HSBC needs US arm despite loan losses
It won't be of much comfort to HSBC Holdings' chairman Stephen Green, but in one sense his bank's strategy of diversification is working as intended.
Even though falling United States house prices forced HSBC to make US$17 billion worth of provisions against bad loans last year, while the credit crunch inflicted another US$2 billion of write-downs on its credit trading positions, the rapid growth of HSBC's Asian and Middle Eastern businesses enabled the bank to turn in record after-tax profits of US$19 billion for 2007.
This is how diversification is supposed to work. You spread your activities across a broad range of countries and businesses. Then, when one area turns down, growth in the others will compensate for any losses, smoothing your earnings stream. In theory shareholders should be happy.
In reality of course, HSBC's shareholders are hopping mad. They are not comparing HSBC's 10 per cent pre-tax profit growth favourably with the performance of competitors like Citigroup or UBS, which saw earnings crushed last year. Instead they are contrasting it adversely to the 27 per cent increase in 2007 pre-tax profit announced last week by emerging markets banking specialist Standard Chartered.
If only HSBC had not diversified into the US back in 2003 with its US$15 billion acquisition of Household International, they reason, that capital could have been more efficiently employed in Asia, and HSBC could be returning Standard Chartered-type profit growth today.
One aggrieved shareholder, fund management company Knight Vinke, estimated that without the Household purchase, HSBC's share price would be between 25 and 40 per cent higher than it is now. Last week Knight Vinke demanded that HSBC either wind up or divest Household - now renamed HSBC Finance - and refocus its business on emerging markets, predicting 'a massive re-rating of HSBC's shares' if it does.
Yesterday Mr Green dismissed the notion that he would walk away from HSBC Finance as 'as unreasonable as it is unrealistic'. Yet HSBC is already bending to the prevailing wind, winding down its US lending books and shifting capital away from developed markets and towards Asia. For example, the bank is in talks to sell 400 branches in France for US$3 billion and has vowed to seek acquisitions in emerging markets.
In the circumstances, this makes good sense. Yet the collapse of HSBC's North American profits - just US$91 million last year, compared with nearly US$4.7 billion in 2006 - does not undermine the argument for the bank's diversification into the US.
Geographic spread has repaid HSBC's shareholders well over most of the last ten years. Exposure to developed markets supported HSBC's stock during the Asian crisis of 1998 and the downturn of 2002, when Standard Chartered shares suffered far more heavily. It is only since the credit crunch began to bite last year that Standard Chartered has made up lost ground.
It is also worth bearing in mind that making acquisitions in emerging markets is intensely difficult and time-consuming, and well-nigh impossible on the scale of the Household purchase. For example, HSBC is still awaiting official approval for its purchase of a US$6 billion, 51 per cent stake in Korea Exchange Bank, agreed with the seller over six months ago.
Seen in that light, it was not HSBC's diversification into the US market that was the mistake. That made sense. The real error was for HSBC's bosses to abandon sound banking principals by venturing into the subprime market, gulled by reassurances that computers could successfully model the behaviour patterns of borrowers with bad credit records, and so protect the bank from the build up of risk.
Mr Green and his team have now learnt that lesson at considerable cost, and are re-orienting the bank towards growth markets, especially in Asia. But for a bank of HSBC's size, it will be essential to retain a considerable exposure to stodgier developed markets like the US. Shareholders may not be happy in the short term, but they will definitely be grateful when the next downturn hits emerging markets. That is the point of diversification.