LONDON -- As the world's third‑largest bank, and one of its very largest publicly quoted companies, HSBC (HSBA 1.71%) (HBC 2.64%) is a business with very definite attractions. A 120 billion-pound FSTE 100 constituent, last year the bank earned a pre-tax profit of 21.9 billion pounds on revenues of 83.5 billion pounds.
And with margins like that, it's no wonder that this defensively positioned business is popular with many investors. Today, with its shares changing hands at 646 pence, the bank is rated on a prospective price-to-earnings ratio of 11 and offers income investors a tempting forecast dividend yield of 4.6%.
But how safe is that share price? And -- of vital importance to income investors -- how safe is that dividend? In short, how could an investment in HSBC adversely affect investors' wealth?
In this series, I set out to help investors answer just these questions. My starting point: HSBC's latest annual report, where the company's directors are obliged to address the issue of risk.
Risk management
One immediate thing that I'm looking for is an acknowledgement that risks do exist, and that they need managing.
The good news? As you'd expect from a business of HSBC's size and caliber, the company has in place a risk management policy, a system of regular reviews, and a number of high-level committees tasked with monitoring the risks that the business has identified.
But what, precisely, are those risks that the company faces?
Read the small print, and HSBC identifies no fewer than eight risks as having a significant prospective impact on the company's financial performance. They range from eurozone meltdowns to regulatory change, and from Internet fraud to social media.
So let's take a look at three of the biggest.
Eurozone default
High on HSBC's own assessment of the risks that it faces is the bank's eurozone exposure. As the bank points out to investors, a eurozone sovereign default -- even in a eurozone peripheral economy -- is by no means unthinkable.
And the dangers are obvious: While the bank's own direct exposure has been carefully managed, innumerable counterparties are less fortunate. As the bank puts it:
"There is an increasing risk of sovereign defaults by the peripheral eurozone countries which would place further pressure on banks within the core European countries that are exposed to these sovereigns. Although our exposure to the peripheral eurozone countries is relatively limited, we are exposed to counterparts in the core European countries which could be affected by any sovereign crisis."
Clearly, the resulting impact on the bank could be serious. In a few terse paragraphs, HSBC highlights the possibility for credit and market risk losses, contracting trade and capital flows, bank recapitalization, spread compression, and tightening liquidity. In short, hello again, 2008 -- or perhaps worse.
What can the bank do about it? More than might be imagined. More geographically diverse than many other large banks, HSBC has only moderate exposure to the eurozone anyway. But, as the bank explains, it is actively managing even that, by reducing exposure and taking other, unspecified, measures to limit risk.
Eurozone departure
What would happen if a eurozone country elected to leave the currency bloc -- or, worse, was kicked out?
Once unthinkable, the past year and a half has seen active speculation about the departure of Greece and, to a lesser extent, other peripheral countries. As HSBC puts it:
"The risk of a eurozone member departing from the currency union is a plausible scenario. Should it materialize it would have a significant impact on the entire financial sector and the wider economy. It would crystallize sovereign risks and those to the bank and corporate sectors, and the disruption caused would affect consumer activity. "
Clearly, the risk is a very real one, although perhaps one that has moderated in recent weeks. And should it happen, the bank acknowledges that it could incur significant losses stemming from the exit of one or more countries from the eurozone and the ensuing return to their local currencies.
What's more, it adds, should such an event happen in a disorderly manner, it could trigger banking defaults in companies with which it does business, and have a knock‑on effect on the global banking system.
What is the bank doing about it? In short, it has prepared and tested detailed operational contingency plans to deal with such a scenario, and is keeping those plans under close review as events develop.
Regulatory risk
Post-2008, the world is a different place. America's "Volcker Rule," Chancellor George Osborne's bank levy, Basel capital adequacy rules, the U.K. Independent Commission on Banking -- HSBC is exposed to a wide range of possible regulatory-imposed changes on how it runs its business. As the bank puts it:
"Financial service providers face increasingly stringent and costly regulatory and supervisory requirements, particularly in the areas of capital and liquidity management, conduct of business, operational structures, and the integrity of financial services delivery. Increased government intervention and control over financial institutions, together with measures to reduce systemic risk, may significantly alter the competitive landscape."
From pay and bonuses through to capital ratios and ring-fencing, the rules of the game are changing, in short. What can HSBC do about it? Not much, beyond -- as it has been -- lobbying and preparing for the inevitability of some sort of change.
That said, the bank is closely engaged with the governments and regulators in the countries in which it operates, to help ensure that the new requirements are properly thought through and understood, so that they can be implemented in an effective manner. It is also ensuring that its capital and liquidity plans take into account the potential effects of the changes.
Risk vs. reward
Two superstar investors who are well-used to weighing risks are Neil Woodford and Warren Buffett.
On a dividend re‑invested basis over the 15 years to Dec. 31, 2011, Neil Woodford delivered a return of 347%, versus the FTSE All‑Share's distinctly more modest 42% performance. Buffett, for his part, has delivered returns of over 20% per annum since 1965, transforming himself into the world's third-wealthiest person.
Each, as it happens, is the subject of two special reports prepared by Motley Fool analysts. And they're yours to freely download, without any obligation.
So click here to download this free special report profiling the investment logic behind eight of Woodford's largest and most successful current picks.
And click here to discover which beaten-down British share Buffett has been buying of late -- and why he bought it, and the price he paid.
