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Sneak previews: Deutsche and RBS

2014/02/16

Let us hope that this will not become a habit. As David Enrich (The Wall Street Journal) wrote the other day on Twitter

The tactics to choose a favorable moment (in case of Deutsche Bank a Sunday) ahead of the regular presentation of results to confront the markets with bad news illustrates how much, five years after the peak of the financial crisis, both institutions are still struggling to explain their activities and performance to the public in a damage-limiting way. What happened to the two banks which were once the biggest in the world? The following is a short compilation of information from banks’ press releases, media comments and other readily available sources to find out what the main problems are. Of course, this is no substitute for a thorough analysis. If not mentioned otherwise, data are from the banks’ official websites.

At first glance, besides being big, both institutions do not have much in common. After a £45.5 billion taxpayers’ bailout in 2008, RBS is controlled by the UK government. In contrast, as I wrote elsewhere, Germany’s Number One prides itself that it never had, and never will have, state aid. (But, as I showed as well, this statement must be taken with a grain of salt.) In many respects, however, both are characteristic for the current state of banking in Europe.

Deutsche Bank Ergebnis 2013_Tab-a

1  As of 12/31/12. SNL Financial: http://www.snl.com/InTheMedia.aspx
2  Preliminary or estimated.
http://www.zerohedge.com/news/2013-06-15/deutsche-bank-horribly-undercapitalized-its-ridiculous-says-former-fed-president-hoe
4  Based on European IFRS accounting rules as of the end of 2012. Federal Deposit Insurance Corp Vice Chairman Thomas Hoenig in an interview. http://www.reuters.com/article/2013/06/14/us-financial-regulation-deutsche-idUSBRE95D0X620130614
5  Based on U.S. GAAP. Deutsche Bank’s Chief Financial Officer Stefan Krause in a Reuters  interview, when asked about Hoenig’s comments. http://www.reuters.com/article/2013/06/14/us-financial-regulation-deutsche-idUSBRE95D0X620130614
6  As of June 2013, based on IFRS. Deutsche Bank’s Chief Financial Officer Stefan Krause in the Reuters interview, when asked about Hoenig’s comments. http://www.reuters.com/article/2013/06/14/us-financial-regulation-deutsche-idUSBRE95D0X620130614
 7 http://www.rbs.com/news/2014/01/rbs-issues-trading-update.html
Asset size

In an effort to reduce risks and meet stricter rules from regulators, both banks reduced assets in recent years. They were not the only ones. According to a report from the European Banking Authority, between December 2011 and June 2013, European Union banks shed more than $1.1 trillion of assets in a shift away from risky investments such as asset-backed debt.

In 2008, at the peak of the financial crisis, RBS was the biggest bank in the world by assets, followed by Deutsche Bank. At the end of 2013, Deutsche Bank ranked eighth, and RBS 16th, worldwide while Industrial and Commercial Bank of China, HSBC Holdings and Crédit Agricole Group had risen to the top of the list.

Like many financial figures, asset size is an ambiguous concept. It is noteworthy that all of the above-mentioned banks follow IFRS accounting principles. SNL Financial speculated that if JP Morgan, now the Number Six worldwide, followed the same principles instead of U.S. GAAP, it would most likely rank as the largest bank in the world.

The question is whether this is a good sign. The key difference between IFRS and GAAP is the treatment of derivatives. As SNL wrote: “IFRS filers must include the gross amount of derivative assets on their balance sheets, while U.S. GAAP filers report the net amount”.

Deutsche Bank, which is among the few banks that report their balance sheets under both GAAP and IFRS, may serve as an example. As of 31 December 2008, the bank’s total assets were €2,002 billion under IFRS and €1,030 billion under U.S. GAAP ‘pro-forma’ (Ackermann 2009).

