Banks are likely to pare back their equities businesses even after early 2012's stock market rally, with faltering trading volume not expected to return to pre-crisis highs, HSBC's global head of equities said.

The scaling back of banks' proprietary trading desks was one factor contributing to a cut in traded volumes that has in turn left the rally looking shaky, Patrick George told Reuters.

Equities volumes will not go back to the levels of 1998-2008. That whole cycle will not come back. That's down to regulatory changes, the lack of leverage in the system etc.

In the longer term, although trading volumes would pick up from recent lows, they would not return to peak levels seen between 2005 and 2008, adding to the pressure on firms to rethink their business models.

HSBC's cash equities department was well placed strategically after the firm spent 2-1/2 years turning it around, George said. But most banks were still going through a period of strategic soul-searching.

The question being asked at every major firm is: 'Do I need 2,000-2,500 people in equities in the current environment?'. HSBC declined to say how many staff worked in its equities department.

In equities markets, HSBC posted an operating profit of $961 million for 2011, up 27 percent on 2010.

In financing and equity capital markets, the unit that advises on listings, operating income for 2011 was $3.2 billion, up 14 percent on 2010.

The bank ranks 12th in the world as an adviser on equity and equity-related transactions in the year to date, according to Thomson Reuters data. Citi and Goldman Sachs are the top two banks.

Most major investment banks have been cutting jobs across the board, in their bond and stock trading units as well as in advisory, since mid-2011, as stricter capital rules loom and the euro zone debt crisis hurts revenues.

The new rules and lower volumes would leave banks with very little room to expand their equity operations even if the market rose further, George said.

While equities divisions are less capital intensive than some other areas of a bank, margins on trades are slimmer and banks with large staffs need to deal in huge volumes for the business to be very profitable.

If the volumes do not come back, something has to give.

Banks will not compete in every single country, in every single market, to every single client... Banks have already started to retrench into their core markets. The competitive landscape is definitely changing, George said.

At HSBC, that strategy meant aligning the equities unit with the finance-led, emerging market-driven and European-focused DNA of the bank, George said. We don't want to go and sell U.S. domestic equities products to U.S. clients, he added.

HSBC's UK rival Royal Bank of Scotland has shed the bulk of its equities division, while Italy's UniCredit ditched its western European equities business last year to partner another firm.

UNUSUAL DYNAMICS

European stocks have climbed strongly since November, aided by two injections of cheap European Central Bank cash into the banking system, but trading volumes were down 16 percent in January and February compared with a year ago, World Federation of Exchanges data showed.

Either people didn't expect this rally to come in, or don't believe in it, or don't believe it is sustainable and so are not stepping in at those levels...year-to-date activity is not as good as it should be for a market that is up 10 percent, George said.

A lack of hedge fund activity was contributing to the low volumes, George said, citing data from HSBC's prime brokerage that suggested gearing among hedge funds was still around record lows.

While a recent revival in European new stock market listings after an eight-month lull suggested investors were putting the worst of the sovereign debt panic behind them, many remained sidelined.

Some, most notably the retail segment of the market, were still cautious, George said, citing a recent visit to the United States where he met a number of large mutual and hedge funds.

If you speak to the big asset managers that manage money for retail, they are happy that the market has gone up, as they are naturally long and their assets have gone up, but they have not seen fresh inflows into their funds.

(Editing by Nigel Stephenson)