The Fed’s $157M Fine For Deutsche Bank May Lead To The Bank Failing This Year’s Stress Test

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Late last week, the Federal Reserve announced its decision to hand out a total of $156.6 million in fines to Deutsche Bank (NYSE:DB) as a part of two enforcement actions. [1] Notably, one of the enforcement actions was linked to the bank’s failure to prevent proprietary trading activity by its employees – making this the first major action by a U.S. regulator against a bank for failure to comply with the Volcker Rule.

Now, the Fed highlights the fact that both enforcement actions against Deutsche Bank stem from a lack of adequate internal control policies at the bank. It should be noted that this was a key factor behind the Fed’s decision to reject Deutsche Bank’s capital return plan for 2016 last June (see Lots Of Winners In The Fed’s 2016 Stress Test, But Deutsche Bank, Santander Stumble Again). With the enforcement actions bringing this issue back in the spotlight this year, it looks like Deutsche Bank will also fail the Fed’s stress test in 2017 on qualitative grounds.

Deutsche Bank has been struggling to clean up its operations over recent years, even as it works its way through a significant legal backlog. The Fed’s latest fines indicate that the bank still has a lot to do to get its house in order. If the bank is not able to fix its deficiencies quickly, it may be subject to similar fines from regulators around the world in the future – something that presents a sizable downside risk to our $18 price estimate for Deutsche Bank’s stock.

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See our full analysis for Deutsche Bank

Deutsche Bank’s path to recovery since the economic downturn of 2008 has been much more difficult than that of most other global banking giants – especially its U.S.-based peers – because the bank draws a bulk of its revenues from Europe. As Europe has seen economic conditions return to normal at a much slower pace than the U.S., this had a direct impact on Deutsche Bank’s results over the years. In addition to poor operating results, the bank has also had to contend with a long list of legacy legal issues, while stricter regulatory requirements forced it to shore up its balance sheet. The bank’s ongoing struggle to transform its business model is no secret, with its latest large-scale reorganization plan being revealed in March (see Understanding The Impact Of Deutsche Bank’s New Reorganization Plan On Its Long-Term Value).

While we believe that Deutsche Bank is certainly on the path to recovery, one notable stumbling block remains its relatively weak oversight and internal controls framework. The Federal Reserve has flagged a lack of adequate controls in the bank’s U.S. subsidiary in each of the last two stress tests, and judging by the regulator’s latest action, things still appear far from perfect. Deutsche Bank was fined $136.9 million fine because its forex traders used electronic chat rooms to reveal their trades to competitors – a practice that cost many major banking giants billions of dollars in settlements as it led to forex rate rigging by these banks. The Fed imposed an additional $19.7 million fine as the bank failed to identify proprietary trades carried out by employees that are prohibited under the Volcker rule.

As the fines were announced before Deutsche Bank reported its results for Q1 (scheduled for April 27th), the bank will incur a one-time increase in operating expenses for the first three months of the year – dragging down operating expenses for the quarter. Although the impact of this fine will be marginal, the real issue would be if Deutsche Bank is not able to fix its inadequate internal controls soon. Failure to remedy things in a timely manner could result in more such compliance and legal costs in the future, which could hurt earnings considerably going forward.

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Notes:
  1. Federal Reserve announces two enforcement actions against Deutsche Bank AG that will require bank to pay a combined $156.6 million in civil money penalties, Federal Reserve Press Releases, Apr 20 2017 []