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Deutsche Bank's Accounting Raises Questions

Regarding the risks in Germany's banking system, it should be pointed out that large German Banks are among the most highly leveraged in Europe relative to their net tangible capital. This is when the known risks are considered, but it has recently turned out that there are also hitherto unknown, hidden risks. Consider in this context the recent revelation that Deutsche Bank has kept loans to Brazil and Italy off the books, as well as loans to Greek banks and other dubious debtors such as Dexia, in spite of the fact that it remains fully exposed to the associated credit risks. Mind, DB apparently did nothing illegal here - but this accounting practice does mask the extent of risk the bank is exposed to.

Between 2008 and 2011 Deutsche Bank AG, the largest bank in Germany and one of the largest in the world, made loans to Italian bank Banca Monte dei Paschi di Siena SpA and Brazilian bank Banco do Brasil SA totaling $3.3 billion but did not include these transactions in financial reports sent to investors. Similar loans were made to Dexia SA, TT Hellenic Postbank SA, National Bank of Greece, and Qatari bank Al Khaliji.

These loans are part of $395.5 billion in liabilities that Deutsche Bank AG has offset with other liabilities, an amount equal to 19 percent of the company's total reported assets. Deutsche Bank spokesperson Kathryn Hanes says that these accounting practices are proscribed by law and that Deutsche Bank's actions are in line with the letter and intention of financial regulations. She also claims that this information does not impact the company's financial health or key financial ratios.(emphasis added)

Nothing to see here, move right on! Until one considers the finer details of these 'netting' transactions that is:

Secured loans usually entail a company providing collateral in exchange for cash that a bank has on hand, and the collateral is held until the loan is repaid in full. Instead, Deutsche Bank AG sold its collateral, government bonds in this case, to come up with the cash to make the loan, leaving it with an obligation to return the bonds.

Under the terms of the agreement Deutsche Bank AG was only obligated to return the 'cheapest-to-deliver' equivalent of the bonds, protecting it from devaluation but leaving the bank exposed to default. This maneuver effectively put a short on the government bonds, exposing Deutsche Bank to greater risk than if it had simply held the bonds for the duration of the loans. Deutsche Bank then sold credit-default insurance to investors, recording an immediate €60 million profit at the outset of the Monte Paschi deal. (emphasis added)

In other words, these 'secured' loans are not really secured, unless one considers what is effectively a short position on the bonds that were provided as collateral to represent adequate security. In addition, DB apparently 'spiced' the deals up by writing credit default swaps, exposing it to even more credit risk.

As Bloomberg further reports, this isn't the first time DB has obscured its true financial position by means of accounting practices that are not necessarily illegal, but certainly raise questions about how to properly evaluate the risks the bank is exposed to.

Meanwhile, the banks that have received the loans in question were able to continue to report ownership of the bonds DB has sold, allowing them to misrepresent their own financial health as well. In fact, that appears to have been the true reason for the odd accounting treatment of these transactions. While Deutsche's hands are considered legally clean, those of e.g. Monte Dei Paschi apparently are not:

Monte Paschi is currently being investigated by Italian prosecutors for using the loan to hide losses, and both Banca Monte dei Paschi di Siena SpA and Banco do Brasil SA continued to report ownership of the bonds that were used as collateral since they were due to receive them back. Prosecutors have not alleged any wrongdoing on the part of Deutsche Bank AG in this case.

However, analysts say that netting makes it difficult to accurately gauge the company's financial health and that it goes against the spirit of financial regulations by hiding the real amount of risk that Deutsche Bank has on its books.

This isn't the first time Deutsche Bank AG has been accused of obscuring financial information this year. In the aftermath of the Libor scandal the bank was previously investigated for possibly hiding $12 billion in losses by incorrectly valuing its derivative portfolio. (emphasis added)

We're not sure at this point what, if anything, came of the above mentioned investigation into derivatives accounting, but would note that derivatives open a great many possibilities for 'obscuring' balance sheet information.

Leverage Ratios of European Banks

Below are a few chart that illustrate the fact that the leverage of German as well as French banks is extremely high. These snapshots are from different sources and are not 100% congruent. It depends a bit on the precise definitions of balance sheet items. The first chart shows both average bank liabilities as a percentage of the host country's national debt and its GDP, as as well as bank assets as a percentage of net tangible equity capital.

(click to enlarge)

Banks in different countries: their liabilities as a percentage of the public debt and the GDP of the host country, and their assets divided by net tangible equity capital. Note that in terms of the latter measure, German banks were leveraged 52:1 at the time this snapshot was taken (in 2011) - the highest amount of leverage of all banking systems considered here (via Bridgewater) - click to enlarge.

The next chart shows the leverage of individual 'systemically important' banks according to an article at Daily FX, which is supposed to be based on Basel definitions as of 2012 (it also shows where these ratios should be according to Basel 2 and Basel 3). Note that in this case SocGen has to our knowledge disputed the conclusions of the original source regarding its leverage ratio, so one has to take this particular information with a grain of salt.

(click to enlarge)

Leverage ratios of individual 'systemically important' banks (via Daily FX) - click to enlarge.

And lastly, a chart published by the IMF in 2012, showing the average net assets/net tangible common equity ratios of banking systems in different countries. This chart shows slightly less leverage than the Bridgewater chart further above, presumably due to slight differences in definitions of what exactly constitutes tangible equity. Still, the esential message remains the same: German and French banks are sporting extremely high leverage ratios.

(click to enlarge)

Average bank leverage by country, IMF 2012. Germany and France both have extremely leveraged banking systems.

In summary, even if one disregards the 'hidden exposure' to credit risk such as that revealed in DB's loans to assorted rather dubious borrowers, bank leverage in Europe remains worryingly high. It is no wonder that the 'banking union' isn't getting off the ground as smoothly as some would like. It also explains why there was such a panic over the exposure of European banks to sovereign debt in 2011. While the outright panic has subsided, the reasons for it remain firmly in place.

(click to enlarge)

Deutsche Bank's share price over the past decade. The market seems more sanguine about DB than about many other European banks, but the bank is highly leveraged and exposed to a lot of risk as a result. Its greatest strength is probably its domestic loan book.

Charts by Bridgewater, Daily FX, IMF and BigCharts.

Source: Hidden Risks At German Banks