Free Custom «Analysis of Risk Management of HSBC» Essay Paper

Introduction

HSBC Bank USA, National Association, is an American based bank that is headquartered in New York; its regular head office is located in McLean, Virginia. The bank is a subsidiary of British company HSBC Holdings plc. Through its numerous branches, both local and international, HSBC has achieved a lot in its multinational banking and financial service operations. According to the Federal Deposit Insurance Cooperation (FDIC), in assets and capitalization rank, HSBC is considered as the 13^th best bank in the United States. Guided by its vision and primary core values, the bank has managed to build trustworthiness and loyalty with its customers, employees, and investors. As at 2015, HSBC had a credit rating of AA, and this attributes have made Well Fargo surpass Citigroup Inc. by assets in the same year.

However, the company’s CEO and president, Patrick J. Burke, claims that the company’s progress has not been perfect. The reason for such progress was the pressure mounted by expectations of others and that of the company as well. Additionally, the external market has even posed more challenges to the company. Nonetheless, HSBC has managed to cope with the dynamism in technology and communication sector, which has changed tremendously within a decade. HSBC has witnessed the period of a series of economic advancements and downturns, since the great depression and the 2008 financial crisis. Due to these factors, another major financial institution has collapsed, hence setting up a new wave of the industry regulations. In this respect, the company has set strategies and policies that adopt, along with stakeholders’ needs and regulations.

 

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Thus, the current paper seeks to analyze Well Fargo performance over the last five years, mainly focusing on its interest rate exposure, market risk exposure, credit risk exposure, liquidity risks exposure, and off-balance sheet exposure. Finally, the paper examines the company’s capital adequacy, profitability position, risk management, and sovereign risk exposure. Throughout the paper, the bank will also be compared with the other U.S. well-performing banks, such as Citigroup Inc. and JPMorgan Chase Bank to illustrate its position among big competitors. The current paper will underpin the discussion with the company’s statistics information from FDIC website.

Interest Rate Risk Exposure

Interest rate risk refers to the risk exposed to bond owners due to the fluctuation of interest rates. Like other companies, HSBC is also exposed to the interest rate risks. Without any measures to counter, risk is high, since many companies choose to borrow using floating rates, as well as employing some interest hedge strategies. For instance, borrowers tend to use the hedging strategies, such as collars, interest rates swaps, and caps to avoid using the fix-rate loans. Borrowers achieve this by borrowing on a floating-rate basis by applying the use of swap; cap and collar separate transaction strategies (Mirza & Holt, 2011). As a result, this will hedge against the interest rate increase, unlike typical fixed-rate loans. Another risk emanates from the companies, which have an access to a fixed-rate debt, as they have a need to improve their cash flows, whenever it is of their interest, and if fixed rate debt is experiencing an adverse impact on profit margin. In this case, companies will want to use the interest rate transaction strategies.

The competitive pressure from big performers, such has JPMorgan Chase Bank, and Citigroup has greatly affected HSBC’s management of interest risks. Specifically, the competition has limited WEC’s ability to manage the risks through discretionary pricing of loans’ and deposits’ rates. According to HSBC annual report (2010), the limitation has seen many customers loan rates, indexed to broad market rates, instead of a prime lending rate, which the bank can easily manipulate. The company has also experienced a sluggish growth for the last five years, especially when it is attached to the latest increase in loan demand, which has, consequently, affected the funding structure.

Basis risk is another interest risk rate, affecting HSBC due its imperfect relationship in the modification of the rates that earned a pay on different instruments, alongside the related replacing characteristics. The difference generates to increase the risk, since they trigger the unexpected changes in the cash flows and returns distributed among the assets, and liabilities off-balance sheet instruments when the interest rates change.

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Market Risk Exposure

Market risk refers to the shifting and fluctuating movement of market risks, such as interest rates, equity prices, credit spreads, commodity prices, equity prices, as well as the exchange rates. Therefore, when these market risk factors shift unfavorably, it tends to reduce the bank’s value of income and portfolio. Moreover, HSBC has set their objectives in a way that controls and manages risk exposure; the objectives are supposed to maximize the earnings, while ensuring the Group’s status is maintained by providing a consistent market profile. The company has achieved this split between trading portfolios and non-trading portfolios to separate the types of market risk exposure. The trading portfolio comprises of the scenario that emanates from propriety position taking, market making, and other designated marked-to-market situations (HSBC, 2010). To achieve a clear and distinct separation, the company discloses the designated marked-to-market portfolio separately to contribute to the trading value at risk. HBSC’s retail and commercial assets and liability generate and manage the interest rate of the non-trading portfolios. Also, it is the duty of the company’s Group Management Board to manage the market risks, while using the approved limits. Each portfolio, kind of risk, type of products are set to limits under the limit with market liquidity, as the yardstick to measure the level of a desired limit.

