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Tuesday, 24 October 2017

Deutsche in risky capital stand-off

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People & Markets

Acute market pressure unlikely to subside as bank resists costly equity raise

Deutsche Bank is showing no signs of backing down from its stance of refusing to raise capital ahead of a multi-billion dollar settlement with US regulators, despite signs that the risky strategy is already beginning to weaken its franchise, with a small number of clients pulling business from the bank in recent days.

The German bank is resistant to doing any pre-emptive capital raise, amid concern that such a move could weaken its hand in negotiations, with any additional funds potentially giving the US Department of Justice the confidence to extract more money without fear of destabilising the bank.

At the same time, a collapse in Deutsche’s shares, which hit their lowest level in 33 years on Friday, has severely limited the bank’s ability to raise capital without imposing a severe dilution on its current shareholders and without incurring huge underwriting costs.

Chief executive John Cryan continued to say on Friday that the bank had “strong fundamentals”, reflecting an attitude within the bank that there is no immediate need to raise capital. He said there were “unjustified concerns” about the bank’s position, adding that “we fulfil all current capital requirements”.

But the bank is coming under growing pressure to ditch the strategy, which is designed to minimise the DoJ fine and avoid a severely dilutive capital raise. With reports that some hedge funds – albeit only a handful of the bank’s 20 million clients – are pulling business from the bank, many feel Cryan needs to move immediately to avoid further damage.

Dumb

“A rights issue would be a dumb thing to do in that it will put money straight into the DoJ’s pocket but sometimes a really bad idea is the only thing possible,” said Dan Davies, a senior research adviser at Frontline Analysts. “The need for capital is right here, right now. It’s like finding a lump – it doesn’t mean you’re going to die but it does mean that you need to do something and the one thing you absolutely mustn’t do is ignore it and hope it will get better.”

Internally, senior bankers are also beginning to question the strategy.

“The wider question at the moment is why is management being so stubborn in keeping with the same strategy that is not working,” said one.

Both sides are currently locked in negotiations. The DoJ – which is demanding US$14bn to settle an investigation into the bank’s residential mortgage-backed securities business between 2005 and 2007 – is keen to extract the maximum political capital during an election year.

“It’s like finding a lump – it doesn’t mean you’re going to die but it does mean that you need to do something”

For its part, Deutsche has said it has “no intent to settle these potential civil claims anywhere near the number cited”.

With both sides far apart, the potential for talks to be protracted is high. But Deutsche sees the US$14bn demand as unreasonable. Bank of America issued over nine times more RMBS than Deutsche, yet paid only US$5bn in its DoJ settlement – although the alleged misdemeanours and the degree of co-operation with the regulator may have been very different.

“It’s game theory: if the bank raises capital now, they basically pre-empt the settlement, they give their game away at a time when they trying to negotiate the figure down,” said Martien Lubberink, associate professor at Victoria University of Wellington, New Zealand.

Few options

Market dynamics also mean the German bank has little choice but to sit out the talks.

Under existing rules, it could issue new shares equivalent to up to 10% of its outstanding shares without offering pre-emption rights to all shareholders. But at a current share price of €10.50 and with a standard discount of 5%, that would probably only raise about €1.4bn – too little to draw a line under concerns.

A rights issue could raise more. But as such a deal is likely to be capped at the equivalent of 50% of outstanding shares, it would probably only raise a net €5bn once an appropriate discount and hundreds of millions of euros of underwriting fees are taken into account.

A rights issue would also require a potentially combustible extraordinary general meeting of shareholders and a weeks-long sale process, and result in a painful dilution for existing shareholders.

There is also huge doubt that investors would even be willing to back such a deal. Shareholders have already been diluted three times by share sales over the past few years. They have also seen management continually miss and then lower return targets, while at the same time paying out billions of euros in bonuses every year.

“I don’t think they should or will do anything until after there is a better handle on the DoJ,” said the head of equity syndicate at a bank that has previously sold new shares for Deutsche. “The big issue will be persuading investors that they can generate returns that are interesting.”

Risks

There is big upside if the gamble pays off, however. The shares currently price in the risk of a large dilution and a fine well above the bank’s €5.5bn provision. But if the DoJ settlement comes in significantly below that mark, the necessity for a rights issue may go away – at least in the short term – and the shares may rally.

Deutsche has indicated that it should be able to add to those provisions this year, possibly by around €1.5bn. But its results were poor in the first half – normally its best part of the year – resulting in it putting very little aside. The second half may be equally tough, especially if it is losing business because of the ongoing concerns.

Added to that, Deutsche will be keen to retain some of its provisions for other ongoing investigations into past alleged misconduct. All together, it is certainly possible that the DoJ settlement could eat into its €49bn of phase-in common equity Tier 1 capital.

“It is a fragile bank, but talk about bankruptcy and bail-outs is premature – capital is higher than it was during the crisis,” said Lubberink. “That said, there is a lot of uncertainty, especially over how much equity might be wiped out by a fine. Shareholders are clearly finding it difficult to work out what their stakes might be worth.”

By avoiding a capital raise, bosses are also creating a risk that, when the settlement comes, its CET1 will take a hit that pushes it below the European Central Bank’s supervisory review and evaluation process requirements of 10.75%. As of June, the ratio was 12.2%, implying a €6bn buffer (once provisions are gone) before the SREP requirement is breached.

Uncomfortable call

But breaching the SREP requirements would not of itself leave the bank in any serious trouble, analysts say.

“The SREP requirement is a risk, but falling below requirements won’t trigger anything horrific,” said Davies. “It is more likely just going to result in a very uncomfortable call from the regulator demanding you form a plan to get back above the level.”

“It is a fragile bank, but talk about bankruptcy and bail-outs is premature – capital is higher than it was during the crisis”

According to Lubberink, regulators are likely to be heavily involved in any major decisions being taken by Deutsche right now, implying that any decision to resist immediate pressure to sell equity will have been sanctioned by regulators who have deep and detailed knowledge of the bank’s capital situation.

“Regulators are keen to avoid a repeat of 2008, when they had to step in at the last minute during a time of acute crisis,” he said. “People have learned. Also, information and monitoring is far better today. You can be sure that the ECB, Bundesbank, Bafin and others will be closely involved in all Deutsche’s big decisions right now.”

Of course, selling shares is not the only source of capital for Deutsche. According to Davies, the bank could strengthen its capital at the next bonus round by zero-ing bonuses, or forcing employees to take shares. That would be deeply unpopular, but could help solve a potential problem. The bank paid €2.4bn in bonuses last year, even after registering the biggest loss in its history during the third quarter.

“If Deutsche needs equity, then there is a huge client base just ready to take this stuff in the form of the bank’s staff,” he said. “You could force bonuses to be paid in stock. It wouldn’t be popular, but people would understand why it is necessary. This is the moment that could make or break Cryan’s career, and a decision like that could be a master-stroke.”

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