Deutsche Bank’s $7.2 Billion Deal With DoJ Won’t Dent Its Capital Ratio Figure
Deutsche Bank (NYSE:DB) reached a $7.2-billion settlement in principle with the U.S. Department of Justice (DoJ) over its pre-2008 mortgage-related misgivings late last week – putting an end to the uncertainty that has prevailed around the potential impact of the high-profile lawsuit on the German banking giant over the last couple of years. [1] News about the settlement took center-stage in mid-September, when the DoJ sought $14 billion in fines for the bank’s misrepresentations of mortgage-backed securities (MBS) prior to the economic downturn. [2] The news triggered a sell-off in Deutsche Bank’s shares – sending them to an all-time low of ~$11 by late September – primarily due to the impact of the larger-than-expected fine on the bank’s sub-par capital ratio figure (see Why Deutsche Bank Is Trading At All-Time Lows).
As a part of the settlement, Deutsche Bank will pay the DoJ a civil monetary fine of $3.1 billion and will provide $4.1 billion in customer relief. The customer relief component is in the form of loan modifications and other services to affected homeowners, and will not have any impact on the bank’s income statement. Going by similar settlements by other U.S. banking giants over the years, the fine figure of $3.1 billion should be tax deductible. Because of this, we believe that the overall impact of the $7.2-billion final settlement amount on Deutsche Bank’s capital ratio figure will be minimal.
Deutsche Bank’s settlement with the DoJ marks the removal of a major hurdle in its path to long-term profitability. We continue to believe that the bank’s ongoing large-scale reorganization plan will help it streamline its operations, and maintain a price estimate of $23 for Deutsche Bank’s shares, which is about 25% above the current market price.
See our full analysis for Deutsche Bank
Forced to shrink its securities trading business due to stricter rules, and struggling to integrate Postbank’s operations with its own retail banking operations since 2010, Deutsche Bank has been unable to realize incurred considerable restructuring costs under its long-term reorganization plan (Strategy 2020). This has hurt the bank’s profits for each quarter over recent years – in turn putting pressure on the bank’s capital ratio figure. The bank’s weak capital situation has only been made worse by billions of dollars in legal overhang.
The DoJ’s investigation into Deutsche Bank’s mortgage-backed securities issued before 2008 represented the single biggest legal liability for the bank – especially with the regulator demanding $14 billion to settle the issue in September. [2] Notably, a monetary fine of that magnitude for Deutsche Bank could have pushed the bank’s capital ratio figure below the minimum regulatory requirement. As the bank could only remedy this by issuing new stock, this would have diluted the stake of existing shareholders in the bank – which is why the bank’s share price tanked immediately after news of a $14-billion fine.
But the final fine figure is almost half the original amount. And less than half of the actual fine has a direct implication on the income statement and, hence, on the capital ratio figure. The table below summarizes how Deutsche Bank’s core common equity tier 1 (CET1) capital ratio will be affected by the announced fine of $7.2 billion, as compared to a possible fine of $14 billion (the worst-case scenario). Do note that most of the calculations are in euros – Deutsche Bank’s reporting currency.
We assume here that the bank would have reported a net income figure of €400 million for Q4 2016 without the impact of the fine. As the bank announced that it will incur a pre-tax charge of $1.17 billion (€1.1 billion) because of the monetary fine component of $3.1 billion (€3 billion), we deduce the existing provision figure to be the difference of €1.9 billion. [1]
As detailed above, a settlement figure of $14 billion (with ~45% of this figure being a one-time monetary fine) would result in Deutsche Bank’s CET1 capital ratio falling below 12% at the end of full-year 2016 from almost 12.6% at the end of Q3 2016. But the announced fine figure will drag the CET1 ratio figure down by less than 10 basis points. More importantly, the proposed settlement brings to a close Deutsche Bank’s single biggest legal battle – paving the way for the bank to work through its remaining legal issues and focusing its efforts on generating sustainable profits.
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- Deutsche Bank agrees on settlement in principle with the DoJ regarding RMBS, Deutsche Bank Press Releases, Dec 23 2016 [↩] [↩]
- Deutsche Bank confirms negotiations with DoJ regarding RMBS, Deutsche Bank Press Releases, Sep 16 2016 [↩] [↩]