Edward Chow remembers the nervous days of the early 1990s in Hong Kong, when tens of thousands of people left the then-British colony, fearful of what would happen when Chinese rule returned.

Among the most high profile departures was that of HSBC, the company most closely associated with the rise of Asia's financial center and the territory's de facto central bank. While HSBC's red and white ATMs remained ubiquitous from Hong Kong's bustling commercial district Central to the dingy alleys of Sham Shui Po, the bank's decision to move its HQ to London suggested it saw its future in Europe and the United States.

It really felt like Hong Kong and China's glory days were over, says Chow, a retired teacher and longtime HSBC shareholder. This was a few years after tanks rolled on Tiananmen Square, and things looked really horrible for Hong Kong and HSBC's departure really made a lot of us feel like the good days were over.

It's a different world now. After two decades spent expanding in Britain, the United States and other developed economies, the world's third biggest bank is shifting its focus back to its Asian roots, and especially China. HSBC wants to become the financier and international bank of choice for China's growing band of entrepreneurs, just as it bankrolled Hong Kong's tycoons in the second half of the 20th century. As capital markets open up and cross-border takeovers and bond deals are struck in yuan rather than dollars, it also aims to become one of the top investment banks in China, despite the fact it ranks outside the top 10 globally.

In many ways -- history, connections, staff -- HSBC is well positioned for a push into China. Bankers in Asia and the west see it as slotting in between China's massive domestic banks and the foreign banks that seem to blow hot and cold over the world's most populous country. As proof of its commitment, HSBC soon hopes to become the first international company to list on the stock exchange in Shanghai, a city in which it first set up in April 1865, a month after it opened in Hong Kong.

Key staff are already making the shift east from London. Last January, CEO Michael Geoghegan swapped his office in London's Canary Wharf financial district for one in HSBC's stylish Norman Foster-designed building overlooking Hong Kong Harbour, saying he wanted to be nearer the action. West is coming east and we want to be at the gate into China and be in China itself, he declared. When Geoghegan was ousted in a boardroom power struggle in September, his successor Stuart Gulliver opted for Hong Kong too. Other members of the leadership team are also making the move, including Paul Thurston, named last month as head of retail banking and wealth management, and Chris Meares, head of private banking.

But nothing is guaranteed. HSBC shares have fallen by just over a fifth over the last decade, broadly in line with the global bank sector but lagging far behind arch-rival Standard Chartered. It also faces fierce competition in China and, by some measures, has been lagging foreign rivals in winning big deals. Its unseemly boardroom fight, which also saw a new chairman installed, has hit the company's reputation for tidy planning. HSBC is also still sorting through a disastrous and costly housing loans adventure in the United States -- losses that could reach $50 billion. Given such a high-profile failure in the world's biggest economy, can HSBC make it work in the second biggest?

There's headroom for more growth, but it's not massive until there is more liberalization and it's not going to be quick, says Steven Hayne, banking analyst for Morgan Stanley in London. As foreign banks target Asia in search of growth, competition is pretty fierce. Banks are expanding there and the Chinese banks themselves are getting more sophisticated and developing their capabilities and shouldn't be underestimated.

PROMISE AND PITFALLS

To get an idea why HSBC (and every other major bank in the world, for that matter) wants to be in China, consider what McDonald's served up there in August. The American fast food giant sells millions of burgers each week in China and expects to almost double in size to more than 2,000 stores within four years. It wasn't food that got the banks salivating, though, but the first bond by a foreign company denominated in yuan -- also known as renminbi (RMB), or the the people's currency.

Growth in China has averaged around 10 percent a year for the last decade and shows little sign of slowing. As trade flows with the rest of the world increase -- HSBC says they will reach $5 trillion by 2015, which means growth of 13 percent a year -- more of China's cross-border trade will be settled in yuan.

On paper, HSBC is well placed to take a good chunk of business in that yuan-denominated trade. It is often one of the first foreign entities to win key licenses in China. It was the first to settle a cross-border yuan trade last year, the first to handle a yuan-denominated interest rate swap in Hong Kong in October, and it became the first international bank to complete yuan settlements in six continents with a deal in Brazil last month.

