Interview with Stuart Lewis, Chief Risk Officer of Deutsche Bank AG.
Mr Lewis, people reading the newspapers over the last few weeks could be taken aback that you’re able to find the time to give interviews, instead of poring over scenario calculations in preparation for the merger with Commerzbank.
(Laughs) I believe our CEO Christian Sewing has already made a very clear statement concerning the merger speculation.
He said that Deutsche Bank has to improve its profitability first, before it tackles other topics.
That’s right. We are working to deliver on our own.
In any case a lot has been written about the bank recently: that it is considering a holding company structure, that it will have to set up a subsidiary in London because of Brexit, that it requires a capital increase because of its derivative positions, and so on. Where is the deluge of such reports coming from?
There is a lot of interest in us and a lot of speculation. I would, however, like to stress that our bank has become much sounder and more resilient over the last six years. We have improved our risk systems, and we are investing a lot in managing our credit, market and operating risks appropriately and to future-proof our risk management structure.
So what’s keeping you busy at the moment? With regard to the risks facing the bank what’s currently your number one priority?
As Deutsche Bank’s risk manager you have to assess, among other things, how macroeconomic risks might impact the bank. For example, right now we are currently assessing what the consequences of a prolonged trade dispute might be. We’re currently running a variety of stress tests within the bank.
And what are your conclusions?
Our assessment is that a trade dispute would impact our bank's individual businesses in very different ways. We’re alive to this and are monitoring the risks on a daily basis. Our strong capital base is very valuable in this context.
Which business sectors would be particularly hard hit?
It may be stating the obvious but a trade dispute would particularly impact countries and industries which are highly globalised and exposed to international markets.
At a time when you’re concerned about a trade war does counterparty risk also assume greater significance?
We are analysing which sectors would be harmed by a prolonged trade war and which counterparties or clients would be affected. Yes, if there were to be a major shock, then this could expose a number of clients to challenges.
What conclusions do you draw from this?
As a risk manager your primary focus is, of course, managing your own risks – both on- and off-balance sheet – for example, exposures to derivatives counterparties. As far as Deutsche Bank is concerned, we are well positioned. The large financial institutions, the hedge funds and also the other market participants generally provide us with collateral. This would help us to mitigate losses even in the case of a default.
What else is on your mind?
Another area that we are addressing is the potential impact of Brexit.
What’s the biggest concern on that front?
Brexit is such an important topic for me as a risk manager primarily because there are so many uncertainties associated with it. That is why proceeding in a timely and meticulous fashion is a priority for us. Deutsche Bank is, however, well placed overall to absorb the impact of the UK’s exit from the EU. Regardless of the ultimate outcome of the Brexit negotiations we will ensure that we have a presence where our clients operate. Some time ago, we had already decided that Frankfurt will become the main booking location for the business of our Corporate & Investment Bank. This plan is already being implemented.
For example, the new business of settling euro-denominated derivatives. How much of a factor is the problem of contract continuity? Not only many a regulator on the continent is concerned that contracts signed under British law might no longer be enforceable or are likely to be contested.
There are many issues with derivative contracts, across the industry, and we therefore have had numerous discussions with our clients. There are at least two main questions. From a licensing perspective, unless there is an agreement between the EU and UK, post Brexit there will be challenges for banks in processing certain existing financial contracts with EU clients from the UK. From the point of view of the choice of governing law, we expect English law to remain the dominant choice for these types of contracts for the time being. But, of course, there is a great deal of uncertainty on these issues. Ultimately, however, I expect an appropriate dose of pragmatism to return to this issue. That is why I am not too pessimistic about either old or new contracts
This means the threat of a trade war has a higher priority for you than Brexit.
Yes, because a prolonged or even escalated trade war would trigger a more serious impact over the longer term than Brexit – our economists share this view.
How do you actually safeguard against a trade war, if the results of the stress tests that you’re currently running within the bank don’t prove to be reassuring?
Of course in those areas where you identify particularly high risks you try to reduce them - by selling or reducing positions, or using derivatives for example.
The reform of benchmark interest rates could cause headaches for regulators, banks and supervisors in the near future. But it is still completely unclear what a new Euribor will look like. What does that mean for Deutsche Bank?
