Deutsche Bank Case

Deutsche Bank made its entrance into the world in 1870 and it was one of the first banks to adopt universal banking as it promoted and facilitated trade relations between Germany and other overseas markets. Deutsche Bank acquired smaller banks in Germany in order to be the most prominent bank in their home base in addition to having a global reach. Following World War I, inflation took over Germany causing many borrowers to default on their loans forcing the bank to sell most of its assets in order to stay alive (however that diminished their global presence). The bank’s involvement during World War II with the transferring of the Jewish customers holdings to the German Government led to the Allied forces disbanding the bank into 10 different banks. Before Deutsche bank separated; they were focused on traditional banking that operated in commercial and retail banking. Ten years later through mergers of former parts of the bank, Deutsche Bank was reestablished. By 1958 the bank began to gain its foothold in the global market again by acquiring major banks in Italy, Spain, the United Kingdom, and the United States.

By 2001 Deutsche was present in 70 countries and listed on the NYSE. In addition, to becoming a global bank again, they had shifted their business focus from traditional retail banking toward global investment banking. The goal was to become a “one-stop shop”, that way a customer can come to the bank for all their financial needs. The reasoning behind their strategy was good because this way they are expanding into new markets, making Deutsche Bank an option for more customers, and also providing more services to existing customers. The shift into investment banking led to extreme growth that required increased leverage to cover its costs and came with a great degree of risk. The debt Deutsche Bank took on allowed them to generate greater profits, but also left them financially stressed with the introduction of the Basel III requirements. Banks make money by charging fees and commissions on services they provide to customers while also using deposits and borrowed money to invest in project that have a higher rate of return than what they are paying out.

That includes charging higher interest rates on loans than the interest payments they pay on deposits held. An investment bank underwrites securities for individuals, corporations or governments, in order to help them raise capital. It also assists companies with mergers and acquisitions. Investment banks contain a sales and trading division as well. This is where the bank acts as an intermediary between customers and traders. The sales people contact clients and coordinate with the traders who decide what position to take and then they complete the transaction for the clients. The best ways to characterize a bank are based on the business segments they operate in and how large of a clientele scope they have. For instance, do they operate regionally or globally and are they involved in investment banking, commercial and retail banking, or both. Deutsche Bank would be characterized as a global bank that engages in both commercial and investment banking.

Because of Deutsche Bank’s large scope and diversified business segments, they are able to service more clients around the world. Deutsche Bank is also considered a systemically important financial institution (SIFI), meaning that its collapse would pose a serious risk to the economy. Deutsche Bank revolutionized the way they did business between 2002 and 2012. It increased its total revenue by $4,881 or approximately 18% between those ten years. By 2002 a significant portion of its revenues came from investment banking activities with its peak in 2007. In 2002, the percentage of revenue from investment banking was 52% and by 2012 it was 56% (peaking in 2007 with 62%). On the other hand commercial banking also increased during this time period from 22% to 32% in 2012. Asset management activity related revenue is the only one that decreased during this time period from 14% to 11%.

In the prior ten years, the bank significantly increased their investment banking assets from EUR640 billion to EUR1,860 billion. In order to fund the increasing asset growth between 2002-2007 Deutsche Bank increased their leverage by a significant amount. In 2002 they had the highest leverage among their industry peers with 33.3x, while BNP Paribas followed close behind with 30.9x. In 2007 Deutsche Bank increased their leverage to 71.3x blowing their peers out of the water with the closest being Barclays with 45.9x. After the financial crisis hit, Deutsche bank had to decrease their leverage to 44.1x but still higher than any other peer.

From 2002 to 2007 the bank had an 83% annual growth rate, but those increased profits did not come from productive assets, but simply just a result of increased leverage as seen when comparing Deutsche Bank’s ROA v. ROE. The bank consistently had an exponentially high ROE when the economy was doing well and led to a significant loss when the economy was in a recession in 2008. ROA stayed below .5% and above -.18% during those 10 years even when ROE reached a high of 26.72% and a low of -12.91%. ROA did not rise the way ROE did because increased debt has the potential to lower revenues as more money is spent servicing that enormous debt and if net income falls due to increased expense ROA declines but ROE can still rise as it does not effect shareholder equity.

