Deutsche Bank Markets Research
Rating Company Date 31 August 2016 Hold HSBC Holdings Plc Special Report Asia Hong Kong Reuters Bloomberg Exchange Ticker Price at 30 Aug 2016 (HKD) 56.20 Banking / Finance 0005.HK 5 HK HSI 0005 Price target - 12mth (HKD) 53.00 Banks ADR Ticker ISIN 52-week range (HKD) 63.25 - 45.80 HBC US4042804066 HANG SENG INDEX 22,821
Capital Map: the cost of "being Stephen Andrews, CFA HSBC" Research Analyst (+852 ) - 2203 6191 Understanding the group dividend & distribution of capital [email protected] The announcement of a US$2.5bn share buyback at HSBC's interim results surprised market consensus that had been factoring in the prospect of a David Lock dividend cut. In this report we lay out a "Capital Map" for the HSBC Group that shows clearly where the group allocates capital geographically, what the Research Analyst returns generated on that capital are & what the cash dividend paying (+44) 20 754-11521 capability is of each operating company up to the group. This we believe not [email protected] only helps shed greater light on the sustainability of group dividend but illuminates the areas where the group still has large sums of capital allocated Key changes inefficiently. TP rises to 525p, but HSBC does not screen cheap. Retain Hold. Price target 51.30 to 53.00 ↑ 3.3% Half of the group’s capital is making just 1-2% RoE Provisioning 4,235.5 to ↓ -2.2% Asia remains at the heart of HSBC. ASIA & MENA combined represent roughly (FYE) 4,142.3 50% of group capital today & we expect these operating companies to make Net profit 8,073.5 to ↑ 6.4% an aggregate 12-13% RoE this year, sufficient to support 75-85% of the group (FYE) 8,587.2 Source: Deutsche Bank cash dividend on a sustainable basis. The problem is the rest of the world (and Hold co) where the group has US$85-90bn of equity making an aggregate of Price/price relative just 1-2% RoE. Over the next 2-3 years we see limited cash dividend paying ability from these businesses funded out of ongoing earnings. This is a huge 105 drag on group returns & to a large extent we believe is structural rather than 90 cyclical in nature if group capital allocation/strategy does not change. 75
Over distributing but dividend “safe” for this year and most likely next 60 Relative to subsidiary cash earnings HSBC is over distributing. The buyback is 45 therefore being funded by capital freed up by shrinking the group (e.g. for 9/14 3/15 9/15 3/16
2016 the disposal of Brazil). To the extent that the freed capital was not HSBC Holdings Plc making the group cost of capital we would view this as a positive. With capital HANG SENG INDEX (Rebased)
being stripped out of Latam this year & the US next year the dividend looks Performance (%) 1m 3m 12m safe for both 2016 & 2017. However, the group does still need to grow into the current dividend burden & we should expect limited book value per share Absolute 11.2 10.6 -8.1 growth for the next 2-3 yrs which is likely to cap share price appreciation. HANG SENG INDEX 4.2 10.6 5.6
Source: Deutsche Bank
Is the cost of “being HSBC” too high relative to global synergies achieved? We believe our “Capital map” exercise also sheds greater light on the cost of “being HSBC”. Our analysis identifies two clear costs: 1) capital trapped in subsidiaries making sub-CoE returns but are viewed as essential to generating group-wide synergies (e.g. GBM in the US); 2) the cost of group centre (we estimate this alone is c.2-3% drag on group RoE). At present we believe there is little compelling evidence that the benefits of running a global HSBC are outweighing these costs. Whilst this remains the case it is hard to see HSBC’s shares out-perform peers with cleaner & less complex business models.
For forecast changes, valuation and risks please see pages 15-16. Forecasts And Ratios Year End Dec 31 2014A 2015A 2016E 2017E 2018E PER (x) 13.8 12.3 16.7 13.4 10.2 Price/book (x) 1.03 0.91 0.82 0.81 0.79 Source: Deutsche Bank estimates, company data
______Deutsche Bank AG/Hong Kong Distributed on: 08/30/2016 22:16:30GMT Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 057/04/2016.
31 August 2016
Banks HSBC Holdings Plc
Model updated:30 August 2016 Fiscal year end 31-Dec 2013 2014 2015 2016E 2017E 2018E
Running the numbers Data Per Share Asia EPS (stated)(USD) 0.84 0.69 0.65 0.44 0.54 0.71 EPS (DB) (USD) 0.79 0.82 0.68 0.62 0.67 0.72 Hong Kong Growth Rate - EPS (DB) (%) -16.8 3.7 -17.2 -8.2 7.9 7.8 DPS (USD) 0.49 0.50 0.51 0.51 0.51 0.51 Banks BVPS (stated) (USD) 9.27 9.24 8.73 8.82 8.93 9.18 Tang. NAV p. sh. (USD) 7.76 7.80 7.48 7.69 7.80 8.06 HSBC Holdings Plc Market Capitalisation 204,290 183,375 157,178 141,409 141,409 141,409 Shares in issue 18,654 19,056 19,517 19,601 19,489 19,611 Reuters: 0005.HK Bloomberg: 5 HK Valuation Ratios & Profitability Measures Hold P/E (stated) 12.9 13.8 12.3 16.7 13.4 10.2 P/E (DB) 13.8 11.7 11.8 11.7 10.8 10.0 Price (30 Aug 16) HKD 56.20 P/B (stated) 1.2 1.0 0.9 0.8 0.8 0.8 Target Price HKD 53.00 P/Tangible equity (DB) 1.4 1.2 1.1 0.9 0.9 0.9 ROE(stated)(%) 9.1 7.4 7.2 5.0 6.1 7.9 52 Week range HKD 45.80 - 63.25 ROTE (tangible equity) (%) 10.3 10.5 8.9 8.2 8.7 9.1 ROIC (invested capital) (%) 8.6 8.8 7.6 7.1 7.5 8.0 Market Cap (m) HKDm 1,096,838 Dividend yield(%) 4.5 4.8 5.9 7.0 7.0 7.0 USDm 141,409 Dividend cover(x) 1.7 1.4 1.3 0.9 1.1 1.4
Profit & Loss (USDm) Company Profile Net interest revenue 35,535 34,705 32,531 30,844 29,203 29,746 HSBC is one of the world's leading banking and financial Non interest income 29,266 26,704 27,308 22,739 23,821 24,363 institutions with c.6,600 offices and 58 million customers in 81 countries across Europe, Hong Kong, Asia-Pacific, Commissions 0 0 0 0 0 0 Middle East, North Africa, North America and Latin Trading Revenue 0 0 0 0 0 0 America. At FY12 46% of its loan book was in Europe, Other revenue 29,266 26,704 27,308 22,739 23,821 24,363 17% in Hong Kong, 17% in Asia & Middle East, 14% in Total revenue 64,801 61,409 59,839 53,584 53,024 54,109 North America and 5% in Latin America. HSBC has 4 main Total Operating Costs 38,712 41,410 39,807 37,562 34,441 30,711 business divisions: Retail Banking & Wealth Management, Commercial Banking, Global Banking and Markets and Employee Costs 0 0 0 0 0 0 Global Private Banking. At FY12 38% of loan balances Other costs 38,712 41,410 39,807 37,562 34,441 30,711 were in RBWM, 29% in Commercial, 28% in GBM, and 5% Pre-Provision profit/(loss) 26,089 19,999 20,032 16,022 18,583 23,398 in Private Banking. Bad debt expense 5,849 3,851 3,721 4,142 3,704 3,676 Operating Profit 20,240 16,148 16,311 11,879 14,879 19,722 Pre-tax associates 2,325 2,532 2,556 2,501 2,498 2,498 Pre-tax profit 22,565 18,680 18,867 14,380 17,377 22,220 Tax 4,765 3,975 3,771 3,501 4,518 5,777 Other post tax items -2,169 -1,590 -2,524 -2,292 -2,394 -2,429 Stated net profit 15,631 13,115 12,572 8,587 10,465 14,014 Goodwill 0 0 0 0 0 0 Extraordinary & Other items -935 2,456 626 3,583 2,590 148 Bad Debt Provisioning 0 0 0 0 0 0 Investment reval, cap gains / losses 0 0 0 0 0 0 DB adj. core earnings 14,696 15,571 13,198 12,170 13,055 14,162
Key Balance Sheet Items (USDm) & Capital Ratios Risk-weighted assets 1,214,939 1,219,800 1,102,995 1,033,274 1,009,232 1,035,229 Interest-earning assets 992,089 974,660 924,454 855,347 857,924 876,699 Customer Loans 992,089 974,660 924,454 855,347 857,924 876,699 Total Deposits 1,370,653 1,350,642 1,289,586 1,241,200 1,218,758 1,224,739 Stated Shareholder Equity 174,615 177,510 171,943 172,154 173,751 181,417 Equals: Tangible Equity 146,078 149,933 147,338 150,101 151,698 159,364 Tier 1 capital 145,641 152,739 153,303 149,288 150,885 158,552 Tier 1 ratio (%) 12 13 14 14 15 15 o/w core tier 1 capital ratio (%) 10.8 10.9 11.9 12.5 12.8 13.0
Credit Quality Gross NPLs/Total Loans(%) 3.67 3.00 2.57 3.00 3.00 3.00 Risk Provisions/NPLs(%) 42 42 40 40 40 40 Bad debt / Avg loans (%) 0.59 0.39 0.39 0.47 0.43 0.42 Bad debt/Pre-Provision Profit(%) 22.4 19.3 18.6 25.9 19.9 15.7
Growth Rates & Key Ratios Growth in revenues (%) -5 -5 -3 -10 -1 2 Growth in costs (%) -10 7 -4 -6 -8 -11 Growth in bad debts (%) -30 -34 -3 11 -11 -1 Growth in RWA (%) 8 0 -10 -6 -2 3 Net int. margin (%) 2.13 1.94 1.92 1.97 1.86 1.85 Cap.-market rev. / Total revs (%) nm nm nm nm nm nm Total loans / Total deposits (%) 72 72 72 69 70 72
ROTE Decomposition Revenue % ARWAs 5.54 5.04 5.15 5.02 5.19 5.29 Net interest revenue % ARWA 3.04 2.85 2.80 2.89 2.86 2.91 Non interest revenue % ARWA 2.50 2.19 2.35 2.13 2.33 2.38 Costs/income ratio (%) 59.7 67.4 66.5 70.1 65.0 56.8 Bad debts % ARWAs 0.50 0.32 0.32 0.39 0.36 0.36 Tax rate (%) 23.5 24.6 23.1 29.5 30.4 29.3 Adj. Attr. earnings % ARWA 1.06 1.07 0.92 0.91 1.03 1.14 Capital leverage (ARWA/Equity) 8.2 8.2 7.8 7.2 6.8 6.6 ROTE (Adj. earnings/Ave. equity) 8.7 8.8 7.2 6.5 7.0 7.5
Source: Company data, Deutsche Bank estimates
Stephen Andrews, CFA +852 - 2203 6191 [email protected]
Page 2 Deutsche Bank AG/Hong Kong
31 August 2016
Banks HSBC Holdings Plc
Table Of Contents
Executive Summary ...... 4 Introducing the HSBC Group “Capital Map” ...... 4 Capital allocation: Introducing our HSBC “Capital Map” ...... 5 1. Where is the capital allocated? ...... 6 2. Prospects for future capital distribution ...... 9 The cost of “being HSBC”: Assessing Holding Co. costs… ...... 12 Conclusions: let’s not get carried away ...... 13 Forecast changes...... 15 Valuation & risks ...... 15 HSBC Asia ...... 17 The centre of group economic profit generation ...... 17 HSBC North America ...... 24 A decade of value destruction ...... 24 HSBC Europe ...... 38 Formed by acquisition, but undergoing structural change ...... 38 Ring-fencing means further structural change ...... 39 Recent performance ...... 40 HSBC Bank plc ...... 42 Key issues for future dividend potential...... 47 Cash flow forecasts ...... 62 Valuation...... 63 HSBC Hold Co ...... 65 Black box? ...... 65
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31 August 2016
Banks HSBC Holdings Plc
Executive Summary
Introducing the HSBC Group “Capital Map”
Overview It is not often we see a bank stock for which consensus is factoring in a dividend cut surprise the market with the announcement of a share buyback. HSBC did just that at its 2016 interim results. On a reported basis we expect 2016 will see HSBC over distributing earnings for the first time since 2008 (Figure 1). This may remain the case for at least a couple of years. However it is the cash flows from the group operating companies paid up to the group that underpin the cash dividend paying ability of the holding company (i.e. the listed entity). This cash flow has 2 elements to it:
1) A cash dividend paid out of the ongoing earnings stream of the operating companies up to the group
2) Cash freed up from underperforming businesses that can be paid up to the group and returned to shareholders
It is the latter that we believe is “plugging the dividend gap” this year and To the extent that capital allowing the buyback (via the sale of Brazil). To the extent that capital return is return is being freed up from being freed up from businesses & geographies that are unlikely to make their businesses & geographies cost of capital we view this as a positive development. It is also telling that that are unlikely to make their group capital ratios are now in a position where management feels cost of capital we view this as comfortable to return this capital (with PRA approval) post almost a decade of de-leveraging. This is a meaningful turning point for the group. In this regard a positive development we see plenty of scope for a further rationalization of the capital allocated to the group’s North American operations (US$33bn as of end H1 16 making just a 1-2% RoE). However what really matters at the end of the day is RoE. With an underlying RoE forecast to be just 6-7% and a high payout ratio we see limited if any growth in book value per share over the next 2-3 years. Whilst the dividend may well be held at current levels a lack of growth in book value per share is likely to cap share price appreciation hence our Hold rating.
Figure 1: EPS vs. DPS over the last 12 years Figure 2: Book value per share
1.80 12.00 16% 1.60 15% 10.00 1.40 14% 1.20 8.00 13% 12% 1.00 6.00 11% 0.80 10% 0.60 4.00 9% 0.40 fully loadedCET1 NAV & & TNAV NAV pershare 2.00 8% 0.20 7%
0.00
FY16e
FY04 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15
FY05 0.00 6%
1H05 1H06 1H07 1H04 1H08 1H09 1H10 1H11 1H12 1H13 1H14 1H15 1H16
EPS (Stated) Dividend per share (paid, cash) Dividend per share (paid) CET1 NAV Tangible NAV
Source: Deutsche Bank estimates & company data Source: Company data
Page 4 Deutsche Bank AG/Hong Kong
31 August 2016
Banks HSBC Holdings Plc
To help investors better understand capital flow & distribution around the HSBC group this report looks to address 3 questions:
1) Where is capital in HSBC group allocated? We build a map of the legal subsidiary tree & capital allocation of HSBC (rather than how it is usually shown on a business / geographic management view). This shows the allocation of resources, performance of businesses and flow of dividends around the group. 2) What is the prospect for future distributions from subsidiaries and the group? We assess performance, capital requirements, and distribution outlook for the 3 principal subsidiaries representing Asia, North America & Europe. We also examine future structure & capital requirements for the UK ring-fence. 3) What is the cost of “being HSBC”? The sum is smaller than the parts. Often ignored in the HSBC Group context, we put an estimate on the cost of the Hold Co operations (not easily visible within company accounts). This is an important part of the cost of ‘being HSBC’ – and which the ‘value of the international network’ needs to outweigh in the long run.
Capital allocation: Introducing our HSBC “Capital Map”
HSBC is a complex business (many would say too complex). To help simplify it using details from many subsidiary accounts we have built a map estimating where HSBC’s capital sits across its global legal structure. This is aimed to deliver 2 things in a simple to use form:
1) Show capital allocation at the operating company level and importantly the returns generated on that capital. For this we use a simple “traffic light” color scheme: Green is capital making cost of capital, Amber for operating companies that are within a couple of % of making cost of capital (or have scope to get there within 1-2 years) and red where the operating company is not making cost of capital and seems unlikely to any time soon. There is clearly still too much “red ink” on the capital map, notably in North America in Europe. The “green ink” is dominated by Asia which is essentially the Hong Kong Shanghai Banking Corporation (HBAP).
2) Level of CET1 capital & dividend paying capability via either ongoing earnings or capital freed up from underperforming businesses: Capital returned to shareholders via either the dividend or buybacks has to sit at the listed entity, i.e. the holding company level. This map is intended to show both how well capitalized each operating company is (i.e. where might there be excess capital or capital holes) and also the expected net dividend (net of any downstream) to be paid up to the holding company. The map is for 2016 which shows clearly the dividend being paid out of Latin America as a result of the sale of the Brazilian business. Coupled with the cash dividend out of Asia/MENA this is enough to cover the group cash dividend and announced buyback for this year. For 2017 the group has already indicated it intends to dividend excess capital out of its US business (HSBC North America Holdings) which we estimate at YE 16 will have a CET1 16.5% CET1 capital ratio (i.e. excess capital).
Deutsche Bank AG/Hong Kong Page 5
31 August 2016 Banks HSBC Holdings Plc
0.8 0.2 3.0 0.5 4.2 0.5 6.2 0.8 1.5 0.1 2.0 2.1 0.3 1.3 0.2 1.4 0.0 15.4 7.5% 2.0% 21.4% 15.3% 12.6% 13.0% 13.1% 14.7% 13.0% Est RoE Est RoE Est RoE Est RoE Est RoE Est RoE Est RoE Est RoE Est RoE Earnings Earnings Earnings Earnings Earnings Earnings Earnings Earnings Earnings Est. Capital Est. Capital Est. Capital Est. Capital Est. Capital Est. Capital Est. Capital Est. Capital Est. Capital S.A.E Bank BoCom East Ltd.East HSBC HSBC Bank HSBC Bank HSBC HSBC Bank Co. Limited (China) Limited Hang Seng BankHang Malaysia BerhadMalaysia The Saudi British (Taiwan) Limited HSBC HSBC Bank Egypt Australia Limited Australia HSBC HSBC Bank Middle HSBC HSBC Bank (China) 9.2 1.2 90.0 11.1 87.0 11.2 83.2 10.5 79.0 10.0 12.8% 13.3% 13.1% 13.2% 13.5% ASIA/MENA Est. Est. Est. Est. Est. Capital Capital Capital Capital Capital Est RoE Est RoE Est RoE Est RoE Est RoE Earnings Earnings Earnings Earnings Earnings Corp. Limited
(UK) Limited (UK) HSBC HSBC Finance (Netherlands) Hang Seng BankHang The Hongkong & Shanghai Banking HSBC Holdings BV HSBC Holdings HSBC Asia Holdings HSBC Asia 0.4 0.0 0.9 1.4 0.4 0.0 0.7 0.5 3.0 3.0 6.5 0.5 1.7 0.1 -4.5 -0.1 -0.1 -0.1 N.A. N.A. 35.0 7.7% 7.9% 6.5% 4.0% -3.1% -3.1% 10.6% 75.3% -12.8% Est RoE Est RoE Est RoE Est RoE Est RoE Est RoE Est RoE Est RoE Est RoE Est RoE Earnings Earnings Earnings Earnings Earnings Earnings Earnings Earnings Earnings Earnings Est. Capital Est. Capital Est. Capital Est. Capital Est. Capital Est. Capital Est. Capital Est. Capital Est. Capital Est. Capital
plc (Turkey) HSBC HSBC UK Head office (Suisse) (Suisse) S.A. (Suisse) (Suisse) S.A. (UK) Limited (UK) HSBC HSBC France HSBC HSBC Private Burkhardt AG HSBC HSBC Bank A.S. HSBC CoHSBC Hold / Banking Holdings HSBC HSBC Bank Malta n and RoE. and n HSBC HSBC Trinkhaus & HSBC HSBC Private Bank M&S Retail Finance Retail M&S HSBC Asset Finance EUROPE 0.3 0.2 1.9 44.4 4.4% 61.5% 9.0 5.3% 170.8 Est RoE Est RoE Earnings Earnings Est. Capital Est. Capital plc. (UK) (UK) HSBC HSBC Invoice Finance HSBC HSBC Bank 3.9 0.4 4.6 1.0 0.3 -0.4 N.A. N.A. 19.8 9.0% 1.4% -8.0% Est. Capital Earnings Est RoE t returns is that is that capital 2016 t US$ bn making? returns estimates, Est. Est. Est. Est. Capital Capital Capital Capital Est RoE Est RoE Est RoE Est RoE Earnings Earnings Earnings N.A. (USA) Corporation HSBC HSBC Finance HSBC HSBC Securities HSBC Holdings PLC. HSBC HSBC Bank USA. HSBC HSBC Bank Canada
0.3 0.2 -0.1 -0.1 25.4 19.8 32.9 29.0 1.4% 0.6% -0.5% -0.5% ? NORTH AMERICA NORTH Est. Est. Est. Est. Capital Capital Capital Capital Est RoE Est RoE Est RoE Est RoE Earnings Earnings Earnings Earnings Inc. HSBC HSBC North HSBC USA Inc. HSBC USA HSBC HSBC Overseas (North America) America Holdings Holdings (UK) Ltd. (UK) Holdings HSBC HSBC Investments 0.5 0.1 0.5 3.4 0.3 8.6% 18.0% 18.0% Note HSBC UK doesn’t exist as a formal legal structure, but we show it here to demonstrate the UK business capitalconsumptio UKbusiness the to demonstrate it here show butwe structure, legal aas formal exist UKdoesn’t HSBC Note Est. Est. Est. Capital Capital Capital Est RoE Est RoE Est RoE Earnings Earnings 2.9 0.2 7.0% HSBC HSBC Latin America HSBC HSBC Bank Argentina Holdings (UK) Limited (UK) Holdings HSBC HSBC Latin America BV AMERICA here is the capital allocated capital is the here HSBC Capital Map 1: Where is equity allocated & wha allocated 1: is equity HSBC Where Capital Map Est.
Capital Est RoE LATIN Earnings : W Makes cost of capital Sub-cost of capital returns Potential for cost of capital returns 3 HSBC HSBC Mexico SA
KEY: Figure Figure
Source: Deutsche Bank, Company data & filings. filings. & data Company Bank, Deutsche Source: 1.
