Opaque Assets at Europe Investment Banks Fuel Capital Doubtsby
Deutsche Bank holds most Level 3 trading assets, derivatives
Investors should be ‘more circumspect’ on values, analyst says
Eight years after the financial crisis, Europe’s biggest investment banks are holding illiquid assets amounting to more than half their combined shareholders’ equity, underlining concerns about capital.
Deutsche Bank AG, Credit Suisse Group AG and Barclays Plc say their hardest-to-value securities -- known as Level 3 assets -- were worth $102.5 billion at the end of June. These include investments that gained notoriety in the financial crisis, from bespoke credit derivatives to mortgage-backed bonds.
“The scale of Level 3 assets is material in terms of the banks’ capital levels,” said Simon Chester, who helps manage $39 billion of fixed-income securities at American Century Investment Management in London. “If there were to be a significant mistake or miscalculation where they have got the valuations wrong, that could be problematic.”
While such assets aren’t the only hangover for Europe’s biggest investment banks, they’re contributing to lingering doubts about their health. The firms are still paying fines and settling lawsuits, often for misconduct relating to excesses from before the financial crisis. Trading revenue is shrinking, while negative interest rates are squeezing lending margins and investment returns.
“I’d like to see more progress on shrinking their most complex securities and derivatives,” said Olaf Struckmeier, who helps manage 268.5 billion euros ($304 billion) at Union Investment in Frankfurt. “It doesn’t help to have this hanging over them.”
Shares of Deutsche Bank plunged by about half over the last year, as did those of Credit Suisse, which is moving away from investment banking to focus on wealth management under Chief Executive Officer Tidjane Thiam. Barclays, led by CEO Jes Staley, tumbled by around a third. All three trade below book value, a signal investors doubt their assets are worth as much as company accounts indicate.
The European banks have trailed their U.S. competitors in cutting risky assets to meet tougher capital rules, and progress has come at a cost. In the first half, the units housing assets targeted for disposal -- which include some Level 3 holdings -- had combined pretax losses of $5.89 billion. That compares with the $3.55 billion of pretax profits the three banks generated in the period.
Banks split assets into three categories: Level 1 for those with transparent prices, like stocks; Level 2 for assets where some external data is available, including over-the-counter derivatives such as interest-rate swaps; and Level 3 for the most illiquid. Banks value these using their own models based on historical data and risk assumptions.
“They’re hard to unwind,” said Howard Davies, the chairman of Royal Bank of Scotland Group Plc, in a Bloomberg Television interview Monday. “It’s not that they are not performing, they may be performing as intended, but if a bank needs more capital they are impossible to realize as there just isn’t a ready market for them.”
Some credit default swaps and interest-rate hedging products classified as Level 3 have maturities of as much as 30 years and structures that make them “very, very difficult to exit,” he said. RBS, once one of the world’s biggest banks, shrank its own Level 3 assets by 80 percent to 4.2 billion pounds ($5.5 billion) since the end of 2008.
Deutsche Bank, Credit Suisse and Barclays cut their Level 3 holdings by 62 percent, on average, since then. That compares with an average 76 percent reduction at the five biggest U.S. investment banks -- JPMorgan Chase & Co., Citigroup Inc., Goldman Sachs Group Inc., Bank of America Corp. and Morgan Stanley -- their filings show.
Regulators are making it costlier for banks to hold assets which rely on internal models by forcing them to hold additional capital in reserve against such investments.
“Most of these products, with interest rates where they are, probably have some reasonable value,” said David Moss, who helps oversee more than $230 billion as head of European equities at BMO Global Asset Management in London. “But the capital requirements needed against them mean that it is probably virtually impossible to earn a return.”
The banks are stepping up efforts to cut unwanted holdings. Credit Suisse sold a portfolio of credit-default swaps, consisting of about 54,000 trades, to Citigroup, two people with knowledge of the sale said this month. Barclays has a “strong pipeline of announced disposals,” Finance Director Tushar Morzaria told analysts last month. Deutsche Bank unwound a long-dated structured transaction in July and plans to shut its unit housing non-core holdings this year, according to CEO John Cryan.
Officials for the three firms declined to comment for this article.
Deutsche Bank, Europe’s largest investment bank, has larger holdings of trading assets and derivatives than its two competitors, company filings show. David Hendler, founder of Viola Risk Advisors and a veteran bank analyst, said the prices assigned to many of those assets probably don’t adequately reflect the dearth of demand.
“You have to be a lot more circumspect,” Hendler said. “Look at it on a standalone basis and then decide, what would an opportunistic investor pay for this?”
Others say the worry is misplaced. Just because an asset is designated Level 3 doesn’t mean it’s toxic, said Marco Troiano, an analyst at Scope Ratings in London.
“All you can take from the fact that they are on Level 3 is the lack of liquidity and observable parameters for valuation inputs, not that they have potential losses or problems,” Troiano said.
Big securities firms will always hold some assets which are impossible for outsiders to value and they have proved in recent years that they can manage them, said Chester. Investors can also take comfort from regulators’ scrutiny of Level 3 holdings in stress tests, he said.
Brian Moynihan, the CEO of Bank of America, told Bloomberg Television this month that European banks have been slow to shrink risky assets because there’s less investor demand in the region than in the U.S.
“They’re getting to it at a pace that’s more slow and people are going to be critical of it, but you’ve got to understand it’s hard,” he said.