An interesting article appeared
in Deutsche Welle on July 28 on the European banks amid the upcoming European stress
tests, as well as the future of Italian banks. The article focused particularly
on Deutsche bank since the IMF recently commented that the bank is the most
dangerous because of all the systemic risk it has acquired from derivative
financial instruments and to the international banking system.
In looking at the consolidated
financial statements for 2015, its net loss was at -6,772 billion euros (from 1,691
billion profit in year 2014), while the earnings per share for 2015 was -5.06
euros, compared to 1.34 euros for 2014. From the key risk metrics, I noticed
that the internal capital adequacy ratio from 174% in 2014 dropped to 146%.
Capital adequacy ratio (CAR)
is a measure of the bank’s capital and is expressed as a percentage of the bank’s
risk weighted credit exposure. This is used to protect depositors and promote
stability in the banking system around the world. This ratio measures tier 1
which absorbs losses without requiring the bank to stop trading, and tier 2
(selling all the assets in the business, pay off creditors, and distribute the
remaining to the principal partners). The formula to calculate it is CAR = tier
1 capital + tier 2 capital / risk weighted assets.
Minimum capital requirements
are essential to make sure that banks have enough capital to sustain losses. If
a bank is declared insolvent this would shake up the credibility of the banking
system, as it did in the case of the Italian banks. The article compares
Deutsche bank to Lehman due to the large number of derivatives contracts.
Derivatives are financial
products that are used to hedge against currency exposure or interest rate
fluctuations, and the article mentions that the bank has a massive trade in
derivatives. In looking at the consolidated balance sheet for Deutsche bank, on
the liabilities side I notice that trading liabilities are worth 52.3 billion
euros (2015) from 41.8 billion, and financial liabilities designated at fair value
of profit or loss at 44.8 billion versus 37.13 billion in fiscal 2014.
The sums of derivatives are
calculated by adding together the values of all derivatives contracts even if
some cancel each other out (zero sum game). An example is interest rate swaps.
A swap is an agreement between two parties to exchange a set of cash flows in
the future for the same amount. Party A might agree to pay a fixed rate of
interest on say $100,000 each year for the next five years. Party B will pay a
floating rate of interest on the same amount of $100,000. The parties come
together and agree to swap the cash flows of an instrument that may be debt
(interest payments) or to the value of a foreign currency.
This exposure inherits risk
to say the bank, because it is the same risk that the two counterparties are
trying to protect themselves from. So the bank has two problems: managing a
portfolio of swaps, and second, price them so that it can make a profit.
So if one investor buys a
contract to hedge against a rising interest rates, and the other takes the
opposite position, for the same amounts, then the risk is zero. Another risk is
when the counterparty to the deal defaults on the obligation and is unable to
deliver on his side of the deal.
Today derivatives are more
strictly regulated and that is why banks are required to set aside much higher
capital requirements. Deutsche bank failed the stress tests in the US, and the
upcoming European stress tests are for July 29. Whether it passes the tests
will depend on how well it managed its credit policy. For example, credit
policy in Germany may have been too strict compared to that of their Italian
counterparts.
Italian banks lack capital
and recently there has been worries about bailing out Italian banks with taxpayers’
money. Although this is prohibited by the EU laws, a waiver to the rule may be
granted. Italy’s third largest bank by assets, Monte dei Paschi di Siena has
been on the eye of the cyclone. The retail and investment bank had, according
to the balance sheet I looked up, total assets of 169 billion euros (fiscal December
2015) from 179 billion in fiscal 2014.
Loans to customers, and specifically,
mortgages, from 55.3 billion euros in fiscal 2014 to 52.4 billion in fiscal
2015. Total customer loans section is interesting since it points out the non-performing
loans. Non – performing loans in 2014 were 23 billion euros (rounding off) to
24 billion in 2015. Doubtful loans increased from 8.4 billion in 2014 to 9.7
billion in 2015. Unlikely to pay increased from 11.6 billion euros in 2014 to
12.3 billion euros in 2015. Performing loans in 2014 were 96.5 billion euros
and 2015 they were 87.2 billion euros.
From the consolidate report
of operations I am quoting the following: “On 25 November 2015 the ECB sent the
Bank the results of the Supervisory Review and Evaluation Process (SREP), based
on which the Group was asked to reach as of 31 December 2016 and maintain in
the long term a minimum limit, based on transitional measures, in the Common
Equity Tier 1 Ratio of 10.75%. Until that date, the CET1 to be met remains at
10.2%, as communicated on 10 February 2015 “.
Tier 1 common equity capital
in 2015 was 9.1 billion euros compared to 6.4 billion in 2014. The annual
report also shows common equity tier 1. This is a measure of the bank’s core
equity capital compared to its total risk weighted assets, a measure of the
bank’s financial strength. It excludes preferred stock. Risk weighted assets includes
all assets the bank holds and weighted accordingly for credit risk. For example
cash has zero risk, it is much like the assets included in the balance sheet,
which are listed in decreasing liquidity. Percentage wise, tier 1 ratio is
12.8% in 2015 compared to 8.5% in 2014.
As far as Deutsche bank,
according to the chief economist, his assessment is that the bank would not
need tax payers money or face bankruptcy, and estimates that a restructuring
would take place, even breaking up the business of the bank.
Bill T. Alexandratos, MSc., BA
Finance
