17th March 2019

Will the German Mega Zombie Bank (GMZB) take off? | Bank Capital Insights

So, it is official – Two zombies may join up to form a mega bank

Earlier this Sunday, both DB and Commerzbank officially confirmed that they are in exploratory talks about a potential merger.  It looks like the German government is happy to see the two banks combine and create a German national champion bank.  It will take a while before the exact merger details are known assuming the talks culminate in a deal.

To some extent, it reflects the painful realisation that the turnaround efforts at the individual banks have not been successful and the German government sees the merger as a possible way to generate growth and earnings (or shall we say end the misery).

Both banks have similar issues in terms of low growth, high cost base and unprofitable businesses.  They serve different purposes in their domestic markets and it is hoped that a combination would make them competitive and restore earnings.

To me, size alone does not guarantee success – ask the Japanese who have tried this in the last 20 years and yet their banking system is not generating decent returns.  The underlying problem is that the German banks have failed to transform their business models and are not agile to reflect new realities. Plus, the central bank action of low (negative) interest rates makes it extremely tough.

Will the merger make a difference?

At first glance, this looks an interesting option to combine two underperforming banks with similar attributes in terms of low profitability and limited future visibility but with significant scope for cost reductions and a larger capital pool to absorb losses.

But merely creating a much larger entity does not solve the underlying core issues faced by both banks, more so for DB.  The reason being that the bank is too large and too complex to be managed as a standalone entity and any additional merger will only complicate matters and cause further uncertainty.

DB’s issues stem from multiple factors – oversized/overstaffed businesses in FICC land and a strategic failure in the past to redirect capital to the more profitable wealth management and corporate banking businesses.  FICC is a highly cyclical business and one that is undergoing profound structural change. Technology and automation are the key drivers of profitability in that business and DB has been very slow to react and adapt to the new landscape.  What DB needs is a radical restructuring in the FICC business and it needs to get rid of many units that are currently generating very poor returns.  It also needs to downsize its balance sheet exposures significantly.

The merger will require significant decisions to be taken – huge layoffs, big restructuring, systems integration and the potential sale of profitable business units to meet EC competition regulations/requirements.  After all that, there is still no guarantee that the new combined entity would be highly profitable.

Capital shortfall is still there

DB reports good regulatory capital ratios, well above minimum thresholds.  However, a 4% leverage ratio for a bank with EUR 1,324 billion of leverage exposure is just not good enough especially if underlying earnings momentum is weak or even negative.

For example, in a highly hypothetical situation, if the bank had to take say additional EUR 10 billion of provisions/costs for matters discussed above, it would create an almost EUR 8 billion capital hit (assuming current revenues hold) and that would translate to the Tier1 capital dropping to EUR 42.5 billion and leverage ratio falling to 3.2%.  Add to this the EUR 23 billion of Level 3 assets and one gets the picture.   And that is why equity investors are nervous.

Yes, the bank has good liquidity buffers and can withstand potential short-term counterparty/deposit flight.  But the wall of debt that is maturing over the next few years (almost EUR 20 billion every year until 2022) means that the bank is reliant on wholesale markets being open and available.

Equity and AT1 investors be aware, LT2 and NPS investors can smile…

Equity investors have taken notice of the issues and hence give the poor valuation on its stock.  Given the execution risks, the likelihood of large restructuring charges and potential equity recapitalisation, the bank’s stock may not rally.

In my personal opinion, the bank’s AT1s are still not fully reflecting the substantial downside risks especially in the unlikely event of coupons getting turned off in the event of a very large restructuring charge leading to insufficient ADI.

Given that the German government would be a shareholder and may yet inject more equity into the combined entity, DB’s existing LT2 and NPS spreads are likely to tighten significantly.  Also, given the size of the new bank and its global systemic importance, additional support is more than likely and to that extent, the CDS spreads of both banks (both senior and subordinated) are likely to rally.

GJ Prasad

A senior European bank research specialist with significant breadth/in-depth sector knowledge, GJ has researched bank capital instruments extensively - having covered the asset class for more than 15 years as an analyst and 7 years as a risk taker in buy-side roles. His specialisation includes carrying out detailed financial modelling work on the European banks focusing on asset quality, earnings and capital adequacy metrics. His deep-dive work focuses on single name selection and extensive risk analysis on capital securities, especially on structural features, issuer credit profile and equity/AT1 valuation.