Why may netting be a problem in this case? Daniel Gros gave an example:

“In the wake of the market’s reaction to the insolvency of Lehman Brothers … interconnected has been advocated as another principle for not letting a bank fail. Under IFRS this might not be a separate principle from the usual too big to fail, since most interconnections show up in the balance sheet, but not under GAAP. This difference between IFRS and GAAP could resolve to some extent the mystery of why the US authorities were surprised by the extent of the market reaction to the failure of Lehman. Lehman’s balance sheet (total assets around $600 billion, not far from Goldman Sachs) reflected GAAP and thus did not show the extent of the exposure of other market participants. The example from Goldman Sachs suggests that the balance sheet of Lehman under IFRS would have been several times larger, thus giving a better picture of the importance of Lehman. A balance sheet under IFRS would thus give a better picture of the exposure of the bank itself to counterparty risk. Assume a bank has a large amount of derivatives contracts outstanding, but without any significant net exposure. It could still make very large losses in case important counterparties fail and netting arrangements do not work or the pricing of the contracts is distorted, as happens typically in a systemic crisis. This is why the highly leveraged European banks came under such intensive pressure during the acute phase of the crisis.”

And it explains why “deleveraging” plays such a prominent role in current debates about crisis management and prevention. To the extent that Deutsche is reducing its risky activities the difference between its IFRS and GAAP figures should become smaller.

Income

Despite an announced fourth-quarter pretax loss of €1.2 billion Deutsche Bank posted a pretax group profit of €2.071 billion for the full year. It had even a much higher core bank profit of € 5.277 billion, but this was partly eaten up by a €3.206 billion loss of the bank’s internal bad bank, the Non-Core Operations Unit (NCOU).

The £8 billion loss for RBS in the table is a rough estimate. As Robert Peston (BBC) wrote in Pre-crisis mistakes still haunt RBS, these are “not the biggest losses the bank has ever disclosed: in 2008 its losses were three times greater. But so long after the great crash of five years ago, such a dreadful performance will shock many.”

RBS will not have to raise additional capital to absorb the losses. But, as Robert Peston remarked, as for when and whether taxpayers will get back the £46 billion the UK government invested in the bank to save it in 2008, with the shares languishing a third below the price it paid, that looks more and more challenging.

RBS will publish its final full year results on 27 February. Deutsche Bank intends to publish its Annual Report 2013 on 20 March 2014.

Core Tier 1 ratio

As Norton Rose Fulbright, a global legal practice, wrote in their short introduction to the new European Capital Requirements Directive, CRD IV: “The purpose of capital is to absorb the losses that a firm does not expect to make in the normal course of business.”

There are several concepts which differ in the way capital is calculated for regulatory purposes. In general, it is expressed as a percentage of banks’ risk-weighted assets (RWAs) to account for the fact that the quality of assets and the related probability of loss may differ. The riskier the asset, the more capital is needed. The initial Basel Accord of 1988, which for the first time introduced global harmonized capital standards in order to limit credit risks of internationally active banks, called for minimum capital of eight per cent of risk-weighted assets with risk-weights ranging from zero over 20 and 50 to 100 per cent depending on the type of borrower or collateral.

Meanwhile, the framework developed from Basel II over Basel 2.5 to Basel III becoming ever more complex in successively introducing new concepts and new capital charges for market and operational risks, and allowing for new methods of risk measurement. Basel III was released in December 2010 to start in 2013 and be completed by 1 January 2019.

The Basel framework distinguishes between two types of capital. Quoting Norton Rose Fulbright again:  “Tier 1 capital is going concern capital which allows a firm to continue its activities and helps prevent insolvency. The highest form of Tier 1 capital is Common Equity Tier 1 (CET 1) capital. [Additional Tier 1 categories include hybrid capital instruments which combine both debt and equity characteristics. My remark.] Tier 2 capital is gone concern capital which is designed to ensure that depositors and senior creditors are repaid if the firm fails.”

Capital specialist, blogger and former central banker Cetier the First wrote on Pieria in this context: “the numerator of this [CET 1] ratio is mainly accounting equity, including reserves and other comprehensive income; adjusted for prudentially weak accounting items such as Goodwill and Deferred Tax Assets. Common Equity Tier 1 … is capital of the highest quality. We all want banks to have high levels of this type of capital.”

The Basel rules are recommendations. Basel III is transposed into European law under a proposal by the European Commission which divides the current Capital Requirements Directive (CRD) into two legislative instruments: the Capital Requirements Regulation (CRR) and the CRD IV Directive. As before, banks must have total capital of at least 8 per cent of risk-weighted assets. The minimum Tier 1 capital, however, is increased from 4 to 6 per cent including a Capital Conservation buffer, and the minimum requirement for CET 1 is increased from 2 to 4.5 per cent. In addition, member states will be able to apply systemic risk buffers.

