HSBC chairman Sir John Bond talks to Karina Robinson about the transformational impact of the bank’s acquisition of Household International.

The last time in its 138 year history that the Hong Kong and Shanghai Banking Corporation (HSBC) took such a transformational step was in 1992 when it bought Midland Bank, one of the UK’s main banks, vaulting it into the major league from its Hong Kong base. Its latest move, buying US consumer group Household International, is arguably even more revolutionary, as it brings a totally new business into the bank which executives see as being at the forefront of its expansion plans.

“The broad strategic decision is this: two-thirds of every economy in the world is based on consumer expenditure and the more you can get your organisation to sit astride that, frankly, the better for your business,” a pink-shirted Sir John Bond told The Banker in his 41st floor office in the bank’s swanky new London headquarters at Canary Wharf.

There were a number of reasons behind the acquisition, including the need for a substantial US presence in line with the bank’s global ambitions; possibilities on the cost side; and the use of consumer finance as a spearhead into new countries. Also, due to the low interest rate environment in developed markets, the group needed to take on more balance sheet risk in terms of consumer lending to improve its margins, says Richard Staite, an analyst at SG Securities.

Can this new-look HSBC sustain the miracle? Consider the evidence so far: when group chairman Sir John joined the bank in 1961, it had a market capitalisation of $154m. Today, a thousandfold increase gives it the second largest market capitalisation in the banking world, at $133bn. The question is whether such a rate of increase in shareholder value can be sustained by a bank that has taken a colossal step into the unknown.

“It is a lot easier to take a Ł55m market cap organisation to $100m than it is to take a $100bn organisation to $200bn. Sometimes when commentators say, ‘Oh, HSBC results are only up 4%’, well, 4% of $4bn is a lot more than 4% of $1bn. So yes, it gets progressively more difficult,” says Sir John.

This traditional financial services group, where parsimony rules to such an extent that employees must pay for personal telephone calls abroad, is looking to be the world’s leading financial services organisation through its acquisition of Household. Whether it can surpass rival Citibank with a market capitalisation 75% larger at $234bn is another matter. “It is not a goal. HSBC is about quality rather than quantity,” says Sir John. “It is rational that the US economy will produce the largest bank.”

There is another side to the US acquisition. As Household lends to, among others, people with patchy credit histories, there is a large reputation risk for a bank which prides itself on its integrity and fair treatment of customers. And the outcry over the pay for the US executives who run it has been in line with the generally negative press coverage. Ultimately, though, the US group is HSBC’s killer move.

Still, investment banking (see box page 22), private banking and China are also major challenges which will determine whether its star-filled trajectory – pace the 1997 Asian crisis – is sustained.

For better or worse

“It is a transformational deal which will make a big difference, be it positive or negative,” says one of the top 10 investors in HSBC shares. “It is not without risks as it is an area HSBC [does not know] and it is a riskier area of the market anyway.”

The March acquisition of Household for $14.2bn changes the structure of the group as the level of bad debts will henceforth be a big part of the earnings profile. Before, the group was known for its low level of bad debts. Its recent first half results were proof of this: provisions for bad and doubtful debts skyrocketed to $2.4bn from $715m a year earlier. Household’s non-performing loans came in at 3.76% of its total loans; HSBC’s bad and doubtful loans were 0.45% minus troubled Argentina and a new Mexican purchase.

“If the US economy does not muddle through, then loans they are putting on the book now [will be a problem]. We are watching it closely,” says the investor.

The bank denies there is a reputational risk involved in the purchase. Chief executive Stephen Green sees no contradiction between proudly mentioning that HSBC has now become one of the world’s fifty most valuable brands, as measured by consultancy Interbrand, and insisting the bank will not “sail close to the wind in any of our businesses”, notwithstanding its US purchase.

Indeed, Household itself actually sailed so close to the wind that it was involved in a court case to do with punitive interest rates, not an unusual occurrence for that sort of business. It settled for over $484m in October 2002. The global bank is looking to ensure this does not happen again by keeping Household and its subsidiary brands separate from the main bank and its brands, and by spending $150m in 2003 on extra compliance, training and monitoring.

