This has been a terrible day for Deutsche Bank. The stock price has collapsed, and shares are now trading lower than they were in the dark days of 2008 after the fall of Lehman. Yields on CoCos and CDS are spiking too. Despite a reassuring statement from the German Finance Minister that he had “no concerns” about Deutsche Bank, markets are clearly worried that Deutsche Bank may be in serious trouble. And when “serious trouble” means that shareholders, subordinated debt holders and even senior unsecured bondholders could lose part or all of their investment, because of the bail-in rules under the EU’s Bank Recovery and Resolution Directive (BRRD), it is hardly surprising that investors are running for the hills. Even if Deutsche Bank were not in trouble before, it is now.
Unsurprisingly, the CEO, John Cryan, is upbeat about it. Today he issued a statement to staff advising them how to address the concerns of clients:
Volatility in the fourth quarter impacted the earnings of most major banks, especially those in Europe, and clients may ask you about how the market-wide volatility is impacting Deutsche Bank.
You can tell them that Deutsche Bank remains absolutely rock-solid, given our strong capital and risk position. On Monday, we took advantage of this strength to reassure the market of our capacity and commitment to pay coupons to investors who hold our Additional Tier 1 capital. This type of instrument has been the subject of recent market concern.
The market also expressed some concern about the adequacy of our legal provisions but I don’t share that concern. We will almost certainly have to add to our legal provisions this year but this is already accounted for in our financial plan.
I reviewed Deutsche Bank’s financial position as stated in their interim results last week. My findings do not support John Cryan’s statement that the bank is “rock solid”. Its capital and leverage ratios were not particularly strong by current standards, and have deteriorated since the full-year results.
More worryingly, I found evidence that profits in two of the four divisions were only achieved by risking-up: the other two divisions were loss-making. Risking-up to generate profits would, if sustained over the medium-term, require substantially more capital than Deutsche Bank currently has. For two divisions of a bank that is currently delivering NEGATIVE return on equity to adopt strategies which would in due course require more capital does not appear remotely sensible. Though I suppose actually admitting that the bank cannot generate anything like a reasonable return for shareholders without taking significantly more risk would be even worse.
I also share the market’s concern about lack of legal provisions. A large part of the write-off of 5.2bn Euros due to litigation costs and fines in the interim results arose from cases already settled, particularly the record multi-jurisdictional fine for benchmark rate rigging in April 2015, though it also includes the 1.3bn Euros increase in provisions announced in October 2015 to cover charges potentially arising from the investigation of Deutsche Bank's Russian operation for money laundering. But since these provisions seem light for what is a serious offense, and Deutsche Bank faces other potentially very expensive regulatory investigations and legal cases, I do not consider this write-off adequate.
The AT1 statement cited by John Cryan is hardly reassuring. The fact that such a statement had to be issued at all indicates how poor market confidence in Deutsche Bank has become. And the paper-thin 2016 payment capacity and highly optimistic assumptions about the 2017 payment capacity that it discloses do little to improve matters.
So what will happen next? There are already rumors that Deutsche Bank will need a bail-in, which is no doubt why stock and subordinated debt prices have collapsed and CDS prices have soared. Bail-out is an alternative, given Deutsche Bank's systemic importance, though it would probably break EU state aid rules. But if the alternative were meltdown in the financial system due to the threat of bail-in for other systemically-important banks, those rules would no doubt quickly be ditched. Deutsche Bank is by no means the only European bank on a knife edge, and the Bank of Portugal's recent decision to use the BRRD to justify wiping some senior creditors in a solvent bank has fatally undermined the BRRD. The threat of invoking BRRD now would be likely to spark wholesale bank runs all over Europe.
But bailing in creditors, or even contributing taxpayers’ funds, while preserving Deutsche Bank in its present form would in my view be the wrong decision anyway. Deutsche Bank has been living on borrowed time since 2008. It is too big, too diverse and doesn’t make enough money. And despite John Cryan’s belated attempts to define some sort of strategy in today’s note to staff, it has no clear mission. The fact that at the end of the note John Cryan appealed to the staff to tell him what to do speaks volumes.
I have said before that Deutsche Bank should be broken up. Now is the time to do it.