Page 6 Deutsche Bank AG/Hong Kong
31 August 2016 Banks HSBC Holdings Plc
81% 22% 227% 12.5% 15.0% 13.4% $0.1bn $0.1bn $1.2bn CET1 % CET1 % CET1 % CET1 Payout % Payout % Payout % Dividend u/sDividend u/sDividend u/sDividend
Ltd. The Saudi HSBC HSBC Bank HSBC HSBC Bank Egypt S.A.E Egypt Middle East British Bank N.A. N.A. 65% 61% 55% 14.1% 14.6% 14.7% $6.9bn $6.9bn $6.7bn $5.5bn CET1 % CET1 % CET1 % CET1 % CET1 Payout % Payout % Payout % Payout %
Dividend u/sDividend u/sDividend u/sDividend u/sDividend Corp. Limited HSBC Asia HSBC Asia HSBC HSBC Finance Holdings (UK) (UK) Holdings (Netherlands) The Hongkong & Shanghai Banking HSBC Holdings BV HSBC Holdings 0% 0% 0% 0% N.A N.A 59% 79% 74% 90% 46% N.A. N.A. 9.4% 8.7% 12.3% 34.1% 34.1% 14.9% 10.3% $0.1bn $0.0bn $0.0bn $0.3bn $0.1bn $0.0bn $0.0bn $0.4bn -$0.1bn -$4.5bn CET1 % CET1 % CET1 % CET1 % CET1 % CET1 CET1 % CET1 % CET1 % CET1 % CET1 % CET1 Payout % Payout % Payout % Payout % Payout % Payout % Payout % Payout % Payout % Payout % Dividend u/sDividend u/sDividend u/sDividend u/sDividend u/sDividend u/sDividend Dividend u/sDividend u/sDividend u/sDividend u/sDividend plc Limited Limited Finance (Turkey) M&S Retail Retail M&S HSBC Asset Head office (Suisse) (Suisse) S.A. HSBC HSBC France Finance (UK) Finance (UK) HSBC HSBC Private HSBC Private HSBC HSBC Invoice Burkhardt AG HSBC HSBC Bank A.S. HSBC CoHSBC Hold / Banking Holdings HSBC HSBC Bank Malta Bank (Suisse) S.A. HSBC HSBC Trinkhaus & 20% 9.9% t dividends / payout ratio should we expect? 2016 we expect? / payout t ratio should estimates dividends $0.4bn 96% 12.8% CET1 % CET1 $10.3bn Payout % Dividend u/sDividend plc. HSBC HSBC Bank 0% 44% 31% 10.5% 15.5% 16.5% $0.2bn $0.0bn $0.2bn CET1 % CET1 Payout % dividendCash + buyback CET1 % CET1 % CET1 % CET1 Payout % Payout % Payout % Dividend u/sDividend u/sDividend u/sDividend Ltd. Canada America Holdings HSBC HSBC Bank HSBC Holdings PLC. HSBC HSBC North Holdings (UK) (UK) Holdings HSBC HSBC Overseas 0% 0% N.A. N.A. 9.7% 1835% $0.0bn $0.0bn $5.4bn
CET1 % CET1 % CET1 CET1 % CET1 Payout % Payout % Payout % Dividend u/sDividend u/sDividend u/sDividend
0% 9.7% $0.0bn Argentina HSBC HSBC Latin HSBC HSBC Latin HSBC HSBC Bank America BV (UK) Limited (UK) America Holdings HSBC Capital Map 2: What level are subsidiaries capitalized at, and wha capitalizedand at, subsidiaries 2:are HSBC level What Capital Map CET1 % CET1
Payout % : Dividend u/sDividend ds, earnings and CET1 and % ds, earnings Undercapitalised Holdings vs. Holdings capitalised vs. Well Unknown / N.A. 4 SA HSBC HSBC Mexico Figure Figure
Source: Deutsche Bank estimates, company data company estimates, Bank Deutsche Source: Dividen group. the 2016 in which partsstream over/undercapitalized, shows around are figure dividend This the of and group the
Deutsche Bank AG/Hong Kong Page 7
31 August 2016 Banks HSBC Holdings Plc
53 428
4,235 6,768 2,500 2,732 6,737 9,951 5,715 3,553 2017e - - - - Hold co Hold 6.8 2.5 4.2 - - - 10.0 2017e 2017e
7.8 2.5 4.3
- - - 12.8
2016e 2016e Buybacks 155 439 4,303 7,785 2,500 5,247 6,940 8,478 1,807 2016e - - - - 6.5 4.5 12,781 7.6 - - 2015 2015 6.6 2.8 9.5 - - 2014 2014
0 6.4 2.2 9.7 - - 90 2013 HSBC France HSBC Trinkaus & Burkhardt AG (80.7%) 260 2013 2015 4,545 6,548 5,962 1,307 7,619 3,074 3,474 - - - 5.0 1.8 7.7 - - 2012
2012 4.7 1.9 7.8 - - 2011 2011 Cash dividendsCash paid out (net scrip) of
0 , company data , company data 611 367 130 158 3.4 1.1 6.9 - - 2014 2010 2,773 6, 6,424 2,622 9,542 6,769 - - 2010 3.7 1.0 : Europe: capital upstream/downstream capital Europe: : 1.7 - - 2009 : Net capital upstream / downstream downstream / upstream capital Net : 7 2009 10 5 0 5 -
10 15 10 15 20
- - - 0 US$ bn US$ 0 Net capitalNet upstream HSBC Bank Plc. HSBC Malta (70%) 2,000 4,000 6,000 4,000 2,000 173 396 - - - Figure Figure Figure Figure 2013 Source: Deutsche Bank estimates 2,243 6,414 6,397 3,127 9,747 7,504 1,090 Source: Deutsche Bank estimates - -
10 2017e
0 889 394 223 2012 1,754 5,040 2,668 4,398 7,683 5,929
US$ billions US$ 6 - - 2016e 2 2015
2 - 0 2014 353 526 2011 1,852 4,696 4,145 2,750 7,774 5,922 1,226 - - 6 -
…
2013 HSBC North America HSBC NorthAmerica holdings Asia Latam Europe
2012 Buybacks
0 North America North 342 239 2010 2011 1,122 3,413 3,628 2,705 6,913 5,791 2,378 - -
, company data 2010 HSBC Bank Canada AT1 security AT1 coupons (cash) Bank (nolevy tax shield, USD) Hold Co Preference share Preference Co (cash) Hold : 2017e capital walk capital 2017e : : USA: capital upstream/downstream capital USA: : Hold Co Holdunderlyingoperating loss
6 9 2009
0 Cash dividendsCash paid out (net scrip) of
978 788 739 322
- -
2009 ution Hold Co Hold Upstream 2,873 3,700 0 5,057 1,717 2,961 - - -
500 Distrib 1,500 1,000 3,000 2,500 2,000 Figure Figure Figure Source: Deutsche Bank estimates Source: Deutsche Bank estimates
12 2017e
US$ billions US$ 8 2016e
run history of cash flows around group the flows around run ofhistory cash - 4 2015 2017e - 0 2014 2009 4 - … 2013
Asia
Latam Europe
2012 Buybacks
North America North 2011
, company data 2010 estimates
The Saudi British SaudiBritish The Bank (own 40%) Bank East HSBC Middle Limited HongKongThe Shanghai Banking Corporation Limited HSBC Bank EgyptS.A.E AT1 security AT1 coupons (cash)
Bank levy (nolevy taxBank shield, USD)
: Cash flow summary summary flow Cash : a
Hold Co Preference Co HoldPreference share (cash) : Asia: capital upstream / downstream / upstream capital Asia: : : 2016e capital walk capital 2016e : 2009 Hold Co Holdunderlyingoperating loss 11 8 5
Cash dividendsCash paid out (net scrip) of
0
ution Hold Co Hold
Upstream ure
Distrib 1,000 3,000 2,000 1,000 7,000 6,000 5,000 4,000 - Figure Figure Fig Figure Figure
Cash dividends paid out (net of scrip) of (net out dividendspaid Cash Buybacks cash usage Net estimates Bank Deutsche Source: Total upstreamTotal Holdcost Co dividend cash pre positionNet North Americ North Latam Asia Europe USD’m Source: Deutsche Bank Source: Deutsche Bank estimates long + 2016ecapital walks 2017e &
Page 8 Deutsche Bank AG/Hong Kong
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Banks
HSBC Holdings Plc
2. Prospects for future capital distribution
As we have stressed before, to pay a dividend (or undertake a share buyback) HSBC has to have the cash at the Holding company level. Therefore to understand the sustainability of the dividend and potential for future capital return we need to understand the cash flows that can be paid up from the operating company level up to the Holding company. Below we summarize this on a geographic basis as per our “capital map” which helps highlight many of the key issues the group faces (more detailed explanations for each geography can be found in the main body of this report).
Asia/MENA: The centre of group economic profit creation Asia remains at the heart of the HSBC group both strategically and from an We believe that dividends economic profit perspective. If we include MENA alongside Asia then paid to the group from combined these 2 regions now represent about 50% of group capital and well Asia/MENA are able to fund over 100% of group economic profit. Whilst these geographies seems unlikely c75-85% of the group cash to grow profits significantly over the next 2-3 years (it is at its core a dividend payout on a US$ linked liability driven franchise operating in markets where at the moment there is limited demand for US$ borrowing), they may generate a lot of free sustainable basis. cash flow that can be paid up to the group. We would highlight the following issues that are relevant to the group capital/dividend debate in an Asia/MENA context…
We believe that dividends paid to the group from Asia/MENA will be able to fund c75-85% of the group cash dividend payout on a sustainable basis. At the core of this is HBAP which now has a 14.8% CET1 capital ratio (up from 10.5% at YE13) and currently limited RWA growth
A change in the treatment of BoCom can potentially boost group CET1 significantly. Currently the capital treatment of the group’s 19% stake in Bank of Communications is different at a group level vs. at the HBAP operating company level. Aligning the Holding Company to the methodology used at the HBAP level could add at least 25-30bps to the group CET1 capital ratio, but potentially as much as 50-60bps. This is meaningful given the group is already operating in the top half of its 12- 13% target CET1 range.
Placing a conservative multiple on the group’s Asian/MENA operating companies (1.2x book, 9x FY16E P/E; or clean (ex-any central allocations) 1.3x book, 10x FY16E) reveals they contribute 75-80% of group market cap. Squeezing more value out of here on a 1-2 year timeframe looks challenging given the economic backdrop. The challenge is therefore to improve returns on the capital the group has outside of Asia/MENA. North America: Moving on from a decade of value destruction The story in HSBC North American over the next 2-3 years is more about The story in HSBC North freeing up capital from underperforming businesses rather than dividends paid American is more about out of sustainable earnings stream. We would make the following freeing up capital from observations: underperforming businesses rather than dividends paid out The group still has cUS$33bn of capital allocated to its North American operating companies (c20% of group total), these we expect to make just of sustainable earnings a 1% RoE this year. Within this we believe perhaps just cUS$6bn of capital stream is currently making its cost of capital (HSBC Canada + Commercial
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banking in the US). So US$25-26bn of capital is making little if any return, this is clearly not acceptable.
The profitability problem seems structural rather than cyclical in the US, so unless strategy changes returns are likely to remain depressed. Our analysis raises 2 issues: Firstly the US retail business continues to struggle. A return analysis relative to domestic US peers seems to suggest this is a least in part due to business mix, HSBC simply does not want to offer the higher yielding products that generate higher returns at peers (e.g. student loans, auto loans & other types of unsecured consumer credit). So even with US rate rises it is hard to see HSBC ever really being competitive in the US retail banking space given its now limited scale. Secondly is the size of the GBM balance sheet in the US. We appreciate that there may be a degree of capital in the US subsidizing other geographies. However these “global synergies” should also be evident in the US. If GBM genuinely had a competitive global footprint it should be booking revenues in the US for Asian and European corporate, but there is limited if any evidence of this. We continue to believe the scope & scale of capital HSBC has allocated to North America is sub-optimal for shareholders & needs to be revisited.
The recent positive CCAR result for HSBC in the US means that we are hopeful that capital can be stripped out of this market above and beyond the excess capital at the North American Holdings level. We appreciate that HSBC needs to be in the US (as a large US$ clearing bank) but a further streamlining of business lines and reduction in capital allocated may be required. This can be achieved via a number of means e.g. organically shrinking the balance sheet, further sales/disposals (e.g. the US retail/commercial bank, HSBC Canada & even HSBC Mexico) or partnering with a US regional bank who can better leverage HSBC’s existing footprint. All of these options need to be more openly discussed. Note that to give an idea of the upside potential in the US we are currently valuing the US$20bn of capital tied up within the HSBC USA Inc operating company at just 0.3x book value. If the group can get the market to value this at book value then this is equivalent to an extra 55p on the share price (HK$5.5), c10% of the current group market cap.
Europe: a mixed bag HSBC’s European business (which is typically distorted in group accounts due The European operating to the inclusion of Hold Co costs in the region) represents a mixed bag, with companies within the HSBC limited prospects for capital return in the next 3 years in our opinion. There are group still consume c25-30% high quality capital generative businesses within it: UK Retail for example, we of group capital. We see estimate has an underlying ROTE of c.20%. HSBC France’s RoE is sub-COE, limited prospects for any but despite its limited scale performance has been in line with French large- capital return from these cap peers, and it has upstreamed some 70% of its equity base over 10 years in businesses in the next 3 dividends. years.
However, Europe is also the location of the majority of below-the-line charges (conduct costs, fines, restructuring charges); where risk of RWA inflation is higher (just 4% RW for UK mortgages, if this goes to 10%, RoE of UK retail falls around half); CET1 ratio is lower (9.6% for Bank plc) with ring-fencing to follow; and includes Turkey (which HSBC failed to sell) – an ROE drag and likely require additional equity in coming years.
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Figure 12: Net upstream (downstream) from Europe Figure 13: Capital requirements (pre management buffer) (USD) 14% 5,000 4,398 4,000 12% 2,7052,750 3,000 2,3942,267 2,454 10% 1,688 2,000 1,5221,307 8% 804 1,000 439 428 6% 0 4% -1,000 -182 2% -2,000 0% -3,000 2016 2017 2018 2019 2016 2017 2018 2019 2016 2017 2018 2019 -2,873
-4,000 HSBC Holdings plc HSBC Bank plc HSBC UK Ring Fence
FY12 FY13 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY14 FY15
FY16e FY17e FY18e
Pillar 1 Pillar 2A G-SIB / Systemic Risk Buffer CCoB CCyB Implied PRA buffer 2Q16 CET1 ratio Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates
We estimate HSBC’s UK ring fenced bank will need a minimum 9.3% CET1 in 2019 (pre management / regulatory buffers), which means HSBC Bank needs to build to c.11% CET1 (around an additional US$2.7-5.7bn of capital) over 2.5 years for compliance.
We expect US$4-4.5bn (£3-3.5bn) of additional below-the-line charges in the coming 3 years to be booked in Europe (PPI, fines, CTA, ring-fence costs) or c.US$3-3.5bn post-tax.
Potentially US$100-200m of capital for recapitalizing the Turkish subsidiary.
Combining with 2% RWA growth per annum this gives total capital consumption over the next 2.5 years of US$7bn-11bn or US$3- 4.4bn/annum.
Last year the European “Bank” generated underlying earnings of £3bn (before one-offs) or US$4.5bn – representing an adjusted RoE of 8.9%. But 1H16 performance was weaker (lower income, higher impairments, new higher tax rate in UK, 7% u/l ROE). We expect u/l earnings to fall in 2016 and 2017 before recovering to similar levels of 2015 in 2018 (but on a higher capital base, hence an underlying RoE of 8%).
Lower earnings and greater capital build also means lower dividends, which we expect to total just US$1.2bn over 2H16-2018e from the European operating companies (vs. US$5bn in the last 3 years).
Placing a conservative multiple on the group’s European businesses (0.7x book, 8x FY17E P/E) reveals they contribute 20% of the market cap. We expect HSBC Bank plc (the main part of ‘Europe’) to generate 7-8% underlying RoE in the next 3 years (9% in FY15), but stated RoE is likely to be half that level in 2016/17 due to below the line charges.
Upside opportunities could come from: 1) reducing the size / duration of one- off items; 2) lower costs: 66% underlying cost/income ratio in 2016e is too high, 964 branches in UK alone; or 3) improving income generation, particularly non-interest income (around 45% of income, middle-of-the-pack in Europe despite GBM / GPB / higher affluent customer base).
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The cost of “being HSBC”: Assessing Holding Co. costs…
The logic of HSBC is that the different operating companies around the world create a synergistic benefit for clients who value the group’s geographic “connectivity”. The additional revenues generated from this “connectivity” needs to be sufficient to offset both the cost of running the group Holding company and also the RoE drag from capital trapped in geographies that are making sub-cost of capital returns but are viewed as essential to creating the positive “network effect” (for example the US).
We believe our Capital Map helps to identify the geographies where capital is allocated and making a sub-par return. It also we believe helps throw some light on the drag from the cost of “running HSBC”, i.e. the costs associated with the holding company. What we term as the cost of “being HSBC” is the sum of these two drags on shareholder value that needs to be offset by incremental revenues generated by the network effect. To justify a pan- regional strategy such as HSBC’s the latter has to comfortably outweigh the former. At present we believe the evidence is not supportive that this is now the case given how far the regulatory goal posts have moved in recent years.
Hold Co costs around US$4.5bn A key element of the cost of “being HSBC” equation that is often ignored by the market is the significant cost of running the group holding company. HSBC Holdings has 4 principal subsidiaries (North America, Latam, Europe (Bank plc) and Asia (Finance) which form the consolidated group. However, HSBC Holdings earnings do not equal the sum of the earnings of subsidiaries, and neither do the dividends which are up-streamed to it match the dividends which are paid out. This is due to the cost of the Hold Co, which includes funding/financing costs, AT1 issuance costs (below the line), bank levy, and operating expenses for the hold co/head office.
We estimate the adjusted loss after tax in 2015 for Hold Co (i.e. after one-off / volatile items like own credit) was US$4.5bn. This is made up of a bank levy of US$1.4bn, US$1bn of AT1 & preference share coupons, and an underlying pre- tax operating loss of US$2.8bn. The cost of the hold co has increased considerably, driven by bank levy, AT1 and regulatory/compliance costs. It now represents an RoE/RoTE drag of 2.5-3% on the group, and we expect this drag to remain in the coming years (bank levy reduces materially from 2021).
Figure 14: Breakdown of Hold Co forecasts Figure 15: Hold Co RoE 2,000 0.0% 1,000 -0.5% 0 -1.0% -1,000 -2,000 -1.5% -1.3% -1.5% -3,000 -1.6% -2.0% -1.9% -4,000 -2.5% -5,000 -2.5% -2.6% -2.6% -2.5% o/w Bank o/w Adjusted Tax shield AT1 Hold Co Adjusted -3.0% levy Underlying PBT security Preference earnings -2.9% -3.1% -3.0% -3.0% loss coupons share -3.5% (cash) (cash) 2013 2014 2015 2016e 2017e 2018e
2013 2014 2015 2016e 2017e 2018e RoE drag RoTE drag
Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data
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In effect, a decent portion of Hold Co cost represents the cost of “being HSBC” – bank levy, higher capital requirements (and AT1), and compliance spend are the cost of being a global interconnected institution. For the HSBC Holdings business model to be justified and sustainable in the long-run, the revenues and profits generated from the ‘value of the international network’ need to outweigh this Hold Co cost - and capital requirements that go with it. At present it is difficult to see how they do.
Conclusions: let’s not get carried away
Bottom-up valuation Our bottom up valuation of the component entities of HSBC (Figure 16, more detail within the report) indicates a value of around 531p / HK$54 for the businesses, around 4% below the current share price. Note we use ‘clean’ valuation for the component businesses which exclude any allocated Hold co costs (given we have Hold Co separately in this table).
Figure 16: Bottom-up valuation of components (ex dividends / buybacks) Equity P/B Value Per share Per share Per share (US$, bn) (US$, bn) USD HKD GBP Asia + MENA 85.7 1.3 102.5 5.90 45.8 4.50 US + CAD 32.9 0.5 16.5 0.84 6.6 0.64 Europe + Switzerland 47.4 0.7 36.1 1.62 12.6 1.24 Latam 3.4 1.3 4.4 0.23 1.8 0.17 Hold Co N.A. -36.0 -1.63 -12.7 -1.25 Total 171.0 0.8 136.1 6.95 53.9 5.31 Source: Deutsche Bank estimates, company data. Assumes 1.3x book for Latam, US$2.5bn for Swiss private banking business
Buyback in 2016, another likely in 2017. But not sustainable HSBC’s decision to launch a US$2.5bn buyback following completion of Brazil sale took to the market by surprise at interim results. We see further potential for US$2.5bn of upstreamed capital from North America Holdings during 2017 (worth c.10GBp / HK$1 per share if used as a buyback). However, beyond these two transactions, we see no low-hanging fruit in the group to fund the next buyback or a return to dividend growth. Asia remains very much the core driver of profitability, dividends (Figure 17) and thus valuation – but the rest of the group is still underperforming.
Figure 17: Net capital upstream 2016+17 Figure 18: Cash flow of HSBC Holdings 16,000 15 13,677
14,000 10 US$ US$ bn 12.8 12,000 5 9.7 9.5 10.0 6.9 7.8 7.7 7.6 10,000 0 1.7 -1.0 -1.1 -1.9 -1.8 -2.2 -2.8 -4.5 -4.3 -4.2 8,000 -3.7 -3.4 -5 -4.7 -5.0 -6.4 -6.6 6,000 5,300 -6.5 -7.8 -6.8 -10 -2.5 4,000 2,887 -2.5 -15 2,000 868 -20 0 2009 2010 2011 2012 2013 2014 2015 2016e 2017e North America Latam Asia Europe Net capital upstream Hold co Cash dividends paid out (net of scrip) Buybacks
Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates
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US offers the most realistic opportunity for improvement For an increase in distribution, we need to see a meaningful improvement in returns for Europe and/or the US. Too much capital in the group is currently tied up in low RoE businesses. Of the two geographies, the US offers the most near-term potential via stripping additional capital out of the US bank above and beyond the current excess held at the North America Holding company level. Unfortunately the European business faces headwinds of restructuring, a lower-interest rate environment (which we see as the key risk for European banks), and a need to increase capital resources over the next 3-4 years.
The cost of “being HSBC” raises existential questions for the group The estimated US$4.5bn annual bill for Hold Co that we estimate in this report plus the capital trapped making sub-par returns in subsidiaries to generate the “network effect” raises more fundamental questions for HSBC. Unless this bill comes down meaningfully in the coming years, or “network” related revenues increase, it remains a considerable drag on group returns, and thus valuation.
It may not be the right moment for HSBC to consider a wholesale breakup of the group into 3-4 separate companies – some Hold Co / central costs would undoubtedly trickle down into the separate business. Indeed there may never be a perfect time, given the risks and frictional costs involved. However, we struggle to think of a time in recent history when the case for a breakup of HSBC has been stronger.
HSBC Holdings was not built for a world of global compliance standards, sustained low-interest rates, and higher capital requirements & costs for larger banks. It is symbolic that HSBC, a bank which has throughout its history pointed to the growth opportunities in its footprint, has chosen now to begin a return of capital rather than re-deployment to growth within the group. Deleveraging may have ended, but growth remains tepid. For HSBC to justify its business model we think it needs to better demonstrate that the “value of the international network” more than offsets the cost of “being HSBC”. The benefits of the network need to exceed the drag of Hold Co for investors to justify paying any premium. Currently this is not obviously the case.
Disclosure wish-list Constructing our “Capital Map” and writing this report has involved looking at a large volume of subsidiary disclosures, many of which are listed on HSBC’s websites or available from Companies House. However, there are additional disclosures which we think would aid investors in understanding the group structure and dividend outlook:
A published P&L for the Hold Co / Head office which gives a breakdown of revenues / cost items. This would be helpful for tracking and forecasting the cost of “being HSBC”. The ‘Other’ division in consolidated accounts at present is difficult to forecast and is not explicitly the cost of the Hold Co.
A full balance sheet of United Kingdom business + Pillar 2A disclosures for Bank plc (and UK ring-fenced entity when it is created). Other companies with UK subsidiaries (e.g. Santander UK) already disclose the Pillar 2A.
Annual cash flow disclosure summary which indicates the flow of cash from / to subsidiaries in the group. Holdings has a separate balance sheet / cash flow but this doesn’t show the source at present.
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Forecast changes
Our forecast changes are shown below. We have increased AT1 costs, given recently completed issuance of an 8th AT1 security, revised up revenues by c.1%, and reduced LLPs slightly. Overall this represents an increase in earnings of 3-5% over the forecast period, and higher on EPS due to buybacks / lower sharecount.
