Deutsche Bank Improved Its Balance Sheet By Losing A Lot Of Money

Bank earnings season is always a little surreal, I guess because there's an inherent surrealism about banking. Deutsche Bank reported earnings today,1 and those earnings had an up-is-down quality that Bloomberg's summary captured in this amazing sentence:2

Deutsche Bank AG, Europe’s biggest bank by assets, exceeded a goal for raising capital levels as co-Chief Executive Officer Anshu Jain focused on bolstering the firm’s finances rather than limiting losses.

So there's one way of running a business where you bolster your finances by making money. And then there is global banking. Here is another, possibly even more astonishing line from the same article:

Deutsche Bank “took pain” in the quarter by booking a loss to boost its capital ratio without selling shares, Jain said.

Booking a loss to boost its capital ratio. Losing money, in the regular universe, should reduce your capital: capital is mostly retained earnings. Everything here is backwards.

Here is how Deutsche Bank boosted its capital ratios without (1) raising capital from the market or (2) making money:

That is, losing €2.2 billion3 is more than outweighed, for capital purposes, by (1) getting rid of €28bn of assets by "portfolio optimization" or slimming down non-core operating units and (2) "getting rid" of €26bn of assets by changing how the computers are programmed. It is not hard to find various people who will tell you that that's kind of bullshit, and you can read about some of them in a footnote.4

We talked earlier today about how some people are worried about how much flexibility banks have to just change their computer programming to tweak their capital requirements. Other people might think it's kind of nice that different banks take different risk-weighting approach, and that a diversity of approaches might lead to a more robust financial system. Still you might be suspicious of the banks whose approaches look, in aggregate, more aggressive than their peers. And you might take a look at the bubbly charts in that post and notice that Deutsche Bank sort of lurks in the lower-right, most-aggressive corner of those charts, overlapping with SocGen among the banks that rely heavily on internal models and have relatively low RWAs compared to their total assets.5

And then you might ponder the fact that Deutsche Bank found an extra €26bn of RWA optimization to squeeze out of its computers. Diversity of risk-weightings among banks might help robustness; diversity over time is harder to be excited about.

The prose of DB's earnings announcement is pretty impenetrable - "While several actions taken to mobilize Strategy 2015+ had an expected material impact on our fourth quarter financial results," etc. - but I was tickled to note that part of the mobilization of Strategy 2015+ is "set[ting] the bank on course for fundamental cultural change." Here is what that means:

The management is determined to bring about deep cultural change at Deutsche Bank. Short term measures are an overhaul of the compensation practices and the continued tightening of the control environment. The Bank significantly reduced the bonus pool. Full year variable compensation is down to 9% of revenues – the lowest level for many years. Additionally, the Compensation Panel, chaired by Jürgen Hambrecht, made a series of recommendations which played a part already in the 2012 compensation. The Panel recommended, for example, that the Bank reduces deferrals, thus reducing the compensation cost for future years. It also advised that measures of performance for clients play a greater role in performance management assessments. Longer term measures towards achieving deep cultural change include issues like client integrity, operational discipline and cross-silo cooperation. These areas of focus were identified by conducting the most comprehensive dialogue with employees in recent years.

So all of those things sound good, no? Obviously not for DB bankers - "significantly reduced the bonus pool," ouch - but from a safety-and-soundness-etc. perspective. Comp, and its relationship to incentivizing risk, is a key element of bank culture. I just ... I could be wrong, but I have a sneaking suspicion that how a bank does its capital-ratio modelling - how aggressively it tries to optimize around regulation and minimize capital requirements - is also an important part of its culture. And one that didn't make it into DB's overhaul.

Implementation of new strategy with significant impact on 2012 results [DB]
4Q2012 Financial Data Supplement [DB]
Analyst call presentation [DB]
Deutsche Bank Beats Capital Goal as Jain Shrugs Off Loss [Bloomberg]
Deutsche Bank swallows $4 billion of charges for cleanup [Reuters]

1.Nah, they didn't "report earnings," they announced the "Implementation of new strategy with significant impact on 2012 results."

2.Also in up-is-down: (1) "Deutsche Bank Posts Surprise $3 Billion Loss," (2) +2.7% at 2pm.

3.Some of which is like goodwill and so probably not all that good for capital, whatever, we are overgeneralizing here.

4.Like this guy:

There is some discussion about how Deutsche Bank achieved the capital level improvement, said Piers Brown, an analyst at MacQuarie Bank Ltd. in London.

“There is a fair amount of reduction due to model optimization rather than asset disposals,” he said. “There is a lot of inherent suspicion about models currently. It is not helpful that a lot of the improvement is coming through that.”

Or this guy:

Changes to Deutsche's internal risk models helped drive the reduction in RWA, which analysts said could come back to haunt the bank if regulators harmonize the way banks estimate the riskiness of their loan books.

"They might apply some minimum floor for RWAs, which would cost Deutsche Bank a lot ... Their internal models could have to be thrown out the window," said Espirito Santo analyst Andrew Lim, who has a "sell" recommendation on Deutsche Bank shares.

5.SocGen!

For ease of reference here's the 2010 chart: