Stuart Lewis: «Deutsche Bank has cut its exposure to derivatives»
di Isabella Bufacchi
7' di lettura
Deutsche Bank didn't get one euro from the State to strengthen its capital during the Great Crisis. Without State guarantees, but helped by stricter banking prudential regulation and supervision, in the last ten years from 2008 to today, DB has been cutting its balance sheet and most of all it has been reducing the risks in its balance sheet: especially those risks that destroyed many gigantic banks during the Great Crisis. DB didn't have to cut non-performing exposures (NPE) as the NPE/total assets ratio at DB has always been low and it is now about 0.8%.
«I can definitely say that DB is a safe bank», says Stuart Lewis, Chief Risk Officer and member of the Management Board at DB since 2012, in an exclusive interview with IlSole24Ore. Lewis is also chairman of Deutsche Bank S.p.A. in Italy.
Ten years ago Deutsche Bank was trading over €40 on the stock exchange. On November 2008 its stock had gone sharply down just above €14, now it hovers around €10. The market continues to look at DB with a critical eye, focusing on profitability, costs, earnings, revenues and also on risks. In particular the derivatives exposure of DB is under scrutiny, so much so as the less liquid and illiquid assets on its total assets. Compared to ten years ago, at the peak of the Great Financial Crisis, is DB a safer bank nowadays?
I can definitely say that DB is a safe bank. Ten years ago, in 2008, our derivatives gross exposure amounted to more than 50% of our total assets, now it is 24%. And in the last 10 years, our balance sheet shrank massively too: from €2.2 trillion in 2008 to €1.4 trillion in 2018. In 2013 and 2014 DB went through a massive “compression” of its derivatives exposure.
What does it mean to make a “derivatives compression”?
You need to know the traditional way of derivatives trading: instead of closing a position, traders often used to make a new derivative with the opposite flow, so that the netting would result in zero risk position but on gross notional terms the portfolio increased. Our balance sheet was cleaned up in 2013 and 2014 to clean the balance sheet from this kind of operations that were doubling our gross volume of derivatives.
The size of derivatives does scare markets off, whether derivatives are compressed or not. People usually make a mistake when they look at the notional amount of the underlying assets of OTC derivatives, when the focus is on that impressive US$ 530 trillion notional value given by the BIS. Let's instead look at the gross market value of global OTC derivatives which at the end of 2017 amounted to US$ 10 trillion: what is DB's derivatives trading portfolio compared to this figure?
Gross notional derivative exposure is no reflection of credit or market risk. Let's look at the flows. It is important to start by saying that derivatives are cash flows on underlying assets. So we never refer to derivatives portfolios in terms of the notional value of the underlying assets, what counts is the cash flow. The derivatives risk is made of the asset price sensitivity, the mark-to-market of our positions and the counterparty risk: assessing the probability that the counterparty of a derivative is not able to meet its obligations. The gross size of our derivatives trading portfolio, at market value according to European accounting standards IFRS, is made of the present value of the future cash flows: €348 billion is the flow owed to us by our counterparties and €276 billion is the flow that DB owes to the counterparties. The netting of these two oppositeflows brings it down to a net derivatives exposure of €72 billion.
Some market players think that NPEs are better than OTC derivatives because NPE are collateralised by real estate assets, so their recovery value is higher or the risk is lower compared to derivatives. Derivatives traded on official exchanges, such as futures and traded options, are backed by margins which must be paid to the clearing houses, initial margins and even intraday margins. Are there margins in OTC derivatives too? How can you collect margins on tailor made OTC derivative products?
The bulk of our derivatives portfolio is collateralized, as most derivatives are collateralized. OTC derivatives have been collateralized for the past twenty years and recent financial market regulation like EMIR and Dodd Frank have increased the level of collateralisation. To the extent possible, we also use clearing houses (“central counterparties”) for OTC derivative transactions. We thereby benefit from the credit risk mitigation achieved through the CCP's margining system and the clearing members' default fund contributions.
In what way do derivatives in your trading portfolio get to be collateralized?