The Bundesbank provides a chart (regrettably only available in German) illustrating the changes coming with Basel III, which may be helpful:

Basel III: Changing Capital Definitions

Deutsche Bank Ergebnis 2013_Graph-a

Source: Deutsche Bundesbank.

Many investors are already expecting full Basel III compliance. Furthermore, the asset quality review (AQR) the ECB is conducting between November 2013 and October 2014 in preparation of the Single Supervisory Mechanism (SSM) sets a capital benchmark of 8 per cent CET 1. This comprises (a) the CRD IV 4.5 per cent CET 1 minimum requirement plus (b) the 2.5 per cent Capital Conservation buffer included in Basel III, and (c) an add-on of 1 per cent to take into account the systemic relevance of the banks considered significant under the SSM Regulation (ECB). As observers note, in this the AQR is de facto foreshortening the CRD IV transition period as none of these components have been required in full under CRD IV by 1 January 2014.

As a consequence, many European banks, including Deutsche Bank and RBS, have started to measure capital accordingly. For 2013, Deutsche Bank is presenting a CRD 4 Common Equity Tier 1 capital ratio “fully loaded”, while RBS apparently intends to report a wider core Tier 1 ratio. “Fully loaded” in this context means the final ratio after all phase-in arrangements shown in the table below have taken place.

Deutsche Bank Ergebnis 2013_Tab-b

Source: Bank for International Settlements.

RBS is expected to see a significant fall in capital levels as a consequence of the announced Q4 losses. If its reported ratio of 11 per cent is transformed into a fully loaded Basel III Core Tier One capital ratio the expected resulting figure is between 8.1 and 8.5 per cent at the end of December 2013 – down from 9.1 per cent at the end of September. Moody’s reacted promptly and put RBS’s debt “on review for downgrade”. The credit rating agency argued that

“the bank has indicated that at this point in time its capital targets for 2015 and 2016 remain unchanged because these costs, which although being incurred earlier than forecast, were already accounted for in its three-year capital plan. However, their acceleration leaves RBS with less flexibility to manage other unforeseen charges that could further affect its capital position.”

And: “Moody’s considers RBS’s recovery plan as clear, credible and positive for its creditors over the medium-term, albeit not immune from execution risk. The rating agency believes that, if adequately executed, the recovery plan will gradually improve the bank’s currently weak asset quality profile, increase its solvency and will eventually restore the bank’s sustainable profitability. However, RBS’s recent announcement demonstrates that its management faces a number of short-term headwinds, which could challenge the implementation of this plan and in turn be negative for its creditors. In addition, Moody’s believes that the overall downside risks associated with the bank’s recovery have increased.”

For Deutsche Bank, at first glance, despite the poor Q4 results the figures look impressive. In increasing its capital by €3 billion and reducing its risk-weighted assets by more than €100 billion the bank managed to improve its CET 1 capital ratio from 6 per cent at the beginning of 2012 to almost 10 per cent at the end of December 2013.  But, this appears less remarkable for one of the biggest banks in Europe considering that, these days, “the median Core Tier 1 capital ratio of the largest euro area banks stands close to 12%” (ECB).

Is Deutsche Bank still “horribly undercapitalized” as Federal Deposit Insurance Corp Vice Chairman Thomas Hoenig said in June 2013 in a Reuters interview? Hoenig would probably stick to his view. His remark focused less on published figures than on the fact that the Basel rules allow banks to use their own internal models to calculate how risky their assets are and how much capital they must hold thereby enabling lenders to appear well-capitalized when they are not. (See for the history and basic principles of the main concept to determine a bank’s Value at Risk (VAR) here.)

In a recent American Banker article, Mayra Rodriguez Valladares of MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm, made a similar argument: “Banks struggle to produce high quality and consistent data for their securitization risk measurement models. Every time I poll a classroom of market participants on how they value securitized products or how they measure the products’ risk, the choices are more numerous than at Baskin Robbins. Even the Basel Committee’s own studies last year confirmed that risk-weighted assets vary significantly between banks even when they have similar exposures.”

