'What's up with Deutsche Bank?', by Goldman Sachs and others
Is it still safe to join a European investment bank? Sure, Deutsche's shares are up 14% this morning following the German bank's promise to contemplate buying-back some of its senior bonds. Sure, yields on CoCos are now falling back. Sure, Credit Suisse CEO Tidjane Thiam has declared the panic overdone. But, several banking analysts still have several lingering doubts.
Analysts at Goldman Sachs issued a note yesterday reiterating their neutrality on Deutsche's stock. While Deutsche might be able to allay concerns about its ability to pay coupons on its CoCos in 2017 for the moment, Goldman analysts said the bank still faces the same underlying issue: the structural weakness of its business model.
Meanwhile, the banking analysts at Bernstein Research have issued a broader note casting aspersions on the whole European investment banking sector, along with various US broker dealers.
This is what you need to know.
1. Goldman Sachs says Deutsche's problems are about more than restructuring and litigation charges
Deutsche Bank €6.8bn net loss for 2015 was mostly down to (yet more) restructuring and litigation charges. For Deutsche watchers, the loss shouldn't have come as a surprise: CEO John Cryan flagged the likely pain when he announced his Strategy 2020 plan in October. 2016 and 2017 are both likely to bad for Deutsche, said Cryan. - Things will only take a turn for the better in 2018.
This is all well and good, if investors are prepared to be patient. - Events this week suggest they may not be.
Moreover, analysts at Goldman Sachs say Deutsche's problems go deeper than its litigation and restructuring charges. In a note issued in September (to which they referred yesterday), they pointed out that even when these charges are normalized Deutsche has a problem with returns. Witness the chart below. When Goldman's analysts adjusted the long-term (15-year) time series of Deutsche's return on target equity (ROTE) by applying normalized levels of litigation and restructuring and re-calibrated the tangible book value (TBV) to its level in the first half of 2015 (as well as the expected steady-state level in 2018), the bank ended up with a return on equity of just 4% over the past 15 years.
In other words, whatever's going at Deutsche is not transitory.
Source: Goldman Sachs
2. Deutsche needs to seriously restructure its business - and to get a grip on headcount
In yesterday's note, Goldman's analysts said Deutsche's problems will continue until it restructures its business along the lines they suggested in September. And in September, they said Deutsche needs to give up on chasing revenues and to seriously cut costs. Most importantly, they said Deutsche needs to get a proper grip on headcount which keeps increasing despite promises to cut it back.
"An absolute cost, and headcount, target is required [at Deutsche]," said Goldman's analysts in September, pointing to the charts below - which show headcount increasing everywhere, except asset and wealth management in the period between 2012 and mid-2015. Since then, headcount at Deutsche's investment bank has - needless to say, increased even further - it rose by 9% last year as 2,700 staff were added in support roles.
Net, John Cryan wants to cut around 7,000 staff from Deutsche bank between now and 2020. However, Deutsche's record on restraining headcount is not good. - If investors are to have confidence in Cryan's plan some serious cuts will need to start appearing soon.
Source: Goldman Sachs
3. Deutsche Bank is badly under-capitalized, and it's not the only one
In a separate note out today, analysts at Bernstein Research say European investment banks and the US broker dealer sector in general are still under-capitalized despite six years spent trying to remedy the situation.
When deferred tax assets (DTAs) are excluded, Bernstein's analysts point out that Deutsche's tangible equity is a mere 2.7% of its tangible assets. The only bank with a lower ratio than this is Credit Agricole (ACA), with 2.3%, although Credit Suisse isn't much better with 3.0%. Standard Chartered looks healthy, with 7.3% but is being punished by the markets as an emerging markets bank with commodities exposure, says Bernstein. Meanwhile, the under-capitalized French banks (Credit Agricole, SocGen - GLE, and BNP Paribas) are seemingly being protected by implicit regulatory backing by the French government.
Source: Bernstein Research
4. If credit markets are right, investment banking revenues will fall by around 30% this year
Bernstein's analysts say this week's moves in the price of banks' credit default swaps (CDS) - the price of insuring against default on bond coupon or principal payments - bode badly for banks' revenues.
Last time spreads rose like this was during the global financial crisis (GFC), points out Bernstein. And then, investment banking revenues went on to collapse by 30%-40%.
"If credit markets are right about the state of the world …and they generally are," Bernstein's analysts say investment banking revenues could fall another 30% in 2016. A "vicious circle" is at play as "higher spreads lead to more risk off leads to earnings drags leads to even higher spreads," they claim.
Moreover, as spreads blow-out, Bernstein says European banks will find it even harder to increase their capital ratios by deleveraging and dumping risk weighted assets. - Suddenly, capital becomes a problem again, which is not good given European banks are so under-capitalized to begin with.
Source: Bernstein Research and Bloomberg
5. Aaaaand, European investment banks aren't in much of a position to cut costs
Lastly, Bernstein's analysts say investment banking in Europe has, "basically become a fixed cost business in Europe (given regulation around compensation) with the most volatile income stream."
Take the example of Barclays in the chart below: fixed compensation now accounts for the bulk of pay in the investment bank and is expected to rise rather than fall between now and 2018.
If revenues across investment banks really do drop by 30% in 2016, the implication is that European banks will be faced with one real option: harsh cuts to headcount which could damage their franchises irrevocably for the future. Looks like 2016 could be 'fun.'
Source: Bernstein Research
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