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Banks, Financial

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Categorized | Banks

Deutsche Bank: 5 scenarios for future

Posted on October 2, 2016

File photo of workers walking past the London headquarters of Deutsche Bank in the City of London...Workers walk past the London headquarters of Deutsche Bank in the City of London, Britain in this May 19, 2015 file photo. Deutsche Bank posted a 20 percent rise in revenue at its lucrative bond trading business in the third quarter, helping to take the sting out of its previously announced record 6 billion-euro ($6.6 billion) group pre-tax loss. REUTERS/Toby Melville/Files©Reuters

    The travails for Deutsche Bank are far from over — even if John Cryan, the bank’s British chief executive, is now rushing to settle the US Department of Justice’s probe into alleged mis-selling of mortgage securities, the toxic products at the heart of the financial crisis.

    The initial $14bn demand from the DoJ — rejected by Deutsche Bank — threatens to undermine investor and client confidence in Germany’s biggest lender. Analysts think the market jitters over the fine have exposed much deeper structural weaknesses plaguing Europe’s banking system: negative interest rates, weak economic growth and tightening regulation are all dragging the industry’s profitability far below its cost of capital.

    Europe’s biggest investment bank, which has a €1.8tn balance sheet and employs 100,000 people, is teetering on the brink of an existential crisis. Here are five things to watch for what happens next at the German bank.

    Best settlement scenario  

    Achieving a settlement with the DoJ is Mr Cryan’s top priority, and he has been spending most of his time recently in the US trying to bring talks swiftly to a close. If Deutsche Bank could settle the case for close to its $3bn-$5bn target and complete the sale of its $4bn minority stake in China’s Huaxia Bank, it could put a stop to swirling speculation about its weak capital position. This should trigger a rebound in its share price, which has slumped to three-decade lows, and shore up client confidence in its financial position. The bank could then present investors with a beefed up strategy to rebuild profitability and strengthen its balance sheet when it presents quarterly results in late October. Crisis over.

    Chart: Deutsche Bank litigation charges

    Dilutive capital raise

    Even before the DoJ’s unexpected $14bn demand landed, Deutsche Bank had been widely expected to have to raise capital, most likely through a rights issue. Its common equity tier one ratio (CET1) — the key measure of balance sheet strength — was 10.8 per cent in June, well below most rivals and its own target of 12.5 per cent. Deutsche Bank has put aside €5.5bn to cover the cost of litigation, but every $1bn of extra provisions would erode its CET1 ratio by 0.25 percentage points. Another problem is that given the share price more than halved in the past year to a level 70 per cent below its book value, an equity issue would be prohibitively dilutive. It would also make it even tougher to generate a return on equity above its cost of capital. Kian Abouhossein, analyst at JPMorgan, estimated that a rights issue at a 25 per cent discount could raise as much as €5.6bn, adding less than 1.4 percentage points to its CET1 ratio — not enough to hit its target, especially after a big fine. There are also questions over whether investors would be prepared to inject more capital only to fund a big settlement with the DoJ and without a clear idea of how Deutsche Bank can rebuild its profitability from heavy losses last year. 

    Chart: Banks balance sheet strength

    Further asset sales

    If the DoJ keeps demanding significantly more than the $5bn settlement that Deutsche Bank seems prepared to accept, the German bank would have to consider other options to steady the ship, including more disposals. A big part of Mr Cryan’s initial strategy was to deleverage the balance sheet by selling or floating Postbank, the former post office bank it acquired in 2010, but this has faltered because of a lack of obvious buyers and poor market conditions. A senior European policymaker said Deutsche Bank could benefit from an ample supply of cheap funding from the European Central Bank to tide it over while it works on disposals. Hedge funds have pushed for a sale of its asset management division, which is estimated to be worth some $8bn. But Mr Cryan has dismissed rumours that this option was back on the table after an abortive attempt to offload it a few years ago.

    Chart: Level 3 bank assets

    Crisis of clients — and confidence

    Some hedge funds have been pulling collateral for derivatives trades from Deutsche Bank — raising fears of a run on Germany’s biggest bank. If talks with the DoJ drag on it could cause other clients, such as large asset managers and corporate treasurers, to start reducing their exposure to the bank. Sharp drops in client revenues could prompt rating agencies to downgrade the bank — which is already hovering just above junk status — forcing more clients to jump. The regulator could step in to order the bank to wipe out its most junior debt and convert other unsecured loans into equity — rebuilding its balance sheet, but sending waves of losses through the financial system.

    Government steps in

    Faced with an evaporation of client confidence in Deutsche Bank, which threatens to spiral out of control, Angela Merkel’s government could step in and backstop a deeply discounted capital raising. Less than a year away from a general election and already under fire over her decision to allow vast numbers of immigrants into the country, Ms Merkel would be loath to take such a step. Europe’s new rules for bank rescues only allow states to inject money into ailing banks once they have imposed losses on creditors equivalent to 8 per cent of liabilities. In Deutsche Bank’s case this would equate to €139bn of bondholder losses, which risks spreading contagion across the financial system. Any attempt to bypass the rules would trigger cries of foul play from countries such as Italy, which have been prevented from rescuing their own banks under pressure from Berlin. One possibility being mooted in some quarters is for the government to engineer a merger of Deutsche Bank with Commerzbank, in which Berlin already has a minority stake. While this is unpopular with officials, it may allow the government to provide support to Deutsche Bank without it being considered state aid.

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