Jonathan Rochford, CFA
October 04, 2016
Jonathan Rochford, CFA @ Narrow Road Capital
Portfolio Manager at Narrow Road Capital

Deutsche Bank Needs a Bail-In, Here’s How It Can Be Done

Deutsche Bank is at best borderline for both solvency and profitability with a bail-in the best option to rectify that


Deutsche Bank
Needs a Bail
-
In, Here’s How It Can Be Done
Following the confirmation that hedge funds have started to reduce their capital and trading with Deutsche Bank its
position is now perilous. It is correct to say that Deutsche Bank doesn’t have a liquidity crisis and that even if it did the
Bu
ndesbank could provide
it
with unlimited liquidity. But liquidity alone doesn’t guarantee a bank can continue to
operate in the long term, solvency and profitability are essential as well. Deutsche Bank is at best borderline for both
solvency and profitabi
lity with
little
prospect
of
either improving materially
in the medium term
. Deutsche Bank needs
to substantially restructure its business activiti
es and balance sheet, both of those will take time and
capital
neither of
which
Deutsche Bank
has.
Insufficient Cap
ital
Unlike
other
global banks Deutsche Bank has failed to adequately lift its capital levels since the collapse of Lehman
Brothers eight years ago. It
has been allowed to remain undercapitalised due to weak European regulators, which are
fighting against global efforts
to have all banks
increase capital levels.
Whilst German
and Itali
an regulators are
fighting
for lower capital levels and
avoid
ing
dealing wit
h their
problem
banks Switzerland
and the US are
implementing much
higher capital levels, part
icularly for the largest banks.
On Deutsche Bank’s preferred measure, risk weighted assets, it sits
behind
most
of
its peers
. That’s after
it
ha
s
gone
through a
capital optimisation
exercise
which reduced
risk weighted assets without reducing their balance sheet
by
the same proportion
. On the more rigorous leverage ratio
shown below,
Deutsche Bank
is dead last at
less than
half
of its peer group average.
When
Europe’s
most systemically important bank
is the
most poorly capitalised of its peer
group that is a major problem that needs to be corrected as
soon as possible.
Source:
FDIC
Deutsche Bank’s current
equity at
book value is
€
61
.
9
billion but its market capitalisation is only
€
15
.
8
billion. It
s
total
assets are
114.3
times its market capitalisation and its price to book ratio is
25.5%
.
The only peers with ratios this bad
are Italian banks who have
d
ubious
solvency and very high levels of non
-
performing loans.
To get from the
2
.
68
% tier
one
capital ratio shown above to the 5% leverage ratio many consider the minimum acceptable
level
requires
€
4
0
.
1
billion
of new equity
.
Not P
rofitable
T
here
are
t
hree
primary ways
f
or
a bank
to
increase its
capital
. Firstly, profits can be retained rather than
paid out
as
dividends.
Deutsche Bank
has
n
’
t
been meaningfully profitable since
2011
. The table
below
shows the net income after
taxes for Deutsche Bank since 2009. The
combined
total of the last seven and half years is
€
7
.
8
billion
,
an average of
€
1
.
04
billion per year.
That equates to a return
on equity
of
1.68%
since
2009
.
Over the last four and a half years the
cumulative loss is
€3
.8 billion
with the average return on equity
-
1.38%.
Period
Net Profit After Tax
(
€
billion)
Full year 2009
4,958
Full year 2010
2,330
Full year 2011
4,326
Full year
2012
316
Full year 2013
681
Full year 2014
1,691
Full year 2015
-
6,772
Half year 2016
256
Total
7,786
The CEO has stated that 2016 will be a peak year for restructuring
, meaning investors should expect a loss for
2016.
The fine
being
negotiated
with t
he US
Department of Justice
will have a significant impact
this year
. Further fines
for
new scandals
, t
he difficulties of operating in a negative interest rate environment
a
nd the potential for another
European or global downturn mean
there is
a material risk of losses
continuing
in future years. Given sufficient time
and
capital Deutsche Bank would restructure
substantially
,
r
idding itself of
un
profitable
and low return
activities
.
Unfortunately, it has squandered the opportunities it had over the last eight years and
now
doesn’t have either
the
time or capital needed to facilitate th
e necessary
cuts.
