Could Deutsche's Travails Impact on ECB Policy?

Led by German collosus Deutsche Bank, euro-area financials are having a torrid time of late, and some analysts think this could make the ECB more bold when it comes to deciding on further easing.

The current steep sell-off in European bank shares, led by troubled German lender Deutsche Bank (DB), and fears about the Euro-zone system in general, may illicit a sharper policy reaction from the ECB at their key March meeting than had previously been expected.

Should anything in excess of a 10 basis point cut to interest rates be announced, expect the euro to head sharply lower. Indeed, anything unexpected from the ECB could well undermine the shared currency.

"The ECB will be looking at financial markets with alarm," says ING’s Global Head of Strategy and Head of EMEA and LATAM Research, Christopher Turner. "weakness in European bank stocks and enforced de-leveraging will weigh on credit growth."

ING are of the opinion that this could well prompt a larger ECB response on March 10th.

Before the sudden sell-off in bank stocks, most analysts had expected the ECB to make a modest 10 basis point cut to the deposit rate, however, given fresh concerns about the state of European financial institutions, the ECB may have concerns about lowering the deposit rate any further, as this too could have a negative impact on bank’s ability to make returns.

Previously the ECB had paid institutions for the privilege of looking after their money, as with most banks, however since lowering their deposit rates below zero (they currently stand at -0.3%) the ECB now charges banks to look after their money.

This has led some analysts, such as those at Barclays, to argue that the ECB is unlikely to lower deposit rates much further, for fear of placing too much pressure on euro-zone banks which could actually have the opposite effect to the one desired:

“Even if we believed that further depo rate cuts were an option (ie. below -50bp), we see limited space for such moves.

“Deeply negative rates in a context of rising liquidity surplus can severely hurt banks’ profitability, thus raising the risk of an increase in bank lending rates.

“Not only do banks have to deal with low yields and compressed margins that affect their earnings on bond portfolios and lending activity, but further, in some euro area countries, their ability to pass the cost of ECB deposits to final clients is limited by national legislation that does not allow banks to charge negative rates on retail deposits.””

If Turner is correct, the ECB could try a more aggressive approach and use a different set of easing tools, such as increasing the scope of eligible bonds in its QE programme to include corporate debt, an idea proposed by analysts at BofA, or include part-private-part-public company debt, as suggested by Barclays.

CoCos go Loco

A steep fall in the price of a bond called a CoCo or Contingent Convertible Bond, was at the root of the panic selling of financial stocks, which led to a 9.4% drop in Deutsche’s stock on Monday and a further 5.0% fall on Tuesday.

Coco’s are a rare form of bond, invented since the financial crisis, which convert into shares if certain negative conditions are met, such as the share price falls to a low level or a bank’s capital-ratio falls below a certain level.

The new equity effectively means that in the event of the bank running into trouble, the Coco bond-holders become the new owners, however, there are drawbacks for holders – for example, unlike a normal bond the issuer is not obliged to repay the principle, also regulators can also stop them even from paying the interest, and they are one of the last debt instruments in line to be paid.

On the plus side the interest payments are high at 6-7%, reflecting their high risk premium.

In a recent note ING’s Turner explains:

“Eurostoxx banks index is already off 10% this week.

“The source of current stress, are Cocos - securities issued by banks to improve regulatory capital and see investors, not tax payers, suffer losses if important capital thresholds are breached.

“In return investors commonly received yields in the 6-7% area and this asset class was one of the best performers last year.

“The nub of the problem for banks is profitability – current stress has been triggered by Deutsche Bank’s Q4 results last week and fears, since denied, that it would not pay a coupon on its CoCos.

“Over recent years banks have attempted to meet higher capital standards by issuing securities like CoCos or shrinking their Risk Weighted Assets.

“Current stress only points to more de-leveraging.”

The panic started after Coco bonds fell from 94% of their price at origination to only 74% in a matter of days, a sign investors had soured on them – no doubt as a result of the DB’s Q4 results as well as general global risk aversion.

In addition, with Deutsche, the weight of litigation costs from the recent Libor scandal, as well as other potentially illegal activities involving Mortgage Backed Securities and ‘mirror trades’, could cost the bank billions in legal fees, fines and compensation down the line.

The German Bank’s shares made a recovery on Wednesday, however, after the CEO John Cryan said the bank was “rock solid”.

It's stock price was further supported after it announced a massive 50bn bond buy-back of Senior level debt, ie those bonds which have creditor seniority in the event of a default.

By removing the highest senority debt, the move was probably meant to help shift Coco holders, whose debt has low senority, up the queue of creditors, and so reassure them they would get paid.

According to figures quoted in the Financial Times, Deutsche has sold about 10bn worth of coco’s in total, with 1.75bn at 6% interest.

If we assume an average interest rate of 6% for all 10bn, not just the 1.75, then Deutsche’s annual repayments on that debt would amount to about 600m.

Given the bank has 220bn in reserves, that does not seem like an unaffordable amount.

It seems possible, therefore, that concerns they might not be able to pay, may have been somewhat exaggerated – at least on the face of it.

Nevertheless given Deutsche is not the only bank who's Coco's are 'going loco' but that Santatnder and UniCredit have also seen large moves lower in the price of their Coco's it shouldn't be ignored as a risk factor either, especially given the huge complexity of bank finances. 

Potential Contamination Threat

Coco’s were an invention which was meant to protect governments from having to bailout large banks, however as Turner notes the risk appears to be seeping into government debt markets as well:

“CoCos were meant to separate bank from sovereign risk.

“Yet the poor performance of Italian banks has pushed Italy’s sovereign CDS out to 2014/15 highs.

“With financially sensitive currencies of GBP and USD under pressure, the ECB EUR trade-weighted index has now pushed back to levels last seen in early 2015.”