S&P Lowers HSBC's Rating Outlook

On Thursday, Standard & Poor’s Ratings Services (S&P) downgraded its outlook on HSBC Holdings plc ( HBC - Analyst Report ) and its other rated holding companies to ‘Negative’ from ‘Stable’.

The downward revision was propelled by the company’s failure to abide by regulatory compliances, including the rules related to U.S. anti-money laundering standards. However, it affirmed the 'A+/A-1' long- and short-term counterparty credit ratings for HSBC and other units.

Apart from inquiry over anti-money laundering (AML) standards, the bank was also accused of selling payment protection insurance (PPI) and interest rate hedging products in the U.K. in a misappropriate manner. Moreover, the bank has been accused of breaching rules related to U.S. mortgage foreclosure practices.

After year-long investigations into HSBC’s compliance with anti-money laundering rules, the subcommittee alleged that the bank failed to meet the rules. This could possibly result in hefty penalties. Apart from the senatorial committee, the Department of Justice and the Office of Foreign Asset Control are also probing the bank.

The investigation revealed substantial lapses in the bank's anti-money laundering compliance. This resulted in a worldwide displacement of funds from riskier nations through the bank and indicates prospective failure of HSBC’s enterprise risk management.

According to S&P, the actions on the part of U.S. regulators are uncertain. Therefore, HSBC has kept aside about $700 million to meet regulatory fines. As of the six months ended June 30, 2012, HSBC has also made provisions of $2 billion for regulatory fines and associated costs over $1.1 billion made in 2011.

Moreover, HSBC is already facing an enquiry related to the London Interbank Offered Rate, or the LIBOR. Although the bank is not officially charged for any wrongdoing, it is feared that such allegations and investigations might tarnish the goodwill of the company.

Last month, HSBC reported results for the first half of 2012 with its net income declining nearly 7% year over year. Additionally, factors that continue to persist include the impact of the deepening Euro-zone crisis, various investigations related to its business operations and regulatory restrictions on its financials.

All these negative issues related to the bank, along with S&P’s reassessment of HSBC’s capabilities, resulted in a downward revision.

According to S&P, upgrading the rating outlook to stable depends on certain factors. These include senior management’s full control over the bank’s activities and insignificant after-effects of the recent issues. Moreover, HSBC’s balance sheet position remains intact, which would facilitate the bank to survive amidst the volatile global economic conditions.

Moreover, other rating agencies such as Fitch Ratings and Moody’s Investor Service – the rating arm of Moody’s Corporation ( MCO - Analyst Report ) – have a negative outlook on HSBC.

Our Viewpoint

Though HSBC is working to address such issues, further rating downgrades could be implemented following pressure on the bank’s trading business and profitability from regulatory intrusion or client discontent. Moreover, this rating downgrade will affect investors’ confidence in the stock, depicting the legal issues faced by the company.

Currently, the harsh impact of the deepening Euro-zone crisis is our primary concern. Moreover, HSBC is suffering from a weak revenue growth in its mature markets, attributable to the ongoing low interest rates and regulatory restrictions. However, the company is poised to benefit from its extensive global network, strong capital position, business re-engineering efforts and strong asset growth.

HSBC currently retains a Zacks #3 Rank, which translates into a short-term Hold rating. Considering the fundamentals, we also maintain a long-term ‘Neutral’ recommendation on the stock.