Sunday, June 16, 2013

Deutsche Bank: A Bogus Slight or Just Slightly Bogus??

Reuter's reported FDIC Vice-Chairman Hoenig's hyperbole regarding Deutsche Bank's seemingly poor capital position. This caused ZeroHedge, the BĂȘte Noire of detached objectivity, to lavishly hyperventilate on the same without considered thought - with both  sufficiently retweeted to insure some nervous-nellies will be shorting DB stock or buying DB CDS protection, without delay.

I am no apologist for banks, least not for German Banks, who've rarely missed an opportunity to miss join a crisis. That said, I do reckon that these presumed obscene numbers and ratios are an artifact of their securities financing business (including liquid markets delta-one and all manner of back-to-back swaps as it is for MS, UBS, and CA). All such undertakings cause a balance-sheet gross up of assets, but take no account of margin or collateral that is the equivalent of (if not superior to) bank equity in regards to financed assets.

Consider, for example, if a DB customer deposits $100 at DB, and borrows a further $600 from DB to buy a total of $700 of bonds. DB's core equity is unchanged, but both the assets and liabilities on their balance sheet have increased. But the $100 of equity the client has deposited/pledged/posted is, to the bank, the equivalent (and I'd argue superior to)  $100 of core equity because under the terms of the loan, it is "first loss", where the bank maintains strict covenants over the type of collateral, minimum required margin in the acct, rights to liquidate under certain conditions, and so forth. So before the bank loses a penny, the margin must completely evaporate. In practice, demands for additional margin/collateral are issued as soon as agreed thresholds are perforated. Failure to perform triggers a liquidation of positions by the bank, NOT to the detriment of the bank, but to their customer who bears the equity-like risk of the positions. Moreover, it's contiunously marked-to-market, in contrast to a traditional bank loan that is typically unsecured and unmargined initially, slow-moving to reprice, not subject to variation margin, and difficult to call-in or on-sell.

But for all such securities companies who finance positions similarly, this equity/collateral of the client, this equity-like buffer upon which they lend against the entirety customers' position, doesn’t show up on THEIR balance sheet as equity, but rather as a liability, offset by the investment assets held on their clients behalf. No matter that, under the example above, the capital ratio is > than 15% with all the covenant cards proverbially-stacked in their favour. So, a 2% tier-1 to assets ratio is a rather meaningless measure of risk, loss or actual capital sufficiency in relation to it's positions. One would need to know the bank's tier-one equity PLUS customer equity and/or liquid-market collateral held in order to make a sensible apples-to-apples comparison before declaring them a hazard. 

Furthermore, financed positions like prime brokerage (as well as repo, delta-one) are typically liquid market instruments. No illiquids. No binary instruments like CatBonds. Sensibly large haircuts and low leverage for concentrated volatile positions (e..g. a Biotech portfolio), outsized position in relation to its historical liquidity, higher, but by no means stupid finance for liquid, well-hedged diversified stuff. Over two decades (speaking as a customer) they have all (DB, MS, GS, UBS, CA) extremely good risk management and control - much better in fact than the oversight of their own prop traders.  And they are positively draconian in comparison to the terms of an ordinary commercial bank loan.  

Vice-Chairman Hoenig is not the first to scare people with non-apple-to-apple comparisons that dramatically misunderstand the nature of these relatively prudent and well-risk-managed financing businesses (oh god, I know this sounds like an ass-lick straight from "Pseuds Corner" but its true!). Which is not to say they are without risk, but that this risk is not accurately reflected (i.e. severely overstated) in the too-often cited bogus ratios. There are lots of legitimate reasons to take aim at the banks in general, and Deutsche Bank in particular be it LIBOR manipulation, tax fraud, hiding losses, etc., but using a mis-specified capital-to-assets ratio, unfit for purpose, is disingenuine and not one of them - especially if one's purpose is to understand their actual capital position and consequential risk, free from hyperbole.


Anonymous said...

A deposit in a bank is not equity on the balance sheet.

"Cassandra" said...

An unlevered deposit in a savings account, checking account, time-deposit, etc. is certainly NOT, as you suggest, neither equity nor even like bank equity. However, the moment that you pledge your deposit (or your securities) as collateral for a loan against that deposit or securities, it becomes very much like equity from the risk-viewpoint of the bank and its investors. NOT because the bank can counts it as tier-one equity so it can shoot the moon, but rather because the terms of its loan against the securities collateral purchased with the deposit and extended financing is economically identical to equity, where the customer must further maintain a minimum equity (call it a buffer against loss) indemnifying the bank against loss up to the amount of equity it holds before becoming a general creditor to the entity in the event of a catastrophe. So when looking at risk if you really want to know the risk position of the bank, Tier-one to assets is dumb for a large securities financing operation who holds loadsa customer faux-equity (ignored) while assets on the balance balloon. Get it?