Company Reports

Deutsche Bank: On Life Support, Will It Pull Out? twitter: @PhatSpock

October 3, 2016

Viola Risk Advisors ( has been actively covering and forecasting the downward spiral in Deutsche Bank’s (DB) fundamentals since late July when Wall Street & Europe was on vacation. To reach out to more interested parties in order to discuss DB’s destiny, we hosted a global conference call on Friday, September 30 at 11am New York City time or 4pm London time, 5pm Paris/Frankfurt/Rome/Barcelona time. This was a short 20-30 minutes call that answered the following key Stakeholder Stack concerns for 1) debt investors, 2) equity investors, 3) counterparty risk managers and 4) regulators concerned about systemic risk.

  1. How did Deutsche Bank get into this fundamental mess and can it recover on its own without external State of Germany assistance or outside investor extraordinary capital support?
  2. Why is Deutsche Bank’s predicament so dire from both capital & liquidity viewpoints?
  3. Why has Wall Street & major world governments been so hesitant to give the Stakeholder Stack the “real-deal” view?
  4. Which major European banks are next if a Pan-European bank contagion is ignited by investor/counterparty concerns about Deutsche Bank that spreads the insecurity to other Euro banks?
  5. What about the Italian banking system, is it caput?
  6. How Viola Risk Advisors can help.

Viola Risk Advisors’ Capital Framework – Global Banks Need More
For the last two years, Viola Risk Advisors has been using a capital framework consistent with the thoughts of FDIC Vice Chairman Thomas Hoenig whereby we both believe that the global systemic banks are woefully under-capitalized. This is especially so given their importance to proper credit/loan allocation functions, payment system stability roles, and as stewards of well-functioning credit counterparty exposure allocation for securities, foreign exchange and derivatives trading. Since these roles are critical to proper capital and banking market functioning, the global systemic banks must be so-called “nuclear-proof” when it comes to the public’s confidence & trust in their capabilities.

Two years ago at a FDIC Research conference in Washington DC, we listened to Vice Chairman Hoenig suggest that leverage ratios (and by inference supplemental leverage ratios (SLR)) were the best measurement of risk, since on-balance sheet assets were not risk weighted, and off-balance sheet and derivative exposures were not well captured. This capital measure was the purest and most meaningful measure of overall balance sheet leverage as it avoided the pitfalls of undercounting risk using Tier 1, Common Equity Tier 1 (CET1) and other Basel III risk-weighted ratios. At the time most U.S. banks SLRs hovered in the range of 5% to 6%. Vice Chairman Hoenig suggested that these ratios should be double to triple those levels or 10% to 15% in order to make their stability and system confidence beyond reproach and thereby maintain capital markets and banking system confidence & trust.

While Vice Chairman Hoenig has been one of the pioneers on the higher capital front, along with former FDIC Chairman Sheila Bair, there was not regulatory consensus on this front to give it even more momentum to become the new minimum capital levels. But in the last weeks a major thought-leader on capital levels confirmed this notion when former Federal Reserve Chairman Alan Greenspan began talking to the press that capital levels for banks should be much more elevated or around 20% to 30% of assets. While not providing further details than that on the capital front, this comment was made in reference to the dramatic elimination of too much recent bank regulation, especially Dodd-Frank Act and Basel III Accords, which have become too bureaucratic, overly complex, not easily understood by the market-place, chock full of unintended consequences and basically squelch the proper functioning of banks in the marketplace across lending, trading, structuring and other markets.

Question 2 – Higher Capital & Liquidity are One and the Same in a Contagion Situation – High is Better
So to answer question 2, despite the regulators well-intended actions, capital and liquidity levels are still too low. Capital needs to be much higher when measured by the SLR ratio or in the range of 10-15% and not just over a threshold of 5.5% as most major European banks are aiming for. Looking back at history, most of the merchant banking houses of the Middle Ages, through the Renaissance period and on to the Great Age of Exploration were capitalized from 10% to 30%. These included the great Medici banks, the Genoa banks, Bruges, Antwerp, and Amsterdam ones that financed the exploration of new routes to gather the goods from the former “Spice Trade” destinations in the Far East. These ancient banks were so well-capitalized because the risks were high when exploring with wooden ships to far-off places. Similarly for today’s European banks, the risks to the current banking system from the wreckage left from complex derivatives and structured product and general poorly performing oil-based and Russian loans are still aggravating many big European banks overall balance sheets.

And further answering question 2, the best form of long-dated liquidity is equity as it cannot leave the bank when troubles ignite. So higher capital levels in essence insure that liquidity is further strengthened. While the bank C-suite will not be happy with that answer as we wrote almost two years ago, bank stocks have generally been rewarded for higher capital levels over the last several years since the passage of the Dodd Frank Act (see: Why a Fortress-Balance Sheet Matters to the C-Suite).