Leverage ratio

Many observers consider the leverage ratio a better method to show a firm’s ability to absorb sudden losses. A leverage ratio compares a bank’s capital to its total assets without using risk-weightings.

Basel III for the first time introduces a minimum target for a non-risk-based leverage ratio of 3 per cent. The leverage ratio is defined as Tier 1 capital divided by a measure of non-risk weighted assets which covers not only on-balance sheet assets, but also off-balance sheet instruments such as derivatives (Mayra Rodríguez Valladares). The ratio is intended to serve as a backstop to the risk-based capital requirement and also to help contain system wide build up of leverage. As a new regulatory tool it is not binding at this stage but an additional feature at the discretion of supervisory authorities.

In Europe, under the CRR banks will have to publish leverage ratios from 2015 onwards.  BaFin explains the further process: “A harmonized EU-wide concept for the leverage ratio is to be determined by early 2018. Currently it is not foreseeable whether it will apply as a binding risk-dependent criterion alongside of the (then already applicable) risk-based minimum own funds requirements (Pillar I) or instead will be adopted as part of an institution’s Supervisory Review and Evaluation Process (SREP) (Pillar II).”

Whoever hoped that the leverage ratio is a less ambiguous concept than risk-weighted measures however will be disappointed. The figures may vary widely as debates about Deutsche Bank’s results show. Thomas Hoenig, for example, claimed that at the end of 2012 Deutsche Bank’s leverage ratio stood at 1.63 per cent based on European IFRS accounting rules. Confronted with this statement in June 2013 Deutsche Bank’s Chief Financial Officer Stefan Krause said the number then stood at 2.1 per cent. He added however that using U.S. generally accepted accounting principles, the ratio stood at a much more comfortable 4.5 per cent.

JP Morgan estimated that in 2015 Deutsche Bank will have a leverage ratio of 2.4 per cent thereby missing the 3 per cent Basel III target in a group with Credit Suisse (2.5 per cent) and Société Générale (2.9 per cent). This compares with Barclays (3.4 per cent), Morgan Stanley (3.6 per cent) UBS (4.0 per cent) and Goldman Sachs (4.1 per cent).

Laura Stevens (The Wall Street Journal) observed in this context that “few banks in Europe have faced the degree of scrutiny or doubt about capital and leverage calculations that Deutsche Bank has”. The hypothetical measures included in the bank’s calculations of the leverage ratio are widely considered far too optimistic.

Apparently, Deutsche uses a mix of IFRS and GAAP which shows a more favorable picture than the JP Morgan figures: Quoting Laura Stevens again: “The bank last month said it has already hit its targets on its leverage ratio under the newly instituted European guidelines, with a ratio of 3%, using an “adjusted” balance sheet of €1.583 trillion, which is calculated in part using U.S. accounting rules. The U.S. rules typically reduce the size of the balance sheet. There are still too many unknowns to calculate the bank’s leverage ratio under the new proposals, the bank said.”

RBS is not in the JP Morgan list published by the Wall Street Journal. Its estimated leverage ratio of 3.6 at the end of 2013 is already above the Basel III target. This is a positive sign which, however, should not be seen isolated. Experts emphasize that the leverage ratio is most useful in combination with other measures.

For instance, Mayra Rodríguez Valladares wrote: “Critics of the proposed guidelines argue that the leverage ratio would encourage banks to transact riskier on- or off-balance sheet instruments. If banks were to do that, however, this added riskiness would raise banks’ RWAs and force them to increase their capital. This action would also impact their liquidity coverage ratio [another Basel III component] by making the banks less liquid since most risky assets do not count for the LCR. This is another reason why the leverage ratio is an important complement to the RWA and liquidity buffers.”

Cetier the First’s critique focuses on the capital concept. He noted that under Basel III definition, “the numerator is Common Equity Tier 1 plus subordinated, debt-like, securities. These securities are really weak bank capital. They are not even perpetual as they can be repaid within 5 years. Banks are fascinated by these hybrids, even though they tend to end in tears …” And: “Under Basel III rules, a bank can meet a leverage ratio of 30% with 10% Common Equity Tier 1 and 20% hybrid securities. That is exactly where we don’t want to end up. We learned from the crisis that hybrid securities failed abysmally in their role of capital. Hybrids acted like debt, thus not absorbing the losses they promised to absorb. … hybrids are accidents waiting to happen.” And he concluded for the Common Equity Tier 1 ratio and the leverage ratio: “Neither of both ratios are perfect. Using both ratios may therefore have merit.”

