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Monday, January 20, 2014

Addendum To Deutsche Bank - An Exploding Cost/Income Ratio!

A bank's P+L statement is a most complex piece of accounting. However, it can also be explained in simple ways as follows:

A bank has net operating revenues (interest margins, trading profits and fees) and operating costs (ranging from personnel to depreciation). Once operating costs are paid out of net operating revenues, the resulting surplus can be applied to the following:

* risk costs
* taxes
* dividends
* retained earnings
(in that order)

Deutsche reported a cost/income ratio (CIR) of 73% at year-end 2013. That means: for every Euro earned, 73 cents went to cover operating expenses and only 27 cents were available for risk costs, taxes, dividends and retained earnings. The 27 cents are often referred to as 'risk absorption capacity' (the lower that capacity, the greater the probability that risk losses move right to the bottom line).

73% is a very high CIR for a bank like Deutsche (I had never checked it before but I would have expected it to be no greater than 60%). But here comes the shocker.

Back in 2012, Deutsche announced a cost reduction plan and in 1Q13, the CIR had declined to 64% (down from 77% a quarter before). However, since 1Q13, the CIR increased in following quarters to 72%, 72% and 87% (!) in the final quarter. This is a most dangerous trend!

A bank with high operating costs blows up its balance sheet to generate more net interest revenue. The leverage increases accordingly. When a bank, like Deutsche, decides to reduce leverage, the balance sheet is reduced, net interest revenue declines and leverage accordingly (unless operating costs decline in the same proportion as net interest revenue, which is highly unlikely).

And the conclusion is? Well, the conclusion is that, as Deutsche's CIR increases and/or remains high, its loss absorption capacity becomes quite limited. As evidenced by the fact that Deutsche reported a 1,2 BEUR loss in 4Q13.

6 comments:

  1. Not to forget about Hypo Real Estate, Commerzbank and Danske Bank....

    Imho the big total sum will arise from everywhere

    H.Trickler

    ReplyDelete
  2. See also ...

    "Falling Short of Expectations? Stress-Testing the European Banking System", Viral V. Acharya and Sascha Steffen

    "The eurozone is mired in a recession. In 2013, the GDP of all 17 eurozone countries fell by 0.5% and the outlook for 2014 shows considerable risks across the region. To stabilize the common currency area and its (partly insolvent) financial system, a eurozone banking union is being established. An important part of the banking union is the Single Supervisory Mechanism (SSM), which will transfer the oversight of Europe’s largest banks to the European Central Bank (ECB). Before the ECB takes over this responsibility, it plans to conduct an Asset Quality Review (AQR) in 2014, which will identify the capital shortfalls of these banks. A comprehensive and decisive AQR will most likely reveal a substantial lack of capital in many peripheral and core European banks. This study provides estimates of the capital shortfalls of banks that will be stress-tested under the AQR using publicly available data and a series of shortfall measures. We document which banks will most likely need capital, where a public back-stop is likely needed, and, as many countries are already highly leveraged, where a EU-wide backstop might be necessary."

    http://www.sascha-steffen.de/uploads/5/9/9/3/5993642/aqr_stress_tests_-_15_jan_2014.pdf

    Cf. especially Appendix I to IV, pages 21 to 25

    ReplyDelete
    Replies
    1. This is the study to which I had made a link in my post (in German, though).

      Delete
    2. Sorry, the link was not in this post but in the one on "The Banking Crisis Is Moving North".

      Delete
  3. If i recall well you mention before months DB for its leverage ratio!
    The increased Cost/Income ratio is possibly a way to "hide" more losses? As an empirical evidence greek banks also increased their CIR considerably over the last years dealing with huge losses. This ratio improved lately however.

    Too many terms. Confusing!

    https://www.db.com/ir/en/download/Deutsche_Bank_4Q2013_results.pdf

    There is not a reference (for my view) in tangible book value or a specific mark for intagibles- goodwill. The effort to reduce leverage is remarkable.

    MS

    ReplyDelete
    Replies
    1. As I explained, the risk costs become below the CIR. There are various ways to hide credit risk but they would not affect the CIR.

      When the CIR goes up, it means that the relationship of operating costs to net operating operating revenue is deteriorating. That can be because costs go up, or revenues to down, or a combination of the two.

      The key is the 'risk absorption capacity', i. e. how much money is left after operating costs have been paid for. The higher the CIR, the lower the risk absorption capactiy. If a bank has a very low CIR, it can take risk losse while still showing overall a profit. When the CIR is high, risk losses fall right through to the bottom line.

      Delete