Deutsche Bank’s struggle to raise capital Iakov Frizis is an Economic Researcher and Paul Lirette is Senior Economist at CASE – Center for Social and Economic Research While European private banks have attempted to build their capital buffers in a bid to restore confidence across the financial system, a weak financial market environment has created challenges to these goals. A perfect example of this is illustrated by recent volatile investor reaction to the news that Deutsche Bank (DB) could be facing substantial fines from the US Department of Justice, a move which has sent volatility rippling through the market. In order to prevent a repeat of Deutsche Bank’s recent bout of turmoil, European private banks will need to adjust to the ‘new normal’ of weak profitability and undergo a restructuring of their business model. Such a dramatic step may be the only way to ensure greater stability and, perhaps more importantly, to regain the confidence of shell-shocked investors. A financial market environment that is not conducive to raising capital The 2008 global financial crisis and the ensuing and ongoing eurozone sovereign debt crisis placed an enormous amount of pressure on the European financial sector, and several members required third-party assistance to bail-out over-indebted banks. Fast forward to 2016, and the European Union is still plagued by the woes of its banking sector, where banks find themselves positioned against several factors that continue to stifle profitability. A key factor in this context includes the unconventional monetary policies introduced by the European Central Bank (ECB) to address the legacies from the recent crises. For example, negative interest rates were introduced by the ECB for the first time in June 2014 in an attempt to discourage savings and promote investment (the current rate on deposit facilities stands at -0.4%). However, negative deposit rates have forced private banks to either operate under tighter margins or to pass these extra costs on to consumers, hoping for the best. The adverse impact of negative interest rates is further enhanced by the asset purchasing programme (APP, more commonly known as quantitative easing, or QE). Even though the impact of QE on bank profitability remains largely under-researched, recent studies underscore the policy’s association with substantial adverse effects for banks, with the largest being a reduction of bank revenue from loans/securities due to lower margins and flatter yield curves. Capital in the European Union and stress test outcomes How has this unfavourable environment impacted the banking sector? This July, the European Banking Authority (EBA) released its European Union banking stress test results, giving a clue to just how the industry is faring. The test, which covered roughly 70% of all EU banking assets, is a theoretical economic and financial shock simulation meant to demonstrate the resilience of the EU banking sector. Overall, this exercise is designed to inform supervisors as they assess banking sector health, promote the importance of adequate capital levels and urge banks to repair balance sheets. A key headline message flowing from the EBA’s stress test report is that the EU banking sector, as a whole, has made significant progress in shoring up its capital base, characterized by a weighted average CET1 ratio of 13.2% for the end of 2015, 200 bps and 400 bps higher than the 2014 and 2011 averages, respectively. Overall, the report indicates that CET1 capital (Tier 1 capital) in the sample of banks analysed has increased by roughly US$190 billion since December 2013. However, scratching below the surface of the stress test results reveals weakness in important financial institutions, particularly for Deutsche Bank (Germany’s largest bank). The underlying shock introduced for the test, an adverse economic growth scenario that carries an impact of 380 bps decrease to the weighted average CET1 ratio, resulted in Deutsche Bank’s (DB’s) common equity Tier 1 ratio to drop to 7.8% by 2018, down from 13.19% in 2015. As displayed in Figure 1, this leaves DB relatively more thinly capitalized than its peers in the event of financial market turmoil. This is particularly concerning given that the IMF recently identified DB as a major source of outward spill-over to publicly listed banks in Germany and one of the most important net contributors to systemic risks in the global banking system. In large part, this result can be attributed to Germany’s highly competitive banking sector. According to the October 2015 Report on financial structures released by the ECB, the five largest banks in Germany account for a mere 32% of total assets held. This makes Germany the most fragmented, and thus one of the more competitive, banking structures in the eurozone, which implies that profitability for bigger lenders is spread out across the large number of lenders and eroded. As a result, return on equity (ROE) in Germany is among the lowest in the eurozone (see Figure 2). Deutsche Bank falls under the scrutiny of the US Department of Justice All of these issues came to a head this September, as Deutsche Bank’s capacity to withstand negative external shocks was put to the test when it confirmed a news leak reporting that the US Department of Justice (DOJ) plans to impose a US$14 billion fine on the bank, which intends to settle a probe into illicit mortgage lending activity during the lead-up to the global financial crisis. Allegations, dating back as far as 2005, are linked to the bank’s involvement in the formation and supply of residential mortgage-backed securities (RMBs), a piece of traded security notorious for its involvement in converting risky homeowner loans into plain vanilla bonds. While this is not the first time DB has faced fines of this denomination, this time the estimated amount of the fine appears to exceed the bank’s litigation reserves, which, as of June 2016, were at US$6.2 billion. Signs of immediate investors’ distress linked to the prospect of a US$14 billion fine from the US DOJ were evident in the rapid drop of 21.8% in DB share prices between September 9th and 27th. While DB share prices have rebounded slightly over the past month, the overall trend for the year is a downward decline, currently standing roughly 31.7% lower than in January 2016 (Figure 3). A similar trend can be observed in DB’s €1.75 billion 6% alternative Tier 1 note, the more risky contingent convertible capital bond (also known