Global Diversification or Domestic Focus? A look at HSBC Holdings plc and Lloyds Banking Group plc.

Global and local banking business models each have their own advantages and their disadvantages. Global diversification can help abank reduce its earnings volatility and take advantage of faster growing economies. With domestic focus, the bankbuilds scale in one key market, allowing it to become more cost efficient and increase customer profitability.

Before the financial crisis, almost every major bank pursued the global growth strategy, but things are verydifferent now.Greater underlying profitability has enableddomestic banks tooutperform globally diversified banks. Furthermore, the stock markets currently value domestic banks at much higher multiples on book value.

Spread too thinly

Lloyds (LSE: LLOY) shares arevalued at a27% premium to its book value, but the bank is still attractive on an earnings basis its forward P/E ratio is just 10.6. This compares to HSBCs (LSE: HSBA) 4% discount to book value and aforward P/E of 11.4.

HSBCs underperformance is the result of the bank spreading capital too thinly across too many markets. With 22 key markets, HSBC does not have enough local scale needed to keep costs low in many markets. The bank shouldrethink its the worlds local bankslogan.

Complexity

Complexity is another problem, causing HSBCto spend as much as $1 billion more annually on regulatory and compliance costs than it did before the financial crisis. Its cost to income ratio was 67.3% in 2014, compared to Lloyds 51%. Regulators also demand systemically important banks to hold more capital.

Lloyds, being less complex, can hold less capital. This raises the banks leverage, allowing itto generate a higher return on equity. Some analysts would argue that this makes Lloyds inherently more risky, butits simplicity is its counterbalance.

Higher leverage is not the only reason for Lloyds stronger returns on equity; it is also the result of its huge local scale and the profitability of retail and commercial banking in the UK market. The average return on equity for retail and commercial bankingin the UK is usually in the mid-teens, after PPI redress provisions and other fines are excluded.

The recovering UK economy is also more attractive, relative to slowing emerging markets. Benefiting from the improving economy, Lloyds is seeing its loan loss provisions fall, which has a direct impact to thebanks bottom line.

Too little, too late

Strict regulations and limits on foreign ownership has made it difficult for foreign banks to build sufficient scale in emerging markets. A market share of at least 10% is generally regarded as the minimum needed to be sufficiently cost efficient for retail banking. HSBC falls short of this 10% threshold in many markets.

HSBCs management appears to recognise this, by looking to sell its Brazilian retail bank. Although a sale of its Brazilian unit may provide a short-term boost to its share price; in the longer term, it is too little, too late.To become more competitive,HSBC needs toexit many more markets.

Outperform

Lloyds, which is already on the mend, faces less execution risks. It will soon return to regular dividend payments and its return on equity (ROE) is getting closer to its 13.5-15% target. In contrast,HSBC has lowered its ROE target from 12-15% to more than10%.

With emerging market economies slowing, even meeting that 10% ROE target could bedifficult. The contrasting outlooks between the two banksshould help Lloyds to continue to outperform HSBC in the medium term.