Deutsche Bank: Universal Banks are a Benefit to Society. Really?

A gentleman named Jan Schildbach of Deutsche Bank (DB) has published a research report “Universal banks: Optimal for clients and financial stability; Why it would be wrong to split them up.” This report is remarkable for many reasons, but not because it makes a convincing investment case for mega banks. Rather, it proves that anybody can make a case for any proposition so long as one carefully avoids touching any inconvenient facts.

The TBTF banks are parasites that drain resources from society. This ridiculous, self-serving analysis by one of the most hideous examples of “too-big-to-fail” makes that point nicely. Indeed, as one reads the DB report, it is tempting to laugh – were the subject no so sad and so serious. Keep in mind that my firm, Institutional Risk Analytics, calculates Economic Capital and Risk Adjusted Return on Capital (RAROC) for all US banks. The RAROCs for the top US universal banks are usually ~ 0 or even negative, as shown in the table below.

Note that DB does not provide sufficient disclosure to the public to perform the RAROC calculations in the same way as for US banks. Note also that even Wells Fargo (WFC), which has no investment banking or OTC derivatives dealer operations, routinely delivers a RAROC that is barely in positive territory. And we are talking about Q2 2012 here; the numbers from before the crisis are even worse, reflecting the de-levering that has occurred since that time. What these numbers basically suggest is that all of the large, TBTF banks are consistent value destroyers using any rational measure.

Schildbach opens his discussion by saying that there are “key advantages of the universal banking model:”

1) Broad range of services for customers
2) Lower costs for customers and the real economy
3) Greater financial stability

The trouble is that none of these statements are true. More, if Schildbach bothered to look at the nominal and risk-adjusted equity returns of the large universal banks, he would conclude the opposite.

While the “too-big-too fail” banks such as DB, JPMorgan Chase (JPM) and Citigroup © do provide a wide range of services to clients, this is hardly a reason to support larger banks. The services provided by these behemoths are also provided by smaller firms, which tend to provide far better service. Large organizations tend to treat customers as statistics because, as we all know, there are no economies of scale in banking.

This point regarding the economic efficiency of larger banks is entirely missed by Schildbach, who states that:

“Universal banks are able to leverage revenue and cost synergies through economies of scale and scope. These benefits are passed on to universal banks’ customers and investors. Ultimately these benefits lower the costs of finance for society as a whole.”

But, again, this is completely wrong. Not only do large universal banks have lower nominal and risk-adjusted returns than smaller banks, but the periodic need to be bailed out by government renders the largest banks a nightmare for investors and the public. In the case of C and JPM, for example, these institutions require massive subsidies from the public that the DB analyst does not even mention in his report. Even in nominal terms, banks such as C and JPM have been consistent value destroyers. But when you start to reckon the risk-adjusted returns on capital for the TBTF banks, the net is negative.

Most of the earnings of the top four US banks, for example, are attributable to subsidized markets such as housing and derivatives. In the case of the former, the US government allows the big banks to earn supra-normal returns by originating mortgage loans that are several points below the market cost of credit. A 30-year fixed rate mortgage at 3% is about 3% below the actual cost of this loan because Uncle Sam takes first loss on the credit. The free market rate for a 30-year loan where a private investor takes the credit risk is about 6%, assuming a prime borrower and an 80/20 conventional mortgage. Far from providing a benefit to society, the TBTF bank is a net consumer of subsidies from the public in this case.

Or let’s look at the market for OTC derivatives, another market that is very important for DB, JPM and C. In this market, banks are allowed to continue trading even when a obligor defaults. In the US, the TBTF banks are exempt from the automatic stay in bankruptcy when it comes to OTC derivatives. This crucial exemption is worth tens of billions of dollars per year and represents a considerable subsidy from public and private investors to the big banks. Yet somehow the DB analyst misses this point entirely in his analysis. This is hardly a surprise since DB is one of the largest players in OTC derivatives in the world.

The next point made in this amazing document involves lower cost of funds. Mr. Schildbach states that TBTF banks are able to benefit their customers because of lower funding costs. And why do the universal banks have lower funding costs? Because these institutions are considered “too big to fail,” of course. When you grant a monopoly to a large bank like DB, for example, it is natural that the institution is going to have lower funding costs than smaller banks that are forced to fund independent of government subsidies. DB has a lower cost of funds than smaller banks because it is given preferential access to funding by the central banks and because it has a near-monopoly in its home market.

Just look at the bailouts coming from the EU nations to the bond holders of the largest banks and one thing becomes crystal clear: the more bankrupt the institution, the larger the subsidies for the bond holders. Bear in mind that I know the people who are handling bad asset sales for DB and the other German lenders, so let’s dispense with the pretense that these banks are even remotely solvent. In fact, the German government is orchestrating massive forbearance for all banks via the off-balance sheet liquidation of bad assets by DB and other domestic lenders.

This report is ridiculous on many levels, but the fact that it was published by DB, a profoundly insolvent large bank, speaks volumes about the true objective of the author. If you measure the tangible equity of the entire DB group vs. total assets, what is known as a leverage ratio, the bank has lower capital than any large US bank. Only the canard of capital to “risk weighted assets” brought to us via Basel III allows DB to keep operating.

But if you start to assign real risk weights to the OTC derivatives business inside DB, the picture grows quite alarming. In these terms, DB and the other large, “universal” banks of the EU are all arguably insolvent looking only at domestic asset problems but especially if you start to haircut capital to reflect bank exposures to Greece, Spain, Portugal and France. And yet somehow Mr. Schildbach and his colleagues at DB are able to publish a report making the case that universal banks like DB are a net benefit to the public.

At one point in the report, Mr. Schildbach actually states that “universal banks are beneficial to financial stability (and thus taxpayers),” this because of the flow of credit to large enterprises. The author somehow ignores the fact that all of the major universal banks in the EU are net recipients of subsidies at present. Indeed, on Page 10 of the report, Mr. Schildbach talks about the top banks in the FX markets and the important services they provide to customers. The only trouble is that many of these institutions are insolvent and are, in some cases, being liquidated by their host governments. Let’s take a quick look at some of the top names on the list:

The first name on the list, DB, is a ward of the German state. Without a steady flow of subsidies and forbearance with respect to bad assets by German authorities, the bank would have failed during the latest crisis. Citigroup is a ward of the US government after receiving a massive public bailout. Barclays is not dead yet but has a profoundly troubled franchise and problematic management team (LIBOR??) and is selling assets to keep itself afloat. UBS is retreating entirely from the US market and is being liquidated by Swiss authorities after repeated fiascos in the private banking and investment banking sectors. HSBC is likewise on the rocks and is retreating from a complete disaster in the US banking sector (Household Finance??). JPMorgan is nominally profitable, but is downsizing after the London Whale trading scandal. RBS is a ward of the state in the UK and is being liquidated. Like UBS, Credit Suisse is reeling from a succession of bad investments and management missteps. Morgan Stanley is just barely keeping its nose above water having seen its revenue base cut in half since the start of the crisis.

Overall, this DB report seems to be a feeble effort at public relations, not a true analysis of the financial and economic performance of the largest banks. The notion that the TBTF banks are providing a net benefit to society is laughable, yet that is precisely the key point made Mr. Schildbach over and over in his report. The only explanation that seems to make sense is that DB intended to publish this analysis as a PR piece, but somehow the wires were crossed and the report was instead published under the guise of serious research. In either case, the analysis is entirely unconvincing.

Christopher Whalen

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