“Household has the opportunity to be a benchmark of quality. We want it to be a responsible business helping set the standard for the industry,” newly-appointed chief executive Mr Green said when presenting HSBC group’s results for the first time in August.

The bank had been saying it was looking for a three-legged geographical spread. With Household, it doubled its US exposure. North America now contributes 27% of pretax profits, Europe 35% and Asia 38%, although the dependence on Hong Kong still seems too high when on its own it contributes 27% of pre-tax profit.

HSBC did not take the obvious route of acquiring a mainstream American bank because “9700 banks occupy the prime space, competing for 60% of the population. With the 40% non-prime population, you have five major players competing,” says Sir John.

In terms of cost, the deal was reasonably priced at 1.7 times book value. Whether William Aldinger, chairman and chief executive, is reasonably priced and worth the estimated $37.5m he will be paid over the next three years in salary, guaranteed bonuses, shares and general perks is another matter especially when Household’s shareholder returns failed to beat the S&P 500 Index over the latest four year period and investor worries about predatory lending and accounting irregularities surfaced under his watch. In comparison, Sir John, from April 2003, receives a base salary of Ł970,000, a performance-related bonus of up to 250% of salary, and a pension worth Ł308,000 a year plus options.

However, Household’s management are key to this transaction as the elite 400-strong cadre of HSBC international managers have no experience in this field, and when it is the designated spearhead of future growth, knowledgeable management is key.

The business is not as downmarket as has been mooted in the pages of the press, although the bank is partly to blame for this image problem due to its wariness towards the media.

“UK investors may not have a complete understanding of the nature of the Household customers,” says Stuart Fowler, head of the UK equity team at Axa Investment Management, which has a 1% stake in the bank. “They are substantially less risky than they are perceived to be.”

It is true that the clients are not only those with a minimal income; they also include lower level white-collar workers, the self-employed, and those who in other developed countries would not have a problem opening a bank account. In fact, over half of Household’s business is in the prime sector. The US unit’s credit card business allows access to a much more upmarket range of customers. Its UK arm, for example, recently signed a deal with John Lewis, a favourite department store of the middle classes, although this would not have been possible before it had the respectable aura of HSBC surrounding it.

In the same way, the bank’s access to cheaper funding gives Household over $1bn in potential cost savings per year, plus over $200m within two years in synergies from call centre co-operation and technology consolidation. Still, the extra provisions needed to cover improved controls cancel out some of those savings.

New territory

But the excitement for Sir John lies in the roll-out of the Household model. He points out that over the next 30 years, 50% of the increase in world demand is forecast to come from emerging markets. Consumer finance will be the first step for many of the aspiring middle classes as they buy a car, then a house and then choose a credit card.

Yet reproducing the model in the existing 80 countries and territories where “the world’s local bank” – as its advertising goes – has a presence is only part of the story. It can be used as a scout to check out opportunities in new markets without committing large amounts of capital or the bank’s brand. Poland is a current example, with HCF, Household’s UK brand, going in with Dixon’s, the electrical goods retailer. HSBC had been considering acquiring a banking licence and putting its toe in the water, but decided Household’s idea was better as a first step.

Russia may well be next as the bank admits it is top of the agenda. It is the classic HSBC play: a vast country with a large population and a wealth of natural resources. Nevertheless, its boom-bust cycles and unconventional business practices have made even HSBC wary. Building a bridgehead through Household, however, is lower risk than buying a bank.

In the developed world, a bank acquisition in Italy is on the cards, says a top executive, who believes the local regulatory authorities will be less hostile to a UK purchaser than they have been to the Spanish, French or Germans. This could be merged with CCF, the French bank bought in 2000 which HSBC sees as its eurozone bank. In the meantime, consumer finance is a good starting point.

Building on HSBC’s 2002 purchase of Bital, Mexico’s fifth-largest bank, bought for a total of almost $2bn, Mr Green now sees an opportunity to involve Household in targeting the immigrant population to the US as well as the second or third generation. “The biggest bilateral remittances flows in the world are from the US to Mexico,” he says. However, a host of other financial institutions, including Citibank, as well as Bank of America in association with Spanish bank Santander’s Mexican operations, are all focusing on this market.