Figure 19: Forecast changes
OLD FORECASTS NEW FORECASTS CHANGES (£m) CHANGES (%) 2015e 2016e 2017e 2018e 2015e 2016e 2017e 2018e 2015e 2016e 2017e 2018e 2015e 2016e 2017e 2018e NII 32,531 30,844 29,203 29,746 32,531 30,844 29,203 29,746 0 0 0 0 0% 0% 0% 0% OOI 27,308 22,391 23,472 24,007 27,308 22,739 23,821 24,363 0 348 349 356 0% 2% 1% 1% Total income 59,839 53,235 52,675 53,753 59,839 53,584 53,024 54,109 0 348 349 356 0% 1% 1% 1% Opex -39,807 -37,912 -34,450 -30,772 -39,807 -37,562 -34,441 -30,711 0 350 8 61 0% -1% 0% 0% PPP 20,032 15,323 18,225 22,980 20,032 16,022 18,583 23,398 0 698 358 417 0% 5% 2% 2% LLPs -3,721 -4,235 -3,849 -3,990 -3,721 -4,142 -3,704 -3,676 0 93 145 315 0% -2% -4% -8% Underlying PBT 16,311 11,088 14,377 18,990 16,311 11,879 14,879 19,722 0 791 502 732 0% 7% 3% 4% Associates 2,556 2,489 2,498 2,498 2,556 2,489 2,498 2,498 0 0 0 0 0% 0% 0% 0% Stated PBT 18,867 13,577 16,875 21,488 18,867 14,368 17,377 22,220 0 791 502 732 0% 6% 3% 3% Tax / Minorities / AT1 -6,295 -5,515 -6,641 -7,875 -6,295 -5,793 -6,912 -8,206 0 -278 -272 -331 0% 5% 4% 4% Earnings 12,572 8,062 10,234 13,614 12,572 8,575 10,465 14,014 0 514 231 401 0% 6% 2% 3% Adjusted earnings 13,198 11,582 12,639 13,614 13,198 12,170 13,055 14,162 0 588 416 549 0% 5% 3% 4%
EPS stated (US$c) 64 41 52 68 64 44 54 71 0.0 2.6 1.8 4.0 0% 6% 3% 6% EPS adjusted (US$c) 68 59 64 68 68 62 67 72 0.0 3.0 2.9 4.7 0% 5% 4% 7% DPS (US$c) 51 51 51 51 51 51 51 51 0.0 0.0 0.0 0.0 0% 0% 0% 0% BVPS (US$c) 873 880 881 897 873 882 893 918 0.0 1.7 11.9 20.8 0% 0% 1% 2% TBVPS (US$c) 748 767 770 789 748 769 780 806 0.0 1.8 9.2 17.3 0% 0% 1% 2%
Divisional PBT 2015e 2016e 2015e 2016e 2015e 2016e 2015e 2016e 2014 2015e 2016e 2017e 2014 2015e 2016e 2017e RB&WM 4,967 4,833 6,127 6,982 4,967 4,833 6,127 6,982 0 0 0 0 0% 0% 0% 0% Commercial Banking 7,973 8,120 8,252 8,499 7,973 8,219 8,562 8,968 0 99 309 469 0% 1% 4% 6% GB&M 7,910 6,788 7,383 8,038 7,910 7,580 7,726 8,388 0 792 343 350 0% 12% 5% 4% GPB 344 -343 386 428 344 -343 486 541 0 0 100 113 0% 0% 26% 26% Other -2,327 -5,821 -5,274 -2,460 -2,327 -5,921 -5,524 -2,660 0 -100 -250 -200 0% 2% 5% 8% Total 18,867 13,577 16,875 21,488 18,867 14,368 17,377 22,220 0 791 502 732 0% 6% 3% 3% Source: Deutsche Bank estimates, company data.
This leaves HSBC trading at 10.8x 2017 earnings, 0.9x TNAV, 0.8x NAV for a running cash dividend yield of c.5%. This compares with the European average of 9.6x 2017 EPS, 0.8x TNAV, 0.7x NAV and 5-6% dividend yield; and an Asia average of 1.2x NAV and 9.1x 1-yr forward earnings.
Valuation & risks
We use two methodologies to value HSBC: Sum-of-the-parts (SoTP, shown below) and Dividend-Discount-Model (DDM); our 12-month target price is the average of the two. We assume 10% cost of equity and a 0% growth rate. For the SoTP, we use 2018e bank earnings (previously 2017e), and then value each business division based on our assessment of appropriate clean P/E multiples. We also apply a conglomerate discount of 10%, and include an NPV of below- the-line items out to 2018, and time value of money to convert our 2018E SOTP to a 12 month target.
Our TP rises from 51.3HKD to 53HKD, which is 5% below the current price (56HKD). Rating remains Hold.
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Figure 20: HSBC SoTP Net Average Ave P/E P/TNAV Value Value per profit RWAs allocated (USD'm) share (2018E) (USD'm TNAV (USD) 2018E) (USD'm) 2018E RBWM 5,167 170,770 25,982 9.0x 1.8 46,503 238.6 Commercial Banking 6,636 420,068 63,913 8.7x 0.9 57,737 296.3 GBM 6,207 375,836 57,183 8.0x 0.9 49,656 254.8 GPB 401 18,778 2,857 11.0x 1.5 4,406 22.6 Other -1,820 36,778 5,596 7.0x -2.3 -12,742 -65.4 HSBC Group 16,591 1,022,230 155,531 8.8 0.9 145,560 746.9 Minus Minorities and hybrids -2,429 8.8x -21,308 -109.3 NPV of non-operating items -148 -7,547 -38.7 Total FV 14,014 155,531 8.3 0.8 116,705 599 Less conglomerate discount 10% -11,671 -59.9 FV net 105,035 539.0 12-month target (USD) 612.2 12-month target (HK$) 47.5 Source: Deutsche Bank estimates
Key upside risks are an improvement in Emerging Markets outlook, lower- than-expected loan losses, better-than-expected outcomes for regulation, lower costs, and better than expected distributions / buybacks. Key downside risks relate to regulatory change, legacy liabilities, a slowdown in emerging markets, and a sustained low interest rate environment.
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HSBC Asia
The centre of group economic profit generation
Asia remains the jewel in the crown of the HSBC group and at its heart is its fully owned operating company The Hong Kong Shanghai Banking Corporation Ltd. (HBAP). Whilst growth here has slowed over the last 1-2 years and the capital it is required to hold has increased (the HKMA is a prudent regulator) we believe this subsidiary still generates over 100% of the economic profit generated by the group. On a clean basis HBAP has consistently been generating US$13-14bn of PBT in recent years, roughly what we expect it to report again in 2016. The bulk of the profitability still comes from its dominant position in the HK market (via both its 62% ownership of Hang Seng Bank and HSBC Hong Kong).
Figure 21: HBAP PBT split between HK and Rest of Asia Figure 22: Estimated split of Asian PBT by country Pac 16,000 Tawian, 1% Other, 6% 14,000 Sing., 4% 12,000 Malay., 3% 10,000 China, 6% 8,000
6,000 HK, 58% BoCom, 14% 4,000
2,000
0 Indo., 1% India, 5% Australia, 2% Rest of Asia Hong Kong
Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data
An end of de-leveraging approaching in Asia as well HSBC in Asia has not been immune to rising global capital standards and like the HSBC group the HBAP balance sheet has seen a significant increase in capital ratios over the past 3-5 years. From a tangible equity to assets perspective this has now increased to a little over 8%, the highest level seen in over 25 years (well above levels seen heading into the GFC or Asian crisis). On an end-point CET1 capital perspective HBAP finished H1 16 at an impressive 14.8%. This is however off a low RWA/Assets ratio of just 34-35% reflecting the Asian franchises relative low loan to deposit ratio of just 58% (49.5% in HK). We believe the Asian business is at risk of seeing some RWA inflation over the next 2-3 and would expect the group to want to run HBAP’s CET1 ratio in the 14-15% range until the fog finally lifts from the shifting regulatory capital back drop. The good news however is that we now believe that the CET1 capital ratio of HBAP is in the appropriate range. Given the relatively weak RWA growth outlook in the region at present this means that excess capital can be dividend up to holdings to fund a large proportion of the group’s annual dividend burden.
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Figure 23: HBAP tangible equity to assets ratio Figure 24: HBAP CET1 capital ratio Vs RWA/Assets ratio 9.0% 45.0% 16.0% 8.0% 40.0% 14.0%
7.0% 35.0% 12.0% 6.0% 30.0% 10.0% 5.0% 25.0% 8.0% 4.0% 20.0% 6.0% 3.0% 15.0% 4.0% 2.0% 10.0% 5.0% 2.0% 1.0% 0.0% 0.0% 0.0% 2010 2011 2012 2013 2014 2015 2016E
CET1 Captial ratio RWA/Assets Source: Deutsche Bank estimates, company data Source: Deutsche Bank, company data
The significant increase in capital requirements has weighed heavily on HBAP’s reported RoE which on a clean basis we estimate is still a respectable 14-15%. Breaking this down further HK we believe still dominates as a result of its markedly profitable retail and commercial banking businesses in that market (c75% of HK PBT). HK we estimate is still delivering an impressive 16- 17% RoE whilst the rest of Asia is most likely 10-11%. As you would expect, the decline in RoA has been much less significant and HBAP RoA has averaged around 1.0% for the 7-8 years since the GFC when US rates dropped to zero. Note we show the RoA below adjusted for the BoCom associate income. HSBC owns a 19% stake in BoCom and accounts for it as an associate which means it books 19% of BoCom reported net profit on a post-tax basis through the P&L. From a cash perspective it only receives the dividend (a c20% payout ratio) so we often chose to adjust earnings onto a “cash basis”, especially when considering the scope to pay dividends up to the group.
Figure 25: HBAP clean RoTE & RoTE ex-associates Figure 26: HBAP Clean RoA & RoA ex-associates
Clean RoTE Clean RoTE ex-associates Clean RoA Clean RoA ex-associates 1.80% 50.0% 1.60% 45.0% 1.40% 40.0% 35.0% 1.20% 30.0% 1.00% 25.0% 0.80% 20.0% 0.60% 15.0% 0.40% 10.0% 0.20% 5.0% 0.00% 0.0%
Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data
Lack of volume growth means strong cash returns to the group Volume growth in HK and indeed around Asia has slumped over the past 1-2 years. This is especially true for the US$ funding hubs of HK and Singapore which are core parts of the HSBC franchise in the region. This has led to very subdued growth in RWAs and limited opportunities to put incremental capital to work at attractive returns. Whilst the RMB continues to weaken relative to
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the US$ we do not expect this outlook to change dramatically so expect HBAP to be in a position where it is generating significant excess capital over the next 1-2 years. We believe HSBC group subsidiaries are typically asked to payout 60-70% of earning to the group via dividends. If we use a number towards to top end of this range for HBAP for the next 1-2 years then we think it can upstream US$5.5-6.5bn a year to the group holding company and still maintain a CET1 capital ratio in the 14-15% range. Note when assessing this dividend paying capability we have assumed a reasonably challenging revenue operating environment encompassing low single digit volume growth, no US rate rises and a rise in the HBAP loan impairment charge to above a cyclical average.
Figure 27: HBAP loan impairment charge Figure 28: HBAP loan impairment charge split between HK and the Rest of Asia Pac
2.00% 4.00% HK Rest of APAC 3.50% 1.50% 20yr average = 3.00% 45-50bps 2.50%
1.00% 2.00%
1.50%
0.50% 1.00%
0.50%
0.00% 0.00% 1997 2000 2003 2006 2009 2012 2015 1997 2000 2003 2006 2009 2012 2015 -0.50% -0.50% -1.00% Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data
Figure 29: HSBC Asia loan book split by geography Figure 30: HSBC Asia loan book split by type of loan (H1 16) (H1 16) Others Taiwan 7% 3% Sing Other Mortgages 7% Corporate 27% Malaysia 43% 4%
China HK 10% 60% Indo. 1% Other personal India 11% 3% Australia 5% Property related 19% Source: Company data Source: Company data
In the table below we show our estimate for the cash dividend paying capability of each of the operating companies and associate holdings that consolidate in to “HSBC Holdings BV” in our capital map for the group. This essentially captures the dividend flows from all of the businesses in Asia and MENA. In addition to HBAP the other meaningful business is HSBC Bank Middle East. This business is currently repositioning its balance sheet and according to its H1 16 accounts paid a US$ 900mn dividend up to the group in H1 16 (including a US$500mn special dividend). This is over distributing
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relative to the business’s sustainable earnings stream so we see this dropping back to a more sustainable level over the next 12-18 months. We also include the dividend from the group’s 40% share on the Saudi British Bank (SABB) and also a dividend from the group’s business in Egypt. Combined we see a US$ 6.5-7.0bn sustainable dividend stream coming out of Asia and MENA combined.
To put this in to context at a group level based on a stable dividend of 51cents We estimate that HSBC’s and the group share count as of the end of H1 16 of 19,813mn shares the Asian and MENA operating gross group dividend burden is equivalent to US$10.1bn a year. However the companies & associates can group typically has a large scrip take up each year that is normally between fund 75-85% of the group’s 20-30% (although we note it was a little lower this year). This lowers the cash current cash dividend burden payout to roughly US$7-8bn a year. Based on this simple math and our modeling of the sustainable cash dividend paying capability of the Asian and MENA operating companies we estimate that Asia/MENA combined can fund 75-85% of the HSBC group cash dividend burden for 2016-17.
Figure 31: Forecast cash dividends paid up to group from Asia/MENA 2013 2014 2015 2016E 2017E Hong Kong Shanghai Banking Corp. 6,065 5,516 4,742 5,486 6,202 HSBC Bank Middle East 165 725 826 1,205 300 The Saudi British Bank 107 111 191 106 110 HSBC Bank Egypt S.A.E. 60 71 203 143 100 Total paid to HSBC Holdings BV. 6,397 6,424 5,962 6,940 6,712 Source: Deutsche Bank estimates, company data
Figure 32: Assessing cash dividends that can be paid from HSBC’s Asia/MENA operating companies up to the group holding company (FY 16E)
US$c6.9bn cash dividend paid to group
Est. Est. 0.8 US$c100mn 87.0 HSBC Bank Capital HSBC Capital Egypt S.A.E Holdings BV Est RoE 21.4% Est RoE 13.3%
Est. US$c6.8bn 3.0 US$c110mn The Saudi Capital British Bank Est RoE 15.3%
Est. Est. Est. HSBC Bank 4.2 US$c1.2bn HSBC Asia 83.2 US$c5.5bn The Hongkong 79.0 Capital Capital Capital Middle East Holdings & Shanghai Ltd. Est RoE 12.6% (UK) Limited Est RoE 13.1% Banking Corp. Est RoE 13.2%
Source: Deutsche Bank estimates
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A capital boost from changing regulatory capital treatment of BoCom? One final aspect relating to the group’s capital position that is worth We estimate a shift in the mentioning is a potential shift in how the group accounts for its 19% holding in regulatory accounting policy Bank of Communications (BoCom) from a regulatory capital perspective. for the group stake in BoCom Currently at a group level we believe the group includes its share of BoCom’s could result in at least a 25- RWAs that it owns (i.e. 19%) in the denominator of its CET1 ratio and the 30bps uplift in the group associate stake at its carrying value in the numerator. This we estimate implicitly now gives the BoCom stake a 10.5-11% CET1, i.e. lower than the CET1 capital ratio but perhaps group as a whole so it is now a drag on tier 1 capital. much more
Figure 33: Estimated BoCom RWAs as a percentage of Figure 34: BoCom carrying value of HSBC Group balance HSBC group RWAs sheet (US$mn) 16.0% 18,000 16,000 14.0% 14,000 12.0% 12,000 10.0% 10,000 8.0% 8,000 6.0% 6,000 4.0% 4,000 2.0% 2,000 0.0% 0
Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data
At the HBAP level however the treatment is different. Instead nothing related to BoCom is included in RWAs and alternatively the associate holding in BoCom is deducted from CET1 capital (subject to a threshold CET1 inclusion limit for holdings in other financial corporations). Given that in theory the maximum capital HSBC can lose on its BoCom investment is the value it holds it at on the balance sheet if the group moves to adopt a similar approach to that used by HBAP we estimate CET1 capital at a group level could improve by at least 25-30bps. This assumes a full deduction of the capital the group has invested in BoCom from CET1 capital. In reality it may be able to include some of the capital in BoCom up to a threshold limited (expressed as a % of CET1) so the CET1 uplift could actually be more significant, 50-60bps is not an unreasonable assumption.
Interestingly even if we take just a 25-30bps impact this is equivalent to cUS$2.5-3.0bn of capital which is roughly similar to the size of the announced buyback (note we do not view the two as related but it indicates that such a change in accounting policy could be meaningful).
Valuing Asia/MENA on a “Standalone” basis As our “Capital map” for HSBC shows it is really only the operating companies The group equity allocated to in Asia and MENA that currently make their cost of capital on a regular and Asia and MENA has steadily sustainable basis. From a capital allocation perspective we estimate that these increased in recent years to businesses represent about US$85-90bn of the group’s reported equity and stand at c50% of group total made a 14-15% RoE last year that we see dropping to 13-14% this year. These today are still impressive returns given the prevailing ultra low US$ interest rate environment given HBAP is still largely a low cost of funds liability driven
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franchise. The capital allocated to these 2 regions has increased in recent years as per group strategy and sits at c50% of reported equity today.
We illustrate the importance of the contribution from Asia/MENA in the chart We estimate that the HSBC below that shows the returns made on the capital allocated to Asia/MENA vs has US$85-90bn of equity those in the rest of the group. Note in this exercise we have allocated to allocated to business outside Asia/MENA a proportional share of the UK bank levy (US$675mn) and group of Asia that are making just 1- central costs (US$750mn post tax). This lowers the RoE to 11.5-12.0% for FY 2% RoE 16 but reflect the additional cost burdens for those businesses of being part of a global group. Given that on a “clean” basis the group is only expected to make a 6-7% RoE this year this means that the c50% of group capital that is allocated to the rest of the world is making just a 1-2% return on equity on an underlying basis. This unfortunately is not a one off, it has been a similar story for at least the past 3-4 years despite the ongoing repositioning the group has been undertaking.
Figure 35: HSBC Group reported equity split Asia/MENA Figure 36: HSBC clean RoE profile for Asia/MENA vs. the vs. the rest of the world YE 16E rest of the world YE 16E
14.0%
12.0%
10.0% Asia & MENA Rest of Group 50% 8.0% 50% 6.0%
4.0%
2.0%
0.0% Group Asia/MENA Rest of World Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates
Having modeled most of the operating companies of the HSBC group in Asia and the Middle East in the table below we show a simple sum of the parts valuation as to what these businesses could be worth. In this exercise we value the 3 listed entities (Hang Seng Bank, BoCom and SABB) at their current market prices and apply price to book vs. RoE and P/E multiples to the other businesses. We have benchmarked against regional peers and believe we have been relatively conservative vs. what could be achieved if these business were actually separately listed on an exchange. We value “HSBC Asia” at 1.2x YE 16E book value which is equivalent to a modest 9x earnings. MENA we value at a little over 1x book, equivalent to just 8x earnings. For the MENA block as a whole this results in a valuation of c1.2x book or 9x FY16E earnings, equivalent to just over US$100bn of market capitalization. This is equivalent to c75% of HSBC group current market cap which underpins the importance of the Asian franchise to the group’s share price. Note every 0.1x we add to the P/B multiple we apply to the Asian/MENA franchise adds c5-6% to the group share price.
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Figure 37: Simple sum-of-the-parts valuation for HSBC’s Asian & MENA operations YE 16 ($mn) Est Equity Est RoE P/B P/E Value US$ Per share HK$ Per share GBP Hong Kong 37,386 15.4% 1.59x 10.3x 59,473 23.67 2.35 - Hang Seng (62.14%) 9,593 13.4% 2.14x 16.0x 20,563 8.19 0.81 - HSBC HK 27,793 16.1% 1.40x 8.7x 38,911 15.49 1.54 BoCom (19.03%) 15,797 12.5% 0.64x 5.1x 10,174 4.05 0.40 Rest of Asia Pac 24,876 10.2% 0.97x 9.5x 24,222 9.64 0.96 Total HSBC Asia 78,060 13.2% 1.20x 9.1x 93,870 37.37 3.70 HSBC Middle East 4,116 13.5% 1.15x 8.5x 4,734 1.88 0.19 SABB (40% stake) 3,267 12.5% 0.92x 7.3x 3,008 1.20 0.12 HSBC Egypt 893 12.6% 1.00x 7.9x 893 0.36 0.04 Total MENA 8,276 13.0% 1.04x 8.0x 8,635 3.44 0.34 Total MENA + Asia 86,336 13.2% 1.19x 9.0x 102,505 40.80 4.05 Source: Deutsche Bank estimates
Whilst we believe the valuation we have applied to HSBC’s Asian/MENA franchises above is conservative the outlook for these markets is challenging on a 2-3 year timeframe. As such we do not think it will be easy to improve reported returns to much above the 13-14% we expect for 2016 given a slower volume growth outlook, cyclically low impairments and much higher regulatory capital requirements. As such any permanent re-rating at a group level from a price to book basis is unlikely to be driven by Asia. Instead the focus we believe needs to be on improving returns on capital elsewhere. To illustrate this point in the table below we show that using our valuation for the Asian/MENA franchise derived above relative to the group current market cap. The “stub valuation” for the group ex-Asian/MENA leaves that capital attributed to the rest of the world trading at just 0.4x book value. Given we are talking about US$85bn of equity this is a significant value gap if the group were able to either make its cost of capital in these regions or if not free up the capital and return it to shareholders. To put this into context if the group can get this capital outside of Asia/MENA to be value at just 1.0x book that is worth an extra £1.80-1.90 per share (HK$ 18-20) equivalent to roughly 35% of the current market cap. With this in mind and our capital map showing the recent news that the group can now dividend capital out of its North American holdings company that has cUS$30bn of capital, the limited return becomes all the more pressing.
Figure 38: Implied value the market attributes to the equity HSBC has outside of Asia/MENA is equivalent to just 0.4x book YE 16 (US$mn) Equity Value P/B Asia/MENA 86,336 102,505 1.19x Rest of Group 85,268 37,046 0.43x Group 171,604 139,551 0.81x Source: Deutsche Bank estimates
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HSBC North America
A decade of value destruction
HSBC’s interim results threw the investor spotlight back on to the capital We estimate HSBC has supporting the group’s North American businesses. Our DB “Capital map” for cUS$33bn of capital backing the group suggests that it currently has cUS$33bn deployed to this region, its operations in NAFTA equivalent to c20% of total group capital. The problem for HSBC shareholders which have generated an RoE is for the best part of a decade now a large part of this capital has both been of just 1-2% for the past 5 tied up and making limited if any return. The key question is, are we now at a turning point? years
Figure 39: Assessing the cash dividend paid to group from HSBC’s North American business Est. US$ 2-3bn paid to group in 2017 (but largely excess cash)
Est. Est. 32.9 US$150mn 3.9 HSBC Overseas Capital HSBC Bank Capital Holdings (UK) Ltd. Canada Est RoE 0.6% Est RoE 9.0%
Est. US$ 2-3bn
Est. 29.0 HSBC North Capital America Holdings (US$3-4bn ex cess cash)
US$0mn
HSBC Investments Est. Est. 25.4 US$0mn HSBC Finance 4.6 (North America) Capital Capital Corporation Inc. RoE -0.5% Est RoE -8.0%
US$0mn Est. HSBC 1.0 US$0mn Capital Securities (USA) Est RoE N.A.
Est. Est. 19.8 US$0mn HSBC Bank 19.8 HSBC USA Inc. Capital Capital USA. N.A. Est RoE 1.4% Est RoE 1.4%
Source: Deutsche Bank, HSBC Group
The news that in the recent US Comprehensive Capital Analysis and Review (CCAR) carried out by the Federal Reserve that HSBC applied and received approval to pay a dividend out of its North American Holding company for the first time in a decade is, we believe, significant. As we show below we believe the group had cUS$3-4bn of cash held at the North American Holdings company level which represents the proceeds of the disposal of the US card
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business and upstate NY branches carried out in 2012. We now expect US$2- 3bn of this to be paid up to the group in 2017 which management have highlighted could be used to support a further share buyback next year.
