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Probability of Default: Deutsche Bank – November 2016

The financial strength of Deutsche Bank has been the subject of main stream financial news throughout this year. Analysts have been commenting on the bank’s likelihood of default, its ability to maintain ratings, to make money and increase capital, in light of litigation woes, downsizing, depressed share prices and lack lustre financials. This post looks at some of the recent developments for Deutsche Bank and assesses its strength in relation to its rivals using a probability of default measure.

Early November 2016 Fitch placed Deutsche Bank under negative ratings watch for its longer term issuer default, short term issue default viability and debt ratings. This indicates that there is a possibility that Fitch might lower the bank’s ratings if the outlook and results remain unfavourable. This is in view of the listless investment environment and the bank’s ability to generate revenue and increase capital in the next year. Further, the bank’s outstanding legal costs are a source of worry. This includes the $14 billion fine imposed by the US Department of Justice in early October 2016 following findings of the bank’s contributory role to the 2007-2008 subprime mortgage crisis. The fines are significantly in excess of the provisions the bank has set aside to cover its legal risks amounting to $5.9 billion as of the end of September 2016.

stock-prices

Source: Google Finance – Historical Prices. DB – Deutsche Bank; C – Citigroup Inc.; JPM – JP Morgan Chase

The bank has disclosed a third quarter profit in 2016 following cuts and/ or simplification in its resources, activities and regions. It also showed an improved capital position in light of its deleveraging efforts – getting the green light from Chinese authorities to finally sell its stake in Hua Xia. Further asset sales are planned, including the sale or public offer of its German retail banking subsidiary PostBank.

However, investors and rating agencies are still cautious given:

  1. The enormity of the government fine and the size of the bank’s legal risk reserves
  2. Deutsche bank’s ability to pay off the fines without causing a contagion event and triggering another global recession, given that the German government has categorically stated that it will not bail the bank out, and the fact that it is a major bank of Germany and the fourth largest bank in Europe
  3. The ability of the bank to generate revenue when the corporate investment environment is still lack lustre
  4. The fact that its competitors in the US such as Citi, JPMC and Goldman Chase have performed well by comparison which has and will continue to impact Deutsche’s market share in the US and globally
  5. Stricter regulatory environment and higher capital requirements in the coming years in light of new regulations compared with the bank’s ability to raise capital
  6. The fact that it has waived/ cut dividend payments for 2015 & 2016 which has impacted investor sentiment

Earlier this year, the price of Credit Default Swaps on Deutsche bank spiked indicating an increased probability of default following consecutive quarterly losses in 2015. In recent news articles there is still apprehension regarding the strength of the bank. In this post we see how Deutsche Bank compares with its competitors (Citi, JP Morgan Chase & Goldman Sachs) by looking at the probability of default measure assessed using the Merton structured approach.

For this analysis we have used share prices and quarterly and annual Balance Sheet data available on Google Finance. The Merton approach calculates the probability of default by using the

  • Market value of assets (assumed to be equal to the Total Assets from the balance sheet),
  • Asset volatility and
  • Book value of liabilities (Total Liabilities from the balance sheet).

Asset volatility is derived by transforming the more observable equity volatility using the Black Scholes formula, the market value of assets, asset volatility and the market value of equity. Daily equity volatility is estimated from the historical share price series (considering 252 days from a given balance sheet date), which is then annualized for 252 trading days.

The market value of equity used in the transformation is also a function of the market value of assets, the book value of liabilities and the asset volatility, hence the process for determining asset volatility and default probabilities is an iterative one. For a more detailed review of the method you may like to view the Merton Structure approach PD study note.

We have determined 1 year and 5 year probabilities of default as given below:

one-year-probability-of-default

1-Year PDDeutscheCitiJP Morgan ChaseGoldman Sachs
30/09/20162.5940%0.0539%0.0015%0.0044%
30/06/20161.4855%0.0996%0.0070%0.0094%
31/03/20160.4399%0.0182%0.0015%0.0016%
31/12/20150.0720%0.0005%0.0001%0.0001%
30/09/20150.0543%0.0003%0.0001%0.0000%
31/12/20140.0014%0.0000%0.0000%0.0000%
31/12/20130.0000%0.0000%0.0000%0.0000%

five-year-probability-of-default

5-Year PDDeutscheCitiJP Morgan ChaseGoldman Sachs
30/09/201639.14%10.39%3.75%4.99%
30/06/201632.03%12.65%5.71%6.20%
31/03/201620.73%7.51%3.72%3.80%
31/12/201511.39%2.87%1.87%1.93%
30/09/201510.39%2.52%1.78%1.39%
31/12/20143.66%1.14%0.47%0.35%
31/12/20130.25%0.23%0.41%0.12%

Deutsche Bank is clearly underperforming in relation to its peers with a greater likelihood of default. Probabilities of default for the bank have increased over the past 3 years.

References:

Data sources:

  • Google Finance
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