In terms of the rest of Latin America, which contributes only 1% of pretax profits, HSBC has had problems in Argentina while its Brazilian operations are very small for a bank that lays great emphasis on grasping opportunities in large emerging economies.

In Asia, India is a market where Mr Green is looking to expand as it is only responsible for 1% of group profit and has a growing middle class.

China is the ultimate market for HSBC, and one in which the bank has to prove itself by leveraging its Hong Kong and Shanghai roots to make money in a way that the majority of foreign investors find difficult. It already has an 8% stake in Bank of Shanghai and, in 2002, it bought, for $60m, a 10% stake in Ping An Insurance, the third-largest insurer in China with over 25 million policy-holders. But, just as interesting is the prospect of expanding one of Household’s brands there.

Still, China has no chance of being material in the next five years, say analysts, although they expect HSBC to be one of the biggest players there long-term.

“It won’t be [material to profits] on my watch but China is going to be huge. As recently as 1820, China’s economy was substantially larger than America’s. How can 22% of the world’s population account for less than 4% of the world’s GNP?” says Sir John. “Do I think HSBC will be on every street corner in China? Of course not. But there will be an opportunity for us to have a significant business in mortgages, credit cards, import/export, investment products [and] investment banking.”

Any other business?

At the end of the day, though, Household represented less than 10% of pre-tax profits in the first half of 2003 and, however much it expands, getting other businesses right is just as important. The largest profit contributor was what HSBC calls its corporate, investment banking and markets unit which, at $2.2bn, represented 33% of pretax profits, followed by personal financial services (retail banking) at 30%, commercial banking (small and medium-sized businesses) at 24% and private banking at only 4%.

Of those areas, corporate looks like one of the most challenging, while private banking is going through continued restructuring and turmoil. HSBC has yet to deliver on its goal of being one of the five best private banks in the world.

A former private banker at HSBC complains about the integration of several businesses bought in recent years, including the private banking empire of the now late Edmond Safra, a Lebanese-born billionaire, which included his Republic New York bank: “When they bought Republic there was a legacy of problems there since Safra business was done on the shake of a hand and there was not much security on loans. Then mixing [the existing business of] Samuel Montagu with the Republic lot [was not a success], and they were trying to recruit someone from Merrill Lynch for private banking. But they have no strategy, they have lost all private client players and recruited second liners into the business.”

In terms of expanding retail financial services, the bank’s client list of almost 100 million places it well in order to fulfil its vision of selling more products to existing customers in the developed markets in order to fund retirement savings – although a host of other banks are looking to do the same.

“The only OECD country with a growing population is America. We will have a huge wealth management opportunity in mature Western markets. On average in the UK and America, 70% of the assets are in the hands of people over 50. What we have to do is find a way of looking after them in terms of investment, pension, medical and so forth,” says Sir John.

On the commercial and retail side, HSBC has few critics. It has leveraged its technology to deliver a full range of products worldwide by tailoring them for local conditions. “They and Citibank are unique,” says Ray Soifer, founder of US-based Soifer Consulting. “They are the only banks that operate as local retail banks around the world.”

Meanwhile, the senior succession has, to all appearances taken place with a minimum of fuss, in the HSBC way, with lay preacher Mr Green part of a collegiate management team and Stuart Gulliver, co-head of the corporate banking division as the heir apparent. There may be a bit more jostling for position when Sir John retires as chairman in an estimated few years time – although he will not reveal when – as for every one of the fifty top jobs there are three internal candidates.

“In the long term, assuming Household is integrated successfully, as we expect, the issue of finding long-term channels for growth will be at the top of the agenda as Hong Kong has very low growth while UK and US consumer lending is likely to slow,” argues Alastair Ryan, European banks analyst at UBS in London.

Lacklustre profit growth in the first half – with revenues only up over 4% excluding the effect of recent acquisitions – points to the need for more acquisitions. The bank is an efficient, value-creating, buying machine which focuses on relatively well-managed, undervalued assets. (A case in point: it bought Household at 1.7 times book value compared with Citigroup’s purchase of sub-prime lender Associates at 2.9 times book value). But as its private banking division shows, merging new units can be troublesome, and it will need to expand this area.

