates based on management’s cash flow projections, extrapolated in perpetuity using a nominal long-term growth rate based on current Gross Domestic Product for the countries within which the CGU operates. Cash flows are extrapolated in perpetuity due to the long-term perspective within the group of business units making up the CGUs. The discount rate used is based on the cost of capital HSBC allocates to investments in the countries in which the CGU operates. The cost of capital assigned to an individual CGU and used to discount its future cash flows can have a significant effect on its valuation. The cost of capital percentage is generally derived from an appropriate capital asset pricing model, which itself depends on inputs reflecting a number of financial and economic variables including the riskfree rate in the country concerned and a premium to reflect the inherent risk of the business being evaluated. These variables are established on the basis of management judgement.

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Notes on the Financial Statements (continued)

25 Goodwill and intangible assets (continued) Management judgement is required in estimating the future cash flows of the CGUs. These values are sensitive to the cash flows projected for the periods for which detailed forecasts are available, and to assumptions regarding the long term sustainable pattern of cash flows thereafter. While the acceptable range within which underlying assumptions can be applied is governed by the requirement for resulting forecasts to be compared with actual performance and verifiable economic data in future years, the cash flow forecasts necessarily and appropriately reflect management’s view of future business prospects. Two key assumptions upon which management has based its determination of the recoverable amount of the CGUs are the discount rate and the nominal long-term growth rate. The discount rates used in the impairment test in 2012 was 11% (2011: in the range of 10% to 11%) across different CGUs. The nominal long-term growth rates used in the impairment test in 2012 for Hong Kong and Rest of Asia-Pacific were 4.7% and 5.0% respectively (2011: 7.9% and 7.8%). b The present value of in-force long-term insurance business (‘PVIF’) (i) PVIF specific assumptions The following are the key assumptions used in the computation of PVIF for Hong Kong, being the main life insurance operation:
2012 Risk free rate ............................................. Risk discount rate ..................................... Expenses inflation .................................... Lapse rate .................................................. 0.60% 7.46% 3.00% 0%-20% for all years 2011 1.47% 8.00% 3.00% 0%-20% for the first policy year and 0%-15% for renewal years

(ii) Movement in PVIF for the year ended 31 December
The group 2012 HK$m At 1 January ..................................................................................................................... Value of new business written during the year ................................................................ Movements arising from in-force business: – expected return .............................................................................................................. – experience variances ..................................................................................................... – changes in operating assumptions ................................................................................ Investment return variances .............................................................................................. Changes in investment assumptions ................................................................................. Other adjustments ............................................................................................................. Changes in PVIF of long-term insurance business .......................................................... Exchange differences and other ........................................................................................ At 31 December ................................................................................................................ 20,232 5,559 (1,077) 162 (153) (94) 133 (98) 4,432 (239) 24,425 2011 HK$m 14,767 4,982 (1,277) 55 (748) (232) 1,871 873 5,524 (59) 20,232

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25 Goodwill and intangible assets (continued) c Other intangible assets The group
2012 Computer software HK$m Cost At 1 January ............................................................... Additions .................................................................... Disposals/amounts written-off ................................... Exchange and other movements ................................ At 31 December ......................................................... Accumulated amortisation and impairment At 1 January ............................................................... Amortisation charge for the year ............................... Impairment ................................................................. Disposals/amounts written-off ................................... Exchange and other movements ................................ At 31 December ......................................................... Net book value at 31 December ................................ 9,776 1,303 (208) 650 11,521 Customer/ merchant relationships HK$m 1,889 – (30) (17) 1,842

Other1 HK$m 2,253 – – 114 2,367

Total HK$m 13,918 1,303 (238) 747 15,730

5,991 1,398 130 (193) 327 7,653 3,868

915 164 – (31) (9) 1,039 803

34 16 16 – – 66 2,301

6,940 1,578 146 (224) 318 8,758 6,972

2011 Computer software HK$m Cost At 1 January ............................................................... Additions .................................................................... Disposals/amounts written-off ................................... Exchange and other movements ................................ At 31 December ......................................................... Accumulated amortisation and impairment At 1 January ............................................................... Amortisation charge for the year ............................... Impairment ................................................................. Disposals/amounts written-off ................................... Exchange and other movements ................................ At 31 December ......................................................... Net book value at 31 December ................................ 8,208 1,767 (173) (26) 9,776 Customer/ merchant relationships HK$m 1,905 – (2) (14) 1,889

Other1 HK$m 2,318 37 (4) (98) 2,253

Total HK$m 12,431 1,804 (179) (138) 13,918

4,640 1,283 264 (173) (23) 5,991 3,785

727 202 – (2) (12) 915 974

32 11 – (4) (5) 34 2,219

5,399 1,496 264 (179) (40) 6,940 6,978

1 ‘Other’ includes operating licenses which were recognised during the acquisition of the assets, liabilities and operations of The Chinese Bank in Taiwan in 2008. These have an indefinite useful life as there are no economic or legal restrictions to limit their use. The carrying value of this intangible asset was allocated to relevant business units in Taiwan.

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Notes on the Financial Statements (continued)

25 Goodwill and intangible assets (continued) The Bank
2012 Computer software HK$m Cost At 1 January ............................................................... Additions .................................................................... Disposals/amounts written-off ................................... Exchange and other movements ................................. At 31 December ......................................................... Accumulated amortisation and impairment At 1 January ............................................................... Amortisation charge for the year ............................... Impairment .................................................................. Disposals/amounts written-off ................................... Exchange and other movements ................................ At 31 December ......................................................... Net book value at 31 December ................................ 7,715 908 (170) 596 9,049 Customer/ merchant relationships HK$m 1,264 – – 22 1,286

Other HK$m 44 – – 34 78

Total HK$m 9,023 908 (170) 652 10,413

4,760 1,111 75 (169) 302 6,079 2,970

604 105 – – 10 719 567 2011

5 24 – – 1 30 48

5,369 1,240 75 (169) 313 6,828 3,585

Computer software HK$m Cost At 1 January ............................................................... Additions .................................................................... Disposals/amounts written-off ................................... Exchange and other movements ................................ At 31 December ......................................................... Accumulated amortisation and impairment At 1 January ............................................................... Amortisation charge for the year ............................... Impairment .................................................................. Disposals/amounts written-off ................................... Exchange and other movements ................................ At 31 December ......................................................... Net book value at 31 December ................................ 6,424 1,371 (74) (6) 7,715

Customer/ merchant relationships HK$m 1,269 – (2) (3) 1,264

Other HK$m 12 37 (5) – 44

Total HK$m 7,705 1,408 (81) (9) 9,023

3,647 1,019 173 (74) (5) 4,760 2,955

503 105 – (2) (2) 604 660

9 1 – (5) – 5 39

4,159 1,125 173 (81) (7) 5,369 3,654

The above intangible assets are amortised over their finite useful lives as follows: Computer software Customer/merchant relationships Other (excluding operating licenses) from 3 years to 5 years from 3 years to 10 years from 3 years to 10 years

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25 Goodwill and intangible assets (continued) An impairment test was carried out in respect of the operating licenses in Taiwan as at 1 July 2012. The result confirmed that there was no impairment. The impairment test was performed by comparing the recoverable amount of the relevant cash generating units (‘CGUs’), determined by a value in use calculation, with the carrying amounts of the CGUs. The calculation uses cash flow estimates based on management’s cash flow projections, extrapolated in perpetuity using a long-term growth rate applicable to the banking industry in Taiwan. The discount rate used is based on the cost of capital the group allocates to Taiwan. The cost of capital used to discount its future cash flows can have a significant effect on its valuation. The cost of capital percentage is derived from the capital asset pricing model which is the same model used to compute the discount rate for goodwill impairment testing. Management judgement is required in estimating the future cash flows of the CGUs. These values are sensitive to the cash flows projected for the periods for which detailed forecasts are available and to assumptions regarding the long-term sustainable pattern of cash flows thereafter. While the acceptable range within which underlying assumptions can be applied is governed by the requirement for resulting forecasts to be compared with actual performance and verifiable economic data in future years, the cash flow forecasts necessarily and appropriately reflect management’s view of future business prospects. Two key assumptions upon which management has based its determination of the recoverable amount of the CGUs are the discount rate and the long-term growth rate. The discount rate used during 2012 was 13% (2011: in the range of 12% to 13%). The long-term growth rate used in the impairment testing during 2012 was 3% (2011: 3%). 26 Property, plant and equipment a Property, plant and equipment
Land and buildings HK$m Cost or valuation At 1 January 2012 ............................ Exchange and other adjustments ..... Additions .......................................... Disposals .......................................... Elimination of accumulated depreciation on revalued land and buildings ............................... Surplus on revaluation ..................... Reclassifications .............................. At 31 December 2012 ...................... Accumulated depreciation At 1 January 2012 ............................ Exchange and other adjustments ..... Charge for the year .......................... Disposals .......................................... Elimination of accumulated depreciation on revalued land and buildings ............................... Reclassifications .............................. At 31 December 2012 ...................... Net book value at 31 December 2012........................ Total at 31 December 2012 ............. 75,090 (159) 240 (2) The group Investment properties HK$m 4,616 – – – Land and buildings HK$m 48,318 (177) 234 (1) The Bank Investment properties HK$m 147 – – –

Equipment HK$m 21,922 62 1,750 (824)

Equipment HK$m 13,862 (2) 1,033 (393)

(1,857) 7,223 (431) 80,104

– 834 (168) 5,282

– – (682) 22,228

(1,106) 3,636 (9) 50,895

– 50 – 197

– – (628) 13,872

21 1 1,897 –

– – – –

16,313 52 2,117 (772)

– 1 1,162 –

– – – –

10,451 (1) 1,299 (366)

(1,857) (2) 60 80,044

– – – 5,282

– (335) 17,375 4,853 90,179

(1,106) – 57 50,838

– – – 197

– (328) 11,055 2,817 53,852

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Notes on the Financial Statements (continued)

26 Property, plant and equipment (continued)
Land and buildings HK$m Cost or valuation At 1 January 2011 ............................ Exchange and other adjustments ..... Additions .......................................... Disposals .......................................... Elimination of accumulated depreciation on revalued land and buildings ............................... Surplus on revaluation ..................... Reclassifications .............................. At 31 December 2011 ...................... Accumulated depreciation At 1 January 2011 ............................ Exchange and other adjustments ..... Charge for the year .......................... Disposals .......................................... Elimination of accumulated depreciation on revalued land and buildings ............................... Reclassifications .............................. At 31 December 2011 ...................... Net book value at 31 December 2011........................ Total at 31 December 2011 ............. 63,148 11 545 (7) The group Investment properties HK$m 3,503 – – – Land and buildings HK$m 41,423 (9) 505 (3) The Bank Investment properties HK$m 126 – – –

Equipment HK$m 20,530 (212) 2,325 (697)

Equipment HK$m 13,149 (222) 1,397 (456)

(1,593) 12,948 38 75,090

– 1,033 80 4,616

– – (24) 21,922

(1,001) 7,477 (74) 48,318

– 21 – 147

– – (6) 13,862

2 – 1,615 (3)

– – – –

14,832 (181) 2,263 (599)

– – 1,004 (3)

– – – –

9,637 (182) 1,382 (384)

(1,593) – 21 75,069

– – – 4,616

– (2) 16,313 5,609 85,294

(1,001) – – 48,318

– – – 147

– (2) 10,451 3,411 51,876

b The carrying amount of land and buildings, had they been stated at cost less accumulated depreciation, would have been as follows:
The group 2012 HK$m Cost less accumulated depreciation .............................. 18,847 2011 HK$m 19,575 The Bank 2012 HK$m 14,031 2011 HK$m 14,541

c

An analysis of land and buildings carried at valuation or cost (before deduction of accumulated depreciation) is as follows:
The group 2012 HK$m Land and buildings carried at valuation ...................... Other land and buildings stated at cost ........................ Land and buildings before deduction of accumulated depreciation ........................................ 80,094 10 80,104 2011 HK$m 74,901 189 75,090 The Bank 2012 HK$m 50,895 – 50,895 2011 HK$m 48,318 – 48,318

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26 Property, plant and equipment (continued) d The net book value of land and buildings and investment properties comprises:
The group 2012 HK$m In Hong Kong: Long leaseholds (over fifty years) ............................. Medium-term leaseholds (between ten and fifty years) .................................. Short leaseholds (less than ten years) ........................ 35,604 38,716 76 74,396 Outside Hong Kong: Freehold ..................................................................... Long leaseholds (over fifty years) ............................. Medium-term leaseholds (between ten and fifty years) .................................. Short leaseholds (less than ten years) ........................ 2011 HK$m 34,787 34,182 90 69,059 The Bank 2012 HK$m 30,216 11,985 76 42,277 2011 HK$m 29,818 10,004 90 39,912

4,562 174 6,157 37 10,930 85,326

4,444 157 5,978 47 10,626 79,685

3,537 126 5,058 37 8,758 51,035

3,489 112 4,905 47 8,553 48,465

Analysed as follows: Land and buildings .................................................... Investment properties ................................................

80,044 5,282 85,326

75,069 4,616 79,685

50,838 197 51,035

48,318 147 48,465

The group’s land and buildings and investment properties were revalued at 30 November 2012 and updated for any material changes at 31 December 2012. The basis of valuation for land and buildings and investment properties was open market value, depreciated replacement cost or surrender value as noted in note 3(o). In determining the open market value of investment properties, expected future cash flows have been discounted to their present values. The net book value of ‘Land and buildings’ includes HK$10,108m (2011: HK$9,384m) in respect of properties which were valued using the depreciated replacement cost method or surrender value. The surplus on property revaluation was HK$8,057m (2011: HK$13,981m). Amounts of HK$5,327m (2011: HK$9,656m) and HK$836m (2011: HK$1,041m) were credited to the property revaluation reserve and the income statement respectively. The amount credited to the property revaluation reserve of HK$5,327m (2011: HK$9,656m) is stated after deduction of non-controlling interests of HK$841m (2011: HK$1,412m) and deferred tax of HK$1,053m (2011: HK$1,872m). The amount credited to the income statement comprises the surplus of HK$834m (2011: HK$1,033m) on revaluation of investment properties, and HK$2m (2011: HK$8m) relating to the reversal of previous revaluation deficits that arose when the value of certain land and buildings fell below depreciated historical cost or surrender value. Land and buildings and investment properties in Hong Kong, Macau and mainland China, representing 95% by value of the group’s properties subject to valuation, were valued by DTZ Debenham Tie Leung Limited who has recent experience in the location and type of properties. The valuations were carried out by qualified valuers who are members of the Hong Kong Institute of Surveyors. Properties in eleven countries, which represent 5% by value of the group’s properties, were valued by different independent professionally qualified valuers.

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Notes on the Financial Statements (continued)

26 Property, plant and equipment (continued) e Properties leased to customers The group’s investment properties are rented out under operating leases. The leases typically run for a period of 2-3 years and may contain an option to renew and the terms will then be renegotiated. During the current year, HK$216m (2011: HK$191m) was recognised as rental income in the income statement in respect of operating leases. The total future minimum lease payments receivable under non-cancellable operating leases are as follows:
The group 2012 HK$m Within one year ........................................................... After one but within five years ................................... 181 98 279 2011 HK$m 163 92 255 The Bank 2012 HK$m 18 8 26 2011 HK$m 9 18 27

27 Leasehold land and land use rights The net book value of the group’s interests in leasehold land and land use rights that have been accounted for as operating leases is analysed as follows:
The group 2012 HK$m In Hong Kong: Medium-term leaseholds (between ten and fifty years) ..... 313 2011 HK$m 330 The Bank 2012 HK$m 75 2011 HK$m 77

The above amounts were included within ‘Prepayments and accrued income’ in ‘Other assets’ (note 28).

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28 Other assets
The group 2012 HK$m Current taxation recoverable .............................................. Assets held for sale ............................................................. Prepayments and accrued income ....................................... Accrued interest receivable ................................................. Acceptances and endorsements .......................................... Other ................................................................................... 1,029 48,280 3,823 14,992 31,965 86,964 187,053 2011 HK$m 676 8,117 3,135 14,524 31,750 42,113 100,315 The Bank 2012 HK$m 823 44,669 1,926 5,806 21,191 69,065 143,480 2011 HK$m 550 8,005 1,558 5,774 21,001 20,123 57,011

Assets held for sale comprise assets acquired by repossession of collateral for realisation, own properties held for sale, certain investments and assets of businesses to be sold, including the following: On 5 December 2012, we entered into an agreement to dispose of our entire shareholding in Ping An, consisting of 613,929,279 shares, at a fixed price of HK$59 per share. The fixing of the sale price gave rise to a contingent forward sale contract, the fair value of which at year end was based on the difference between the agreed sale price and the market price for the shares, adjusted for an assessment of the probability of the transaction being completed. The adverse fair value of this contract was HK$2,694m at 31 December 2012, recorded in net trading income. The investment in Ping An is accounted for as an available-for-sale investment and carried at fair value with unrealised gains or losses recorded in other comprehensive income. At 31 December 2012, the fair value of our investment in Ping An was HK$39,813m, included in ‘Assets held for sale’, with HK$31,701m accumulated unrealised gains in other comprehensive income. These unrealised gains include HK$3,591m of gains which arose after the date of the sale agreement and represent the difference between Ping An's share price at the year end and the agreed sale price. The gain from this transaction is HK$28,110m, being the proceeds of HK$36,222m based on the agreed sale price of HK$59 per share, less the original cost of HK$8,112m. The income statement impact of this transaction is a loss of HK$2,694m in 2012 and a net gain in 2013 of HK$30,804m. On 26 October 2012, the group entered into an agreement to sell the assets and liabilities, other than the statutory deposits, of the Taiwan branch of HSBC Life (International) Limited to Allianz Taiwan Life Insurance Company Limited. The transaction is subject to regulatory approvals and is expected to complete during the first half of 2013. On 20 December 2012, the group entered into an agreement to sell its entire 18% shareholding in Bao Viet Holdings (‘Bao Viet’) to Sumitomo Life Insurance Company. The transaction is subject to regulatory approvals and is expected to complete during the first quarter of 2013. Gold bullion balances were reclassified from ‘Loans and Advances to customers’ to ‘Other assets’ during the year to reflect better the substance of the gold lending business.

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Notes on the Financial Statements (continued)

29 Customer accounts
The group 2012 HK$m Current accounts ................................................................. Savings accounts ................................................................. Other deposit accounts ........................................................ 831,256 2,063,565 980,063 3,874,884 2011 HK$m 696,435 1,826,893 1,041,673 3,565,001 The Bank 2012 HK$m 509,183 1,433,809 474,408 2,417,400 2011 HK$m 410,911 1,275,503 533,658 2,220,072

30 Trading liabilities
The group 2012 HK$m Certificates of deposit in issue ............................................ Other debt securities in issue .............................................. Short positions in securities ................................................ Deposits by banks ............................................................... Customer accounts .............................................................. 3,470 15,479 48,116 7,982 108,293 183,340 2011 HK$m 5,790 15,738 44,891 6,642 98,370 171,431 The Bank 2012 HK$m 796 15,159 26,519 7,430 32,242 82,146 2011 HK$m 1,379 14,999 18,780 5,911 37,890 78,959

31 Financial liabilities designated at fair value
The group 2012 HK$m Deposits by banks ............................................................... Customer accounts .............................................................. Debt securities in issue ....................................................... Liabilities to customers under investment contracts .......... 271 1,366 6,414 36,219 44,270 2011 HK$m 302 1,618 3,990 34,482 40,392 The Bank 2012 HK$m 271 1,366 6,094 – 7,731 2011 HK$m 302 1,618 3,990 – 5,910

At 31 December 2012, the carrying amount of financial liabilities designated at fair value was HK$81m higher than the contractual amount at maturity (2011: the carrying amount was HK$56m higher than the contractual amount). At 31 December 2012, the accumulated loss in fair value attributable to changes in credit risk was HK$13m (2011: the accumulated gain was HK$9m). 32 Debt securities in issue
The group 2012 HK$m Certificates of deposit ......................................................... Other debt securities ........................................................... 29,066 45,581 74,647 2011 HK$m 37,281 40,191 77,472 The Bank 2012 HK$m 9,243 31,163 40,406 2011 HK$m 18,871 27,489 46,360

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33 Other liabilities and provisions
The group 2012 HK$m Accruals and deferred income ............................................ Liabilities of business held for sale ..................................... Provisions for liabilities and charges (note 35) .................. Acceptances and endorsements .......................................... Share based payment liability to HSBC ............................. Other liabilities ................................................................... 24,705 4,811 2,144 31,965 2,560 28,606 94,791 2011 HK$m 23,286 21,970 1,686 31,750 2,729 26,893 108,314 The Bank 2012 HK$m 15,013 3,451 1,266 21,191 2,068 15,898 58,887 2011 HK$m 13,441 21,970 1,184 21,001 2,212 11,777 71,585

34 Liabilities under insurance contracts issued
Gross HK$m 2012 Non-life insurance liabilities Unearned premiums .............................................................................................. Notified claims ...................................................................................................... Claims incurred but not reported .......................................................................... Other ..................................................................................................................... 39 12 26 43 120 Life insurance liabilities to policyholders Life (non-linked) ................................................................................................... Life (linked) .......................................................................................................... Investment contracts with discretionary participation features ............................ Reinsurance HK$m – – – – – Net HK$m 39 12 26 43 120

210,825 33,948 28 244,801

(1,389) (3,103) – (4,492) (4,492)

209,436 30,845 28 240,309 240,429

Total liabilities under insurance contracts ............................................................ 2011 Non-life insurance liabilities Unearned premiums .............................................................................................. Notified claims ...................................................................................................... Claims incurred but not reported .......................................................................... Other .....................................................................................................................

244,921

1,674 984 256 145 3,059

(157) (203) (35) – (395)

1,517 781 221 145 2,664

Life insurance liabilities to policyholders Life (non-linked) ................................................................................................... Life (linked) .......................................................................................................... Investment contracts with discretionary participation features ............................

176,238 30,055 86 206,379

(228) (6,666) – (6,894) (7,289)

176,010 23,389 86 199,485 202,149

Total liabilities under insurance contracts ............................................................

209,438

Amounts recoverable from reinsurance of liabilities under insurance contracts issued are included in the consolidated balance sheet in ‘Other assets’.

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Notes on the Financial Statements (continued)

34 Liabilities under insurance contracts issued (continued) a Movement of liabilities under insurance contracts (i) Non-life insurance
Gross HK$m 2012 Unearned premiums At 1 January ......................................................................................... Gross written premiums ...................................................................... Gross earned premiums ....................................................................... Business disposals ............................................................................... Foreign exchange and other movements ............................................. At 31 December ................................................................................... Notified and incurred but not reported claims At 1 January ......................................................................................... – Notified claims ................................................................................ – Claims incurred but not reported ..................................................... Claims paid in current year ................................................................. Claims incurred ................................................................................... Business disposals ............................................................................... Foreign exchange and other movements ............................................. At 31 December – Notified claims ................................................................................ – Claims incurred but not reported ..................................................... Total at 31 December .......................................................................... 2011 Unearned premiums At 1 January ......................................................................................... Gross written premiums ...................................................................... Gross earned premiums ....................................................................... Foreign exchange and other movements ............................................. At 31 December ................................................................................... Notified and incurred but not reported claims At 1 January ......................................................................................... – Notified claims ................................................................................ – Claims incurred but not reported ..................................................... Claims paid in current year ................................................................. Claims incurred ................................................................................... Foreign exchange and other movements ............................................. At 31 December – Notified claims ................................................................................ – Claims incurred but not reported ..................................................... Total at 31 December .......................................................................... 1,674 2,935 (2,550) (2,037) 17 39 Reinsurance HK$m (157) (365) 341 181 – – Net HK$m 1,517 2,570 (2,209) (1,856) 17 39

1,240 984 256 (1,135) 1,206 (1,341) 68 12 26 38

(238) (203) (35) 98 (99) 246 (7) – – –

1,002 781 221 (1,037) 1,107 (1,095) 61 12 26 38

1,495 3,318 (3,135) (4) 1,674

(158) (455) 456 – (157)

1,337 2,863 (2,679) (4) 1,517

1,303 1,008 295 (1,420) 1,387 (30) 984 256 1,240

(262) (219) (43) 147 (161) 38 (203) (35) (238)

1,041 789 252 (1,273) 1,226 8 781 221 1,002

116

34 Liabilities under insurance contracts issued (continued) (ii) Life insurance liabilities to policyholders
Gross HK$m 2012 Life (non-linked) At 1 January ......................................................................................... Benefits paid ........................................................................................ Increase in liabilities to policyholders ................................................. Foreign exchange and other movements ............................................. At 31 December ................................................................................... Life (linked) At 1 January ......................................................................................... Benefits paid ........................................................................................ Increase in liabilities to policyholders.................................................. Foreign exchange and other movements ............................................. At 31 December ................................................................................... Investment contracts with discretionary participation features At 1 January ......................................................................................... Benefits paid ........................................................................................ Increase in liabilities to policyholders.................................................. Foreign exchange and other movements ............................................. At 31 December ................................................................................... Total liabilities to policyholders .......................................................... 2011 Life (non-linked) At 1 January ......................................................................................... Benefits paid ........................................................................................ Increase in liabilities to policyholders ................................................. Foreign exchange and other movements ............................................. At 31 December ................................................................................... Life (linked) At 1 January ......................................................................................... Benefits paid ........................................................................................ Increase in liabilities to policyholders.................................................. Foreign exchange and other movements ............................................. At 31 December ................................................................................... Investment contracts with discretionary participation features At 1 January ......................................................................................... Benefits paid ........................................................................................ Increase in liabilities to policyholders.................................................. Foreign exchange and other movements ............................................. At 31 December ................................................................................... Total liabilities to policyholders .......................................................... Reinsurance HK$m Net HK$m

176,238 (6,931) 42,376 (858) 210,825

(228) 143 (1,315) 11 (1,389)

176,010 (6,788) 41,061 (847) 209,436

30,055 (7,286) 10,972 207 33,948

(6,666) 5,233 1,842 (3,512) (3,103)

23,389 (2,053) 12,814 (3,305) 30,845

86 (62) 1 3 28 244,801

– – – – – (4,492)

86 (62) 1 3 28 240,309

145,960 (6,399) 36,997 (320) 176,238

(161) 178 (183) (62) (228)

145,799 (6,221) 36,814 (382) 176,010

28,920 (1,958) 3,150 (57) 30,055

(5,567) 385 (802) (682) (6,666)

23,353 (1,573) 2,348 (739) 23,389

170 (85) 1 – 86 206,379

– – – – – (6,894)

170 (85) 1 – 86 199,485

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Notes on the Financial Statements (continued)

35 Provisions for liabilities and charges Provisions for liabilities and charges
The group 2012 HK$m At 1 January ........................................................................ Additional provisions/increase in provisions ..................... Provisions used ................................................................... Amounts reversed ............................................................... Exchange and other movements ......................................... At 31 December .................................................................. 1,686 1,835 (1,362) (225) 210 2,144 2011 HK$m 1,359 767 (276) (85) (79) 1,686 The Bank 2012 HK$m 1,184 1,053 (970) (135) 134 1,266 2011 HK$m 858 707 (243) (54) (84) 1,184