We have documentation with counterparties which refers to certain benchmark rates, so if there is a new benchmark banks will need to determine whether that documentation is still valid.
If you consider the combination of the threat of a trade war, Brexit and the benchmark interest rates reform – would you say that your work has become harder over the past two years?
In the last few years we have experienced new regulatory requirements. This ties up resources of course. At the same time, we are working to equip ourselves for future regulation such as the final Basel III rules that are due to be introduced over a five-year period starting in 2022.
Nevertheless specific incidents do also occur over and over again that give rise to specific risks. A few months ago, for instance, Deutsche Bank raised eyebrows with an erroneous transfer of 28 billion Euros to a Eurex account. How do you model such risks?
Let me first put that incident into context: the bank detected and put in train steps to rectify the error itself within a few minutes. The money has never left our house, no financial loss was incurred. We investigated the reasons for it conscientiously and took the appropriate steps to ensure such an error is not repeated. In the non-financial risk area alone we differentiate between about 20 top risks. High-value payments are one of those. In the case of larger payments we therefore always apply the principle of dual control. Over and above the principle of dual control we have introduced additional automated controls.
One operational risk is money laundering. A few days ago BaFin appointed a special representative for Deutsche Bank to address deficiencies in anti-money laundering. Was this because of negligence regarding this risk, because longstanding requirements were inadequately implemented?
We are strongly committed to operating within regulatory compliant practices for the identification of our clients (Know Your Client). We are in agreement with BaFin that we have to improve these processes in the Corporate & Investment Bank further. The bank will work together with BaFin and the special representative KPMG to fulfil the regulatory requirements as soon as possible and within the given timeframe. This is an issue for the whole industry which involves high investments. Every bank has to constantly examine how it can improve its safeguards and also structure them more efficiently, for example by using artificial intelligence. We’re confident that we’ll succeed in this.
Cyber risks are another risk that everyone is talking about, but it’s one which is difficult to model.
Indeed, cyber risks are captured in our operational risk models nowadays – both for the likelihood and severity. A capital requirement is calculated for this, based on model calculations on loss frequency and amounts. In addition, Deutsche Bank has materially improved governance in this area – for example by putting its own specific control body in place, as part of the supervision of non-financial risks. Its mandate includes controls on transaction and process activities, as well as on infrastructure risks in order to prevent process failures and to ensure the confidentiality, integrity and availability of data and information, as well as the identification of archiving risks. As risk managers, we ensure that the business divisions have sound plans in place in order to get critical business processes and functions back up and running in the event of disruptions caused by technical or construction-related incidents or natural disasters and cyber-attacks.
The bank's risk-weighted assets attributable to operational risks have increased recently.
It is true that they increased from 52 billion euros in 2012 to 92 billion Euros last year. They have risen steadily, but have stabilised recently.
Cyber risks don’t worry you as much as the threat of a trade war.
Whenever I have to deal with a risk, I think about how high is the probability that it will occur and how significant the impact would be if it were to occur. I would say that a trade war seems to be more probable than a successful cyber-attack. The impact of a trade dispute would be manageable whereas it is far more difficult to estimate the impact of a cyber-attack, which could possibly be more profound, though. There is always a trade-off between what is more visible and could harm us and what is less likely, but could have more profound effects. And that's not all: when considering risks, there is another aspect that needs to be taken into account.
And what is that?
There are risks that potentially impact earnings. However, there are also some risks that simultaneously open up earnings opportunities, for example in the form of higher market volatility, which in turn can boost our trading business.
Sometimes, however, things run less smoothly in investment banking. This is what investors discovered last year when Deutsche Bank specified around 60 billion Euros of balance sheet relating to problematic legacy items. Is there an update on how this portfolio has developed since then?
There is no question of their being “problematic”. This was a portfolio of non-strategic positions amounting to 20 billion Euros of risk-weighted assets (excluding operational risk), which we want to dispose step by step.
Well, they are problematic because they tie up capital and put sensitive pressure on ROE because the bank doesn't earn any money with them.