Assets Sales
Not
Sufficient
The second way to
raise capital is t
o sell assets and Deutsche Bank
is making a great deal of noise about its asset sale
plans. The sales of the
UK
and
Chinese
insurance businesses will together raise approximately
€
4
.
5
billion
.
A
sale of
the asset
management business
might raise €10 billion
. Altogether that’s
€
14
.
5
billion
which is helpful but not nearly
enough. The flipside of asset sales is that future profit
s
are
reduced, exacerbating the profita
bility issues already
outlined.
Sufficiently Large
Capital Raising
Near Impossible
The
third
way a bank can
strengthen its balance sheet
is b
y
conducting a capital raising.
The problem for Deutsche
Bank
is that the amount needed is simply too high based on the current metrics.
A
ny investment banker will tell you
raising
254
% of market capitalisatio
n is extremely optimist
ic
. T
o a
chieve that for a business
with a history of being
marginally profitable
is near on impossible.
A
Bailout or Bail
-
in
is Needed
Taking into account the lack of capital and the very unlikely prospects for an equity raising or asset sales to be sufficient
,
Deutsche Bank needs either a bailout or a bail
-
in. A bailo
ut by the German government is legally possible given the
gaps in the regulation
that c
an
be exploited. The key question is whether the German government would be willing to
do so. In recent years Angela Merkel and her key ministers have consistently den
ounced the possibility of the Italian
government providing a bailout to
Italian banks. In recent months they have been adamant they won’t bailout
Deutsche Bank.
I’m cynical enough to know that politicians can change their minds extremely quickly when
the pressure is on. I
acknowledge there is a decent chance that the German government will do that soon. What the rest of this article
aims to show is that there is a way to recapitalise Deutsche Bank without taxpayer funds. If there’s a decent solution
th
at doesn’t involve taxpayer funds I think that solution
can
win out
.
Bail
-
in
Mechanics
The recently introduced European regulations lay out a framework for how a bail
-
in would work. Equity, additional
tie
r 1 securities (Coco’s or
hybrids
) and subordinated debt can be written off completely
if the bank is declared non
-
viable.
Senior debt, particularly that provided by large institutions can also be converted to equity in order to lift
reserves. By undertaking a combination of those two processes Deutsche Bank’s
undercapitalis
ation
could be quickly
rectified
.
The table b
elow lays out the liabilities
and equity
on Deutsche Bank’s balance sheet. Equity, additional tier 1 and
subordinated debt securities are
broken out
. Senior debt has been broken
into two categories,
t
h
e portion
which
could
be expect
ed to be bailed
-
in and th
at
where it is uncertain. For the purpose of this exercise a conservative approach
has been taken
,
the amount that could be bailed
-
in
is
likely much larger.
Capital Item
Amount (
€
billion)
Senior
debt
–
not
available for
bail
-
in
1,567,405
Senior
debt
–
available
for bail
-
in
156,079
Subordinated debt
6,826
Additional tier 1
6,171
Non
-
tangible equity
17,644
Tangible equity
49,165
Total
1,803,290
How
Much M
ore Capital is Needed?
In determining how much additional capital is needed a target capital level
must
be chosen. If a bail
-
in is
executed it
needs to be a one
-
time exercise that removes all concerns
about
Deutsche Bank
’
s solvency
.
Lifting
the
cor
e equity tier
1
ratio just to the average level of its peers is not enough, it must go much further.
A core equity tier one leverage
ratio of 9
% would lift Deutsche Bank to the top of the list amongst its global peers. This
would provide strong reassuranc
e that another bail
-
in won’t be needed
.
It
would also provide breathing room
t
o
undertake the overdue restructuring of
unprofitable
and marginal
businesses. At a 9
% level,
another
€
111
.
5
billion of
tangible equity
is required
.
This
would
come
from the write
-
off o
f
additional tier 1
,
subordinated
debt
and
€
98
.
5
billion
of senior debt being
converted
to equity.
This implies that
63
.
1
% of the
senior debt
a
ble to be bailed
-
in need
s
to be
converted to equity.
For every
€
100 they are currently owed
bailed
-
in
s
en
ior debt holders would receive
€
36
.
9
0
in new senior debt
as well
as mater
ial value in new equity. To
assist the transition, the regulators and Deutsche Bank should work together to
see that those who
receive
new equity can be offered a transparent and orderly means to sell down th
ose
shares.
