HSBC Holdings PLC

HSBC Holdings PLC

Introduction

HSBC Holdings PLC is a public limited liability company that operates in the financial services and global banking industry. The company is one of the oldest banking institutions in the world and was founded in 1865, operating under the name “The Hong Kong and Shanghai Banking Corporation.” The name was, however, changed in 1991 to the current business name, HSBC Holdings PLC. Currently, the company has set up more than 9,500 financial institutions in different states around the world, including North and South America, Asia, Europe, Africa as well as in the middle east. The firm has effectively managed to employ more than 310,000 employees.

The vision statement of the firm is based on the firm’s intention to position itself as a leading international banking and financial institution in the United Arab Emirates. However, regardless of the steps that the company takes to ensure that they achieve their set objectives, there several challenges that they face (Johannes, Dedy, & Muksin, 2018). First, in the course of its operations, there are several risks that the company faces emanating from its external business environment. In contrast, the employees play a crucial role in developing a competitive edge of the business (Eisenberg, 2018). Some of the risks that emanate from the external business environment include direct competition from other financial institutions, high prices by the suppliers as well as the transfer of company employees to the competitor companies.

Secondly, the company faces liquidity risks that emanate from the management of their financial resources. These are risks that emerge from the internal operations of the business that can be effectively managed and significantly reduced for the overall benefit of the company (Hopkinson, 2016). However, for this to be made possible, the organizations need to ensure that proper management policies are implemented together with strong financial systems (Renfroe & Smith, 2016). Finally, the interest rate risks refer to the adverse conditions that the organizations face due to interest rate movements. The paper will provide an analysis of the source, measurement, management   the regulatory infrastructure for HSBC Holding PLC on the interest rate risk, liquidity risk, and operational risk

1. Interest Rate Risk

The interest rate risk is an exposure that the banks and other financial institutions face when the economy faces adverse movements in the value of interest rates. Banks are usually forced to accept such risks, but they can use the interest rates risks that they face as an opportunity to increase their profitability and shareholder value. However, when there is an excess of the interest rates risk in the economy, the financial institutions normally face significant threats in their net earnings as well as their capital base (Kose, Arteta, Stocker, & Taskin, 2016). The changes in the interest rates courses a dip in the earnings of the bank as a result of the changes in the value of net interest income as well as the interest rate sensitive income and operating expenses. The changes in the interest rates can have a significant effect on the value of the bank’s balance sheet, assets, and liabilities.

Sources

HSBC Holdings PLC is a fairly large banking and financial institution in UAE. As of 2014, the bank was ranked as the fourth largest corporation in the world in line with the size of assets valued at $2,670 billion and the second-largest bank, according to the net revenues recorded by the bank standing at $146.50 billion. The main drivers of interest rates risk in the banks are the bank loans (HSBC Holdings plc, 2019).

The main sources of interest rate risks that HSBC Holding PLC includes Repricing risks and optionality risks. The repricing risks refer to the financial intermediaries that the banks usually face in their operations, the primary form of interest rate risk that arises from the differences in timing in the maturity and repricing of the assets, off-balance-sheet (OBS) positions and liabilities of the banks. The repricing mismatches are usually crucial to the operations of the businesses, especially for banks that operate in the international markets (Jennifer, David, & Suchita, 2016). The bank normally issues long term fixed-rate loans that are normally covered by the short-term deposits from their customers. The deposits could easily face a decline in the future income of the banks from the position that the interest rates increase in the underlying asset. The drop in the cash flows paid on the funding of the organization’s loans being fixed over the lifetime of the loan.

The basis risks provide another source of interest rate risk for HSBC Holdings PLC. This risk normally arises from the risk of imperfect correlation in the adjustment rates that are earned and paid using different instruments that have similar repricing characteristics (Stefania, Thomas, & Min, 2015). The changes in the interest rates normally result in significant changes in the cash flows and earnings of an organization that are usually spread across the assets, off-balance-sheet (OBS) positions, and liabilities of the banks.

