The Real Meaning Of Deutsche Bank’s Decline

Having worked at Deutsche Bank for many years, I’m always tuned in to stories on it. And this week has been replete with them. Many focus on the announcement of dramatic staff cuts or the bank’s potential involvement in the scandal-hit 1MDB investment fund. But the real story is Deutsche’s balance sheet challenges.

Over the past year the Deutsche Bank stock price has fallen by one third. Worryingly, its valuation as measured by the price-to-book ratio is languishing at 0.2, which means the market is applying an 80% discount to assets held by the bank. It’s no wonder, then, that the bank has just announced a major reboot, its fifth in seven years – this time to shrink its equities division, cut 18,000 staff.  The announcement has grabbed headlines, but its Deutsche’s balance sheet that should garner most interest.

Interest Rates Matter

It is tempting to blame this decline entirely on poor management, but we need to factor in market conditions. There is clear correlation between the level of interest rates and bank valuations (first chart). Both Japan and the Euro-area have very low interest rates and their bank sector valuations are very low. Meanwhile, countries like the US, Canada, and Australia have higher interest rates and higher bank sector valuations. And over the past year, as global interest rates have fallen, so have bank sector valuations in all regions. So, US bank outperformance could be due less to management skill than better market conditions.

FICC Reliance

That said, Deutsche Bank still has lower valuations (at 0.2) than other Euro-area banks (at 0.6). One reason for this discount is DB’s reliance on fixed income, currency, and commodities (FICC) profits. Falling market volatility, increased balance sheet charges, higher compliance costs, and electronification of trading have all battered these in recent years. Our measure of FICC market conditions shows a strong correlation with Deutsche’s valuation gap (second chart). On this basis, the best hope for a recovery in the stock price (after resolving legacy issues) would be higher market volatility.

Sell, Sell, Sell

A deeper issue remains, however. If the bank values its assets much higher than Deutsche bank shareholders (as the price-to-book is far below 1), why not just sell those assets to prove shareholders wrong? Therein lies the more interesting dimension to Deutsche’s decline: it could be symptomatic of a broader issue of poor market liquidity conditions. That is, the ability to buy or sell market securities at a reasonable price could be severely curtailed, so perhaps Deutsche cannot easily find buyers for these assets. We could get evidence of this as Deutsche did also announce it will be selling EUR288 bn of assets associated with the businesses it is shrinking. So, any missed deadlines on these liquidations would be a worrying sign.

Slippery Liquidity

Of course, Deutsche is not alone in suffering poor valuations to its book value, so there is a broader banking issue at play. Moreover, last December we saw markets plunge on poor liquidity conditions. And this year, we’ve heard of several asset managers such as Woodford and H20 struggle to offload illiquid assets. So, the illiquidity problem is plaguing more than just banks. What this means is that rather than viewing Deutsche Bank’s woes as a potential European banking problem, it is instead a sign that low market volatility, narrow credit spreads, and booming stock markets are masking a deeper global market liquidity problem. And that does not bode well for when the next downturn or crisis eventually hits.

Chart 1: Bank Valuations Depend on Country’s Interest Rates

Source: Macro Hive, Bloomberg

Chart 2: Deutsche’s Reliance on FICC Hurt by Poor Market Conditions

Source: Macro Hive, Bloomberg