The McDonald's bond, though, was arranged by Standard Chartered. Goldman Sachs handled an even bigger yuan-denominated bond soon after from Caterpillar, the giant U.S. maker of earth-moving equipment. While HSBC typically tops Asia-Pacific bond market activity, it ranks behind more than 20 domestic Chinese firms, UBS, Goldman Sachs and Deutsche Bank in mainland Chinese issuance this year. It has also missed out in China's red-hot IPO market, where local banks like CICC and international rivals like Goldman, Morgan Stanley and UBS have been grabbing most of the lucrative deals.

As China gets more ambitious, competition is likely to get even tougher. For one thing, Beijing will ensure its own banks take a lead role on most local deals. Foreign banks are expected to grow their share of China's bank market over the next 40 years to 10 percent from 2 percent now, bankers in the region say. That's a relatively modest proportion but should still represent almost $80 billion a year by 2050, according to analysts at Goldman Sachs.

The market is big enough that the crumbs that China throws out will keep the international banks interested, says Joe Studwell, author of Asian Godfathers, a book that charts the rise of modern Hong Kong and South-east Asian tycoons. But the Chinese are not dumb enough to deregulate their financial markets prematurely and become another Latin American or south-east Asian carcass for Wall Street and the City of London to pick over.

IN CHINA, SMALL CAN BE BIG

HSBC likes to portray itself as different from other foreign banks. When rivals like Royal Bank of Scotland and Bank of America pulled back from China during the latest financial crisis to fight fires at home, it stayed put -- a decision it hopes China's leaders, regulators and businesses will remember. There's a chance for HSBC to slip in early and become almost a semi-domestic bank in China. It's a foreign bank, make no mistake about that, but they are a longstanding friend of China, said a banker with long experience in the region.

And while HSBC may have so far missed out on the big name bond deals, bankers point to trade financing and a more modest recent transaction -- financing for auto maker SAIC's $500 million investment in Detroit's General Motors -- as examples of where the bank is strong. HSBC stepped in quickly with the credit facility after Chinese authorities wavered on allowing state-backed SAIC to invest in GM's IPO, people familiar with the deal said. It was a deal laced with symbolism: a Chinese firm becoming a cornerstone investor in America's flagship auto-maker GM in the world's biggest IPO, with the world's two most powerful governments involved in the talks. That was a big deal ... there's greater (Chinese) confidence building to go overseas, and that will continue, one person familiar with the deal said.

Executives interviewed for this article know the bank will never compete in mainstream retail banking in China. For a start, Chinese regulators restrict the number of branches foreign banks can open -- HSBC outlets are expected to be capped at 300 to 400 -- as well as how much they can loan and even profitability. Given such strictures there's no way HSBC or any other foreign bank can compete with Chinese giants such as ICBC, which has 18,000 branches and is now the biggest bank in the world by market value.

HSBC currently has just 102 outlets in China, the most of any foreign bank. Growth, it believes, will come from the expanding number of affluent Chinese who need services such as wealth management and offshore products -- it hopes to almost treble its personal customers to 270,000 by 2013 -- and financing firms like SAIC and thousands of smaller companies.

To achieve that, HSBC is going deeper into the mainland. The bank used to be largely located in first-tier cities such as Beijing and Shanghai, but has recently moved to second- and third-tier cities such as Taiyuan, Shenyang and Dalian. Its name has helped. You can see for yourself how crowded it is, says Hu, a bank teller at an HSBC branch in Shenzhen on a weekday afternoon. We are a good brand name and we have people walking in here from other banks with bags of cash to deposit. 'Second-tier' in China can mean a city of 10 million; even HSBC's rural branches -- it now has a dozen -- aim to sell a range of products to local farmers with turnovers a mid-sized western firm would be proud of.

One of the tactics in this gradual approach has been to buy direct and indirect stakes in myriad local financial firms. HSBC's stakes include 19 percent of Bank of Communications (BoCom), China's fifth biggest bank, and 16.1 percent of Ping An Insurance. It also has small stakes in Bank of Shanghai, Industrial Bank and Yantai City Commercial Bank, plus fund management and insurance joint ventures. The approach seems to be working. The bank's Chinese stakes are now worth about $22 billion at current valuations, more than four times the $5 billion they cost, while profits from the mainland China business are on course to top $2 billion in 2010, up from $1.6 billion last year. Analysts at Goldman Sachs estimate HSBC's mainland earnings could jump to $7 billion by 2015, and may eventually comprise a third of the bank's total profits, up from 12 percent in 2009.