From the fact that the risk exposure in the market is high, HSBC has adopted the Value at Risk VAR model to screen and control the market risk exposure. VAR allows the company to estimate the imminent loses that could arise from risks position due to constant variation of market rates and policies over a particular time period and a given degree of significance (usually, 99.1 confidence). HSBC is aware of the dynamism of the market rate changes; therefore, it calculates VAR daily, based on the past simulation. In fact, extrapolation of the past simulation hints about the future scenario of market rates buys, relating between the foreign exchange rates and interest rates. As much as VAR is a valuable guide, HSBC has not fully relied on its reports without actually considering the existing limitations. For instance, relying on historical information in predicting the future events may not cover all the potential risks, especially the one that is extreme in its nature (Mirza & Holt, 2011).

Credit Risk Exposure

Credit risk refers to the financial losses that are likely to occur when customers fail to adhere to the payment obligation under a stipulated contract. These risks occur from the principal, leasing transactions, trade finance, as well as off-balance sheet items, such as credit derivatives and guarantees credit risks. HSBC has adopted an IRB advanced model as a plan to increase its coverage in a standardized model. However, HSB has found it challenging to achieve a suitable environment to favor the approval and operation of internal risk-based analysis. On the contrary, the Prudential Regulation Authority (PRA) has provided practical measures to limit the modeling strategies that are used to determine the risk weight assets, thus generating a high demand for capital. The set measures are comprised of 45% floor for the loss given default on HSBC’s credit risks exposure to acquire a supervisory slotting for the accurate commercial real estate exposures. Specialized lending relies on the performance of essential long-term assets as collateral. HSBC aligns exposure to specialized lending by considering the political and legal environment of the project, financial strength, and assets characteristics (Morrey & Guyton, 2009).

Similar to bigger competitors, like JPMorgan, and Citigroup, HSBC has set its strategies to mitigate the credit risks. Many banks have fallen victims of credit risks, despite the governing policies set to structure the packages of credit offered. HSBC has implemented this policy alongside valuation meters to evaluate the degree of credits risk before considering lending; one of the tools for lending is the production capacity, as well as mitigating. One of the mitigating tools is the use of collateral. Physical collateral is also applied in different forms that cover the leasing transactions specialized lending, since physical assets form guaranteed repayment to each credit facility (Saunders & Cornett, 2008). Moreover, HSBC has created charges on borrower’s business assets, such as stocks, debtor, and premises, while pledges are made along available cash, reals estate, and market securities to facilitate loans to private the group extends the loan without benefiting from other forms of security. Another tool used by HSBC to mitigate credit risk is the financial collateral. It is achieved by imposing the charges in instruments, such as bonds, cash, and equities. This security reapplied to cover much of the over the counter activities, especially in transactions of safety, such as security lending and borrowing, reports, and response reverse.

Liquidity Risk Exposure

Liquidity risks refer to a financial risk that arises within a particular period when commodities, securities, financial assets cannot be traded quickly without affecting prices in the market. This risk is high during the economic downturn, when there are fears of bank runs, yet it is still an eminent threat in the banking industry. HSBC is not an exception and the company also experiences liquidity risks, as it is a common threat; thus, their task is to ensure that in order to be able to pay out the anticipated withdrawals, they ought to have sufficient funds (HSBC, 2010).

HSBC has a cash-flow testing model to asses liquidity risk. HSBC does not control liquidity through the explicit allocation of capital, which is typical with standard industry practice. Financial analysts have criticized this technique, claiming it is not an appropriate mechanism for managing these risks. However, HSBC is aware that having a strong capital base can be useful to minimize liquidity risks, as it creates an environment that allows an entity to raise funds by providing a capital buffer. The funds are deployed in liquid positions, thereby reducing credit risks that were taken by providers of funds to the Group (Morrey & Guyton, 2009).

The liquidity risk exposure provides inherent characteristics, which creates uncertainty over the amount of settlement of claims liabilities that may occur to trigger the liquidity risks. The HSBC manages this exposure by estimating their cash flows, particularly on the activities expected to stem from insurance funds at the balance sheet date. The estimates always account for future funds from renewal premiums, hence creating new business cashflow. Another tool that can be used to manage liquidity risk is liquidity -adjustment VAR that employs an exogenous liquidity risk into the value at risk model. VAR model helps in determining the time required to liquidate the untraded portfolio (Commerce Clearing House, 2010). HSBC attempted to employ this approach, whereby the time taken in the risk assessment is adjusted by the time required to liquidate a position. Diversification of liquidity providers is another strategy deployed that is used to mitigate the liquidity strategy (Commerce Clearing House, 2010). For instance, JPMorgan Chase uses this strategy by coupling several liquidity providers, such that when one provider increases the cost of supplying liquidity, the impact is mitigated. According to the American Academy of Actuaries (AAA), a bank will be in a good financial position, in case it has to develop a long-term liquidity line of credits. HSBC, as a credit issuer, is ought to have a high credit rating to expand the chances of liquidating the assets at any given time.

Off-Balance Sheet Exposures

Off balance sheet refers to a company’s long term and short term assets, which do not appear on the balance sheets at the end of the fiscal year. Assets are considered off-balance sheet items if the company does not have a legal claim of responsibility. For example, HSBC typically records the issued loan in the bank’s book. The loans become an off-balance sheet item after they are scrutinized and sold off as an investment. Scrutinized debts are not recorded in the books. Thus, they are qualified as off-balance sheet items. Another typical off balance sheet element is an operating lease. There are several types of off-balance sheets, but the one that is most commonly used by the commercial banks is derivatives. Derivatives are diversified as if it could be applied to hedge against the different kinds of risks, which have an impact on the future operations of the bank (Commerce Clearing House, 2010).