Key sources of Q4 losses

In the centre of the pre-announcements of Deutsche and RBS were the losses that considerably weaken their 2013 results. Deutsche’s fourth-quarter pretax loss of €1.2 billion came as a surprise as analysts had expected a fourth-quarter profit of about €698 million. Under the impression of an ongoing series of legal disputes, investigations and scandals media interest focused on litigation costs for which the bank took a €528 million charge. Thomas Atkins (Reuters) reminded the readers that the bank was fined $1.9 billion in December by the U.S. Federal Housing Finance Agency to settle claims that it defrauded two U.S. government-controlled companies in the sale of mortgage-backed securities before the 2008 financial crisis and that it was also fined €725 million by EU antitrust regulators for rigging interest rates. All in all, he wrote, Deutsche spent €2.5 billion on fines and settlements in 2013 and, at the end of the year, its litigation reserves had declined to €2.3 billion.

An even bigger source of losses for Deutsche Bank was writedowns in credit, debt and funding (CVA, DVA, FVA) which amounted to €623 million. The bank explained: “FVA is an adjustment being implemented in 4Q2013 that reflects the implicit funding costs borne by Deutsche Bank for uncollateralized derivative positions”.

FVA is a comparably new concept which is reported by a small number of banks, including both Deutsche and RBS. According to Matt Cameron (Risk Magazine) this is “primarily because there is no standard approach, and some accountants have been reluctant to sign off on the adjustments.” He further wrote:

“At its heart, FVA is a simple concept. For traders, it reflects the funding cost generated when hedging an uncollateralised client trade in the interdealer market, where two-way posting of margin is standard – the market risk may be fully offset, but the collateral requirements are asymmetrical. When a dealer is in-the-money on the client trade, it would have to post collateral to its hedge counterparty, and would therefore need to borrow money from its internal treasury, which is a funding cost.

On the flipside, if the dealer is out-of-the-money on the client trade, it receives collateral from its hedge counterparty, and if the collateral is assumed to be rehypothecable, the dealer should be able to lend that collateral to its treasury, which is a funding benefit.”

Deutsche Bank is not the first bank to see its results weakened by FVA. Sarah Butcher mentioned the example of JP Morgan’s results for 2013:

“FVA made an important appearance in JPMorgan’s fourth quarter results, announced today. Until combined adjustments for FVA and debt valuation (DVA) were added to results for the quarter, JPMorgan did quite well. However, JPMorgan registered a $1.5bn FVA cost in the fourth quarter. Once combined DVA and FVA were factored in, the bank did incredibly badly – return on equity fell to a mere 6% in the corporate and investment bank and costs there rose to 81% of revenues.”

There were others as well. Nomura recorded a loss of ¥10 billion ($98 million) after introducing FVA for its over-the-counter derivatives portfolio in 2013. Lloyds Banking Group and Barclays reported £143 million and £101 million of FVA respectively for the year 2012 and RBS reported FVA of £475 million in its fourth-quarter report for 2012 (Matt Cameron).

Another source of Q4 losses for Deutsche Bank was €509 million of cost-to-achieve (CTA), a cost related to the bank’s restructuring process. In September 2012, the bank had presented its Strategy 2015+ which emphasized three aspects: the need for organic growth of its capital base, the reduction in risk and higher operating performance.

One element of the process was a restructuring of the bank’s business which now consists of

Corporate Banking & Securities (CB&S)

Global Transaction Banking (GTB)

Deutsche Asset & Wealth Management (DeAWM)

Private & Business Clients (PBC)

Consolidation & Adjustment (C&A)

Non-Core Operations Unit (NCOU).

Beside the Non-Core Operations Unit (NCOU) which for the fourth quarter 2013 recorded a loss before income taxes of €1.1 billion, two of the segments, CB&S and GTB, contributed substantially to the bank’s fourth-quarter losses – with the decline in CB&S revenues by €916 million outstanding. This figure has a special quality as it concerns the flagship of the group, investment banking.

