The problems at Deutsche Bank
by John Kay
July 22, 2016
In the years before the global financial crisis, bank CEOs competed like schoolboys to demonstrate that ‘my return on equity is larger than yours’. The display was led by Josef Ackermann, chief executive of Deutsche Bank from 2002 and chairman from 2006 to 2012, who announced a target of 25 per cent return on equity. In 2008, as the global financial crisis broke around him, he proudly announced that this target had been achieved.
Return on equity (RoE) is a ratio of profit to shareholders’ funds, and there are two ways to increase a ratio. You can raise the numerator – the profit – or you can reduce the denominator – the equity capital. Reducing equity is easier. RoE is a seriously misleading measure of profitability. For businesses that are not very capital-intensive – such as asset management, or other professional service firms such as accountants – high returns on equity are achievable because the capital requirement is so small. Capital-intensive businesses – in the modern economy they are principally banks, utilities and resource companies – can achieve high returns on equity only through extreme leverage, as Deutsche Bank did.
Even as the thinly capitalised Deutsche Bank was benefiting from state guarantees of its liabilities, it was buying back its own shares to reduce its capital base. And whatever return on equity was claimed by the financial officers of Deutsche Bank, the shareholder returns told a different, and more enlightening, story: the average annual total return on its shares (in US dollars with dividends re-invested) over the period May 2002 to May 2012 (Ackermann’s tenure as chief executive of the bank) was around minus 2 per cent. RoE is an inappropriate performance metric for any company, but especially for a bank, and it is bizarre that its use should have been championed by people who profess particular expertise in financial and risk management.
The key to a high return on equity is to have little equity in your capital base – to have very high leverage – and Deutsche Bank achieved this to more dramatic effect than any large company in history. At the onset of the global financial crisis equity represented less than 2 per cent of the liabilities of Germany’s largest bank. How could anyone suppose that a trading entity with liabilities twenty, thirty, even fifty times its capital would remain stable, far less be an appropriate repository for the savings of individuals and the credit system of a nation? No other industry operates on such a thin capital base, and no financial institution would lend to a non-financial institution whose finances were so insecure. But Deutsche Bank was thought to be impregnable, like Citigroup and AIG – and, thanks to the German government and European Central Bank, it is. When government stands behind you, it is not necessary to be profitable to be politically and economically powerful – or well placed to provide handsome rewards to senior employees.
The search for high returns on equity, led by Deutsche Bank, encouraged banks to build these very large balance sheets based on positions in FICC. At Deutsche, the pursuit of return on equity produced a balance sheet in which shareholders’ equity amounted to less than 2 per cent of total assets and liabilities – a leverage ratio of over fifty to one. The risk capital available to Deutsche Bank – with shareholders’ equity of €54 billion in 2012 – is not much greater than the funds available to the largest hedge funds. In 2014 Renaissance had funds under management of $38 billion and Paulson $24 billion. (J.P. Morgan and Citigroup, with shareholder funds over $200 billion, are way ahead of any hedge fund, although these banks, like Deutsche Bank, are engaged in many activities other than trading.) But banks with large retail deposit bases have significant competitive advantages in trading, as a result of the size of the collateral they offer and the implicit or explicit government guarantee of their liabilities. The scale of their activities is altogether different – and with it the potential consequences of trading losses.
However this fifty-to-one ratio actually substantially understates the leverage at Deutsche Bank, because derivative contracts create leverage. Suppose that, instead of buying a share for $100, I acquire a widely employed derivative instrument, a contract for difference in respect of that share. Through the CFD I promise to pay you, whenever I close the contract, the difference between the share price and its current value of $100. For all practical purposes this is equivalent to borrowing $100 to buy the share, and the risk management processes of a bank will record an ‘exposure’ of $100. But so long as the share price remains around $100 the accounts will record this contract at its ‘fair value’ – which is zero.
The two global banks with the largest derivatives exposures are J.P. Morgan and Deutsche Bank. The derivatives exposure of J.P. Morgan is around $70,000 billion and of Deutsche Bank €55,000 billion. These figures are, respectively, about one-and-a-half times the total value of all the assets in the USA, and twenty times German national income. But the numbers in the balance sheets of these banks are much lower. Deutsche Bank declares its investment in derivatives at €768 billion: not a small amount, but only a modest fraction of the bank’s exposure.
Credit risk is the supposed purview of regulatory capital requirements. And one response to the global financial crisis has been to require that more derivative contracts be cleared through exchanges. The objective is to enable assets and liabilities with the same counterparty to be offset. This measure is intended to reduce this risk in banks, at the price of creating new risk within the exchanges themselves. But whatever the extent of hedging, the sophistication of risk models and the impact of regulatory supervision, the scale of activity takes the breath away. One-tenth of 1 per cent of €55 trillion is €55 billion, and a loss of that amount would destroy either bank.
Deutsche Bank draws up its primary accounts under IFRS (International Financial Reporting Standards), the European accounting standard.11 Under US GAAP (Generally Accepted Accounting Principles), derivatives disappear almost completely from the balance sheets of American banks. The indefatigable ISDA (which commissioned that legal opinion from Mr Potts) naturally believes GAAP is superior, and has provided data comparing major banks under the two systems. Judged by size of balance sheet as reported in annual accounts, the five largest Western banks are all European, led by France’s BNP Paribas. But if IFRS is used, the top places are taken by Bank of America and J.P. Morgan.
I suspect most readers – and certainly the writer – will simply feel at a loss to cope with these figures. €55,000,000,000,000 is a number beyond comprehension – beyond the comprehension of politicians, regulators or, importantly, the people who run Deutsche Bank. The scale of Deutsche Bank’s everyday activities – deposits of €577 billion, and loans of €397 billion – is itself extraordinary, yet insignificant relative to the bank’s total financial exposure – only 1 per cent of it. The amounts of support that the British and US governments put behind their country’s banking systems – estimated at £3 trillion and $23 trillion respectively – were sufficient to buy all the non-housing assets of these countries, yet far below the potential size of the indebtedness of these banking systems.
To help you grasp the enormity of the figures being discussed I’ll remind you that 1 Light Year == 5.88 Trillion miles, so the figure we’re talking about here is 10 Light Years of Euros.