Of which: provisions for restructuring costs
The group 2012 HK$m At 1 January ........................................................................ Additional provisions/increase in provisions ..................... Provisions used ................................................................... Amounts reversed ............................................................... Exchange and other movements ......................................... At 31 December .................................................................. 476 619 (683) (92) (33) 287 2011 HK$m 83 631 (233) (8) 3 476 The Bank 2012 HK$m 439 483 (556) (78) (32) 256 2011 HK$m 77 580 (211) (2) (5) 439

36 Subordinated liabilities Subordinated liabilities consist of undated primary capital notes and other loan capital having an original term to maturity of five years or more, raised by the Bank and the group for the development and expansion of its business.
2012 HK$m Undated floating rate primary capital notes .......................................................... 9,355 9,355 Floating rate subordinated notes due 2018, callable from 20131 .......................... Floating rate subordinated notes due 2020, callable from 2015 ........................... Floating rate subordinated notes due 2017, callable from 20122 .......................... Fixed rate (4.35%) subordinated bonds due 2022, callable from 20173 ............... Fixed rate (5.05%) subordinated bonds due 2027, callable from 20224 ............... 338 1,608 – 1,267 1,299 13,867 1 2 3 4 The interest rate on the A$42m callable subordinated floating rate notes due 2018 will increase by 0.5% from March 2013. The US$300m callable subordinated floating rate notes due 2017 were redeemed in July 2012. The interest rate on the RM500m 4.35% callable subordinated bonds due 2022 will increase by 1% from June 2017. The interest rate on the RM500m 5.05% callable subordinated bonds due 2027 will increase by 1% from November 2022. 2011 HK$m 9,386 9,386 332 1,580 2,328 1,227 1,261 16,114

The Bank
US$1,200m

The group
A$42m A$200m US$300m RM500m RM500m

118

37 Preference shares Authorised At both 31 December 2012 and 31 December 2011, the authorised preference share capital of the Bank was US$13,450.5m comprising 3,750.5m cumulative redeemable preference shares of US$1 each, 7,500m non-cumulative irredeemable preference shares of US$1 each and 2,200m cumulative irredeemable preference shares of US$1 each. At a group level, there was an additional INR1,320m (2011: INR900m) of authorised preference share capital comprising 13.2m compulsorily convertible preference shares of INR100 each in the share capital of a subsidiary.
The group 2012 HK$m Issued and fully paid Redeemable preference shares ............................................ Irredeemable preference shares .......................................... Share premium .................................................................... 11,243 68,231 3,872 83,346 2011 HK$m 24,862 68,354 3,880 97,096 The Bank 2012 HK$m 11,243 68,080 3,872 83,195 2011 HK$m 24,862 68,227 3,880 96,969

500,000 cumulative redeemable preference shares were issued in 1997, which have a mandatory redemption date of 2 January 2019 but may be redeemed at the Bank’s option on or after 2 January 2003, subject to the consent of the Hong Kong Monetary Authority. The shares are redeemable at the issue price of US$1,000 per share, comprising nominal value of US$1 per share and premium on issue of US$999 per share. 1,750m cumulative redeemable preference shares were issued in 2007, which have mandatory redemption dates between 29 March and 24 November 2017 but may be redeemed at the Bank’s option on or after dates starting between 29 March and 24 November 2012, subject to the consent of the Hong Kong Monetary Authority. The shares are redeemable at the issue price of US$1 per share. 250m cumulative redeemable preference shares were redeemed on 29 March 2012 at US$1 per share and 1,500m cumulative redeemable preference shares were redeemed on 26 November 2012 at US$1 per share. 400m cumulative redeemable preferences shares were issued in 2008, which have a mandatory redemption date of 29 March 2023 but may be redeemed at the Bank’s option on or after 29 March 2018, subject to the consent of the Hong Kong Monetary Authority. The shares are redeemable at the issue price of US$1 per share. 1,050m cumulative redeemable preferences shares were issued in 2009, which have a mandatory redemption date of 2 January 2024 but may be redeemed at the Bank’s option on or after 2 January 2019, subject to the consent of the Hong Kong Monetary Authority. The shares are redeemable at the issue price of US$1 per share. 550m cumulative redeemable preference shares, issued in 2006, were redeemed at the issue price of US$1 per share on 21 December 2011. The total number of issued cumulative redeemable preference shares at 31 December 2012 was 1,450.5m (2011: 3,200.5m). No cumulative redeemable preference shares were issued during the year (2011: nil). The non-cumulative irredeemable preference shares were issued at nominal value, and may be cancelled subject to 30 days’ notice in writing to shareholders and with the prior consent of the Hong Kong Monetary Authority. In the event of cancellation, holders of the shares shall be entitled to receive the issue price of US$1 per share held together with any unpaid dividends for the period since the annual dividend payment date immediately preceding the date of cancellation, subject to the Bank having sufficient distributable profits. The number of issued non-cumulative irredeemable preference shares at 31 December 2012 was 6,653m (2011: 6,653m). No non-cumulative irredeemable preference shares were issued during the year (2011: nil).

119

T H E H O N G K O N G A N D S H A N G H A I B A N K I N G C O R P O R AT I O N L I M I T E D

Notes on the Financial Statements (continued)

37 Preference shares (continued) The cumulative irredeemable preference shares were issued at nominal value, and may be cancelled subject to 30 days’ notice in writing to shareholders and with the prior consent of the Hong Kong Monetary Authority. In the event of cancellation, holders of the shares shall be entitled to receive the issue price of US$1 per share held together with any unpaid dividends for the period since the annual dividend payment date immediately preceding the date of cancellation, subject to the Bank having sufficient distributable profits. The number of issued cumulative irredeemable preference shares at 31 December 2012 was 2,130m (2011: 2,130m). No cumulative irredeemable preference shares were issued during the year (2011: nil). The holders of the preference shares are entitled to one vote per share at shareholder meetings of the Bank. 8.7m compulsorily convertible preference shares (‘CCPS’) were issued by HSBC InvestDirect Securities (India) Limited (‘HSBC InvestDirect’) in 2009 at a nominal value of INR100 each. These shares may be converted into fully paid equity shares of HSBC InvestDirect at any time after one year from the date of allotment of the CCPS by written notice. The conversion shall be made at par or premium as may be determined by the Board of HSBC InvestDirect at the time of the conversion. The CCPS shall carry a fixed dividend of 0.001% of the face value per annum. After ten years following the allotment of the CCPS all outstanding CCPS shall be converted at par or premium as may be determined by the Board of HSBC InvestDirect at the time of the conversion. During the year HSBC InvestDirect issued an additional INR450m of CCPS (2011: Nil) comprising 4.5m CCPS of INR100 each. These shares may be converted into fully paid equity shares of HSBC InvestDirect at any time after three months from the date of allotment of the CCPS by written notice. The conversion shall be made at par or premium as may be determined by the Board of HSBC InvestDirect at the time of the conversion. The CCPS shall carry a fixed dividend of 0.001% of the face value per annum. After six months following the allotment of the CCPS all outstanding CCPS shall be converted at par or premium as may be determined by the Board of HSBC InvestDirect at the time of the conversion. HSBC InvestDirect converted 2.5m CCPS in to 3,906,250 equity shares of INR10 each at a premium of INR64 per share amounting to INR250m during 2012. 38 Share capital Authorised The authorised ordinary share capital of the Bank at 31 December 2012 was HK$80,000m (2011: HK$50,000m) divided into 32,000m (2011: 20,000m) ordinary shares of HK$2.50 each subsequent to the increase in authorised ordinary share capital by the creation of HK$30,000m divided into 12,000m new ordinary shares of HK$2.50 each on 26 November 2012. 11,511,335,607 new ordinary shares were issued during 2012 (2011: 3,078,560,000). Issued and fully paid
The group and the Bank 2012 2011 HK$m HK$m Ordinary share capital .............................................................................................................................. 58,969 30,190

Ordinary shares of HK$2.50 each At 1 January ............................................................................................................................................. Issued during the year ............................................................................................................................... At 31 December ........................................................................................................................................

The group and the Bank 2012 2012 Number HK$m 12,076,147,294 11,511,335,607 23,587,482,901 30,190 28,779 58,969

The holders of the ordinary shares are entitled to receive dividends as declared from time to time, rank equally with regard to the Bank’s residual assets and are entitled to one vote per share at shareholder meetings of the Bank.

120

39 Reserves Regulatory reserve The Bank and its banking subsidiaries maintain a regulatory reserve to satisfy the provisions of the Banking Ordinance and local regulatory requirements for prudential supervision purposes. At 31 December 2012, the effect of this requirement is to restrict the amount of reserves which can be distributed to shareholders by HK$19,426m (31 December 2011: HK$17,108m). Retained profits Retained profits are the cumulative net earnings of the group that have not been paid out as dividends, but retained to be reinvested in the business. Property revaluation reserve The property revaluation reserve represents the difference between the current fair value of the property and its depreciated cost. Available-for-sale investment reserve The available-for-sale investment reserve includes the cumulative net change in the fair value of available-for-sale investments other than impairments which have been recognised in the income statement. Cash flow hedge reserve The cash flow hedge reserve comprises the effective portion of the cumulative net change in the fair value of cash flow hedging instruments related to hedged transactions. Foreign exchange reserve The foreign exchange reserve comprises all foreign exchange differences arising from the translation of the financial statements of foreign operations as well as from the translation of liabilities that hedge the Bank’s net investments in foreign operations. Other reserve The other reserve mainly comprises the share-based payment reserve account and other non-distributable reserves. The share-based payment reserve account is used to record the amount relating to share options granted to employees of the group directly by HSBC Holdings plc.

121

40 Maturity analysis of assets and liabilities

The following is an analysis of assets and liabilities by remaining contractual maturities at the balance sheet date:

The group

On demand HK$m 360,798 23,079 – 5,232 – – – – – – – – – – – – – 419,697 120,034 22,014 30,470 56,977 26,231 3,869 7,976 4,957 – 36 – – – – – – – – 252,996 165,126 – – – – – – – – – –

Due within 1 month HK$m

Due between 1 and 3 months HK$m Due after 5 years HK$m Trading instruments HK$m Non-trading derivatives HK$m

Due between 3 and 12 months HK$m

Due between 1 and 5 years HK$m

No contractual maturity HK$m

Total HK$m 1,111,199 23,079 184,711 93,085 176,264 419,697

332,279

–

– –

Notes on the Financial Statements (continued)

176,264 –

T H E H O N G K O N G A N D S H A N G H A I B A N K I N G C O R P O R AT I O N L I M I T E D

122
38,664 – – – – 25,272 727,634 757,731 787,672 – – – – 67,768 – – – – 14,087 9,378 2,912 6,476 – – – – 7,825 1,049,264 2,297 – – – – 5,869 792,325

– – – – – 138,085 – – – – – 119,273 38,634 90,179 2,629 55,169 358,080

24 24 – – – 255,694 18,871 51 18,820 –

557 557 – – – 250,361 34,623 1,241 33,382 –

1,040 1,040 – – – 433,467 83,593 11,541 72,052 –

10,720 10,300 – 420 – 651,084 343,059 57,076 285,983 –

5,080 5,080 – – – 630,123 136,023 85,484 50,539 –

52,058 – 52,058 – – (9,771) 9,873 – 2,502 7,371

– – – – 394,787 – – – – – 6,710 – – – – – 821,194

– – – – 4,169 – – – – – – – – – – – 4,169

69,479 17,001 52,058 420 398,956 2,349,043 626,042 155,393 463,278 7,371 176,004 119,273 38,634 90,179 2,629 187,053 6,065,327

2012 Assets Cash and short-term funds ................. Items in the course of collection from other banks ............................ Placings with banks maturing after one month .............................. Certificates of deposit ........................ Hong Kong Government certificates of indebtedness .............................. Trading assets ..................................... Financial assets designated at fair value ........................................ Debt securities .................................... Equity shares ...................................... Other ................................................... Derivatives ......................................... Loans and advances to customers ...... Financial investments ........................ Debt securities held to maturity ......... Debt securities available for sale ....... Equity shares available for sale ......... Amounts due from Group companies ...................................... Interests in associates and joint ventures ................................. Goodwill and intangible assets .......... Property, plant and equipment ........... Deferred tax assets ............................. Other assets ........................................

109,567

– – – – 11,063

Total assets ........................................

767,258

40 Maturity analysis of assets and liabilities (continued)

The group

On demand HK$m

Due within 1 month HK$m Total HK$m

Due between 1 and 3 months HK$m Due after 5 years HK$m Trading instruments HK$m Non-trading derivatives HK$m

Due between 3 and 12 months HK$m

Due between 1 and 5 years HK$m

No contractual maturity HK$m

176,264 35,525 100,676 408,438 – – – 5,315 – 11,463 30,060 – 249 – – – 591,726 312,047 273,596 66,575 34,280 – 268 – 338 – – 3,029 – – – – 38 – 2,875 – – – – 1,299 15,266 237,702 – 16,923 9,355 68,080 382,488 – – 3,492 – 1,734 28,394 5,444 – 20,927 – 12,842 18,029 2,270 – 40,177 – 445 2,766 319 – 4,736 – 12,058 196 36,096 – – 6,725 – 7,607 – 393,264 – – 27,112 – – – – – – 603,716 – 8,242 269,579 – – 1,837 211,488 – – 4,949 13,055 – – 288 118 – – – – – – – – 183,340

–

–

–

–

–

–

–

– – – – – – 3,887 – – – – – – – – – 3,887

176,264 35,525 244,135 3,874,884 183,340 44,270 397,151 74,647 6,725 97,618 94,791 244,921 3,842 16,923 13,867 83,346 5,592,249

– 128,143 2,972,206 –

2012 Liabilities Hong Kong currency notes in circulation .................................. Items in the course of transmission to other banks ................................. Deposits by banks .............................. Customer accounts ............................. Trading liabilities ............................... Financial liabilities designated at fair value .................................... Derivatives ......................................... Debt securities in issue ...................... Retirement benefit liabilities .............. Amounts due to Group companies .... Other liabilities and provisions .......... Liabilities under insurance contracts issued .............................. Current tax liabilities ......................... Deferred tax liabilities ....................... Subordinated liabilities ...................... Preference shares ...............................

141 – – – 31,964 7,739

123

7,219 258 – – –

Total liabilities ..................................

3,323,934

40 Maturity analysis of assets and liabilities (continued)

The Bank

On demand HK$m 168,717 17,355 – 1,994 – – – – – – – – – – – – – 284,573 45,276 10,447 13,570 7,660 20,881 49 473 – – – – – – – – – – – – – – – – 189,400 136,448 – – – – –

Due within 1 month HK$m Total HK$m 761,187 17,355 80,200 20,150 176,264 284,573

Due between 1 and 3 months HK$m Due after 5 years HK$m Trading instruments HK$m Non-trading derivatives HK$m

Due between 3 and 12 months HK$m

Due between 1 and 5 years HK$m

No contractual maturity HK$m

266,622

–

– –

Notes on the Financial Statements (continued)

176,264 –

T H E H O N G K O N G A N D S H A N G H A I B A N K I N G C O R P O R AT I O N L I M I T E D

124
124,519 – – – – – 16,314 471,036 463,451 446,520 – – – – 60,228 – – – – 4,501 – – – – 5,798 589,027 27,852 – 13,258 – 15,882 – 22,461 – – – – – 622 393,315

– – – – – 86,889 – – – – – 58,819 40,919 4,765 53,852 1,333 53,599 211,223

– – – – – 132,086 10,051 – 10,051 –

– – – – – 118,459 11,789 – 11,789 –

– – – – – 230,952 40,131 – 40,131 –

1,432 1,432 – – – 374,239 170,746 – 170,746 –

– – – – – 345,644 24,115 – 24,115 –

– – – – – (5,549) 3,485 – 972 2,513

– – – – 388,298 – – – – – 13,126 – – – – – – 685,997

– – – – 3,541 – – – – – – – – – – – – 3,541

1,432 1,432 – – 391,839 1,282,720 260,317 – 257,804 2,513 321,600 58,819 40,919 4,765 53,852 1,333 143,480 3,900,805

2012 Assets Cash and short-term funds ................. Items in the course of collection from other banks ............................ Placings with banks maturing after one month .............................. Certificates of deposit ........................ Hong Kong Government certificates of indebtedness .............................. Trading assets ..................................... Financial assets designated at fair value ........................................ Debt securities .................................... Equity shares ...................................... Other ................................................... Derivatives ......................................... Loans and advances to customers ..... Financial investments ........................ Debt securities held to maturity ......... Debt securities available for sale ....... Equity shares available for sale ......... Amounts due from Group companies ...................................... Investments in subsidiaries ................. Interests in associates and joint ventures ................................. Goodwill and intangible assets .......... Property, plant and equipment ........... Deferred tax assets ............................. Other assets ........................................

104,502 –

– – – – 2,418

Total assets ........................................

636,695

40 Maturity analysis of assets and liabilities (continued)

The Bank

On demand HK$m

Due within 1 month HK$m Total HK$m

Due between 1 and 3 months HK$m Due after 5 years HK$m Trading instruments HK$m Non-trading derivatives HK$m

Due between 3 and 12 months HK$m

Due between 1 and 5 years HK$m

No contractual maturity HK$m

176,264 25,766 89,398 220,659 – – 5,667 97,552 – – 1,734 101,963 – – 3,404 6,469 – – 288 50 – – – – – – – – 82,146

–

–

–

–

–

–

–

– – – – –

176,264 25,766 204,520 2,417,400 82,146

– 104,029 1,990,707 –

125
395,228 136,702 139,155 37,544 29,512

2012 Liabilities Hong Kong currency notes in circulation .................................. Items in the course of transmission to other banks ................................. Deposits by banks .............................. Customer accounts ............................. Trading liabilities ............................... Financial liabilities designated at fair value .................................... Derivatives ......................................... Debt securities in issue ...................... Retirement benefit liabilities .............. Amounts due to Group companies .... Other liabilities and provisions .......... Current tax liabilities ......................... Deferred tax liabilities ....................... Subordinated liabilities ...................... Preference shares ............................... – – 4,855 – 33,803 20,747 – – – – 92,070 – – 3,347 – 9,600 20,281 255 – – – 5,444 – 7,537 – 13,157 7,530 1,790 – – – 2,270 – 22,763 – 439 2,151 48 – – – – – 1,904 – 12,058 97 – – – 15,115 17 – – 3,710 – 4,714 – 6,194 9,355 68,080 – 390,282 – – 18,969 – – – – – 491,397 – 1,802 – – – – – – – – 1,802

– – – – 61,211 3,367 255 – – –

7,731 392,084 40,406 3,710 149,237 58,887 2,348 6,194 9,355 83,195 3,659,243

Total liabilities ..................................

2,335,833

40 Maturity analysis of assets and liabilities (continued)

The group

On demand HK$m 311,104 34,546 – 13,008 – – – – – – – – – – – – – 447,968 143,663 18,542 29,835 47,138 17,917 5,559 6,872 4,399 – 45 – – – – – – – – – – – – – 189,622 107,273 – – – – –

Due within 1 month HK$m Total HK$m 919,906 34,546 198,287 88,691 162,524 447,968

Due between 1 and 3 months HK$m Due after 5 years HK$m Trading instruments HK$m Non-trading derivatives HK$m

Due between 3 and 12 months HK$m

Due between 1 and 5 years HK$m

No contractual maturity HK$m

311,907

–

– –

Notes on the Financial Statements (continued)

162,524 –

T H E H O N G K O N G A N D S H A N G H A I B A N K I N G C O R P O R AT I O N L I M I T E D

126
71,033 – – – – 20,434 727,358 687,309 771,881 – – – – 15,898 – – – – 22,152 – – – – 4,034 942,846 5,138 7,621 6,722 3,407 – – – – 8,817 675,903

– – – – – 124,518 – – – – – 91,785 34,839 85,294 2,325 16,692 306,873

332 332 – – – 233,188 43,713 873 42,840 –

1,145 1,145 – – – 239,508 73,793 2,223 71,570 –

1,684 1,684 – – – 358,702 197,476 5,452 192,024 –

10,389 9,749 – 640 – 644,001 254,224 53,873 200,351 –

3,822 3,822 – – – 542,255 106,331 72,299 34,032 –

40,298 30 40,268 – – (11,301) 46,896 – 1,719 45,177

– – – – 376,636 – – – – – 11,121 – – – – – 835,725

– – – – 660 – – – – – – – – – – – 660

57,670 16,762 40,268 640 377,296 2,130,871 722,433 134,720 542,536 45,177 152,730 91,785 34,839 85,294 2,325 100,315 5,607,480

2011 Assets Cash and short-term funds ................. Items in the course of collection from other banks ............................ Placings with banks maturing after one month .............................. Certificates of deposit ........................ Hong Kong Government certificates of indebtedness .............................. Trading assets ..................................... Financial assets designated at fair value ........................................ Debt securities .................................... Equity shares ...................................... Other ................................................... Derivatives ......................................... Loans and advances to customers ...... Financial investments ........................ Debt securities held to maturity ......... Debt securities available for sale ....... Equity shares available for sale ......... Amounts due from Group companies ...................................... Interests in associates and joint ventures ................................. Goodwill and intangible assets .......... Property, plant and equipment ........... Deferred tax assets ............................. Other assets ........................................

47,688

– – – – 12,288

Total assets ..........................................

658,925

40 Maturity analysis of assets and liabilities (continued)

The group

On demand HK$m

Due within 1 month HK$m Total HK$m

Due between 1 and 3 months HK$m Due after 5 years HK$m Trading instruments HK$m Non-trading derivatives HK$m

Due between 3 and 12 months HK$m

Due between 1 and 5 years HK$m

No contractual maturity HK$m

162,524 47,163 92,898 453,716 – – – 6,161 – 26,259 25,653 – 450 – – – 652,300 376,403 226,384 68,918 45,801 – 352 – – – – 3,000 – 2,328 – – 10 – 1,912 – – – – 2,488 28,742 208,485 – 14,712 9,386 68,354 347,706 – – 15,207 – 6,737 28,003 – – 8,444 – 9,154 38,293 5,796 – 42,221 – 140 3,257 360 – 4,006 – 9,675 176 33,999 – – 8,097 – 4,673 – 379,989 – – 37,675 – – – – – – 589,095 – 18,399 307,705 – – 2,565 162,600 – – 821 14,761 – – 231 123 – – – – – – – – 171,431

–

–

–

–

–

–

–

– – – – – – 3,263 – – – – – – – – – 3,263

162,524 47,163 222,582 3,565,001 171,431 40,392 383,252 77,472 8,097 108,423 108,314 209,438 4,126 14,712 16,114 97,096 5,236,137

– 107,668 2,626,096 –

2011 Liabilities Hong Kong currency notes in circulation .................................. Items in the course of transmission to other banks ................................. Deposits by banks .............................. Customer accounts ............................. Trading liabilities ............................... Financial liabilities designated at fair value .................................... Derivatives ......................................... Debt securities in issue ...................... Retirement benefit liabilities .............. Amounts due to Group companies .... Other liabilities and provisions .......... Liabilities under insurance contracts issued .............................. Current tax liabilities ......................... Deferred tax liabilities ....................... Subordinated liabilities ...................... Preference shares ...............................

237 – 1,433 – 18,783 8,259

127

953 314 – – –

Total liabilities ...................................

2,926,267

40 Maturity analysis of assets and liabilities (continued)

The Bank

On demand HK$m 151,511 29,821 – 5,987 – – – – – – – – – – – – – 317,321 84,073 6,467 9,024 9,943 15,283 1,584 493 – – 6 – – – – – – – – – – – – – 176,113 70,393 – – – – –

Due within 1 month HK$m Total HK$m 612,265 29,821 108,873 23,987 162,524 317,321

Due between 1 and 3 months HK$m Due after 5 years HK$m Trading instruments HK$m Non-trading derivatives HK$m

Due between 3 and 12 months HK$m

Due between 1 and 5 years HK$m

No contractual maturity HK$m

214,248

–

– –

Notes on the Financial Statements (continued)

162,524 –

T H E H O N G K O N G A N D S H A N G H A I B A N K I N G C O R P O R AT I O N L I M I T E D

128
96,765 – – – – – 11,478 443,332 465,298 425,758 – – – – 9,417 – – – – 14,752 – – – – 3,162 525,472 20,340 – 19,943 – 13,375 – 20,075 – – – – – 428 344,360

– – – – – 77,229 – – – – – 57,724 28,139 4,831 51,876 1,098 14,952 188,796

– – – – – 120,632 27,138 – 27,138 –

728 728 – – – 122,399 45,761 – 45,761 –

172 172 – – – 182,890 118,641 – 118,641 –

1,383 1,383 – – – 375,521 115,164 – 115,164 –

– – – – – 305,645 17,719 – 17,719 –

– – – – – (7,714) 37,884 – 713 37,171

– – – – 370,361 – – – – – 14,455 – – – – – – 702,137

– – – – 317 – – – – – – – – – – – – 317

2,283 2,283 – – 370,678 1,176,602 362,307 – 325,136 37,171 248,001 57,724 28,139 4,831 51,876 1,098 57,011 3,615,341

2011 Assets Cash and short-term funds ................. Items in the course of collection from other banks ............................ Placings with banks maturing after one month .............................. Certificates of deposit ........................ Hong Kong Government certificates of indebtedness .............................. Trading assets ..................................... Financial assets designated at fair value ........................................ Debt securities .................................... Equity shares ...................................... Other ................................................... Derivatives ......................................... Loans and advances to customers ..... Financial investments ........................ Debt securities held to maturity ......... Debt securities available for sale ....... Equity shares available for sale ......... Amounts due from Group companies ...................................... Investments in subsidiaries ................. Interests in associates and joint ventures ................................. Goodwill and intangible assets .......... Property, plant and equipment ........... Deferred tax assets ............................. Other assets ........................................

63,048 –

– – – – 2,822

Total assets .........................................

519,871

40 Maturity analysis of assets and liabilities (continued)

The Bank

On demand HK$m

Due within 1 month HK$m Total HK$m

Due between 1 and 3 months HK$m Due after 5 years HK$m Trading instruments HK$m Non-trading derivatives HK$m

Due between 3 and 12 months HK$m

Due between 1 and 5 years HK$m

No contractual maturity HK$m

162,524 38,577 72,539 280,554 – – 15,677 128,032 – – 1,926 66,418 – – 821 11,311 – – 231 63 – – – – – – – – 78,959

–

–

–

–

–

–

–

– – – – –

162,524 38,577 158,746 2,220,072 78,959

– 67,552 1,733,694 –

129
462,083 190,583 113,825 42,127 41,138

2011 Liabilities Hong Kong currency notes in circulation .................................. Items in the course of transmission to other banks ................................. Deposits by banks .............................. Customer accounts ............................. Trading liabilities ............................... Financial liabilities designated at fair value .................................... Derivatives ......................................... Debt securities in issue ...................... Retirement benefit liabilities .............. Amounts due to Group companies .... Other liabilities and provisions .......... Current tax liabilities ......................... Deferred tax liabilities ....................... Subordinated liabilities ...................... Preference shares ............................... – – 4,378 – 53,074 12,954 7 – – – 90,280 – – 14,169 – 13,494 18,936 275 – – – – – 3,293 – 9,661 30,372 2,155 – – – 5,796 – 21,294 – 422 2,479 4 – – – 101 – 1,793 – 10,105 103 – – – 28,742 13 – – 4,150 – 2,620 – 5,884 9,386 68,227 – 375,712 – – 33,258 – – – – – 487,929 – 1,453 – – – – – – – – 1,453

– – 1,433 – 32,892 4,121 307 – – –

5,910 377,165 46,360 4,150 152,906 71,585 2,748 5,884 9,386 96,969 3,431,941

Total liabilities ...................................