Whilst the market has focused on the excess capital held at the North American Holding company level we believe that this is only part of the opportunity. The real issue the group has is the ongoing profitability of the remaining US$25-26bn of equity allocated to the rest of the US business which is currently making little if any return. This is split between 3 operating companies HSBC Finance Corporation with cUS$5bn, HSBC Bank USA with cUS$20bn and HSBC Securities (USA) (the capital base of this operating company is not disclosed but we estimate it to be the smallest of the 3). Either freeing up this capital or improving returns is likely to be a key driver of the group’s share price over the next 2-3 years. We appreciate that as a large global bank with a strong US$ funding base HSBC requires a US presence. However we do question if the current shape and scale of its North American operations is fit for purpose and is optimal for group returns and shareholders. The opportunity to now accelerate a restructuring of the US given the capital freed up now has a clear path back up to the group holding company we believe is compelling.
As we show below HSBC North America Holdings ended H1 16 with a CET1 capital ratio of 16.6%. This would imply US$2-3bn of excess capital above and beyond what might be required to maintain a healthy CET1 that could be paid up to the Group Holdings company in 2017 to help fund either the group dividend or support an additional buyback.
Figure 40: HSBC North American Holdings regulatory capital ratios (US$ mn) Q4 14 Q1 15 Q2 15 Q3 15 Q4 15 Q1 16 Q2 16 Core equity 29,244 29,308 29,001 29,153 28,728 29,040 29,035 Deductions -1,319 -1,783 -1,782 -1,808 -1,912 -2,725 -2,813 - Goodwill -1,623 -1,623 -1,623 -1,623 -1,623 -1,623 -1,623 - Other 303 -160 -159 -185 -289 -1,102 -1,191 CET1 27,925 27,525 27,219 27,345 26,817 26,316 26,222 CET1 Capital ratio 17.5% 15.3% 15.2% 15.4% 15.7% 15.3% 16.6% AT1 capital 3,716 3,219 3,108 3,091 2,670 2,727 3,145 Total Tier 1 capital 31,641 30,744 30,327 30,436 29,487 29,043 29,367 Tier 1 capital ratio 19.8% 17.1% 16.9% 17.2% 17.3% 16.8% 18.5% Total Capital 41,701 38,186 38,124 37,800 38,666 37,192 37,409 Total Capital ratio 26.1% 21.2% 21.3% 21.3% 22.6% 21.6% 23.6% RWAs 159,865 180,230 179,180 177,193 170,757 172,369 158,349 Absolute change 530 20,365 -1,050 -1,986 -6,436 1,612 -14,021 RWA/Assets 55.1% 59.7% 64.6% 60.8% 62.8% 59.6% 53.6% Total Assets 290,101 301,957 277,249 291,611 271,889 289,057 295,535 Source: Deutsche Bank, Federal Financial Institutions Examination Council
The end of Household is nigh On the 5th December 2006, almost a decade ago, HSBC put out a profit warning that heralded the start of the US sub-prime crisis. Since then the old “Household” book (now held within HSBC Finance Corporation) has been a constant drag on group returns since it was put in to run-off. The good news is that we believe an end is now in sight. The Asset base of HSBC Finance has shrunk from a peak of US$190bn to less than US$20bn today with a
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receivables book (including held for sale) of just US$10-11bn. Whilst there remains a lot of work to still be done we think we are just a couple of years away now from HSBC Finance being dissolved bringing to an end the drag of legacy assets from the old Household business.
Figure 41: HSBC estimated asset split in North America Figure 42: Estimated reported equity of HSBC Group in + Canada USA + Canada by operating company
Other/HSBC Securities (USA) HSBC Canada Other/HSBC Securities (USA) HSBC Canada HSBC Finance Corp. HSBC Bank USA HSBC Finance Corp. HSBC Bank USA 400,000 35,000 350,000 30,000 300,000 25,000 250,000 20,000 200,000 15,000 150,000
100,000 10,000
50,000 5,000
0 0 Q4 14 Q1 15 Q2 15 Q3 15 Q4 15 Q1 16 Q2 16 Q4 14 Q1 15 Q2 15 Q3 15 Q4 15 Q1 16 Q2 16 Source: Company data Source: Company data
In addition to the gradual decline in HSBC Finance Corps asset base we have It is incorrect to continue to seen a reduction in the gap between carrying value on the balance sheet and blame the poor returns HSBC fair value of the loan receivables book. At its peak post the global financial generates in North America crisis deducting this “fair value gap” from reported equity resulted in a purely on the legacy negative US$20-25bn equity value for HSBC Finance as we show in the chart Household book as HSBC below. As the book has been run-down, sold off and written off this has swung to a positive value of US$4-5bn. It remains uncertain as to exactly how much Finance now represent just capital may eventually be freed up from HSBC Finance but the days of c15% of capital allocated to attributing a zero or negative value to the capital tied up in HSBC Finance the region seem to be behind us. As of the end of the first half of 2016 this business had reported equity of US$4.8bn, a meaningful amount but only c15% of the total capital the group has allocated to North America. This also means that it is incorrect to continue to blame the poor returns HSBC generates in North America purely on the legacy Household book.
Figure 43: The Asset base of HSBC Finance is now down Figure 44: HSBC Finance reported equity less fair value to less than US$20bn from a high of cUS$180bn gap on receivables book 10 200 180 5 160 0 140 120 -5 100 -10 80 60 -15 40 -20 20 0 -25
Source: Company data Source: Company data
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HSBC Bank US: No clear path to cost of capital returns Whilst we can see the group winding down HSBC Finance Corp in the next couple of years and a route back to making cost of capital within both the Canadian and Mexican businesses over time we remain somewhat confused by the group strategy related to HSBC Bank USA. This consumes US$20bn of group capital, equivalent to roughly 2/3rds of all the capital HSBC has invested in the USA and Canada. Yet over the past 5 years it has struggled to make more than a c2% RoE and shows little sign of improvement in the foreseeable future. The impact of regulatory change (e.g. a rising equity/assets ratio) and the ultra low rate environment have both played their part in depressing returns but this is also true for the other regional US banks. As we show in the table below a peer group of banks of a similar size of HSBC Bank USA are still generating decent returns of a c13% RoTE and 105-110bps RoA.
Figure 45: HSBC Bank USA rolling 12 month RoE has Figure 46: Rolling 12 month risk adjusted NIM Vs remained stubbornly low in recent years tangible equity to assets 14.0% Tangible equity/Assets Risk adjusted NIM 12.0% 2.50% 10.0% 10.0% 9.0% 2.00% 8.0% 8.0% 1.50% 7.0% 6.0% 6.0% 4.0% 1.00% 5.0%
2.0% 4.0% 0.50% 3.0% 0.0% 0.00% 2.0% -2.0%
-4.0% Source: Company data, Deutsche Bank analysis Source: Company data
Figure 47: US regional banks still make decent returns, well above HSBC Bank USA Fifth Third SunTrust PNC USB M&T BB&T 2015 2016E 2015 2016E 2015 2016E 2015 2016E 2015 2016E 2015 2016E Interest income 2.88% 2.95% 2.76% 2.91% 2.65% 2.65% 3.01% 2.99% 2.89% 3.15% 3.26% 3.38% Interest expense -0.34% -0.40% -0.19% -0.21% -0.24% -0.31% -0.29% -0.31% -0.28% -0.33% -0.37% -0.34% Net interest income 2.54% 2.55% 2.57% 2.70% 2.41% 2.34% 2.72% 2.68% 2.61% 2.82% 2.89% 3.03% Non-interest income 2.15% 1.93% 1.71% 1.69% 1.97% 1.88% 2.21% 2.19% 1.66% 1.42% 2.03% 2.04% Revenues 4.69% 4.48% 4.29% 4.39% 4.38% 4.23% 4.93% 4.87% 4.28% 4.24% 4.92% 5.08% Costs -2.70% -2.74% -2.71% -2.70% -2.69% -2.61% -2.65% -2.67% -2.57% -2.44% -3.16% -3.10% Operating profit 1.99% 1.74% 1.58% 1.69% 1.69% 1.62% 2.27% 2.21% 1.70% 1.80% 1.76% 1.98% Impairments -0.28% -0.29% -0.09% -0.25% -0.07% -0.15% -0.27% -0.31% -0.15% -0.13% -0.22% -0.28% Other -0.01% -0.02% -0.07% -0.07% -0.06% -0.05% -0.05% -0.05% -0.02% -0.02% -0.07% -0.07% PBT 1.69% 1.43% 1.42% 1.36% 1.57% 1.41% 1.95% 1.85% 1.53% 1.65% 1.47% 1.63% Tax/Other -0.74% -0.57% -0.44% -0.44% -0.46% -0.43% -0.57% -0.55% -0.57% -0.65% -0.42% -0.54% RoA 0.95% 0.86% 0.98% 0.92% 1.10% 0.98% 1.37% 1.30% 0.96% 0.99% 1.05% 1.08% Equity/Assets 11.2% 11.4% 12.2% 12.2% 13.1% 12.8% 10.9% 10.8% 13.0% 13.1% 13.0% 13.3% RoE 8.4% 7.5% 8.1% 7.6% 8.4% 7.6% 12.6% 12.0% 7.4% 7.6% 8.0% 8.2% RoTE 11.1% 9.8% 12.0% 11.0% 12.2% 10.8% 18.7% 17.5% 11.7% 11.8% 13.3% 13.9% Source: Deutsche Bank estimates
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Figure 48: Relative size of YE16E assets Figure 49: Relative size of YE16E tangible equity
500 35.0
450 30.0 400 25.0 350 300 20.0 250 15.0 200 150 10.0 100 5.0 50 - 0.0 US PNC BB&T HSBC SunTrust Fifth Third M&T US PNC HSBC BB&T SunTrust Fifth Third M&T Bancorp Bank USA Bank Bancorp Bank USA Bank
Source: Deutsche Bank Source: Deutsche Bank
In the table below we show an aggregate DUPONT analysis for a selection of US regional commercial bank vs. that for HSBC Bank USA. The return on assets is significantly lower at a “bank” level. An obvious explanation for part of this is business mix. As we show in the pie-chart below a lot of the balance sheet within HSBC Bank USA is consumed by the Global Banking and Markets business (GB&M). This was c75% of assets at the end of H1 16 but generated just 35-40% of revenues over the past 12 months. This GBM balance sheet in the US is used to support the group businesses elsewhere in the world. For example management frequently point out that it books significant revenues for US corporate clients in other geographies. So we would agree, up to a point, that returns may be depressed somewhat due to “booking centre” issues. However logically this should also act in reverse. If GBM genuinely had a competitive global footprint it should be booking revenues in the US for Asian and European corporate, but there is limited if any evidence of this.
Figure 50: HSBC Bank USA returns relative to aggregate returns of regional US commercial Bank Aggregate HSBC Bank USA 2015 2016E 2015 2016E Interest income 2.90% 2.96% 1.77% 0.93% Interest expense -0.28% -0.31% -0.52% -0.32% Net interest income 2.62% 2.65% 1.25% 1.26% Non-interest income 2.01% 1.94% 0.85% 0.65% Revenues 4.63% 4.59% 2.09% 1.91% Costs -2.74% -2.71% -1.63% -1.49% Operating profit 1.89% 1.88% 0.47% 0.42% Impairments -0.18% -0.24% -0.18% -0.23% Other -0.05% -0.05% 0.00% 0.00% PBT 1.65% 1.59% 0.28% 0.19% Tax/Other -0.52% -0.52% -0.12% -0.06% RoA 1.13% 1.07% 0.17% 0.12% Equity/Assets 12.1% 12.1% 9.8% 9.4% RoE 9.3% 8.8% 1.7% 1.3% RoTE 13.7% 12.9% 1.9% 1.4% Source: Deutsche Bank estimates, company data
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Figure 51: Asset mix of HSBC Bank USA Figure 52: Revenue mix of HSBC Bank USA
PB Other PB RBWM 3% 0% 7% 8% RBWM 28% CMB 12%
GBM 37%
Commercial GB&M 28% 77%
Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data
The US balance sheet is also surprisingly capital intensive from a risk density perspective (as measured by RWAs/Assets) compared to the rest of the group. This is likely to be impacted by legacy positions in GBM that still need to roll- off. This will free up capital over time and now that the group’s can finally start paying up capital from the North American we expect there to be a growing debate as to exactly how much balance sheet and capital is suitable for the group to run with in North America. Whilst we agree HSBC does need a North American presence we question if it needs cUS$160bn of RWAs within the North American Holdings company with US$26bn of CET1 capital backing it. In addition to the excess capital being repaid to the parent company we are hopeful that the North American balance sheet and hence RWAs can be shrunk a meaningful amount over the next couple of years freeing up further capital to be returned to shareholders. We find limited evidence that the capital supporting the US business is allowing the group to generate excess returns elsewhere in its network. In Asia for example a c13% RoE and 1.0% RoA (clean ex non-cash associate income) at HBAP is not dissimilar to returns achieve by local peers with similar business mix but no global network.
Figure 53: HSBC Bank USA has a high RWA/Assets ratio relative to the rest of the group despite a proportionally larger GBM balance sheet
90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0%
Source: Deutsche Bank estimates, company data
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The poor returns in the US Bank are not however simply related to the GB&M balance sheet booked in that geography. In the table below we show a Dupont analysis for the US RBWM and Commercial banking divisions combined. Yet again it paints a depressing picture with a pre-tax RoA of just c70-80bps on a rolling 12 month basis which we estimate is just a 5% RoE. By way of comparison we estimate that the big 4 US banks are making something around a 20% RoE on their retail and commercial banking operations (which are largely domestic US, see charts below). The commercial banking business actually makes decent returns. The issue remains the retail bank in the US which continues to struggle.
Figure 54: Dupont analysis for HSBC Bank USA retail and commercial banking businesses RBWM CMB RBWM & CMB Combined 2014 2015 2016E 2014 2015 2016E 2014 2015 2016E Average Assets 19,325 20,086 21,005 27,210 31,632 30,920 46,535 51,718 51,925 Net interest income 4.15% 3.86% 3.86% 2.94% 2.68% 2.73% 3.44% 3.14% 3.19% Non-interest income 2.14% 1.66% 1.50% 1.13% 0.94% 0.91% 1.55% 1.22% 1.15% Revenues 6.29% 5.52% 5.37% 4.07% 3.62% 3.64% 4.99% 4.36% 4.34% Costs -6.35% -5.64% -5.05% -2.51% -2.28% -2.16% -4.10% -3.58% -3.33% Operating profit -0.06% -0.12% 0.32% 2.20% 2.11% 2.19% 0.89% 0.77% 1.01% Impairments -0.14% -0.32% -0.21% -0.22% -0.70% -0.34% -0.15% -0.40% -0.22% Other 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% PBT -0.20% -0.44% 0.10% 1.98% 1.41% 1.85% 0.74% 0.38% 0.79% Source: Deutsche Bank, HSBC
Figure 55: Estimated Rolling 12 month aggregate RoE for Figure 56: Estimated Rolling 12 month aggregate RoA Big 4 US banks retail/commercial banking operations vs. for Big 4 US banks retail/commercial banking operations wholesale/markets vs. wholesale/markets
25.0% 1.60% 1.40% 20.0% 1.20%
15.0% 1.00% 0.80% 10.0% 0.60% 0.40% 5.0%
0.20%
Q1 12 Q2 12 Q3 12 Q4 12 Q1 13 Q2 13 Q3 13 Q4 13 Q1 14 Q2 14 Q3 14 Q4 14 Q1 15 Q2 15 Q3 15 Q4 15 Q1 16
0.0% 0.00% Q4 11
Q4 11 Q1 12 Q2 12 Q4 12 Q2 13 Q3 13 Q4 13 Q1 14 Q2 14 Q3 14 Q4 14 Q1 15 Q2 15 Q3 15 Q1 16 Q2 16 Q3 12 Q1 13 Q4 15
Retail/Wealth Wholesale/Markets Retail/Wealth Wholesale/Markets
Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data
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Like the broader HSBC Bank USA business we think the underlying problem with the retail business returns relative to peers is balance sheet structure. In essence the balance sheet is now too skewed to low risk, lower return assets in the core business (which makes the RWA density highlighted above somewhat surprising). For example…
Loans expressed as a % of total assets are just 35-40% at HSBC Bank USA vs. c2/3rds of assets at local peers. This skews the asset mix towards lower yielding assets, this is partly structural and related to the GBM issue highlighted above.
Within the loan book mix HSBC Bank USA has a lower proportion of retail lending which tends to be higher margin. Also with the retail loan book post the consumer credit issue related to the GFC the group no longer targets some of the highest yielding parts of the consumer finance space. As such its retail loan book is heavily skewed towards lower margin mortgages.
Within the retail banking division in HSBC Bank USA c70-75% of revenues are currently coming from net interest income. With a low LDR in the retail business of c55%, a low yielding retail loan book relative to peers and ultra low interest rates meaning limited liability spread income this has resulted in a retail revenue base that has been de-risked to such a degree that its barely cover the cUS$1.1bn annualized retail banking cost base. Unless one of the above factors changes, which seems unlikely in the short- term, the profitability of the core US retail bank is unlikely to improve significantly in our opinion. The issue to do with the structure of the US retail loan book we believe stems from a management desire to not be in many of the consumer lending businesses in the US that other banks view as core products. The sale of the group credit card business in 2012 also means HSBC is underweight this product in the US market vs. is peers.
Figure 57: HSBC Bank USA asset mix (H1 16) Figure 58: Loan to deposit ratio of HSBC Bank USA
LDR Retail LDR CMB LDR Other, 5.2% Cash, 160.0% interbank & REPO, 23.4% 140.0% Loans, 37.3% 120.0% 100.0% 80.0% 60.0% 40.0% 20.0% Securities, 0.0% 34.1%
Source: Deutsche Bank, HSBC Source: Deutsche Bank, HSBC
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Figure 59: Balance sheet yield analysis HSBC Bank USA vs. US peers Fifth Third SunTrust PNC US Bancorp M&T HSBC Bank USA Retail loans 3.82% 3.95% 4.37% 4.95% 4.13% 3.59% Commercial loans 3.22% 3.09% 3.15% 3.16% 3.85% 2.46% Total loans 3.45% 3.48% 3.58% 4.05% 3.99% 2.74% Total yield on earning assets 3.34% 3.22% 3.13% 3.44% 3.51% 1.98% Cost of funds 0.67% 0.43% 0.56% 0.58% 0.56% 0.93% Source: Deutsche Bank, Company data
Figure 60: Loans as % of assets HSBC Bank USA vs. US Figure 61: Loan book split peers
80% Total Retail Corporate/Commercial 70% 100% 60% 90% 80% 50% 70% 40% 60% 50% 30% 40% 20% 30% 20% 10% 10% 0% 0% SunTrust M&T BankFifth Third BB&T US PNC HSBC Fifth Third SunTrust PNC US Bancorp M&T HSBC Bank Bancorp Bank USA USA
Source: Deutsche Bank, Company data Source: Deutsche Bank, Company data
Figure 62: Retail loan book split HSBC Bank USA Vs peers (H1 16)
Other retail Cards Home Equity Mortgages
100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Fifth Third SunTrust PNC US Bancorp M&T HSBC Bank USA
Source: Deutsche Bank, Company data
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Figure 63: Average yield on different parts of HSBC Bank Figure 64: Average yield on retail loan books USA Balance sheet
3.00% Cards 10.3% 6.00% 2.50% 5.00%
2.00% 4.00%
1.50% 3.00% 2.00% 1.00% 1.00% 0.50% 0.00% 0.00% Loans Trading REPOs Securities Interbank Total yield securities
Source: Deutsche Bank, HSBC Source: Deutsche Bank, HSBC
In its current form and with its existing return profile it is very hard to argue that HSBC’s US operations are not still destroying significant shareholder value almost a decade after the group’s initial profit warning fired the starting gun on the sub-prime crisis. As such the US$20bn of reported equity tied up in HSBC Bank USA, unless there is a dramatic shift in strategy, is likely to continue to be valued at significantly less that book value. This will weigh heavily on the group multiple. It is clearly possible to make good returns in banking in the US as the table below illustrates. A peer group of US regional banks is currently trading on 1.5-1.6x YE16E tangible book value. We estimate that the market is currently valuing the US$18bn of tangible equity in HSBC USA Inc. at 0.3x book, equivalent to just US$6-8bn. To illustrate the extent of the upside on HSBC Group share price if more value can be extracted from HSBC USA Inc if we were to value this business at just 1.0x book rather than 0.3x then this is equivalent to an additional US$14bn, 10% of group market cap or 55 pence as share.
Figure 65: Summary valuation and return profiles of US regional banks Share Rec P/E 16 P/E 17 P/TB 16 P/TB 17 RoTE 16 RoTE 17 RoA 16 RoA 17 2015 yield 2016 yield price Fifth Third 19.5 Hold 11.8x 16.5x 1.12x 1.06x 9.8% 6.4% 0.86% 0.57% 2.7% 2.7% SunTrust 42.1 Buy 11.4x 11.8x 1.20x 1.14x 11.0% 9.8% 0.92% 0.80% 2.2% 2.4% PNC 85.6 Buy 11.7x 11.3x 1.24x 1.17x 10.8% 10.5% 0.98% 0.92% 2.3% 2.5% BB&T 37.5 Buy 13.0x 12.8x 1.83x 1.73x 13.9% 13.3% 1.08% 1.04% 2.8% 3.1% M&T Bank 118.1 Hold 14.7x 14.2x 1.74x 1.70x 11.8% 11.7% 0.99% 0.95% 2.4% 2.4% US Bancorp 43.0 Hold 12.8x 12.7x 2.15x 2.00x 17.5% 16.2% 1.30% 1.19% 2.3% 2.5% Simple average 12.6x 13.2x 1.55x 1.47x 12.9% 11.9% 1.07% 0.97% 2.5% 2.6% Source: Deutsche Bank estimates, company data
Canada: Solid but suffering a cyclical downturn Canada is perhaps the only operating company in HSBC’s NAFTA block that has consistently made its cost of capital since the Global Financial Crisis with just under US$4bn of tangible equity in the country making on average over the past 6-7 years a 12-13% RoE. Returns over the past 12 months have however slumped as a combination of the ongoing ultra low interest rate environment and a rising impairment charge (Canada’s resource rich economy has been hit by the commodities price slump) have dragged on earnings. Our model of HSBC Canada suggests the business should make a c9% RoE this
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year before recovering to 11-12% in the medium term. We note that although these returns are better than the rest of HSBC’s businesses in North America (and indeed the group as a whole) they do still lag their Canadian peers. Based on consensus estimates the big Canadian banks are expected to make an RoE of 13-14% this year and currently trade on c1.6x book. The better profitability of HSBC’s Canadian business relative to the US results from a smaller GBM balance sheet and a very profitably commercial banking business. Again like the US retail business the Canadian retail business has struggled in recent years with a cost/income ratio in the 80-90% range impacting profitability.
