OREANDA-NEWS. August 04, 2015.  Fitch Ratings says Deutsche Bank AG's (Deutsche Bank; A/Negative/a) progress in improving underlying revenue in all its divisions in 2Q15 was weighed down by continued high litigation charges and higher operating expenses. If the new co-CEO is successful in bringing down Deutsche Bank's cost efficiency to be more in line with its global trading and universal bank (GTUB) peers, it would be positive for the bank's credit profile. The results have no immediate effect on Deutsche Bank's ratings.

A 17% year-on-year (y-o-y) increase in revenue, largely driven by Deutsche Bank's investment banking (CB&S) and wealth and asset management divisions (DeAWM), and a 3.6% q-o-q reduction in risk-weighted assets (RWA) allowed the bank to make progress towards its 2020 strategic targets in 2Q15. In particular, the return on average tangible equity improved to, albeit still weak, 5.7% (2Q14: 2.2%; 2020 target: above 10%) and the bank's fully-applied CRDIV common equity Tier 1 (CET1) ratio improved 30bps q-o-q to 11.4% (2020 target: around 11%). which places Deutsche Bank in the middle of its GTUB peer group.

The leverage ratio, despite improving to 3.6%, remains at the low end of the peer group. However, the bank's plans for significant further balance sheet reduction should bring the leverage ratio more in line with peers.

Despite revenue improvements, a EUR1.2bn net litigation charge (of which EUR797m was booked in the bank's non-core operating unit; NCOU), largely relating to US mortgage litigation, and higher operating expenses, partly from regulatory initiatives, meant that Deutsche Bank's cost-to-income ratio was unchanged at around 85% (2020 target: around 65%), which is the weakest in the GTUB peer group.

Despite significant litigation reserves (EUR3.8bn at end-2Q15), we expect litigation-related charges to remain significant in the short- to medium-term. Management stated that costs resulting from its strategic review, conclusions of which will be announced in October, would likely be front-loaded, which will put further pressure on Deutsche Bank's cost base in the short to medium term. Also, costs relating to the re-IPO of Deutsche Postbank AG (Postbank; A-/Watch Negative/1), expected by end-2016, as well as the ongoing repositioning of CB&S will in our view weigh heavily on Deutsche Bank's cost base.

Deutsche Bank's pre-tax income in 2Q15 (EUR1,228m) was significantly higher than the EUR917m reported a year ago but 17% lower than the previous quarter, which is seasonally a more favourable quarter for trading activities. Excluding the bank's NCOU (which reported a EUR909m pre-tax loss, 138% up q-o-q, largely due to litigation costs), Deutsche Bank's pre-tax income improved 15% q-o-q (and 42% y-o-y) to EUR2,137m. Consequently, the pre-tax return on equity ratio in the bank's strategic activities improved to 13.2% in 2Q15 (from 12% in 1Q15 and 12.1% in 2Q14), which compares adequately with most peers.

CB&S, Deutsche Bank's largest segment, reported solid revenue (EUR4,313m), 23% higher y-o-y and only 7% below 1Q15. CB&S's result benefited to some extent from favourable foreign currency (FX) movements but nonetheless compares well with most GTUB peers'.

Revenue in the bank's strong fixed income sales and trading franchise (EUR2,110m) were 20% lower q-o-q (16% higher y-o-y). Similar to its peers, within fixed income, FX revenue and revenue from the bank's rates business improved while revenue from its credit and emerging market debt franchises were markedly lower. Revenue in Deutsche Bank's other CB&S segments (debt and equity origination; equity sales and trading) held up well. Operating expenses in CB&S were 15% higher y-o-y in 2Q15, largely due to adverse FX movements and higher regulatory costs. Pre-tax income in CB&S improved sharply in 2Q15 to EUR1,200m and accounted for 50% of Deutsche Bank's core pre-tax profit (ie. excluding NCOU and corporate centre).

Pre-tax profit in Deutsche Bank's private & business clients segment (PBC; including Postbank) was 27% higher y-o-y (10% lower q-o-q) at EUR483m or 20% of core pre-tax profit in 2Q15. With revenue stagnant at EUR2,358m, improvements were entirely driven by lower costs to achieve and impairment charges, and the non-recurrence of charges from loan processing fees. Within PBC, Postbank's pre-tax contribution fell sharply while the contribution from international PBC improved marginally.

Revenue in Deutsche Bank's global transaction banking (GTB) segment remained resilient but pre-tax profit (EUR283m; 12% of core pre-tax profit) was dampened by both higher regulatory costs and litigation charges. Foreign exchange movements and reserve releases drove the y-o-y improvement in pre-tax profit for the division.

DeAWM (pre-tax profit of EUR422m or 18% of core pre-tax profit) remained Deutsche Bank's best-performing segment with y-o-y and q-o-q increases in both revenue (+25%, +3%) and pre-tax profit (+107%, +45%). Revenue benefited from higher performance fees (16% of revenue vs. 13% in 1Q15) and solid net new asset flows (EUR15bn for the quarter).

Within NCOU, Deutsche Bank made solid progress in further reducing balance sheet exposures (down 28% y-o-y at EUR35bn at end-2Q15) and RWA (down 22% at EUR44bn). This was achieved without incurring excessive exit costs; excluding litigation charges booked in NCOU, the segment's pre-tax loss for the quarter would have amounted to EUR112m.

Pre-tax loss in Deutsche Bank's corporate centre (called consolidation and adjustments) was significantly larger in the quarter at EUR250m (EUR124m in 2Q14 and EUR18m in 1Q15), as a result of the negative impact from the movement in USD and EUR interest rates, higher funding valuation adjustments and a EUR92m negative impact from the purchase of additional Postbank shares.

Deutsche Bank's fully-applied CET1 capital decreased slightly in the quarter (by EUR400m to EUR47.4bn) as a result of negative FX movement, dividend payments and the accrual for coupon payments on additional Tier 1 instruments (EUR4.6bn outstanding at end-2Q15). Lower securitisation inventory in CB&S led to a decline in market risk RWAs, which was the main driver of a 30bps q-o-q increase to 11.4% in the bank's CET1 ratio. Similar to peers, further RWA reduction without affecting business lines (and corresponding revenue) will, in our view, be challenging given, among other things, the upward pressure on operational risk RWA (19% of total RWA at end-2Q15 vs. 17% at end-2014) and regulatory initiatives to review model-based RWA calculations.

Deutsche Bank's Tier 1 leverage ratio improved 16bps during the quarter to 3.6% with a solid 5.7% reduction in leverage exposure (to EUR1,461bn) more than offsetting a slight drop (-1.1%) in fully-applied Tier 1 capital (EUR51.9bn). Lower derivative exposures led the improvement in leverage, partly offset by higher lending exposures. Management expects to achieve its 2020 target of above 5% by the deconsolidation effect of Postbank (40bps), CB&S deleveraging (40bps), reductions in NCOU (20bps) and internal capital generation. While the bank expects to achieve the CB&S deleveraging largely through optimising current exposures and the disposal of low-yielding assets, the negative impact on revenue from this is difficult to predict and could be higher than management's projections (EUR800m exit costs and EUR600m reduction in CB&S run-rate revenue according to the bank's 2020 strategic plan announced in April 2015).