2,002,523

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Notes on the Financial Statements (continued)

41 Analysis of cash flows payable under financial liabilities by remaining contractual maturities The group
On demand HK$m At 31 December 2012 Hong Kong currency notes in circulation ............................... Items in the course of transmission to other banks ............................. Deposits by banks ........................... Customer accounts .......................... Trading liabilities ............................ Financial liabilities designated at fair value ..................................... Derivatives ...................................... Debt securities in issue ................... Amounts due to Group companies .. Other financial liabilities ................ Subordinated liabilities ................... Preference shares ............................ Loan commitments ......................... Financial guarantee and credit risk related guarantee contracts ......... Due within 3 months HK$m Due between 3 and 12 months HK$m Due between 1 and 5 years HK$m Due after 5 years HK$m

Total HK$m

176,264 – 128,158 2,972,878 183,340 141 393,498 – 59,786 7,322 – – 3,921,387 1,184,203 59,065 5,164,655

– 35,525 109,010 680,668 – 120 186 9,283 13,195 49,764 475 950 899,176 380,861 – 1,280,037

– – 1,863 215,788 – 5,525 707 21,817 12,853 15,123 400 1,317 275,393 26,529 – 301,922

– – 4,993 14,444 – 2,338 2,622 43,080 470 2,422 4,919 9,068 84,356 12,554 – 96,910

– – 326 204 – 36,482 (13) 5,624 11,996 120 14,275 104,973 173,987 – – 173,987

176,264 35,525 244,350 3,883,982 183,340 44,606 397,000 79,804 98,300 74,751 20,069 116,308 5,354,299 1,604,147 59,065 7,017,511

At 31 December 2011 Hong Kong currency notes in circulation ............................... Items in the course of transmission to other banks ............................. Deposits by banks ........................... Customer accounts .......................... Trading liabilities ............................ Financial liabilities designated at fair value ..................................... Derivatives ...................................... Debt securities in issue ................... Amounts due to Group companies .. Other financial liabilities ................ Subordinated liabilities ................... Preference shares ............................ Loan commitments ......................... Financial guarantee and credit risk related guarantee contracts .........

162,524 – 107,693 2,626,340 171,431 244 380,205 1,433 56,459 7,641 – – 3,513,970 1,101,283 48,432 4,663,685

– 47,163 111,446 766,222 – 114 205 21,703 33,025 48,661 189 874 1,029,602 327,017 – 1,356,619

– – 2,595 167,859 – 138 765 9,260 9,195 37,000 2,724 1,413 230,949 31,249 – 262,198

– – 882 16,729 – 6,006 2,065 44,378 165 2,791 3,996 9,148 86,160 13,080 – 99,240

– – 265 211 – 34,362 94 5,197 9,706 118 16,089 117,189 183,231 9 – 183,240

162,524 47,163 222,881 3,577,361 171,431 40,864 383,334 81,971 108,550 96,211 22,998 128,624 5,043,912 1,472,638 48,432 6,564,982

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41 Analysis of cash flows payable under financial liabilities by remaining contractual maturities (continued) The Bank
On demand HK$m At 31 December 2012 Hong Kong currency notes in circulation ............................... Items in the course of transmission to other banks ............................. Deposits by banks ........................... Customer accounts .......................... Trading liabilities ............................ Financial liabilities designated at fair value ..................................... Derivatives ...................................... Debt securities in issue ................... Amounts due to Group companies .. Other financial liabilities ................ Subordinated liabilities ................... Preference shares ............................ Loan commitments ......................... Financial guarantee and credit risk related guarantee contracts .......... Due within 3 months HK$m Due between 3 and 12 months HK$m Due between 1 and 5 years HK$m Due after 5 years HK$m

Total HK$m

176,264 – 104,037 1,990,783 82,147 – 390,424 – 81,128 3,220 – – 2,828,003 727,721 32,317 3,588,041

– 25,766 95,133 318,830 – 116 76 8,428 43,395 34,111 82 950 526,887 289,784 – 816,671

– – 1,757 103,564 – 5,513 515 8,022 13,164 6,883 246 1,317 140,981 7,467 – 148,448

– – 3,447 7,095 – 2,270 1,373 24,677 462 2,007 1,310 9,068 51,709 9,065 – 60,774

– – 326 121 – – (54) 2,194 12,115 66 12,577 104,823 132,168 – – 132,168

176,264 25,766 204,700 2,420,393 82,147 7,899 392,334 43,321 150,264 46,287 14,215 116,158 3,679,748 1,034,037 32,317 4,746,102

At 31 December 2011 Hong Kong currency notes in circulation ............................... Items in the course of transmission to other banks ............................. Deposits by banks ........................... Customer accounts .......................... Trading liabilities ............................ Financial liabilities designated at fair value ..................................... Derivatives ...................................... Debt securities in issue ................... Amounts due to Group companies .. Other financial liabilities ................ Subordinated liabilities ................... Preference shares ............................ Loan commitments ......................... Financial guarantee and credit risk related guarantee contracts ..........

162,524 – 67,552 1,733,781 78,959 – 375,832 1,433 66,152 3,840 – – 2,490,073 675,165 25,448 3,190,686

– 38,577 88,366 409,918 – 114 67 18,661 66,577 28,844 121 874 652,119 234,915 – 887,034

– – 1,955 68,089 – 138 428 3,559 9,690 29,789 207 1,413 115,268 11,650 – 126,918

– – 882 12,387 – 6,006 843 21,706 447 2,206 1,313 9,148 54,938 8,713 – 63,651

– – 265 126 – 117 38 1,974 10,161 74 12,604 117,062 142,421 6 – 142,427

162,524 38,577 159,020 2,224,301 78,959 6,375 377,208 47,333 153,027 64,753 14,245 128,497 3,454,819 930,449 25,448 4,410,716

The balances in the above tables will not agree directly with the balances in the consolidated balance sheet as the table incorporates, on an undiscounted basis, all cash flows relating to principal and future coupon payments (except for trading liabilities and trading derivatives). In addition, loan commitments and financial guarantee contracts are generally not recognised on the balance sheet. Trading liabilities and trading derivatives have been included in the ‘On demand’ time bucket, and not by contractual maturity, because trading liabilities are typically held for short periods of time. The undiscounted cash flows payable under hedging derivative liabilities are classified according to their contractual maturity. The undiscounted cash flows potentially payable under loan commitments and financial guarantee contracts are classified on the basis of the earliest date they can be called. Cash flows payable in respect of customer accounts are primarily contractually repayable on demand or at short notice. In practice, however, short-term deposit balances remain stable as inflows and outflows broadly match and a significant portion of loan commitments and guarantee contracts expire without being drawn upon. The group’s approach to managing liquidity risk is set out in note 52.

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Notes on the Financial Statements (continued)

42 Reconciliation of operating profit to cash generated from/(used in) operations
2012 HK$m Operating profit ..................................................................................................................................... Net interest income .................................................................................................................................. Dividend income ...................................................................................................................................... Depreciation and amortisation ................................................................................................................. Amortisation of prepaid operating lease payments ................................................................................. Loan impairment charges and other credit risk provisions ..................................................................... Loans and advances written off net of recoveries ................................................................................... Other provisions for liabilities and charges ............................................................................................. Provisions used ........................................................................................................................................ Surplus arising on property revaluation .................................................................................................. Gains on investment properties ............................................................................................................... (Profit)/loss on disposal of property, plant and equipment and assets held for sale ............................... (Profit)/loss on disposal of subsidiaries, associates and business portfolios .......................................... Impairment on interests in associates and joint ventures ......................................................................... Gains less losses from financial investments .......................................................................................... Share-based payments granted cost free .................................................................................................. Movement in present value of in-force business ..................................................................................... Interest received ....................................................................................................................................... Interest paid .............................................................................................................................................. Operating profit before changes in working capital .......................................................................... Change in treasury bills with original term to maturity of more than three months ............................... Change in placings with banks maturing after one month ...................................................................... Change in certificates of deposit with original term to maturity of more than three months ................. Change in trading assets .......................................................................................................................... Change in trading liabilities ..................................................................................................................... Change in financial assets designated as fair value ................................................................................. Change in financial liabilities designated as fair value ........................................................................... Change in derivative assets ...................................................................................................................... Change in derivative liabilities ................................................................................................................ Change in financial investments held for backing liabilities to long-term policyholders ...................... Change in loans and advances to customers ........................................................................................... Change in amounts due from Group companies ..................................................................................... Change in other assets ............................................................................................................................. Change in deposits by banks ................................................................................................................... Change in customer accounts .................................................................................................................. Change in amounts due to Group companies .......................................................................................... Change in debt securities in issue ............................................................................................................ Change in liabilities under insurance contracts issued ............................................................................ Change in other liabilities ........................................................................................................................ Exchange adjustments ............................................................................................................................. Cash generated from/(used in) operations .......................................................................................... 89,919 (82,419) (522) 5,738 18 3,578 (4,924) 1,358 (1,362) (2) (834) (30) (5,247) 395 (2,634) 1,751 (4,432) 101,158 (29,909) 71,600 (107,676) 13,576 (11,498) (29,901) 13,212 (12,101) 3,878 (21,677) 13,958 (27,345) (224,461) (23,275) (57,677) 21,553 328,713 (12,944) (2,503) 38,390 3,723 1,804 (20,651) 2011 HK$m 76,287 (75,672) (729) 5,638 18 3,059 (4,138) 723 (276) (8) (1,033) 3 9 – (128) 2,274 (5,524) 90,790 (27,458) 63,835 (56,042) (48,730) (15,773) (39,833) 19,897 (3,066) 65 (74,674) 73,414 (19,813) (243,760) (15,097) (49,408) 54,755 251,757 22,043 18,189 31,468 47,405 (49) 16,583

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43 Analysis of cash and cash equivalents a Change in cash and cash equivalents during the year
2012 HK$m Balance at 1 January ....................................................................................................................... Net cash inflow before the effect of foreign exchange movements ............................................... Effect of foreign exchange movements .......................................................................................... Balance at 31 December ................................................................................................................. 688,673 19,859 (1,346) 707,186 2011 HK$m 618,199 70,898 (424) 688,673

b Analysis of balances of cash and cash equivalents in the consolidated balance sheet
2012 HK$m Cash in hand and sight balances with central banks ...................................................................... Items in the course of collection from other banks ........................................................................ Placings with banks ........................................................................................................................ Treasury bills .................................................................................................................................. Certificates of deposit ..................................................................................................................... Other eligible bills .......................................................................................................................... Less: items in the course of transmission to other banks ............................................................... 214,104 23,079 384,385 114,937 4,141 2,065 (35,525) 707,186 2011 HK$m 110,107 34,546 481,842 96,443 11,421 1,477 (47,163) 688,673

c

Disposal of subsidiaries and businesses
Banking businesses HK$m Assets Loans and advances to customers ....................................... Other assets ......................................................................... Interests in associates and joint ventures ........................... Total assets excluding cash and cash equivalents ............... Liabilities Customer accounts .............................................................. Other liabilities ................................................................... Liabilities under insurance contracts ................................... Total liabilities ..................................................................... Aggregate net assets/(liabilities) at date of disposal, excluding cash and cash equivalents ............................. Gain on disposal including costs to sell .............................. Add back: costs to sell ......................................................... Selling price ......................................................................... Satisfied by Cash and cash equivalents received/(paid) ......................... Cash and cash equivalents sold ........................................... Cash consideration received/(paid) up to 31 December 2012............................................................... Cash still to be received/(paid) at 31 December 2012 ........ Total cash consideration ...................................................... 7,638 78 – 7,716 2012 Insurance businesses HK$m 1 3,157 – 3,158

Other HK$m 84 5 1,295 1,384

Total HK$m 7,723 3,240 1,295 12,258

18,830 1,787 – 20,617 (12,901) 1,318 69 (11,514) (11,477) – (11,477) (37) (11,514)

– 332 3,487 3,819 (661) 1,239 77 655 723 (120) 603 52 655

– 41 – 41 1,343 2,690 18 4,051 4,018 – 4,018 33 4,051

18,830 2,160 3,487 24,477 (12,219) 5,247 164 (6,808) (6,736) (120) (6,856) 48 (6,808)

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Notes on the Financial Statements (continued)

44 Contingent liabilities and commitments

a Off-balance sheet contingent liabilities and commitments
The group 2012 HK$m Contingent liabilities and financial guarantee contracts Guarantees and irrevocable letters of credit pledged as collateral security .............................................. Other contingent liabilities ........................................ 2011 HK$m The Bank 2012 HK$m 2011 HK$m

225,483 345 225,828

192,428 359 192,787

153,546 295 153,841

128,827 454 129,281

Commitments Documentary credits and short-term trade-related transactions ............................................................ Forward asset purchases and forward forward deposits placed ...................................................... Undrawn formal standby facilities, credit lines and other commitments to lend ....................................

39,902 3,000 1,561,277 1,604,179

44,524 2,524 1,425,590 1,472,638

32,707 8 1,001,322 1,034,037

33,233 255 896,961 930,449

The above table discloses the nominal principal amounts of off-balance sheet transactions, the amounts relating to other contingent liabilities and the nominal principal amounts relating to financial guarantee contracts. Contingent liabilities and commitments are mainly credit-related instruments which include non-financial guarantees and commitments to extend credit. Contractual amounts represent the amounts at risk should contracts be fully drawn upon and clients default. Since a significant portion of guarantees and commitments are expected to expire without being drawn upon, the total of the contractual amounts is not representative of future liquidity requirements.

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44 Contingent liabilities and commitments (continued) b Guarantees (including financial guarantee contracts) The group provides guarantees and similar undertakings on behalf of both third party customers and other entities within the group. These guarantees are generally provided in the normal course of the banking business. The principal types of guarantees provided, and the maximum potential amount of future payments which the group could be required to make, were as follows:
The group 2012 HK$m Guarantees in favour of third parties Financial guarantee contracts1 ................................... Standby letters of credit which are financial guarantee contracts2 ............................................... Other direct credit substitutes3 ................................... Performance bonds4 ................................................... Bid bonds4 .................................................................. Standby letters of credit related to particular transactions4 ........................................................... Other transaction-related guarantees4 ........................ Guarantees in favour of other HSBC Group entities...................................... 34,735 20,620 42,551 64,220 2,752 20,608 29,773 215,259 10,224 225,483 2011 HK$m 26,694 19,684 38,211 54,429 2,169 12,169 31,892 185,248 7,180 192,428 The Bank 2012 HK$m 18,896 9,527 33,719 46,674 1,615 16,007 15,438 141,876 11,670 153,546 2011 HK$m 12,904 10,294 32,311 39,289 1,602 7,630 17,678 121,708 7,119 128,827

1 Financial guarantees are contracts that require the issuer to make specified payments to reimburse the holder for a loss incurred because a specified debtor fails to make payment when due in accordance with the original or modified terms of a debt instrument. The amounts in the above table are nominal principal amounts. 2 Standby letters of credit which are financial guarantee contracts are irrevocable obligations on the part of the group to pay third parties when customers fail to make payments when due. 3 Other direct credit substitutes include re-insurance letters of credit related to particular transactions and trade-related letters of credit issued without provision for the issuing entity to retain title to the underlying shipment. 4 Performance bonds, bid bonds, standby letters of credit and other transaction-related guarantees are undertakings by which the obligation on the group to make payment depends on the outcome of a future event.

The amounts disclosed in the above table reflect the group’s maximum exposure under a large number of individual guarantee undertakings. The risks and exposures from guarantees are captured and managed in accordance with HSBC’s overall credit risk management policies and procedures. Guarantees are subject to HSBC’s annual credit review process.

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Notes on the Financial Statements (continued)

45 Assets pledged as security for liabilities and collateral accepted as security for assets
The group 2012 HK$m Assets pledged to secure liabilities Financial assets1 pledged to secure liabilities...................... Liabilities secured by financial assets ................................. Collateral accepted as security for assets Fair value of the collateral permitted to sell or repledge in the absence of default2 ................................. Fair value of collateral actually sold or repledged .............. 91,466 85,789 2011 HK$m 117,963 112,721 The Bank 2012 HK$m 78,813 73,309 2011 HK$m 74,594 70,013

202,321 27,245

120,319 14,504

179,350 11,838

88,197 5,980

1 Financial assets comprise treasury bills, debt securities, equities and deposits 2 These transactions are conducted under terms that are usual and customary to standard securities borrowing and reverse repurchase agreements. The group is obliged to return equivalent securities.

46 Capital commitments
The group 2012 HK$m Expenditure contracted for ................................................. Expenditure authorised by the Directors but not contracted for ..................................................... 4,231 8 4,239 2011 HK$m 3,511 6 3,517 The Bank 2012 HK$m 2,446 3 2,449 2011 HK$m 3,355 2 3,357

Capital commitments mainly relate to the commitment to purchase premises and equipment. 47 Lease commitments The group leases certain properties and equipment under operating leases. The leases normally run for a period of one to ten years and may include an option to renew. Lease payments are usually adjusted annually to reflect market rentals. None of the leases include contingent rentals. Future minimum lease payments under non-cancellable operating leases are as follows:
The group 2012 HK$m Premises Amounts payable within – one year or less ............................................................... – five years or less but over one year ................................ – over five years ................................................................ 2011 HK$m The Bank 2012 HK$m 2011 HK$m

2,841 4,597 821 8,259

3,734 4,603 1,103 9,440

1,325 2,213 510 4,048

1,414 2,385 761 4,560

Equipment Amounts payable within – one year or less ............................................................... – five years or less but over one year ................................

92 78 170

71 100 171

6 10 16

6 9 15

136

48 Segmental analysis The group’s operating segments are organised into two geographical regions, Hong Kong and Rest of Asia-Pacific. Due to the nature of the group, the chief operating decision-maker regularly reviews operating activity on a number of bases, including by geographical region and by global businesses. Although the chief operating decision-maker reviews information on a number of bases, capital resources are allocated and performance assessed primarily by geographical region and the segmental analysis is presented on that basis. In addition, the economic conditions of each geographical region are highly influential in determining performance across the different types of business activity carried out in the region. Therefore, provision of segment performance on a geographical basis provides the most meaningful information with which to understand the performance of the business. Geographical information is classified by the location of the principal operations of the subsidiary or, in the case of the Bank, by the location of the branch responsible for reporting the results or advancing the funds. Information provided to the chief operating decision-maker of the group to make decisions about allocating resources and assessing performance of operating segments is measured in accordance with HKFRSs. Due to the nature of the group’s structure, the analysis of profits shown below includes intra-segment items between geographical regions with the elimination shown in a separate column. Such transactions are conducted on an arm’s length basis. Shared costs are included in segments on the basis of actual recharges made. Products and services The group provides a comprehensive range of banking and related financial services to its customers in its two geographical regions. The products and services offered to customers are organised by global businesses:


Retail Banking and Wealth Management offers a broad range of products and services to meet the personal banking, consumer lending and wealth management needs of individual customers. Products typically include current and savings accounts, mortgages and personal loans, credit cards, debit cards, insurance, global asset management services, wealth management and local and international payment services; Commercial Banking product offerings include the provision of financial services, payments and cash management, international trade finance, treasury and capital markets, commercial cards, insurance, and online and direct banking offerings; Global Banking & Markets provides tailored financial solutions to major government, corporate and institutional clients and private investors worldwide. The client-focused business lines deliver a full range of banking capabilities including financing; advisory and transaction services; a markets business that provides services in credit, rates, foreign exchange, money markets, securities services and principal investment activities; and Global Private Banking provides a range of services to meet the banking, investment and wealth advisory needs of high net worth individuals.







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Notes on the Financial Statements (continued)

48 Segmental analysis (continued) Total assets
2012 HK$m Hong Kong .......................................................................... Rest of Asia-Pacific ............................................................ Intra region .......................................................................... 3,944,090 2,639,425 (518,188) 6,065,327 % 65.0 43.5 (8.5) 100.0 HK$m 3,594,991 2,429,228 (416,739) 5,607,480 2011 % 64.1 43.3 (7.4) 100.0

Total liabilities
2012 HK$m Hong Kong .......................................................................... Rest of Asia-Pacific ............................................................ Intra region .......................................................................... 3,736,637 2,373,800 (518,188) 5,592,249 % 66.8 42.4 (9.2) 100.0 HK$m 3,436,629 2,216,247 (416,739) 5,236,137 2011 % 65.6 42.3 (7.9) 100.0

Interests in associates and joint ventures
2012 HK$m Hong Kong .......................................................................... Rest of Asia-Pacific ............................................................ 1,739 117,534 119,273 % 1.5 98.5 100.0 HK$m 1,525 90,260 91,785 2011 % 1.7 98.3 100.0

Credit commitments and contingencies (contract amounts)
2012 HK$m Hong Kong .......................................................................... Rest of Asia-Pacific ............................................................ 868,161 961,846 1,830,007 % 47.4 52.6 100.0 HK$m 769,088 896,337 1,665,425 2011 % 46.2 53.8 100.0

Property, plant and equipment, goodwill and intangible assets acquired in the year
2012 HK$m Hong Kong .......................................................................... Rest of Asia-Pacific ............................................................ 1,018 972 1,990 % 51.2 48.8 100.0 HK$m 1,740 1,167 2,907 2011 % 59.9 40.1 100.0

138

48 Segmental analysis (continued) Consolidated income statement
Hong Kong HK$m 2012 Interest income .................................................................... Interest expense ................................................................... Net interest income ............................................................. Fee income .......................................................................... Fee expense ......................................................................... Net trading income ............................................................. Net income from financial instruments designated at fair value ................................................... Gains less losses from financial investments ..................... Dividend income ................................................................. Net earned insurance premiums ......................................... Other operating income ...................................................... Total operating income .................................................... Net insurance claims incurred and movement in liabilities to policyholders ........................................... Net operating income before loan impairment charges and other credit risk provisions .................... Loan impairment charges and other credit risk provisions Net operating income ........................................................ Operating expenses ........................................................... Operating profit ................................................................ Share of profit in associates and joint ventures .................. Profit before tax ................................................................ Tax expense ........................................................................ Profit for the year ............................................................. Profit attributable to shareholders ...................................... Profit attributable to non-controlling interests ................... Net operating income – external ........................................................................... – inter-company/inter-segment ......................................... Depreciation and amortisation included in operating expenses .......................................................................... Restructuring costs .............................................................. 47,577 (7,422) 40,155 28,770 (4,100) 9,892 3,799 2,510 489 46,304 14,991 142,810 (49,401) 93,409 (603) 92,806 (36,947) 55,859 640 56,499 (8,051) 48,448 43,113 5,335 84,627 8,179 (4,187) (176) Rest of Asia-Pacific HK$m 71,566 (29,295) 42,271 19,126 (3,906) 9,315 814 124 33 6,317 4,632 78,726 (5,582) 73,144 (2,975) 70,169 (36,109) 34,060 18,170 52,230 (9,959) 42,271 39,895 2,376 72,218 (2,049) (1,551) (990) Intra-segment elimination HK$m (3,632) 3,625 (7) (1,675) 1,675 7 – – – – (4,286) (4,286) – (4,286) – (4,286) 4,286 – – – – – – – – (4,286) – – Total HK$m 115,511 (33,092) 82,419 46,221 (6,331) 19,214 4,613 2,634 522 52,621 15,337 217,250 (54,983) 162,267 (3,578) 158,689 (68,770) 89,919 18,810 108,729 (18,010) 90,719 83,008 7,711 156,845 1,844 (5,738) (1,166)

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Notes on the Financial Statements (continued)

48 Segmental analysis (continued)
Hong Kong HK$m 2011 Interest income .................................................................... Interest expense ................................................................... Net interest income ............................................................. Fee income .......................................................................... Fee expense ......................................................................... Net trading income ............................................................. Net expense from financial instruments designated at fair value ................................................... Gains less losses from financial investments ..................... Dividend income ................................................................. Net earned insurance premiums ......................................... Other operating income ...................................................... Total operating income ....................................................... Net insurance claims incurred and movement in liabilities to policyholders .......................................... Net operating income before loan impairment charges and other credit risk provisions ...................................... Loan impairment charges and other credit risk provisions Net operating income .......................................................... Operating expenses ............................................................. Operating profit ................................................................... Share of profit in associates and joint ventures .................. Profit before tax .................................................................. Tax expense ........................................................................ Profit for the year ................................................................ Profit attributable to shareholders ...................................... Profit attributable to non-controlling interests ................... Net operating income – external ........................................................................... – inter-company/inter-segment ......................................... Depreciation and amortisation included in operating expenses .......................................................................... Restructuring costs............................................................... 42,309 (7,035) 35,274 27,022 (4,162) 7,691 (4,230) 310 723 39,738 13,229 115,595 (35,778) 79,817 (938) 78,879 (36,106) 42,773 424 43,197 (7,703) 35,494 31,165 4,329 Rest of Asia-Pacific HK$m 68,706 (28,310) 40,396 19,315 (3,880) 12,510 (293) (182) 6 5,932 2,674 76,478 (4,611) 71,867 (2,121) 69,746 (36,232) 33,514 14,659 48,173 (9,763) 38,410 36,426 1,984 Intra-segment elimination HK$m (3,557) 3,559 2 (1,171) 1,171 (2) – – – – (4,514) (4,514) – (4,514) – (4,514) 4,514 – – – – – – – Total HK$m 107,458 (31,786) 75,672 45,166 (6,871) 20,199 (4,523) 128 729 45,670 11,389 187,559 (40,389) 147,170 (3,059) 144,111 (67,824) 76,287 15,083 91,370 (17,466) 73,904 67,591 6,313

70,903 7,976

71,088 (1,342)

– (4,514)

141,991 2,120

(4,047) (520)

(1,591) (344)

– –

(5,638) (864)

140

48 Segmental analysis (continued) Net operating income by global business
Retail Banking and Wealth Management HK$m Year ended 31 December 2012 External ........................................ Intercompany/intersegment .......... Year ended 31 December 2011 External ........................................ Intercompany/intersegment .......... 51,777 12,636 Global Banking & Markets HK$m 64,408 (11,061) Global Private Banking HK$m 401 336

Commercial Banking HK$m 37,800 638

Other HK$m 2,459 5,993

InterSegment HK$m – (6,698)

Total HK$m 156,845 1,844

48,615 10,904

31,821 1,984

61,508 (10,824)

(196) 597

243 6,334

– (6,875)

141,991 2,120

Information by country
Net external operating income1 2012 2011 HK$m HK$m Hong Kong .......................................................................... Mainland China ................................................................... Australia ............................................................................... India .................................................................................... Indonesia .............................................................................. Malaysia .............................................................................. Singapore ............................................................................ Taiwan.................................................................................. Vietnam ................................................................................ Other ................................................................................... Total .................................................................................... 84,627 10,941 6,952 8,771 5,069 7,547 8,876 3,795 1,424 18,843 156,845 70,903 11,952 7,115 9,684 4,715 7,232 8,028 3,717 1,606 17,039 141,991 Non-current assets2 2012 2011 HK$m HK$m 82,780 121,854 1,544 2,362 5,001 1,109 1,589 2,487 1,401 3,534 223,661 91,177 91,687 1,629 2,342 5,349 1,033 1,256 2,564 2,742 5,151 204,930

1 Net external operating income is attributable to countries based on the location of the principal operations of the subsidiary or branch. 2 Non-current assets consist of property, plant and equipment, goodwill, other intangible assets, interests in associates and joint ventures and certain other assets expected to be recovered more than 12 months after the reporting date.

