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Friday, 15 December 2017

Double or quits for Deutsche Bank

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People & Markets

Rights issue allows bosses to avoid cuts, but risky gambles leave investors even more exposed

Rising fears that uncertainty over its capital levels might inflict long-term damage on the business and lead to an exodus of clients drove bosses at Deutsche Bank into an embarrassing €8bn capital raising, according to insiders at the bank.

The move comes after two years of promises not to dilute shareholders, and investors at the firm’s annual general meeting reacted angrily to being asked to stump up cash for the fourth time since the onset of the financial crisis. Shareholders and analysts are increasingly asking questions about the bank’s leadership, which has continually misjudged the regulatory and economic headwinds facing its businesses.

“They have been trying to run this business at the very low end of acceptable capital and patience has run out,” said Erin Davis, a senior analyst at Morningstar. “Although the bank had until 2019 to meet the new rules, both markets and clients have obviously demanded they do it now.”

The €8bn tap is divided into a €6.3bn rights issue and a €1.75bn placement of shares to Qatar’s royal family. Together with the sale of €5bn of Additional Tier 1 bonds (of which €3.5bn was completed last week), it will boost capital by a fifth, but will further dilute returns for shareholders, who have already suffered two profit warnings in the past eight months as bosses underestimated a downturn in the bank’s flagship fixed-income business.

Although painful for investors, the capital raising allows co-chief executive Anshu Jain to avoid deep cuts at the fixed-income business he helped build in a risky strategy that runs against the road chosen by some rivals and which if unsuccessful could saddle investors with low returns for years.

“Deutsche has for far too long been too reliant on its investment bank,” said Davis. “They should have found a more balanced business model when they could – but they didn’t. So in that context this looks like the least bad option they have right now, but I don’t see their plans for returns working out.”

Indeed, some argue the relatively poor performance of Deutsche’s other units has left it with no option but to double down in the higher-yielding investment bank.

“Unlike banks such as UBS or Barclays, which have other strong and high-margin businesses such as wealth management, credit cards or retail banking, Deutsche only really has its investment bank to drive earnings growth,” said an analyst who declined to be named because his firm is working on the rights issue. “Its asset and wealth management business is work in progress and returns in German retail banking are unexciting.”

Gamble

The bank maintains that it can reach a 12% return-on-equity in 2015 – even though it only delivered 2.6% last year and 1.5% the year before with a much smaller equity denominator – with Jain gambling that by staying in fixed-income, the bank will be able to pick up market share and grow revenues. It is also planning a push in the US, where it hopes to boost its market share and revenues.

“Management are clearly keen to take the gamble, but who knows how this might work out”

Not all are convinced that will work because of an ongoing and severe downturn in the asset class. Deutsche is already heavily exposed to fixed-income trading, which brings in about half of investment bank revenues. In addition, the bank also faces multi-billion euro fines from regulators.

“This would make sense if rivals were leaving the market and the revenue pie remained the same, but the pie is quite clearly shrinking,” said Arun Melmane, an analyst at Canaccord. “Management are clearly keen to take the gamble, but who knows how this might work out. There is a strong possibility that the regulatory regime could get even worse, and these decisions could make that painful.”

Bosses maintain that if they get it wrong, going down the capital raising route now means that they can cut the balance sheet later if they need to – rather than cut now and reduce earnings capacity. But that only reinforces the view of some that Deutsche is more dependent on leverage than other banks.

“Management has been repeatedly caught out by the rapid changes in regulatory focus since the crisis and should really have started deleveraging earlier, in parallel with many of its rivals,” said the analyst who declined to be named. “They now have no option but to bite the bullet and address the capital issue head-on.”

About-turn

The about-turn comes after two years of reassurances from bosses that the bank would hit capital targets through retained earnings. But they misjudged how regulators would calculate the leverage ratio, assuming not all assets would be included.

That prompted a frantic shedding of assets to make up for the bank’s misjudgements, with the firm cutting almost €400bn – equivalent to a fifth of its balance sheet – between the end of 2012 and the end of last year. Rather than cut entire businesses, as some rivals have done to boost ratios, the bank hoped that a more efficient use of resources would be enough to get it there.

But as revenues have plummeted, that strategy has unravelled. With clients and investors beginning to lose confidence in the bank, bosses were forced to switch embarrassingly to plan B.

(For more on the rights issue and the AT1 deal, see pages 6 and 7.)

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