In his Bloomberg View Money Stuff column, Matt Levine looks at Deutsche Bank’s choice to raise capital by selling shares to employees in lieu of bonuses or to outside investors. He presents the choice as an arbitrage trade between an informed investor (the employees) and blind gamblers (outside investors).
I am not going to offer any comments on his presentation other than to point out it illustrates why banks need to provide transparency so outside investors can properly assess them.
Deutsche Bank AG might need to raise capital. One thing that makes it hard for banks to raise capital is that banks know what is in them and no one else does. There is a market for lemons problem. Banks are opaque and complicated, and if there is one thing the last few years have taught us, it is that there is always some new scandal lurking. The banks know what they own and what they’re up to, and what scandals are lurking, but the investors who might buy their equity don’t, or at least, they don’t trust that they know everything they need to. And banks tend to raise capital when their risks and scandals are most off-putting. “Here, have some of this bucket of writhing goop,” the banks offer, and the investors turn up their noses.
On the other hand, if you are already immersed in the goop, maybe you’ll think that it’s not that bad? That’s the main logic behind stuff like this:
Deutsche Bank AG, Europe’s biggest investment bank, is exploring alternatives to paying bonuses in cash as Chief Executive Officer John Cryan seeks to boost capital buffers and shore up investor confidence, according to people familiar with the matter.
Executives at the German lender have informally discussed options including giving some bankers shares in the non-core unit instead of cash bonuses, said the people, who asked not to be identified because the deliberations are private. Another idea under review is replacing the cash component with more Deutsche Bank stock, they said.
This trade is essentially a price arbitrage. If you sell Deutsche Bank stock to outsiders who don’t know or trust the bank, they won’t pay you that much for it. But if you give it to insiders instead of cash for their bonuses, those insiders know and trust the bank — because they work there and have had a hand in making the goop — or at least they have to act like they do anyway. So you can get more bang for your buck by paying employees in shares than you can by selling shares to the public and using the proceeds to pay employees in cash. And this is especially true of the goopiest of the goop: Shareholders might dramatically discount the price of non-core operations, and raising capital by selling non-core equity directly to investors is particularly unappealing, but the bankers who understand the weird non-core stuff might be thrilled to own it.
There is a counter-argument that Deutsche Bank employees should value the goop less than the market does, because after all they are already swimming in it, and they can’t diversify away their exposure to Deutsche Bank the way a regular investor could. These plans could “make retaining top staff more of a challenge,” says Bloomberg Intelligence analyst Arjun Bowry. But this idea has worked great for Credit Suisse in the past, where bonuses paid in “toxic securities” that no one else wanted gave employees huge returns. Generally, the arbitrage should work if the bank is (1) embattled and (2) fundamentally sound, that is, if there’s a big enough disconnect between how the public values the bank’s weird stuff and how the employees do. Making employees eat the bank’s cooking is fine, if they find it delicious. If they think it’s poison, and have to eat it, they should quit. But if they think that then they shouldn’t really be selling shares to the public either.