Many industry insiders say HSBC would love to own more of BoCom, but Beijing has capped its holding in the bank. That means HSBC must make its existing deals and joint ventures -- schemes such as a credit card venture with BoCom that has 15 million cards in issue -- work harder. It is also trying to get a securities license, which has given UBS, Goldman Sachs and a select few an edge, and is expected to soon strike a deal with a local securities firm or brokerage.

Peter Wong, chief executive of HSBC's China business, told Reuters that by 2020 we should have close to 300 branches enabling us to reach target customers in the vast majority of key centers. We should have the insurance joint venture working well, we should have a securities business, and we should have a pretty good share of the DCM (debt capital markets) and ECM (equity capital markets) markets. And we'll be a big player in terms of taking our customers out on the international markets.

Chinese bankers say government connections and family ties remain vital. China's complex network of tycoons, and government and local officials means managers at HSBC, like all other banks operating in the country, spend much of their time building up relationships. Consultancies typically set up by the friends and relatives of top party officials can help firms build the right guanxi or networks of influence when they need it. Honestly, when you get to the big state-owned guys, it's a lot less about expertise and a lot more about how to get into their good books, said a foreign banker who has been working in China for the past 10 years. All the important decisions are made by the top boys in the headquarters and the Beijing officials, and those are the ones you need to get comfortable with.

HSBC and other large foreign banks operating in China are unlikely to make use of these consultants because of their long histories operating in the country, the bankers said, but others may find it a convenient way of dealing with the bureaucracy.

WASTED BILLIONS, WASTED TIME, WASTED FOCUS

Even if HSBC was able to grow more quickly in China, its disastrous recent experience in the United States seems to have left it wary of hasty expansions.

The company now admits its $14.8 billion, 2003 acquisition of Chicago-based consumer finance firm Household Finance was a bad deal. John Bond, HSBC's powerful chief executive and later chairman (he stood down in 2006), believed he had snapped up a bargain when Household's shares fell on the back of rising financing costs and accusations that the firm had duped low income borrowers. HSBC said it could finance Household's loans far more cheaply due to its massive deposit base and stellar credit rating. Bond, who also pushed the bank hard in China through his tenure, said at the time: We think the U.S. consumer is the engine room for growth.

Not everyone at HSBC agreed. Nobody understood the logic, other than it was cheap, said one former HSBC employee. Staff sitting in Asia were saying: What! Why? Really? A few investors and analysts also questioned the deal's logic. Citigroup's bank analysts said the deal was the riskiest move in HSBC's modern history while Merrill Lynch said the shift into risky consumer lending looks a bit strange.

They were right to be skeptical. Buying Household Finance, America's largest consumer finance lender, gave HSBC access to 50 million new customers in the United States and to the fast-growing market for risky loans to low-income borrowers. But the deal also moved the bank downscale, and saddled HSBC with a business that had been hounded for years by consumer protection advocates who were angry with Household's predatory lending to the poor and its failure to fully disclose the fees it charged. Just before the deal, Household had agreed to pay back almost $500 million to customers to settle charges in 20 states. Household had a bad reputation well before HSBC decided to buy them, says Matthew Lee, the founder of New York-based Inner City Press, a leading campaigner against predatory lending.

Though notoriously frugal, Bond signed off on a pay package worth well over $30 million for Household boss William Aldinger and promised access to a private jet and dental care for life for Aldinger and his wife. The package was ridiculed by the British press, but Bond at first appeared vindicated -- the sub-prime market grew and Household made $9 billion in profits in the first three years under HSBC.

That encouraged the British parent to become even more aggressive in the United States. Renamed HSBC Finance, the U.S. division boasted that it had a team of experts with PhDs who could predict consumer behavior. It ramped up lending in 2005 and early 2006, buying portfolios of loans from other banks -- a stark and risky contrast to HSBC's traditional method of originating loans through its branch network where it could screen borrowers.