Question 1: “Transaction Banking” Blew Them Up, With Bad Balance Sheet Exposures
Getting back to Question 1, how did Deutsche Bank get into this mess, it has been the result of 20 years of miss-placed banking strategy that valued “the transaction” over the “customer relationship”. Pioneered by the old Bankers Trust over 30 years ago, banks that did not have solid, AAA-type corporate banking and corporate finance relationships were the pioneers of securitization, derivatives technology and other financial engineering in order to service legitimate client needs. However, many of these banks hit the wall and dramatically stumbled and failed as “the transaction” became more important than “the relationship” or the responsibility to conduct stable banking activities. Many “transaction” banks such as Bankers Trust and Salomon Brothers were acquired as they transgressed too far and were acquired by other stronger entities. Drexel Burnham, the king of junk bonds in the 1980s, failed from a mismatch of assets and liabilities in the midst of the junk bond crisis of 1989-1991.  And almost 20 years later Lehman Brothers and Bear Stearns failed on the troubles with sub-prime/Alt. A mortgages, other “scratch and dent” mortgage-backed securities and on the illiquid real estate investment fronts. Across the pond in Europe, UBS, RBS and ABN-AMRO all basically failed from structured finance and other illiquid Level 3 exposures that required state government intervention see: DB: Death March Math, Capital Whacked By Level 3s!.

So, too Deutsche Bank followed in this quest to replace “transaction” profits for “relationship” profits. Their zeal to originate them has left their balance in a wrecked state with overly high concentrations of Level 3 assets that don’t cash flow away and comprise up to 50% of book equity as well as other weak on-balance sheet exposures. The consequence is a surprisingly weak business unit operating profit profile that cannot dig its way out of its capital shortfall in a healthy organic fashion. So we would ask what private investor would invest in such a weak business proposition. We do not think DB can get significant outside capital and 7 billion euros or so is nothing in the face of a possible roughly $100 billion euro systemic shortfall. Even using Greenspanian math, the bank needs $167 billion euros of pure equity for a 10% capital level rate, and it only has approximately 62 billion euros of book equity, far short of bridging the gap for systemic stability, confidence and trust. So the $14 billion dollar mortgage settlement with US authorities, may be whittled down to $5 billion-ish is a spit in the ocean of DB’s problems and just a side-show distracting from the endemic core banking problems. For more of the history of Deutsche Bank’s bad banking ways see: DB: Dead & Buried?.

Course of Action: German Central Bank Should Ring-Fence Deutsche Bank
As the damage has been done and for Deutsche Bank it is fatal, the bank now requires German State intervention in order to stabilize its funding, and to prevent further spreading of liquidity risk throughout the banking system. As we wrote in early August (see: Deutsche Bank: The Rise & Fall of the 4th Banking Reich), given Deutsche Bank’s importance as a major intermediary in Germany and the European region, we believe that the eventual course of action is for the German Central Bank to give DB governmental assistance similar to what Citigroup received at the depth of the U.S. credit crisis. In that vein, we believe that the German Central bank should ring-fence DB’s balance sheet by protecting it from a liquidity “run on the bank” syndrome, just as the Fed did for Citigroup in November 2008. Similar to the Citigroup/U.S. government intervention, the German government would take a significant equity stake in Deutsche Bank and provide a significant multi-billion credit line. Also, the German government should guarantee losses on a significant amount of the troubled assets that DB still carries on its balance sheet. The troubled assets should be hived off into a run-off/sell-off “bad bank” similar to what Citigroup did with Citi Holdings.

The risk to the Stakeholder Stack is the timing of these actions given the delicate and complex political and economic impacts of executing this “bad bank” restructuring on Germany and Europe. Net, net, we believe that Germany can handle this situation given its large economy with a GDP of €3.36 trillion. We believe the cost of resolving Deutsche Bank in the worst case is less than 5% of German GDP, so not a catastrophic event for the economy. Yet, the timing is still difficult to game, and as the fundamentals continue to deteriorate with no improvement in core earnings, there will be more market pressures exerted on Deutsche Bank across its stakeholders’ stack that includes the debt funding markets further eroding, counterparty markets restricting activities such as trading and derivatives hedging. Further, these factors will drive the regulators to take more restrictive actions forcing DB to rein in trading/capital markets and high risk leveraged lending activities.

Question 3: Walls Street’s & Government’s Silence on DB’s Destiny – It’s Deafening!
While the rest of Wall Street was eating steaks & lobsters in the Hamptons/Nantucket/Martha’s Vineyard & the Cape, Viola Risk Advisors was doing the yeoperson’s work of further unraveling the complex risk at Deutsche Bank. And as Europe went on August holiday prancing on the sunny Mediterranean beaches and eating their fine artisanal cheeses, charcuterie and prawns, Viola Risk Advisor’s was further digging into Deutsche Bank’s Level 3’s and comparing them to the other major U.S. banks and Euro capital markets bank players (see: DB: Death March Math, Capital Whacked By Level 3s!).

So why was Wall Street & major governments so silent and sanguine about DB’s difficulties? It is because it is not in their self-interests to actively police the system. For Wall Street it is like the police union’s so-called “blue code of silence” where it is not acceptable for a fellow policeman or union to “rat out” a fellow officer wearing the badge. That is because if one officer is found to be foul or a felon it makes the whole union look poorly and questions arise as to whether there are more corrupt police.

