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In an interesting twist of events, the Financial times has a story on how Deutsche Bank (DB) will shrink its balance sheet by 20% over the next 2-3 years, to conform to new regulations and especially Basel III regulations.

At the very heart of the matter is bank leverage. While there are many ratios one can use to measure leverage, one of the simplest is the leverage ratio, which measures equity to total assets.

The table below shows the leverage ratio for Deutsche Bank and selected U.S. money center banks. While I have showed a similar table in the past, I am showing it to you again, so you understand just how much of a balloon the balance sheet of Deutsche Bank is.


(Click to enlarge)

Deutsche Bank's leverage ratio is about 2.75%. To put that in prospective, a negative swing of about 3% of the value of the company's balance sheet will wipe out the entire equity position of the company. Whereas Citigroup (C), Wells Fargo (WFC) and Bank of America (BAC) need over 10% and only JPMorgan (JPM) needs about 9%.

And since Citigroup has had major balance sheet repairs over the past few years, we can assume that the assets on the balance sheet are probably close to what they say they are, whereas in Deutsche Bank, there has been no major restructuring. So in addition to the leverage problem, there is also the question if you trust the balance sheet. Personally speaking, I don't.

But the question is, even if Deutsche Bank reduces its balance sheet by 20%, will that reduce the leverage of the bank enough to make investors confident enough they won't be wiped out in the future, if and when another major world crisis happens?

As the table below shows, reducing the company's balance sheet by 20% will not cut it. The bank's balance sheet will come nowhere close to having a leverage ratio similar to U.S. banks. In fact, Deutsche Bank needs to reduce its balance sheet by about 70% in order for its balance sheet to resemble its U.S. competitors.


(Click to enlarge)

The funny thing is that Deutsche Bank's claims (via the FT) the balance sheet reduction will not impact earnings by much. How is this possible? I have no idea, unless they are earning nothing on these assets. I do admit this is a possibility.

But if these assets are income producing assets, then I don't understand how reducing the balance sheet will not impact earnings by a lot. Especially if the bank's balance sheet is reduced by more than 20%, as I think it will eventually have to do.

Bottom line

The way I see, unless U.S. banks have assets that are not depicted on their balance sheets, either Deutsche Bank has to reduce its balance sheet by a lot more than 20% (to come close to a leverage ratio of major U.S. money center banks) or it will have to increase equity by a lot, or a combination of both.

In addition, reducing its balance sheet will most definitely have an impact on earnings, because a big portion of the banks earning are a function of its over-bloated balance sheet.

So the long term issues are, the possibility of lower earnings, dilution (the FT says they plan on increasing capital by 6 billion euros soon) and finally, a sudden negative surprise, where investors discover that portions of the bank's balance sheet are not worth what investors thought they might be worth, when the liquidation of the balance sheets begins.

Finally, let me reiterate what I have said many times over the past several months (please consider: Operation Bank Twist: Sell European Banks, Buy U.S. Banks). If you have to be in banks, stay long U.S. money center banks and sell or sell short (upon technical weakness) their European counterparts.

Source: Deutsche Bank's Balance Sheet Needs To Be Reduced More Than 20%