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Notes on the Financial Statements (continued)

49 Related party transactions a Immediate and ultimate holding company The group is wholly owned by HSBC Asia Holdings BV. HSBC Asia Holdings BV is in turn wholly owned by HSBC Asia Holdings (UK) Limited, which is wholly owned by HSBC Holdings BV. HSBC Holdings BV is wholly owned by HSBC Finance (Netherlands), which is wholly owned by HSBC Holdings plc (incorporated in England). The group’s related parties include the parent, fellow subsidiaries, associates, joint ventures, post-employment benefit plans for the benefit of the group’s employees, Key Management Personnel, close family members of Key Management Personnel and entities which are controlled or jointly controlled by Key Management Personnel or their close family members. Transactions with the immediate holding company included the redemption of preference shares and the payment of interest on preference shares. As at 31 December 2012, the Bank has issued HK$83,195m of preference shares to its immediate holding company (2011: HK$96,969m). These are classified as liabilities on the balance sheet. Transactions with the ultimate holding company included the issuance of subordinated liabilities and the payment of interest on subordinated liabilities. As at 31 December 2012, the Bank has issued HK$11,905m of subordinated liabilities to its ultimate holding company (2011: HK$9,599m). These are classified as liabilities on the balance sheet. Income and expenses for the year
Immediate holding company 2012 2011 HK$m HK$m Interest expense1 ......................................................... Other operating income .............................................. Other operating expenses ........................................... 2,386 – 19 2,337 – 30 Ultimate holding company 2012 2011 HK$m HK$m 277 243 1,394 172 150 1,584

1 Interest expense paid to the immediate holding company represents interest on preference shares. Interest expense paid to the ultimate holding company represents interest on subordinated liabilities.

Information relating to preference shares can be found in the ‘Notes on the Financial Statements’ where the following are disclosed: interest expense on preference shares (note 4(b)) and preference shares issued (note 37). Balances at 31 December The group
Immediate holding company 2012 2011 HK$m HK$m Amounts due from1 ...................................................... Amounts due to2 ......................................................... – 84,555 – 98,243 Ultimate holding company 2012 2011 HK$m HK$m 191 12,285 167 9,990

The Bank
Immediate holding company 2012 2011 HK$m HK$m Amounts due from1 ...................................................... Amounts due to2 ......................................................... – 84,555 – 98,243 Ultimate holding company 2012 2011 HK$m HK$m 151 12,122 167 9,916

1 Amounts due from the ultimate holding company are mainly IT cost recoveries. 2 Amounts due to the immediate holding company included preference shares of HK$83,195m (2011: HK$96,969m). Amounts due to the ultimate holding company included subordinated liabilities of HK$11,905m (2011: HK$9,599m).

Guarantees made by the ultimate holding company to and on behalf of the group amounted to HK$326m (2011: HK$283m).

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49 Related party transactions (continued) b Share option and share award schemes The group participates in various share option and share plans operated by HSBC whereby share options or shares of HSBC are granted to employees of the group. As disclosed in note 50, the group recognises an expense in respect of these share options and share awards. The cost borne by the ultimate holding company in respect of share options is treated as a capital contribution and is recorded within ‘Other reserves’. In respect of share awards, the group recognises a liability to the ultimate holding company over the vesting period. This liability is measured at the fair value of the shares at each reporting date, with changes since award date adjusted through the capital contribution account within ‘Other reserves’. The balances of the capital contribution and the liability as at 31 December 2012 amounted to HK$2,638m and HK$2,561m respectively (2011: HK$2,915m and HK$2,729m respectively). c Pension funds At 31 December 2012, HK$12.6bn (2011: HK$12.5bn) of pension fund assets were under management by group companies. Total fees paid or payable by pension plans to group companies for providing fund management, administrative and trustee services amounted to HK$47m for the year (2011: HK$53m). d Subsidiaries and fellow subsidiaries The group entered into transactions with its fellow subsidiaries in the normal course of business, including the acceptance and placement of interbank deposits, correspondent banking transactions and off-balance sheet transactions. The activities were on substantially the same terms, including interest rates and security, as for comparable transactions with third party counterparties. The group shares the costs of certain IT projects with its fellow subsidiaries and also used certain processing services of fellow subsidiaries on a cost recovery basis. The Bank also acted as agent for the distribution of retail investment funds for fellow subsidiaries and paid professional fees for services provided by fellow subsidiaries. The commissions and fees in these transactions and services are priced on an ‘arm’s length’ basis. The aggregate amount of income and expenses arising from these transactions during the year and the balances of amounts due to and from the relevant parties at the year end are as follows: Income and expenses for the year
Fellow subsidiaries 2012 2011 HK$m HK$m Interest income ............................................................................................................................... Interest expense .............................................................................................................................. Fee income ...................................................................................................................................... Fee expense ..................................................................................................................................... Other operating income .................................................................................................................. Other operating expenses1 .............................................................................................................. 429 872 2,582 734 3,022 5,843 445 797 2,470 935 3,227 5,169

1 In 2012 payments were made of HK$920m (2011: HK$1,271m) for software costs which were capitalised as intangible assets in the balance sheet of the group.

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Notes on the Financial Statements (continued)

49 Related party transactions (continued) Balances at 31 December The group
Fellow subsidiaries 2012 2011 HK$m HK$m Assets Trading assets ................................................................................................................................. Financial assets designated at fair value ........................................................................................ Other assets ..................................................................................................................................... Liabilities Trading liabilities ............................................................................................................................ Financial liabilities designated at fair value .................................................................................... Other liabilities ............................................................................................................................... 6,710 4,966 164,136 175,812 27,112 2 57,010 84,124 Guarantees ...................................................................................................................................... Commitments .................................................................................................................................. 10,224 5,051 11,120 5,390 136,051 152,561 37,675 5 59,605 97,285 7,180 6,689

The Bank
Subsidiaries 2012 HK$m Assets Trading assets ............................................................. Financial assets designated at fair value .................... Other assets ................................................................. Liabilities Trading liabilities ........................................................ Financial liabilities designated at fair value ............... Other liabilities ........................................................... 6,537 – 157,159 163,696 7,764 – 64,856 72,620 Guarantees .................................................................. Commitments .............................................................. 2,441 36,460 2011 HK$m 3,486 – 113,761 117,247 7,421 – 54,655 62,076 1,039 38,484 Fellow subsidiaries 2012 2011 HK$m HK$m 6,589 – 151,163 157,752 11,205 – 51,930 63,135 9,229 3,885 10,970 – 119,616 130,586 25,837 – 53,803 79,640 6,080 3,639

Derivative balances In addition, the group and the Bank had the following derivative asset and derivative liability balances with other HSBC Group entities:
The group 2012 HK$m Derivative assets ......................................................... Derivative liabilities ................................................... 83,270 96,442 The Bank 2011 HK$m 85,977 90,663 2012 HK$m 87,291 99,688 2011 HK$m 89,781 93,677

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49 Related party transactions (continued) e Associates and joint ventures The group provides certain banking and financial services to associates and joint ventures, including loans, overdrafts, interest and non-interest bearing deposits and current accounts. Details of interests in associates and joint ventures are given in note 24. Transactions and balances during the year with associates and joint ventures were as follows: The group
2012 Highest balance Balance at during the year 31 December HK$m HK$m Amounts due from associates – subordinated ............................................................ – unsubordinated ....................................................... Amounts due from joint ventures – subordinated ............................................................ – unsubordinated ....................................................... – 27,056 39 787 27,882 Amounts due to associates ......................................... Amounts due to joint ventures ................................... 6,589 1,034 7,623 Commitments .............................................................. 2,529 – 20,784 6 1 20,791 2,020 – 2,020 349 2011 Highest balance during the year HK$m 34 23,418 13 1,107 24,572 4,536 1,488 6,024 1,431 Balance at 31 December HK$m 33 19,183 6 966 20,188 3,672 1,013 4,685 711

The Bank
2012 Highest balance Balance at during the year 31 December HK$m HK$m Amounts due from associates – unsubordinated ....................................................... Amounts due from joint ventures – unsubordinated ....................................................... 5,448 787 6,235 Amounts due to associates ......................................... Amounts due to joint ventures ................................... 1,190 1,032 2,222 Commitments .............................................................. 2,164 1,297 1 1,298 697 – 697 225 2011 Highest balance during the year HK$m 7,509 881 8,390 1,065 1,486 2,551 1,012 Balance at 31 December HK$m 3,825 876 4,701 1,065 1,011 2,076 351

The disclosure of the year-end balance and the highest balance during the year is considered the most meaningful information to represent transactions during the year. The transactions resulting in amounts to and from associates and joint ventures arose in the ordinary course of business and on substantially the same terms, including interest rates and security, as for comparable transactions with third party counterparties.

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Notes on the Financial Statements (continued)

49 Related party transactions (continued) f Key Management Personnel Key Management Personnel are defined as those persons having authority and responsibility for planning, directing and controlling the activities of the Bank and the group. It includes members of the Board of Directors and Executive Committee of the Bank and the Board of Directors and Group Managing Directors of HSBC Holdings plc. The following table shows the expense in respect of compensation for Key Management Personnel of the Bank for services rendered to the Bank:
2012 HK$m Salaries and other short term benefits ............................................................................................. Retirement benefits – Defined contribution plans .......................................................................................................... – Defined benefit plans ................................................................................................................... Termination benefits ....................................................................................................................... Share-based payments .................................................................................................................... 235 11 1 14 83 344 2011 HK$m 220 8 2 – 110 340

Transactions, arrangements and agreements involving Key Management Personnel Transactions, arrangements and agreements are entered into by the group with companies that may be controlled by Key Management Personnel of the group and their immediate relatives. These transactions are primarily loans and deposits:
2012 HK$m During the year Highest average assets1 ................................................................................................................... Highest average liabilities1 ............................................................................................................. Contribution to the group’s profit before tax ................................................................................. At the year end Guarantees ...................................................................................................................................... Commitments .................................................................................................................................. 32,044 36,208 775 2011 HK$m 43,416 39,548 818

4,034 7,698

3,874 6,417

1 The disclosure of the highest average balance during the year is considered the most meaningful information to represent transactions during the year.

The above transactions were entered into in the ordinary course of business and on substantially the same terms, including interest rates and security, as comparable transactions with persons or companies of a similar standing or, where applicable, with other employees. The transactions did not involve more than the normal risk of repayment or present other unfavourable features. The group adheres to Hong Kong Banking Ordinance Section 83 regarding lending to related parties; this includes unsecured lending to Key Management Personnel, their relatives and companies that may be directly or indirectly influenced or controlled by such individuals. No impairment losses have been recorded against balances outstanding during the year with Key Management Personnel, and there are no specific impairment allowances on balances with Key Management Personnel at the year end.

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49 Related party transactions (continued) g Loans to officers Officers are defined as the Board of Directors, Executive Committee members and the Secretary of the Bank and the Boards of Directors of the ultimate holding company, HSBC Holdings plc, and intermediate holding companies. Particulars of loans to officers disclosed pursuant to section 161B of the Hong Kong Companies Ordinance are as follows:
Aggregate amount of loans outstanding at 31 December 2012 2011 HK$m HK$m By the Bank ................................................................ By subsidiaries ............................................................ 80 10 90 73 13 86 Maximum aggregate amount of loans outstanding during the year 2012 2011 HK$m HK$m 101 13 114 83 15 98

50 Share-based payments a Income statement charge
2012 HK$m Restricted share awards ..................................................................................................................... Performance share awards ................................................................................................................. Savings-related share option plans .................................................................................................... 1,497 – 256 1,753 1,751 2 2011 HK$m 1,907 17 350 2,274 2,274 –

Equity-settled share-based payments ................................................................................................ Cash-settled share-based payments ...................................................................................................

The above charge was computed from the fair values of the share-based payment transaction when contracted, that arose under employee share awards made in accordance with HSBC’s reward structures. b HSBC Share Awards
Award Policy Purpose  Rewards employee performance, potential and retention of key employees  To defer variable pay Restricted  Vesting of awards generally subject to continued share awards employment with HSBC (including GPSP  Vesting often staggered over three years. GPSP awards) awards vest after five years  Certain shares subject to a retention requirement post-vesting. In the case of GPSP awards retention applies until cessation of employment  Awards generally not subject to performance conditions  Awards granted from 2010 onwards are subject to clawback provision prior to vesting Performance share awards  Vesting of awards based on three independent performance measures (relative TSR (40%), economic profit (40%) and growth in earnings per share (‘EPS’) (20%)) and an over-riding ‘sustained improvement’ judgment by the HSBC Group Remuneration Committee  Performance conditions are measured over a three year period and reviewed annually  Awards are forfeited to the extent the performance conditions have not been met  Additional awards made throughout the three-year vesting period  Original award together with the additional share awards are released after three years of continued employment within HSBC Group  Shares awarded without corporate performance conditions

 Align interests of executives with the creation of shareholder value and recognise individual performance and potential  To reflect HSBC’s relative and absolute performance over the long-term, taking account of an external measure of value creation, a measure of the extent to which the return on capital invested in HSBC is in excess of a benchmark return and a direct measure of the profits generated for shareholders  To promote widespread interest in HSBC shares amongst employees  Rewards eligible employees for their prior year performance  High performing and/or senior and middle managers are normally eligible to receive achievement shares during their annual pay review

Achievement share awards

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Notes on the Financial Statements (continued)

50 Share-based payments (continued) Movement on HSBC share awards
The group Restricted share awards 2012 2011 Number Number (000s) (000s) 50,225 17,450 (30,929) 690 (1,396) 36,040 0.75 38,476 17,380 (4,674) 744 (1,701) 50,225 0.68 Performance share awards1 Achievement share awards1 2012 2011 2012 2011 Number Number Number Number (000s) (000s) (000s) (000s) – – – – – – – 283 10 (61) – (232) – – – – – – – – – 2,911 33 (2,886) (12) (46) – –

Outstanding at 1 January ....................... Additions during the year ....................... Released in the year ................................ Transferred in the year............................ Lapsed in the year .................................. Outstanding at 31 December ................. Weighted average remaining vesting period (years) .....................................

1 Additions during the year comprised reinvested dividend equivalents.

c

HSBC Share Option Plans
Award Savings-related share option plans Policy Purpose  Exercisable within three months following the first  Eligible employees save up to £250 per month (or its anniversary of the commencement of a one-year equivalent in US dollars, Hong Kong dollars or savings contract or within six months following Euros), with the option to use the savings to acquire either the third or fifth anniversaries of the shares commencement of three-year or five-year contracts,  To align the interests of all employees with the respectively creation of shareholder value  The exercise price is set at a 20% (2011: 20%) discount to the market value immediately preceding the date of invitation (except for the one-year options granted under the US sub-plan where a 15% discount is applied)  Long-term incentive plan between 2000 and 2005 during which certain HSBC employees were awarded share options  To align the interests of those higher performing employees with the creation of shareholder value

Executive Share  Vesting of awards based on achievement of certain Option Scheme TSR targets (‘ESOS’) and  Exercisable between third and tenth anniversaries of Group Share the date of grant Option Plan  Plan ceased in May 2005 (‘GSOP’)

The table on page 150 shows the movement on HSBC share option plans during the year. Calculation of fair values Fair values of share options/awards, measured at the date of grant of the option/award, are calculated using a BlackScholes model. When modelling options/awards with vesting dependent on HSBC’s Total Shareholder Return (‘TSR’) over a period, the TSR performance targets are incorporated into the model using Monte Carlo simulation. The fair values calculated are inherently subjective and uncertain due to the assumptions made and the limitations of the model used.

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50 Share-based payments (continued) Significant weighted average assumptions used to estimate the fair value of options granted

1-year SavingsRelated Share Option Schemes 2012 Risk-free interest rate1 (%) .................................................................. Expected life2 (years) .......................................................................... Expected volatility3 (%) ...................................................................... Share price at grant date (£) ................................................................ 2011 Risk-free interest rate1 (%) .................................................................. Expected life2 (years) .......................................................................... Expected volatility3 (%) ...................................................................... Share price at grant date (£) ................................................................ 0.4 1 25 5.54

3-year SavingsRelated Share Option Schemes 0.6 3 25 5.54

5-year SavingsRelated Share Option Schemes 1.2 5 25 5.54

0.8 1 25 6.37

1.7 3 25 6.37

2.5 5 25 6.37

1 The risk-free rate was determined from the UK gilts yield curve. A similar yield curve was used for the International Savings-Related Share Option Plans. 2 The expected life of options depends on the behaviour of option holders, which is incorporated into the option model on the basis of historical observable data and is not a single input parameter but a function of various behavioural assumptions. 3 Expected volatility is estimated by considering both historic average share price volatility and implied volatility derived from traded options over HSBC shares of similar maturity to those of the employee options.

The expected US dollar denominated dividend yield was determined to be 5% per annum in line with consensus analyst forecasts (2011: 4.5%) which vested in subsequent years.

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Notes on the Financial Statements (continued)

50 Share-based payments (continued) Movement on HSBC share option plan The group
Savings-related option scheme with exercise price set in GBP Number WAEP1 (000s) £ 14,587 4,270 (2,864) (6,876) (59) 9,058 586 3.93 4.46 4.82 3.68 3.89 4.08 3.59 Savings-related option scheme with exercise price set in HK$ Number WAEP1 (000s) HK$ 43,733 11,481 (4,134) (20,449) (99) 30,532 820 53.06 55.47 54.99 39.90 53.59 45.54 40.10

ESOS and GSOP Number WAEP1 (000s) £ 2012 Outstanding at 1 January ................ Granted during the year .................. Forfeited/expired in the year ........... Exercised during the year ................ Transferred in the year..................... Outstanding at 31 December .......... Exercisable at 31 December ........... At 31 December 2012 Weighted average fair value of options granted during the year ... Weighted average share price at the date the options were exercised . Weighted average remaining contractual life (years) ................ Exercise price range ....................... 2011 Outstanding at 1 January ................ Granted during the year .................. Forfeited/expired in the year ........... Exercised during the year ................ Transferred in the year..................... Outstanding at 31 December .......... Exercisable at 31 December ........... At 31 December 2011 Weighted average fair value of options granted during the year ... Weighted average share price at the date the options were exercised . Weighted average remaining contractual life (years) ................ Exercise price range ....................... 1 Weighted Average Exercise Price. 15,554 – (4,222) (48) (81) 11,203 11,203 6.95 – 7.29 6.02 6.41 6.83 6.83

– 6.08 1.00 6.02 - 7.54

1.01 5.57 1.40 3.31 - 6.18

12.74 67.85 1.60 37.88 - 94.51

19,895 – (4,171) (107) (63) 15,554 15,554

7.07 – 7.54 6.03 7.74 6.95 6.95

15,404 3,551 (2,757) (1,719) 108 14,587 317

3.99 5.10 4.88 5.47 3.71 3.93 6.01

45,306 4,857 (4,039) (2,355) (36) 43,733 50

40.72 64.99 53.06 60.99 35.98 53.06 91.61

– 6.45 1.57 6.02 - 7.96

1.25 5.40 1.75 3.31 - 6.69

15.68 69.24 2.02 37.88 - 94.51

During the year, options granted for schemes with option prices set in euros and US dollars were insignificant.

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51 Fair value of financial instruments Fair value is the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction. Financial instruments measured at fair value on an ongoing basis include trading assets and liabilities, instruments designated at fair value through profit or loss, derivatives, and financial instruments classified as available-for-sale (including treasury and other eligible bills, debt securities and equity securities). Transaction costs are not included in the fair value calculation. Trade origination costs such as brokerage, fee expense, and post-trade costs are included in operating expenses. The future cost of administering the over-the-counter derivative portfolio is also not included in fair value, but is expensed as incurred. Control framework Fair values are subject to a control framework that aims to ensure that they are either determined, or validated, by a function independent of the risk-taker. For all financial instruments where fair values are determined by reference to externally quoted prices or observable pricing inputs to models, independent price determination or validation is used. In inactive markets, direct observation of a traded price may not be possible. In these circumstances, the group will source alternative market information to validate the financial instrument’s fair value, with greater weight given to information that is considered to be more relevant and reliable. The factors that are considered in this regard are, inter alia:       the extent to which prices may be expected to represent genuine traded or tradable prices; the degree of similarity between financial instruments; the degree of consistency between different sources; the process followed by the pricing provider to derive the data; the elapsed time between the date to which the market data relates and the balance sheet date; and the manner in which the data was sourced.

For fair values determined using a valuation model, the control framework may include, as applicable, independent development or validation of (i) the logic within valuation models; (ii) the inputs to those models; (iii) any adjustments required outside the valuation models; and (iv) where possible, model outputs. Valuation models are subject to a process of due diligence and calibration before becoming operational and are calibrated against external market data on an ongoing basis. To this end, ultimate responsibility for the determination of fair values lies within the Finance function, which reports functionally to the Group Finance Director. Finance establishes the accounting policies and procedures governing valuation, and is responsible for ensuring that these comply with all relevant accounting standards. Determination of fair value of financial instruments carried at fair value Fair values are determined according to the following hierarchy: (a) Level 1 – Quoted market price Financial instruments with quoted prices for identical instruments in active markets. (b) Level 2 – Valuation technique using observable inputs Financial instruments with quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in inactive markets and financial instruments valued using models where all significant inputs are observable. (c) Level 3 – Valuation technique with significant unobservable inputs Financial instruments valued using models where one or more significant inputs are unobservable.

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51 Fair value of financial instruments (continued) The best evidence of fair value is a quoted price in an actively traded market. The fair values of financial instruments that are quoted in active markets are based on bid prices for assets held and offer prices for liabilities used. Where a financial instrument has a quoted price in an active market and it is part of a portfolio, the fair value of the portfolio is calculated as the product of the number of units and quoted price and no block discounts are applied. In the event that the market for a financial instrument is not active, a valuation technique is used. The judgement as to whether a market is active may include, but is not restricted to, the consideration of factors such as the magnitude and frequency of trading activity, the availability of prices and the size of bid/offer spreads. The bid/offer spread represents the difference in prices at which a market participant would be willing to buy compared with the price at which they would be willing to sell. In inactive markets, obtaining assurance that the transaction price provides evidence of fair value or determining the adjustments to transaction prices that are necessary to measure the fair value of the instrument requires additional work during the valuation process. Valuation techniques incorporate assumptions about factors that other market participants would use in their valuations, including interest rate yield curves, exchange rates, volatilities, and prepayment and default rates. For collateralised counterparties and in significant major currencies, the group has adopted a discounting curve that reflects the overnight interest rate (‘OIS discounting’). Prior to 2010, in line with market practice, discount curves did not reflect this overnight interest rate component but were based on a term LIBOR rate. During the period, the group applied an OIS discounting curve to an expanded range of significant currencies in line with evolving market practice. The financial effect of this change was not significant at the time of adoption. The majority of valuation techniques employ only observable market data. However, certain financial instruments are valued on the basis of valuation techniques that feature one or more significant market inputs that are unobservable, and for them the derivation of fair value is more judgemental. An instrument in its entirety is classified as valued using significant unobservable inputs if, in the opinion of management, a significant proportion of the instrument’s carrying amount and/or inception profit (‘day 1 gain or loss’) is driven by unobservable inputs. ‘Unobservable’ in this context means that there is little or no current market data available from which to determine the level at which an arm’s length transaction would likely occur, but it generally does not mean that there is absolutely no market data available upon which to base a determination of fair value (consensus pricing data may, for example, be used). In certain circumstances, primarily where debt is hedged with interest rate derivatives, the group records its own debt in issue at fair value, based on quoted prices in an active market for the specific instrument concerned, if available. Where quoted prices are not available, the own debt in issue is valued using valuation techniques, the inputs for which are either based upon quoted prices in an inactive market for the instrument, or estimated by comparison with quoted prices in an active market for similar instruments. In both cases, the fair value includes the effect of applying the credit spread which is appropriate to the group’s liabilities. The change in fair value of issued debt securities attributable to the group’s own credit spread is computed as follows: for each security at each reporting date, an externally verifiable price is obtained or a price is derived by incorporating our own credit spreads in the valuation. Then, using discounted cash flow, each security is valued using a LIBOR-based discount curve. The difference in the valuations is attributable to the group’s own credit spread. This methodology is applied consistently across all securities. Structured notes issued and certain other hybrid instrument liabilities are included within trading liabilities and measured at fair value. The credit spread applied to these instruments is derived from the spreads at which the group issues structured notes. Gains and losses arising from changes in the credit spread of liabilities issued by the group reverse over the contractual life of the debt, provided that the debt is not repaid at a premium or a discount.

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51 Fair value of financial instruments (continued) Fair value adjustments Fair value adjustments are adopted when the group considers that there are additional factors that would be considered by a market participant that are not incorporated within the valuation model. The magnitude of fair value adjustments depends upon many entity-specific factors, and therefore fair value adjustments may not be comparable across the banking industry. The group classifies fair value adjustments as either ‘risk-related’ or ‘model-related’. The majority of these adjustments relate to Global Banking and Markets. Movements in the level of fair value adjustments do not necessarily result in the recognition of profits or losses within the income statement. For example, as models are enhanced, fair value adjustments may no longer be required. Similarly, fair value adjustments will decrease when the related positions are unwound, but this may not result in profit or loss. Risk-related adjustments (i) Bid-offer HKAS 39 requires that portfolios are marked at bid or offer, as appropriate. Valuation models will typically generate mid-market values. The bid-offer adjustment reflects the cost that would be incurred if substantially all residual net portfolio market risks were closed using available hedging instruments or by disposing of or unwinding the actual position. (ii) Uncertainty Certain model inputs may be less readily determinable from market data, and/or the choice of model itself may be more subjective. In these circumstances, there exists a range of possible values that the financial instrument or market parameter may assume and an adjustment may be necessary to reflect the likelihood that in estimating the fair value of the financial instrument, market participants would adopt rather more conservative values for uncertain parameters and/or model assumptions than those used in the valuation model. (iii) Credit risk adjustment methodology The credit risk adjustment is an adjustment to the valuation of OTC derivative contracts to reflect within fair value the possibility that the counterparty may default and the group may not receive the full market value of the transactions. The group calculates a separate credit valuation adjustment (‘CVA’) and debit valuation adjustment (‘DVA’) for each group legal entity and, within each entity, for each counterparty to which the entity has exposure. The group calculates the CVA by applying the probability of default of the counterparty conditional on the nondefault of the group, to the expected positive exposure of the group to the counterparty, and multiplying the result by the loss expected in the event of default. Conversely, the group calculates the DVA by applying the probability of default of the group, conditional on the non-default of the counterparty, to the expected positive exposure of the counterparty to the group, and multiplying by the loss expected in the event of default. Both calculations are performed over the life of the potential exposure.