The same holds for Wall Street as it along with Deutsche Bank are among the Top Six biggest trading counterparties in the world. So, when one of the major counterparties stumble, there is a huge internal reflex to not besmirch a fellow broker as it may exacerbate the particular company’s liquidity and stability. Even more self-centered is that criticizing a fellow broker, can come back to bite the commenting company as their own liquidity and stability would come under question given the similarities and direct/indirect trading relationships. We were on the sell-side and were often quoted behind the scenes not to cover the company we worked for and not to be too harsh on a fellow broker as it invited questions about the commenting broker. Just the facts of life on Wall Street and though we have not been on the sell-side for 15 years, we understand it is still the case.

As for the government silence, it too is self-serving as governments and their regulators prefer to operate beyond the public eye to solve their country’s systemic banks problems in a quiet and orderly fashion among the “private club members” of the financial system. This is the contradictions of the regulatory apparatus in that it wants market discipline of bank activities in order to rein in risk, but really does not trust the markets to referee risk, and thus deliberates in an opaque fashion behind the scenes. Since regulators and governments are by their very nature much more bureaucratic than swift and sometimes violent market responses, we believe it only further amplifies the risk problems and ultimate bailing out costs and solutions. So, in conclusion, investors/risk managers should not look to Wall Street nor government/regulators to get your exposures downsized in front of the oncoming risk tsunami’s. Just not in their DNAs!

Question 5: Future of Italian Banking, Finito?!?
We will answer question 5 before question 4, since the future of Italian Banking impacts the German government’s predicament about intervening on Deutsche Bank. As we noted in early September, the Italian banking system needs radical transformation and Italy does not have the sovereign strength to do so without suffering punishing rating agency consequences (currently rated Baa2/BBB-). Since Italy cannot solve its own banking system problems, as we noted in our recent report (see: Italian Banking: Finito as Financial Intermediaries?), the EU and more specifically Germany & France as the leaders in the EU block need to bridge-loan Italy along the way, quite similar to the Greek bailouts of recent years.

As we noted in the Italian Banking Finito report:

Italian Banking is a non sequitur as it has failed in its mission to provide adequate credit to the country’s domestic borrowing companies and retail customers in a well credit risk underwritten way. The solution to the “Italian Banking” situation is NOT a wholesale across-the-board recapitalization of the major banks, but a combination of a “US-style Resolution Trust Corporation” process for the weak and less systemically significant banks such as Monte dei Paschi di Sienna (MDPS). At the same time, it is a ring-fencing exercise for the largest Italian bank, UniCredit, whereby it will require a European Union-led “bridge credit line” that has an equity-like takeout component. We believe that this will be accomplished via a European Union initiative since Italy’s sovereign risk position is too weak for it to recapitalize its biggest bank and other major banks. Over the succeeding two years, this credit line should be re-equitized (paid down) via secondary equity offerings to the private sector over an 18 to 24 month’s time-line, as major restructuring targets are met. This action would be a similar arrangement to what Citigroup underwent during its ring-fencing episode in 2008 by the US FED & FDIC.

Smaller players like Monte dei Paschi di Sienna require a “bank closure” resolution in a swift RTC-like fashion. At this writing, it seems that the Italian banking authorities and MDPS’ supervisory board is beginning this process as it was announced last week that MDPS’ bank CEO was asked to resign and did so given the bank’s precarious position with its stock down by 60%+ year-to-date. Still, the entire top management team and supervisory board needs to be dismissed by the ECB and Italian banking authorities due to the management’s terrible track records the last decade. Euro and domestic authorities should seize the bank and a temporary management team put in place.

So, Germany’s responsibilities are manifold in Europe and it is not only the German banking sytem’s major banks, both Deutsche Bank and Commerzbank that they need to overhaul, but also contribute in a major way to Italian bank overhaul. Therefore, Germany has a complex menu of rescue actions ahead of it and this further impacts its political process that could drag out outcomes to both Germany bank and Italian banking solutions. Not an easy political/financial tight-rope wire to walk, even for Germany Chancellor Angela Merkel.

Question 4: What major European banks are Next?
As we noted in the conference call, we believe that Deutsche Bank and the Italian banking system are not the only extremely weakened banks in Europe. According to the NYU V-Lab, the Top 5 European banks with alarming levels of systemic risk after Deutsche Bank include: BNP Paribas which is closely behind the big German bank, then Barclays and Societe Generale that are the next level, about 20% less, and neck and neck in their systemic exposures. The next pack of banks another 20% behind are RBS, HSBS, Banco Santander, UniCredit. Lloyds, Credit Suisse, Commerzbank and UBS are at the next level another 15% behind. Over the coming weeks we will be having more conference calls and reports reviewing the specific risks that these banks face. Still, the ones we are most concerned with include: BNP, Barclays, SocGen, RBS, UniCredit, and Commerzbank. Stay tuned for more value-added research on these fronts from Viola Risk Advisors

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