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The Long Read: The real time bomb in Deutsche Bank's assets is the amount of derivatives

by Antonella Olivieri

24 Exclusive content for IT24

Be it “in” or “out,” when the “bail” comes knocking it means that the bank is already burning. And when shareholders and bondholders (the people who trusted the bank by investing their money) are left alone to cope with the damages, we can't expect the market to choose national interest over business interest, which demands to take to your heels when you smell smoke.

And when it happens, stock prices plummet (like what we’ve seen since the beginning of this year, with the introduction of the bail-in), distrust grows (and trust is the basis of credit) and there is a general alert among account holders who, next in line after the market, are called on to pay the bill (if they have more than the secured €100,000). But, whatever the investor's nature, we can't deny that the stock exchange got it right.

Excluding Italian banks – dealing with the large amount of non performing loans, but adequately covered by capital and guarantees – Deutsche Bank is the worst stock in the Eurozone in the Stoxx 600 index. The week of February 8, before a bounce on the 12th, Deutsche Bank was losing almost 40% compared to the beginning of this year, and not by chance.

When we look at balance sheets (we are talking about the data on the main European banks, collected by R&S-Mediobanca and updated to the first half of 2015), the German bank's problem is not liquidity (the lack of which, as demonstrated by Lehman, is the harbinger of failure).

At the end of 2015, the Frankfurt-based bank had €215 billion of liquid assets and it used €5 billion to buy back its bonds; by doing so Deutsche Bank has demonstrated that the rumors about its difficulties in paying coupons were unfounded. And if it wasn't enough to fix the situation, at the moment it helped raise the stock price.

But the real time bomb in Deutsche Bank's assets is the amount of derivatives that – according to the data for the first half of 2015 – despite the recent decrease is still equal to €543.3 billion and represents one third of the total assets. We are not back to the 19 times peak reached in 2012, before the 2014 recapitalization injected €8.5 billion of fresh assets, but today derivatives are worth 9 times the tangible net worth of the bank. No one else within the Eurozone is as much exposed.

In order to make a comparison we can consider Intesa-Sanpaolo, which is at the lowest level (among the 21 ”giants” of continental credit according to R&S) with derivatives worth 1 times the value of tangible net worth, while UniCredit is at 1.8.

It could be that the use of assets for activities other than traditional credit is due to the pursuit of a greater profitability (in 2012, Deutsche's ROE was 0.4%, and it grew up to 3.6% around mid-2015), but the risks become higher.

Deutsche Bank is the only “big player” in the Eurozone having in risk weighted assets (the regulatory capital ratio) a credit risk limited to 61.3% (against the continental average 81.5% of the two main Italian banks), with 14.8% of RWA represented by the market risk: more than twice the 6.8% average (including British and Swiss banks) and almost three times the percentage for the two main Italian banks (5.3%).

What's the matter then? Considering the never-ending changes of market, it's hard never to lose.

Well, in the case of Deutsche Bank a 15.5% loss on the derivatives stock would be enough to completely wipe out net capital (€75.4 billion) and subordinated bonds (€8.5 billion). The same situation that Italy’s tiny Banca Etruria and its other rescued bedfellows confronted after lowering non performing loans' worth by more than 80%.

But generally speaking, the risk is the financial leverage which is higher than the average (tangible assets equal to 21.3 times the tangible net capital) not only for German banks (28 times Deutsche Bank and 23.6 times Commerzbank), but also for French ones (above 28 times both SocGen and Bnp). And for Deutsche, SocGen and Bnp the result would be the same: a 5% loss on the total assets (including intangible assets) would wipe out both capital and subordinated debt.

Also Bnp has a significant derivatives stock (€559.6 billion), but owning assets for €92.1 billion and €14.6 billion of subordinated debt it can handle a 19.1% loss on derivatives before reducing its capital to zero. What distinguishes French banks in the continental picture is mostly the inclination to invest on non-liquid bonds that in the four French banks considered (Bnp, Crédit Agricole, Bpce, SocGen) has increased by 30% compared to 2012.

The numbers on the table are more limited if compared to the derivatives' issue: Bnp, the French bank with the highest level of derivatives (€28.7 billion, 1.2% of total assets) reaches 35.1% of the tangible net capital, while Deutsche Bank (€31.3 billion, 1.8% of total assets) is at 51.3%, the highest level within the Eurozone.

And if hiding the dust under the carpet is not possible anymore, it is obvious that the whole system is in big trouble. Maybe, before transferring the bill to the market, it would be better to figure out how to pay it.