I regard banks and other financial institutions as black boxes, largely because it is hard to account for the value of their assets. However, there is a different and more fundamental reason why these companies are hard to asses: they are too complex to understand. There are just too many contracts and regulations that they have to honor. The complexity of these businesses makes them very dangerous. The risks of these firms cannot be quantified or even described until after they surface in the news.
HSBC's (HBC) money laundering investigation and settlement are just the latest example of this. Analysts would not have predicted this would have been a material risk until now. Other scandals abound and demonstrate that financials are, at best, speculative bets.
HSBC entered into a huge settlement agreement with the U.S. Department of Justice over money laundering investigations. The settlement involves HSBC paying about $1.92 billion, which includes a $1.25 billion forfeiture and $665 million in civil penalties in exchange for a deferred prosecution agreement - a deal where the government allows an entity being investigated to avoid charges provided it meets certain conditions, such as commitment to specified reforms overseen by a monitor or an internal compliance body and payment of fines or penalties. The settlement payment is the largest payment ever made by a bank, eclipsing the $619 million in similar penalties paid by Netherland's ING Groep (ING) last June.
As agreed, HSBC shall create a board to implement anti-money laundering controls and install an officer to report about group money laundering, aside from spending on a review regarding "know your customer" procedures that would amount to $700 million over five years. U.S. Treasury's Office of Foreign Assets Control and Financial Crimes Enforcement Network former head Robert Werner was tapped by HSBC to head the compliance board and be the reporting officer on group money laundering.
The U.S. Justice Department and Senate investigations found numerous violations committed by Europe's largest bank which include among others, HSBC's failure to comply with an anti-money laundering review resulting to exclusion of trillions of dollars in wire transfers and hundreds of millions of dollars in Mexican illegal drug money passing through U.S. bank accounts. U.S. Treasury Undersecretary David S. Cohen said, "Despite the well-known illicit finance risks associated with Mexican drug trafficking organizations, HSBC inexplicably placed Mexico in its lowest possible risk category. As a result, it allowed billions in wire transactions and bulk cash to pass through its gates with minimal if any monitoring." HSBC's Mexican and U.S. units failed to monitor around $670 billion in wire transfers and about $9.4 billion in dollar purchases.
HSBC allowed about $660 million in Office of Foreign Assets Control's prohibited transactions to course through U.S. financial institutions from countries with economic sanctions such as Cuba and Iran, sometimes instructing banks from these countries on how to format payments to avoid U.S. blocking or rejection. Investigators also identified 2,300 transactions from March 2004 to June 2010 amounting to $430 million that violated economic sanctions imposed against Cuba, Libya, Iran, Sudan and Burma. The bank's lax oversight and failure to implement adequate programs and anti-money laundering procedures left dangerous gaps that drug dealers and other criminals readily exploited.
Senate investigation revealed that HSBC also handled 'U-turn transactions' through U.S. financial institutions involving money from Iran to non-U.S. banks, editing transaction records to hide information about its real clients. An audit by Deloitte likewise revealed about 25,000 transactions with sanctioned Iran worth around $19.4 billion were processed, 90% of these passing through the U.S.
The Justice Department's decision not to prosecute HSBC was influenced by several factors such as the impact on the company's employees and the potential economic effect. U.S. Justice Department's Assistant Attorney General for Criminal Division Lanny Breuer said,
As bad has HSBC's conduct was, this is not a case where the HSBC people intended to create money laundering. What they did do was they affirmatively violated the Bank Secrecy Act, they did not have the controls in place that they needed to do. This was insidious and wrong and had occurred over decades of time and we've held them very much accountable. I'm not sure you can find a more robust resolution.
HSBC management apologized for its past actions and omissions. HSBC Chief Executive Officer Stuart Gulliver said,
We accept responsibility for our past mistakes. We have said we are profoundly sorry for them, and we do so again. The HSBC of today is a fundamentally different organization from the one that made those mistakes.
I respectfully disagree. The root cause of these problems is that complex financial companies like HSBC are very, very hard to manage. Mistakes will probably be made in the future. Heightened compliance may help in the short run, but it will likely focus on what happened in the past rather than anticipate unpredictable future scandals.
Searching for Cheap Bets
Prudent investors should shy away from financials. Some investors refuse to do this. For these risk-seekers, the question is whether HSBC is cheap relative to is peers based on this scandal. Consider these price multiples:
The Royal Bank of Scotland
Bank of America
Mitsubishi UFJ Financial
PNC Financial Services
Wells Fargo & Company
Bank of Montreal
The Toronto-Dominion Bank
The Bank Of Nova Scotia
Canadian Imperial Bank of Commerce
HSBC's stock is not cheap based on price-to-book, price-to-sales, or price-to earnings multiples when compared to its peers. This stock is not a good deal at current price levels, even for speculators.
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