Deutsche Bank – Is Pulling Out Of The U.S. A Solution? – Deutsche Bank Aktiengesellschaft (NYSE:DB)

AGM provides no real clues to future strategy

DB held its AGM on 23 May but anyone hoping this might be the stage for CEO Sewing to lay out a new strategy after the Commerzbank talks was to be disappointed. His speech contained lots of generalities but few specifics. The only hint of what may be to come was his comment about the CIB investment banking division that “we’re prepared to make tough cutbacks”. He also stated “we will further tighten our capital allocation and implement our hurdle rates rigorously”.

There’s an increasing volume of press speculation about big cutbacks to the US investment bank (for example this article by Reuters).

Would this be a solution?

DB’s US balance sheet is large

The first point to make is that DB’s US balance sheet is large. The US holding company that encompasses the investment bank (DB USA Corporation) has total assets of $133bn. In addition to this, DB has a further $213bn of assets in its two New York branches, mainly commercial loans. In sum, that’s about 30% of DB’s entire asset base (currently $1.2tn on a net derivative basis).

A full exit from the US is pretty much unimaginable and CEO Sewing did say in his AGM speech that he wants to maintain a strong presence there.

But what about focussed cuts to the investment bank?

In some respects the US investment bank seems an odd place to start when thinking about restructuring. Its recent performance has actually been pretty good with US Federal Reserve data showing that DB USA Corp made a $524m net profit in 2018 and $254m net profit in 1Q19. That puts its return on equity at 6% in 2018 and 11% in 1Q19.

That’s actually a much better performance than the rest of DB’s investment bank, which posted ROE of only 0.9% in 2018 and -0.6% in 1Q19. In fact, when put alongside DB’s other divisions (Private & Commercial Bank and Asset Management), DB USA Corp was the second most profitable after Asset Management for both 2018 and 1Q19. Without the US business, CIB’s overall performance would be worse, with ROE for the non-US businesses being negative in both 2018 and 1Q19.

Source: company report & accounts, FRY-9C Fed filings

On the face of it the UK, the other big centre of DB’s investment bank, seems a more logical place to start cutting back. DB’s geographical P&L disclosures show that its UK operations lost €872m pre-tax in 2018 and €354m in 2017.

Deutsche Bank - Is Pulling Out Of The U.S. A Solution? - Deutsche Bank Aktiengesellschaft (NYSE:DB)

Source: company report & accounts

If not profits, what other reasons are there for cutting back in the US?

All of the above would suggest that cutting back the US investment bank is more likely to worsen than improve DB’s overall profitability position. So what other benefits are there?

One consideration is that DB USA Corp’s return to profitability is a recent phenomenon. If we open the window a bit wider we see the unit lost $1.1bn in 2017 and $0.6bn in 2016. Largely this was due to litigation expenses, which were $1.3bn in 2016 and $0.4bn in 2017.

Deutsche Bank - Is Pulling Out Of The U.S. A Solution? - Deutsche Bank Aktiengesellschaft (NYSE:DB)

Source: company report & accounts, FRY-9C Fed filings

Litigation is probably a big and valid reason why DB might want to cull the US even if the business is currently profitable: most of the expensive legal cases of recent years have originated there and even if the litigation horizon looks relatively clear at the moment, that could easily change. DB may just not want to take the chance of having another RMBS-style scandal (which cost $7.2bn to settle in 2017).

The fact that DB has failed successive Federal Reserve CCAR stress tests also implies there are still big deficiencies in its compliance and control functions in the US. A commitment to downsize the business probably wouldn’t hurt its chances of passing the 2019 test.

US regulators force DB to substantially overcapitalise its US operations

But my guess is this is mostly about capital. Partly because of the control deficiencies in DB’s US business, US regulators have demanded that ever more capital be “parked” there and they have limited the amount of profit upstreaming DB can undertake from its US entities to the parent company. Consequently, any profits DB makes in the US basically can’t be used to pay dividends or to fund growth in other parts of the group.

As the next chart shows, DB USA Corp had a core tier 1 regulatory capital ratio of 25% in 1Q19, almost double the level of DB Group (13.7%).

Deutsche Bank - Is Pulling Out Of The U.S. A Solution? - Deutsche Bank Aktiengesellschaft (NYSE:DB)

Source: company report & accounts, FRY-9C Fed filings

Is releasing capital from the US of benefit to DB shareholders?

This is a hard question to answer since it depends partly on the stance of US regulators. If DB cuts even more balance sheet in the US and further de-risks the business, would it be allowed to extricate the freed-up capital or might US regulators demand it remains there? The experience of the last few years is sobering on this question: over the period 2016 to 1Q19 risk-weighted assets in DB USA Corp have already fallen by 23% but the amount of capital held in the business has actually increased by 26%.

There is a risk that exiting parts of the US investment bank just sees a reduction in profits without an offsetting freeing up of capital.

Even if capital can be extracted and if (a big if) DB decided to return it to shareholders, would they be better off?

Again, there’s no black and white answer. Hypothetically, if DB took 30% of the capital of DB USA Corp and returned it to shareholders it could be worth ~€0.9 per share or 15% of the current share price (the difference between valuing it at 1x and valuing it at DB’s current P/TNAV multiple of 0.25x).

Deutsche Bank - Is Pulling Out Of The U.S. A Solution? - Deutsche Bank Aktiengesellschaft (NYSE:DB)But there’s a cost in terms of foregone profits that would knock about 1% off DB’s ROE, based on the 1Q19 data. It’s perfectly plausible that the value of the freed-up capital would be lost in a further contraction of DB’s P/TNAV multiple to reflect the group’s lowered ROE and the reduced profitability of the remaining CIB business.

Conclusions

There are no easy options for DB, not least because it lacks a profitable core business it can shrink back to.

Cutting the US investment banking business answers investors’ call for action. But it looks a double-edged move. On the one hand it could free up capital and probably lower DB’s exposure to future litigation risk.

But it comes at the cost of foregoing a stream of income that currently looks more profitable than the group average. It would lower both group ROE and the ROE of DB’s remaining investment banking activities.

This suggests any share price upside from revaluing the capital released from the US could well be lost through a further contraction of DB’s valuation multiple.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.