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.
Catalyst
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
(already high) US$547 mn revenue impact.
FED proposal implies >$13 bn capital transfer, intragroup …The FED proposal requires large foreign banking institutions to organize all of their US operations under a single IHC, which in turn has to comply with capital, leverage and liquidity requirements similar to those of US BHCs.
The FED proposal, if implemented as it currently stands, will have substantial implications for Deutsche Bank AG (NYSE:DB) (ETR:DBK)’s capital position. This is for a number of reasons, but two features in their view are the most important:
- DBK Group is highly levered, in a European and a US peer group context (Exhibit 5). The simple leverage ratio (TA/TE) stood at 30x at end 4Q12, roughly 2x the level of the US banks and some 50% higher when compared to the likes of UBS or BNP. That said, DBK’s leverage is on a par with that of CS.
- The geographic distribution of DBK’s capital is uneven within the group. Last reported data for Taunus (4Q12) shows a negative Tier 1 capital position of US$5.6 bn, for example, implying a negative capital position in the US, and a position of substantial capital surplus outside of it (Exhibit 5).
The FED aims to achieve a standalone capitalization of IHCs inline with that of US BHCs, and apply supervision of IHCs both on a risk-based (CT1 ratio) as well as a simple leverage basis. Goldman analyzes the effect on Deutsche Bank’s capitalization (at the group level, on its US operation and on “Deutsche Bank ex US”). Goldman states that their analysis first estimates the hurdle rates, followed by total assets and RWA.
The math is complicated but we provide the main details and a chart from the analysts:
As per Goldman Sachs:
We estimate capital hurdle rates as follows:
- CET1 hurdle rate: 9%. We estimate the applicable minimum capital requirement in the US is 4.5%, to which we add a 2.5% capital conservation buffer, resulting in a 7% CET1 minimum. To this we add a G-SIFI buffer of 2.5%, given DBK’s classification into the top bucket of SIFIs (together with JPM / C / HSBC). This would bring the hurdle rate to 9.5%, but given the comparable US banks currently operate at levels at or around 9%, we have used this as the more appropriate benchmark.
- Minimum Tier 1 leverage ratio: 3%. The FED proposal states that the IHC would also be supervised on a simple leverage basis – here the minimum is 3%.That said the US banks currently report leverage ratios of twice that.
Estimates for total assets:
- Our starting point for estimating total average assets of Taunus is its last reported amount, as of end 2011, when they stood at US$463 bn. This is the asset base, reported by the FED as of end 2011, for the purpose of calculating leverage, which differs from the consolidated end-of-period reported assets.
- Since end 2011, DBK Group has reduced total assets by US$113 bn. We assume that 80% of this reduction relates to Taunus, bringing our estimate for end 2012 assets (for leverage ratio purposes) to US$373 bn (a reduction of US$90 bn).
Estimates for RWAs:
- We assume a B1 to B3 RWA inflation of 30%, which is in line with the RWA increase reported by the US banks. The results are shown in Exhibits 5 and 6 (for the detailed calculations, see Appendix 1).
- The stock of 2012E RWA, calculated in this way, is US$85 bn. On the basis of the above, we derive a capital requirement, under a 9% CET1, of US$7.7 bn. With the starting position of -US$6 bn, the total amount of capital transfer need is US$13 bn. This rises to US$17 bn if the leverage ratio of 3% is applied as an overlay. DBK has levers to reduce low-risk assets and thus the leverage ratio. We therefore see the capital transfer implied by the CT1 ratio as the more relevant one.