Measurement

There are several interest rate risk measurement methods that HSBC Holdings PLC uses. The measurement methods are usually divided into short term measures and long-term measures. The most common method used for the short-term measurements of the interest rate risks is the static gap method. The static gap method is a system that provides the bank with regular reports of the attempts to highlight the possible gaps shortly (Kathryn & Williams, 2017). Reports provide information about cases where the changes in interest rates of the assets, off-balance-sheet (OBS) positions, and liabilities of the banks do not occur contemporaneously. The size of the gaps provides information on the size of IRR exposure that the banks face. On the other end, the main long-term measure that the banks use as a measure of the interest rate risk is the earnings at risk (EaR) (Yaniv, Luo, Mary, & Feng, 2016). This is a measurement method that provides the organizations with a quantification of the potential exposure that the organization faces in its capital. The exposure to this end is quantified from the reduction in the long-term earnings of the organization as well as the dip in the economic value of the firm’s capital (Seidel, 2018). Furthermore, to complement the EaR system, HSBC Holdings has also adopted the use of the economic value of equity. This is a system that allows the analysts to project the cash flows from their assets.

Management

HSBC Holdings PLC uses several approaches for the management of the interest rate risks that they face. First, the company has effectively developed adequate risk management policies and procedures to guide the management on how best to reduce the risks that they face. The Basel Committee on Banking Supervision, (2016) places it as a requirement for the banks to develop policies and procedures that are clearly defined to help limit and control the risks associated with interest rates (Basel Committee on Banking Supervision, 2016). One of the methods that the organization uses is the adoption of hedges in the project’s financial transactions. The hedges are normally guided by strong financial analysis that the management undertakes to determine the exposures resulting from the impact of interest rates on project IRR, NPV, and Return on Equity (Beverlander, 2019). Secondly, the company has also adopted several internal controls to reduce the risks and hire independent auditors to help eliminate the risks. Another risk mitigation mechanism that the company uses is the use of internal controls (Gomez & Thesmar, 2020). The controls include such factors as credit approval, pricing, portfolio management, and the use of credit risk analytical tools. These tools ensure that proper regulations are set to reduce the risks that the organization faces from variations in interest rates

Regulatory infrastructure

There are currently no major regulations set by the central bank in the UAE on the interest rate risks. However, the banks are provided with a maximum value to which they should set their interest rates for their products and services. However, the banks are encouraged to remain innovative by trying to reduce and leverage the risks that they face from changes in interest rates.

2. Liquidity Risk

This is the risk that a bank or an institution may be unable to meet its most immediate or short-term financial needs, usually within a year through their cash flow or assets. This is caused by the inability of the bank to convert their assets or equity into cash without a significant capital loss, which may be as a result of no buyers or an inefficient market. Liquidity risk can be classified into funding liquidity risk and market liquidity risk.  Funding is the ability of the bank to fund its liabilities, while the market liquidity risk is the ability to convert an asset into cash in the market easily. Liquidity is important for banks to ensure that they meet the deposit demands as they fall due as well as taking advantage of profitable investment opportunities as they arise

Sources

To better understand the sources of liquidity risk for most institutions and especially banks, we discuss the sources of liquidity. The sources of liquidity are categorized into primary and secondary. The primary involves the sources that the bank uses for the daily information, which includes cash from sales, receivables, and short-term investments. It also includes short term funding from bank loans and credits from the suppliers and how well the bank can generate sufficient working capital by effective management of the available cash. The secondary sources are those that are not part of the usual operations of the businesses, and this may include the renegotiation of already existing debts, bankruptcy filing, or liquidation of short-term assets. For banks such as HSBC, the sources of liquidity risk are either internal or external.

Internal Sources

These are risks that originate within the business and are within the control of the business. They include:

• On balance sheet risk- These are items that appear in the bank’s balance sheet, and it the risk carried by these activities.
• Off-balance sheet risk- This is the risk by the bank due to its involvement in the contingent assets and liabilities. Both the on-balance sheet and off-balance sheet occur as a result of a mismatch between assets and liabilities.
• Credit risk- It is the risk of default by borrowers on their debt obligations.
• Interest rate risk- This is the risk posed to capital gains from investments due to changes in interest rates.
• Operational risk- This is the risk of loss resulting from failed internal processes and systems.
• Currency risk- This is the risk of potential losses due to appreciation or depreciation of the currency.

