Deutsche Bank’s Plan To Cut 3,400 Trading Clients Will Hurt Revenues, But Should Improve Capital Condition In The Long Run
Deutsche Bank (NYSE:DB) has discontinued debt and equity trading services to as many as 3,400 of its trading clients, in what is the latest attempt by the German banking giant to improve margins for its investment banking business while also chipping away at its balance sheet. [1] The bank concluded that it was “not strategically viable” to serve these clients, as the revenues generated from them were not sufficient to cover the overall costs incurred – especially since trading assets tie up a considerable amount of the bank’s capital.
Deutsche Bank has been under considerable pressure from investors as well as regulators over recent months for lagging its peers in terms of meeting regulatory capital requirements. At the same time, costs related to its long-term reorganization plan (Strategy 2020) have also eroded profits. The situation is only made worse by the fact that the bank is expected to incur billions of dollars in settlement costs from its outstanding legal issues. These factors have put Deutsche Bank in a precarious situation when it comes to maintaining minimum capital ratios. Unless the bank can quickly improve its profits and reduce its risk-weighed assets (RWAs), it might have to issue more shares to make up for the shortfall – a bad option for the bank as its shares are currently trading near all-time lows. Although the announced plan to cut 3,400 clients will hurt revenues in the short run, overall profit margins should improve soon. Additionally, the move should help the bank slash some of its trading-related RWAs in the near future.
We believe that Deutsche Bank is on the right track in terms of addressing its profitability and capital concerns, and stick to our price estimate of $25 for Deutsche Bank’s shares. Although this price target is significantly ahead of the current market price, we believe some of the bank’s problems are somewhat overblown (see Why Deutsche Bank Is Trading At All-Time Lows).
See our full analysis for Deutsche Bank
The investment banking industry has seen a major upheaval across the globe since the economic downturn of 2008, as stricter regulatory requirements forced many major players to revamp their investment banking division. Restrictions on proprietary trading, higher capital requirements and limits on investments in private equity and hedge funds resulted in most of the banks reducing their trading arm to a fraction of their pre-2008 size. However, Deutsche Bank initially resisted this change, and did not lay out any major changes to its investment banking operations as a part of its long-term reorganization plan Strategy 2015+ in late 2012 (see A Detailed Look At Deutsche Bank’s New Reorganization Plan ‘Strategy 2020’).
But declining profits and increasing capital costs forced the bank to announce a series of measures to refocus its investment banking divisions as a part of its Strategy 2020 last April (see Deutsche Bank Set For Complete Shake-up As Part Of ‘Strategy 2015+’). This included a reduction in balance sheet of the investment banking division by €200 billion, redeployment of €50-70 billion worth of existing assets towards client-focused operations, discontinuation of its prime brokerage offerings for hedge funds, and also the closure of its low-profit trading units. These measures, coupled with strong trading revenues over recent quarters, have resulted in a noticeable improvement in operating margins for Deutsche Bank’s investment banking division, even though the actual margin figure has suffered over recent years due to litigation and restructuring costs.
But as Deutsche Bank grapples with the issue of maintaining its capital ratio figures in light of heavy settlement costs it is likely to incur in the near future, it makes sense for it to find ways to shrink its balance sheet further. As this, in turn, will reduce the minimum level of capital it needs to hold under the Basel III norms, the bank may be able to avoid the severely dilutive option raising capital through the issuance of fresh shares. The recently announced decision to discontinue services to 3,400 smaller clients appears to be one of several steps Deutsche Bank can take to reduce its asset base in a fairly short period without adversely affecting overall profits. The most direct impact of this move is expected to be in the form of lower FICC (fixed income, currencies and commodities) trading assets for the bank in the near future. You can see how a reduction in FICC trading assets affects our estimate for the bank’s share price by making changes to the chart below.
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- Deutsche Bank to Cut Off Around 3,400 Clients, The Wall Street Journal, Dec 3 2016 [↩]