Illiquid assets at Europe investment banks fuel capital doubts

Frankfurt

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 US$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 US$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 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 US 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 pre-tax losses of US$5.89 billion. That compares with the US$3.55 billion of pre-tax profits the three banks generated in the period.

Banks split assets into three categories: Level 1 for those with transparent prices, such as 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. "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 realise 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. BLOOMBERG