The reason for the decline is found in bond markets. As Thomas Atkins remarked: “Revenue at Deutsche’s debt-trading business, which accounts for nearly three quarters of its trading revenue, fell by almost a third, much more than at U.S. rivals which also suffered from a bond trading slowdown ahead of a cut in the Federal Reserve’s bond buying to help the U.S. economy. … Deutsche, one of Europe’s major bond trading houses, has been able to vacuum up business from rival banks that are scaling back. But tougher regulatory demands after the financial crisis have forced it to shed assets itself.”

In contrast to Deutsche Bank’s results, RBS’s losses were widely expected. Markets were surprised however by the amount of provisions made. As Robert Peston wrote:

“£1.9bn of costs to cover fines and damage claims for mis-selling mortgage bonds in the US, along with other penalties for market manipulation;

Another £650m of losses for mis-selling payment protection insurance;

A further £500m of losses for compensating small businesses who were wrongly sold interest rate hedging products.

And … up to £4.5bn of further losses on bad loans and investments, together with unspecified losses on the accelerated sale of dodgy assets.”

This latter amount for “accelerated and increased impairments” results from an effort to get rid of a pool of non-core assets. For this purpose, RBS established an internal bad bank, RBS Capital Resolution, on 1 January 2014. In its 2013 Q3 results the bank explained:

“RBS announces management actions to accelerate the building of its capital strength and to enhance its strategic focus on its core UK businesses and its international corporate capabilities.

● The measures will include the creation of an internal “bad bank” to manage the run-down of high risk assets projected to be £38 billion by the end of 2013. The goal is to remove 55-70% of these assets over the next two years. While there is inevitable uncertainty associated with running down such assets, there is a clear aspiration to remove all these assets from the balance sheet in three years.

● Faster run-down of high risk assets is expected to entail accelerated and increased impairments in Q4 2013 of £4.0 billion to £4.5 billion but the capital impact of this will be neutralised by a commensurate reduction in expected loss capital deductions. The net impact on the current Core Tier 1 ratio is expected to be a reduction of c.10 basis points. However, the new strategy will result in a strengthening of the Group’s capital ratios in the medium term.”

With the establishment of an internal bad bank, RBS followed the earlier example of Deutsche Bank and others.  As I wrote elsewhere, in recent years, in particular German financial institutions developed a high level of bad-bank sophistication finding ways for banks to “clean” their balance sheets by transferring non-performing loans and other loss-generating assets to special institutions.

There are several possible variants of official and private, internal and external solutions (See, for example, McKinsey 2009:  Bad Banks: Finding The Right Exit From The Financial Crisis). Compared to external solutions an internal bad bank is simpler to set up. The disadvantage is a lack of “clear separation in terms of a clean balance sheet separation and de-consolidation of risks”, but “while this on-balance sheet solution still lacks efficient risk transfer, it provides a clear signal to the market and increases transparency of the core bank’s performance” (McKinsey).

Experiences with bad banks are mixed (see for example my earlier article here about the Japanese experience with both private and public solutions). Ulrike Dauer (The Wall Street Journal) reported in January 2014 that “Deutsche Bank is selling noncore assets to boost its capital ratios, complementing an effort last year to end questions about its capital adequacy by issuing about €3 billion of new shares. That effort generated large losses in the fourth quarter as the bank sold assets at cut-rate prices, according to people familiar with the matter. The bank previously has said it aimed to sell about €80 billion of assets in 2013. By the end of the third quarter, it had sold about €66 billion.”

—–

The figures presented here are preliminary. The picture will become clearer when the banks publish their final full year results.

But, the real cause of concern at the moment seems less that still more bad news may emerge, but the fact that here in both cases a point in time was chosen for the announcement that took markets by surprise. The banks appeared less driven by the wish to provide as much information and transparency as possible to convince investors that, even if their results are still deplorable, they actually are “at the forefront of cultural change in the financial services sector” as Deutsche Bank claims to be, but to get as little notice as possible. Unfortunately, this strategy is already imitated. For instance, on 3 February, in an unusual announcement 10 days ahead of its results, Lloyds reported that it is setting aside another £1.8bn for compensation for mis-selling PPI credit insurance.

As Phillipa Leighton-Jones (The Wall Street Journal) wrote: “Sneak previews are becoming all the rage in European banking.”

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