Deutsche Bank (part 1)

Monday 09/26/16

     U.S. stocks are near all time highs, but that doesn’t mean that all stocks around the world are doing well. This week I want to take a look at one particular company that could pose problems for the global financial system.

Deutsche Bank

     Deutsche Bank, Germany’s largest bank and the third largest European bank by assets, has been making new lows on a near daily basis. Its stock is trading lower than it did during the housing crisis in 2008 and 2009 (see figure 1). Deutsche Bank has had numerous problems since 2008 and has been slowly declining. Not only were they caught up in the mortgage crisis as one of the worst offenders, but they were also holders of much of the toxic debt from peripheral European companies. Instead of focusing on how Deutsche Bank got itself into its precarious situation, I want to look at the most pressing issues at the moment.

Regulatory Fine

     The recent selling pressure in Deutsche Bank has mostly been related to a fine from the U.S. department of Justice. The initial claim is for $14 billion, which is close to the current market capitalization of Deutsche Bank. This number is scaring market participants for many reasons, but they are unlikely to pay the entire $14 billion. Deutsche Bank is hoping for an outcome similar to Goldman Sachs’. Goldman’s fine for a similar offense was intially $15 billion, but was negotiated down to about $5 billion. However, Deutsche Bank is facing other fines for violating international sanctions against Russia among others. All of these fines are taking a toll on struggling Deutsche Bank who is desperately trying to keep its common equity tier 1 capital ratio above 10% (CET1 ratio).

Rule Changes

     First, let’s understand what the CET1 ratio is by looking at a simplified definition and example. The simple definition for common equity tier one capital is equity + retained earnings +/- some other instruments that affect equity. To determine the ratio we divide Common equity tier one capital (CET1) by risk-weighted assets (RWA); risk weighted assets are its assets (loans) adjusted by a formula to determine the riskiness of those assets. Let’s look at a simple example: Let’s say you start a bank with $10,000 in equity (your own money) and you attract $100,000 worth of deposits, then you take that $100,000 and make loans. So you now have $10,000 in equity, $100,000 in liabilities and $100,000 in assets. You understand that some of your loans won’t be repaid so you adjust the value of your assets to $90,000. So now you divide your equity ($10,000) by your RWA ($90,000) and you get your CET1 ratio of 11.1%.

     At the end of the second quarter Deutsche Bank reported a CET1 ratio of 10.82%. The minimum requirements for this ratio will be rising to 7% in 2019. A fine of $14 billion would likely bring their ratio below 10% and further fines and continued weak financial performance would drag that number even lower. Deutsche Bank and other European banks are also fighting upcoming regulatory changes that would negatively impact their RWA by changing the formula used to determine risk. Based on other ratios it appears that European banks are overestimating risk weighted assets compared to other global banks. Going back to our equation it is clear that Deutsche Bank is facing serious pressure on both the numerator and the denominator.

     These upcoming rule changes are particularly worrying to investors in Deutsche Bank’s coco bonds which we will discuss in more detail next week. We will also take a look at Deutsche Bank’s financial performance as well as some positive developments that could help save Deutsche Bank.

Part 2