External Sources

They refer to factors outside the business control or environment. They include

• Political risk- this is the risk that an investment may not pay off due to political instability.
• Systematic risk- this is an inherent risk to the entire market.
• Event risk- It is the risk of an unexpected event harming the financial performance of the bank.

Figure 1:Sources of Liquidity Risk

Measurement

Liquidity risk is measured using liquidity ratios as follows-

Current Ratio- It is the most commonly used ratio to measure liquidity. It is calculated as the ratio of current assets to the current liabilities. It is expressed as a decimal or percentage, and a higher value is better as it indicates the bank can easily meet its obligations.

Quick Ratio- Also referred to as the acid test ratio. It measures how well the bank can offset its obligation without selling the inventory. It is calculated by deducting the inventory from the current asset and dividing it by the current liabilities. A quick ration of more than 1 indicates that the bank can easily pay off its short-term obligations.

Other ratios such as interest coverage ratio to measure how well the bank can pay off the interest on debt can be an indicator of liquidity at some point. The cash flow to debt ratio makes a comparison of the total debt to the generated cash flows to show how long it would take for the company to pay off all its debts.

HSBC Holdings PLC maintains minimum liquidity coverage ratio requirement and minimum net stable funding ratio in this regard.

Management

Liquidity risk can be managed by the management of cash flows, which may include optimization of working capital, maintenance of committed financing facilities, and a liquidity buffer. The key concepts in risk management are to identify the risks early, monitor the risk, carry out stress tests, and have a contingency plan in place. The methods to mitigate risks are-

Cashflow Forecasting- Comparing the bank’s budget with regular cash flow forecasts and analyzing the variances arising helps to prompt an appropriate action in advance to remedy the unfavorable situation. Sensitivity analysis helps to show cash fluctuations’ effects on the bank and assist in developing emergency plans in advance.

Optimizing Working Capital- Working capital affects the cashflow of the bank and has an impact on profitability; therefore, proper monitoring is vital. The working capital can be assessed through debtor days, where it indicates the average number of days customers take to pay their debts and should not exceed the standard terms of the bank. These creditor days indicates the average period it takes to pay the supplier to avoid paying them too soon and underutilizing the cash.

Financing facilities- The different sources of financing, either external or internal available to the bank, carry different costs and conditions. The cost and purpose of the funds should reflect the short term and long-term needs. The duration, availability, and conditions attached need to be evaluated before making decisions on one facility.

Liquidity Buffer- This refers to the liquid assets that the bank maintains to help it meet an unexpected shortfall in cashflows. To avoid large fluctuations, banks can maintain a liquidity buffer. HSBC Holdings PLC maintained a liquidity buffer of $542,436 million in the last quarter of 2019

HSBC Holdings PLC has an internal liquidity and funding risk framework that allows it to withstand severe stress. It is designed in a way that it adapts to changing business model, regulations, and the market. The management of liquidity risk is undertaken locally in all its branches. Each entity manages the liquidity risk on a stand-alone basis.

Regulatory Infrastructure

There are globally agreed standards to help banks control and mitigate liquidity risk. There is a various regulatory framework introduced by individual financial regulators in their jurisdictions that when the banks comply, they help lower the risk such as Individual Liquidity guidance, Liquidity Coverage Ratio and the Net stable Funding ratio. The only regulatory infrastructure that exists to govern liquidity risk in the banks is the accounting principles developed by GAAP and IFRS. These principles are developed to ensure that the financial institutions operate diligently and disclose all the information relating to their liquidity risk.

3. Operational Risk

Operational risk is the possibility of a financial loss occurring from failed systems, procedures, and policies. Banks face risk as a result of disruptions from daily operations, which lead to either direct or indirect losses. The causes could be criminal activities, fraud, or employee errors. The sources of operational risk can be classified as internal and external.