By the time the housing market and U.S. economy soured in 2007, HSBC Finance's loan book had swelled to about $170 billion, up from $101 billion when HSBC had bought Household. They wanted to be in sub-prime and they wanted to diversify into the U.S. and the two things came together with Household and it was a disaster, says Glen Suarez, head of investments at Knight Vinke Asset Management, an activist hedge fund based in Monaco that started a campaign to force the bank to fix its U.S. problems and focus on Asia.

Suarez says Knight Vinke first contacted HSBC in April 2007 but was given short shrift by management. In September of that year, the fund, which was backed by the giant California Public Employees Retirement System (CalPERS) and other huge pension funds looking to protect their members, went public: it had bought 21.9 million shares and wanted a constructive dialogue to address concerns. Knight Vinke said it wanted HSBC to quit the United States and France, and reinvest proceeds in Hong Kong and Asia. It also wanted a review of strategy and corporate governance shortcomings.

Our view was the strategy, particularly in Household, was essentially driven by the desire for diversification, Suarez told Reuters. But diversification was spreading them too thin across the globe. They were trying to be all things to all men and the capital was being spread in such a way that they didn't get any comparative advantage or scale, and they were making up for that by leveraging the business up.

The self-dubbed World's local bank had no desire to engage in a public row with a powerful shareholder, and Chairman Stephen Green said he would not leave Household bondholders high and dry by walking away. In early 2007 it began limiting the damage by turning away new business and the operation is being slowly run down. The full scale of the losses will not be known for years, but Knight Vinke estimates them at about $50 billion.

Knight Vinke no longer owns shares in HSBC and says it has done what investors asked it to achieve. Some of its investors still hold shares in the bank, including CalPERS, whose stake is worth almost $500 million. The three critical changes that we wanted have taken place -- the CEO moving to Hong Kong, the decision to effectively shut down Household and changing the structure of the board, Suarez said. With these changes, I expect HSBC's performance to improve, but it will take time.

CHINESE ROOTS

Founded 145 years ago on sound Scottish banking principles by a colonial shipping official, the Hong Kong and Shanghai Banking Corporation has long been held in lofty esteem in its city of birth. Even with its head office in far away London for the past 17 years, Hong Kong parents and grandparents are fond of giving the bank's shares as gifts during Chinese New Year and at weddings and college graduations. HSBC accounts for two-thirds of the banknotes in issue in Hong Kong and provides a bank account, life insurance product or pension to half of the city's 7 million people.

In its early days, the bank made its name in government financing, acting as banker to the Hong Kong government and issuing banknotes. It handled China's first public loan -- the 8 percent Foochau loan of 1874 -- and later issued loans for railway construction, shipping, coal mines and other infrastructure projects in China and across Asia. Financing of trade grew, and by the end of the 19th century the bank was the biggest regional player, raising capital in Europe and lending it more freely in Asia than other banks were willing to do.

By 1911 it had become the headquarters of the China Consortium, a group of banks that financed economic development. Yet it was clearly part of the old world establishment. For a Chinese businessman to get to see decision-makers in the British colonial banks was like seeking an audience with God, an octogenarian businessman said of the pre-revolution era in Studwell's Asian Godfathers.

Two world wars put the brakes on trade and the victory of the Chinese Communist party in 1949 forced the bank to close almost all its offices in China and retreat to Hong Kong. A boost there came from its relationships with Shanghai manufacturers who also fled the mainland for the British colony. Later, the bank would benefit from ties to some of Hong Kong's emerging tycoons, including entrepreneurs like Y.K. Pao, who would become the world's leading private ship owner, Li Ka Shing, to whom HSBC controversially sold a controlling stake in telecoms firm Hutchison Whampoa, and Cheng Yu-Tung, a property billionaire.

NEW HOME?

HSBC formally reconsiders its headquarters every three years by studying issues such as tax and regulation, time zone and talent pool. The next review is in 2011. Since 1993, London has come out on top. Could that change?

Maybe not at the next review, say investors and analysts, but certainly this decade. HSBC says it remains committed to London. But it is one of a trio of banks -- Standard Chartered and Barclays are the other two -- that have suggested it might leave if the environment for banks becomes too hostile because of tax rises or if the government forces banks to separate their retail arms from investment banking -- dubbed casino banking by some politicians.