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Notes on the Financial Statements (continued)

51 Fair value of financial instruments (continued) From 31 December 2012, the group revised its methodologies for determining the CVA and DVA for derivatives. Historically, the probability of default used in the CVA calculation has been based on the group’s internal credit rating for the counterparty, taking into account how credit ratings may deteriorate over the duration of the exposure based on historical rating transition matrices, and the probability of default used in the DVA calculation has been zero. As a result of evolving market practice, the group has decided to revise the methodology for determining the probability of default to one that uses credit default swap (‘CDS’) spreads where these are available and reliable for a specific counterparty, including for the group with respect to the DVA, or relevant proxies where relevant CDS spreads are not available. The derivation of a proxy has regard to the range of market practice, and considers relevant data in this context, including CDS index and rating transition data. For most products, to calculate the expected positive exposure to a counterparty, the group uses a simulation methodology to incorporate the range of potential exposures across the portfolio of transactions with the counterparty over the life of an instrument. The simulation methodology includes credit mitigants such as counterparty netting agreements and collateral agreements with the counterparty. A standard loss given default assumption of 60% is generally adopted for developed market exposures, and 75% for emerging market exposures. Alternative loss given default assumptions may be adopted where both the nature of the exposure and the available data support this. The net impact of these changes was insignificant on the consolidated income statement of the Bank and the group. For certain types of exotic derivatives, where the products are not currently supported by the simulation, or for derivative exposures in smaller trading locations, where the simulation tool is not yet available, the group adopts alternative methodologies. These may involve mapping to the results for similar products from the simulation tool or, where such a mapping approach is not appropriate, a simplified methodology is used, generally following the same principles as the simulation methodology. The calculation is applied at a trade level, with more limited recognition of credit mitigants such as netting or collateral agreements than used in the simulation methodology described previously. The methodologies do not, in general, account for ‘wrong-way risk’. Wrong-way risk arises where the underlying value of the derivative prior to any credit risk adjustment is positively correlated to the probability of default of the counterparty. Where there is significant wrong-way risk, a trade specific approach is applied to reflect the wrong-way risk within the valuation. With the exception of certain central clearing parties, all third party counterparties are included in the credit risk adjustment calculation and credit risk adjustments are not netted across group entities. Model-related adjustments (i) Model limitation Models used for portfolio valuation purposes may be based upon a simplifying set of assumptions that do not capture all material market characteristics. Additionally, markets evolve, and models that were adequate in the past may require development to capture all material market characteristics in current market conditions. In these circumstances, model limitation adjustments are adopted. As model development progresses, model limitations are addressed within the valuation models and a model limitation adjustment is no longer needed. (ii) Inception profit (Day 1 profit or loss reserves) Inception profit adjustments are adopted where the fair value estimated by a valuation model is based on one or more significant unobservable inputs. The accounting for inception profit adjustments is discussed in note 3(h). An analysis of the movement in the deferred Day 1 profit or loss reserve is provided in note 17(c).

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51 Fair value of financial instruments (continued) Fair value valuation bases The approach used to calculate the fair value of each type of financial instrument is as follows: Loans, including leveraged finance and loans held for securitisation Loans held at fair value are valued from broker quotes and/or market data consensus providers where available. Where unavailable, fair value will be determined using valuation techniques. These techniques include discounted cash flow models, which incorporate assumptions regarding an appropriate credit spread for the loan, derived from other market instruments issued by the same or comparable entities. Debt securities, treasury and eligible bills, and equities These instruments are valued based on quoted market prices from an exchange, dealer, broker, industry group or pricing service, where available. Where unavailable, fair value is determined by reference to quoted market prices for similar instruments or, in the case of certain mortgage-backed securities and unquoted equities, valuation techniques using inputs determined from observable and unobservable market data. Derivatives Over-the-counter (i.e. non-exchange traded) derivatives are valued using valuation models. Valuation models calculate the present value of expected future cash flows, based upon ‘no-arbitrage’ principles. For many vanilla derivative products, such as interest rate swaps and European options, the modelling approaches used are standard across the industry. For more complex derivative products, there may be some differences in market practice. Inputs to valuation models are determined from observable market data wherever possible, including prices available from exchanges, dealers, brokers or providers of consensus pricing. Certain inputs may not be observable in the market directly, but can be determined from observable prices via model calibration procedures or estimated from historical data or other sources. Examples of inputs that are generally observable include foreign exchange spot and forward rates, benchmark interest rate curves and volatility surfaces for commonly traded option products. Examples of inputs that may be unobservable include volatility surfaces, in whole or in part, for less commonly traded option products, and correlations between market factors, such as foreign exchange rates, interest rates and equity prices. Structured notes The fair value of structured notes valued using a valuation technique is derived from the fair value of the underlying debt security, and the fair value of the embedded derivative is determined as described in the paragraph above on derivatives. Trading liabilities valued using a valuation technique with significant unobservable inputs principally comprised equity-linked structured notes, which are issued by the group and provide the counterparty with a return that is linked to the performance of certain equity securities, and other portfolios. The notes are classified as level 3 due to the unobservability of parameters such as long-dated equity volatilities and correlations between equity prices, between equity prices and interest rates and between interest rates and foreign exchange rates. Asset-backed securities While quoted market prices are generally used to determine the fair value of these securities, valuation models are used to substantiate the reliability of the limited market data available and to identify whether any adjustments to quoted market prices are required. For asset-backed securities, including residential mortgage-backed securities, the valuation uses an industry standard model and the assumptions relating to prepayment speeds, default rates and loss severity based on collateral type, and performance, as appropriate. The valuation’s output is benchmarked for consistency against observable data for securities of a similar nature. Private equity and strategic investments The group’s private equity and strategic investments are generally classified as available-for-sale and are not all traded in active markets. In the absence of an active market, an investment’s fair value is estimated on the basis of an analysis of the investee’s financial position and results, risk profile, prospects and other factors, as well as by reference to market valuations for similar entities quoted in an active market, or the price at which similar companies have changed ownership.

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Notes on the Financial Statements (continued)

51 Fair value of financial instruments (continued) Analysis of fair value determination The following table provides an analysis of the basis for the valuation of financial assets and financial liabilities measured at fair value in the consolidated financial statements: The group
Valuation techniques with using significant observable unobservable inputs inputs Level 2 Level 3 HK$m HK$m

Quoted market price Level 1 HK$m At 31 December 2012 Assets Trading assets ................................ Financial assets designated at fair value ........................................... Derivatives ..................................... Available-for-sale investments1 ..... Assets held for sale ........................ Liabilities Trading liabilities ........................... Financial liabilities designated at fair value ................................ Derivatives ..................................... At 31 December 2011 Assets Trading assets ................................ Financial assets designated at fair value ........................................... Derivatives ..................................... Available-for-sale investments1 ..... Liabilities Trading liabilities ........................... Financial liabilities designated at fair value ................................ Derivatives ..................................... 62,723 – 6,951

Third party total HK$m

Amounts with HSBC entities HK$m

Total HK$m

219,233 46,122 5,049 680,145 39,813

200,232 21,808 309,812 398,349 –

232 1,549 825 11,712 3,878

419,697 69,479 315,686 1,090,206 43,691

– – 83,270 – –

419,697 69,479 398,956 1,090,206 43,691

109,526 44,270 290,099

11,091 – 3,659

183,340 44,270 300,709

– – 96,442

183,340 44,270 397,151

306,444 33,552 3,146 544,954

140,294 20,637 286,765 459,528

1,230 3,481 1,408 17,085

447,968 57,670 291,319 1,021,567

– – 85,977 –

447,968 57,670 377,296 1,021,567

53,214 – 6,117

103,703 40,392 285,427

14,514 – 1,045

171,431 40,392 292,589

– – 90,663

171,431 40,392 383,252

1 An analysis of available-for-sale investments across balance sheet lines can be found in note 10.

There were no material movements between Level 1 and Level 2 during the year.

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51 Fair value of financial instruments (continued) The Bank
Valuation techniques with using significant observable unobservable inputs inputs Level 2 Level 3 HK$m HK$m

Quoted market price Level 1 HK$m At 31 December 2012 Assets Trading assets ................................ Financial assets designated at fair value ........................................... Derivatives ..................................... Available-for-sale investments1 ..... Assets held for sale ........................ Liabilities Trading liabilities ........................... Financial liabilities designated at fair value ................................ Derivatives ..................................... At 31 December 2011 Assets Trading assets ................................ Financial assets designated at fair value ................................ Derivatives ..................................... Available-for-sale investments1 ..... Liabilities Trading liabilities ........................... Financial liabilities designated at fair value ................................ Derivatives .....................................

Third party total HK$m

Amounts with HSBC entities HK$m

Total HK$m

174,057 – 4,653 528,194 39,813

110,353 1,432 299,456 164,010 –

163 – 439 7,608 3,878

284,573 1,432 304,548 699,812 43,691

– – 87,291 – –

284,573 1,432 391,839 699,812 43,691

40,295 – 6,795

37,994 7,731 282,067

3,857 – 3,534

82,146 7,731 292,396

– – 99,688

82,146 7,731 392,084

234,611 – 2,539 453,706

81,546 2,283 277,227 219,516

1,164 – 1,131 12,773

317,321 2,283 280,897 685,995

– – 89,781 –

317,321 2,283 370,678 685,995

25,746 – 5,856

46,973 5,910 276,699

6,240 – 933

78,959 5,910 283,488

– – 93,677

78,959 5,910 377,165

1 An analysis of available-for-sale investments across balance sheet lines can be found in note 10.

There were no material movements between Level 1 and Level 2 during the year.

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Notes on the Financial Statements (continued)

51 Fair value of financial instruments (continued) Reconciliation of fair value measurements in Level 3 of the fair value hierarchy The following table provides a reconciliation of the movement between opening and closing balances of Level 3 financial instruments, measured at fair value using a valuation technique with significant unobservable inputs: The group
Assets Designated at fair value through profit or loss HK$m 3,481 80 Liabilities

Availablefor-sale HK$m At 1 January 2012 ..................... Total gains or losses recognised in profit or loss ........................ Total gains or losses recognised in other comprehensive income .................................... Purchases ..................................... Issues ........................................... Sales ............................................ Deposits / settlements ................. Transfers out ............................... Transfers in ................................. At 31 December 2012 ................ Total gains or losses recognised in profit or loss relating to those assets and liabilities held at the end of the reporting period1 ...................... At 1 January 2011 ....................... Total gains or losses recognised in profit or loss ........................ Total gains or losses recognised in other comprehensive income .................................... Purchases ..................................... Issues ........................................... Sales ............................................ Deposits / settlements ................. Transfers out ............................... Transfers in ................................. At 31 December 2011 ................. Total gains or losses recognised in profit or loss relating to those assets and liabilities held at the end of the reporting period1 ....................... 17,085 (169)

Held for trading HK$m 1,230 28

Derivatives HK$m 1,408 227

Assets held for sale HK$m – –

Held for trading HK$m 14,514 669

Derivatives HK$m 1,045 3,080

467 419 – (37) (982) (5,071) – 11,712

32 104 – (689) (355) (163) 45 232

(3) 760 – (303) (190) (2,662) 386 1,549

8 – – – (24) (811) 17 825

– – – – – – 3,878 3,878

238 – 2,195 – (1,756) (5,083) 314 11,091

(5) – – – (124) (492) 155 3,659

25 22,155 (324)

25 2,035 (60)

71 2,437 52

220 1,372 782

– – –

(42) 14,514 (433)

(2,893) 1,612 282

(1,460) 3,544 – (85) (4,597) (2,273) 125 17,085

(30) 1,070 – (737) (625) (916) 493 1,230

(4) 1,459 – (157) (44) (1,276) 1,014 3,481

(14) – – – 87 (930) 111 1,408

– – – – – – – –

(71) – 2,368 – 3,886 (8,009) 2,259 14,514

3 – – – (106) (768) 22 1,045

(8)

5

60

58

–

(167)

(265)

1 The amount has been reported on a net basis, after taking into consideration the total gains or losses arising from those transactions where the risk has been backed out to other HSBC entities.

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51 Fair value of financial instruments (continued) The Bank
Assets Designated at fair value through profit or loss HK$m – – Liabilities

Availablefor-sale HK$m At 1 January 2012 ..................... Total gains or losses recognised in profit or loss ........................ Total gains or losses recognised in other comprehensive income .................................... Purchases ..................................... Issues ........................................... Sales ............................................ Deposits / settlements ................. Transfers out ............................... Transfers in ................................. At 31 December 2012 ................ Total gains or losses recognised in profit or loss relating to those assets and liabilities held at the end of the reporting period1 ...................... At 1 January 2011 ........................ Total gains or losses recognised in profit or loss ........................ Total gains or losses recognised in other comprehensive income .................................... Purchases ..................................... Issues ........................................... Sales ............................................ Deposits / settlements ................. Transfers out ............................... Transfers in ................................. At 31 December 2011 ................. Total gains or losses recognised in profit or loss relating to those assets and liabilities held at the end of the reporting period1 ...................... 12,773 –

Held for trading HK$m 1,164 25

Derivatives HK$m 1,131 (87)

Assets held for sale HK$m – –

Held for trading HK$m 6,240 546

Derivatives HK$m 933 2,942

662 6 – – (954) (4,879) – 7,608

32 104 – (689) (355) (163) 45 163

– – – – – – – –

5 – – – (31) (596) 17 439

– – – – – – 3,878 3,878

95 – 1,970 – (2,117) (3,018) 141 3,857

(5) – – – (117) (374) 155 3,534

131 17,708 (5)

16 1,968 (60)

– 112 (34)

(25) 1,075 871

– – –

(47) 7,791 (480)

(2,788) 1,495 192

(1,896) 3,001 – – (3,877) (2,158) – 12,773

(30) 1,070 – (737) (625) (915) 493 1,164

– – – (78) – – – –

(15) – – – (25) (884) 109 1,131

– – – – – – – –

(49) – 1,952 – (59) (3,169) 254 6,240

(1) – – – (73) (702) 22 933

214

2

–

183

–

(155)

(203)

1 The amount has been reported on a net basis, after taking into consideration the total gains or losses arising from those transactions where the risk has been backed out to other HSBC entities.

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Notes on the Financial Statements (continued)

51 Fair value of financial instruments (continued) Some investments in unlisted equity shares were transferred to assets held for sale and the observability of valuations of certain debt securities resulted in these assets being transferred out of level 3 during the year. Transfers into level 3 resulted from the valuations of certain debt securities becoming unobservable during the year. For assets designated at fair value through profit or loss, the observability of valuations of certain debt securities resulted in these assets being transferred out of level 3 during the year. Transfers into level 3 resulted from the valuations of certain debt securities becoming unobservable during the year. For derivative assets and liabilities, an increase in the observability of equity volatilities and interest rate basis spreads during the year resulted in transfers out of level 3. For held-for-trading liabilities, transfers into level 3 were due to a reduction in the observability of volatilities and correlations. Transfers out of level 3 resulted from an increase in the observability of volatilities and correlations. For assets and liabilities classified as held for trading, realised and unrealised gains and losses are presented in the income statement under ‘Net trading income’. Fair value changes on assets and liabilities designated at fair value are presented in the income statement under ‘Net income / (expense) from financial instruments designated at fair value’. Realised gains and losses from available-for-sale securities are presented under ‘Gains less losses from financial investments’ in the income statement while unrealised gains and losses are presented in ‘Fair value changes taken to equity’ within ‘Available-for-sale investments’ in other comprehensive income. Effects of changes in significant non-observable assumptions to reasonably possible alternatives As discussed above, the fair values of financial instruments are, in certain circumstances, measured using valuation models that incorporate assumptions that are not supported by prices from observable current market transactions in the same instrument and are not based on observable market data. The following table shows the sensitivity of fair values to reasonably possible alternative assumptions.

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51 Fair value of financial instruments (continued) Sensitivity of fair values to reasonably possible alternative assumptions The group
Reflected in income statement Favourable changes HK$m At 31 December 2012 Derivatives/trading assets/trading liabilities ...................... Financial assets/liabilities designated at fair value ............ Financial investments: available-for-sale ........................... At 31 December 2011 Derivatives/trading assets/trading liabilities ...................... Financial assets/liabilities designated at fair value ............ Financial investments: available-for-sale ........................... 665 155 – Unfavourable changes HK$m (642) (155) – Reflected in other comprehensive income Favourable Unfavourable changes changes HK$m HK$m – – 1,171 – – (1,171)

353 348 –

(281) (348) –

– – 1,663

– – (1,663)

The Bank
Reflected in income statement Favourable changes HK$m At 31 December 2012 Derivatives/trading assets/trading liabilities ...................... Financial assets/liabilities designated at fair value ............ Financial investments: available-for-sale ........................... At 31 December 2011 Derivatives/trading assets/trading liabilities ...................... Financial assets/liabilities designated at fair value ............ Financial investments: available-for-sale ........................... 587 – – Unfavourable changes HK$m (563) – – Reflected in other comprehensive income Favourable Unfavourable changes Changes HK$m HK$m – – 761 – – (761)

223 – –

(153) – –

– – 1,232

– – (1,232)

Changes in fair value recorded in the income statement The following table details changes in fair values recognised in the income statement during the period, where the fair value is estimated using valuation techniques that incorporate significant assumptions that are not supported by prices from observable current market transactions in the same instrument, and are not based on observable market data:   the table details the total change in fair value of these instruments; it does not isolate that component of the change that is attributable to the non-observable component; and instruments valued with significant non-observable inputs are frequently dynamically hedged with instruments valued using observable inputs; the table does not include any changes in fair value of these hedges.

The group 2012 HK$m At 31 December Derivatives/trading assets/trading liabilities ........................ Financial assets/liabilities designated at fair value ............. (2,690) 71

2011 HK$m (369) 60

The Bank 2012 HK$m (2,844) –

2011 HK$m (173) –

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Notes on the Financial Statements (continued)

51 Fair value of financial instruments (continued) Fair value of financial instruments not carried at fair value The following table provides an analysis of the fair value of financial instruments not measured at fair value in the balance sheet. For all other instruments the fair value is equal to the carrying value: The group
31 December 2012 Carrying value Fair value HK$m HK$m Assets Placings with banks ...................................................... Loans and advances to customers ................................. Debt securities ............................................................... Liabilities Deposits by banks .......................................................... Customer accounts ......................................................... Debt securities in issue .................................................. Subordinated liabilities .................................................. Preference shares ........................................................... 546,908 2,349,043 163,819 548,115 2,335,254 176,172 31 December 2011 Carrying value Fair value HK$m HK$m 654,581 2,130,871 143,062 654,756 2,101,243 151,363

244,135 3,874,884 74,647 13,867 83,346

244,136 3,875,259 74,854 12,497 73,762

222,582 3,565,001 77,472 16,114 97,096

222,697 3,565,036 77,330 14,157 86,932

The Bank
31 December 2012 Carrying value Fair value HK$m HK$m Assets Placings with banks ....................................................... Loans and advances to customers .................................. Liabilities Deposits by banks .......................................................... Customer accounts ......................................................... Debt securities in issue .................................................. Subordinated liabilities .................................................. Preference shares ........................................................... 246,104 1,282,720 246,718 1,274,154 31 December 2011 Carrying value Fair value HK$m HK$m 341,527 1,176,602 341,970 1,159,635

204,520 2,417,400 40,406 9,355 83,195

204,520 2,417,576 40,552 7,894 73,611

158,746 2,220,072 46,360 9,386 96,969

158,743 2,220,031 46,245 7,354 86,805

The following table lists those financial instruments for which their carrying amounts are a reasonable approximation of fair values because, for example, they are short term in nature or reprice to current market rates frequently:
Assets Cash and balances at central banks Hong Kong Government certificates of indebtedness Items in the course of collection from other banks Endorsements and acceptances Short-term receivables within ‘Other assets’ Accrued income Liabilities Items in the course of transmission to other banks Hong Kong currency notes in circulation Endorsements and acceptances Short-term payables within ‘Other liabilities’ Accruals Investment contracts with discretionary participation features within ‘Liabilities under insurance contracts’

The fair values of financial instruments that are not carried at fair value on the balance sheet are calculated as described below. The calculation of fair value incorporates the group’s estimate of the amount at which financial assets could be exchanged, or financial liabilities settled, between knowledgeable, willing parties in an arm’s length transaction. It does not reflect the economic benefits and costs that the group expects to flow from the instruments’ cash flows over their expected future lives. Other reporting entities may use different valuation methodologies and assumptions in determining fair values for which no observable market prices are available, so comparisons of fair values between entities may not be meaningful and users are advised to exercise caution when using this data.

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51 Fair value of financial instruments (continued) The following types of financial instruments are measured at amortised cost unless they are held for trading or designated at fair value through profit or loss. Where assets or liabilities are hedged by derivatives designated and qualifying as fair value hedges, the carrying value of the assets or liabilities so hedged includes a fair value adjustment for the hedged risk only. Fair values at the balance sheet date of the assets and liabilities set out below are estimated for the purpose of disclosure as follows: Loans and advances to customers The fair value of loans and advances to customers is based on observable market transactions where available. In the absence of observable market transactions, fair value is estimated using discounted cash flow models. Performing loans are grouped, as far as possible, in to homogenous pools segregated by maturity and interest rates and the contractual cash flows are generally discounted using the group’s estimate of the discount rate that market participants would use in valuing instruments with similar maturity, re-pricing and credit risk characteristics. The fair value of a loan portfolio reflects both loan impairments at the balance sheet date and estimates of market participants’ expectations of credit losses over the life of the loans. For impaired loans, fair value is estimated by discounting the future cash flows over the time period they are expected to be recovered. Financial investments The fair values of listed financial investments are determined using bid market prices. The fair values of unlisted financial investments are determined using valuation techniques that take into consideration the prices and future earning streams of equivalent quoted securities. Deposits and customer accounts For the purpose of estimating fair value, deposits and customer accounts are grouped by remaining contractual maturity. Fair values are estimated using discounted cash flows, applying current rates offered for deposits of similar remaining maturities. The fair value of deposits repayable on demand is assumed to be the amount payable on demand at the balance sheet date. Debt securities in issue and subordinated liabilities The fair value of debt securities in issue and subordinated liabilities is based on quoted market prices for the same or similar instruments at the balance sheet date. The fair values in this note are stated at a specific date and may be significantly different from the amounts that will actually be paid on the maturity or settlement dates of the instruments. In many cases, it would not be possible to realise immediately the estimated fair values given the size of the portfolios measured. Accordingly, these fair values do not represent the value of these financial instruments to the group as a going concern. For all classes of financial instruments, fair value represents the product of the value of a single instrument, multiplied by the number of instruments held. No block discount or premium adjustments are made. The fair values of intangible assets, such as values placed on portfolios of core deposits, credit card and customer relationships, are not included above because they are not financial instruments.

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Notes on the Financial Statements (continued)

52 Risk management The group’s activities involve the analysis, evaluation, acceptance and management of financial risks. The principal financial risks are:       credit risk; liquidity and funding risk; market risk (including foreign exchange, interest rate and equity price risks); operational risk; insurance risk; and capital management

The HSBC Group Head Office formulates high-level risk management policies for the HSBC Group worldwide. The group’s risk management policies and procedures are subject to a high degree of oversight and guidance to ensure that all types of risk are systematically identified, measured, analysed and actively managed. In addition, internal audit is responsible for the independent review of risk management and the control environment. a Credit risk Credit risk is the risk of financial loss if a customer or counterparty fails to meet a payment obligation under a contract. It arises principally from direct lending, trade finance and leasing business, but also from derivatives and off-balance sheet products such as guarantees and from the group’s holding of debt and other securities. Credit risk generates the largest regulatory capital requirement of the risks we incur. The group has standards, policies and procedures dedicated to controlling and monitoring risk from all such activities. The group’s principal credit risk management procedures and policies, which follow policies established by HSBC Group Head Office, include the following:      Formulating credit policies which are consistent with the Group credit policy and documenting these in detail in dedicated manuals. Establishing and maintaining the group’s large credit exposure policy. This policy delineates the group’s maximum exposures to individual customers, customer groups and other risk concentrations. Establishing and complying with lending guidelines on the group’s attitude towards, and appetite for, lending to specified market sectors and industries. Undertaking an objective assessment of risk. All commercial non-bank credit facilities originated by the group in excess of designated limits are subject to review prior to the facilities being committed to customers. Controlling exposures to banks and other financial institutions. The group’s credit and settlement risk limits to counterparties in the finance and government sectors are designed to optimise the use of credit availability and avoid excessive risk concentration. Managing exposures to debt securities by establishing controls in respect of the liquidity of securities held for trading and setting issuer limits for financial investments. Separate portfolio limits are established for assetbacked securities and similar instruments. Controlling cross-border exposures to manage country and cross-border risk through the imposition of country limits with sub-limits by maturity and type of business. Controlling exposures to selected industries. When necessary, restrictions are imposed on new business, or exposures in the group’s operating entities are capped. Maintaining and developing risk ratings in order to categorise exposures meaningfully and facilitate focused management of the attendant risks. Rating methodology is based upon a wide range of financial analytics together with market data-based tools which are core inputs to the assessment of counterparty risk. Although automated risk-rating processes are increasingly used for the larger facilities, ultimate responsibility for setting risk grades rests in each case with the final approving executive. Risk grades are reviewed frequently and amendments, where necessary, are implemented promptly.



  

164

52 Risk management (continued) Both the HSBC Group Head Office and the group’s Risk Management Committee (‘RMC’) receive regular reports on credit exposures. These include information on large credit exposures, concentrations, industry exposures, levels of impairment provisioning and country exposures. RMC has the responsibility for risk approval authorities and approving definitive risk policies and controls. It monitors risk inherent to the financial services business, receives reports, determines action to be taken and reviews the efficacy of the risk management framework. The Executive Committee (‘EXCO’) and RMC are supported by a dedicated group risk function headed by the Chief Risk Officer, who is a member of both EXCO and RMC and reports to the Chief Executive. The Risk Committee also has responsibility for oversight and advice to the Board on risk matters. The key responsibilities of the Risk Committee in this regard include preparing advice to the Board on the overall risk appetite tolerance and strategy within the group and seeking such assurance as it may deem appropriate that account has been taken of the current and prospective macroeconomic and financial environment. The Risk Committee is also responsible for the periodic review of the effectiveness of the internal control and risk management frameworks and advising the Board on all high level risk matters. The Risk Committee approves the appointment and removal of the group Chief Risk Officer. (i) Credit exposure Maximum exposure to credit risk Our credit exposure is spread across a broad range of asset classes, including derivatives, trading assets, loans and advances to customers, loans and advances to banks and financial investments. The following table presents the maximum exposure to credit risk from balance sheet and off-balance sheet financial instruments, before taking account of any collateral held or other credit enhancements (unless such credit enhancements meet accounting offsetting requirements). For financial assets recognised on the balance sheet, the maximum exposure to credit risk equals their carrying amount; for financial guarantees and similar contracts granted, it is the maximum amount that we would have to pay if the guarantees were called upon. For loan commitments and other credit-related commitments that are irrevocable over the life of the respective facilities, it is generally the full amount of the committed facilities.

