Deutsche Bank Fails Stress Test

Deutsche Bank Fails Stress Test
In the second round of the Federal Reserve's annual two-stage stress tests, designed to assess how well the sector could withstand another financial crisis..

In the second round of the Federal Reserve's annual two-stage stress tests, designed to assess how well the sector could withstand another financial crisis, the US division of Deutsch Bank has failed to pass. 

31 out of 35 institutions passed both tests. 

Background 

President Woodrow Wilson signed the Federal Reserve Act into law on December 23, 1913, whereby the Federal System would serve as the US Central Bank. Prior to the Act, the US financial and banking system was plagued by credit scarcity and frequent bank failures. American colonial banks were driven by the barter system and commodity money. Secretary of the Treasury, Alexander Hamilton, developed a plan for a federal banking system to solve the nation’s credit problems after the War of Independence. 

The onset of the Industrial Revolution saw expansion of finance and commerce with private entities functioning within the larger decentralised banking system. Bank panics or “runs” occurred frequently where lenders would hurriedly withdraw deposits leading to financial crises. Hence, it was necessary for the Congress to pass a law for state controls and policies for the banks. 

The Federal Reserve carries out its supervisory and regulatory responsibilities and supporting functions primarily by promoting the safety and soundness of individual financial institutions supervised by the Federal Reserve. Reports thus produced by the Federal Reserve are used a gauge for the effective functioning of banking systems within US. 

Deutsche Bank is a German investment bank and financial services company headquartered in Frankfurt, Hesse, Germany. The bank is present in 58 countries with a large presence in Europe, the Americas and Asia. Deutsche Bank was one of the major drivers of the collateralized debt obligation (CDO) market during the housing credit bubble from 2004 to 2008, creating about $32 billion worth. It was found that the bank was churning out bad CDOs. Moreover, Greg Lippmann, head of global CDO trading, was betting against the CDO market, with approval of management. As of 2017 Deutsche Bank is the 17th largest bank in the world by total assets. 

Analysis 

The Federal Reserve releases an annual two-pronged test with the objective of preventing a financial crisis like that of 2008. The test includes the Dodd Frank Act Stress test (a quantitative evaluation of the impact of stressful economic and financial market conditions on firms’ capital) and the Comprehensive Capital Analysis and Review (CCAR) (an evaluation of firms’ capital adequacy and planned capital distributions such as dividend payments and common stock purchases). To put it simply, thefirst test simulates firms’ capacity under recession conditions, while the second test examines the plans for capital distribution. 

The bank passed the Dodd Frank Stress Test, but failed the CCAR, a test for large complex firms. Theresults cover all of Deutsche Bank’s non-branch U.S. assets, including its mortgage lending and debt financing subsidiary, and its sizable Wall Street broker-dealer trading business. 

"Deutsche Bank USA continues to make progress across a range of programmes and will continue to build on these efforts and to engage constructively with regulators to meet both internal and regulatory expectations," the bank said. 

The German lender’s financial health globally has been under intense scrutiny after S&P cut its rating and questioned its plan to return to profitability. Shares fell by 1% after the report was released. It has failed the tests in 2015 and 2016. 

“Concerns include material weaknesses in the firm’s data capabilities and controls supporting its capital planning process, as well as weaknesses in its approaches and assumptions used to forecast revenues and losses under stress,” the Fed said in a statement. Now, the bank has to invest in technology, operations, risk management and a change in administrative capacity. 

Goldman Sachs and Morgan Stanley were only granted "conditional" passes. State Street (STT), a custodian bank that is paid to safeguard clients' assets, also drew concerns from regulators. 

After the results were announced, Morgan Stanley said that it will distribute $6.8 billion, in line with last year’s payout. Goldman Sachs said it would return up to $6.3 billion, including $5 billion through share buybacks and $1.3 billion in dividends, which will rise to a quarterly rate of 85 cents per share from 80 cents. 

The Federal Reserve is moving towardeliminating passing and failing grades for its stress tests of the nation’s largest banks, replacing them with a capital ratio that the lender must meet during the following year. 

Counterpoint 

The Journal of Financial Intermediation released a study where they found stress test disclosures are associated with significantly higher absolute abnormal returns, as well as higher abnormal trading volume. Riskier companies seem to be more affected by the stress test information. They found no evidence that stress test disclosures have reduced the production of private information. After disclosure begins, stress tested firms attract equity analysts without changing analysts’ forecast dispersions. 

Assessment 

Our assessment is that the results acknowledges weaknesses in Deutsche Bank’s operations and risk management. We feel that while the test might not reveal absolute accuracy, the results of the qualitative and quantitative assessments provide financial intermediaries and participants in the financial market with a more comprehensive analysis for the future. We believe that the new test for capital ratio might provide more definite results for short term investments and operations.

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