Deutsche Bank: Free Falling Without a Parachute

Jonathan Rochford

Deutsche Bank’s shares have been trading like a penny stock this year with numerous daily movements over 5% and a year to date fall of 32%. The cost to insure its senior and subordinated debt via credit default swaps is up around 150% in 2016. It’s contingent convertible (CoCo) securities have fallen by 24%. Based on the how the markets are pricing its securities, Deutsche Bank is in free fall.

A big part of the reason for Deutsche Bank suffering more than other banks is that it remains undercapitalised. Like many of its peers, Deutsche Bank was highly leveraged heading into the financial crisis. It survived, but unlike other major global banks, choose not to materially increase its capital in years since 2009. The table below shows the quantum of the problem, comparing it with America’s largest bank, JP Morgan and Australia’s largest bank, CBA. On a tangible equity to tangible assets basis, Deutsche Bank is still a long way short of its peers.

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Undercapitalised banks have three main ways to improve their position. Firstly, banks can raise capital by accruing profits instead of paying out profits as dividends. As Deutsche Bank recorded a significant loss in 2015 this option isn’t available. Secondly, banks can raise new equity. The problem for Deutsche Bank is that after the fall in its share price this year its market capitalisation is minuscule compared to its asset base. An equity raising, if it was able to be done, would be minimal and would barely improve the capital ratios.

The third option for undercapitalised banks is to ask their home government for a bailout. The European Union has introduced new regulations this year that specifically limit governments from bailing out their banks. In effect, equity, CoCo’s, subordinated debt and at least some senior bondholders need to be wiped out before the German government could provide assistance. This leaves Deutsche Bank and its investors without a parachute.

The only course left is for Deutsche Bank to continue on and hope that the next year or two bring significant profits that will restore confidence, rebuild reserves and lift the share price enough to support a major equity raising. The key to that pathway will be the quality of the balance sheet. If Deutsche Bank has made poor lending decisions in recent years, then the difficult economic conditions ahead will expose that and bring down the bank. If the loans are good, then Deutsche Bank should survive in some form.

Written by Jonathan Rochford for Narrow Road Capital on February 13, 2016. Comments and criticisms are welcomed and can be sent to info@narrowroadcapital.com

Disclosure

This article has been prepared for educational purposes and is in no way meant to be a substitute for professional and tailored financial advice. It contains information derived and sourced from a broad list of third parties and has been prepared on the basis that this third party information is accurate. This article expresses the views of the author at a point in time, and such views may change in the future with no obligation on Narrow Road Capital or the author to publicly update these views. Narrow Road Capital advises on and invests in a wide range of securities, including securities linked to the performance of various companies and financial institutions.


Jonathan Rochford

Narrow Road Capital is a credit manager with a track record of higher returns and lowers fees on Australian credit investments. Clients include institutions, not for profits and family offices.

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Patrick Poke

Great read. I had initially thought that the questions being raised about Deutsche's capital adequacy were overblown, but it looks like they could be in a more challenging position than I'd realised.

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