as CoCos). CoCos are hybrid securities that are designed to absorb losses either by converting into common equity or by suffering a principle write-down when the capital of the issuing bank falls below a certain level. In mid-September, the price of CoCo bonds dropped to 73 euro cents, nearly breaking the historical lows recorded in February when DB was in the midst of market unrest forcing them to put in place a US$5.4 billion bond buy-back scheme. In part, the drop in CoCo prices reflect investors’ concerns that DB would not be in a financial position to pay coupons on these instruments if significant risks were to materialize. Weak client confidence is also evident through developments in its 5-year Credit Default Swaps (CDS), a security that basically functions as insurance against default. Despite low correlation between CoCos and CDS in ordinary times, news of the impending fine resulted in a sharp increase in demand for CDS securities, leading to a spike in CDS spreads to nearly 250 bps, more than doubling the 95 bps CDS spreads reported in January. More than just legal troubles Recent weak client confidence in DB stems (primarily) from investors comparing DB’s available litigation reserves with the potential size of the US DOJ fine. While DB has publicly announced that it will challenge the fine, it is unclear what the final payment will be. But factors that will certainly come into consideration are the practical and political considerations for a penalty large enough to destabilize the systemically important DB and provoke a new financial crisis. Looking at DB’s balance sheet in the absence of the DOJ fine, however, there are less concerns for liquidity shortage over the medium term, a sentiment also quoted by Standard & Poor’s and Moody’s back in February. In non-extraordinary times, the bank has 124% liquidity coverage ratio, out of a minimum 100%, while 72% of its balance sheet consists of retail depositors who tend to be less risk averse than hedge funds. This translates to roughly US$235 billion of cash and liquid securities. Meanwhile, concerns are principally associated with two points: first, what the FT has branded as DB’s US$39 billion credibility gap, ie. the difference between the lender’s tangible assets and its US$16.9 billion market capitalisation; second, the estimated worth of DB’s balance sheet, which is put to question by the structure of its Tier 1 assets, 72% of which is comprised by Level 3 assets, considered to be the most illiquid and ambiguously valued of possible Tier 1 assets. Nonetheless, in response to the recent dwindling of consumer sentiment, DB has started undergoing painful but necessary reforms to ensure greater resilience moving forward. More specifically, in November 2016, the bank sold its stake of Huaxia, a Chinese lender, for US$3.37 billion in addition to efforts to restructure costs by implementing a hiring freeze in October, scrapping bonus awards for top management, freezing dividend payments and downsizing the bank by an approximate 9,000 employees. Also, the bank announced that, if needed, it could raise an approximate of US$15 billion in capital through disposing of its retail subsidiary Postbank and its asset management division. Dealing with a new normal Since the 2008 global financial crisis and the 2009 eurozone sovereign debt crisis, it has been a difficult time for the European banking sector as a whole. Lending institutions have been faced with an adverse financial market environment, muted economic growth and pressures to undergo painful business model restructuring. The difficulties faced by DB to remain profitable in this type of environment serves as a stark reminder of unfinished reforms to address crises legacies and how quickly investors react to bad news. This reminder not only holds true for DB, but for most private banks in a number of advanced economies. Until all financial market players become more comfortable in this new normal, where capital requirements are fulfilled and reforms are fully realized to address the legacies from the recent crises, it is clear that investors will continue to be more cautious. As such, moving forward, better and more transparent data will play a key role in communicating with the public and in allowing supervisors to learn the early warning signs of financial market pinch points. This includes continued efforts to continue improving stress testing methodologies and conducting macroprudential stress tests regularly to better monitor vulnerability for prompt action if risks build up.
... better and more transparent data will play a key role... in allowing supervisors to learn the early warning signs of financial market pinch points

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Figure 1. Costs of banking sector fragmentation in Germany Source: European Banking Authority Figure 2. EBA’s stress test results - Impact on CET1 capital ratio from 2015-18 in adverse scenario Source: European Banking Authority *not all bank names displayed, results in descending order: NRW.BANK, Swedbank – group, Svenska Handelsbanken – group, N.V. Bank Nederlandse Gemeenten, Skandinaviska Enskilda Banken – group, OP Osuuskunta, DNB Bank Group, Nykredit Realkredit, Nordea Bank – group, Danske Bank, Jyske Bank, Groupe Crédit Mutuel, Powszechna Kasa Oszczędności Bank Polski SA, Belfius Banque SA, KBC Group NV, BFA Tenedora de Acciones S.A.U., Groupe Crédit Agricole, Intesa Sanpaolo S.p.A., Lloyds Banking Group Plc, Landesbank Hessen-Thüringen Girozentrale, Groupe BPCE, La Banque Postale, Landesbank Baden-Württemberg, Volkswagen Financial Services AG, ABN AMRO Group N.V., DekaBank Deutsche Girozentrale, OTP Bank Nyrt., Banco Popolare - Società Cooperativa, ING Groep N.V., Criteria Caixa, S.A.U., Unione Di Banche Italiane Società Per Azioni, HSBC Holdings, Banco Santander S.A., Norddeutsche Landesbank Girozentrale, BNP Paribas, Bayerische Landesbank, Banco Bilbao Vizcaya Argentaria S.A., Banco de Sabadell S.A., Erste Group Bank AG, Coöperatieve Centrale Raiffeisen-Boerenleenbank B.A., The Royal Bank of Scotland Group Public Limited Company, Société Générale S.A., Deutsche bank, The Governor and Company of the Bank of Ireland, Commerzbank AG, Allied Irish Banks plc, Barclays Plc, UniCredit S.p.A., Banco Popular Español S.A., Raiffeisen-Landesbanken-Holding GmbH, Banca Monte dei Paschi di Siena S.p.A. Figure 3. The cost of lost confidence Source: Yahoo Finance

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