Bond Trading Wave Gets Harder for European Banks to Catch

Deutsche Bank and others have capital constraints and restructuring distractions

By Paul J. Davies

Deutsche Bank, whose Frankfurt, Germany, headquarters is shown Monday, remains constrained by relatively thin capital. Photo: Alex Kraus/Bloomberg News

The capital markets business is back. While U.S. investment banks are taking advantage, it is less certain that Europeans can.

J.P. Morgan and Morgan Stanley have both reported big rebounds in fourth-quarter bond trading. Corporate debt markets have seen strong new issuance to start 2017 as well, which is normally an indicator of good trading activity. But large European investment banks face obstacles in getting in on the action: They may be frustrated by capital concerns or distracted by restructuring.

Deutsche Bank could see the biggest recovery in 2017. Even it needs the right sort of activity, though, and smart ways of taking it on.

Trading related to foreign exchange and interest rates is likely to be the biggest spur to activity, according to analysts at Goldman Sachs, which they say will benefit Deutsche Bank and Barclays more than Credit Suisse. If successful, Deutsche should enjoy the biggest rebound in earnings expectations, though partly because expectations have been slashed heavily.

Since the start of 2015, forecasts for 2017 profit at Deutsche’s investment bank division have been cut by more than half, according to Credit Suisse analysts.

Recovery from a low base is better than no recovery at all, though. The question is whether Deutsche can jump on the increase in activity. The German bank remains constrained by its relatively thin capital, which makes it harder to take on extra risk to earn more revenue.

It has reached a $7.2 billion settlement with U.S. authorities over mortgage bond sales—one of the major uncertainties hanging over it—but it still has to settle a highly uncertain probe related to Russian equity trades, which could eat up more capital.

Furthermore, the finalization of global capital-rule changes has been delayed until at least March, leaving the industry in the dark about how much more capital it needs. Analysts at Credit Suisse think Deutsche will need to raise €5 billion to €6 billion ($5.4 billion to $6.4 billion) to meet its final requirements.

There are things that Deutsche can do to get revenue without straining capital. For example, it can lay off large parts of the counterparty credit risk involved in derivatives trading to big hedge funds or other sophisticated investors. The extra business would be slightly less profitable, but it still would boost overall returns.

Banks also can take less risk by shifting the assets off their books much more quickly. A good indication of how much trading assets a bank holds is its value-at-risk number. Less risk by that measure doesn’t have to mean weaker revenue. J.P. Morgan’s fourth-quarter trading value-at-risk was 30% lower than for the same period in 2015, but its trading revenue was 30% higher. Morgan Stanley also cut risk while boosting revenue.

Deutsche could pull off a similar trick and have its investment bank start to look healthier.

The problem is the cost of past bad behavior and very high central costs, which will still drag down overall returns this year, limiting the benefits to Deutsche’s shareholders.

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