Figure 66: HSBC Canada Rolling 12 month RoE Figure 67: HSBC Canada Rolling 12 month loan impairment charge 18.0% 1.40% 16.0% 1.20% 14.0% 1.00% 12.0% 10.0% 0.80% 8.0% 0.60% 6.0% 4.0% 0.40% 2.0% 0.20% 0.0% 0.00%
Source: Company data, Deutsche Bank estimates Source: Company data, Deutsche Bank estimates
Figure 68: HSBC Canada Revenue Split (Rolling 12 Figure 69: HSBC Canada Asset Split H1 16 month) Other GBM 2% 20% RBWM 29% RBWM 32% GBM 44%
CMB CMB 46% 27%
Source: Company data Source: Company data
A final point to make on HSBC Canada is that it only has a 10.4% CET1 capital. We would stress this is not out of line with the listed Canadian banks that are currently reporting Basel III CET1 capital ratios of around 10.0-10.5%. However none of the Canadian banks currently qualify as Global Systemically Important Financial Institutions (G-SIFI) which come with higher required capital buffers. If HSBC Canada were to be run with a target CET1 capital ratio more in-line with the 12-13% target at the HSBC Group level it would probably require an additional US$600-700mn of CET1 capital Vs H1 16 levels. This would be an additional drag on RoE relative to its domestic Canadian peer group.
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Figure 70: HSBC Canada net interest income vs. reported Figure 71: HSBC Canada CET1 Capital ratio NIM
CET1 ratio RWAs/Assets Net interest income Reported NIM 11.4% 48.0% 450 3.00% 11.2% 47.0% 400 2.50% 11.0% 46.0% 350 10.8% 300 2.00% 45.0% 10.6% 250 44.0% 1.50% 10.4% 200 43.0% 10.2% 150 1.00% 42.0% 10.0% 100 0.50% 9.8% 41.0% 50 9.6% 40.0% 0 0.00% 9.4% 39.0% Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2
11 12 12 12 12 13 13 13 13 14 14 14 14 15 15 15 15 16 16 Source: Company data Source: Company data
Valuing HSBC North America Given the return profile HSBC’s North American operations and the lack of an obvious path to it making cost of capital on a 2-3 year view we believe it is not surprising that the market affords it such a low multiple. In our sum of the parts below we are valuing the US bank at just 0.3x book as discussed above. As we near the end of the decade long wind-down of HSBC Finance (previously “Household”) we are now more optimistic that some of the US$4.6bn of equity still tied up in that balance sheet may eventually be freed up so we apply a 0.5x P/B multiple here. The remainder of the equity in HSBC North America Holdings represents the capital backing HSBC Securities and excess cash held at the holding company level. We value this at 0.75x book reflecting our belief that as per the recent US CCAR evaluation the group will be able to dividend out US$2- 3bn of this in 2017. Note that this payout is out of cash reserves and reflects the proceeds of the sale of the card business & upstate NY branch network back in 2012. It should not therefore be viewed as sustainable. The dividend paying capability of the North American operations which is funded out of ongoing earnings looks likely to remain minimal in a group context over the next 2-3 years.
The last part of the pie to value in a North American context in the Canadian business which we currently value at 1.2x YE 16E book, equivalent to c13x FY16E earnings. This is a lower multiple that its Canadian peers but this reflects the lower level of profitability that we have discussed above. Pulling this all together results in a value for the whole of the North American business in our “Capital map” of just US$16.5bn. This represents a multiple of 0.5x the reported equity of US$33bn.
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Figure 72: SOTP valuation for HSBC North America YE 16 ($mn) Est Equity Est RoE P/B P/E Value US$ Per share Per share HK$ GBP HSBC USA Inc 19,898 1.4% 0.30x 22.9x 5,970 2.38 0.24 HSBC Finance 4,590 -8.8% 0.50x N.A. 2,295 0.91 0.09 HSBC Securities/Cash 4,712 0.2% 0.75x N.A. 3,534 1.41 0.14 at Hold Co/Other HSBC North America 29,200 -0.5% 0.40x N.M. 11,798 4.70 0.47 Holdings HSBC Canada 3,952 9.1% 1.20x 13.3x 4,742 1.89 0.19 Total HSBC North 33,152 0.6% 0.50x N.M. 16,540 6.58 0.65 America Source: Deutsche Bank estimates
What could move the dial in the US from a shareholder perspective? The above analysis does of course make the assumption that the current status quo does not change. We think the current strategy for NAFTA is unlikely to generate returns in excess of cost of capital. Specifically for North America we do see a number of alternative options. Whilst we do not intend to cover them in-depth in this report three potential avenues for the North American business to improve returns to shareholders include…
A more aggressive shrinking of the GBM balance sheet and RWAs in the US Bank and HSBC Finance that will accelerate capital paid up to the group. We believe the passing of the CCAR test and the approval from the US regulators to pay out a dividend from the North American holdings company is significant. Whilst the market has focused on the potential for a buyback related to the excess cash held at the North American holdings company level (we estimate US$2-3bn) this may just be the tip of the ice- berg. We are curious as to whether or not in a post CCAR approval world the balance sheet of HSBC USA Inc can now be shrunk more aggressively freeing up incremental capital to be paid up to the group. Clearly the capital is not making an acceptable return where it is currently allocated, but prior to the recent favorable CCAR results even if it was freed up it may well have remained trapped in the US. If indeed HSBC USA Inc.’s balance sheet was being run “fat” then we may see RWAs and assets shed in that business faster than the market is currently anticipating. This could increase the quantum of capital paid up to the group and potentially improve returns on the remaining, smaller equity base left in the US.
A shift in stance in the retail banking business to make it “look and feel” more like its regional US peer group. This will however most likely involve going up the risk curve in the personal lending space to improve margins in the US retail bank. Given the pain of the write-offs taken on the consumer finance books during the GFC are still fresh in current management’s minds we are not yet sure that this is a path HSBC will want to take. We have however noted that HSBC’s business in Mexico is now growing its retail loan books much more aggressively after a multi- year period of de-risking. It will be interesting to see if the US business follows suit over the next 1-2 years as this could represent an inflection point in the US retail bank’s returns.
Think about non-organic solutions to improve US returns. If HSBC’s appetite for risk in the US remains unchanged it is not obvious to us that the returns in its US business will improve to an acceptable level. If this does prove to be the case HSBC Group may well not be the best owner of
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its US retail and commercial banking operations. In fact we would also potentially include HSBC Canada and indeed HSBC Mexico also in this bucket. All of these businesses are making sub-par returns when compared to their domestic peers in their home markets. There is no evidence whatsoever of positive network effects benefiting these North American businesses in their home markets. They would however we believe be attractive assets to other North American banking groups with greater potential to extract synergies. This could involve an outright disposal or HSBC Group taking a large minority stake in an enlarged US bank (subject to limits related to regulatory capital deductions). Impact of a US rate rise as per group disclosure… A section on HSBC’s US operations would not be complete without some discussion on the impact of a US rate rise on the group profitability. Over the years this topic has been well covered by the investment community so to keep this short in the table below we show the group’s disclosure as to the impact of a 100bps parallel shift in the yield curve over a 12 month period on net interest income (modeled as a 25bps rise at the start of each quarter). To get an impact on profitability we annualize this number (to estimate the full year impact of the quarterly 25bps rises), assume pretty much all of it drops to the pre-tax level and then tax it at the group’s incremental tax rate (we use 26%). This suggest a boost to net profit of cUS$2bn which is about 15% of earnings. If we place this on a 10x multiple it is equivalent to roughly 14-15% of the group current market cap.
Figure 73: HSBC group estimated impact of a 100bps parallel shift in the yield curve over a 12 month period US$ bloc Rest of HK$ bloc Rest of Asia Sterling Bloc Euro bloc Total Est. Est. Post tax Americas bloc Annualised bloc impact +25bps 496 57 615 2 82 121 1,373 2,746 2,032 -25bps -779 -62 -817 -79 -442 -22 -2,201 -4,402 -3,257 Source: Company data, Deutsche Bank estimates
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HSBC Europe
Formed by acquisition, but undergoing structural change
Although HSBC had a presence in Europe within the first decade of the company’s birth (1865), it was not until 1992 when HSBC purchased Midland Bank that HSBC gained a substantial footing in UK & Europe (incl Midland’s Trinkaus & Burkhardt stake). As part of the then purchase of Midland, HSBC agreed to move head office to London to meet UK regulatory requirements.
In 1990s/2000s HSBC also expanded into Turkey (via acquisition of Demirbank), France & Italy (via acquisition of Credit Commercial de France), Poland (acquisition of Polski Kredyt Bank S.A.) and further in the UK (M&S Finance). Today, ‘Europe’ represents two principal subsidiaries: HSBC Bank plc (which has the majority of the European business) and HSBC Private Bank (Suisse) S.A. for the Swiss Private Bank operations, which was sold from HSBC Bank plc to HSBC Group Holdings in 2012.
Figure 74: A breakdown of HSBC’s principal European subsidiaries
HSBC Holdings plc
HSBC Private HSBC Bank Plc Bank (Suisse) S.A.
70.03% 99.99% HSBC Bank Malta HSBC France
HSBC Trinkaus & 80.65% HSBC A.S. Burkhardt A.G. (Turkey)
HSBC Bank International M&S RFSHL Limited (Jersey)
HSBC Asset HSBC Invoice Finance (UK) Finance (UK) Ltd Limited
HSBC Private HSBC Private Bank (C.I.) Bank (UK) Limited Limited
HSBC Trust Company (UK) Limited Source: Deutsche Bank, HSBC
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Ring-fencing means further structural change
The structure will change again before 2019, as HSBC moves to create a separate ring-fenced bank as part of UK Ring-fencing requirements. The proposed approach is shown in Figure 75. We would expect the creation of a new HSBC UK Holding company below HSBC Holdings, and for UK assets within HSBC Bank plc to be transferred into the this new holding company as new subsidiaries (ring-fenced and non-fenced) in the coming years.
Figure 75: HSBC Proposed approach for ring-fencing
Source: HSBC company presentation
This would leave HSBC Bank plc effectively as a Holding company with stakes in HSBC France, Trinkaus & Burkhardt, Malta and Turkey subsidiaries. It is possible that this (now non-UK) entity could be transferred to Frankfurt / France / Dublin for as ‘HSBC Europe’ for EU passporting needs post-Brexit if required.
Our guess at what this structure will look like in 2019 is shown in Figure 76. From a cashflow perspective there should be no difference for HSBC group, providing that capital requirements remain net similar across the new entity structures and that the independent board of the UK ring fenced entity continues to approve upstreaming of dividends.
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Figure 76: DB estimate of likely structure of HSBC Europe in 2019
HSBC Holdings plc
HSBC Private Bank HSBC Bank Plc ‘HSBC UK plc’ (Suisse) S.A.
Ring-fenced entity HSBC Bank Malta HSBC France (RBWM, CMB, GPB)
HSBC Trinkaus & HSBC A.S. (Turkey) Non-ring-fenced Burkhardt A.G. entity (GBM)
Source: Deutsche Bank estimates
Recent performance
Disclosures: difference between geographic and subsidiaries due to Hold Co From a disclosure perspective HSBC’s European business is complicated by the inclusion of bank levy and Holdco/Head Office revenues & costs within ‘Europe’ given the location of bank headquarters.
In reality these sit at the Holding Company level, but not at the HSBC Bank plc level. Though trivial for the overall group, this does affect how we benchmark the profitability of Europe and the potential movement of dividends up from the HSBC Bank plc subsidiary.
There are 3 sources of disclosures:
HSBC ‘Europe’ as disclosed in annual HSBC Holdings plc accounts. This includes everything in Europe, including all bank levy / holding company costs as well as HSBC Private Banking Holdings (Suisse) which was spun out of HSBC Bank plc and into HSBC Holdings as a separate sub in 2012.
HSBC Bank plc report and accounts give everything in HSBC ‘Europe’ except for Switzerland, Bank levy and Hold Co P&L. This includes subsidiaries for France, Malta, Turkey and Germany.
HSBC UK – a recent edition to HSBC’s disclosures, which gives a P&L (but no full balance sheet) for the United Kingdom. This includes Hold Co/Head office costs and bank levy but excludes the rest of Europe.
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Figure 77: Deciphering HSBC’s disclosures
HSBC Europe Geographic segment US$1,129bn assets HSBC Bank plc Subsidiary US$1,078bn assets HSBC Private Banking HSBC France Holdings (Suisse) S.A. HSBC Bank Malta HSBC A.S. (Turkey) HSBC Trinkaus & Burkhardt
‘HSBC UK’ UK Quarterly datapack Incl. M&S disclosure Bank levy + Hold co revs & costs
Source: Deutsche Bank graphic
This results in 3 very different P&L accounts: United Kingdom was lossmaking on an underlying and reported basis in FY15, whilst the Bank plc has higher reported earnings due to the lack of Hold Co/Bank levy costs.
It is therefore important to note that for the purposes of analyzing the cashflow around the group the geographic disclosures for Europe do not match the subsidiary accounts: Bank levy & Hold Co losses come directly out of Hold Co, not Europe itself, and so we need to analyse the performance of HSBC Bank plc rather than ‘Europe’ or ‘United Kingdom’. We now take a closer look at HSBC Bank plc.
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Figure 78: Three different P&Ls for Europe / UK HSBC Bank plc (USD) HSBC Europe (USD) HSBC UK (USD) P&L FY13 FY14 FY15 FY13 FY14 FY15 FY13 FY14 FY15 Net Interest Income 10,894 10,921 10,419 10,712 10,611 10,005 7,112 10,103 7,409 Non interest Income (net of claims) 9,200 8,661 9,248 10,255 10,960 11,053 7,156 5,626 8,084 Total Income 20,094 19,583 19,667 20,967 21,571 21,058 14,268 15,729 15,493 Costs -13,420 -15,630 -14,395 -17,613 -20,217 -19,733 -12,111 -15,577 -15,555 Pre-provision profit 6,675 3,952 5,272 3,354 1,354 1,325 2,157 152 -62 Loan impairments -1,520 -740 -735 1,530 764 690 -1,003 -215 -248 Associates 0 5 3 1 6 8 6 7 10 PBT 5,155 3,218 4,540 1,825 596 643 1,160 -56 -300 Taxation -1,180 -929 -1,524 Preference share payments -64 -58 -49 Attributable Profit 3,911 2,231 2,968 Payments on other equity instruments 0 0 -193 Attrib. Profit to ordinary shareholders 3,911 2,231 2,775
Adjusted P&L FY13 FY14 FY15 FY13 FY14 FY15 FY13 FY14 FY15 Income 20,298 20,663 19,357 21,536 22,279 20,400 14,933 16,868 14,898 Costs -12,190 -13,286 -12,409 -15,060 -16,561 -17,328 -13,937 -18,084 -17,706 PPP 8,108 7,378 6,948 6,476 5,718 3,072 996 -1,216 -2,808 Loan impairments -1,520 -740 -735 -1,530 -764 -690 -1,003 -215 -248 Associates 0 5 3 1 6 8 6 7 10 Adjusted PBT 6,589 6,643 6,216 4,947 4,960 2,390 -1 -1,424 -3,046 Source: Deutsche Bank estimates, company data
HSBC Bank plc
Around a third of group revenues, costs and profit Within the context of the group, HSBC Bank plc represents around 40% of loans and deposits, around 33/34% of revenues and costs, 20% of impairments and 24-30% of PBT.
Figure 79: HSBC Bank plc in context of group (2015)
100% 90% 80% 70% 59% 62% 69% 67% 64% 67% 66% 70% 60% 73% 80% 76% 80% 50% 40% 30% 20% 41% 38% 31% 33% 36% 33% 34% 30% 10% 27% 20% 24% 20% 0%
HSBC Bank plc Other
Source: Deutsche Bank estimates, company data
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HSBC Holdings Plc
The risk weighting for HSBC Bank plc is less than the rest of the group, driven across RBWM (aided by UK mortgages) and GBM (which suggests the more RWA-intensive parts of GBM are booked & run out of elsewhere in the group). HSBC Bank plc also has a lower proportion of equity allocated to its balance sheet / RWA size, which means the CET1 of the subsidiary is lower than the group overall (9.6% at 1H16 vs. 12.1% at the group level).
Figure 80: RWA/loans (2015) Figure 81: Loan/deposit comparison (2015)
250% 227% 120% 109%
200% 186% 100% 91% 84%83%84% 78% 75% 78% 80% 72% 68% 150% 139%137%141% 134% 141% 58% 60% 119% 53% 60% 48% 52% 100% 83% 89% 40% 56% 60% 45% 40% 50% 24% 20%
0% 0% RBWM Commercial GBM GPB Total RBWM Commercial GBM GPB Total Banking Banking
HSBC Group HSBC Bank plc Other HSBC Group HSBC Bank plc Other
Source: Deutsche Bank. Only Credit IRB RWAs disclosed by division for HSBC Bank plc. These have Source: Deutsche Bank estimates been scaled up using Total RWAs.
Divisional mix within HSBC Bank plc is shown in Figure 79. Commercial represents 42% of profit, with RBWM and GBM on around 30% each.
Figure 82: Divisions in context of HSBC Bank plc (2015)
100% 27% 80% 29% 34% 21% 34% 30% 41% 40% 38% 60% 65% 65% 29% 27% 26% 54% 27% 17% 42% 40% 16% 44% 20% 41% 41% 35% 37% 36% 38% 36% 29% 36% 31% 11% 0% -2% -2% -20%
RBWM Commercial GBM GPB Other
Source: Deutsche Bank estimates, company data
Solid underlying profitability, u/l RoTE of around 10%, but recent conduct drag Despite the financial crisis, HSBC Bank plc has remained profitable on a reported and adjusted basis over the last 11 years. Impairments have consistently outperformed the wider group over time (Figure 84).
Adjusted PBT in 2013-15 has been generally consistent with reported PBT from 2005-2009. The multi-billion gap between reported earnings and adjusted PBT recently has been generally dominated by conduct risk & legal charges, including PPI. As discussed later, this remains a key risk for future cash distributions from the subsidiary.
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Figure 83: HSBC Bank plc profitability £m Figure 84: Impairment rate compared (£m)
6,000 3.50%
3.00% 5,000 2.50% 4,000 2.00%
3,000 1.50%
2,000 1.00%
0.50% 1,000 0.00% 0 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 HSBC Bank plc HSBC Europe HSBC UK HSBC Group Attributable Profit to ordinary shareholders PBT Adjusted PBT
Source: Deutsche Bank estimates, company data Source: Deutsche Bank
RoTE peaked in 2008 (driven by the lower TNAV level, more detail below), and was around 10-12% on an adjusted basis in recent years. Return on assets has fallen from pre-crisis levels and is currently around 40bps.
Figure 85: RoTE over time Figure 86: RoA over time
60.0% 0.6%
50.0% 0.5% 40.0% 0.4% 30.0% 0.3% RoA (stated) 20.0% RoA (adjusted) 10.0% 0.2%
0.0% 0.1% FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15
0.0% RoTE (stated, tangible s'holder equity) FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 RoTE (adjusted, tangible s'holder equity)
Source: Deutsche Bank Source: Deutsche Bank
No balance sheet growth post the financial crisis HSBC Bank plc balance sheet has barely grown in 7 years: loan balances are down both in GBP and USD, whilst deposits are broadly stable. This is reflective of the lower growth environment in Europe, and a lower market share for new business in the UK (despite having amongst the lower mortgage rates in the market, UK mortgage balances are unchanged 2012-2015).
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Figure 87: Balances in GBP m over time Figure 88: Balances in US$ over time
400,000 800,000
350,000 FY07 700,000 FY07 300,000 FY08 600,000 FY08
250,000 FY09 500,000 FY09 FY10 FY10 200,000 400,000 FY11 FY11 150,000 300,000 FY12 FY12 100,000 200,000 FY13 FY13 50,000 100,000 FY14 FY14 0 FY15 0 FY15 RWAs Loans and advances Customer accounts RWAs Loans and advances Customer accounts to customers to customers
Source: Deutsche Bank Source: Deutsche Bank
However, as with other parts of the group, capital requirements have increased, which has required additional retained equity. Shareholder equity troughed at just £18bn in 2008 (a staggering 51x leverage at the time) following adverse movements in ‘other comprehensive income’. Since then equity has grown (and TNAV has built faster as goodwill has been written down over time). The CET1 ratio has also improved, from 6% to 10-12% (Basel 2) but currently sits at 9.6% (fully loaded Basel 3 rules).
Figure 89: Equity & tangible equity over time Figure 90: Core Tier 1 ratio over time (CRD 4 from 2014).
40 14.0% 33.9 33.9 12.1% 35 11.4% 31.1 31.7 32.4 12.0% 30.1 10.2% 10.5% £ billions £ 30 9.6% 26.0 26.6 26.9 10.0% 9.1% 23.8 24.4 8.7% 25 23.4 8.0% 19.6 20.1 6.6% 20 18.2 5.9% 15.5 6.0% 15 13.5 4.0% 10 6.4 5 2.0% 0 0.0% FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15
Ordinary shareholders' equity Tangible equity Core Tier 1 - ruling framework Core Tier 1 - fully loaded CRD4
Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data
Turning to capital upstream / downstream, HSBC Bank has net upstreamed capital in every year except 2005 (broadly neutral) and 2009 (rights issue). On average the last 11 years have seen around £1bn of capital upstreamed, or around US$1.7bn on exchange rates over the period. Capital return has been lower in recent years due to lower attributable profit (below the line items) and capital build as Basel 3 rules were introduced.
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Figure 91: Dividends and capital downstream (£m) Figure 92: Net capital downstreamed / (upstreamed)
-4,000 5,000 4,398 -2,974 -2,775 -3,000 4,000 -1,970 -2,000 -1,591 -1,706 -1,750 -1,715 2,705 2,750 -1,400 -1,230 3,000 2,394 2,267 2,454 -941 -855 -1,000 2,000 1,688 1,522 0 0 0 0 1,307 0 1,000 402 306 1,000 675 510 0 2,000 -182 1,500 1,750 -1,000 3,000 2,776 -2,000 4,000 -3,000 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15 -2,873 -4,000 Capital downstreamed Dividends upstreamed to HSBC Holdings FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14 FY15
Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data
We can also track the sources of cash dividends from subsidiaries within HSBC Bank plc.
Figure 93: Sources of dividend cash within HSBC Bank plc USDm 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 HSBC Bank Plc. -182 1,688 2,394 2,267 -2,873 2,705 2,750 4,398 2,454 1,522 1,307 o/w HSBC France 603 543 1,518 1,924 934 955 164 0 478 0 445 o/w HSBC Malta (70%) n/a 60 90 52 32 28 29 29 32 18 14 o/w HSBC Trinkaus & Burkhardt AG (80.7%) 59 66 72 78 73 -91 79 73 75 -333 63 o/w HSBC Private Banking Holdings (Suisse) S.A. (-2012) 100 90 440.7 490 0 930 0 o/w Implied rest of HSBC Bank plc -944 929 273 -276 -3,912 883 2,478 4,296 1,869 1,838 785 Source: Deutsche Bank estimates, company data
Pre-2011, these subsidiaries paid for most of the net cash contribution from HSBC Bank plc to HSBC Group Holdings – in particular HSBC France which contributed around US$1bn a year. However, since 2011, these contributions have fallen significantly: HSBC France did not pay a dividend at all in 2012 and 2014, HSBC Private Bank Holdings was divested from HSBC Bank plc, and Trinkaus required a capital injection. The cash dividend has therefore had to come from the rump of HSBC Bank plc - effectively the UK business.
Figure 94: Sources of cash dividend (2005-2015) Figure 95: Sources of cash dividend (2011-2015)
9 8.2 12 11.3 7.6 8 10 7 8
6
USD billions USD USD billions USD 5 6 4 4 3 2.1 2 1.1 2 0.1 0.0 0 1 0.4 0.2 0.0 0 -2 HSBC France HSBC Malta HSBC Trinkaus HSBC Private Implied rest of HSBC France HSBC Malta HSBC Trinkaus HSBC Private Implied rest of (70%) & Burkhardt Banking HSBC Bank plc (70%) & Burkhardt Banking HSBC Bank plc AG (80.7%) Holdings AG (80.7%) Holdings (Suisse) S.A. (Suisse) S.A. (up to 2012) (up to 2012)
Source: Deutsche Bank estimates, company data Source: Deutsche Bank, company data
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Key issues for future dividend potential
1) Below the line items – how much more to go? Below-the-line charges have been a source of pain for HSBC Bank plc post the crisis. From 2013-15 alone a cumulative US$4bn of (often non-tax deductible) charges have been taken alone.