Compared to JPMorgan Chase Banks and the Citigroup, HSBC has extremely small percentage ratio of derivatives to a total asset. About current capital guidelines, any commercial bank in possession of any assets and any off-balance sheet item, they have a duty to display the obligation and assurance to various categories of risks. In the normal cause of business, HSBC engages in several transactions that include both on and off-balance sheet risks. Such transactions primarily involve lending individual customers and other financial institutions. As at 2009, HSBC has made fewer loans, as compared to its competitors, and this suggests that the bank experienced a lower insurance cost, and lower occupancy expenses, thereby improving lost estimates on the off-balance credit. Furthermore, the replacement for off-balance sheet risk exposure that is kept in other liabilities comprises of probable and actual loss of credit, which stems from the off-balance sheet items, such as an undrawn promise to lend and letter of credit. HSBC mitigates the off-balance sheet risk by using and advanced credit risk methodology to facilitate the approximation of losses suffered in intrinsic in pools of HSBC loans and leases (Gobat, Yanase, & Maloney, 2014).

Capital Adequacy

Capital adequacy has the capital requirement that refers to the minimal amount of capital needed by the financial institution, as recommended by the commercial banks. In other words, it is a measure of banking capital, expressed as a bank’s risks weighted credit exposure. The Capital Adequacy Ratio (AR) is the ratio of equity held by a company to the risk-weighted assets. The limit is set to create a protection that ensures an institution does not become insolvent after lending the excess leverage. With the aid of the current regulation, Basel III rules were introduced to improve the consistency, quality, transparency, of the capital base to combat credit risks, as well as the risks associated with capital framework. Basel III covers one type capital required by the regulators, which is the tier 1 capital, and not on level 2 capital. The rule has set a minimum of 4% on tier 1 capital and 8% of as minimum of the Capital Adequacy Ratio (Gobat, Yanase, & Maloney, 2014).

As from 2013 to 2015, HSBC has determined the tier one capital using the one capital and the revenue and loss estimates against risk weighted average assets, controlled by the supervisory severely adverse scenario. In the findings, common tier 1 and equity tire 1, tier 1 leverage were the forecasted over a three-quarter period, testing the projected period. Tier 1 capital is determined to be based on the definition weighted risk assets and tier 1 capital. The alterations in the projecting regulatory capital ratio are propelled by the pre-provision net loss because of the forecast, which illustrates both an increase in operation risk losses and a fall in the net interest rates. Despite the fact that HSBC forecasted a fall in the net income, still a tier 1 common ratio of above 5% minimum ratio of the capital plan rule established under Federal Reserve was projected (U.S. Senate Committee on Banking, Housing, and Urban Affairs, 2010). About Basel III rule capital requirement, HSBC had a capital requirement above the minimum target along their capital level. JPMorgan and Citigroup major banks have a relatively similar ratio, so HSBC should continue to maintain this ratio over time and avoid approaching the minimum requirement. Basel III’s full implementation rolls out in 2018, and it could cost HSBC more in future to have to increase this ratio (Saunders & Cornett, 2008).

Profitability (ROA, ROE)

Profitability refers to the ability of business to generate profit. From the ROA and ROE over the last five years, HSBC current profitability can be traced and forecasted. HSDC Bank has a lower ROA and ROE, as compared to JPMorgan and Citigroup over the last five years. Return on capital is calculated as the ratio of net income to total assets (Net Income/Net Assets). ROA is a useful ratio, as it determines the rate at which the company uses its assets to turn them into earnings. On the one hand, as at 2015, HSBC had a ROA of 0.5% against Citigroup 0.95% and a perfect 2% of JPMorgan Chase Bank (Mirza & Holt, 2011). On the other hand, ROE is calculated as the ratio of net income against shareholders equity. ROE helps to determine the way company converts investor’s funds into profits. Similarly, HSBC’s ROE has was lower, as compared to JPMorgan Chase ‘sand Citigroup’s ROE.

Risk Management

The banking industry is highly volatile and this exposes the smaller banks to many financial risks in the market. These risks are brought by the competitiveness nature of the market of the major risk is interest rates’ fluctuation. Bigger banks, as Citigroup and JPMorgan Chase, have the advantages of controlling both the market interest rate and the internal interest rate, as they have a large accumulation of assets. Another inevitable threat to HSBC performance is the issue of securitization. For instance, Mortgaged-backed securities lead to losses when there is a fall in the market rate. Under securitization, there is a higher risk of bad debts occurrence, as some borrowers default on their loans (HSBC, 2010).

Like JPMorgan Chase and Citigroup, HSDC has turned to loan sale strategy as a tool to mitigate the risks. The objective of selling a loan rebalances the portfolio within a short period of time. Through loan sales, HSBC non-performing assets can be shifted to avoid the loan reserve and cost of collecting loans.