Would You Rather Own A Business That Discloses Unusually Bad Operational Losses, Or One Whose Management Doesn’t Tell You Any Bad News At All?

I-OnAsia Risk Advisory Review: HSBC & Hang Seng Financial Sub-Index OpRisks
By James Tunkey & Jacqueline Evers

I-OnAsia’s Risk Advisory team has just completed a study of the most recent decade’s risk management disclosures by the Hang Seng Index’s Financial Sub-Index constituents to investors.  The research, led by our senior associate Jacqueline Evers, has yielded two troubling insights: HSBC has experienced a decade of unusually high levels of losses due to bad business practices; and, the vast majority of other Finance Sub-Index constituents are not being fully transparent in their annual reporting about operational losses.

Our team is reminded of the sick game in 3rd grade, where you give your classmate two bad options (kiss the tail end of a dog, or eat a worm).  We’ve been asking: Would You Rather Own A Business That Discloses Unusually Bad Operational Losses, Or One Whose Management Doesn’t Tell You Any Bad News At All?

Clearly, most people would prefer to invest in good managers who are transparent.

About I-OnAsia’s Risk Advisory Study

For over 15 years, I-OnAsia’s Risk Advisory team has used the Bank for International Settlements (BIS) standards for classifying operational risks, breaking out OpRisks into the following categories:

1.       Internal Fraud
2.       External Fraud
3.       Employment Practices & Workplace Safety
4.       Clients Products & Business Practices
5.       Damage to Physical Assets
6.       Business Disruption & System Failures; and,
7.       Execution, Delivery& Process Management.  

Since 2004, I-OnAsia’s Risk Advisory team has maintained a database of OpRisk losses reported by all Hang Seng Index constituents in their annual reports.  Our database goes back to World War II, and includes both financial and non-financial institutions.

I-OnAsia’s Risk Advisory team uses this database to deliver unique due diligence and risk management assessments.  I-OnAsia’s understanding of historic OpRisks at property companies has helped inform our advisory on build-outs of new regional headquarters for multinationals.  

I-OnAsia’s most recent study has updated OpRisk loss data for the forty-six constituents of the Hang Seng Index in 2018.  

HSBC’s Business Practices: A Major Source of OpRisk Losses

HSBC reported roughly US$11 billion (in today’s dollars) in OpRisk losses between 2009 and 2018, according to analysis of HSBC annual reports by I-OnAsia’s Risk Advisory team.  Nearly three quarters of this amount was from foreign fines, penalties, and judgements.  

There is no doubt that HSBC’s retail and commercial banking networks in Europe and the Americas have opened the company to heavy foreign regulatory scrutiny, but HSBC’s business practices have gotten it into trouble in Hong Kong as well as in western markets.   Key problems have been identified in:

  • Foreign exchange rate fixing;
  • Precious metals trading;
  • Payment protection insurance;
  • Interest rate derivatives;
  • U.S. mortgage securitization activity;
  • U.K. Consumer Credit Act lending; and,
  • Anti-money laundering and sanctions-related failures.

These unusually heavy losses due to internal business practices ultimately resulted in HSBC’s turning to a new external Group Chairman in late 2017.  

The take-away: bad business practices and weak oversight and compliance can cause so much pain for shareholders that it can bring down an executive team.

Concerning Lack of OpRisk Loss Event Disclosure at Eight Hong Kong Listed Financials

China Construction Bank reported a combined US$7.5 billion (in today’s dollars) in non-fraud related OpRisk losses between 2008 and 2018, and a certain amount of OpRisk loss is expected each year at any bank around the world.  During the same timeperiod, HKEx reported a substantial loss event due to business practices.

None of the other eight Hang Seng Finance Sub-Index constituents reported a single significant operational risk loss event to investors in their annual reports between 2008 and 2018:

Hang Seng Bank; AIA Group; Industrial and Commercial Bank of China; Ping An Insurance; BOC Hong Kong; China Life; Bank of Communications; and/or, Bank of China.

Unfortunately it is difficult to say for sure whether this lack of reported losses was due to superior risk management practices at these eight companies.  It is I-OnAsia’s assessment, based on a global review of data submitted by financial industry peers to the BIS, that zero reports of OpRisk losses by eight large institutions over an entire decade is unusual and potentially concerning.

Details disclosed to the public by HSBC in its annual reports about OpRisk losses provided an opportunity for investors to understand the specifics of problems at the bank, and advocate for improvements.  The absence of OpRisk loss reports raises questions about whether public investors have a strong enough grasp on the risks associated with these eight enterprises.

Another take-away: without detailed data on OpRisks, investors in financial institutions may be flying blind to bad business practices.