Figure 96: Below the line items (cumulative 2013-15) £m
Gain on disposal of Visa Europe 416 Gain on change in delivering ill-health benefits 280 Change in credit spread on long-term debt 192 DVA adjustments 41 Operational losses (dissolved company) 10 Other provisions 0 Madoff related litigation costs -41 Costs to establish UK ring-fenced bank -96 Fair value movement on non-qualifying hedges -185 Restructuring and related costs -200 Provision arising from a review of compliance with the … -383 Costs to achieve -567 Settlements and provisions in connection with legal and … -1,432 UK customer redress charges -1,946 -2,500 -2,000 -1,500 -1,000 -500 0 500 1,000
Source: Deutsche Bank estimates, company data
Four particular items remain an issue: UK customer redress (mainly PPI), Cost- to-achieve (as part of the wider HSBC group plans), settlements for legal matters (in GBM, no specified legal case) and cost of ring-fence set up.
Figure 97: HSBC Bank plc below-the-line items 2013-15 £m 1H13 2H13 1H14 2H14 1H15 2H15 1H16 Fair value movement on non-qualifying hedges -7 -1 -6 -145 9 -6 -29 Provision arising from a review of compliance with CCA Act 0 0 -215 -164 8 -13 1 DVA adjustments 198 -153 -47 -96 52 10 77 Gain on disposal of Visa Europe 0 0 0 0 0 0 416 Change in credit spread on long-term debt -14 -153 -38 55 82 61 199 Revenue adjustments 177 -307 -306 -350 151 52 664
UK customer redress charges -267 -520 -144 -633 -92 -266 -24 Restructuring and related costs -66 -30 -31 -41 -33 1 0 Gain on change in delivering ill-health benefits 280 0 0 0 0 0 0 Costs to achieve 0 0 0 0 0 -258 -309
Operational losses (dissolved company) 0 10 0 0 0 0 0 Madoff related litigation costs -193 0 85 87 0 0 -20 Settlements and provisions in connection with legal and 0 0 0 -746 -511 -100 -75 regulatory matters Costs to establish UK ring-fenced bank 0 0 0 0 0 -41 -55 Cost adjustments -246 -540 -90 -1,333 -636 -664 -483 Source: Deutsche Bank estimates, company data
Payment Protection Insurance: charges have totaled nearly £3bn since 2011, with charges taken each year. As at 1H16 HSBC had a provision stock of £0.5bn, with a monthly claim of around £28m. This implies around 20 months of coverage for payouts. Given that the FCA has recently proposed extending the deadline for PPI claims to June 2019, it seems likely that further provisions are required. We assume a further £0.5bn.
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Figure 98: PPI charges 2011-2015 (£m) Figure 99: HSBC coverage as at 1H16
1,200 1,064 1,000
HSBC 1H13 2H13 1H14 2H14 1H15 2H15 1H16 800 Starting stock 836 662 631 452 674 593 701 Redress utilisation 403 289 294 256 141 186 165 600 Top-up 229 257 115 479 60 294 0 507 486 479 Ending stock 662 631 452 674 593 701 536 400 353 Per month redress utilisation 67 48 49 43 23 31 28 Months coverage at period end 9.8 13.1 9.2 15.8 25.3 22.7 19.5 200
0 2011 2012 2013 2014 2015
Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data
CTA: up to 1H16 HSBC Group had spent around US$1.8bn of the US$4.5bn budget, with around US$850m within HSBC Bank plc. Given Bank plc represents around a third of group costs it seems reasonable to expect a further c.US$0.8-1bn of CTA costs over 2016/17.
Legal provisions: difficult to forecast. We have US$1.5bn of provisions in our Group forecasts, of which the majority we would expect to be in GBM Europe.
Cost of ring-fencing: company has said it expects this to cost US$1-2bn in set up costs. So far around £100m has been expensed so the majority of this will come over the coming years.
Putting this all together it seems reasonable to expect c.US$4-4.5bn (£3-3.5bn) of additional below-the-line charges in the coming 3 years, which post-tax consumes c.US$3-3.5bn which cannot be upstreamed to group holdings.
2) Subsidiary performance & outlook The cash flows of HSBC Bank plc will of course also depend on the underlying performance of the business: for cash upstream…or capital injection. A meaningful portion of HSBC Bank plc performance and exposure is within subsidiaries. We list the principal subs in Figure 103 and Figure 102 for which we have been able to get 2015 accounts.
20-25% of balance sheet is in these principal subsidiaries (which includes France, Turkey, Malta and Trinkaus). These subsidiaries are generally higher capitalized than the HSBC Bank plc as a whole. Around 40% of PBT & operating profit is in the subsidiaries, driven in particular by higher income margins, lower C/I ratio and similar leverage (19x). Of the subs, only Turkey (which HSBC tried to sell in 2015) is loss- making. Interestingly around 75% of cash dividends paid by HSBC Bank plc in 2015 were sourced from these subsidiaries (Figure 100). Therefore for cashflow upstreaming from Europe, HSBC Bank plc subsidiaries are an important component of the picture (and source of cash). Largest here is HSBC France (US$445m dividends declared in 2015), followed by a number of UK subsidiaries (including very high ROE asset and invoice finance businesses). Payout ratios are 90% for France, 59% for Malta, and 56% for Trinkaus.
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Figure 100: Dividends by subsidiary (2015) Figure 101: Earnings by subsidiary (2015)
HSBC France 445 HSBC France 496 HSBC Asset Finance (UK) Limited 303 HSBC Asset Finance (UK) Limited 385 HSBC Life (UK) Limited 122 HSBC Invoice Finance (UK) Limited 155 HSBC Invoice Finance (UK) Limited 115 HSBC Trinkaus & Burkhardt AG 136 HSBC Trust Company (UK) Limited 84 HSBC Private Bank (UK) Limited 111 HSBC Trinkaus & Burkhardt AG 63 HSBC Trust Company (UK) Limited 58 HSBC Bank Malta p.l.c. 14 Marks & Spencer Retail Finanial … 44 Marks & Spencer Retail Finanial … 0 HSBC Life (UK) Limited 34 HSBC Private Bank (UK) Limited 0 HSBC Bank Malta p.l.c. 23 HSBC Bank A.S. [Turkey] 0 HSBC Bank A.S. [Turkey] -119 Other HSBC Bank plc 410 Other HSBC Bank plc 1,694 0 100 200 300 400 500 -500 0 500 1,000 1,500 2,000
Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data
Figure 102: Principal subsidiaries of HSBC Bank plc (1) USDm Location Ownership Currency Date Equity Loans Deposits Assets CET1 RWAs CET1 ratio HSBC Asset Finance (UK) Limited England 100.0% USD 2014 511 8,254 7,208 10,360 511 n/a n/a HSBC Bank A.S. [Turkey] Turkey 100.0% USD 2015 930 6,859 6,510 10,843 911 9,737 9.4% HSBC Bank Malta p.l.c. Malta 70.0% USD 2015 502 3,577 5,392 7,882 359 2,918 12.3% HSBC France France 100.0% USD 2015 6,467 41,958 35,736 183,476 5,255 35,388 14.9% HSBC Invoice Finance (UK) Limited England 100.0% USD 2015 252 n/a n/a 6,057 252 n/a n/a HSBC Life (UK) Limited England 100.0% USD 2015 370 24 0 2,025 370 n/a n/a HSBC Private Bank (UK) Limited England 100.0% USD 2015 1,902 7,836 6,844 9,659 1,864 4,721 39.5% HSBC Trinkaus & Burkhardt AG Germany 80.7% USD 2015 2,124 8,548 14,081 23,602 1,781 17,286 10.3% HSBC Trust Company (UK) Limited England 100.0% USD 2015 92 509 387 527 92 210 44.0% Marks & Spencer Retail Financial England 100.0% USD 2015 412 5,094 3,723 6,731 308 3,545 8.7% Services Holdings Limited Subtotal of principal subs 13,000 79,929 75,537 254,216 11,250 69,582 16.2% Rest of HSBC Bank plc 42,566 303,151 417,684 824,519 21,261 270,339 7.9% HSBC Bank plc total 55,567 383,080 493,221 1,078,736 32,511 339,921 9.6% Principal subs as % of HSBC Bank 23% 21% 15% 24% 35% 20% n/m Source: Deutsche Bank estimates, company data
Figure 103: Principal subsidiaries of HSBC Bank plc (2) USDm Revs Opex PPP Impair Other PBT PAT Divi Revenu C/I PPP/as Impair Other PBT ROA Levera RoE ments es / ratio sets ments ge assets HSBC Asset Finance (UK) Limited 477 -89 388 0 0 388 385 303 4.6% 18.6% 3.7% 0.0% 0.0% 3.7% 3.7% 20.3 75.3% HSBC Bank A.S. [Turkey] 691 -530 161 -257 0 -96 -119 0 6.4% 76.7% 1.5% -2.4% 0.0% -0.9% -1.1% 11.7 -12.8% HSBC Bank Malta p.l.c. 196 -132 64 -12 0 52 33 19 2.5% 67.3% 0.8% -0.2% 0.0% 0.7% 0.4% 15.7 6.5% HSBC France 2,631 -1,811 820 -134 0 686 496 445 1.4% 68.8% 0.4% -0.1% 0.0% 0.4% 0.3% 28.4 7.7% HSBC Invoice Finance (UK) Limited 262 -57 205 -10 0 195 155 115 4.3% 21.7% 3.4% -0.2% 0.0% 3.2% 2.6% 24.0 61.5% HSBC Life (UK) Limited 79 -40 39 0 0 39 34 122 3.9% 50.7% 1.9% 0.0% 0.0% 1.9% 1.7% 5.5 9.2% HSBC Private Bank (UK) Limited 379 -225 154 -15 0 139 111 0 3.9% 59.3% 1.6% -0.2% 0.0% 1.4% 1.1% 5.1 5.8% HSBC Trinkaus & Burkhardt AG 813 -588 225 0 17 241 169 78 3.4% 72.4% 1.0% 0.0% 0.1% 1.0% 0.7% 11.1 7.9% HSBC Trust Company (UK) Limited 114 -41 72 0 0 72 58 84 21.5% 36.2% 13.7% 0.0% 0.0% 13.7% 11.1% 5.7 63.1% Marks & Spencer Retail Financial 503 -382 121 -41 0 80 44 0 7.5% 75.9% 1.8% -0.6% 0.0% 1.2% 0.6% 16.3 10.6% Services Holdings Limited Subtotal of principal subs 6,144 -3,894 2,250 -470 17 1,797 1,365 1,166 2.4% 63.4% 0.9% -0.2% 0.0% 0.7% 0.5% 19.3 10.1% Rest of HSBC Bank plc 13,735 -10,651 3,084 -269 -10 2,805 1,694 410 1.7% 77.5% 0.4% 0.0% 0.0% 0.3% 0.2% 19.4 4.0% HSBC Bank plc total 19,663 -14,392 5,271 -735 3 4,539 3,016 1,569 1.8% 73.2% 0.5% -0.1% 0.0% 0.4% 0.3% 19.4 5.4% Principal subs as % of HSBC Bank 30% 26% 41% 63% 439% 38% 44% 74% Source: Deutsche Bank estimates, company data
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With CET1 ratios generally healthy for most of the subsidiaries (most are above the Bank plc level, Figure 117), the outlook for dividend cashflow should be driven by earnings performance (rather payout ratios) – most important of which is HSBC France and the UK invoice and asset finance subs.
HSBC France has reported RoE and RoTE which have been broadly in line with French peers (Figure 106, Figure 107). Our French banks analyst expects stable RoE (7-8%) and RoTE (8-9%) performance in 2016-2018, and it doesn’t seem unreasonable to expect HSBC France to performance in line with these trends. Given 14.3% CET1 at 1H16 (well above other French banks at c.11-12%) an annual dividend of around US$400-500 looks sustainable.
Figure 104: French banks RoE over time Figure 105: French banks RoTE over time
40.0% 50.0% 40.0% 30.0% 30.0% 20.0% 20.0% 10.0% 10.0% 0.0% 0.0% -10.0% -20.0% -10.0% -30.0% -20.0% -40.0%
BNP Paribas Societe Generale Credit Agricole SA BNP Paribas Societe Generale Credit Agricole SA HSBC France Total / average HSBC France Total / average
Source: Deutsche Bank estimates, company data, Factset Source: Deutsche Bank estimates, company data
Trinkaus & Burkhardt and Malta RoE trajectories have looked more challenging as of late, but earnings and cash contribution to the group is relatively small (averaging under Figure 106: HSBC Trinkaus & Burkhardt RoE Figure 107: HSBC Bank Malta RoE over time 18% 30% 16% 25% 14% 12% 20% 10% 15% 8% 6% 10% 4% 2% 5% 0% 0% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 1997 2002 2007 2012 1998 1999 2000 2001 2003 2004 2005 2006 2008 2009 2010 2011 2013 2014 2015 1996 Source: Deutsche Bank estimates, company data, Factset Source: Deutsche Bank estimates, company data, Factset Turkey was lossmaking in 2015, but made 9% RoE in 2009-11. HSBC Turkey is relatively exposed to the retail segment (one of the highest consumer/total loans in Turkish banking system at c.35%) which was hit by regulatory pressure. After Turkey had its balance of payments crisis in 2011 (which was consumption driven), measures were introduced by the regulator to make consumer lending more capital intensive, which has affected HSBC Turkey. Page 50 Deutsche Bank AG/Hong Kong 31 August 2016 Banks HSBC Holdings Plc Figure 108: Turkey RoE & earnings performance Figure 109: HSBC Bank A.S. CET1 ratios over time 200 15.0% 14.0% 159 161 12.6% 144 150 10.0% 12.0% 98 10.4% 10.4% 100 9.7% 5.0% 10.0% 9.4% 50 23 0.0% 8.0% 0 -5.0% 6.0% -50 -26 -100 -10.0% 4.0% -150 -120 -15.0% 2.0% 2009 2010 2011 2012 2013 2014 2015 0.0% Earnings (USD) ROE 2012 2013 2014 2015 1Q16 Source: Deutsche Bank estimates, company data, Factset Source: Deutsche Bank Meanwhile CET1 ratio had fallen to 9.4% at 2015 (though recovered slightly in 1Q16). It has paid no dividend in recent years. The biggest risk in the context of HSBC Bank plc is that capital needs to be downstreamed. The capital ratio is lower than Turkish peers (Figure 110), though this should be higher than the 2019 requirements (8.5% Tier 1 + any countercyclical). With just under US$10bn of RWAs in Turkey, every 100bps required for downstreaming represents c.US$100m of cash. Figure 110: Turkey 2015 Tier1 / CET1 ratios compared 16.0% 14.1% 14.0% 13.5% 13.1% 13.4% 12.0% 11.2% 10.3% 10.0% 9.4% 8.0% 6.0% 4.0% 2.0% 0.0% Akbank Garanti Halkbank Isbank Vakifbank Yapi Kredi HSBC Bank Turkey Source: Deutsche Bank estimates, company data, Factset 3) UK business: solid business undermined by below-the-line charges The rest of HSBC Bank plc is effectively the UK, which is made up of 3 main businesses: Retail banking, commercial banking and GBM. Private Banking is relatively small. The disclosures for this are best available in the datapacks that HSBC publishes quarterly (history back to 2013). However, as discussed earlier, we need to exclude ‘other’ which includes a lot of the Hold Co costs not actually in HSBC Bank plc (for more detail see the Hold Co section). Over the last 3 years around 40% of income / profitability is in the retail business, 40% of profitability / 30% of income is in commercial banking, 20% of profitability / 30% of income in GBM (Figure 111 & Figure 112). Deutsche Bank AG/Hong Kong Page 51 31 August 2016 Banks HSBC Holdings Plc Figure 111: Underlying PBT by business (USD) Figure 112: Underlying income by business (USD) 2,500 7,000 6,000 2,000 5,000 1,500 4,000 FY13 FY13 1,000 FY14 3,000 FY14 FY15 2,000 FY15 500 1,000 0 0 RBWM Commercial GBM GPB RBWM Commercial GBM GPB Banking Banking Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data RoE for the UK business is impacted by ‘other’ and one off items (particularly conduct / legal charges in retail / GBM). On a headline basis, UK has been loss making. Excluding ‘other’ division but including one-offs, the RoE is around 6%, and excluding both ‘other’ and one-offs (i.e. ‘true’ underlying performance) gives us an RoE of around 10% over the last 2 years. As the main location of many of the negative below-the-line one-offs (which we expect to continue) the RoE of UK will continue to be lower at the headline level in coming years. Figure 113: RoE estimates for UK Figure 114: UK underlying PBT (ex-other) 15.0% 2,500 10.0% 2,000 5.0% 1H14 0.0% 1,500 2H14 -5.0% 1H15 1,000 -10.0% 2H15 -15.0% 1H16 500 -20.0% 0 4Q14 4Q15 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 1Q15 2Q15 3Q15 1Q16 2Q16 RoE (Stated, RoE RoE (ex-Other, RoE (ex-Other, 1Q13 11% CET1) (underlying, stated 11% underlying 11% 11% CET1) CET1) CET1) Source: Deutsche Bank estimates, company data. Note we use 11% x RWAs, and then scale up capital Source: Deutsche Bank estimates, company data to get equity by the same proportion as in HSBC Bank plc Commercial Business: we know from subsidiary filings for asset finance and invoice finance that these are high RoE businesses (60-70%), and generated c.US$0.6bn of PBT (around 30% of commercial PBT). However, we expect that the rest of the business is significantly less profitable due to higher equity allocation, and higher impairments (80% of UK impairments are in commercial banking). GBM business: though we don’t have RWAs by UK segment, we know from HSBC Bank plc filings that the risk weightings for GBM in HSBC Bank plc are lower than the wider group. Cost/income ratio is around 70-80% in recent years. Retail: we expect this is the highest RoE business of the 3, driven by very low capital requirements for mortgages (HSBC has just a 4% IRB credit Page 52 Deutsche Bank AG/Hong Kong 31 August 2016 Banks HSBC Holdings Plc risk weight for UK mortgages, so £80bn of mortgages are backed by just £0.3bn/US$0.4bn of equity), combined with much lower impairments. In the UK HSBC operates under 3 brands: HSBC, Marks & Spencer and First Direct and has around 7% market share in lending, 10% market share in deposits making it the 6th largest in the UK (behind Lloyds, Barclays, RBS, Santander, Nationwide). Our estimate of 16 year performance of HSBC’s UK retail business is shown in Figure 115 below (note that the last 3 years are from UK specific disclosures, before this we have relied on HSBC Bank plc disclosures). ‘Actual performance’ has been impacted by one-off items, underlying performance points to around 21% RoTE. The cost income ratio has deteriorated in recent years, as income margins have fallen. This is the main difference between HSBC and the industry (income margins are better, impairments in line, leverage higher). Figure 115: HSBC UK retail estimated 15-year performance 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 vs. industry Net interest margin % 4.2 3.9 3.9 n/a n/a n/a n/a n/a 4.0 2.9 3.0 2.9 2.9 2.9 2.8 2.9 0.3 Non interest margin % 3.2 3.1 2.5 n/a n/a n/a n/a n/a 3.0 1.9 1.8 1.6 1.5 1.4 1.5 1.1 0.5 Total income margin % 7.3 7.0 6.4 n/a 5.6 5.4 5.3 5.2 7.0 4.8 4.7 4.5 4.4 4.3 4.4 4.0 0.8 Cost/income ratio % -68 -69 -68 n/a n/a n/a n/a n/a -50 -54 -55 -54 -53 -58 -73 -72 -20.0 PPP margin % 2.3 2.2 2.1 n/a n/a n/a n/a n/a 3.5 2.2 2.1 2.1 2.1 1.8 1.2 1.1 -0.4 Impairment rate % -0.7 -0.5 -0.4 n/a n/a n/a n/a n/a -1.2 -1.4 -1.0 -0.6 -0.5 -0.2 -0.2 -0.2 0.0 PBT margin % 1.4 1.6 1.7 1.6 1.6 1.4 1.3 1.0 2.3 0.9 1.1 1.4 1.5 1.5 0.9 0.8 -0.5 ROA % 1.0 1.1 1.2 1.1 1.2 1.0 0.9 0.7 1.7 0.6 0.8 1.0 1.2 1.1 0.7 0.6 -0.4 Leverage 37x 34x 33x 36x 36x 38x 36x 36x 26x 25x 23x 25x 21x 34x 31x 31x 5x U/L RoTE (historic capital)* 36.5 41.9 42.1 40.8 45.8 40.0 34.6 26.5 55.6 17.6 19.6 25.7 27.2 22.8 21.3 21.1 -5.7 U/L RoTE (11% RWAs)** 25.5 29.6 30.4 28.6 29.9 25.5 22.9 18.7 37.2 13.1 17.7 24.1 27.9 24.6 20.9 21.8 -14.9 Act. RoTE (historical capital)*** 36.5 54.4 42.1 40.8 45.8 40.0 34.6 26.5 55.6 17.6 19.6 21.9 10.2 12.3 6.2 11.0 -12.3 vs. underlying 0.0 12.