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Deutsche Bank (NYSE:DB) raised a lot of concerns towards the end of 2011 when it reported that it had a pro-forma Basel III core Tier 1 capital ratio of 6.6% – one of the lowest among all the banking groups included in the list of global systemically important banks (G-SIBs) by the Financial Stability Board (FSB) then. But the largest German bank has come a long way since then to notch up a capital ratio figure of 8.8% by the end of Q1 2013 – a milestone it achieved by cutting down on its risk-weighed assets by selling its non-core business units as well as by playing around with the asset classes it holds to benefit the most from current Basel III provisions. [1]

And to top it off, the bank also gave in to investor pressure to finally issue fresh equity worth €3 billion in late April. With the latest round of stock issuance, Deutsche Bank’s capital ratio jumped to 9.5% – hitting the minimum level mandated for it by the FSB (see The Basel III Challenge For Banks: Why Extra Capital Requirements?). The bank is now among the best capitalized G-SIB, along with UBS (NYSE:UBS), BNP Paribas (OTC:BNPZY), HSBC (HBC) and Morgan Stanley (NYSE:MS). [2]

But, going by the capital shortfall estimate provided by Germany’s financial regulator BaFin about the country’s largest banks earlier this week, it seems that Deutsche Bank’s efforts to shore up its balance sheet are not yet over. [3] So, what more can we expect from Deutsche Bank on the Basel III readiness front in the near future?

We maintain a $54 price estimate for Deutsche Bank’s stock, which is about 15% ahead of the current market price. A large part of this price difference can be attributed to the negative sentiment towards European banks due to the weak economic outlook for the region.

The German banking industry was a laggard compared to other countries in terms of Basel III readiness until quite recently – something that is made amply evident by the fact that BaFin estimated the capital shortfall among the largest German banks to be around €32 billion ($42 billion) late last year. (ref:3) But the banks, including Deutsche Bank and its closest rival in the country Commerzbank (OTCPK:CRZBF) , have responded to the situation quite well by tightening their purse strings, retaining all their earnings, undertaking several divestments and reallocating their capital towards assets that are viewed more favorably under the Basel III norms.

Most importantly, both Deutsche Bank and Commerzbank shed their inhibitions towards raising more capital from the equity market by going ahead with their share issuance plans. The effectiveness of all these steps is visible as the shortfall for German banks has shrunk to €14 billion ($18 billion) in less than a year.

Now coming to Deutsche Bank, the German banking giant was placed in "Bucket 4" by the FSB as part of its classification of the G-SIBs, which means that the bank will be subject to an additional capital requirement of 2.5% over and above the minimum base requirement of 7% – a total of 9.5%. Once the Basel III norms kick in, Deutsche Bank will be allowed to hand out dividends only if its balance sheet shows a capital ratio of 9.6% or above. As Deutsche Bank’s current capital ratio of 9.5% is greatly subject to the underlying calculation of its risk-weighed assets value, any change implemented by the Basel committee in this regard could negatively impact the ratio figure.

In such an event (and also given the demand for an increase in capital by BaFin) Deutsche Bank will be forced to withhold dividends yet again in the future – choosing to retain all its earnings. This will show a marked impact on Deutsche Bank’s share value as can be understood by making changes to the chart below which captures the bank’s dividend payout ratio as adjusted for any share repurchases.

Notes:

  1. Cash call helps shore up Deutsche Bank’s balance sheet, Financial Times, April 30 2013
  2. Europe’s banks turn to capital raising to meet Basel III, Financial Times, May 13 2013
  3. Germany’s top banks €14bn short of Basel III capital, says BaFin, Financial Times, May 28 2013

Disclosure: No positions

Source: Understanding Deutsche Bank's Challenges With Basel III Compliance