Whilst Deutsche Bank could theoretically just re
start trading
after the new shares were
issued, relisting without a
n
opportunity for new shareholders to sell down to more natural equity owners
c
ould be substantially disorderly and
may result i
n
much greater losses in value and confidence in banks tha
n
wou
ld otherwise be the case.
Potential Capital Sell
-
Down Process
There’s two types of approach that could help facilitate the sale of shares by those who are seeking to exit
; a right
s
issue model and
an IPO model. The table below summarises some of t
he diff
erent features of each
that
could apply in
the case of a Deutsche Bank bail
-
in.
Right
s
Issue Model
IPO Model
Timeframe to sell
-
down equity
2
-
3 weeks
2
-
3 months
Key activities
Converting debt to equity,
conducting bookbuild
Converting debt to equity,
management preparing new
business plan
, global roadshow,
conducting bookbuild
Effect on recovery rate
Reduced recovery rate for
bailed
-
in senior debt
Enhanced recovery rate for
bailed
-
in senior debt
Effect on other banks and
capital markets
Limited
period of uncertainty
until recovery rate is
finalised
Extended period of uncertai
nty
until recovery rate is
finalised
The rights issue model is the most efficient, but it doesn’t a
llow for
Deutsche Bank management
to
prepare
a solid
pitch to potential new investors. Management would have
only a few days
to develop their strategy for making the
bank profitable again and li
mited time to explain that to the many large global investors that may want to buy shares.
The IPO model takes longer, but would allow
management to put forward a clear plan on what businesses it will exit,
what that will cost and the additional profitabil
ity that could be generated over time. The downside of the additional
time is that it increases the potential for contagion to other banks as investors remain unsure of what recovery they
will receive
on their new shares
for a longer period
.
Allowing
over the counter
trading to continue
on senior debt
would allay some of the
se concerns.
As a guide to th
e
possible
recovery
for bailed
-
in senior debt
, other European banks were generally trading at
0.5 to
1.0 times book value
in early September.
T
his implies
th
e new equity is worth
€89.2
–
€178.
4 billion. When combined
with the new senior debt of €57.5
billion
this a total recovery of 94.0%
–
151.1% on the old senior debt. I
f an IPO
process was used this would open up the opportunity for the old
subordinated debt
, additional tier 1 and
equity
owners
to receive some value. If a bookbuild ended up realising more than a 100% recovery for senior debt holders,
which is reached if the price to book i
s
0.55 or ab
ove,
the
additional
value could be
allocated
to
the
subordinated
capital
owners
via the natu
r
al order of priority.
This process would largely el
iminate
arguments that value wasn’t
maximised, neutering the possibility of ongoing litigation as has been the case with Fannie Mae and Freddie Mac.
Conclusion
Deutsche Bank’s position is currently marginal as it is woefully
under
capitalised and has no clear prospect
of
becoming
meaningfully profitable. As the world’s largest derivative
trader
and
Europe’s
most systemically important bank this is
untenable
.
Deutsche Bank is three times larger than Lehman Brothers, making the
possibility of an unexpected and
uncoordinated failure completel
y unacceptable.
Deutsche Bank needs substantial time and capital to execute a
turnaround
, neither of which it now has. It does not have the profitability to grow its capital base quickly or t
o support
a capital raising of the
size it needs
. Deutsche Bank n
eeds either a bail
-
in or a bail
out.
An orderly bail
-
in process would deliver Deutsche Bank the additional time and capital it needs. In the first instance,
the bank should be declared non
-
vi
able with all equity, additional tier 1 and subordinated debt written
off. By
converting
63.1
% of
long term
senior debt
to
new equity
the leverage
ratio would
increase
to an unquestionably strong
9%
. B
a
sed on recent
peer
comparisons,
bailed
-
in senior debt holders w
ould receive a recovery of
at least
94%
of
their
current position. Using an IPO model, where management
develops and
presents
a
new strategy to potential investors
over a
2
-
3
month
period
, would allow
the recipients of
newly issued
equity
an orderly process to sell
-
down their equity
.
It also creates the possibility of a
substantial
recovery for
subordinated debt, additional tier 1 and equity investors.
W
ritten by Jonathan Rochford for Narrow Road Capital on
October 4
, 201
6
. 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 informat
ion 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 i
n a wide range of securities, including
securities linked to the performance of various companies and financial institutions.
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