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 -3.8 -17.0 -10.5 -15.1 -10.2 Market share (%) 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 RANK Mortgages n/a n/a n/a n/a n/a n/a n/a n/a 4.7 5.2 5.5 6.0 6.4 6.5 6.3 6.2 6 Unsecured (total) n/a n/a n/a n/a n/a n/a n/a n/a 9.6 9.6 9.2 8.6 9.0 8.8 8.0 7.8 4 Credit cards n/a n/a n/a n/a n/a n/a n/a n/a 14.8 14.5 14.4 13.0 12.7 12.2 11.2 11.0 3 Unsecured n/a n/a n/a n/a n/a n/a n/a n/a 7.8 7.6 6.5 6.3 7.0 6.8 6.2 6.1 3 Total consumer credit 4.1 4.3 4.4 4.4 5.3 5.6 5.9 5.2 5.4 5.8 6.0 6.3 6.7 6.7 6.6 6.6 6 Deposits n/a n/a n/a n/a n/a n/a n/a n/a 15.7 13.8 14.0 14.5 9.7 9.5 9.7 10.0 6 Source: Deutsche Bank estimates, company data We expect pressure on NII in the near term following the reduction in base rates. FD Mackay gave the sensitivity as c.US$200m annually on NII (around 2.5-3% of NII in the UK business overall). Deutsche Bank AG/Hong Kong Page 53 31 August 2016 Banks HSBC Holdings Plc Figure 116: Net interest income (adjusted), US$m 2,500 2,000 1,500 1,000 500 0 3Q15 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 4Q15 1Q16 2Q16 Source: Deutsche Bank estimates, company data, adjusted for NQH 4) Capital requirements: Ring-fence will require more capital, UK RWs low Cash availability for upstream to Group will also depend on capital requirements for HSBC Bank plc and the eventual ring-fence structure HSBC adopts. As mentioned above, the capital ratios for most of the principal subsidiaries of HSBC Bank plc appear healthy (with the exception of Turkey, Figure 118). However, HSBC Bank plc’s ratio (9.6% at FY15 and 1H16) screens low vs. other UK domestic banks (Figure 118). Figure 117: CET1 ratios by sub Figure 118: HSBC Bank plc CET1 ratio vs. UK (1H16) 25.0% 23.4% Marks & Spencer Retail Finanial … 8.7% 20.0% HSBC Bank A.S. [Turkey] 9.4% 14.5% 15.3% HSBC Bank plc 9.6% 15.0% 13.0% 13.5% 11.0% 11.2% 11.6% HSBC Trinkaus & Burkhardt AG 10.3% 9.6% 10.0% HSBC Bank Malta p.l.c. 12.3% 5.0% HSBC France 14.9% HSBC Private Bank (UK) Limited 39.5% 0.0% HSBC Trust Company (UK) Limited 44.0% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% Source: Deutsche Bank Source: Deutsche Bank Does HSBC have enough capital in its subsidiary? We have written separately on the ever-evolving UK capital framework (for a copy of the report, please click here). A summary of the capital stack of UK banks is shown in Figure 119, and we explain how these requirements apply to HSBC’s different subsidiaries below. Page 54 Deutsche Bank AG/Hong Kong 31 August 2016 Banks HSBC Holdings Plc Figure 119: UK capital stack 18% PRA buffer, 1.0% CCyB 16% 1.5% 14% CCoB CCyB 2.5% 1.5% 12% Systemic CCyB CCoB buffer 1.5% 2.5% 10% Pillar 2A CCoB Combined Systemic 3.2% 2.5% buffer buffer 8% Systemic Pillar 2A buffer 2.4% 6% Pillar 2A CCyB, 0.5% 1.8% Min. req. Systemic 4% Min. 3.0% buffer req. Pillar 1 Pillar 1 6.0% 2% 4.5% Min. req. Min. req. 3.0% 2.25% 0% CET1 T1 Total capital CET1 Leverage T1 Leverage Source: Deutsche Bank Pillar 1: this is a minimum requirement applied consistently to all banks, covering credit risk, counterparty credit risk, market risk and operational risk. The total Pillar 1 requirement is 8%, with 4.5% to be met with CET1 capital, 1.5% with AT1 capital and 2% with Tier 2 capital. Applies to HSBC Holdings, HSBC Bank plc and HSBC UK Ring-fence. Pillar 2A: this is a minimum requirement applied at the individual bank level by the PRA, to be met with the same proportions of capital quality as Pillar 1 (i.e. 4.5 / 8 for CET1). Pillar 2A is set in order to cover risks that are either not covered at all, or not covered sufficiently by Pillar 1. These risks include pension risk, concentration risk, market risk, operational risk and interest rate risk in the banking book. The BoE expects some Pillar 2A requirements to transfer to Pillar 1 once the shortcomings in Pillar 1 are addressed under the current Basel proposals. The current average UK Tier 1 Pillar 2A requirement is 2.4% (of which 1.8% is CET1). For HSBC Holdings this is currently 1.3% of CET1. HSBC Bank plc & the ring- fence will have their own Pillar 2A figures, however these are currently not disclosed. For this note we assume it is the same. Capital conservation buffer (CCoB): establishes a basic level of capacity across the system to absorb losses. The fully-phased in CCoB in 2019 will be 2.5% for all banks (currently 0.625%, rising to 1.25% from 1 Jan 2017 and to 1.875% from 1 Jan 2018). Applies to HSBC Holdings, HSBC Bank plc and HSBC UK Ring-fence. Countercyclical buffer (CCyB): a system-wide, time-varying buffer on UK exposures set by the FPC, ahead of a PRA buffer being set. The FPC will use the stress test and other indicators to assess the adequacy of systemic resilience and to set subsequently a CCyB which seeks to offer additional protection against the build-up of systemic risk relating to the financial cycle. A CCyB of 1% is expected when risks are neither subdued nor elevated. Currently set at 0% in the UK. Note HKMA currently sets a CCyB Deutsche Bank AG/Hong Kong Page 55 31 August 2016 Banks HSBC Holdings Plc which applies for HSBC Holdings for HK exposures. A full list of current & pending foreign CCyB rates is available here. For HSBC Bank plc this is effectively zero (0.005%). For the ring-fence there it should be zero (unless the BoE raises it). PRA buffer: if system-wide buffers are not sufficient to cover a bank’s stress losses, the PRA can set a bank-specific PRA buffer to capture risks specific to a particular bank, using the stress test results (and other inputs) to inform this calculation. In this way there is no double-counting with system-wide buffers. Note, however, that there is no mechanical link between setting the buffer and the stress test result. The PRA can also apply a scalar to address risk management and governance weaknesses. HSBC Holdings will be subject to the stress test (and resulting requirements), however the Bank plc will not. Therefore we don’t expect there to be a PRA buffer for the Bank plc / ring-fence. Systemic buffers: For those firms designated as globally systemically important by the FSB, this represents a G-SIB buffer, set at the consolidated level. The latest list of G-SIB firms and categories is available here. HSBC Holdings is in the highest category, which means 2.5% buffer. HSBC Bank plc & the ring-fence have a 0% GSIB buffer. In May 2016 the FPC published details of its framework for setting a Systemic Risk Buffer (SRB) for those firms that are deemed to be systemic at the domestic level. The SRB will apply to ring-fenced banks / large building societies at the ring-fenced sub-group level. HSBC Holdings and HSBC Bank will have an SRB of zero (as they are not the ring-fenced entity). Given the size of HSBC’s UK ring-fenced bank is expected to be around £175bn / US$228bn, Figure 75) this would put it at the lower end of the 1% bucket. Figure 120: Calibration of Systemic Risk Buffer Total assets (£bn) SRB rate Lower threshold Upper threshold 0% - < 175 1% 175 < 320 1.5% 320 < 465 2% 465 < 610 2.5% 610 < 755 3% > 755 Source: BoE Management buffer: group capital guidance is for a management buffer of 1.5%-2.5% (2015 strategy slides). We expect a management buffer at subsidiary levels too - though for capital efficiency it is likely to be towards the lower end for most. For the UK ring-fence, we think a management buffer of c.2% seems reasonable, particularly given how low UK mortgage risk weights are. Page 56 Deutsche Bank AG/Hong Kong 31 August 2016 Banks HSBC Holdings Plc Risk weightings in the UK Using EBA disclosures from the recent stress test we can benchmark HSBC’s risk weights against other UK lenders. For Corporate and SME exposures, HSBC is in the middle of the pack (61% and 53% respectively). However, for retail and mortgage exposures, HSBC is lowest by some margin (Figure 121 Figure 122) with a UK mortgage risk weight of just 4% - for £80bn asset pool. The key risk from an HSBC capital perspective is if so-called ‘Basel 4’ changes introduce floors on risk weightings / assumed P.D, or other regulatory action traps more capital in the UK. We have written on these topics extensively in our ‘Truth and Advertising’ series (email us if you would like a copy). Though HSBC Holdings does not screen particularly impacted vs., other European banks, it benefits from group portfolio effects (UK mortgages are taken with all other mortgages globally). However, it is unclear to us what approach the PRA might take to subsidiary risk weightings (in particular the UK ring-fence). We also note that the PRA recently published a consultation on changes to the IRB approach to calculating RWAs. The proposals seek to address the pro- cyclicality and high variability in risk weights calculated by firms under the IRB approach by setting out expectations about how firms model the probability of default (PD) and loss given default (LGD). PD proposals: At present, firms model PD using either a ‘point in time’ (PiT) model, which only takes account of recent loss experience, or a ‘through the cycle’ (TtC) model, which does not vary PD as economic conditions change. The PRA is proposing firms model using a methodology that sits somewhere in between the two, using a consistent and appropriate assumption for the level of model cyclicality. LGD proposals: firms are already required to incorporate at least 40% reduction in property sale prices from the peak. This calculation includes a forced sale discount, as well as a HPI decline which varies by firm. Too low an assumption can lead to pro-cyclicality in a downturn so the PRA is proposing firms incorporate a HPI fall assumption not less than 25% (in addition to the at least 40% reduction from peak). Firms currently using a PiT model will typically see an increase in Pillar 1 capital requirements, with the opposite being true for firms using TtC models. HSBC says it uses a “statistical model built on internal behavioural data and bureau information, and calibrated to a long-run default rate” for mortgages. Firms currently modeling an HPI fall of less than 25% will see a rise in their LGD, which feeds through into higher Pillar 1 capital requirements. This is likely to be offset by lower stress capital requirements (PRA Buffer set as part of BoE stress test), but it is important to note that, unlike Pillar 1, this buffer is not part of formal minimum requirements. We do not have firm level detail on HPI fall assumptions but the 2014 BoE stress test highlighted some firms used an assumption of <35%. Deutsche Bank AG/Hong Kong Page 57 31 August 2016 Banks HSBC Holdings Plc Figure 121: Retail risk weights by bank on UK exposures (2015) 80% 75%75%75%76% 71%72% 66% 70% 64% 58%59%60% 60% 57% 51% 49%50% 50% 45% 40% 34% 30% 30% 26%26%27% 23%24%25% 21%21% 18%19% 20% 14%14%15%15%15%15% 11% 10% 0% … … … … … - group group group group - - – - Thüringen - NRW.BANK Barclays Plc BNP Paribas BNP DanskeBank Württemberg KBC Group KBC NV - HSBC Holdings ING Groep Groep ING N.V. UniCredit S.p.A.UniCredit Belfius Belfius BanqueSA Commerzbank AG Deutsche Bank Deutsche AG Swedbank Allied Irish Banks Allied plc NordeaBank Erste Group Erste Bank AG Banco SantanderBanco S.A. Générale Société S.A. Groupe Crédit Crédit Groupe Mutuel Intesa Sanpaolo Intesa S.p.A. Banco de Sabadell de Banco S.A. Groupe Crédit Crédit Agricole Groupe ABN AMRO AMRO ABN GroupN.V. Bayerische Landesbank Bayerische Lloyds BankingLloyds Group Plc NorddeutscheLandesbank LandesbankHessen Svenska Handelsbanken Svenska DekaBank Deutsche Deutsche DekaBank Girozentrale LandesbankBaden Volkswagen Financial Services AG Coöperatieve Coöperatieve Centrale Raiffeisen The Royal BankThe Scotland of Group The Governor Governor The andCompany of the BancoBilbao Vizcaya Argentaria S.A. SkandinaviskaEnskilda Banken Source: Deutsche Bank, EBA data Figure 122: Mortgage risk weights by bank on UK exposures (2015) 90% 79% 80% 70% 70% 61% 60% 49%50% 50% 39%39% 35%35%35%36% 40% 32%33%34%34%35% 30% 24%24% 17%18%20% 20% 14%15%15%16%16%17% 10%10%12%12% 10% 4% 0% … … … … … - group group group - – - Thüringen - BarclaysPlc BNP Paribas BNP Danske Bank Danske GroupeBPCE Württemberg KBC KBC GroupNV - HSBC Holdings HSBC ING Groep Groep ING N.V. UniCredit S.p.A.UniCredit Belfius Belfius BanqueSA Commerzbank AG DeutscheBank AG Swedbank Allied Irish Banks Allied plc Erste Group Erste Bank AG BancoSantander S.A. Générale Société S.A. Groupe Crédit Crédit Groupe Mutuel Intesa Sanpaolo Intesa S.p.A. Bancode Sabadell S.A. Groupe Crédit Crédit Groupe Agricole ABN AMROABN GroupN.V. BayerischeLandesbank Lloyds BankingLloyds Group Plc NorddeutscheLandesbank LandesbankHessen Svenska Handelsbanken Svenska LandesbankBaden Coöperatieve Coöperatieve Centrale Raiffeisen The Royal BankThe Scotland of Group The Governor Governor The andCompany of the Banco BilbaoBancoVizcaya Argentaria S.A. SkandinaviskaEnskilda Banken Source: Deutsche Bank, EBA data Page 58 Deutsche Bank AG/Hong Kong 31 August 2016 Banks HSBC Holdings Plc Putting this together: Having worked through the above framework we can build a capital requirement stack for each entity. We show our estimate of current (and future) requirements for HSBC Holdings plc, HSBC Bank plc and HSBC’s UK ring-fenced entity in detail in Figure 126. Our estimate of 2019 CET1 requirements are 11.5% for HSBC Holdings, 8.3% for HSBC Bank plc and 9.3% for HSBC’s ring-fence. Despite having a materially lower capital ratio than UK peers, HSBC Bank plc appears to have >130bps of headroom over its current and 2019 requirements. However, due to the SRB buffer, the ring-fenced entity (when it is established) will have a 1% higher capital requirement than the Bank plc. Given the likely size of the UK ring-fenced business (2/3 of UK loans, we’d expect lower proportion of RWAs – say 50%; and total UK RWAs are around 70% of Bank plc RWAs) this should effectively be binding at the Bank plc level (until re-subsidiariation occurs) at around 9% requirement (8.3% + 0.4*1% = ~9%) for Bank plc. Bank plc is at 9.6% today, 60bps above this 2019 requirement. On the management buffer of 1.5-2.5% (in line with group capital guidance), this gives us a CET1 requirement of 10.5-11.5% for HBSC Bank plc in Jan 2019, an increase of c.90-190bp (or around US$2.7-5.7bn accretion over 2.5 years) from current levels. Figure 123: CET1 requirements by HSBC entity Figure 124: Summary of estimated requirements and buffers 14% 14.0% 13.3% 12.1% 12.3% 12% 11.5% 12.0% 11.0% 10.5% 10% 9.6% 10.0% 9.0% 8% 8.0% 6% 6.0% 4% 4.0% 2% 2.0% 0% 0.0% 2016 2017 2018 2019 2016 2017 2018 2019 2016 2017 2018 2019 HSBC Holdings plc HSBC Bank plc HSBC Holdings plc HSBC Bank plc HSBC UK Ring Fence Today Pillar 1 Pillar 2A Est. 2019 requirement (excl. PRA buffer) G-SIB / Systemic Risk Buffer CCoB CCyB Implied PRA buffer Requirement + mgmt buffer lower bound 2Q16 CET1 ratio Requirement + mgmt buffer upper bound Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data Deutsche Bank AG/Hong Kong Page 59 31 August 2016 Banks HSBC Holdings Plc Figure 125: 2Q16 capital position HSBC Holdings plc HSBC Bank plc HSBC UK Ring fence Resources 01-Jan-16 01-Jan-17 01-Jan-18 01-Jan-19 01-Jan-16 01-Jan-17 01-Jan-18 01-Jan-19 01-Jan-16 01-Jan-17 01-Jan-18 01-Jan-19 CET1 (end point / transitional) 130,670 130,670 130,670 130,670 30,740 30,740 30,740 30,740 n.a. n.a. n.a. n.a. AT1 (end point) 11,375 11,375 11,375 11,375 4,636 4,636 4,636 4,636 n.a. n.a. n.a. n.a. Tier 1 (end point) 142,045 142,045 142,045 142,045 35,377 35,377 35,377 35,377 n.a. n.a. n.a. n.a. Tier 2 (end point) 16,442 16,442 16,442 16,442 10,040 10,040 10,040 10,040 n.a. n.a. n.a. n.a. Total capital (end point) 158,487 158,487 158,487 158,487 45,416 45,416 45,416 45,416 n.a. n.a. n.a. n.a. AT1 (transitional) 21,642 21,642 21,642 21,642 6,384 6,384 6,384 6,384 n.a. n.a. n.a. n.a. Tier 1 (transitional) 152,312 152,312 152,312 152,312 37,124 37,124 37,124 37,124 n.a. n.a. n.a. n.a. Tier 2 (transitional) 34,481 34,481 34,481 34,481 11,845 11,845 11,845 11,845 n.a. n.a. n.a. n.a. Total capital (transitional) 186,793 186,793 186,793 186,793 48,969 48,969 48,969 48,969 n.a. n.a. n.a. n.a. Exposures RWAs 1,082,184 1,082,184 1,082,184 1,082,184 319,179 319,179 319,179 319,179 n.a. n.a. n.a. n.a. Leverage exposure 2,788,000 2,788,000 2,788,000 2,788,000 1,003,805 1,003,805 1,003,805 1,003,805 n.a. n.a. n.a. n.a. Ratios CET1 (end point / transitional) 12.1% 12.1% 12.1% 12.1% 9.6% 9.6% 9.6% 9.6% n.a. n.a. n.a. n.a. Tier 1 (end point) 13.1% 13.1% 13.1% 13.1% 11.1% 11.1% 11.1% 11.1% n.a. n.a. n.a. n.a. Total capital (end point) 14.6% 14.6% 14.6% 14.6% 14.2% 14.2% 14.2% 14.2% n.a. n.a. n.a. n.a. Tier 1 % (transitional) 14.1% 14.1% 14.1% 14.1% 11.6% 11.6% 11.6% 11.6% n.a. n.a. n.a. n.a. Total capital % (transitional) 17.3% 17.3% 17.3% 17.3% 15.3% 15.3% 15.3% 15.3% n.a. n.a. n.a. n.a. Tier 1 leverage ratio (end point) 5.1% 5.1% 5.1% 5.1% 3.5% 3.5% 3.5% 3.5% n.a. n.a. n.a. n.a. CET1 leverage ratio (end point) 4.7% 4.7% 4.7% 4.7% 3.1% 3.1% 3.1% 3.1% n.a. n.a. n.a. n.a. Source: Deutsche Bank Overleaf we show our estimate of the capital requirements for HSBC Holdings, Bank and ring-fence out to 2019. Page 60 Deutsche Bank AG/Hong Kong 31 August 2016 Banks HSBC Holdings Plc Figure 126: HSBC Holdings, Bank and Ring-fence requirements HSBC Holdings plc HSBC Bank plc HSBC UK Ring fence CET1 requirements 01-Jan-16 01-Jan-17 01-Jan-18 01-Jan-19 01-Jan-16 01-Jan-17 01-Jan-18 01-Jan-19 01-Jan-16 01-Jan-17 01-Jan-18 01-Jan-19 Pillar 1 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% 4.5% Pillar 2A 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% 1.3% G-SIB / Systemic Risk Buffer 0.6% 1.3% 1.9% 2.5% 0.0% 0.0% 0.0% 0.0% 0.3% 0.5% 0.8% 1.0% CCoB 0.6% 1.3% 1.9% 2.5% 0.6% 1.3% 1.9% 2.5% 0.6% 1.3% 1.9% 2.5% CCyB 0.2% 0.2% 0.2% 0.2% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Current requirement 7.3% 8.5% 9.8% 11.0% 6.4% 7.1% 7.7% 8.3% 6.7% 7.6% 8.4% 9.3% Mandatory Distribution Restrictions (MDA) 7.1% 8.3% 9.6% 10.8% 6.4% 7.1% 7.7% 8.3% 6.7% 7.6% 8.4% 9.3% Systemic Reference Point 6.4% 7.1% 7.7% 8.3% 5.8% 5.8% 5.8% 5.8% 6.1% 6.3% 6.6% 6.8% Minimum CET1 requirement 5.8% 5.8% 5.8% 5.8% 5.8% 5.8% 5.8% 5.8% 5.8% 5.8% 5.8% 5.8% Stressed loss (2015 stress test) -3.2% -3.2% -3.2% -3.2% n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Implied PRA buffer (DB est) 2.4% 1.8% 1.1% 0.5% n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Implied requirement post 2016 stress test (DB est) 9.6% 10.3% 10.9% 11.5% n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Tier 1 requirements Pillar 1 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% Pillar 2A 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% 1.7% Sum of CRD IV buffers 1.5% 2.7% 4.0% 5.2% 0.6% 1.3% 1.9% 2.5% 0.9% 1.8% 2.6% 3.5% Current requirement 9.2% 10.4% 11.7% 12.9% 8.4% 9.0% 9.6% 10.2% 8.6% 9.5% 10.4% 11.2% Total capital requirement Pillar 1 8.0% 8.0% 8.0% 8.0% 108.0% 8.0% 8.0% 8.0% 208.0% 8.0% 8.0% 8.0% Pillar 2A 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% Sum of CRD IV buffers 1.5% 2.7% 4.0% 5.2% 0.6% 1.3% 1.9% 2.5% 0.9% 1.8% 2.6% 3.5% Current requirement 11.8% 13.0% 14.3% 15.5% 110.9% 11.6% 12.2% 12.8% 211.2% 12.1% 12.9% 13.8% Leverage requirements Minimum requirement 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% Systemic importance buffers (G-SIB & SRB) 0.2% 0.4% 0.7% 0.9% 0.0% 0.0% 0.0% 0.0% 0.1% 0.2% 0.3% 0.4% Countercyclical capital buffer (currently) 0.1% 0.1% 0.1% 0.1% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Tier 1 leverage requirement 3.3% 3.5% 3.7% 3.9% 3.0% 3.0% 3.0% 3.0% 3.1% 3.2% 3.3% 3.4% Minimum CET1 leverage requirement 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% 2.3% MREL requirements (1 Jan 2020) Loss absorption amount (= total capital req) n/r n/r n/r 15.5% n/r n/r n/r 12.8% n/r n/r n/r 13.8% Recapitalisation amount (= P1, P2A total req) n/r n/r n/r 10.3% n/r n/r n/r 10.3% n/r n/r n/r 10.3% Total n/r n/r n/r 25.8% n/r n/r n/r 23.1% n/r n/r n/r 24.1% (Deficit) / surplus vs requirements CET1 vs current requirements (%) 4.8% 3.6% 2.3% 1.1% 3.2% 2.6% 2.0% 1.3% n.a. n.a. n.a. n.a. CET1 vs current requirements (USD m) 52,212 38,684 25,157 11,630 10,233 8,238 6,243 4,249 n.a. n.a. n.a. n.a. CET1 vs est. 2016 requirements (%) 2.4% 1.8% 1.2% 0.6% n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. CET1 vs est. 2016 requirements (USD m) 26,510 19,746 12,982 6,219 n.a. n.a. n.a. n.a. n.a. n.a. n.a. n.a. Tier 1 leverage vs current requirements (%) 1.8% 1.6% 1.4% 1.1% 0.5% 0.5% 0.5% 0.5% n.a. n.a. n.a. n.a. Tier 1 leverage vs current requirements (USD m) 50,355 44,256 38,157 32,058 5,262 5,262 5,262 5,262 n.a. n.a. n.a. n.a. Source: Deutsche Bank estimates, company data 2Q16 capital position on today's rules Resources CET1 (end point / transitional) 130,670 130,670 130,670 130,670 30,740 30,740 30,740 30,740 n.a. n.a. n.a. n.a. AT1 (end point) 11,375 11,375 11,375 11,375 4,636 4,636 4,636 4,636 n.a. n.a. n.a. n.a. Tier 1 (end point) 142,045 142,045 142,045 142,045 35,377 35,377 35,377 35,377 n.a. n.a. n.a. n.a. Tier 2 (end point) 16,442 16,442 16,442 16,442 10,040 10,040 10,040 10,040 n.a. n.a. n.a. n.a. Total capital (end point) 158,487 158,487 158,487 158,487 45,416 45,416 45,416 45,416 n.a. n.a. n.a. n.a. AT1 (transitional) 21,642 21,642 21,642 21,642 6,384 6,384 6,384 6,384 n.a. n.a. n.a. n.a. Tier 1 (transitional) 152,312 152,312 152,312 152,312 37,124 37,124 37,124 37,124 n.a. n.a. n.a. n.a. Tier 2 (transitional) 34,481 34,481 34,481 34,481 11,845 11,845 11,845 11,845 n.a. n.a. n.a. n.a. Total capital (transitional) 186,793 186,793 186,793 186,793 48,969 48,969 48,969 48,969 n.a. n.a. n.a. n.a. Exposures RWAs 1,082,184 1,082,184 1,082,184 1,082,184 319,179 319,179 319,179 319,179 n.a. n.a. n.a. n.a. Leverage exposure 2,788,000 2,788,000 2,788,000 2,788,000 1,003,805 1,003,805 1,003,805 1,003,805 n.a. n.a. n.a. n.a. Ratios CET1 (end point / transitional) 12.1% 12.1% 12.1% 12.1% 9.6% 9.6% 9.6% 9.6% n.a. n.a. n.a. n.a. Tier 1 (end point) 13.1% 13.1% 13.1% 13.1% 11.1% 11.1% 11.1% 11.1% n.a. n.a. n.a. n.a. Total capital (end point) 14.6% 14.6% 14.6% 14.6% 14.2% 14.2% 14.2% 14.2% n.a. n.a. n.a. n.a. 