Few eyebrows must have been raised yesterday when the United States Department of Justice announced that two forex traders at HSBC (LSE: HSBA) had been arrested for front-running a client's order to benefit their trading book. While the incident in question dates back to 2011 and the allegedly ill-gotten gains amounted to 'only' $8m on a $3.5bn order, it was yet another example of the misconduct problems that have plagued the bank since the Financial Crisis and that have led to billions in fines and a decade of disappointing shareholder returns.
The culprit isn't merely traders out to benefit themselves at the expense of clients, but also the near-impossible task of efficiently overseeing 235,000 employees at 6,000 offices in 71 countries. Having a global footprint this large means a multitude of inefficient IT systems requiring constant investment to maintain, employing thousands of compliance officers to implement regulations from scores of different jurisdictions, and the sheer cost of paying that many employees has led to ballooning operating costs for HSBC.
All these expenses meant that in Q1 HSBC's cost-to-efficiency ratio, a measure of a bank's expenses to revenue, was a full 55.2%. While this is an improvement on the 55.7% achieved this time last year, it's still a worryingly high figure and is the reason management is intent on cutting some $5bn in annual costs by next year.
Whether this target can be achieved without impairing the bank's profitability remains to be seen. The glacial pace at which high costs have been tackled has unsurprisingly filtered through to the bottom line and contributed to Q1 pre-tax profits falling 14% year-on-year. And return on equity, an important measure of profitability for banks, has fallen from 11.5% to 9% on an annualised basis.
In the next few years the problem for HSBC is that high costs and falling profitability in Europe and North America are being compounded by the slowdown in its most profitable market, Asia. This slowdown is being led by China's attempt to shift its debt-laden economy towards a more sustainable, consumption-led model.
Although this will be better for all involved over the long term, it led to HSBC booking a 9% fall in adjusted Asian profits last quarter and is putting pressure on dividends, one of the few bright spots for shareholders. Analysts are expecting earnings to only cover dividends 1.2 times this year, which should put income investors on alert that any further fall could lead to slashing shareholder payouts.
So what we have is low dividend cover, economic headwinds in the bank's largest market, sky-high operating costs, and falling profitability. Then if we mix-in the prospect of further regulatory fines and you have a recipe for one bank that I won't be touching with a 10-foot pole anytime soon.
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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has recommended HSBC Holdings. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.