OverviewWith its Q3 2019 results, HSBC Holdings (HSBC, the Group, Issuer Rating of AA low, Stable Trend) highlighted that returns in some of its businesses remained insufficient and, due to a deterioration in the operating environment, decisive action was needed to improve the Group’s profitability. In February 2020 HSBC plans to announce details of a plan, involving the redeployment of capital from low-return businesses to faster growth and higher return markets and an adjustment of its cost base. The new plan is likely to result in substantial upfront restructuring expenses in subsequent quarters. The new plan comes as the operating environment for HSBC’s Asian franchise becomes increasingly challenging. HSBC’s Asian business has been more profitable and growing faster than other parts of the franchise (Exhibit 1).
The Group operates in Hong Kong through its two fully consolidated subsidiaries The Hongkong and Shanghai Banking Corporation Limited, the largest bank incorporated in the region and Hang Seng Bank Limited. While the contribution of Hong Kong to the Group’s results remained strong in 3Q19, the region has seen a rapid deterioration in its economic performance (Exhibit 2), reflecting the social unrest and global trade tensions. The economic outlook for Asia has also deteriorated, as illustrated by the downgrade in IMF’s growth forecasts in October 2019. Given the high importance of the region to the Group, the deterioration in Hong Kong’s economy is likely to add further pressure on profitability, that will also be affected by the restructuring. In our opinion, the slowdown in Asia also represents a risk to the Group’s plan to redeploy more capital into dynamic and profitable businesses.
Details of a major restructuring to be announced in February 2020With the Q3 2019 results HSBC scrapped its RoTE target of more than 11% in 2020 due to a deterioration in the outlook for revenues. It also announced plans for a major Group restructuring, involving the adjustment of the cost base and redeployment of capital from low-return businesses to faster growth and higher return markets. HSBC warned that in Q4 2019 and subsequent periods it could incur significant charges, including the possible impairment of goodwill and additional restructuring charges. The detailed plan will be announced in February 2020 with the FY2019 results.
In our opinion, cost reductions could be broad-based but the focus is likely to be on the businesses that produce subpar returns. Management highlighted that the business in continental Europe, the non-ring fenced bank in the U.K., in particular, its GBM division, and the U.S. business as those producing insufficient returns and likely to see a reduction in allocated capital and costs. Weak returns generated by these businesses can, to some extent, be seen in HSBC’s regional cost-to-income ratios (Exhibits 3 and 4). Management also indicated that cost reduction would be achieved by reducing the complexity in the organisational structure of the Group and new financial targets would be announced.
HSBC’s profitability – growing reliance on Asian in recent years HSBC’s Asian franchise has been outperforming in terms of profitability and growth when compared to HSBC’s other regional divisions. As a result, its contribution to the Group’s profitability has been on the rise. Hong Kong remains the most important contributor to HSBC’s performance, and in 9M 2019 it contributed 53% of the Group’s adjusted PBT, and together with the rest of Asia more than 80% (Exhibit 1). Hong Kong and mainland China, in particular, the Pearl River Delta region, have been strong contributors to the growth of the Asian franchise, in line with the Group’s strategic focus.
HSBC has a very strong presence in Hong Kong. It operates in the region through the wholly-owned Hongkong and ShanghaiBanking Corporation Limited and its 62%-owned subsidiary Hang Seng Bank Limited. Both entities are fully consolidated bythe Group. HSBC is the market leader in Hong Kong with a customer base of 4.6 million, compared to the 7.4 million population of Hong Kong. The Group has more than 200 outlets and provides a full spectrum of products and services. It is the market leader across major products, including customer accounts, customer loans, mortgages, Trade financing, DCM and Dim Sum bonds.1The Retail Banking and Wealth Management division is the main contributor to the Hong Kong franchise. The corporate and institutional businesses, Commercial Banking and Global Banking (CMB and GB&M) are also important contributors to the Hong Kong franchise.
