Daniel Lacalle

Deutsche Bank and the last opportunity

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Deutsche Bank has a new strategy. Unwind the old one.  And it might be the correct decision, as well as its last opportunity to overcome its challenges.

Now Deutsche Bank will make its third capital increase since 2013, a move it wanted desperately to avoid… But it was inevitable.

Details: €8bn capital increase, €2bn disposals and list a minority stake in its Asset Management business.

Based on 687.5 million shares issued, the dilution is 50% and the new shares are issued at a 40% discount to Friday’s close. This capital increase should bring the CET1 capital ratio to 13.4% before disposals. Disposals and other impacts would bring 2018 CET1 capital to 11.8% in 2018 according to consensus.

The question is: Will it be the last one?

The German bank’s shares have recovered dramatically in the past months thanks to the expectation of a new strategy and the improvement in inflation and growth in the EU. The main issue, when it comes to understanding risk, is to understand why the shares fell so heavily before – along with the rest of the European banking system -, even when we were told that banks were “very cheap”.

A few problems that the market identifies in Deutsche Bank, and that we have seen in Italian and Portuguese banks, are:

Capital deficits. An estimated capital requirement of €5.5 billion is expected to exceed €10 billion including the costs of recent fines and the harsh reality that the sale of some non-core assets is likely to be at a price below the book value. Divestments have been delayed and capital requirements became more relevant as the business base deteriorated with negative real interest rates – which depressed the bank margins -, and weak global macro outlooks.

Lower revenues. Deutsche Bank generates almost 50% of its revenues from NII (net interest income on loans). With real rates falling worldwide and more than 25% of the world’s GDP in negative yield territory, the risk to the bank’s income outlook was very relevant.

Costs rise. Even with the cost reduction plans carried out and the efficiency programmes, costs skyrocketed (45% from 2011 to 2015) and revenues did not grow (1% over the same period). The cost-to-revenue ratio remains very worrying. It has soared from 72% in the second quarter of 2014 to 79% in 2015 and is estimated to be 80% in 2017.

Low profitability. A problem for the whole European banking system. But with a core capital requirement of 13%, consensus estimates that Deutsche Bank may not generate profitability above its cost of capital at least until 2018. By 2017, a ROTE (return on tangible assets) of less than 5 % and a return on total assets (ROA) close to 0%.

DEUTSCHE IS NOT LEHMAN

Scaremongers try to call this a “Lehman” moment. But there are many elements that differentiate Deutsche Bank from Lehman Brothers, for example:

  • Non-Performing Loans are not at a worrying level (1.9%, less than 3% in the worst of consensus estimates), and well below the Italian or Portuguese banks, for example.
  • The exposure to derivatives, which is constantly discussed in the media, is enormous – nine times its tangible assets – but it has been that way for many years, it has been falling and we must remember that the risk in derivatives is generated when these are very concentrated in an asset that collapses. Deutsche’s derivatives exposure is very diversified and well managed.
  • Deutsche Bank does not deny its imbalances, and has been increasing core capital and reinforcing its balance sheet for several years. This is a big difference with Lehman. Also, Deutsche has none of the massive exposure to a single risk that the failed US investment bank had.

… But all these problems were already known – or at least feared. What changed last year?

Welcome to the CoCos (Contingent Convertible Bonds). These were very popular bonds issued during the years of Draghi’s “whatever it takes” bubble. These are bonds issued by banks which rating agencies give up to 50% consideration as capital because the coupon can be eliminated if the capital requirements of the issuing bank demand it. These CoCos paid an attractive interest and many investors started to buy it as a “bargain” in the hunt for yield. They were so popular that yields fell from 7% to 4% in very little time. For many investors, buying these contingent convertible bonds had “no risk” and they received a 4-6% coupon because the risk of eliminating the coupon was perceived as very low.

In 2016, the risk that Deutsche Bank would not pay some of the maturities on these bonds generated a domino effect: the stock collapsed, the CDS soared and the alarms went off. It did not happen, and maturities were paid, but the elephant in the room -capital risk- became evident.

The idea that you can stop paying a bond without having an impact on the stock and the bank is – as it always has been – a ridiculous one, and we are seeing a second wave of risk, if confidence continues to deteriorate. Therefore, a real capital increase was inevitable.

This contingent convertible bond solution was a fake and dangerous way to deny the need for aggressive capital increases. It highlighted the balance sheet fragility while putting at risk the entire market cap of the bank due to loss of confidence.

Will Deutsche Bank fall? It is very unlikely. This urgent recapitalization comes as the right answer to a problem that cannot be disguised with empty words and apparently intelligent financial engineering ideas.

But the problems of the European banks remain.

Total banking assets in Europe exceed 300% of the Eurozone’s GDP. At the peak of the crisis, in the US, they did not reach 80%.

Non-Performing Loans in the Eurozone remain above €900 billion.

An erroneous policy of kicking the can further via ultra low rates and high liquidity has made it difficult for banks to recover and strengthen their balance sheet, and monetary policy has made the efforts almost a race to stand still. All divestments and increases in share count were offset by weakening profitability and poor credit demand.

The policy of financial repression in the European Union, has weakened banks, rather than allowing them to strengthen. Despite huge provisions and capital increases, the recovery of the financial sector has been much slower than desirable.

If the ECB persists in denying the problem, it is only going to perpetuate it. It is urgent to put recapitalization mechanisms that do not generate systemic risk, instead of bubble patches like the CoCo bonds.

The mistake of this period is twofold: to compareDeutsche Bank with Lehman, while denying the devastating effects of financial repression in the sector. Laughing at the first undeniable exaggeration, policy makers have ignored the urgent measures needed to solve the second reality.

Today’s capital increase is a step in the right direction. But it needs much more. Put profitability back on the map, really reduce costs and make a detailed roadmap of objectives for investors to rebuild their trust.

Deutsche Bank has a unique opportunity to solve its problems for once and for all. It will require much more than a capital increase. Or it will not be the last one.

Daniel Lacalle. PhD in Economics and author of “Life in the Financial Markets”, “The Energy World Is Flat” (Wiley) and forthcoming “Escape from the Central Bank Trap”.

Image courtesy Google.

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