• Internal- This emanates from the failure of existing systems, inadequate maintenances of servers and software, and inefficient hardware, which has a severe effect on the operations of the bank. A huge workforce contributes to manual errors and miscommunications.
• External- This is factors that emanate from the external environment in which the bank is operating in. They include natural disasters, political instability, weak financial policies of the country, and fraudulent activities by criminals.

Measurement

Operational risk can be measured through statistical approaches, scenario analysis, and scorecards. The banks have three methods from Basel in which to compute this risk which are-

Basic Indicator- Involves applying a 15% fixed ratio to 3 years of annual gross income.

Standardized Measurement Approach- It combines the business indicator with the specific bank operational loss data

Advanced approach- Permits the bank to build its method to assess the risk. The method is then submitted to the regulator for approval and consists of internal and external loss data, business environment, and analysis of potential scenarios.

The Basel III update has an effect on how the operational risk capital is calculated, which has an implication from the internal loss data and how it can be utilized to enhance the bank value. The banks must now calculate the operational risk capital using the standardized measurement approach to limit the influence to a single variable, which is an internal loss multiplier.

HSBC Holdings PLC uses a standardized approach to determine operation risk.

Management of Operational Risk

HSBC Holdings PLC uses

Regulatory infrastructure

The only regulatory infrastructure that exists to govern operational risk in the banks is the accounting principles developed by GAAP and IFRS. These principles are developed to ensure that the financial institutions operate diligently and disclose all the information relating to their operational risk. However, for their continued profitability, HSBC should ensure that they develop principles to guide their operations and performance.

Part B

Fraud risk assessment framework of three associated risks

Fraud risk assessment framework of three associated risks for HSBC Holdings PLC

Interest rate fraud

1. Credit card fraud

This is an internal control required for the organization that should be placed to ensure that the organization and its customers do not suffer from credit card fraud. This is a form of fraud that takes many forms including;

• Accounts takeover
• Counterfeit cards
• Fraudulent applications

These forms of fraud can result in major losses in revenues by the banks without strong controls set in place (Johannes et al., 2018). HSBC Holdings should ensure that they develop strong controls by establishing operating limits and undertake continuous assessments of the effect of interest rate changes on credit.

2. Bank interest rate fraud

The bank interest fraud rate is an issue that could be best explained using the LIBOR scandal that came into light in 2012. This was a system where the bankers were of the major financial institutions were involved in major manipulations of the London interbank offered rate (LIBOR) to fraudulently maximize their profits (Jonathan, Igor, & Peter, 2017). This is a system that provides the average interest rates that the banks should pay when they borrow funds from each other (Daibi & Ngerebo, 2017). Just like in credit fraud, HSBC should develop strong controls, policies, and procedures to guide the regulation of the interest rates. Tough punishments should also be developed for those found to engage in bank interest rate fraud.

Liquidity risk fraud

Liquidity risk fraud comprises two main forms of fraud, namely; asset liquidity and operational funding liquidity risk. The asset liquidity fraud refers to the relative ease that a company can convert its assets into cash (Lena & Alexandra, 2019). The operational funding liquidity, on the other end, refers to the daily cash flows of the banks. HSBC should ensure that they minimize the value of their debt by borrowing only as much as they need to cover the short-term debts (Kenton, 2019). Furthermore, the firm should also ensure that they avoid long-term debts by selling off their investments in the future. Finally, in addition to the strong controls set in place to reduce fraud, detections systems and regular audits should be done to mitigate the risk of liquidity fraud for HSBC Holdings PLC.

Operational risk fraud

The two main operational risk fraud that most banks face is the internal risks as well as the external risks. There are several steps that HSBC Holdings should take to ensure that they reduce the risk of internal and external operational fraud. First, the business should ensure that they effectively curtail any form of business complexities that exist in the business (Kaplan & Cherry, 2018). The number of exceptions that arise in the implementation of business processes should be significantly reduced. Finally, with assistance from the human resource department, the bank should ensure that they reinforce organizational ethics (Stewart, 2016). When the business develops a strong ethical compass within the organizations, they will become successful in mitigating the risk of operational fraud that they face. This can be effectively achieved by combining personal values with other principles and controls on the workforce.