Deteriorating operating environment for the Asian franchiseDBRS Morningstar notes that while Hong Kong remained a strong contributor to the Group’s performance in Q3 2019 the region’s economic performance has been deteriorating. During H1 2019 Hong Kong’s economic growth was weak and below the long-term trend due to weak private consumption growth and contraction in investment spending, reflecting low consump-tion and investment confidence2. The intensification of social protests appears to have had an important impact on the eco-nomic performance. The economy also suffered from poor export performance, reflecting global trade tensions, notably the US-China trade dispute. We note that Hong Kong’s economy is highly dependent on trade with the rest of the world. In 2018, the value of Hong Kong’s total merchandise trade (import and export) represented more than 300% of its GDP. Given its stra-tegic geographical location and infrastructure, Hong Kong is an important intermediary in the trade between the mainland China and the rest of the world3. In October 2019 the IMF downgraded the GDP growth forecast for China, reflecting mainly escalating tariffs and slowing domestic demand following needed measures to rein in debt. Slowing growth in China and spill-overs from Uthe S–China trade tensions have also led to lower growth forecasts for other advanced economies in Asia, including, Korea, and Singapore. Based on the latest WTO report, trade restrictions imposed by WTO members were at their highest levels since 2012 and the trade coverage of import-restrictive measures implemented in the 12 months to mid-October 2019 was esti-mated at USD 747 billion (Exhibit 5).
This has contributed to a deterioration in the outlook for the economies of mainland China and some of the other Asian countries. Hong Kong’s economic performance remained weak in Q3 2019 as the economy re-mained adversely affected by internal and external factors and Hong Kong’s seasonally adjusted GDP declined in real termsby 2.9% YoY, the first decline since the financial crisis (Exhibit 2).
DBRS Morningstar notes that despite this lowering of economic forecasts for the region, the rates of growth should remain superior when compared to those of much of the West. We note that developments in global trade have also a more direct impact on HSBC than through the Hong Kong’s economy. Financing and transactional services related to trade, especially that involving China has been the traditional domain of HSBC since its inception more than 100 years ago and the business continues to represent an important element of HSBC’s current strategy.
HSBC is ranked among the top three players by global revenues from transaction banking, including trade finance and cash management4. Pressures on HSBC’s profitability likely to intensifyThe weakness in Hong Kong’s economy, if persistent, is likely to add to pressures on HSBC’ profitability resulting from the strategic restructuring. Low confidence levels could lead to reduced demand for credit and the Group’s lending and conse-quently revenue growth. Continued weakness of the region’s economy could also lead to the weakening of household income and a deterioration in the corporate sector’s fundamentals. This in turn could undermine borrowers’ debt servicing capability and lead to a deterioration in the Group’s asset quality and the cost of risk.
We note however that the share of Hong Kong in credit exposure is not as high as its share in the Group’s earnings. Hong Kong represents around 30% of the Group’s gross loans and 22% of RWAs (Q3 2019). Furthermore, the quality of the credit exposure benefits from the Group’s high underwrit-ing standards. The residential mortgage portfolio, which represents the main type of retail exposures in Hong Kong (Exhibit 6), has a relatively low proportion of loans with an LTV above 80%. Housing affordability remains stretched, with the price-to-income ratio and the income gearing ratio staying high by historical standards. The Hong Kong government projects that pri-vate housing completion will remain high in the years ahead, which should help narrow the housing supply-demand gap over time, however this unlikely to impact Hong Kong’s residential property prices in the near to medium term. HSBC’s exposure to consumer lending in Hong Kong is not significant.
There are also questions about the status of Hong Kong as an international trade and financial centre in the long term. Any signs of a change in the region’s status and a deterioration in the outlook on the economic performance could lead to cross-border capital flows, which in turn could affect the banking sector’s liquidity and funding and impact the level of domestic interest rates, which is another important driver of banks’ profitability.
We note that any potential outflow of retail and wealth management deposits from HSBC’s network in Hong Kong could in part remain in the Group’s international network and benefit subsidiaries in stable countries with a large Chinese immigrant population, such as Canada or Australia. In our opinion, the deterioration in the economic outlook for Asia represents a risk to the re-deployment of capital into faster growing and more profitable Asian businesses. DBRS Morningstar will watch closely further developments in Hong Kong, given the region’s importance to the Group’s performance.