That doesn't necessarily mean that they are bad assets from the start. We are reducing the portfolio. At the start of June this year, my colleague James von Moltke said the portfolio had already been reduced to 9 billion Euros of RWAs at that time.
In addition to this portfolio, Deutsche Bank reported around 22 billion Euros of level-3 assets in its balance sheet at the end of 2017; these are assets whose valuation can only be estimated, even with comparable assets, due to a lack of market values. Many investors consider this volume to be far too high. Are you planning to scale it back?
At 88 billion Euros, the volume of level-3 assets was four times higher ten years ago. That corresponds to three or four times equity capital at that time. Now it’s one-third. Other banks’ levels vary between 15 and 35 percent. I would not say that it is too high in our case. We are also comfortable with the valuation level. It is regularly reviewed by ourselves and also by the auditor. After all, these assets are not level-3 assets because they involve such high risks, but simply because, in these cases, we don’t have observable market pricing in all criteria. This is why I don't regard these assets as being higher-risk.
Larry Fink, CEO of BlackRock, once said that if there is no market price for an asset, then it’s probably worth nothing. Is he only saying that because he wants to get these assets for free?
We have a range of internal and external indicators that show us that these assets are appropriately valued. After all, we trade in these assets, too, and turn the portfolio over on average every three years. By comparison, the average retention period for assets across the Group is three and a half years. The challenge with the accounting treatment of these assets is simply determining a market value on the valuation date.
So you are not planning to bring the level down?
How the volume develops is dependent in large measure on our clients.
Do you have an outlook on how risk-weighted assets are to develop over the remaining course of the year and in the coming year?
No, but it is common knowledge that we have the goal of maintaining our Common Equity Tier 1 ratio, that is the ratio of Common Equity Tier capital to risk-weighted assets, above 13 percent. At the end of the second quarter this ratio was 13.7 percent. Therefore we have room to grow.
Observers also claim that Deutsche Bank’s inventory of exchange-traded and OTC derivatives, the nominal volumes of which came to no less than 48 trillion Euros at the end 2017, is a cause for concern. This is almost 15 times Germany's GDP and around 5 trillion Euros more than at the end of 2016.
Instead of looking at the nominal amounts of derivatives and adding assets and liabilities, one should offset derivative receivables and liabilities against each other and then look at the market value. Then we are talking about a significantly lower figure. Incidentally, our competitors in the US can do this in accordance with their local accounting rules; however, we can’t at the moment because our bank is subject to IFRS rules. For this reason, it is important to understand that in net terms, our derivatives position amounts, in fact, to 72 billion Euros and not to trillions. This is offset by cash collateral of 40 billion Euros, which we are holding in our portfolio. Then there are additional financial instruments as collateral items, such as German government bonds and US Treasuries. This ultimately leaves an exposure of 23 billion Euros in the middle of this year. And if you look at this amount in the context of our balance sheet, it is by no means oversized compared to our competitors, especially since the volume is distributed among different clients, which ensures a certain amount of diversity and risk diversification. Moreover, we are employing more transaction compression. This is where several individual transactions are replaced by a single transaction that replicates the economic effect of the transactions. This will reduce the nominal volume of the derivatives inventory over time. For this reason, it doesn’t make me uncomfortable at all.
As Deutsche Bank’s CFO James von Moltke explained a few days ago, Deutsche Bank now distinguishes between a total of more than 140 types of risk. What types of risk does this cover?
We have already mentioned risk in the form of large payments. A counterparty defaulting is another. Pension risks are another example. We not only deal with pension risks, but also with mortality risks and many other types of risks - for example, we bear physical security risks in our bank’s buildings. We have created a Risk Appetite Framework that identifies the key risks for each individual division from among the 140 risks. This is really very granular. And many of our employees have now fully understood that we look at risks according to the respective business unit, keeping in mind the full range of risks we face, including, for example, that a risk in one business unit could also impact another unit. This shows me how much the risk culture of our bank has changed. There is now a much greater appreciation of risk management and a different view of the risks than there was prior to the financial crisis.
The interview was conducted by Bernd Neubacher.
18th of October 2018
Stuart Lewis is Chief Risk Officer of Deutsche Bank AG.