The leverage did allow for large financial gains but did cause significant risk as seen in 2008. When compared to JP Morgan Chase, you can see that they had a higher ROA over the years as it was between a low of .25% and a high of 1.13%. This difference is seen because JP Morgan was only levered at most at 20.2x and decreased their leverage to 17.6x in 2007 and 15.1x in 2011. By being less levered they had greater ROAs but less exponential growth and loss in ROE.

With the 2009 European sovereign debt crisis and the U.S. recession, global banks were nowhere close their pre-crisis profitability and investment banking business volumes had spiraled downhill. With such an economic environment the Basel Committee approved Basel III, which increased the minimum Tier 1 equity capital requirement from 4% of risk-weighted assets to between 9.5% and 13.5%. By July 2012 the bank had a core Tier 1 ratio of 10.2% and a total Tier 1 ratio of 13.6% with ratios based on the Basel II rules. In 2013 with Basel III ratios, management projected a core Tier 1 ratio of 7.2%, which reaches the 2013 requirements but is far from the 9.5$ requirement Deutsche Bank would have to meet by 2019. With the new adjusted risk weights assigned to various assets and the heightened capital requirements, Deutsche Bank’s already high leverage is even more exaggerated under Basel III, causing their Tier 1 capital ratio to drop 3%. Since Deutsche Bank is present in over 70 countries; their global presence allows them to abide to regulations in the countries that they choose to conduct business in.

As a result, they will follow regulations that are less demanding of their capital and allows them to operate more freely. With the globalization of regulations Deutsche Bank will no longer have the option to pick and choose which countries laws they will follow because all markets will be under the same rules. This will lead to less risky activities taken on by Deutsche Bank as the global regulations will work to combat that. Even under such an economic environment the financial outlook for Deutsche Bank looks bright as many of their competitors were forced out of the market at this time. Meanwhile, Deutsche bank is increasing its market share by acquiring banks such as Postbank, and gaining the largest market share in U.S fixed income trading by beating out JP Morgan for the top spot. The bank also has a top-five market share in U.S, EMEA, and Asia-pacific Debt Capital Markets transactions. With such market-leading positions Deutsche Bank is seen as a top future prospect for investment banking activities once they begin to pick up again.

With a P/E ratio of 8.2x its trailing 12-month earnings and a P/TB ratio of .60x its tangible book value per share, the value of the bank comes to EUR24.93 (8.2 x 3.04) and EUR24.96 (.60x 41.60) respectively. I value Deutsche Bank at EUR25, which is higher that the stock price as of June 30, 2012 (EUR24.85), showing an undervaluation by the market. The risk and leverage that Deutsche Bank carries makes it a liability to hold, but with top market shares globally and a new leadership with high expectations the growth of the company will only continue as the economic environment worldwide improves. By acquiring Postbank, Deutsche Bank is able to expand the company’s strong position in the German market, take a leading position in the European retail banking business, and significantly enhance the bank’s revenue mix. Postbank’s deposit base would offer a solid funding base for Deutsche Bank.

This will also help Deutsche Bank to increase its equity making it easier for them to meet the Basel III requirements. The risk that Deutsche Bank runs in acquiring Postbank is that they buy into all of the banks assets and liabilities together. Any bad loans or debts that Postbank has will then be Deutsche Bank’s. Leveraging 33.3x means the ratio of total assets to tier 1 capital is 33.3:1; meaning there is a large amount of debt compared to equity. Leverage amplifies gains and losses meaning that the results will be 33.3 times more than it would be without leverage. Deutsche bank should continue to lower their leverage. They have a few options in doing so; they can either shed more assets or increase its equity base through retained earnings or raising capital. I think it is important for the bank to do both options, therefore minimizing the effect of solely taking on one approach. This way the bank will not have to lose a lot of their assets (still keeping their size large) and wont dilute the earnings per share by issuing too much new equity capital.