Deutsche Bank AG (NYSE:DB) (ETR:DBK) shares are down close to 5% on a Goldman Sachs Group, Inc. (NYSE:GS) report which downgrades the large European bank. Goldman Sachs says the Deutsche Bank AG may have to transfer as much as $13 billion in capital to its US unit (as detailed extensively below). The reason for the transfer has to due with a new Fed proposal about capital. Goldman has cut Deutsche Bank from a hold to a sell. The math behind Goldman’s downgrade
“We incorporate the FED proposal by assuming: (1) external CoCo issuance, (2) increased US$ funding costs, and (3) a reduction in DBK’s US asset base. This reduces their 2013-15E EPS by 11%-20%. Their RoTE/CoE-based 12-month price target falls €10 (from €47.0 to €37.3) which implies c.6% potential upside, below the average for Goldman’s banks coverage of 25%.”
We detail the capital rule and Goldman’s key points below:
The FED proposal on foreign banks has a reasonable likelihood of being adopted, in their view. In Europe, Goldman Sachs Group, Inc. (NYSE:GS) sees the greatest impact on Deutsche Bank AG (NYSE:DB) (ETR:DBK) and estimates that satisfying proposed capital rules requires a capital transfer of at least $13 billion to Deutsche Bank’s US unit. Such an intragroup transfer would cause a sharp reduction in Deutsche Bank’s non-US capitalisation, which could increase pressure for an external recap. The proposal is also stringent on funding, as it calls for a liquidity stress test and thus a reduction in short term dollar funding / terming out of dollar liabilities; impact on Deutsche Bank’s profitability could be substantial.
The Fed proposal comment period ends in April, when Goldman believes it will take center stage again, likely reigniting the debates regarding Deutsche Bank AG (NYSE:DB) (ETR:DBK)’s capital and ROE target. On the latter, incorporating the FED proposal has scope to, all else equal, reduce DBK’s ROE target from 12% to below 10%. Furthermore, Goldman Sachs Group, Inc. (NYSE:GS) reduces their ROE forecast to 7%-8% for 2014/15.
Capital: Not the FED’s action – BaFin reaction is key
The FED proposal on foreign banks has a reasonable likelihood of being adopted, in Goldman’s view. Among the European banks they see the greatest impact on Deutsche Bank AG (NYSE:DB) (ETR:DBK). They estimate that for Deutsche Bank to satisfy the proposed capital rules in 4Q12, for example, would require a capital transfer to the US > $13 bn. Deutsche Bank can fund this intragroup. However, for the intragroup capital transfer not to become a recapitalization need, regulatory response – from BaFin, and later the ECB – is key. If a reduction of >$13 billion of capital, available to support non-US (essentially European) operations, is not met with proposal Funding vulnerabilities of European banks operating in the US become apparent March 1, 2013.
The major rating agencies rate DBK on a group basis. Were it to become apparent that a large proportion of DBK’s capital base is not available (or has limited availability) for loss absorption in the rest of the group, Goldman believes this could change.
The impact on DBK is significant for two reasons: (1) DBK is highly levered in the context of the European and US peer group; and (2) the geographic distribution of DBK’s capital is uneven within the group.
Funding: The prime aim of the FED proposal?
Goldman Sachs Group, Inc. (NYSE:GS) believes that the capital implications of the FED proposal have been extensively studied by the market, but not the funding implications. Here, the available detail is opaque, and the analytical complications more numerous.
Furthermore they note that the FED aims to remove a key funding vulnerability uncovered during the crisis – the reliance of foreign banks on short term US dollar funding. This would be achieved through a liquidity stress test on par with that of US BHC view. Their analysis indicates that Deutsche Bank AG (NYSE:DB) (ETR:DBK) could be affected in two ways:
First, they estimate the US dollar maturity mis-match to be $73 billion (end 2011, last reported). With the FED encouraging banks to reduce the maturity gaps, this could result in incremental funding costs.
Second, the European banks have been using the FX swap markets to transform unsecured long-term € liquidity into US$ liquidity. The FED proposal does not explicitly address this issue and it could well be that this area remains “as is”. However, were this to be curtailed, the earnings impact could be substantial, potentially altering the prospects of the business model.
Finally,they attempt to gauge the potential impact on DBK’s P&L. A simple analysis, assuming half of the maturity gap closes at a (an assumed) 150 bp incremental funding cost, implies an