A GSIB in trouble is bad omen for markets
In what was a relatively calm month in European credit markets, came out a press report that the US DOJ was asking $14bn of penalties to DB to settle a US mortgage securities investigation. Such report sent initial shockwaves to the bank securities markets as most analysts had modeled a $3-5bn range as a cost for this settlement. It pushed DB shares to a record low as concerns re-emerged around the bank’s need for extra capital raising, whereas new litigation costs related to some of its Russian operations and foreign currency trading could also materialize shortly. Several days later, the turmoil was exacerbated by new reports that some of DB’s clients were withdrawing collateral from the bank, echoing some of the worst memories of the 2007-08 crisis and raising concerns that it may roil markets and trigger a chain reaction towards a new financial crisis. Last, those events placed DB’s AT1 instruments under significant pressure – they traded at some point below the levels reached during the market selloff of last February – as the bank’s current low level of available distributable items to pay its AT1 coupons could be reduced further.
Poor earnings at the core of DB’s struggle
We believe that DB’s greatest issue does not lie with asset quality, solvency or liquidity. It has more to do with profitability and the bank’s resulting inability to generate organic capital to face potential adverse events. While many large European financial institutions have worked hard on their earnings power since the GFC by rationalizing their business portfolio, restructuring their core operations and streamlining their cost base, it seems that DB has long been in denial on this front. As a result, it recently embarked on a necessary large-scale restructuring program of its activities, putting itself in a position of weakness to face adverse events such as large litigation charges and a negative interest rate environment. Whereas the prospect and/or announcement of significant litigations charges has never raised major concerns on the solvency position of some other large European institutions such as BNPP, CS, HSBC or UBS, DB finds itself today in a much weaker position due to its own idiosyncratic challenges. That’s not to say that European banks are not facing profitability issues, but as JP Morgan’s Jamie Dimon puts it: “6% RoE is not life-threatening, it’s simply bad for shareholders”. The trouble with DB is that its RoE ranged between -10% and +4% over the past 5 years creating little flexibility to address a set of ever more stringent solvency requirements from its regulators. In this case, it may not just be bad for shareholder.
Liquidity will not be the transmission mechanism
Importantly, we think that DB’s liquidity situation is adequate with over €200bn of liquidity reserves, a large deposit base, a diversified funding mix and a well-matched balance sheet. In addition, the bank makes only limited use of CB funding at the moment and could easily step it up if need be, as it has ample unencumbered eligible collateral on its balance sheet. With regards to solvency, we think that DB’s challenge given all its current headwinds will be to reach its 2018 CET1 target without taking extraordinary steps. It has already stopped paying dividends and sold a few assets, but we remain skeptical about its ability to restore market confidence without implementing more drastic actions of the likes of large asset disposals, significant one-off RWA reductions, compensation clawbacks or capital raising. We think that none of those actions would send a negative signal to the market to the extent that they are calibrated to put the DB’s capital deficit topic behind us. Where contagion could however spring is in the AT1 market, in the event DB would be forced to skip one or several coupon(s) on its bonds or, even worse, if it would bail-in some of its subordinated instruments. Even though we believe that the market understands the idiosyncratic situation of DB’s credit position relative to its European peers, we have little doubt that the prospect of the first coupon skipping or capital writedown on a new-style hybrid capital instrument would roil the European subordinated debt market. In our view, this prospect is fairly remote for DB at the moment and we view such risk as more prevalent in the event of an economic recession in Europe – currently not on the horizon.
The European banking sector remains credit friendly
Overall, DB’s current challenges are real but remain manageable and idiosyncratic, in our view. In the meantime, the rest of the banking sector continues to display financial discipline and to manage its balance sheet in a conservative manner. Most European banks generate organic capital to boost their solvency/capital ratios to levels which are consistent – and often in excess – with the forward-looking guidelines required by their regulators. As discussed in this letter last month, the bulk of the recent sector newsflow has remained credit friendly, be it on the earnings, management or regulatory fronts. The few and well-publicized situations which require some extraordinary actions or even potential government intervention are well flagged and not of a systemic nature, in our opinion. As a result, we continue to deploy capital in the sector with a long bias and we see any potential dislocation in the market as an opportunity to add to our high-conviction trades.