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Notes on the Financial Statements (continued)

52 Risk management (continued) Maximum exposure to credit risk before collateral held or other credit enhancements The group
2012 HK$m Cash and short-term funds ...................................................................................................... Items in the course of collection from other banks ................................................................ Placings with banks maturing after one month ...................................................................... Certificates of deposit ............................................................................................................. Hong Kong Government certificates of indebtedness ........................................................... Trading assets ......................................................................................................................... Debt securities .................................................................................................................... Treasury bills and other eligible bills.................................................................................. Other ................................................................................................................................... Financial assets designated at fair value ................................................................................ Debt securities .................................................................................................................... Other ................................................................................................................................... Derivatives .............................................................................................................................. Loans and advances to customers .......................................................................................... Financial investments: Debt securities ................................................................................... Amounts due from Group companies .................................................................................... Other assets ............................................................................................................................. Acceptances and endorsements .......................................................................................... Other ................................................................................................................................... Financial guarantees and other credit-related contingent liabilities ...................................... Loan commitments and other credit-related commitments ................................................... At 31 December ..................................................................................................................... 1,111,199 23,079 184,711 93,085 176,264 389,296 176,757 155,464 57,075 17,421 17,001 420 398,956 2,349,043 618,671 176,004 80,105 31,965 48,140 59,065 1,820,719 7,497,618 2011 HK$m 919,906 34,546 198,287 88,691 162,524 432,908 168,849 230,959 33,100 17,402 16,762 640 377,296 2,130,871 677,256 152,730 77,521 31,750 45,771 48,432 1,683,589 7,001,959

The Bank
2012 HK$m Cash and short-term funds ...................................................................................................... Items in the course of collection from other banks ................................................................ Placings with banks maturing after one month ...................................................................... Certificates of deposit ............................................................................................................. Hong Kong Government certificates of indebtedness ........................................................... Trading assets ......................................................................................................................... Debt securities .................................................................................................................... Treasury bills and other eligible bills ................................................................................ Other ................................................................................................................................... Financial assets designated at fair value: debt securities ........................................................ Derivatives .............................................................................................................................. Loans and advances to customers .......................................................................................... Financial investments: Debt securities ................................................................................... Amounts due from group companies ..................................................................................... Other assets ............................................................................................................................. Acceptances and endorsements .......................................................................................... Other ................................................................................................................................... Financial guarantees and other credit-related contingent liabilities ...................................... Loan commitments and other credit-related commitments ................................................... At 31 December ..................................................................................................................... 761,187 17,355 80,200 20,150 176,264 254,323 125,372 116,214 12,737 1,432 391,839 1,282,720 257,804 321,600 45,231 21,191 24,040 32,317 1,167,024 4,809,446 2011 HK$m 612,265 29,821 108,873 23,987 162,524 302,343 120,575 160,911 20,857 2,283 370,678 1,176,602 325,136 248,001 43,059 21,001 22,058 25,448 1,067,049 4,498,069

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52 Risk management (continued) (ii) Credit quality of financial instruments Four broad classifications describe the credit quality of the group’s lending and debt securities portfolios. These classifications each encompass a range of more granular, internal credit rating grades assigned to wholesale and retail lending business, as well as the external ratings attributed by external agencies to debt securities. There is no direct correlation between the internal and external ratings at the granular level, except insofar as both fall within one of the four classifications. Credit quality classification
Quality Classification Debt securities/ other bills External rating A– and above B+ to BBB+, and unrated B and below Impaired Wholesale lending and derivatives Internal credit Probability of rating default CRR 1 to CRR 2 0 – 0.169 CRR 3 to CRR 5 0.170 – 4.914 CRR 6 to CRR 8 CRR 9 to CRR 10 4.915 – 99.999 100 Retail lending Internal credit Expected loss % rating 1 EL 1 to EL 2 0 – 0.999 EL 3 to EL 5 1.000 – 19.999 EL 6 to EL 8 EL 9 to EL 10 20.000 – 99.999 100+ or defaulted 2

Strong .................... Medium ................. Sub-standard .......... Impaired .................

1 We observe the convention that, in addition to those classified as EL9 to EL10, retail accounts classified EL1 to EL8 that are delinquent by 90 days or more are considered impaired, unless individually they have been assessed as not impaired. (See note 52(v)) 2 The EL percentage is derived through a combination of PD and LGD, and may exceed 100% in circumstances where the LGD is above 100%, reflecting the cost of recoveries.

Quality classification definitions  Strong: Exposures demonstrate a strong capacity to meet financial commitments, with negligible or low probability of default and/or low levels of expected loss. Retail accounts operate within product parameters and only exceptionally show any period of delinquency. Medium: Exposures require closer monitoring, with low to moderate default risk. Retail accounts typically show only short periods of delinquency, with losses expected to be minimal following the adoption of recovery processes. Sub-standard: Exposures require varying degrees of special attention and default risk of greater concern. Retail portfolio segments show longer delinquency periods of generally up to 90 days past due and/or expected losses are higher due to a reduced ability to mitigate these through security realisation or other recovery processes. Impaired: Exposures have been assessed, individually or collectively, as impaired. The group observes the convention, reflected in the quality classification definitions above, that all retail accounts delinquent by 90 days or more are considered impaired. Such accounts may occur in any retail EL (‘Expected Loss’) grade, whereby in the higher quality grades the grading assignment will reflect the offsetting of the impact of delinquency status by credit risk mitigation in one form or another. The group’s policy in respect of impairment on loans and advances and debt securities is set out in notes 3(d) and 3(g) on the Financial Statements. Analysis of impairment allowances as at 31 December 2012 and the movement of such allowances during the year are disclosed in note 19.







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Notes on the Financial Statements (continued)

52 Risk management (continued) Granular risk rating scales The CRR (‘Customer Risk Rating’) 10-grade scale maps to a more granular underlying 23-grade scale of obligor probability of default. These scales are used Group-wide for all individually significant customers, depending on which Basel II approach is adopted for the assets in question. The EL 10-grade scale for retail business summarises a more granular 29-grade scale combining obligor and facility/product risk factors in a composite measure, used Group-wide. The external ratings cited above have for clarity of reporting been assigned to the quality classifications defined for internally-rated exposures. The basis of reporting reflects risk rating systems under the HSBC Group’s Basel II programme and to extend the range of financial instruments covered in the presentation of portfolio quality. Impairment is not measured for financial instruments held in trading portfolios or designated at fair value, as assets in such portfolios are managed according to movements in fair value, and the fair value movement is taken directly through the income statement. (iii) Collateral and other credit enhancements Loans and advances Although collateral can be an important mitigant of credit risk, it is the group’s practice to lend on the basis of the customer’s ability to meet their obligations out of their cash flow resources rather than rely on the value of security offered. Depending on the customer’s standing and the type of product, facilities may be provided unsecured. However, for other lending a charge over collateral is obtained and considered in determining the credit decision and pricing. In the event of default the bank may use the collateral as a source of repayment. Depending on its form, collateral can have a significant financial effect in mitigating our exposure to credit risk. The tables below provide a quantification of the value of fixed charges we hold over a borrower’s specific asset (or assets) where we have a history of enforcing, and are able to enforce, the collateral in satisfying a debt in the event of the borrower failing to meet its contractual obligations, and where the collateral is cash or can be realised by sale in an established market. The collateral valuation in the tables below exclude any adjustments for obtaining and selling the collateral. We may also manage our risk by employing other types of collateral and credit risk enhancements, such as second charges, other liens and unsupported guarantees, but the valuation of such mitigants is less certain and their financial effect has not been quantified. In particular, loans shown in the tables below as not collateralised may benefit from such credit mitigants.

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52 Risk management (continued) Personal lending Residential mortgages including loan commitments by level of collateral
2012 HK$m Not collateralised ................................................................................................................... Fully collateralised ................................................................................................................. – Less than 25% LTV ........................................................................................................... – 25% to 50% LTV ............................................................................................................... – 51% to 75% LTV ............................................................................................................... – 76% to 90% LTV – 91% to 100% LTV Partially collateralised – Greater than 100% LTV ..................................................................................................... – Collateral value ................................................................................................................... Total residential mortgages .................................................................................................... 79 747,689 96,626 329,650 249,448 62,920 9,045 2,929 2,513 750,697 2011 HK$m 1,290 659,976 60,167 230,027 278,216 81,597 9,969 4,156 3,912 665,422

The above table shows residential mortgage lending including off-balance sheet loan commitments by level of collateral. The collateral included in the table above consists of fixed first charges on real estate. The loan-to-value (‘LTV’) ratio is calculated as the gross on-balance sheet carrying amount of the loan and any off-balance sheet loan commitment at the balance sheet date divided by the value of collateral. The methodologies for obtaining residential property collateral values vary throughout the group, but are typically determined through a combination of professional appraisals, house price indices or statistical analysis. Valuations must be updated on a regular basis and, as a minimum, at intervals of every three years. Valuations are conducted more frequently when market conditions or portfolio performance are subject to significant change or where a loan is identified and assessed as impaired. Other personal lending
Other personal lending consists primarily of personal loans, overdrafts and credit cards, all of which are generally unsecured.

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Notes on the Financial Statements (continued)

52 Risk management (continued) Corporate, commercial and financial (non-bank) lending Collateral held is analysed below separately for commercial real estate and for other corporate, commercial and financial (non-bank) lending. This reflects the difference in collateral held on the portfolios. In each case, the analysis includes off-balance sheet loan commitments, primarily undrawn credit lines. Commercial real estate loans and advances including loan commitments by level of collateral
2012 HK$m Rated CRR/EL 1 to 7 ............................................................................................................. Not collateralised .................................................................................................................... Fully collateralised ................................................................................................................. Partially collateralised (A) ..................................................................................................... – collateral value on A .......................................................................................................... Rated CRR/EL 8 to 10 ........................................................................................................... Not collateralised .................................................................................................................... Fully collateralised ................................................................................................................. – Less than 25% LTV ........................................................................................................... – 25% to 50% LTV ............................................................................................................... – 51% to 75% LTV ............................................................................................................... – 76% to 90% LTV ............................................................................................................... – 91% to 100% LTV ............................................................................................................. Partially collateralised (B) ...................................................................................................... – collateral value on B ........................................................................................................... Total commercial real estate loans and advances .................................................................. 314,079 111,895 181,832 20,352 12,735 878 – 486 12 437 17 9 11 392 115 314,957 2011 HK$m 280,706 120,602 144,975 15,129 6,770 616 95 193 – 14 9 14 156 328 203 281,322

The collateral included in the table above consists of fixed first charges on real estate and charges over cash for the commercial real estate sector. The table includes lending to major property developers which is typically secured by guarantees or is unsecured. The value of commercial real estate collateral is determined through a combination of professional and internal valuations and physical inspection. Due to the complexity of collateral valuations for commercial real estate, local valuation policies determine the frequency of review based on local market conditions. Revaluations are sought with greater frequency where, as part of the regular credit assessment of the obligor, material concerns arise in relation to the transaction which may reflect on the underlying performance of the collateral, or in circumstances where an obligor’s credit quality has declined sufficiently to cause concern that the principal payment source may not fully meet the obligation (i.e. the obligor’s credit quality classification indicates it is at the lower end e.g. sub-standard, or approaching impaired).

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52 Risk management (continued) Other corporate, commercial and financial (non-bank) loans and advances rated CRR/EL 8 to 10 only including loan commitments by level of collateral.
2012 HK$m Not collateralised ................................................................................................................... Fully collateralised ................................................................................................................. – Less than 25% LTV ........................................................................................................... – 25% to 50% LTV ............................................................................................................... – 51% to 75% LTV ............................................................................................................... – 76% to 90% LTV ............................................................................................................... – 91% to 100% LTV ............................................................................................................. Partially collateralised (A) ..................................................................................................... – collateral value on A .......................................................................................................... Total ....................................................................................................................................... 6,447 1,784 113 515 547 278 331 2,591 1,011 10,822 2011 HK$m 8,882 1,634 107 588 334 251 354 1,985 1,015 12,501

The collateral used in the assessment of the above primarily includes first legal charges over real estate and charges over cash in the commercial and industrial sector and charges over cash and marketable financial instruments in the financial sector. Government sector lending is typically unsecured. It should be noted that the table above excludes other types of collateral which are commonly taken for corporate and commercial lending such as unsupported guarantees and floating charges over the assets of a customer’s business. While such mitigants have value, often providing rights in insolvency, their assignable value is insufficiently certain. They are assigned no value for disclosure purposes. As with commercial real estate the value of real estate collateral included in the table above is generally determined through a combination of professional and internal valuations and physical inspection. The frequency of revaluation is undertaken on a similar basis to commercial real estate loans and advances; however, for financing activities in corporate and commercial lending that are not predominantly commercial real estate-oriented, collateral value is not as strongly correlated to principal repayment performance. Collateral values will generally be refreshed when an obligor’s general credit performance deteriorates and it is necessary to assess the likely performance of secondary sources of repayment should reliance upon them prove necessary. For this reason, the table above reports values only for customers with CRR 8 to 10, reflecting that these loans and advances generally have valuations which are of comparatively recent vintage. For the purposes of the table above, cash is valued at its nominal value and marketable securities at their fair value. Loans and advances to banks Loans and advances to banks including loan commitments by level of collateral
2012 HK$m Not collateralised ................................................................................................................... Fully collateralised ................................................................................................................. Partially collateralised (A) ..................................................................................................... – collateral value on A .......................................................................................................... Total loans and advances to banks ........................................................................................ 492,106 61,702 20,661 20,054 574,469 2011 HK$m 615,783 64,411 3,847 1,996 684,041

The collateral used in the assessment of the above relates primarily to cash and marketable securities. Loans and advances to banks are typically unsecured. Certain products such as reverse repurchase agreements and stock borrowing are effectively collateralised and have been included in the above as fully or partially collateralised.

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Notes on the Financial Statements (continued)

52 Risk management (continued) Derivatives The International Swaps and Derivatives Association (‘ISDA’) Master Agreement is our preferred agreement for documenting derivatives activity. It provides the contractual framework within which dealing activity across a full range of over the counter (‘OTC’) products is conducted, and contractually binds both parties to apply close-out netting across all outstanding transactions covered by an agreement if either party defaults or another pre-agreed termination event occurs. It is common, and our preferred practice, for the parties to execute a Credit Support Annex (‘CSA’) in conjunction with the ISDA Master Agreement. Under a CSA, collateral is passed between the parties to mitigate the counterparty risk inherent in outstanding positions. The majority of our CSAs are with financial institution clients. Other credit risk exposures In addition to collateralised lending described above, other credit enhancements are employed and methods used to mitigate credit risk arising from financial assets. These are described in more detail below. Government, bank and other financial institution issued securities may benefit from additional credit enhancement, notably through government guarantees that reference these assets. Corporate issued debt securities are primarily unsecured. Debt securities issued by banks and financial institutions include assetbacked securities (‘ABS’s) and similar instruments, which are supported by underlying pools of financial assets. Credit risk associated with ABSs is reduced through the purchase of credit default swap (‘CDS’) protection. Trading assets include loans and advances held with trading intent, the majority of which consist of reverse repos and stock borrowing which by their nature are collateralised. Collateral accepted as security that the group is permitted to sell or repledge under these arrangements is described in Note 45 ‘Assets pledged as security for liabilities and collateral accepted as security for assets’. The group’s maximum exposure to credit risk includes financial guarantees and similar arrangements that it issues or enters into, and loan commitments to which it is irrevocably committed. Depending on the terms of the arrangement, the bank may have recourse to additional credit mitigation in the event that a guarantee is called upon or a loan commitment is drawn and subsequently defaults. Further information about these arrangements is provided in Note 44 ‘Contingent liabilities and commitments’. The carrying amount of assets obtained by taking possession of collateral held as security, or calling upon other credit enhancements, is as follows:
The group 2012 HK$m Residential properties ...................................... Commercial and industrial properties .............. Other assets ...................................................... 115 26 3 144 2011 HK$m 103 6 3 112 The Bank 2012 HK$m 21 23 – 44 2011 HK$m 35 – – 35

Repossessed assets are made available for sale in an orderly fashion, with the proceeds used to reduce or repay the outstanding indebtedness. If excess funds arise after the debt has been repaid, they are made available either to repay other secured lenders with lower priority or are returned to the customer. The group does not generally occupy repossessed properties for its own business use.

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52 Risk management (continued) (iv) Distribution of financial instruments by credit quality The group
Neither past due nor impaired Substandard HK$m Past due not impaired HK$m Impairment allowances HK$m

31 December 2012 Items in the course of collection from other banks .............................. Trading assets .................. – treasury and other eligible bills ................. – debt securities .............. – loans and advances to banks ............................ – loans and advances to customers ..................... Financial assets designated at fair value .................. – debt securities .............. – loans and advances to customers ..................... Derivatives ....................... Loans and advances held at amortised cost .............. – loans and advances to banks ............................ – loans and advances to customers ..................... Financial investments ...... – treasury and other eligible bills ................. – debt securities ............... Other assets ...................... – endorsements and acceptances .................. – other ............................. Total .................................

Strong HK$m

Medium1 HK$m

Impaired HK$m

Total HK$m

21,044 288,274 131,405 131,588 21,001 4,280

2,035 99,986 23,926 44,312 1,190 30,558

– 1,036 133 857 – 46

– – – – – –

– – – – – –

– – – – – –

23,079 389,296 155,464 176,757 22,191 34,884

14,705 14,705 – 334,877 1,792,378 472,123 1,320,255 1,133,090 512,674 620,416 31,901 8,624 23,277 3,616,269

2,716 2,296 420 63,793 1,040,803 72,026 968,777 110,743 21,661 89,082 47,101 22,759 24,342 1,367,177

– – – 286 26,324 2,682 23,642 2,816 563 2,253 774 580 194 31,236

– – – – 33,203 77 33,126 – – – 228 2 226 33,431

– – – – 13,014 – 13,014 5 – 5 101 – 101 13,120

– – – – (9,771) – (9,771) – – – – – – (9,771)

17,421 17,001 420 398,956 2,895,951 546,908 2,349,043 1,246,654 534,898 711,756 80,105 31,965 48,140 5,051,462

1 Includes HK$108,872m of treasury and eligible bills and debt securities that have been classified as BBB+ to BBB- using the ratings of Standard & Poor’s.

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Notes on the Financial Statements (continued)

52 Risk management (continued)
Neither past due nor impaired Substandard HK$m Past due not impaired HK$m Impairment allowances HK$m

31 December 2011 Items in the course of collection from other banks .............................. Trading assets .................. – treasury and other eligible bills ................. – debt securities .............. – loans and advances to banks ............................ – loans and advances to customers ..................... Financial assets designated at fair value .................. – debt securities .............. – loans and advances to customers ..................... Derivatives ....................... Loans and advances held at amortised cost .............. – loans and advances to banks ............................ – loans and advances to customers ..................... Financial investments ...... – treasury and other eligible bills ................. – debt securities2.............. Other assets ...................... – endorsements and acceptances .................. – other ............................. Total .................................

Strong HK$m

Medium1 HK$m

Impaired HK$m

Total HK$m

32,852 371,013 224,302 123,177 22,413 1,121

1,690 61,562 6,657 45,596 3,491 5,818

4 333 – 76 257 –

– – – – – –

– – – – – –

– – – – – –

34,546 432,908 230,959 168,849 26,161 6,939

14,701 14,061 640 320,122 1,778,778 581,800 1,196,978 1,018,523 329,458 689,065 28,910 6,549 22,361 3,564,899

2,701 2,701 – 56,721 954,195 71,227 882,968 99,824 24,047 75,777 46,338 24,320 22,018 1,223,031

– – – 453 23,329 1,252 22,077 1,048 – 1,048 1,635 876 759 26,802

– – – – 26,600 302 26,298 – – – 545 – 545 27,145

– – – – 13,851 – 13,851 57 – 57 93 5 88 14,001

– – – – (11,301) – (11,301) – – – – – – (11,301)

17,402 16,762 640 377,296 2,785,452 654,581 2,130,871 1,119,452 353,505 765,947 77,521 31,750 45,771 4,844,577

1 Includes HK$91,657m of treasury and eligible bills and debt securities that have been classified as BBB+ to BBB- using the ratings of Standard & Poor’s. 2 Includes HK$16m of impaired debt securities overdue more than 1 year.

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52 Risk management (continued) The Bank
Neither past due nor impaired Substandard HK$m Past due not impaired HK$m Impairment allowances HK$m

31 December 2012 Items in the course of collection from other banks .............................. Trading assets .................. – treasury and other eligible bills ................. – debt securities .............. – loans and advances to banks ............................ – loans and advances to customers ..................... Financial assets designated at fair value: debt securities .............. Derivatives ....................... Loans and advances held at amortised cost .............. – loans and advances to banks ............................ – loans and advances to customers ..................... Financial investments ...... – treasury and other eligible bills ................. – debt securities .............. Other assets ...................... – endorsements and acceptances .................. – other ............................. Total .................................

Strong HK$m

Medium1 HK$m

Impaired HK$m

Total HK$m

15,546 190,792 92,288 91,255 3,513 3,736

1,809 63,255 23,926 33,887 501 4,941

– 276 – 230 – 46

– – – – – –

– – – – – –

– – – – – –

17,355 254,323 116,214 125,372 4,014 8,723

576 330,679 931,321 208,565 722,756 613,227 398,367 214,860 18,370 6,482 11,888 2,100,511

856 61,023 565,029 37,414 527,615 83,922 20,978 62,944 26,278 14,350 11,928 802,172

– 137 15,224 49 15,175 145 – 145 509 359 150 16,291

– – 16,251 76 16,175 – – – 62 – 62 16,313

– – 6,548 – 6,548 5 – 5 12 – 12 6,565

– – (5,549) – (5,549) – – – – – – (5,549)

1,432 391,839 1,528,824 246,104 1,282,720 697,299 419,345 277,954 45,231 21,191 24,040 2,936,303

1 Includes HK$94,465m of treasury and eligible bills and debt securities that have been classified as BBB+ to BBB- using the ratings of Standard & Poor’s.

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Notes on the Financial Statements (continued)

52 Risk management (continued)
Neither past due nor impaired Substandard HK$m Past due not impaired HK$m Impairment allowances HK$m

31 December 2011 Items in the course of collection from other banks .............................. Trading assets .................. – treasury and other eligible bills ................. – debt securities .............. – loans and advances to banks ............................ – loans and advances to customers ..................... Financial assets designated at fair value: debt securities ............... Derivatives ....................... Loans and advances held at amortised cost .............. – loans and advances to banks ............................ – loans and advances to customers ..................... Financial investments ...... – treasury and other eligible bills ................. – debt securities .............. Other assets ...................... – endorsements and acceptances .................. – other ............................. Total .................................

Strong HK$m

Medium1 HK$m

Impaired HK$m

Total HK$m

28,334 254,395 154,316 84,222 14,742 1,115

1,483 47,615 6,595 36,277 1,531 3,212

4 333 – 76 257 –

– – – – – –

– – – – – –

– – – – – –

29,821 302,343 160,911 120,575 16,530 4,327

587 317,049 972,734 303,108 669,626 571,375 278,105 293,270 11,255 3,949 7,306 2,155,729

1,696 53,294 519,868 37,739 482,129 76,344 21,596 54,748 30,556 16,665 13,891 730,856

– 335 12,504 386 12,118 1,048 – 1,048 1,080 382 698 15,304

– – 11,786 294 11,492 – – – 82 – 82 11,868

– – 8,951 – 8,951 57 – 57 86 5 81 9,094

– – (7,714) – (7,714) – – – – – – (7,714)

2,283 370,678 1,518,129 341,527 1,176,602 648,824 299,701 349,123 43,059 21,001 22,058 2,915,137

1 Includes HK$81,436m of treasury and eligible bills and debt securities that have been classified as BBB+ to BBB- using the ratings of Standard & Poor’s.

176

52 Risk management (continued) (v) Ageing analysis of past due but not yet impaired financial instruments The amounts in the following table reflect exposures designated as past due but not impaired. Examples of exposures designated as past due but not impaired include loans that have missed the most recent payment date but on which there is no evidence of impairment and short-term trade facilities past due more than 90 days for technical reasons, such as delays in documentation, but where there is no concern over the creditworthiness of the counterparty. The group
Up to 29 days HK$m 31 December 2012 Loans and advances held at amortised cost .... – loans and advances to banks ...................... – loans and advances to customers1 .............. Financial investments ..................................... – treasury and other eligible bills .................. – debt securities ............................................. Other assets ..................................................... 26,876 77 26,799 – – – 96 26,972 31 December 2011 Loans and advances held at amortised cost ... – loans and advances to banks ...................... – loans and advances to customers1 .............. Financial investments ..................................... – treasury and other eligible bills .................. – debt securities ............................................. Other assets ..................................................... 21,616 302 21,314 – – – 138 21,754 30-59 days HK$m 4,874 – 4,874 – – – 37 4,911 3,685 – 3,685 – – – 143 3,828 60-89 days HK$m 1,353 – 1,353 – – – 38 1,391 1,113 – 1,113 – – – 71 1,184 90-180 days HK$m 81 – 81 – – – 31 112 143 – 143 – – – 66 209 Over 180 days HK$m 19 – 19 – – – 26 45 43 – 43 – – – 127 170 Total HK$m 33,203 77 33,126 – – – 228 33,431 26,600 302 26,298 – – – 545 27,145

The Bank
Up to 29 days HK$m 31 December 2012 Loans and advances held at amortised cost .... – loans and advances to banks ...................... – loans and advances to customers1 .............. Financial investments ..................................... – treasury and other eligible bills .................. – debt securities ............................................. Other assets ..................................................... 13,187 76 13,111 – – – 23 13,210 31 December 2011 Loans and advances held at amortised cost ... – loans and advances to banks ...................... – loans and advances to customers1 .............. Financial investments ..................................... – treasury and other eligible bills .................. – debt securities ............................................. Other assets ..................................................... 9,628 294 9,334 – – – 28 9,656 30-59 days HK$m 2,518 – 2,518 – – – 9 2,527 1,700 – 1,700 – – – 16 1,716 60-89 days HK$m 509 – 509 – – – 3 512 410 – 410 – – – 13 423 90-180 days HK$m 21 – 21 – – – 10 31 31 – 31 – – – 14 45 Over 180 days HK$m 16 – 16 – – – 17 33 17 – 17 – – – 11 28 Total HK$m 16,251 76 16,175 – – – 62 16,313 11,786 294 11,492 – – – 82 11,868

1 The majority of the loans and advances to customers that are operating within revised terms following restructuring are excluded from this table.

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Notes on the Financial Statements (continued)

52 Risk management (continued) (vi) Impaired loans and advances The group’s policy for recognising and measuring impairment allowances on both individually assessed loans and advances and those which are collectively assessed on a portfolio basis is described in note 3(d). Analyses of impairment allowances at 31 December 2012, and the movement of such allowances during the year, are disclosed in note 19. b Liquidity and funding risk The management of liquidity and funding is primarily undertaken locally (by country) in our operating entities, in compliance with the Group’s liquidity and funding risk framework (the ‘framework’) and with practices and limits set by the Group Management Board (‘GMB’) through the Risk Management Meeting and approved by the Board. These limits vary according to the depth and liquidity of the markets in which the entities operate. Our general policy is that each defined operating entity should be self-sufficient in funding its own activities. Where transactions exist between operating entities, they are reflected symmetrically in both entities. As part of our Asset, Liability and Capital Management (‘ALCM’) structure, we have established Asset and Liability Management Committees (‘ALCOs’) at Group level, in the regions and in operating entities. The terms of reference of all ALCOs include the monitoring and control of liquidity and funding. The primary responsibility for managing liquidity and funding within the Group’s framework and risk appetite resides with the local operating entity ALCO. Our most significant operating entities are overseen by regional ALCOs, Group ALCO and the Risk Management Meeting. The remaining smaller operating entities are overseen by regional ALCOs, with appropriate escalation of significant issues to Group ALCO and the Risk Management Meeting. Operating entities are predominately defined on a country basis to reflect our local management of liquidity and funding. Typically, an operating entity will be defined as a single legal entity. However, to take account of the situation where operations in a country are booked across multiple subsidiaries or branches:  an operating entity may be defined as a wider sub-consolidated group of legal entities if they are incorporated in the same country, liquidity and funding are freely fungible between the entities and permitted by local regulation, and the definition reflects how liquidity and funding are managed locally; or an operating entity may be defined more narrowly as a principal office (branch) of a wider legal entity operating in multiple countries, reflecting the local country management of liquidity and funding.