However, Household provides a spectacular platform for future growth and for exploring new markets, although the reputational risks of this new business are high. It is a lower risk proposition than buying fully-fledged banks – although HSBC will continue to do so – and a new way for it to increase revenues and profits.

Nonetheless, HSBC has a lot of work to do to catch up with Citigroup, the largest bank in the world with over $1000bn in assets and a return on average equity capital of 38.8%. HSBC’s assets of $759bn leave it at only number seven in the world, while its profitability measured by return on average equity capital is far below its rival’s at 24.8%.

And Sir John, despite insisting that it is definitely not a goal to beat Citigroup in either assets or market capitalisation, betrays more than a passing interest in their respective rankings when told that HSBC is number three in The Banker’s Top 1000 list. “Wait, who’s got more capital than we do! Citi? It’s done in dollars, is it? We’ll just wait for the dollar to weaken,” he jokes.

Excerpts from the interview with Sir John Bond

Household: The strategy is that we have a huge deposit-generating business around the world. What our balance sheet needed was asset generators. Here is a business that generates a huge amount of assets year in, year out. Of course the risk factor is higher so the interest margin of around 11.5% is higher, with the charge-off rate around 4.5%.

Household processes all of its loans automatically, it does not have credit limits, it has marketing limits. At peak periods it processes 1200 loans a second. They have a pre-approved line of credit for every adult citizen in America. You take what works down to Mexico or Brazil.

On the asset side of our balance sheet, HSBC will now have 52% of assets lent as opposed to 42%. The biggest sector of that will be consumer.

There is a view that HSBC has raised its risk profile. As an important part of our due diligence, we asked [Household] when you put together your plan for the year, what did you predict for your bad and doubtful debts and what was the actual outcome. In the last five years, Household’s bad debts were within 5% of their actual prediction. What we have done to HSBC and what the market doesn’t universally understand is we have increased the absolute amount of bad and doubtful loans, but we have actually increased the predictability. We don’t predict our bad debts by 5%, there is always an event out there, an Argentina, or a major corporate collapse that blows us off course.

We have 35 individual integration projects with Household, all of which can benefit our shareholders.

Latin America: The challenge for Latin America is to develop an onshore savings market. The trouble is that nearly all the savings are offshore. That is a matter of confidence and it has a whole host of reasons. What it needs is a lower interest rate structure and a higher savings rate.

Hong Kong: Our colleagues in HK have managed the business for 56 months of deflation. This is a huge achievement: the fact that the bank is still producing results that have a good return on capital, and bad and doubtful debts are under control. Hong Kong will kick into life again, a city of seven million on the edge of the world’s fastest growing economy. What we are going through is a very painful period of cost adjustment. The adjustment HK needs to make is ‘one economy, two systems’. That is exactly what is happening.

US banking: 9700 commercial banks in the US means it is essentially a fragmented business. As it consolidates, I think you should expect to see that the top five banks in the next five years will perhaps be American.

Investment banking: [There is] no confusion whatsoever [about our investment banking strategy]. If so, it must be bad communication on our part. We believe there is a role for a bank that clients will trust for straightforward advice. If you just did it [measured us] from the client list we are probably the third largest in the world.

I don’t ever want to have a phone call from a chairman of a company saying you did well out of the deal, we didn’t.

You do not, in my judgement, acquire clients by buying an investment bank. [If you do that], you acquire people who can leave and if you make them rich by acquisition, they wouldn’t be human beings if you did not diminish their hunger.

Acquisitions: Our acquisition strategy is very heavily tilted towards buying client lists. We don’t need to buy the means of production, we’ve got a huge array of very smart, talented people.

It is quite an interesting washing list we go through when we look at an acquisition target because we are looking at one every day at least. The first thing is do we acquire a client list. Is the technology compatible? Is the character, the human side of the organisation, compatible? Why is it worth more in our hands than their hands? And finally we will get down to the price.

Financial Institutions: Thirty percent of our balance sheet is our competitors, always has been. We are a huge player in the interbank market. We are trying to find a home for over $100bn every day.

Culture: [We have] a group of colleagues who have worked together, who trust each other. We know that we aren’t playing politics, to see who sits next to who at meetings, we are not into that. The way a company behaves is going to be of crucial importance, the dominant feature of life in the 21st century.

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