Deutsche Bank reported a heavy net loss for the second quarter of 2019 of €3.1 billion, after taking €3.4 billion of charges for the transformation it announced on July 7, which will see it exit secondary equities and scale back in rates.
Christian Sewing, chief executive officer, says: “We have already taken significant steps to implement our strategy to transform Deutsche Bank. These are reflected in our results. A substantial part of our restructuring costs is already digested in the second quarter. Excluding transformation charges, the bank would be profitable. In our more stable businesses, revenues were flat or growing.”
Clearly the bank is attempting to front load as much of the expense as it can in 2019 to give it a chance of reporting a token profit next year. It had said it might take €2.8 billion of charges in the second quarter but has got ahead of this target by refining impairment and evaluation calculations sufficiently.
So, Deutsche has already absorbed almost 46% out of the total of €7.4 billion in expenses it expects to take for the whole transformation through to 2022.
However, so far these have mostly been accounting charges relating to valuation adjustments on deferred tax assets, and goodwill impairments on businesses and software. These do not hit the bank’s capital.
Still ahead are the majority of redundancy costs, made up of cash charges that will hit both profits and capital. It remains to be seen how much of these charges will be squeezed into the second half of 2019.
The bank gave 900 staff, mainly in equities, notice of lay-offs in the first 10 days after the restructuring announcement. But the overall plan is eventually to shed 18,000 jobs. While the bank says it will maintain common equity tier-1 (CET1) capital at or above 13% this year, it will likely fall below that next year.
The results showed that, absent restructuring charges, Deutsche would have made a modest net income of just €231 million for the quarter.
While the bank says that revenues in its more stable businesses, such as global transaction banking, private and commercial banking and asset management, remained flat, the corporate and investment bank remains its problem child.
Origination and advisory revenues declined 30% from the same quarter in 2018. This hints at the bank’s potential vulnerability in focusing on a few core strengths. It is strong in credit businesses such as leveraged finance and strong regionally in Europe. But both saw shrinking fee pools. It must hope that both will come back into favour.
The bank says that feedback from clients on its restructuring has been overwhelmingly positive. While equity investors initially reacted unfavourably to the announcement, credit investors have greeted it with cautious optimism. Credit spreads tightened in the run-up to the announcement.
While results may be volatile, it obviously makes sense to exit loss-making businesses and concentrate on those where it has leading market share, such as foreign exchange.
In Euromoney’s 2019 FX survey, Deutsche rose to second place, from eighth in 2018, and ranked first in western Europe, versus fifth last year. In the same survey, Deutsche rose to third place in electronic trading, up from eighth in 2018.
Bjorn Norrman, investment manager in the fixed income team at Kames Capital, says the German lender’s fifth restructuring in seven years finally makes sense: “For too long [it has been] a bank without a coherent business model or disciplined capital allocation; exiting unprofitable investment banking operations and tilting the bank towards corporate banking is a step in the right direction.”
And while Norrman shares the general scepticism over the bank’s ambitious new financial targets – describing aims to grow core revenues by 10% to 2022 at a time when all European banks are struggling under revenue pressure and to cut costs by 25% when IT and compliance spending is on the rise as a “momentous challenge” – he suggests that fixating on the room for error may miss the point.
It doesn’t matter if the targets aren’t fully met, provided the direction is right, costs are decreasing, legacy assets are running off and core revenues are at least holding up- Bjorn Norrman, Kames Capital
“It doesn’t matter if the targets aren’t fully met, provided the direction is right, costs are decreasing, legacy assets are running off and core revenues are at least holding up,” he says. “For all its flaws, Deutsche has a strong position in the areas it’s consolidating into, and with renewed focus should be able to see some positive momentum.”
He suggests the restructuring could be positive for senior and tier-2 bonds. However, the direct benefit from that will be muted for Deutsche if it reduces wholesale funding for a smaller balance sheet. And Norrman is much less optimistic the closer liabilities get to equity.
The bank has lowered its capital target from 13% CET1 to 12.5%, against a current requirement of 11.8%, with the blessing of its regulators. Deutsche expects CET1 to fall perhaps to 12.7% in 2020 from its present level of 13.4%.
Norrman says: “In light of the execution risks, the difficult operating environment and regulatory uncertainty regarding future risk weight inflation, it feels that the new management buffer is on the low side, and AT1 [additional tier-1] holders are at increased risk of coupon restrictions.”
Full details of the restructuring are still not clear. Deutsche has not pulled out of equities completely, it appears, certainly not in Europe. The bank has largely exited from cash equities execution and prime services.
It continues to negotiate with BNP Paribas over the sale of its prime finance and electronic equities platform, for which it expects to receive some consideration. But it appears to be maintaining some research and sales in an effort to support the equity capital markets franchise.
Indeed, the bank’s own analysts have been telling customers that research will remain at the forefront of the firm, saying that as well as FIC, macro, QIS, data science and thematic research, Deutsche is still committed to providing extensive and top-quality company coverage in Europe and in the US. The bank says it will combine equity research and research sales into a newly formed company research and advisory group aimed at institutional clients.
“This is somewhat surprising,” say bank analysts at Citi, “as we estimate institutional advisory payments only account for around 7% to 8% of the equities industry wallet, and it is likely to prove difficult for Deutsche Bank to maintain its current position if it can no longer offer global coverage.”
In the days since the restructuring announcement on July 7, the bank says it has priced a number of equity new issues and won mandates. Will clients continue to support an unusual business model and validate Deutsche’s claim that electronic and algorithmic secondary equities execution is increasingly separated from primary markets?
An exit from equities and rates is therefore likely to have a second-order impact on the credit and FX franchise, in our view- Citi analysts
Citi analysts struggle to see how its ECM franchise can remain competitive without an established execution capability: “With this in mind, it is hard to see how the business will generate sufficient revenues to cover overheads, and we would therefore not be surprised to see a complete exit in future.”
And they continue to see the current management’s revenue assumptions as too optimistic, fearing second-order effects with lost revenues beyond the $2 billion brought in each year in equities and $0.5 billion in rates, where the bank is also cutting back.
“We would expect a number of institutional clients will trade in both equities and credit, while corporates will trade in FX and rates concurrently,” say the Citi analysts. “An exit from equities and rates is therefore likely to have a second-order impact on the credit and FX franchise, in our view.”
Analysts at Barclays sum up the key worry of many of their peers: “We cannot say with confidence that the group will not need to raise equity in the next 12 to 24 months.”
Deutsche insists that it won’t have to do this and continues to stress that losses from winding down non-core assets in its capital release unit (CRU) may not be so large as the market seems to fear.
As at June 30, businesses to be transferred into the CRU accounted on a pro-forma (that is unaudited) basis for €250 billion of leverage exposures and €65 billion of risk-weighted assets. That is less than the figures announced on July 7 of €288 billion of leverage exposure and €74 billion of RWAs that were then based on pro-forma valuations as at December 31, 2018.
Some of that reduction comes from senior management anticipating its own restructuring, for example by allowing equity positions simply to run-off. This €9 billion reduction in RWAs came cost free.
Examining pro-forma numbers requires a great deal of caution; one source describes them as telling a history the bank has not lived. But the key point Deutsche wants the market to accept is that most of what are going into the CRU are fair-value assets. These are not non-performing loans.
Deutsche acknowledges there will be some de-risking costs but says that it does not expect to take large losses on this wind down. It will only sell at a discount to offload assets before they mature when the benefit of early capital release from doing so outweighs the P&L hit.
In the weeks ahead, it will begin to auction off equity derivatives positions. The bank believes there is a high degree of market interest in bidding for these.
Time will tell.