UBS - Deutsche Bank: The Next One To Fall?

2023-03-24 10:50:34 ET

Summary

• Deutsche Bank saw its shares fall and its CDS rates blow up on Friday.
• This reminds some market participants of what happened at Credit Suisse.
• We'll look into the similarities and differences between CS and DB.

Article Thesis

Deutsche Bank Aktiengesellschaft (DB) shares are tumbling in early Friday trading. At the same time, credit default swaps are spiking -- which isn't a good sign. Some market participants are worrying that Deutsche Bank could be the next major bank to run into issues, following Credit Suisse ( CS ). There are, however, some important differences, which is why it is far from guaranteed that Deutsche Bank will follow the same path as Credit Suisse, although it can't be ruled out that DB will be met with a similar fate.

What Happened?

On Friday, in Frankfurt (Germany) trading, Deutsche Bank shares tumbled by double-digits . In US pre-market trading, there was a similar fall in the bank's shares. This followed several days of declining share prices this week.

At the same time, credit default swaps, or CDS, for the bank rose substantially:

Five-year Senior CDS rates rose to almost 200 base points, which is higher than during last summer and fall when CDS rates exploded as well. Right now, insuring against a DB blow-up via CDS is also more costly compared to early 2020, during the peak of the COVID panic. That is remarkable and shows that there must be a considerable amount of market participants that are worried about a potential Deutsche Bank blow-up, otherwise demand for insurance against such a scenario wouldn't be rising drastically. After all, a couple of weeks ago, the CDS rate was less than half as high as it is today, showcasing that the situation has worsened meaningfully in a short period of time -- at least in the eyes of the market (which might be wrong).

Note: Credit Default Swaps are derivatives that allow hedging against a default of a specific borrower, in this case Deutsche Bank. The holder of the CDS receives compensation in case the borrower (here: DB) defaults. Rising CDS rates indicate that demand for insurance, and the cost of insurance, are rising, as a default is seen as more likely by the market.

Is Deutsche Bank The Next Credit Suisse?

Of course, the falling share price and rising CDS rate of Deutsche Bank are seen by many as a sign that the bank could be in trouble. And indeed, the combination of falling shares and rising CDS rates was also seen at other banks before they failed, e.g. at Credit Suisse one week ago. Incidentally, the market also priced in the potential blow-up of CS on a Friday and the takeover by UBS ( UBS ) was organized over the weekend. The same also happened when Silicon Valley Bank (SIVB) blew up over the weekend one week earlier.

Not surprisingly, some market participants are thus fearing that this could be the next domino to fall, or the next major bank to blow up. However, there are some important differences between Deutsche Bank and Credit Suisse:

First, Deutsche Bank is, unlike CS, not a bank that's been suffering from a perpetually falling share price:

Over the last five years, DB saw its shares decline by 30% -- far from a great result, but it's not like almost all of the shareholders' wealth disappeared. A year ago, DB had actually been in positive territory. Contrast this with CS, where shares have fallen dramatically more, and where the price decline has been more consistent.

Second, while CDS rates have risen drastically, they are by far not as high as they were at Credit Suisse before CS was taken over. Credit Suisse CDS peaked at more than 1,000 basis points, or around 5x the level Deutsche Bank CDS are trading right now. In other words, the market priced in a much higher likelihood of a CS default before it was taken over, relative to the likelihood of a DB default that is priced into DB CDS right now.

Third, Deutsche Bank and Credit Suisse also differ when it comes to their profitability and capital position.

Credit Suisse reported a net loss of CHF7.3 billion for 2022 and a net loss of CHF1.6 billion for the previous year. In the recent past, Credit Suisse was thus deeply unprofitable, recording a net loss of almost $10 billion (using current exchange rates) over the last two years. Of course, when an entity is losing money at this pace, it is not surprising to see that depositors lose confidence and that the capital position erodes over time.

Deutsche Bank, meanwhile, has recorded a significant net profit in the recent past. For 2022, the bank recorded a net profit of €5.6 billion, or more than $6 billion, which was the highest profit since 2007. Deutsche Bank saw its revenue grow by 7% during the last fiscal year, while at the same time, the bank managed to lower its non-interest expenses by 5% year over year. In a high-inflation environment, lowering expenses is a strong feat, and DB was rewarded with a steep profitability improvement. While banks can run into trouble even whilst being profitable, e.g. due to a potential bank run, a loss-generating bank naturally is more at risk than a profit-generating bank. First, the profit-generating bank is strengthening its capital position over time, all else equal, while the contrary is true for the loss-generating bank. Second, depositors will be less inclined to get their money out of a profit-generating bank relative to a loss-generating bank, as the profit-generating bank will be perceived as less risky. While a bank run can happen for a profit-generating bank like Deutsche Bank, it seems less likely relative to a bank such as Credit Suisse that was not operating profitably prior to being taken over.

Due to these important differences, I believe that the situation is different at Deutsche Bank, relative to Credit Suisse. While problems can't be ruled out and while it is likely that the ongoing tightening by the Fed, the ECB, and other central banks will continue to put some banks under pressure, it does not look like Deutsche Bank is in a similar position as Credit Suisse, at least for now. The share price decline has been way less pronounced, CDS rates are way lower, and importantly, Deutsche Bank is a profitable company. The bank likely feels that it is well-capitalized, which is why it has proposed a dividend payment -- if management felt that capital levels weren't adequate, it would probably not have done so.

Final Thoughts

Some bank customers have been jittery, and the environment for banks isn't easy, as rising rates have led to losses in the value of treasuries and other fixed-income assets that banks hold on their balance sheets.

That being said, not every bank will end up like Credit Suisse, Silicon Valley Bank, etc. While Deutsche Bank has seen its shares fall in recent days, and while CDS rates have spiked, neither the share price fall nor the CDS rate spike is at a level that would be comparable to what happened at Credit Suisse prior to CS being taken over.

Also, Deutsche Bank has executed well in the recent past when it comes to its operations. Thanks to cost cuts and a focus on margin improvement, it has become quite profitable again -- which is an important differentiator versus Credit Suisse, which was reporting steep losses in recent years.

While a bank run or other major problems can't be ruled out for DB (or, for that matter, any other bank), it does not look like there is a very high likelihood that DB will be the next bank to fail. From what I see today, DB looks significantly stronger than CS, and there's thus considerable less default risk.

There are other banks that look even less risky, however, such as the largest US-based ones, that are more profitable and that benefit from deposit growth as bank customers move from regionals and community banks to the TBTF banks such as JPMorgan ( JPM ). I see these as less risky relative to Deutsche Bank, which is why I do not own DB, even though I see it as less risky than CS.

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