HSBC’s performance once again impacted by higher costs and impairments

Financial Article 396 by Edward Rizzo - Aug 13, 2015

HSBC Bank Malta plc published its interim financial statements on Monday 3 August showing an 8.3% decline in pre-tax profits to €36.3 million. During the first half of 2015, total operating income actually edged 2.8% higher to €89.8 million but costs grew by 7.7% to €49 million and net impairments increased by €2 million.

The figures over recent years clearly indicate that HSBC Malta’s financial performance is being mainly impacted by higher costs and impairments apart from the de-risking strategy taking place and the pressures arising from the low interest rate environment.

During the first six months of 2015, the higher staff costs mainly related to the increased pool of human resources in the risk and compliance areas as well as the additional contributions to the Depositor Compensation Scheme and the new requirement for contributions to the Single Resolution Fund (a pool of money financed by the banks across the European Banking Union which was set up to ensure that medium-term funding support is available while a credit institution is being restructured). This higher level of expenditure should come as no surprise given the clear message by HSBC’s Chairman Mr Sonny Portelli in his address to shareholders in the last two Annual Reports in which he warned of “a substantial rise in regulatory costs”.

Article 396_HSBC Interim Net Profit + Annualised ROE

Further regulatory changes are being discussed across Europe and the ECB is currently in the process of publishing guidelines on national deposit compensation schemes, establishing new rules in relation to a resolution fund across the eurozone and setting the fees that will be charged for its new oversight role of around 130 financial institutions across Europe. These changes will lead to additional costs for HSBC Malta and other banks across Malta and the eurozone.

“future dividends are more likely to mirror movements in profitability assuming the bank can build up its capital base sufficiently by maintaining a payout ratio of 55%.”

During the first half of 2015, HSBC also reported higher costs as a result of currency fluctuations related to outsourced services and the expenses incurred in connection with the newly transferred insurance portfolio.

Moreover, loan impairments increased by €2.2 million during the period under review to €3.6 million. This figure comprises €15.9 million (HY2014: €3.2 million) in new impairments and €12.4 million (HY2014: €1.8 million) in reversals of previous charges. HSBC Malta’s CEO Mr Mark Watkinson described the overall level of impairments registered in the first half of 2015 as being more “normalized” given the regulatory environment and he expects this level of impairment to recur in future reporting periods.

In addition to this challenging cost scenario, banks are also struggling in the current low interest rate environment while HSBC Malta is also undergoing its de-risking strategy.

Some years ago, HSBC Malta adopted the Group-wide strategy of de-risking the business which entailed running down various profitable operations, namely the business of trusts, custody and brokerage. HSBC Malta’s CEO acknowledges that this was a painful decision due to the immediate negative impact on earnings although the overriding objective is to transform the bank into an entity providing more reasonable risk/return metrics. In fact, net fee and commission income declined from €17 million in the first half of 2010 and 2011 to just over €15 million during the six month period under review. However this transformation must be seen in the context of the continuous change in regulations. This was clearly summarized by HSBC Malta’s CEO in his address to shareholders in the 2014 Annual Report in which he noted that HSBC’s strategy is to build “a strong and sustainable business for the long term”.



With respect to net interest income, although this improved slightly to €60 million during the first half of the 2015 financial year, HSBC Malta (similar to other institutions across the banking sector) are being negatively impacted by the continuing low interest environment.

This is in fact impacting banks on several fronts. Deposits are continuing to rise despite the significant decline in interest rates over the years. Since interest rates on deposits are still in positive territory, this implies an expense for any bank. Furthermore, banks have limited opportunities in which to employ excess liquidity – representing the difference between the level of deposits and the amount of loans (either to corporates or retail customers), by investing in fixed-income instruments or placements with other banks including the European Central Bank. Yields on sovereign bonds have declined to very low levels, especially following the start of the quantitative easing programme by the ECB earlier this year, and this reduces the interest income generated by banks on their investment portfolio. Moreover, rates at the ECB have turned negative implying a loss for banks when placing excess liquidity at the ECB. While many would have expected the low interest rate scenario to benefit banks through growth in their loan portfolio since it would be cheaper for individuals and corporates to take on additional borrowing, the reverse is actually happening. Due to the low interest rate on deposits and lack of investment opportunities, many retail and corporate borrowers are using some of their own excess liquidity to repay loans. In fact, during the first six months of the year, loans and advances to customers at HSBC Malta declined by 0.8%. These challenging conditions can be further evidenced from a review over a slightly longer-term period. Since June 2010, HSBC Malta’s deposit base grew by €1 billion while the loan book grew by a mere €44 million translating into a decline in the advances to deposits ratio from 0.77 times in 2010 and 2011 to 0.62 times as at June 2015.

Shareholders generally are likely to have been disappointed with the 8.3% decline in profits during the first half of the year. However, they must have been pleasantly surprised with the higher level of their interim dividend this year which, after taking into account the additional shares distributed earlier this year as part of the bonus issue, has indeed improved by 25%. This is solely due to the implementation of Banking Rule 09 (BR09).

At the end of 2013, the Malta Financial Services Authority amended BR09 which required banks in Malta to hold additional reserves against non-performing loans. Basically, banks are first obliged to determine the level of dividends based on their approved payout ratio but would then need to retain a proportion of these dividends in a reserve. The amount that needs to be retained in this respect is based on the level of non-performing loans. The reserve helps to increase the Tier 1 capital on a bank’s balance sheet. The level of dividends must also be approved by the MFSA before distribution. Banks had a three year transitory period to build up this reserve and to come into line with this new obligation. Thereafter, the level of reserves needs to be maintained in line with any changes to non-performing loans. HSBC had provided for the initial contribution in 2013 and increased this to 85% of the overall requirement during the 2014 financial year. The final balance necessary was provided for from this year’s interim dividend.

During the meeting with financial analysts last week, HSBC Malta’s CFO Mr Rashid Daurov provided an explanation of the way the interim dividend was calculated. He confirmed that HSBC’s dividend payout ratio remained unchanged at 55% implying a gross dividend of €0.056 per share before taking into account BR09 compared to €0.0603 per share in June 2014 – the difference being the decline in profits during the first half of 2015. However, since HSBC was 85% compliant as at the end of 2014, it only required a small top-up in the first half of 2015 when compared to the more aggressive contribution during 2014. As such, the 2015 interim dividend of €0.051 per share represents a 25.9% improvement over the June 2014 dividend which was more heavily impacted by BR09. Since HSBC is now fully compliant with BR09, future dividends are more likely to mirror movements in profitability assuming the bank can build up its capital base sufficiently by maintaining a payout ratio of 55%.

Despite the significant challenges across the banking industry both from an operational aspect as well as from a regulatory perspective, which led to a significant reduction in annualized post-tax return on equity to 10.6% compared to 19.3% in 2011, HSBC Malta believes that the positive performance of many sectors across the Maltese economy will positively impact HSBC and other banking institutions in the medium-term. Mr Watkinson also made reference to the expected growth in the loan book given the large amount of loans already sanctioned but not yet drawn-down. As at 30 June 2015, these amounted to €462 million and are expected to be gradually drawn-down over the next 12 months. While this would be a positive development, it would only partially satisfy HSBC’s goal of improving the loan to deposit ratio to above 80% from the current level of 62.5%. This could only come about if several large projects come to fruition and HSBC agree to participate in any bank financing being required. HSBC and other Maltese banks need a strong increase in loans to generate additional interest income since the low interest rate environment across the eurozone is likely to remain unchanged for many more years to come.

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