Swiss credit (New York Stock Exchange: CS) is currently trading at 0.23x the tangible pound. German Bank (NYSE: DB) is trading at 0.3x tangible book value. These are very distressing valuations for banks, let alone for European banks.
CS, however, is in big trouble due to a steady stream of risk management scandals at its investment bank, including the Archegos Capital fiasco that cost it more than $5 billion. I already wrote about this episode here and noted the following:
Beyond the financial loss, there are other important downstream implications for CS in the short to medium term. While the current stock price looks attractive in the context of the stock’s long-term valuation, I’m not quite ready to buy the dip. There appear to be major risk management issues plaguing its investment bank and resolving them will likely be a lengthy and costly process.
DB, on the other hand, is in excellent shape and has wonderfully executed the strategy envisioned by DB CEO Mr. Sewing. It is on track to achieve a RoTCE above 10% by 2025, thanks to the tailwinds of the paradigm shift in interest rate setting in the Eurozone. He also has a low-risk business model, which means he’s likely to avoid the kind of banana peels that CS walked on.
Problems with Credit Suisse’s business model
On the face of it, CS has a very attractive business mix that builds on a small-cap wealth management business (~two-thirds of the bank) and is complemented by a suitably sized investment bank (~a third party of the bank). It almost looks like a European version of Morgan Stanley (MS), but of course there are differences.
CS Investment Bank primarily caters to credit markets and capital market issues. These are areas that are quite difficult in the current macroeconomic environment. Additionally, due to the Archegos Capital debacle, it was forced out of the Prime Finance business, which is usually a very lucrative and profitable business for investment banks. Additionally, in the current environment, its areas of strength in leveraged finance, M&A and SPAC operations are very attenuated. CS also recorded significant losses (but not yet quantified) on the leveraged buyout of Citrix. On the other hand, CS has little exposure to FX, rates and commodities trading, which are more stable annuity-type trading activities. These business sectors are currently benefiting greatly from the recent market volatility.
With colossal failures in risk management, CS investment banking is now in free fall. This drives up its funding cost and can easily turn into a death spiral as the main rainmakers jump ship. It has already started to play out with the Departure of key executives at Citigroup (C) and others who are “looking for other opportunities”.
The management team has no choice but to restructure and downsize the investment bank and do it as quickly as possible. CS is set to release its strategy update on October 27.
The problem is that restructuring an investment bank is a long, time-consuming, risky and expensive exercise. First, CS will need to raise a significant amount of capital, and in the current environment and given its market capitalization, this is going to be extremely dilutive for existing shareholders.
Second, CS will likely have to create a non-essential bank where it seeks to unwind long-term trades over several years and/or sell them at a significant loss. This non-essential unit will likely suffer losses for many years, as it did during the multi-year restructurings of DB and Barclays (BCS).
Third, the management team will need to determine how to retain key company personnel, especially as US banks expand aggressively into European capital markets.
Finally, regulators will also extract their pound of flesh. CS will need to put in place a credible multi-year program designed to improve its control infrastructure. This will take years to achieve and will be very expensive.
In summary, it will probably be a multi-year story with no guarantee of success. It is important to note that shareholders will come last on the priority list as CS will have to balance the demands of other stakeholders.
The restructuring of Deutsche Bank is a success
After several failed attempts, Mr. Sewing stabilized the Deutsche Bank vessel. The management team implemented the cost reduction program with typical German efficiency. Investment banking focuses on the bread and butter of trading revenue comprising foreign exchange, rates and credit trading. As such, the investment bank appears to be sustainably earning its cost of capital while continuing to take market share. DB exited the stock trading business entirely and thus managed to avoid some of the risks that the likes of CS faced. Importantly, DB’s corporate and private banking accrual business is doing well and showing strong revenue growth.
DB is on track to achieve a RoTCE of 8% for 2022 and with a credible trajectory above 10% in 2025, despite macroeconomic headwinds and the deep recession expected in the Eurozone.
There are also strong tailwinds for DB. This mainly concerns the long-awaited exit from negative rates in the euro zone. Negative rates are completely disrupting the business model of depository institutions’ maturity transformation and have been a major reason for the underperformance of European banks relative to their US counterparts for a decade.
DB projects that it will generate more than €700 million additional from rates in 2022 and €2.5 billion by 2025. Given that Deutsche Bank’s market capitalization is only around 16 billion euros is clearly very important.
DB is also expected to return €8 billion of capital to shareholders by 2025.
Finally, DB’s credit risk profile is super conservative and should perform well even in a deep recession scenario. The bulk of its portfolio consists of moderate LTV German mortgages, as may be the case seen below:
I avoid CS at the moment. At least until the strategy is set on October 27. I expect there will be a capital call soon – there really isn’t a way to restructure the investment bank without raising equity. There is no miracle solution, it will be a long and costly exercise and the interests of shareholders are not necessarily at the forefront. I suspect the stock price will drop further, given the uncertainties. At some point, CS may become investable again or even become a takeover candidate. The wealth management franchise is exceptionally attractive to many suitors. In the meantime, I expect the bleeding to continue, including the departure of key personnel to competitors. Investment banking is at serious risk of sinking into a death spiral.
On the other hand, DB is an extremely attractive risk/reward game at the moment. I expect the stock price to double as/if macro uncertainties pass and interest rate benefits trickle down to financials. In my opinion, the perceived risks are exaggerated. There is no longer any restructuring risk premium attached to this bank and therefore the current share price is meaningless. I remain very optimistic even though I expect a deep recession in the euro zone in 2023.