Compliance with liquidity and funding requirements is monitored by local ALCO which report to the group ALCM on a regular basis. This process includes:          maintaining compliance with relevant regulatory requirements of the operating entity; projecting cash flows under various stress scenarios and considering the level of liquid assets necessary in relation thereto; monitoring balance sheet liquidity and advances to core funding ratios against internal and regulatory requirements; maintaining a diverse range of funding sources with adequate back-up facilities; managing the concentration and profile of debt maturities; managing contingent liquidity commitment exposures within pre-determined limits; maintaining debt financing plans; monitoring of depositor concentration in order to avoid undue reliance on large individual depositors and ensuring a satisfactory overall funding mix; and maintaining liquidity and funding contingency plans. These plans identify early indicators of stress conditions and describe actions to be taken in the event of difficulties arising from systemic or other crises, while minimising adverse long-term implications for the business.

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52 Risk management (continued) Primary sources of funding Customer deposits in the form of current accounts and savings deposits payable on demand or at short notice form a significant part of our funding, and we place considerable importance on maintaining their stability. For deposits, stability depends upon preserving depositor confidence in our capital strength and liquidity, and on competitive and transparent pricing. Professional markets are accessed for the purposes of providing additional funding, maintaining a presence in local money markets and optimising asset and liability maturities. The management of funding and liquidity risk Inherent liquidity risk categorisation We place our operating entities into one of three categories (low, medium and high) to reflect our assessment of their inherent liquidity risk, considering political, economic and regulatory factors within the host country and factors specific to the operating entities themselves, such as the local market, market share and balance sheet strength. The categorisation involves management judgement and is based on the perceived liquidity risk of an operating entity relative to other entities in the Group. The categorisation is intended to reflect the possible impact of a liquidity event, not the probability of an event. The categorisation is part of our risk appetite and is used to determine the prescribed stress scenario that we require our operating entities to be able to withstand and manage. Core deposits A key assumption of our internal framework is the categorisation of customer deposits into core and non-core based on our expectation of the behaviour of these deposits during a liquidity stress. This characterisation takes into account the inherent liquidity risk categorisation of the operating entity originating the deposit, the nature of the customer and the size and pricing of the deposit. No deposit is considered to be core in its entirety unless it is contractually collateralising a loan. The core deposit base in each operating entity is considered to be a long-term source of funding and therefore is assumed not to be withdrawn in the liquidity stress scenario that we use to calculate our principal liquidity risk metrics. The three filters considered in assessing whether a deposit in any operating entity is core are:    price: any deposit priced significantly above market or benchmark rates is generally treated as entirely noncore; size: depositors with total funds above certain monetary thresholds are excluded. Thresholds are established by considering the business line and inherent liquidity risk categorisation; and line of business: the element of any deposit remaining after the application of the price and size filter is assessed on the basis of the line of business to which the deposit is associated. The proportion of any customer deposit that can be considered core under this filter is between 35% and 90%.

Repo transactions and bank deposits cannot be categorised as core deposits. Advances to core funding ratio The group emphasises the importance of core customer deposits as a source of funds to finance lending to customers, and mitigate against reliance on short-term professional funding. Limits are placed on operating entities to restrict their ability to increase loans and advances to customers without corresponding growth in core customer deposits or long-term debt funding with a residual maturity beyond one year. This measure is referred to as the ‘advances to core funding’ ratio. Advances to core funding ratio limits are set by the Risk Management Meeting for the most significant operating entities, and by regional ALCOs for smaller operating entities, and are monitored by ALCM teams. The ratio describes current loans and advances to customers as a percentage of the total of core customer deposits and term funding with a remaining term to maturity in excess of one year. In general, customer loans are assumed to be renewed and are included in the numerator of the advances to core funding ratio, irrespective of the contractual maturity date. Reverse repurchase arrangements are excluded from the advances to core funding ratio.

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Notes on the Financial Statements (continued)

52 Risk management (continued) Stressed coverage ratios Stressed coverage ratios tabulated below are derived from stressed cash flow scenario analyses and express the stressed cash inflows as a percentage of stressed cash outflows over one-month and three-month time horizons. The stressed cash inflows include:   inflows (net of assumed haircuts) expected to be generated from the realisation of liquid assets; and contractual cash inflows from maturing assets that are not already reflected as a use of liquid assets.

In line with the approach adopted for the advances to core funding ratio, customer loans are, in general, assumed not to generate any cash inflows under stress scenarios and are therefore excluded from the numerator of the stressed coverage ratios, irrespective of the contractual maturity date. A stressed coverage ratio of 100% or higher reflects a positive cumulative cash flow under the stress scenario being monitored. Group operating entities are required to maintain a ratio of 100% or greater out to three months under the combined market-wide and HSBC-specific stress scenario defined by the inherent risk categorisation of the operating entity concerned. Compliance with liquidity and funding requirements is monitored by local ALCOs which report to the group ALCM on a regular basis. Advances to core funding ratios and the stressed one-month and three-month coverage ratios for the Bank are provided in the following table based on month end figures:
Advances to core funding ratio 2012 2011 % % Year-end ........................................................... Maximum ......................................................... Minimum ......................................................... Average ............................................................ 73.1 75.0 71.4 73.1 75.0 78.9 70.3 75.9 Stressed one month coverage ratio 2012 2011 % % 129.5 133.6 122.9 129.0 122.9 144.6 116.4 124.0 Stressed three month coverage ratio 2012 2011 % % 126.1 126.2 118.5 123.4 118.5 125.9 109.5 116.2

Liquidity behaviouralisation Liquidity behaviouralisation is applied to reflect our assessment of the expected period for which we are confident that we will have access to our liabilities, even under a severe liquidity stress scenario, and the expected period for which we must assume that we will need to fund our assets. Behaviouralisation is applied when the contractual terms do not reflect the expected behaviour. Liquidity behaviouralisation is reviewed and approved by local ALCOs in compliance with policies set by the Risk Management Meeting. Our approach to liquidity risk management will often mean a different approach is applied to assets and liabilities. For example, management may assume a shorter life for liabilities and a longer-term funding requirement for assets. Contingent liquidity risk Operating entities provide customers with committed and standby facilities. These facilities increase the funding requirements of the group when customers drawdown. The liquidity risk associated with the potential drawdown on non-cancellable committed facilities is factored into our stressed scenarios and limits are set for these facilities. Liquidity ratio under the Hong Kong Banking Ordinance The Hong Kong Banking Ordinance also requires banks operating in Hong Kong to maintain a minimum liquidity ratio. The requirement applies separately to the Hong Kong branches of the Bank and to those subsidiaries which are Authorised Institutions under the Banking Ordinance in Hong Kong.

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52 Risk management (continued) c Market risk Market risk is the risk that movements in foreign exchange rates, interest rates, credit spreads, or equity and commodity prices will result in profits or losses to the group. Market risk arises on financial instruments which are measured at fair value and those which are measured at amortised cost. The objective of market risk management is to control market risk exposures to achieve an optimal return while maintaining risk at acceptable levels. The group monitors market risk separately for trading portfolios and non-trading portfolios. Trading portfolios include positions arising from market-making in exchange rate, interest rate, credit and equity derivative instruments, as well as in debt and equity securities. Trading risks arise either from customer-related business or from proprietary position-taking. The management of market risk is principally undertaken in Global Markets through risk limits approved by the group’s Executive Committee. Wholesale and Market Risk, an independent unit within the Risk function, develops risk management policies and measurement techniques. Risk limits are determined for each location and, within location, for each portfolio. Limits are set by product and risk type with market liquidity being a principal factor in determining the level of limits set. Limits are set using a combination of risk measurement techniques, including position limits, sensitivity limits, as well as value at risk limits at a portfolio level. Similarly, option risks are controlled through full revaluation limits in conjunction with limits on the underlying variables that determine each option’s value. Value at risk (‘VAR’) One of the principal tools used by the group to monitor and limit market risk exposure is VAR. VAR is a technique which estimates the potential losses that could occur on risk positions taken due to movements in market rates and prices over a specified time horizon and to a given level of confidence (99% for the group). VAR is calculated daily. The group uses a historical simulation model which derives plausible future scenarios from historical market data. Potential movements in market prices are calculated with reference to market data from the last two years. The model used assumes a 1-day holding period, as this reflects the way the risk positions are managed. Although a valuable guide to risk, VAR should always be viewed in the context of its limitations. For example:   the use of historical data as a proxy for estimating future events may not encompass all potential events, particularly those which are extreme in nature; the use of a 1-day holding period assumes that all positions can be liquidated or hedged in one day. This may not fully reflect the market risk arising at times of severe illiquidity, when a 1-day holding period may be insufficient to liquidate or hedge all positions fully; the use of a 99% confidence level, by definition, does not take into account losses that might occur beyond this level of confidence; and VAR is calculated on the basis of exposures outstanding at the close of business and therefore does not necessarily reflect intra-day exposures.

 

The group recognises these limitations by augmenting the VAR limits with other position and sensitivity limit structures, as well as with stress testing, both on individual portfolios and on a consolidated basis. The group’s stress testing regime provides senior management with an assessment of the impact of extreme events on the market risk exposures of the group. Trading The group’s control of market risk is based on restricting individual operations to trading within a list of permissible instruments authorised for each site by Wholesale and Market Risk, and enforcing rigorous new product approval procedures. In particular, trading in the more complex derivative products is concentrated in offices with appropriate levels of product expertise and robust control systems. In addition, at both portfolio and position levels, market risk in trading portfolios is monitored and controlled using a complementary set of techniques such as VAR and present value of a basis point, together with stress and sensitivity testing and concentration limits. These techniques quantify the impact on capital of defined market movements.

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Notes on the Financial Statements (continued)

52 Risk management (continued) The total VAR for Global Markets were as follows:
The group 2012 2011 HK$m HK$m Total VAR Year end .................................................................................................. Average ................................................................................................... Maximum ................................................................................................ Minimum ................................................................................................. Total interest rate VAR Year end .................................................................................................. Average ................................................................................................... Maximum ................................................................................................ Minimum ................................................................................................. Total foreign exchange VAR Year end .................................................................................................. Average ................................................................................................... Maximum ................................................................................................ Minimum ................................................................................................. Total credit spread VAR Year end .................................................................................................. Average ................................................................................................... Maximum ................................................................................................ Minimum ................................................................................................. Total trading VAR Year end .................................................................................................. Average ................................................................................................... Maximum ................................................................................................ Minimum ................................................................................................. Interest rate trading VAR Year end .................................................................................................. Average ................................................................................................... Maximum ................................................................................................ Minimum ................................................................................................. Foreign exchange trading VAR Year end .................................................................................................. Average ................................................................................................... Maximum ................................................................................................ Minimum ................................................................................................. Credit spread trading VAR Year end .................................................................................................. Average ................................................................................................... Maximum ................................................................................................ Minimum ................................................................................................. Equity trading VAR1 Year end .................................................................................................. Average ................................................................................................... Maximum ................................................................................................ Minimum ................................................................................................. 1 199 260 473 167 169 209 261 169 43 38 85 23 121 177 325 118 134 136 232 89 95 110 159 68 43 38 85 23 39 47 98 29 26 27 54 14 393 306 463 190 151 141 187 108 49 50 116 28 343 246 380 136 184 131 208 73 98 91 150 62 46 47 99 24 109 67 115 36 15 18 37 5 The Bank 2012 HK$m 173 211 357 159 149 168 212 137 43 39 93 22 69 110 212 67 119 128 227 84 90 101 142 70 43 39 93 22 25 39 82 23 26 27 54 14 2011 HK$m 279 235 326 156 105 121 161 92 51 52 111 29 196 166 247 96 156 118 184 69 101 87 120 59 48 47 95 27 82 57 96 32 15 18 37 5

In addition to equity trading positions managed by Global Markets, the group also has exposure to changes in equity prices and interest rates relating to guarantees given to customers who purchase certain HSBC investment contracts. As at 31 December 2012, a 10% decrease in equity prices would reduce profit before tax and net assets by HK$182m (2011: HK$186m) and a 100 basis points decrease in interest rates would reduce profit before tax and net assets by HK$23m (2011: HK$156m).

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52 Risk management (continued) Non-trading portfolios Market risk in non-trading portfolios arises principally from mismatches between the future yield on assets and their funding cost as a result of interest rate changes. Analysis of this risk is complicated by having to make assumptions on optionality in certain product areas, for example mortgage prepayments, and from behavioural assumptions regarding the economic duration of liabilities which are contractually repayable on demand, for example current accounts. In order to manage this risk optimally, market risk in non-trading portfolios is transferred to Global Markets or to separate books managed under the supervision of the local Asset and Liability Management Committee (‘ALCO’). The transfer of market risk to books managed by Global Markets or supervised by ALCO is usually achieved by a series of internal deals between the business units and these books. When the behavioural characteristics of a product differ from its contractual characteristics, the behavioural characteristics are assessed to determine the true underlying interest rate risk. Local ALCOs regularly monitor all such behavioural assumptions and interest rate risk positions, to ensure they comply with interest rate risk limits established by senior management. As noted above, in certain cases, the non-linear characteristics of products cannot be adequately captured by the risk transfer process. For example, both the flow from customer deposit accounts to alternative investment products and the precise prepayment speeds of mortgages will vary at different interest rate levels. In such circumstances, simulation modelling is used to identify the impact of varying scenarios on valuations and net interest income. Once market risk has been consolidated in Global Markets or ALCO-managed books, the net exposure is typically managed through the use of interest rate swaps within agreed limits. Within the group, banking entities also monitor the sensitivity of projected net interest income under varying interest rate scenarios. The group aims, through its management of market risk in non-trading portfolios, to mitigate the impact of prospective interest rate movements which could reduce future net interest income, whilst balancing the cost of such hedging activities on the current net revenue stream. A large part of the group’s exposure to changes in net interest income arising from movements in interest rates relates to its core deposit franchise. The group’s core deposit franchise is exposed to changes in the value of the deposits raised and spreads against wholesale funds. The value of core deposits increases as interest rates rise and decreases as interest rates fall. This risk is, however, asymmetrical in a very low interest rate environment as there is limited room to lower deposit pricing in the event of interest rate reductions.

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Notes on the Financial Statements (continued)

52 Risk management (continued) Structural foreign exchange exposure The group’s gross structural foreign exchange exposure is represented by the net asset value of the group’s foreign currency investments in subsidiaries, branches and associates, and the fair value of the group’s long-term foreign currency equity investments. The group’s structural foreign currency exposures are managed by the group’s ALCO with the primary objective of ensuring, where practical, that the group’s and the Bank’s capital ratios are protected from the effect of changes in exchange rates. The group considers hedging structural foreign currency exposures only in limited circumstances to protect the capital ratios or the value of capital invested. Such hedging would be undertaken using foreign exchange contracts or by financing with borrowings in the same currencies as the functional currencies involved. Foreign currency investments amounted to the foreign currency equivalent of HK$324,804m (74% of shareholders’ funds) at 31 December 2012, an increase of HK$57,422m from HK$267,382m (78% of shareholders’ funds) at 31 December 2011. Gains or losses on structural foreign currency exposures are taken to reserves. The group had the following structural foreign currency exposures that were not less than 10% of the total net structural foreign currency position:
The group LCYm At 31 December 2012 Chinese renminbi ......................................................... At 31 December 2011 Chinese renminbi ......................................................... 153,638 The Bank LCYm 39,447

HK$m 189,446

HK$m 48,641

117,895

145,347

32,290

39,809

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52 Risk management (continued) d Operational risk Operational risk is the risk of loss arising from fraud, unauthorised activities, error, omission, inefficiency, systems failure or external events. It is inherent in every business organisation and covers a wide spectrum of issues. The group manages this risk through a controls-based environment in which processes are documented, authorisation is independent and transactions are reconciled and monitored. This is supported by an independent programme of periodic reviews undertaken by internal audit, and by monitoring external operational risk events, which ensure that the group stays in line with industry best practice and takes account of lessons learnt from publicised operational failures within the financial services industry. The HSBC Group has codified its operational risk management process by issuing a high level standard, supplemented by more detailed formal guidance. This explains how the group manages operational risk by identifying, assessing, monitoring, controlling and mitigating the risk, rectifying operational risk events, and implementing any additional procedures required for compliance with local regulatory requirements. The standard covers the following:    operational risk management responsibility is assigned to senior management within the business operation; information systems are used to record the identification and assessment of operational risks and to generate appropriate, regular management reporting; assessments are undertaken of the operational risks facing each business and the risks inherent in its processes, activities and products. Risk assessment incorporates a regular review of identified risks to monitor significant changes; operational risk loss data is collected and reported to senior management. Aggregate operational risk losses are recorded and details of incidents above a materiality threshold are reported to the HSBC Group’s Audit Committee; and risk mitigation, including insurance, is considered where this is cost-effective.





The group maintains and tests contingency facilities to support operations in the event of disasters. Additional reviews and tests are conducted in the event that any HSBC office is affected by a business disruption event, to incorporate lessons learnt in the operational recovery from those circumstances. Plans have been prepared for the continued operation of the group’s business, with reduced staffing levels, should a flu pandemic occur. e Insurance risk Insurance risk is the risk, other than financial risk, of loss transferred from the holder of the insurance contract to the insurer. The principal insurance risk faced by the group is that, over time, the combined cost of claims, benefits, administration and acquisition of the contracts may exceed the aggregate amount of premiums received and investment income. The cost of claims and benefits can be influenced by many factors, including mortality and morbidity experience, lapse and surrender rates and, if the policy has discretionary participation features, the performance of the assets held to support the liabilities. The severity of the claims and benefits, as well as the timing, is therefore uncertain. Contracts under which the transfer of insurance risk from the policyholder to the group is not significant are classified as investment contracts. The group manages its insurance risk through underwriting limits, approval procedures for transactions that involve new products or that exceed set limits, risk diversification, pricing guidelines, reinsurance and monitoring of emerging issues, taking into account where appropriate local market conditions and any regulatory requirements that apply. All insurance products, whether internally manufactured or provided by a third party manufacturer, are reviewed by the Product Management Committee. Several methods are used to assess and monitor insurance risk exposures both for individual types of risks insured and overall risks. These methods include internal risk measurement models, sensitivity analyses, scenario analyses and stress testing.

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Notes on the Financial Statements (continued)

52 Risk management (continued) The theory of probability is applied to the pricing and provisioning for a portfolio of insurance contracts. Insurance events are, by their nature, incorporated with a certain degree of randomness and the actual number of events during any one year may vary from those estimated using established statistical techniques. Asset and liability management A principal tool used by the group to manage its exposure to insurance risk, in particular for life insurance contracts, is asset and liability matching. The group actively manages its assets using an approach that considers asset quality, diversification, cash flow matching, liquidity, volatility and target investment return. The goal of the investment process is to achieve the target level of investment return within acceptable parameters. The Investment Committee reviews and approves strategic asset allocation on a periodic basis and establishes investment guidelines. The asset and liability management process is also overseen by the Asset and Liability Management Committee of the group’s insurance business. The group establishes asset portfolios for each major insurance product category consistent with local regulatory requirements. The investment policy defines the asset allocation and restrictions with the aim of achieving the target investment return in the long term. The following table shows the composition of assets and liabilities for each major insurance product category. 93% of both assets and liabilities are derived from Hong Kong. Statement of financial position of insurance manufacturing subsidiaries by type of contract
Life linked contracts1 HK$m At 31 December 2012 Financial assets: – financial assets designated at fair value .......................... – derivatives ............................ – financial investments ........... – other financial assets ........... Total financial assets ............... Reinsurance assets ................... PVIF4 ........................................ Other assets .............................. Total assets ............................... Liabilities under investment contracts designated at fair value .............................. Liabilities under insurance contracts ............................... Deferred tax ............................. Other liabilities ........................ Total liabilities ......................... Total equity .............................. Total equity and liabilities ....... Life non-linked contracts2 HK$m Non-life insurance HK$m Other assets3 HK$m

Total HK$m

36,837 7 – 963 37,807 3,103 – 2 40,912

30,376 1,017 175,773 37,035 244,201 1,389 – 3,941 249,531

– – 81 324 405 – – 1 406

413 2 12,246 1,196 13,857 1,101 24,425 5,595 44,978

67,626 1,026 188,100 39,518 296,270 5,593 24,425 9,539 335,827

7,038 33,948 – – 40,986 – 40,986

29,182 210,853 196 – 240,231 – 240,231

– 120 – – 120 – 120

– – 4,610 4,761 9,371 45,119 54,490

36,220 244,921 4,806 4,761 290,708 45,119 335,827

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52 Risk management (continued)
Life linked contracts1 HK$m At 31 December 2011 Financial assets: – financial assets designated at fair value .......................... – derivatives ............................ – financial investments ........... – other financial assets ........... Total financial assets ............... Reinsurance assets ................... PVIF4 ........................................ Other assets .............................. Total assets ............................... Liabilities under investment contracts designated at fair value .............................. Liabilities under insurance contracts ............................... Deferred tax ............................. Other liabilities ........................ Total liabilities ......................... Total equity .............................. Total equity and liabilities ....... 1 2 3 4 Life non-linked contracts2 HK$m Non-life insurance HK$m Other assets3 HK$m

Total HK$m

28,067 10 4 2,086 30,167 6,666 – 7 36,840

26,016 873 147,049 31,022 204,960 228 – 3,419 208,607

404 – 1,151 1,355 2,910 395 – 190 3,495

120 – 10,843 1,271 12,234 96 20,232 3,879 36,441

54,607 883 159,047 35,734 250,271 7,385 20,232 7,495 285,383

6,633 30,055 (6) – 36,682 – 36,682

27,849 176,324 161 – 204,334 – 204,334

– 3,059 1 – 3,060 – 3,060

– – 3,479 2,625 6,104 35,203 41,307

34,482 209,438 3,635 2,625 250,180 35,203 285,383

Comprises life linked insurance contracts and linked investment contracts. Comprises life non-linked insurance contracts and non-linked investment contracts. Comprises shareholder assets. Present value of in-force long-term insurance contracts.

Underwriting strategy The group’s underwriting strategy seeks diversity to achieve a balanced portfolio and is based on a large portfolio of similar risks over a number of years and, as such, it is believed that this reduces the variability of the outcomes. Reinsurance strategy The group reinsures a portion of the insurance risks it underwrites in order to mitigate its exposures to losses and protect capital resources. The group buys a combination of proportionate and non-proportionate reinsurance to reduce the exposures and uses reinsurance agreements with non-affiliated reinsurers to manage its exposure to losses resulting from certain catastrophes. The group also uses reinsurance to manage financial risk arising from guaranteeing minimum investment performance under a unit-linked insurance product and a traditional nonparticipating insurance product.

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Notes on the Financial Statements (continued)

52 Risk management (continued) Nature of risks covered The following gives an assessment of the nature of risks inherent in the group’s main products: (i) Insurance contracts – non-linked products The basic feature of non-linked insurance business is to provide guaranteed death benefits determined at the time of policy issue. For non-linked insurance products with a savings element, guaranteed surrender benefit, guaranteed maturity benefit, crediting rate guarantees and/or non-lapse guarantee features may be provided. Discretionary participation features allow policyholders to participate in the profits of the life fund by means of annual bonuses. The group has complete contractual discretion on the bonuses declared. It is the group’s goal to maintain a stable dividend scale based on the long-term rate of return. Annual reviews are performed to confirm whether the current dividend scale is supportable. (ii) Insurance contracts – unit-linked products The group writes unit-linked life insurance policies, which typically provide policyholders with life insurance protection and a choice of investment in a variety of funds. Premiums received are deposited into the chosen funds after deduction of premium fees. Other charges for the cost of insurance and administration are deducted from the funds accumulated. Where there is a performance guarantee, the risk is managed through reinsurance. (iii) Investment contracts – retirement funds with guarantees The group underwrites retirement fund business which gives rise to contracts that are classified as investment contracts. Under each retirement scheme, employers and employees are given a choice of funds in which to place their contributions, on which the group provides an investment return or capital protection guarantee for some specific funds. Investment strategy is set with the objective of providing a return that is sufficient to meet at least the minimum guarantee. (iv) Investment contracts – retirement funds without guarantees The group underwrites retirement fund business which gives rise to contracts that are classified as investment contracts. Under each retirement scheme, employers and employees are given a choice of funds in which to place their contributions. The group bears no investment risk under this type of investment contract. (v) Non-life insurance contracts The group assumes the risk of loss from persons and organisations relating to property, liability, accident, health, financial or other perils that may arise from an insurable event. The group manages the risk through underwriting limits, approval procedures for transactions that involve new products or that exceed set authority limits, risk diversification, pricing guidelines, reinsurance and monitoring of emerging issues. Following the disposals of non-life businesses during 2012, this risk is minimal.

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52 Risk management (continued) Concentrations of insurance risks Within the insurance process, concentrations of risk may arise where a particular event or series of events could impact heavily upon the group’s liabilities. Such concentrations may arise from a single insurance contract or through a small number of related contracts, and relate to circumstances where significant liabilities could arise. The group is subject to concentration risk arising from accidents relating to common carriers, conflagration, epidemics, earthquakes and other natural disasters that affect the lives, properties and physical conditions of the policyholders insured by the group. To mitigate these risks, excess of loss and catastrophe reinsurance arrangements have been made by the group. The policyholders of the insurance contracts issued by the group, its associates and joint ventures, are mainly residents of Hong Kong, Macau, mainland China, Taiwan, Singapore, Malaysia, Vietnam, India and South Korea, with the majority in Hong Kong. To determine the concentration of insurance risks and the reinsurance coverage required, scenario analyses are performed to investigate the potential financial impact on the group. Total loss is estimated based on the chosen stress level. Details of the group’s reinsurance strategy are disclosed on page 187. Life business tends to be longer-term in nature than non-life business and frequently involves an element of savings and investment in the contract. An analysis of life insurance liabilities is therefore an appropriate overall measure of insurance exposure, because provisions for life contracts are typically set by reference to expected future cash outflows relating to the underlying policies and a range of assumptions which mainly include interest rate and mortality levels. The process used to determine the assumptions is intended to result in stable and prudent estimates of future outcomes. This is achieved by adopting relatively conservative assumptions which can withstand a reasonable range of fluctuation of actual experience. An annual review of the relevant experience is performed to assess the adequacy of margins that exist between the assumptions adopted and the most likely estimate of future outcome. Since the group is not exposed to significant insurance risk on investment contracts, they have not been included in the insurance risk management analysis. Details of the analysis of life insurance liabilities are disclosed in note 34. Financial risks Managing financial assets backing insurance liabilities may result in the group assuming financial risks. These include market risk, credit risk and liquidity risk. Each of these financial risks is described below, together with a summary of the ways in which the group manages these risks arising from underwriting insurance business. The group is also exposed to investment return guarantee risk for certain investment contracts issued to policyholders. The risk is that the yield on the assets held by the group to meet these guarantees may fall short of the guaranteed return. The framework for the management of this risk is to invest in fixed income securities and adopt a matching approach whereby assets held are managed to meet the liabilities to policyholders. An additional provision is established where analysis indicates that, over the life of the contracts, the returns from the designated assets may not be adequate to cover the related liabilities. The following table analyses the assets held in the group’s insurance manufacturing subsidiaries at 31 December 2012 by type of liability, and provides a view of the exposure to financial risk:

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Notes on the Financial Statements (continued)

52 Risk management (continued) Financial assets held by insurance manufacturing subsidiaries
At 31 December 2012 Life linked contracts HK$m Financial assets designated at fair value – Debt securities ................................ – Equity securities ............................. Financial investments Held-to-maturity: – Debt securities ................................ Available-for-sale: – Treasury bills .................................. – Debt securities ................................ – Equity securities ............................. Derivatives ......................................... Other financial assets ....................... 10 36,827 36,837 Life nonlinked contracts HK$m 15,146 15,230 30,376 Non-life insurance HK$m – – – Other assets HK$m 413 – 413 Total HK$m 15,569 52,057 67,626

– – – – – 7 963 37,807

151,818 – 23,952 3 23,955 1,017 37,035 244,201

– – 81 – 81 – 324 405 At 31 December 2011

12,001 – 191 54 245 2 1,196 13,857

163,819 – 24,224 57 24,281 1,026 39,518 296,270

Life linked contracts HK$m Financial assets designated at fair value – Debt securities ................................ – Equity securities ............................. Financial investments Held-to-maturity: – Debt securities ................................ Available-for-sale: – Treasury bills .................................. – Debt securities ................................ – Equity securities ............................. Derivatives .......................................... Other financial assets .......................... – 28,067 28,067

Life nonlinked contracts HK$m 13,815 12,201 26,016

Non-life insurance HK$m 404 – 404

Other assets HK$m 120 – 120

Total HK$m 14,339 40,268 54,607

– – – 4 4 10 2,086 30,167

131,932 – 15,115 2 15,117 873 31,022 204,960

1,033 – 118 – 118 – 1,355 2,910

10,097 – 728 18 746 – 1,271 12,234

143,062 – 15,961 24 15,985 883 35,734 250,271

The table demonstrates that for linked contracts, the group typically designates assets at fair value. For non-linked contracts, the classification of the assets is driven by the nature of the underlying contract. The assets held to support life linked liabilities represented 12.8% of the total financial assets of the group’s insurance manufacturing subsidiaries at the end of 2012 (2011: 12.1%). The table also shows that approximately 68.7% of financial assets were invested in debt securities at 31 December 2012 (2011: 69.3%) with 17.6% (2011: 16.1%) invested in equity securities. Market risk Market risk can be sub-categorised into interest rate risk, equity and other price risks and foreign currency risk. Each of these categories is discussed further below.