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Tier 1 % (transitional) 14.1% 14.1% 14.1% 14.1% 11.6% 11.6% 11.6% 11.6% n.a. n.a. n.a. n.a. Total capital % (transitional) 17.3% 17.3% 17.3% 17.3% 15.3% 15.3% 15.3% 15.3% n.a. n.a. n.a. n.a. Tier 1 leverage ratio (end point) 5.1% 5.1% 5.1% 5.1% 3.5% 3.5% 3.5% 3.5% n.a. n.a. n.a. n.a. CET1 leverage ratio (end point) 4.7% 4.7% 4.7% 4.7% 3.1% 3.1% 3.1% 3.1% n.a. n.a. n.a. n.a. Deutsche Bank AG/Hong Kong Page 61 31 August 2016 Banks HSBC Holdings Plc Cash flow forecasts We estimate HSBC Bank needs to retain c.90-190bp of CET1 (around US$2.7-5.7bn) over 2.5 years for compliance with UK ring-fencing requirements and to fulfill management guidance on buffers. It seems reasonable to expect around US$4-4.5bn (£3-3.5bn) of additional below-the-line charges in the coming 3 years, representing c.US$3-3.5bn post-tax. Potentially US$100-200m of capital for recapitalizing the Turkish subsidiary (though it is possible this capital could be sourced from other subsidiaries). We assume c.2% growth in RWAs each year for underlying balance sheet growth. On an 11% CET1 this is £0.5bn/annum or US$0.7bn/annum of capital. Over 2.5 years this is US$1.6bn. We assume the management buffer covers any concerns on Basel 4 / risk weight reviews. Figure 127: Summary of requirements US$bn Lower bound Upper bound Capital requirement (10.5-11.5% for Bank plc) 2.7 5.7 Below-the-line charges 3.0 3.5 Turkish recapitalisation 0.1 0.2 2% RWA growth per annum 1.6 1.6 Subtotal (2H16-2018) 7.4 11.0 Per annum 3.0 4.4 Source: Deutsche Bank estimates, company data This gives total capital consumption over the next 2.5 years of US$7bn- 11bn or US$3-4.4bn/annum. Last year the bank generated underlying earnings of £3bn (before one-offs) or US$4.5bn. If this performance is retained it could represent around US$4bn of cumulative dividends for upstream to Hold Co or zero at the lower end of the range above. Figure 128: HSBC Bank plc forecasts Figure 129: HSBC adjusted earnings forecasts 2015 2016e 2017e 2018e 2,500 NII 6,818 7,027 7,152 7,327 OOI 6,052 5,714 5,217 5,618 1,941 2,000 Total income 12,870 12,740 12,369 12,944 1,827 1,769 Opex -9,420 -9,729 -9,440 -8,170 1,554 1,625 PPP 3,450 3,011 2,929 4,774 1,397 1,412 1,500 1,300 1,360 LLPs -481 -558 -577 -613 1,257 1,200 Underlying PBT 2,969 2,453 2,352 4,162 990 Associates 2 -71 -66 -66 1,000 Stated PBT 2,971 2,382 2,286 4,096 Tax / Minorities / AT1 -1,155 -827 -757 -1,228 Earnings 1,816 1,555 1,529 2,868 500 Adjusted earnings 3,015 2,457 2,772 3,179 0 EPS stated (GBp) 218 195 191 359 EPS adjusted (GBp) 362 308 347 398 DPS (GBp) 107 39 38 72 BVPS (GBp) 4,244 4,613 4,766 5,087 TBVPS (GBp) 3,367 3,660 3,813 4,134 Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data Page 62 Deutsche Bank AG/Hong Kong 31 August 2016 Banks HSBC Holdings Plc However, 1H16 performance was weaker at £1,257m of adjusted earnings driven by lower income (not offset in costs), slightly higher impairments, and a higher tax rate (UK surcharge). As such we have earnings lower in 2016 and 2017 before recovering to similar levels in 2018. Given a higher equity base, this equates to an adjusted RoE/RoTE of 8%/10% in 2018. Figure 130: RoE forecasts Figure 131: RoTE forecasts 14.0% 25.0% 12.0% 20.0% 10.0% 15.0% 8.0% 10.0% 6.0% 4.0% 5.0% 2.0% 0.0% 0.0% FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16e FY17e FY18e FY09 FY10 FY11 FY12 FY13 FY14 FY15 FY16e FY17e FY18e RoTE (stated, tangible s'holder equity) RoE (stated, ord s'holder equity) RoE (adjusted, ord s'holder equity) RoTE (adjusted, tangible s'holder equity) Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data Lower earnings, and capital build means lower dividends: we forecast dividends of £0.9bn for 2H16-2018e, or c.US$1.2bn. Figure 132: Core Tier 1 forecasts Figure 133: Dividends / capital upstream 14.0% 5,000 4,398 4,000 12.0% 2,705 2,750 11.0% 3,000 2,454 9.9% 10.3% 9.6% 2,000 1,522 1,307 1,198 10.0% 8.7% 1,000 428 428 8.0% 0 6.0% -1,000 -2,000 4.0% -3,000 -4,000 -2,873 FY09 FY15 FY10 FY11 FY12 FY13 FY14 FY17e FY18e 2.0% FY16e 0.0% FY14 FY15 FY16e FY17e FY18e Net capital upstreamed / (downstreamed) (GBP) Core tier 1 (%) Tier 1 Ratio (%) Net capital upstreamed / (downstreamed) (USD) Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data Valuation Having modeled HSBC Bank plc divisionals, we show a simple sum of the parts valuation for what this business could be worth. We use 2017 adjusted P/E multiples: for RBWM, the average for the UK domestics, for Commercial Banking the average for Europe, for GPB we use a pure play (Julius Baer) and for GBM and ‘other’ we assume 8.0x which we think is appropriate (BNP at 7.3x, Barclays at 9.4x). After excluding prefs / minorities, and an NPV of below-the-line charges out to 2018, we have the bank at 8x 2017, 0.7x TNAV for 9.3% RoTE. This is a slight discount to the European sector (0.76x 2017, 8.4% RoTE and 9.2x TNAV – but which has a dividend yield of 6% vs HSBC Bank plc DPS/BVPS of 1%). Deutsche Bank AG/Hong Kong Page 63 31 August 2016 Banks HSBC Holdings Plc This gives a value of 130p or around 24% of the current share price. Figure 134: HSBC Bank SoTP Ave Average allocated RWAs TNAV Value per Net profit (GBP'm (GBP'm) Value share HSBC SOTP (2017E) (2017E) 2017E) 2017E P/E P/TNAV RoTE (GBP'm) (GBP) RBWM 922 14,414 3,385 9.5x 2.6 27.2% 8,762 44.8 Commercial Banking 1,502 61,590 14,465 9.2x 1.0 10.4% 13,822 70.6 GBM 519 49,718 11,677 8.0x 0.4 4.4% 4,154 21.2 GPB 95 2,401 564 12.0x 2.0 16.8% 1,134 5.8 Other -104 1,300 305 8.0x -2.7 -33.9% -829 -4.2 HSBC Bank plc 2,935 129,424 30,397 9.2x 0.9 9.7% 27,044 138.1 Below the line losses ` -3,260 -16.7 Minus Minorities and hybrids -163 9.2x -1,502 -7.7 Total FV 2,772 30,397 8.0x 0.7 9.1% 22,282 130.5 Source: Deutsche Bank estimates, company data Page 64 Deutsche Bank AG/Hong Kong 31 August 2016 Banks HSBC Holdings Plc HSBC Hold Co Black box? HSBC Holdings has 4 principal subsidiaries (North America, Latam, Europe (Bank plc) and Asia (Finance) which form the consolidated group. However, HSBC Holdings earnings do not equal the sum of the earnings of subsidiaries, and neither do the dividends which are upstreamed to it match the dividends which are paid out. This is due to the cost of the Hold Co. What is in the Hold Co? Funding / financing costs (through income). Most of HSBC’s debt is now financed out of the Hold Co. Net interest earned on capital held centrally Operating expenses for holding company & head office. Includes compliance, stress testing, regulatory costs. Bank levy sits in the Hold Co, and is based on global balance sheet AT1 issuance costs: all AT1 has been issued out of Hold Co Other volatile items: including own credit spread, non-qualifying hedges How big is Hold Co? HSBC does not disclose the explicit P&L for the Holdings Company. However, there are various ways we can try to estimate it: Method 1: using the Annual report ‘other’ division which is defined as containing “the results of HSBC’s holding company and financing operations, which includes net interest earned on free capital held centrally, operating costs incurred by the head office operations in providing stewardship and central management services to HSBC, along with the costs incurred by the Group Service Centres and Shared Service Organisations and associated recoveries. The results also include fines and penalties as part of the settlement of investigations into past inadequate compliance with anti-money laundering and sanctions laws, the UK bank levy together with unallocated investment activities, centrally held investment companies, gains arising from the dilution of interests in associates and joint ventures and certain property transactions. In addition, ‘Other’ also includes part of the movement in the fair value of long-term debt designated at fair value (the remainder of the Group’s movement on own debt is included in GB&M).” These costs are allocated out by geography (though not to subsidiaries) as shown in Figure 135. Positive PBT for other in Asia reflects the Industrial Bank sale during 2015 (US$1.4bn gain). The majority of these costs sit in the UK. Adjusted for disclosed one-off items this gives us an adjusted loss of US$3,869m in 2015, higher than in 2013/14 (Figure 135). The problem with this method is that we may be double counting items which are already within the subsidiary disclosures, and intergroup income / costs may distort the picture (e.g. intersegmental items). That income is US$5bn positive suggests internal charging of funding on an allocation matrix. Deutsche Bank AG/Hong Kong Page 65 31 August 2016 Banks HSBC Holdings Plc Figure 135: Where stated ‘other’ PBT is allocated geographically Country 'Other' PBT Country 'Other' PBT Country 'Other' PBT UK -3,857 Hong Kong 1,327 Egypt 3 France -27 Australia -5 UAE -35 Germany -27 India 141 Other 0 Switerzland -4 Indonesia 31 MENA total -32 Other -17 Mainland China 135 Europe total -3,932 Malaysia 13 Argentina -3 Sinapore -19 Brazil -4 US 55 Taiwan -13 Mexico -18 Canada -21 Other 73 Other -55 North America total 34 Asia total 1,683 Latam Total -80 Source: Company data Method 2: use ‘United Kingdom’ disclosures for ‘Other’ division and assume all of this relates to Hold Co costs. The problem with this method is that any non-Hold Co items relating to the UK business may already be booked within HSBC Bank plc. Method 3: HSBC Bank plc includes UK (and Europe), but not the Hold Co (see Figure 77 for a schematic). So if we take Bank plc results (adjusted for significant items), minus non-UK significant holdings (France, Malta, Trinkaus, Turkey) and compare with United Kingdom disclosures (also adjusted for significant items) this should give us a proxy for Hold Co specific costs. Figure 136 shows the P&Ls under each of these methodologies. Figure 136: Estimating the cost of Hold Co Method 1 Method 2 Method 3 USD $ HSBC Holdings 'Other' HSBC 'UK' 'Other' Deduction method 2013 2014 2015 2013 2014 2015 2013 2014 2015 Income 4,590 5,592 5,456 -416 1,631 354 20 1,114 174 Costs -7,597 -8,480 -9,327 -2,787 -3,501 -4,316 -1,971 -3,692 -4,393 PPP -3,007 -2,888 -3,871 -3,203 -1,870 -3,962 -1,952 -2,578 -4,219 Loan impairments 0 0 0 -2 0 -1 108 92 87 Associates -14 6 2 0 0 -1 -4 2 -7 Adjusted PBT -3,021 -2,882 -3,869 -3,205 -1,870 -3,964 -1,848 -2,485 -4,138 Source: Deutsche Bank estimates, company data The range is relatively wide, but of a similar sort of magnitude. We think Method 3 is the best estimate to use, though it is not perfect: positive income of US$1.1bn in 2014 doesn’t seem logical – it could be fair value gains which the company has not explicitly disclosed as a one-off; whilst impairments are unlikely at the Hold co (except an impairment of an investment holding). This gives us the adjusted loss (US$4,138m). Given that we know the bank levy figure (which has been rising and should have peaked in 2015) we can deduct an estimate of the underlying operating loss for the Hold Co (US$2.8bn for 2015). Assuming a tax shield of 20% (but not for the bank levy – that is non-tax deductible), AT1 coupons (US$860m last year) and Hold Co Pref coupon (US$90m), this gives us a post tax loss of US$4.5bn from hold co in 2015 (Figure 137). Page 66 Deutsche Bank AG/Hong Kong 31 August 2016 Banks HSBC Holdings Plc Figure 137: Earnings estimate for Hold Co USD $ 2013 2014 2015 o/w Bank levy -961 -1,063 -1,421 o/w Underlying operating loss -887 -1,422 -2,717 Adjusted PBT -1,848 -2,485 -4,138 Tax 177 284 543 AT1 security coupons (cash) -483 -483 -860 Hold Co Preference share (cash) -90 -90 -90 Adjusted earnings -2,243 -2,773 -4,545 Source: Deutsche Bank estimates, company data Why is this so big? It is not immediately clear why the Hold Co costs are so high. The rapid rise in bank levy and AT1 coupon are clearly factors (AT1s have almost doubled and 5 years ago the bank levy didn’t exist). But this still leaves an underling operating loss which has almost trebled in 3 years. Even taking into account volatility of items we cannot see easily in the disclosures (e.g. FV movements), this still suggests material cost inflation. A key part of this is likely to be regulatory & compliance costs (US$1.6bn in 2013, $2.4bn in 2014, US$2.9bn in 2015). This alone counts for US$1.3bn of the US$1.8bn of increased operating loss between 2013 and 2015. This leaves US$0.5bn of other cost inflation or lower income. What is the outlook for Hold Co profitability? Regulatory / compliance costs: on the 1H16 conference call FD Mackay said that the rate of investment into regulatory programmes & compliance is slowing, but that there remain a broad range of investments to be completed between now and the end of 2017 (DPA ending). “There will still be an increased cost coming from regulatory compliance programmes, but the level of influence that has overall will decrease”. We read this to mean that the underlying operating loss in hold co is likely to remain elevated in the near term, but should come down after 2017. Bank levy: the bank levy rate is falling from 0.21% in 2015 to 0.18% in 2016, 0.17% in 2017 and 0.16% in 2018. This should see the bank levy fall from around US$1.4bn in 2015 to US$1.2bn in 2016 and then US$50m/year thereafter until 2021 – when the bank levy will only apply to UK liabilities. However, we note that the bank levy rate has been changed regularly by the Chancellor in the past. Tax: UK bank surcharge of 8% we would expect to apply to HSBC’s UK- domiciled businesses. This serves as increasing the tax shield for Hold co (though, of course, is negative for the wider business). AT1 issuance: 8 AT1 instruments have now been issued out of Hold Co (including a recent US$2bn issuance in June 2016). The full annual coupon of all of these instruments is currently US$1.16bn – a US$250m step up from 2015 levels. Overall this equates to a small fall in Hold Co losses over the next 3 years. The forecast is particularly geared to the speed with which compliance investment reduces after 2017, and how much of the regulatory / compliance spend is one-off or ongoing. Deutsche Bank AG/Hong Kong Page 67 31 August 2016 Banks HSBC Holdings Plc Figure 138: Forecasts for Hold Co 2013 2014 2015 2016e 2017e 2018e o/w Bank levy -961 -1,063 -1,421 -1,218 -1,150 -1,083 o/w Underlying loss -887 -1,422 -2,717 -2,745 -2,745 -2,690 Adjusted PBT -1,848 -2,485 -4,138 -3,963 -3,895 -3,772 Tax 177 284 543 768 768 753 AT1 security coupons (cash) -483 -483 -860 -1,160 -1,160 -1,160 Hold Co Preference share (cash) -90 -90 -90 -90 -90 -90 Adjusted earnings/loss -2,243 -2,773 -4,545 -4,444 -4,376 -4,269 Source: Deutsche Bank estimates, company data Figure 139: Breakdown of Hold Co forecasts Figure 140: Hold Co RoE 2,000 0.0% 1,000 -0.5% 0 -1.0% -1,000 -2,000 -1.5% -1.3% -1.5% -1.6% -3,000 -2.0% -1.9% -4,000 -2.5% -5,000 -2.4% -2.6% -2.6% -2.5% o/w Bank o/w Adjusted Tax shield AT1 Hold Co Adjusted -3.0% -2.9% -2.8% levy Underlying PBT security Preference earnings -3.1% -3.0% loss coupons share -3.5% (cash) (cash) 2013 2014 2015 2016e 2017e 2018e 2013 2014 2015 2016e 2017e 2018e RoE drag RoTE drag Source: Deutsche Bank estimates, company data Source: Deutsche Bank estimates, company data The true cost of being HSBC? If our estimate of HSBC Hold Co P&L is close to correct, this suggests that it represents a loss of 2.5% on ROE, or 3% on ROTE – a meaningful drag on group earnings (Figure 140). If HSBC Holdings was instead 4 or 5 separate banks, then of course it would be incorrect to assume that the costs of Hold Co disappear altogether: AT1 issuance, for example would still need to come from subsidiaries, There will undoubtedly be central / infrastructure costs that would fall to the subsidiary level. But, with a c.US$4bn price tag, it is also clear that some savings could be made: Bank levy would be materially lower, sooner. It applies just to the UK balance sheet, if the non-UK entity is re-subsidiarised within Europe in a post-Brexit world. Capital requirements would also be lower: none of the subsidiaries on their own qualify for GSIB buffers, which frees up a meaningful portion of capital, and lowers AT1 issuance requirements & costs. The group’s businesses would be held to local regulatory requirements, not UK standards. Page 68 Deutsche Bank AG/Hong Kong 31 August 2016 Banks HSBC Holdings Plc The large expense on shareholder funds and management time from compliance and regulatory change is, we think, principally due to the scale of the group: implementing similar rules and procedures for >250,000 employees, 71 countries, 47 million customers is a tall order that is unlikely to get any easier. This represents a diseconomy of scale. In effect, a large portion of Hold Co cost represents the cost of being HSBC. For the HSBC business model to be justified and sustainable in the long-term, the revenues and profits generated from the ‘value of the international network’ needs to outweigh this Hold Co cost - and capital requirements that go with it. Deutsche Bank AG/Hong Kong Page 69 31 August 2016 Banks HSBC Holdings Plc Appendix 1 Important Disclosures Additional information available upon request Disclosure checklist Company Ticker Recent price* Disclosure HSBC Holdings Plc 0005.HK 56.20 (HKD) 30 Aug 16 7,14,15 *Prices are current as of the end of the previous trading session unless otherwise indicated and are sourced from local exchanges via Reuters, Bloomberg and other vendors . Other information is sourced from Deutsche Bank, subject companies, and other sources. For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/DisclosureDirectory.eqsr. Important Disclosures Required by U.S. Regulators Disclosures marked with an asterisk may also be required by at least one jurisdiction in addition to the United States. See Important Disclosures Required by Non-US Regulators and Explanatory Notes. 7. Deutsche Bank and/or its affiliate(s) has received compensation from this company for the provision of investment banking or financial advisory services within the past year. 14. Deutsche Bank and/or its affiliate(s) has received non-investment banking related compensation from this company within the past year. 15. This company has been a client of Deutsche Bank Securities Inc. within the past year, during which time it received non-investment banking securities-related services. Important Disclosures Required by Non-U.S. Regulators Please also refer to disclosures in the Important Disclosures Required by US Regulators and the Explanatory Notes. 7. Deutsche Bank and/or its affiliate(s) has received compensation from this company for the provision of investment banking or financial advisory services within the past year. For disclosures pertaining to recommendations or estimates made on securities other than the primary subject of this research, please see the most recently published company report or visit our global disclosure look-up page on our website at http://gm.db.com/ger/disclosure/Disclosure.eqsr?ricCode=0005.HK Analyst Certification The views expressed in this report accurately reflect the personal views of the undersigned lead analyst(s) about the subject issuer and the securities of the issuer. In addition, the undersigned lead analyst(s) has not and will not receive any compensation for providing a specific recommendation or view in this report. Stephen Andrews Page 70 Deutsche Bank AG/Hong Kong 31 August 2016 Banks HSBC Holdings Plc Historical recommendations and target price: HSBC Holdings Plc (0005.HK) (as of 8/30/2016) 90.00 Previous Recommendations 1 80.00 Strong Buy 3 4 2 5 Buy 70.00 Market Perform Underperform Not Rated 60.00 8 Suspended Rating 67 9 50.00 Current Recommendations 40.00 Buy Hold SecurityPrice Sell 30.00 Not Rated Suspended Rating 20.00 *New Recommendation Structure 10.00 as of September 9,2002 **Analyst is no longer at Deutsche 0.00 Bank Sep 14 Dec 14 Mar 15 Jun 15 Sep 15 Dec 15 Mar 16 Jun 16 Date 1. 03/11/2014: Hold, Target Price Change HKD80.00 Jason Napier, 6. 18/02/2016: Hold, Target Price Change HKD55.60 David Lock CFA** 2. 13/02/2015: Hold, Target Price Change HKD73.00 Jason Napier, 7. 22/02/2016: Hold, Target Price Change HKD47.80 David Lock CFA** 3. 24/02/2015: Hold, Target Price Change HKD68.00 Jason Napier, 8. 03/05/2016: Hold, Target Price Change HKD50.00 CFA** 4. 19/06/2015: Hold, Target Price Change HKD69.00 David Lock 9. 03/08/2016: Hold, Target Price Change HKD51.30 5. 03/08/2015: Hold, Target Price Change HKD70.00 David Lock Equity rating key Equity rating dispersion and banking relationships Buy: Based on a current 12- month view of total share-holder return (TSR = percentage change in 500 share price from current price to projected target price 450 52 % plus pro-jected dividend yield ) , we recommend that 400 investors buy the stock. 350 38 % 300 Sell: Based on a current 12-month view of total share- 250 holder return, we recommend that investors sell the 200 150 10 % stock 15 % 100 15 % 21 % Hold: We take a neutral view on the stock 12-months 50 out and, based on this time horizon, do not 0 recommend either a Buy or Sell. Buy Hold Sell Newly issued research recommendations and target prices supersede previously published research. Companies Covered Cos. w/ Banking Relationship Asia-Pacific Universe Deutsche Bank AG/Hong Kong Page 71 31 August 2016 Banks HSBC Holdings Plc Regulatory Disclosures 1.Important Additional Conflict Disclosures Aside from within this report, important conflict disclosures can also be found at https://gm.db.com/equities under the "Disclosures Lookup" and "Legal" tabs. Investors are strongly encouraged to review this information before investing. 2.Short-Term Trade Ideas Deutsche Bank equity research analysts sometimes have shorter-term trade ideas (known as SOLAR ideas) that are consistent or inconsistent with Deutsche Bank's existing longer term ratings. These trade ideas can be found at the SOLAR link at http://gm.db.com. 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