For each counterparty, we assess the mark-to-market of the cash flow exposure and we ask for collateral when there is a credit exposure. Our net derivatives figure of €72 billion is mostly collateralized: the collateral is made of cash mostly in euro and US dollars (€40 billion), and in government bonds, in particular Bunds and US Treasuries (€9 billion). The unsecured net derivatives exposure therefore is only €23 billion and this is not too big. Furthermore, our counterparties in the €23 billion unsecured derivatives net flows exposure are mostly the ones who do not give collateral to anyone. Central banks from advanced economies or supranational entities are derivatives counterparties that do not provide collateral on derivatives.
What is the impact of your derivatives trading portfolio on CET1?
Our derivatives position has a (credit-)risk weighting of €29 billion, which is 8% of our total RWAs
Which kind of market risks is DB exposed to in its derivatives trading portfolio?
Our derivatives portfolio is mainly on interest rates, about 60-65%, then currencies (20-25%) and a small part on equities (8%) and credit derivatives (8%).
Market risks is higher for DB compared to other European banks. RWA for the European banks supervised by the SSM is on average divided into 85% credit risk, 11% operational risks and just 3% market risks. Why is DB so different? How do you explain DB being more exposed to operational and market risks compared to the average of European banks? This is one of the main worries of your stakeholders and shareholders…
What I hear from our shareholders and fixed income investors is that they feel quite comfortable with our solid risk and capital position. The picture of the risk components for Deutsche Bank looks different from some banks, because a significant part of our service for clients is the corporate and investment banking. DB's RWA is 64% on credit risk, 9% on market risk and 27% on operational risk. There are two reasons for this composition. We assess the operational risk with the so-called “advanced measurement approach” (AMA), and this makes it higher compared to average European banks, which mostly use the non model-based approaches. In the past we had, like other banks which were active in investment banking, significant losses and provisions from civil litigation and regulatory enforcement, which have a significant influence on the risk calculation due to the model used. If we compare DB with Swiss, UK and US banks, our peers also have operational risks within a range between 20% and 30%. As for the market risk, that 9% is simply driven by the securities portfolio. Overall we monitor roughly 150 major risks in our bank, and out of these, about 100 risks are non-financial risks.
What is the impact of the new Basel FRTB (Fundamental Review of Trading Book) rules on DB? Market participants expect capital requirements on market risk will increase due to FRTB. Have you assessed the impact of higher capital requirements on DB?
This new set of regulation is not finalized yet so we do not know exactly how it will look like. It should be implemented starting from 2022 and it is going to take several years to fully implement it. It will be very gradual and over the phase-in period, the impact on our capital will be manageable.
Another risk that comes up looking at DB is your exposure to less liquid and illiquid assets , that is, Level 2 and Level 3 assets which do not have transparent prices as Level 1 assets do. European regulators are looking into these classes of assets with greater attention. Level 2 assets can get their price from similar assets, the same cannot be said for Level 3 assets. Some economists have come up with incredible numbers on the size of Level 2 and Level 3 assets in Europe: they say the sum of assets and liabilities Level 2 and Level 3 amount to a monster €6.8 trillion: what is DB's share of this huge pie?
Let's make one thing clear. Level 2 and Level 3 assets are not a description of the riskiness of the assets but a description of the observability of the fair value that you attach to the asset. It is a matter of accounting. Level 1 assets have quoted prices in active markets, so it is easy to see how they trade and perform to assess their fair value. Exchange traded derivatives, like futures and traded options, are in this category. Level 2 assets pricing is determined by reference to similar instruments traded in active markets, comparable assets on observable market data. Many OTC derivatives fall into this category, and also many CDOs. The Level 3 assets prices cannot be determined directly with market-observable information. However, Level 3 assets are traded. These are the complex OTC derivatives, illiquid ABS, CDOs and loans. Now the size: our Level 2 assets amount to 495 billion, out Level 3 assets are 22 billion. If we add Level 2 and Level 3 assets, the sum of Level 2 and Level 3 over total assets is 36%, and this is in line with our peers: Barclays and Credit Suisse are 38%, Citi is 44%, JP Morgan is 29%.
Did DB reduce its Level 3 assets in the last ten years?
Yes, it is now a quarter of what it used to be ten years ago. In 2008, DB had €88 billion in Level 3 assets, they now amount to €22 billion. And out of the €22 billion Level 3 assets, just €8 billion is the mark-to-market value of derivatives.