Asked recently how logistically difficult it would be to move HQ over 6,000 miles, outgoing CEO Geoghegan said it was a hypothetical question, but then quipped: We've done it once from Hong Kong to London so we know how to do it.

London is home to talented and experienced bankers, its time zone is convenient for a global business, and its legal and regulatory structures remain highly respected around the world. But the gap over other cities is narrowing. Britain slapped a 2.5 billion pound annual levy on banks in October, which could cost HSBC about 500 million pounds a year. There is no doubt the arguments for London have weakened relative to other centers, Standard Chartered CEO Peter Sands said in August, adding that shareholders had raised the issue. We don't want to be in a position where being headquartered in the UK represents a significant competitive disadvantage in our markets, and there is a danger of that happening.

Any move may hinge on the success of the Shanghai listing for HSBC. The bank says it's ready to list as soon as it is allowed. But as with much in China's financial markets, the process is proving a slog. Hopes were high the listing would happen this year; now a listing between March and July is seen a strong likelihood. HSBC has said Chinese investors are ready to invest in it, and the listing is expected to raise $3-8 billion. It is not clear if Beijing would require all proceeds to stay in the country, although HSBC may opt to use the capital to grow the mainland business anyway.

HEART-WRECKING FALL

Agnes Wu, a veteran Hong Kong stock market commentator, broke down in tears live on air on March 9, 2009, after HSBC's shares crashed over 20 percent in a hectic few minutes of trading. All banks were suffering and HSBC shares were even more volatile in the run-up to a record $18 billion rights issue.

Wu wiped away tears as she watched the slump. It's a heart-wrecking fall, she said.

It was a low point for the bank in Hong Kong. The cash call was needed to fix a balance sheet damaged by the U.S. losses, which had sparked HSBC's first ever profit-warning. More recently, the power struggle in the boardroom showed all was not well at a firm that prided itself on smooth successions. And just this week, HSBC faced fresh problems, when it and other banks were sued for $9 billion and accused of ignoring warnings that could have helped prevent convicted U.S. swindler Bernard Madoff's $65 billion Ponzi scheme. (HSBC has consistently denied any knowledge of Madoff's scheme.)

But HSBC has come through the financial crisis relatively unscathed. It has not needed a taxpayer bailout and its investors are upbeat on its prospects. The bad debt issues are fading, there's a dividend growth policy in place, and there's the growth in emerging markets. For the next five years you can expect top-line growth that's not obvious for financial institutions in the mature world, says Guy de Blonay, who co-runs Jupiter's 1.4 billion pound Financial Opportunities Fund in London and has HSBC as one of his top 10 holdings.

Retail investors in Hong Kong also remain loyal -- hundreds snaked around a temporary office 20 months ago when the rights issue opened, and ended up buying almost 99 percent of the shares they were allowed. And if they hadn't signed up, some of Asia's wealthy tycoons were ready to step in with the cash, including long-time customers like Li Ka-shing and Cheng Yu-tung.

Incoming CEO Gulliver says he wants the company to be in the top three in China's debt markets and in the top five in equity capital markets. Much will fall on the shoulders of the 30-year HSBC veteran, who held senior roles in Hong Kong before running the investment bank from London. In Hong Kong he dealt regularly with China's state institutions in the 1980s and 1990s. He was on a plane to Beijing on a regular basis, they were his customers, a former HSBC colleague said. He has relationships there that date back 20 years and you can't buy that and can't fake it.

But that doesn't mean progress will be easy. The expansion of overseas banks in China will improve the domestic lenders' know-how and fuel the overseas ambitions of banks like ICBC and China Construction Bank, which dwarf western banks in terms of size but have barely ventured abroad.

As Gulliver and Douglas Flint, who took over as chairman this month, push into China, they might keep in mind a popular phrase used by former Chairman Bond, who was applauded by shareholders when he left the stage in May 2006, but whose legacy has now been tarnished by the problems at Household.

There is a Chinese saying: Today you are a cockerel, tomorrow you are a feather duster. (Additional reporting by Michael Flaherty in Hong Kong and Clare Baldwin and Soyoung Kim in New York, and Kevin Krolicki in Detroit; Editing by Simon Robinson and Sara Ledwith)

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