Will fines finish Deutsche's investment bank?
Sitting in his office in Frankfurt's Kaiserhofstraße, Stefan Mueller, a former proprietary trader from Dresdner and Sal Oppenheim who now runs German brokerage DWGA has long been cognizant of the vultures circling Deutsche's corporate and investment bank. Back in July, he claimed Deutsche's conservative corporate bankers wanted to spin-off the investment bank into a separate entity. Today's news that the U.S. Justice Department (DOJ) wants to slap a $14bn (€12.5bn) fine on Deutsche for mis-selling mortgaged backed securities before the financial crisis would seem to strengthen their hand.
Deutsche intends to fight the fine, but the bank's shares fell 8% this morning after news of its enormity surfaced. They've since recovered slightly, but not enough to reassure the likes of Mueller or the markets.
The proposed $14bn fine is a huge deal for Deutsche
There are various reasons why the DOJ fine is a big deal for Deutsche Bank and the 24,000 people working in Deutsche's corporate and investment bank, of whom 4,700 are in front office investment banking jobs.
1. Deutsche had expected the fine to be a lot lower
As analysts at J.P. Morgan pointed out in a report yesterday, Deutsche had put aside $6.2bn in litigation reserves at the end of June 2016. J.P.M expected Deutsche to put aside a further $2.1bn in the second half of this year and $1.1bn next year, bringing the reserves to $9.4bn in total by the end of 2017.
If the $14bn fine goes through, Deutsche's reserves will therefore be woefully inadequate. To make matters worse, the DOJ isn't the only authority with Deutsche in its sights. There's a possible penalty of between $1bn and $4bn for the bank's alleged involvement in Russian money laundering in the pipeline, and Deutsche's second quarter results highlighted six other pending investigations, at least.
2. The fine is equivalent to 74% of Deutsche Bank's market capitalization
Deutsche Bank's market capitalization currently stands at €16.9bn ($19bn). The DOJ fine is therefore 74% of the bank's current value. It's no surprise Deutsche's shares are plummeting.
3. The fine threatens Deutsche's capital base
This is the crux of the matter. J.P. Morgan's analysts suggested yesterday that a settlement with the DOJ in excess of $4bn would raise questions about Deutsche's capital position. - And Deutsche's capital position was already questionable.
By 2018, Deutsche Bank needs a core equity tier one (CET1) capital ratio of 12.25% under the European Banking Association's Supervisory Review and Evaluation Process (SREP). Even assuming a successful sale of Postbank, J.P. Morgan's analysts were expecting that Deutsche would be below that, at just 11.2%.
That shortfall now looks like being a lot worse. If fines exceed the $9.4bn of litigation provisions Deutsche is expected to have amassed next year, J.P.M says every $1bn extra will reduce Deutsche's 2017 CET1 ratio by 24bps.
Today's proposed $14bn fine therefore implies a 120bps reduction in Deutsche's CET1 ratio. This could be supplemented by a further 96 basis point reduction if the Russian fines come through at the top end of the expected range - To say nothing of additional fines for other misdemeanours.
In the worst case scenario (and assuming a successful sale of Postbank), J.P. Morgan's analysis therefore suggest Deutsche could now arrive in 2018 with a CET1 capital shortfall of 216bps due to the DOJ and Russian fines as well as the 105bps shortfall it was facing already.
Put another way, Deutsche was already facing a $2.5bn capital hole. Unless the DOJ cuts today's fine, the German bank is now facing a capital hole of $7.1bn - and more if other Russian and other fines are levied too.
4. Deutsche will struggle to raise additional capital
The implied 321bps capital shortfall and resulting CET1 ratio of just 9.04% would be an issue for any bank, but for Deutsche Bank it's potentially disastrous. With the bank's share price down 47% since the start of this year, another rights issue is out of the question. And with the cost of insuring Deutsche Bank's debt already high and now rising, tapping bondholders looks impossible too. Of course, there's always the possibility of selling the asset management division - but Cryan ruled this out earlier this week.
5. Deutsche bank will need to make additional big cuts to its risk weighted assets
The other solution is for Deutsche to cut even deeper than it already planned to.
The bank had €402bn of risk weighted assets on its books as of the second quarter of 2016. Deutsche CEO John Cryan already intended to cut the bank's RWAs by €120bn, but there's been little real sign of cuts in the global markets division so far. - At the end of the second quarter, RWAs in global markets were actually up on the previous year, at €170bn, vs. €168bn at Q215. So far, the global markets business has been protected, but the impending capital shortfall resulting from today's fine (even if that fine is cut dramatically) means Deutsche will need to get much more serious about cutting RWAs in future. And, despite Cryan's previous protestations that Deutsche is "unreservedly committed" to its markets business, it looks like a good place to start.
6. Meanwhile, Deutsche's unhappy staff stand to become unhappier still
Deutsche insiders say its investment bank staff are unhappy: "They're scared, and rightfully so." Senior managing directors at the bank have their deferred stock bonuses tied up for five years, and are angry with this year's collapse in the bank's share price. The bank also operates an unusually punitive clawback policy under which the entire tranche of bonuses due to vest in any particular year is wiped out if the bank makes a loss at group level. Not only are 2016 bonuses at Deutsche likely to be awful, and not only have past year's deferred bonuses collapsed, but past year's deferred payouts now look likely to be withheld entirely.
Deutsche risks having its best salespeople and traders poached by rivals as a result. "Other banks are feeding on our people," complains one insider. "Remaining employees are super-concerned, again further impacting performance."
Berenberg analyst James Chappell raised eyebrows in May when he said Deutsche was stuck in a "vicious circle" of falling revenues, impaired profitability and limited options for raising more capital. That circle suddenly looks more vicious than ever.
7. Will Deutsche become RBS?
In the worst of worse case scenarios, the German government could come to the rescue. This is what the ever-pessimistic Mueller is expecting. "The German banking sector will be the number one story in Europe over the next few years," he predicts. "The big German banks are not in a position to raise more capital and they need to. At the end of the day, both Deutsche and Commerzbank will be moved under an umbrella run by the German government. Fundamentally, this is their only chance of survival."
Of course, the fine might always be reduced....
The other alternative is for the DOJ to cut the proposed $14bn fine to something more manageable. The fine itself is widely seen as a tit-for-tat response by the U.S. government to the equally large fine slapped on Apple by the European Union at the end of August. If the EU cuts Apple's fine, maybe the DOJ will cut Deutsche's too?
BreakingViews suggests Deutsche is in a strong bargaining position: perversely, the German bank's capital weakness and systemic importance should make governments think twice before destabilising it further.
The problem is that the DOJ will need to cut the fine by a lot. J.P. Morgan's analysts think a $2.4bn settlement would be manageable for Deutsche, and that the bank could accommodate a $4bn fine, max. Anything more is an issue. Will the DOJ really cut its proposed fine by 70%? The WSJ says there could be "court battles" on the subject. The problem for Deutsche is that court battles take time - and the bank will need to reassure investors on its capital hole as soon as possible.
Photo credit:Go To Jail by FreddieBrown is licensed under CC BY 2.0.