…As debt securities show resilience
Debt markets, however, remain unfazed by the turbulence. As at 31 March, the bank’s common equity tier one (CET1) capital ratio was robust, at 13.7% – that’s well above 10.65%, the minimum requirement set by European Central Bank for 2018. The hard constraint for Deutsche Bank, therefore, is not the amount of capital it has, but rather its leverage exposure and the pot of distributable reserves it uses to pay the coupon on its Additional Tier 1 (AT1) bonds.
AT1 bonds – also known as contingent convertible bonds, or CoCos – are considered to be the riskiest form of debt that banks can issue: they provide capital when a lender needs it most and are converted into equity when their capital level falls below a certain threshold.
Deutsche Bank’s fully loaded leverage ratio is modest, at 3.7%. Therefore, we believe that its additional distributable items (ADI), which determine the payment of AT1 coupons, should command greater attention from investors because they amount to just €1.2bn. Notably, ADI is calculated in accordance with Germany’s GAAP law for statutory accounting and reporting requirements, which is extremely rigid. Deutsche Bank’s ADI – in absolute terms and as a percentage of the subordinated coupon payments – ranks below that of its European peers.
Moreover, this low level of ADI reduces the amount of restructuring costs that Deutsche Bank can absorb in any given year, thereby diminishing the level of change. However, given the vagaries of 2016 – when the US Department of Justice threatened the bank with a $14bn fine to settle an investigation into selling US residential mortgage-backed securities – management will need to tread cautiously. Otherwise, fears that reserves for paying AT1 coupons would fall short due to low ADI could arise, which in turn would weigh on the bank’s stock price, causing funding costs to increase and raising questions about the bank’s stability.
ADI ‘breathing space’
Perhaps these fears may never come to pass. Once Deutsche Bank integrates Postbank, the retail unit it had planned to sell in order to raise capital before March 2018, its ADI reserves could increase and no longer be the lender’s Achilles heel.
Although the benefit has yet to be quantified, Deutsche Bank could move the reserves for general banking risk from Postbank, which stood at €2.23bn at 31 December 2017, to its own ADI pot – a possibility recently flagged by Chief Financial Officer James von Moltke. This would subsequently provide the bank with the breathing space it needs, thereby reducing the cost of issuing new AT1 debt.
Moreover, the European Union has tabled a proposal to standardise the definitions of ADI – and the requirements for calculating them. Such proposals, if adopted, would increase both the amount and fungibility of Deutsche Bank’s reserves, potentially providing further relief.