This article is an extract from Platinum Asset Management's September 2016 quarterly review
Bank's fail because they are 1) illiquid 2) insolvent or 3) both.
Deutsche Bank does not have a liquidity problem. They hold EUR 200bn of highly liquid assets (12.5% of the balance sheet) which are enough to withstand a serious bank run. But ultimately is doesn't matter, because the ECB can and will provide unlimited liquidity support to the bank, if needed.
The solvency question in more nuanced. Normally banks become insolvent because they can't recover money from borrowers or counterparties, they don't have as many assets as they thought. But the value of Deutsche bank's asset isn't being questioned. Rather, its the value of their liabilities that has the market in a spin.
According to its latest disclosure Deutsche Bank faces 14 sets of legal actions. These are contingent liabilities because Deutsche only has to pay if it loses a case. Both the probability of losing those cases and the amount they would have to pay are unknown today. Deutsche makes an estimate and has set aside EUR 5.5bn for these contingencies. It recently emerged that the US Dept of Justice (DOJ) has offered to settle the largest of these actions for EUR 13bn.
Of the EUR 5.5bn Deutsche has provisioned for these contingent liabilties, EUR 3.5bn is thought to be ear-marked for this particular case. This leaves Deutsche Bank EUR 9bn short. It also raises the question of whether the EUR 2bn of reserves set aside for the remaining 13 cases is sufficient or if more will be needed.
Answsers are not forthcoming, most likely because they are unknowable. Remember, this is a proposed settlement, not a penalty awarded by a court. And the DOJ has a history of 'high balling' and then negotiating down. For example Goldman Sachs was hit with a similar figure and ultimately settled for US $5bn. EUR 9bn is therefore a worst case scenario.
Against this EUR 9bn claim and 13 other outstanding cases, Deutsche Bank has EUR 120bn of loss absorbing capital and, under basic assumptions, around EUR 4bn in annual earnings. There is simply no reasonable chance that these litigation costs will cause a loss to the bank's depositors, clients or counterparties, let alone trigger a systemic crisis.
It is possible, however, that shareholders and the holders of some equity-like instruments may end up taking a hit. This relates to a second problem. While Deutsche meets its capital requirements today, the required level of capital will ratchet up each year until 2019, its a moving target. By the end of 2019 the bank will need EUR 49bn of capital, and it currently has EUR 43.5bn. This leaves a EUR 5.5bn shortfall that has to be progressively closed over three and a half years.
There are a lot of moving parts. They may end up settling for well under EUR 13bn with the DOJ. But equally, earnings are volatile in this business and may end up being significantly lower than EUR 4bn. There is little in the way of a margin of safety, particularly where fear-driven clients choose to close accounts or cut relationships because of bad press.
However this is reflected in the stock price. The shares are curently trading at roughly a 75% discount to book value. This indicates that the market is pricing in a reasonably high likelihood of a dilutive capital raising.
Holders of some hybrid instruments are at risk if the bank's capital falls below a certain trigger level, which would trigger the automatic conversion of these bonds into equity. This seems unlikely under current circumstances as it is hard to see how the issues described above would erode capital so much as to trigger a conversion. However they are now vulnerable should the bank experience a second or third unexpected shock.