Ever since the great financial crisis (or GFC as it’s now known in City circles) large banks have struggled to generate the kind of lucrative returns seen before the crisis. Regulation and fragmentation are the two most important factors being blamed for the lack of profitability for banks, and according to a new report from Boston Consulting Group, it’s highly likely that low returns are here to stay for the foreseeable future.
Indeed, Boston Consulting believes that only a handful of investment banks will be able to transform their businesses to the degree where they can generate a robust and sustainable return in the current environment. Specifically, the group believes that there are only three types of investment banks that will ever be able to meet their cost of capital. These groups are: a “flow monster” that has a large balance sheet and lots of trading capacity; a niche complex product operator; and a regional bank with a corporate or asset management focus.
A “flow monster”
HSBC (LSE: HSBA) used to be a “flow monster” with its market leading position in China and trading bases in all of the world’s major financial centres, the group had an unparalleled advantage over its peers. And in today’s world, when the majority of big banks are selling off non-core international operations, HSBC’s global presence would have been extremely valuable.
However, over the past eight years it has exited more than 10 countries and sold off more than 70 operations. There are likely to be more asset sales to come as HSBC’s management chases its target of achieving annual cost savings of $5bn by 2017.
Unfortunately, if the forecast from Boston Consulting is to be believed, then HSBC’s decision to exit so many markets will only hinder the bank’s recovery as it loses its “flow monster” status and becomes more of a regional operator, focused on its Chinese operations.
Broadly speaking, this is bad news for the bank’s shareholders as it implies the group will struggle to generate a return on equity above its cost of capital. It’s estimated that, as a large investment bank, HSBC’s cost of capital is in the region of 10% and management is targeting a return on equity of 10% by 2017. A return on equity that’s below a company’s cost of capital indicates that the firm risks destroying shareholder value.
The bottom line
So overall, it looks as if it’s unlikely that HSBC will be able to generate a return on equity above its cost of capital for the foreseeable future. With this being the case, the bank appears to be destroying that very shareholder value it needs to maintain.
Still, if you’re looking to buy HSBC just for its dividend, the bank’s dividend yield of 8% at current prices looks safe for the time being. The payout is covered 1.3 times by earnings per share and is extremely attractive in today’s low-interest-rate environment. Shares in HSBC currently trade at a forward P/E of 10.8 and City analysts expect earnings per share to fall by 7% this year.