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52 Risk management (continued) Interest rate risk The exposure of the group’s insurance business to interest rate risk arises mainly from its debt securities holdings and the uncertainty of the achievable interest rate when reinvesting the future net cash flows. The held-to-maturity category accounts for a significant portion of the debt securities holdings and is managed to match expected liability payments. The group monitors this exposure through periodic reviews of its asset and liability positions. Estimates of cash flows, as well as the impact of interest rate fluctuations relating to the investment portfolio and insurance reserves, are modelled and reviewed regularly. The overall objective of these strategies is to limit the net changes in the value of assets and liabilities arising from interest rate movements. For participating products, interest rate risk can also be mitigated through sharing of risk with policyholders under the discretionary participation mechanism. A shift in interest yield curves as at 31 December 2012 in all territories in which the group’s insurance subsidiaries operate would have the following impact on the profit for the year and net assets at that date:
31 December 2012 Impact on profit for Impact on the year net assets HK$m HK$m + 100 basis points shift in yield curves ..................... – 100 basis points shift in yield curves ..................... 1,096 (1,424) (1,238) 1,032 31 December 2011 Impact on profit for Impact on the year net assets HK$m HK$m 1,065 (977) (390) 547

The interest rate sensitivities set out above are illustrative only and employ simplified scenarios. It should be noted that the effects may not be linear and therefore the results cannot be extrapolated. The sensitivities reflect the established investment risk sharing mechanism with policyholders for participating products but do not incorporate other actions that could be taken by management to mitigate the effect of the interest rate movements, nor do they take account of any resultant changes in policyholder behaviour. Equity and other price risks The portfolio of securities, including equities and other assets, which the group carries on the balance sheet at fair value, has exposure to price risk. This risk is defined as the potential loss in market value resulting from an adverse change in prices. The risk is mainly mitigated through dynamic asset allocation, portfolio diversification and sharing the risk with policyholders through the discretionary participation feature. Portfolio characteristics are analysed regularly and these risks are regularly reviewed. The group’s investment portfolios are diversified across industries and asset classes, with concentrations in any one company, industry or asset class limited by parameters established by senior management, as well as by statutory requirements. The following table illustrates the impact on the profit for the year and net assets of a 10% variance in equity prices:
31 December 2012 Impact on profit for Impact on the year net assets HK$m HK$m 10% increase in equity prices .................................... 10% decrease in equity prices ................................... 515 (518) 515 (518) 31 December 2011 Impact on profit for Impact on the year net assets HK$m HK$m 629 (1,075) 629 (1,076)

These equity sensitivities are illustrative only and employ simplified scenarios. It should be noted that the effects may not be linear and, therefore, the results cannot be extrapolated. The sensitivities reflect the established investment risk sharing mechanism with policyholder for participating products but do not allow for the effect of other management actions which may mitigate the equity price decline, nor for any resultant changes in policyholder behaviour, that might accompany such a fall. Foreign currency risk Substantial amounts of the assets and liabilities are denominated in two main currencies, Hong Kong dollars and United States dollars. The group adopts a policy of predominantly matching the assets with liabilities in the same currency, effectively reducing the foreign currency exchange rate exposure. Limits are set to ensure that the net foreign currency exposure is kept to an acceptable level. The group uses forward exchange contracts and swaps to manage its foreign currency risk.

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Notes on the Financial Statements (continued)

52 Risk management (continued) Credit risk The group’s portfolios of fixed income securities, and to a lesser extent short-term and other investments, are subject to credit risk. This risk is defined as the potential financial loss resulting from adverse changes in a borrower’s ability to repay the debt. The group’s objective is to earn competitive relative returns by investing in a diversified portfolio of securities. Management has a credit policy in place and limits are established to manage credit quality and concentration risk. The following table presents the analysis of the treasury bills, other eligible bills and debt securities within the group’s insurance business. The definition of the four credit quality classifications is included on page 167. Only assets supporting non-linked liabilities are included in the table as financial risk on assets supporting linked liabilities is predominantly borne by the policyholders. 88.4% (2011: 91.1%) of the assets included in the table are invested in investments rated as ‘Strong’.
Neither past due nor impaired Substandard HK$m Past due not impaired HK$m Impairment allowances HK$m

Strong HK$m 31 December 2012 Supporting liabilities under life non-linked and non-life insurance contracts Financial assets designated at fair value .................... – treasury and other eligible bills ................... – debt securities ................ Financial investments ........ – treasury and other eligible bills ................... – debt securities ................ Supporting shareholders funds1 Financial assets designated at fair value .................... – treasury and other eligible bills ................... – debt securities ................ Financial investments ........ – treasury and other eligible bills ................... – debt securities ................ Total Financial assets designated at fair value .................... – treasury and other eligible bills ................... – debt securities ................ Financial investments ........ – treasury and other eligible bills ................... – debt securities ................

Medium HK$m

Impaired HK$m

Total HK$m

13,755 – 13,755 154,799 – 154,799

1,391 – 1,391 21,052 – 21,052

– – – – – –

– – – – – –

– – – – – –

– – – – – –

15,146 – 15,146 175,851 – 175,851

374 – 374 10,960 – 10,960

39 – 39 1,232 – 1,232

– – – – – –

– – – – – –

– – – – – –

– – – – – –

413 – 413 12,192 – 12,192

14,129 – 14,129 165,759 – 165,759

1,430 – 1,430 22,284 – 22,284

– – – – – –

– – – – – –

– – – – – –

– – – – – –

15,559 – 15,559 188,043 – 188,043

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52 Risk management (continued)
Neither past due nor impaired Substandard HK$m Past due not impaired HK$m Impairment allowances HK$m

31 December 2011 Supporting liabilities under life non-linked and non-life insurance contracts Financial assets designated at fair value ........................ – treasury and other eligible bills ................... – debt securities ................ Financial investments ........ – treasury and other eligible bills ................... – debt securities ................ Supporting shareholders funds1 Financial assets designated at fair value ........................ – treasury and other eligible bills ................... – debt securities ................ Financial investments ........ – treasury and other eligible bills ................... – debt securities ................ Total Financial assets designated at fair value ........................ – treasury and other eligible bills ................... – debt securities ................ Financial investments ........ – treasury and other eligible bills ................... – debt securities ................

Strong HK$m

Medium HK$m

Impaired HK$m

Total HK$m

13,238 – 13,238 134,738 – 134,738

981 – 981 13,460 – 13,460

– – – – – –

– – – – – –

– – – – – –

– – – – – –

14,219 – 14,219 148,198 – 148,198

96 – 96 9,837 – 9,837

24 – 24 988 – 988

– – – – – –

– – – – – –

– – – – – –

– – – – – –

120 – 120 10,825 – 10,825

13,334 – 13,334 144,575 – 144,575

1,005 – 1,005 14,448 – 14,448

– – – – – –

– – – – – –

– – – – – –

– – – – – –

14,339 – 14,339 159,023 – 159,023

1 Shareholders’ funds comprise solvency and unencumbered assets.

The group also has insurance and other receivable amounts subject to credit risk. The most significant of these are reinsurance recoveries. To mitigate the risk of the counterparties not paying the amounts due, the group has established certain business and financial guidelines for reinsurer approval, incorporating ratings by major agencies and considering currently available market information. The group also periodically reviews the financial stability of reinsurers and the settlement trend of amounts due from reinsurers. The split of liabilities ceded to reinsurers and outstanding reinsurance recoveries was as follows:

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Notes on the Financial Statements (continued)

52 Risk management (continued) Reinsurers’ share of liabilities under insurance contracts
Neither past due nor impaired Substandard HK$m Past due not impaired HK$m Impairment allowances HK$m

Strong HK$m 31 December 2012 Linked insurance contracts ........................... Non-linked insurance contracts ........................... Total ...................................... Reinsurance debtors .............. 31 December 2011 Linked insurance contracts ........................... Non-linked insurance contracts ........................... Total ...................................... Reinsurance debtors ..............

Medium HK$m

Impaired HK$m

Total HK$m

2 1,389 1,391 23

3,101 – 3,101 1,020

– – – –

– – – 58

– – – –

– – – –

3,103 1,389 4,492 1,101

3 428 431 27

6,663 194 6,857 18

– – – –

– 1 1 51

– – – –

– – – –

6,666 623 7,289 96

The group has sold a unit-linked life insurance product which provides guaranteed minimum death benefits and guaranteed minimum accumulated benefits which are underwritten by the group but reinsured by a third party. The group has a credit risk exposure in respect of this third party’s ability to meet its reinsurance obligation. At 31 December 2012, the exposure to the third party was HK$3,101m (2011: HK$6,663m). Liquidity risk There are three components of liquidity risk. The first of these arises in normal market conditions and is referred to as funding liquidity risk, specifically, the capacity to raise sufficient cash when needed to meet payment obligations. Secondly, there is market liquidity risk where the size of a particular holding may be sufficiently large that a sale cannot be completed at or around the market price. Finally, there is standby liquidity risk which refers to the capacity to meet payment conditions in abnormal conditions. The group has to meet daily calls on its cash resources, notably from claims arising on its insurance and investment contracts and surrender of policies for surrender value. There is therefore a risk that cash will not be available to settle liabilities when due at a reasonable cost. The group manages this risk by monitoring and setting an appropriate level of operating funds to settle these liabilities. Investment portfolios are also structured with regard to the liquidity requirement of each underlying fund, and surrender penalties and market adjustment clauses are used to defray costs of unexpected cash requirements.

194

52 Risk management (continued) The following table shows the expected maturity of insurance contract liabilities at 31 December 2012: Expected maturity of insurance contract liabilities
Within 1 year HK$m At 31 December 2012 Non-life insurance ................... Life insurance (non-linked) ..... Life insurance (linked) ............. 98 28,558 4,213 32,869 At 31 December 2011 Non-life insurance ................... Life insurance (non-linked) ..... Life insurance (linked) ............. Expected cash flows (undiscounted) 1-5 years 5-15 years Over 15 years HK$m HK$m HK$m 22 86,803 8,073 94,898 1 168,809 42,297 211,107 – 203,753 84,029 287,782 Total HK$m 121 487,923 138,612 626,656

1,782 10,490 3,538 15,810

834 85,770 10,824 97,428

388 148,983 39,266 188,637

56 178,200 98,261 276,517

3,060 423,443 151,889 578,392

Remaining contractual maturity of investment contract liabilities
Linked investment contracts HK$m 115 – – 6,923 7,038 At 31 December 2011 Remaining contractual maturity – due within 1 year ..................................................... – due between 1 and 5 years ...................................... – due between 5 and 10 years .................................... – undated1 ................................................................... Non-linked investment contracts HK$m 25 – – 29,156 29,181 Investment contracts with DPF HK$m 29 – – – 29

At 31 December 2012 Remaining contractual maturity – due within 1 year ..................................................... – due between 1 and 5 years ...................................... – due between 5 and 10 years .................................... – undated1 ...................................................................

Total HK$m 169 – – 36,079 36,248

216 – 259 6,157 6,632

21 – – 27,828 27,849

60 26 – – 86

297 26 259 33,985 34,567

1 In most cases, policyholders have the option to terminate their contracts at any time and receive the surrender values of their policies. The surrender values may be significantly lower than the amounts shown above.

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Notes on the Financial Statements (continued)

52 Risk management (continued) Present value of in-force long-term insurance business (PVIF) The group’s life insurance business is accounted for using the embedded value approach, which, inter alia, provides a comprehensive framework for the evaluation of insurance and related risks. The value of the PVIF asset at 31 December 2012 was HK$24,425m (2011: HK$20,232m), representing the present value of the shareholders’ interest in the profits expected to emerge from the book of in-force policies. The calculation of the PVIF asset was refined in 2011 by incorporating explicit margins and allowances for certain risks and uncertainties in place of implicit adjustments to the discount rate. The valuation now includes explicit risk margins for non-economic risks in the projection assumptions, and explicit allowances for financial options and guarantees using stochastic methods. Risk discount rates are set on an active basis with reference to market risk free yields and have been reduced as a result of removing the implicit adjustments. It should be noted that these refinements introduced greater volatility within the insurance results in response to changes in market conditions. PVIF can be stress-tested to assess the sensitivity of the value of life business to adverse movements of different risk factors. The following table shows the effect on the PVIF as at 31 December 2012 of changes in the main economic assumption:
Impact on results 2012 HK$m + 100 basis points shift in risk-free rate ........................................................................................... – 100 basis points shift in risk-free rate ........................................................................................... 1,111 (1,153) 2011 HK$m 1,101 (687)

The effects on PVIF shown above are illustrative only and employ simplified scenarios. It should be noted that the effects may not be linear and, therefore, the results cannot be extrapolated. The sensitivities reflect the established investment risk sharing mechanism with policyholders for participating products, but do not incorporate other actions that could be taken by management to mitigate effects nor do they take account of consequential changes in policyholder behaviour. Non-economic assumptions Non-economic assumptions including, for non-life business, claims costs and expense rates and, for life business, mortality and/or morbidity, lapse rates and expense rates, are also used for the determination of the policyholder liabilities and PVIF, subject to any relevant local regulatory requirements. The sensitivity of profit for the year and net assets to reasonably possible changes in these non-economic assumptions at 31 December 2012 across all insurance manufacturing subsidiaries is as follows:
Impact on 2012 results Profit after tax Net assets HK$m HK$m 20% increase in claims costs ....................................... 20% decrease in claims costs ...................................... 10% increase in mortality and/or morbidity rates ....... 10% decrease in mortality and/or morbidity rates ...... 50% increase in lapse rates .......................................... 50% decrease in lapse rates ......................................... 10% increase in expense rates ..................................... 10% decrease in expense rates .................................... (3) 3 (362) 374 (1,048) 2,328 (275) 281 (3) 3 (362) 374 (1,048) 2,328 (275) 281 Impact on 2011 results Profit after tax Net assets HK$m HK$m (194) 194 (406) 407 (605) 1,524 (286) 285 (194) 194 (406) 407 (605) 1,524 (286) 285

The effects on PVIF shown above are illustrative only and employ simplified scenarios. It should be noted that the effects may not be linear and, therefore, the results cannot be extrapolated. The sensitivities reflect the established risk sharing mechanism with policyholder for participating products but do not incorporate other actions that could be taken by management to mitigate effects nor do they take account of consequential changes in policyholder behaviour.

196

52 Risk management (continued) f Capital management Our approach to capital management is driven by our strategic and organisational requirements, taking into account the regulatory, economic and commercial environment in which we operate. It is our objective to maintain a strong capital base to support the development of our business and to meet regulatory capital requirements at all times. To achieve this, our policy is to hold capital in a range of different forms and all capital raising is agreed with major subsidiaries as part of their individual and the group’s capital management processes. Our capital management process is articulated in our annual group capital plan which is approved by the Board. The plan is drawn up with the objective of maintaining both an appropriate amount of capital and an optimal mix between the different components of capital. Each subsidiary manages its own capital to support its planned business growth and meet its local regulatory requirements within the context of the approved annual group capital plan. In accordance with HSBC Group’s Capital Management Framework, capital generated by subsidiaries in excess of planned requirements is returned to the Bank, normally by way of dividends. The Bank is primarily the provider of equity capital to its subsidiaries and these investments are substantially funded by the Bank’s own capital issuance and profit retention. As part of its capital management process, the Bank seeks to maintain a prudent balance between the composition of its capital and that of its investment in subsidiaries. The principal forms of capital are included in the following balances on the consolidated balance sheet: share capital, retained profits, other reserves, preference shares and subordinated liabilities. Capital also includes the collective impairment allowances held in respect of loans and advances. Externally imposed capital requirements The Hong Kong Monetary Authority supervises the group on a consolidated basis and therefore receives information on the capital adequacy of, and sets capital requirements for, the group as a whole. Individual banking subsidiaries and branches are directly regulated by their local banking supervisors, who set and monitor their capital adequacy requirements. In most jurisdictions, non-banking financial subsidiaries are also subject to the supervision and capital requirements of local regulatory authorities. Basel II enhancements (commonly known as Basel 2.5) took effect from 1 January 2012. The main changes include raising banks’ capital requirements for trading and securitisation exposures, providing supplemental guidance on risk management principles and strengthening disclosure in corresponding areas. The resulting effect was an increase in risk weighted assets for market risk. The group uses the advanced internal ratings-based approach to calculate its credit risk for the majority of its non-securitisation exposures and the internal ratings-based (securitisation) approach to determine credit risk for its banking book securitisation exposures. For market risk, the group uses an internal models approach to calculate its general market risk for the risk categories of interest rate and foreign exchange (including gold) exposures. As opposed to the standardised (market risk) approach that was used at 31 December 2011, the group has adopted an internal models approach to calculate the general market risk and specific risk for the risk category of equity exposures. The group also uses an internal models approach to calculate its market risk in respect of specific risk for interest rate exposures. The group uses the standardised (market risk) approach for calculating other market risk positions as well as trading book securitisation exposures, and the standardised (operational risk) approach to calculate its operational risk. During the year, the individual entities within the group and the group itself complied with all of the externally imposed capital requirements of the Hong Kong Monetary Authority.

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Notes on the Financial Statements (continued)

52 Risk management (continued) Basel III In December 2010, the Basel Committee issued two documents: ‘A global regulatory framework for more resilient banks and banking systems’ and ‘International framework for liquidity risk measurement, standards and monitoring’, which together are commonly referred to as ‘Basel III’. In June 2011, the Basel Committee issued a revision to the former document setting out the finalised capital treatment for counterparty credit risk in bilateral trades. The Basel III rules set out the minimum common equity tier 1 (CET1) requirement of 4.5% and additional capital conservation buffer requirement of 2.5%, to be phased in sequentially from 1 January 2013, becoming fully effective on 1 January 2019. Any additional countercyclical capital buffer requirements will also be phased in, starting in 2016 to a maximum level of 2.5% effective on 1 January 2019, although individual jurisdictions may choose to implement larger countercyclical capital buffers. In addition to the criteria detailed in the Basel III proposals, the Basel Committee issued further minimum requirements in January 2011 to ensure that all classes of capital instruments fully absorb losses at the point of non-viability before taxpayers are exposed to loss. Instruments issued on or after 1 January 2013 may only be included in regulatory capital if the new requirements are met. The capital treatment of securities issued prior to this date will be phased out over a 10-year period commencing on 1 January 2013. The provisions of the Banking (Capital) (Amendment) Rules 2012 (‘BCAR 2012’) came into effect on 1 January 2013 to implement the first phase of Basel III capital standards in Hong Kong (‘Basel III rules’). The changes in minimum capital ratio requirements are phased in from 1 January 2013 to 1 January 2019, while the capital treatment for counterparty credit risk is effective from 1 January 2013. 53 Special purpose entities The group enters into certain transactions with customers in the ordinary course of business which involve the use of special purpose entities (‘SPEs’) to facilitate or secure customer transactions. The group structures that use SPEs are authorised centrally prior to being established to ensure appropriate purpose and governance. The activities of SPEs administered by the group are closely monitored by senior management. The most significant categories of complex or non-transparent structures using SPEs are discussed in more detail below. Structured credit transactions The group provides structured credit products to third-party professional and institutional investors who wish to obtain exposure to a reference portfolio of debt instruments. In such structures, the investor receives returns referenced to the underlying portfolio by purchasing notes issued by the SPEs. The group enters into contracts with the SPEs, generally in the form of derivatives, in order to pass the required risks and rewards of the reference portfolios to the SPEs. In certain transactions the group is exposed to risk often referred to as gap risk. Gap risk typically arises in transactions where the aggregate potential claims against the SPE by the group pursuant to one or more derivatives could be greater than the value of the collateral held by the SPE and securing such derivatives. The group often mitigates such gap risk by ensuring high quality collateral, hedging the risk, or incorporating features allowing managed liquidation of the portfolio. Securitisations The group also uses SPEs to securitise customer loans and advances that it has originated in order to diversify its sources of funding for asset origination and/or for capital efficiency purposes. In such cases, the loans and advances are transferred by the group to the SPEs for cash, and the SPEs issue debt securities to investors to fund the cash purchases. The group may also act as a derivative counterparty or provide a guarantee. Credit enhancements to the underlying assets may be provided to obtain investment grade ratings on the senior debt issued by the SPEs. These SPEs are consolidated when the group is exposed to the majority of risks and rewards of ownership. The group’s exposure is the aggregate of any holdings of notes issued by these vehicles, the reserve account positions intended to provide credit support under certain pre-defined circumstances to senior note holders and any derivatives or guarantee provided. Off balance sheet financial guarantees are disclosed in note 44 (b).

198

53 Special purpose entities (continued) Third-party financing SPEs The group also transacts with third party SPEs in the normal course of business for a number of purposes, for example, to provide finance to public and private sector infrastructure projects, for asset and structured finance transactions and for customers to raise finance against security. The assets are generally ring-fenced by the SPE and, in most cases, the customer, a sponsor or third party provides some credit enhancement or guarantee in the structure. The group generally provides financing in the form of senior lending or debt instruments but may also enter into derivative contracts with these SPEs. These SPEs are consolidated when the group is exposed to the majority of risks and rewards of ownership. The derivative and lending exposures are generally secured by the SPE’s assets, with credit enhancement and/or guarantees provided by third parties. The group’s risk in relation to the derivative contracts and trading positions with these SPEs is managed within the group’s market risk framework (see ‘Market risk’ in note 52c). Credit risk is managed within the group’s credit risk framework (see ‘Credit risk’ in note 52a). 54 Legal proceedings US regulatory and law enforcement investigations In December 2012, HSBC Holdings plc, the Bank’s ultimate parent company, entered into agreements to achieve a resolution with US and UK government agencies that have investigated HSBC’s conduct related to inadequate compliance with anti-money laundering (‘AML’), US Bank Secrecy Act (‘BSA’) and sanctions laws. This was as a result of investigations by the US Department of Justice (‘DoJ’), the Federal Reserve, the Office of the Comptroller of the Currency and the US Department of Treasury’s Financial Crimes Enforcement Network in connection with AML/BSA compliance in various parts of the HSBC Group. As part of the resolution, HSBC and HSBC Bank USA, N.A. entered into a deferred prosecution agreement (the ‘US DPA’) with the DoJ, the United States Attorney’s Office for the Eastern District of New York, and the United States Attorney’s Office for the Northern District of West Virginia, and a deferred prosecution agreement with the New York County District Attorney, and consented to a cease and desist order with the Federal Reserve. HSBC also entered into an undertaking with the UK Financial Services Authority (‘FSA’) to comply with certain forward-looking obligations with respect to anti-money laundering and sanctions requirements over a five-year term. Under these agreements, HSBC will continue to cooperate fully with US and UK regulatory and law enforcement authorities and take further action to strengthen their compliance policies and procedures. Over the five-year term of the agreements with the DoJ and FSA, an independent monitor will evaluate HSBC’s progress in fully implementing these and other measures it recommends, and will produce regular assessments of the effectiveness of HSBC’s compliance function. If HSBC fulfils all of the requirements imposed by the US DPA and other agreements, the DoJ’s charges against it will be dismissed at the end of the five-year period. The above agreements cover the activities of all entities in the HSBC Group, including the Bank and its subsidiaries. As at 31 December 2012, there has been no specific action taken against the Bank or any of its subsidiaries in relation to the above investigations, and no financial penalties have been incurred and none are anticipated. Other matters The group is named in and defending legal actions in a number of jurisdictions including Hong Kong, arising out of its normal business operations. None of the actions is regarded as material litigation, and none is expected to result in a significant adverse effect on the financial position of the group, either collectively or individually. Management believes that adequate provisions have been made in respect of such litigation.

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Notes on the Financial Statements (continued)

55 Ultimate holding company The ultimate holding company of the Bank is HSBC Holdings plc, which is incorporated in England. The largest group in which the accounts of the Bank are consolidated is that headed by HSBC Holdings plc. The consolidated accounts of HSBC Holdings plc are available to the public on the HSBC Group’s web site at www.hsbc.com or may be obtained from 8 Canada Square, London E14 5HQ, United Kingdom. 56 Nature of business The group provides domestic and international banking and related financial services, principally in the Asia-Pacific region. 57 Events after the balance sheet date On 5 December 2012, we announced an agreement to sell our shares in Ping An. This transaction completed on 6 February 2013. See note 28 for further details on the transaction. On 7 January 2013, Industrial Bank Co., Ltd. (‘Industrial Bank’) completed a private placement of additional share capital to a number of third parties, thereby diluting the group’s equity holding from 12.8% to 10.9%. As a result of this and other factors, the group considers it is no longer in a position to exercise significant influence over Industrial Bank and ceased to account for the investment as an associate from that date, giving rise to an accounting gain of approximately HK$9.5bn. Thereafter, the holding is recognised as an available-for-sale financial investment. 58 Approval of accounts The accounts were approved and authorised for issue by the Board of Directors on 4 March 2013.

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The Hongkong and Shanghai Banking Corporation Limited HSBC Main Building 1 Queen’s Road Central, Hong Kong Telephone: (852) 2822 1111 Facsimile: (852) 2810 1112 www.hsbc.com.hk

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