Deutsche's Near Miss
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After the collapse of Silicon Valley Bank in March, investors didn’t waste much time surveying the landscape to see who might be next. For reasons we discussed at the time, bank failures tend not to happen in isolation. Sure enough, a few weeks later, First Republic Bank fell into receivership. First Republic was Silicon Valley’s closest peer in style and substance – a “growth” bank centred on California whose balance sheet was similarly long interest rate risk and short stable funding.
Over in Europe, Credit Suisse also failed in March – or at least its regulators lost patience and forced a resolution. Its closest peer? Deutsche Bank. The week after Credit Suisse was taken over, Deutsche’s stock fell and the price paid to insure its debt soared. Germany’s chancellor was asked if Deutsche was the new Credit Suisse as he and others mobilised to defend it.
Three months on, Deutsche Bank is still standing. “Frankly, what’s gratifying is after the market took a look, quite quickly – and, by the way, without us necessarily having to speak for ourselves – the market saw that we didn’t have the vulnerabilities that the market was concerned about, whether it was interest rate risk or stability of deposits and on and on,” said the bank’s Chief Financial Officer, James von Moltke, at an investor event last week.
He’s right – Deutsche Bank never assumed the same kind of interest rate risk as other banks, and its funding proved more durable. Although only a third of total deposits were insured via statutory protection schemes, much of the rest came from sticky operational accounts that corporate customers need to keep replenished. Unlike investors, customers remained unmoved. Some deposits fled but the company attributes only around a third of that to the prevailing banking crisis, equivalent to 1% of its overall deposit base. By the end of the quarter, the bank’s liquidity coverage ratio – a measure of how much liquidity it has on hand to meet potential outflows – had risen slightly, giving it a €63 billion buffer against regulatory requirements.
Von Moltke must have been relieved the panic didn’t happen five years earlier. The quarter all this was going on turned out to be the most profitable quarter for Deutsche Bank in ten years. The bank reported a profit before tax of €1.9 billion and generated a return on tangible equity in excess of 8% – a far cry from the sub-2% returns the bank was doing through much of the late 2010s. Credit Suisse ultimately failed because it didn’t have sufficient profitability to sustain itself. That same charge was once levelled at Deutsche Bank but, just in time, it turned the corner.
This week we look at Deutsche Bank’s near-miss.
The Flow Monster
Deutsche Bank came to investment banking later than Credit Suisse, but each realised that they would have to pivot their strategy towards it at around the same time. Although Credit Suisse had acquired a stake in First Boston in 1974, it wasn’t until 1988 that the business was subsumed into the overall group. “We want to create an organisation…that allows us to be a major player in every area of financing activity around the globe,” said Credit Suisse chairman Rainer Gut.
Deutsche Bank recognised that globalisation was a major theme it too should respond to. “The advancing globalisation is increasingly threatening our position in the domestic market,” recorded a future chairman in a memo. The bank had built a significant overseas presence through representative offices and branches, but the emphasis remained on traditional commercial banking. In 1988, chairman Alfred Herrhausen made a speech to his directors advocating for a global expansion strategy, noting that in investment banking it was losing the race to American, British and Swiss rivals.
Deutsche had an additional incentive to look for opportunities abroad. Profitability in its domestic banking business was coming under pressure as interest rates started to fall. As we discussed in The German Bank Paradox, German banking is a highly fragmented industry. Deutsche Bank, in spite of its name, had just a 5% market share in personal and corporate banking. Although business volumes grew through the 1980s, profits did not. Group return on equity fell from an average 10.1% in the 1970s to 8.8% in the 1980s. And a lot of that derived from industrial shareholdings; in the late 1980s, around half of Deutsche’s market capitalisation was attributable to its holding in Daimler-Benz, a hangover from the days when it would acquire positions in client companies in the course of restructurings or to provide financial assistance.
In 1989, Deutsche Bank satisfied Herrhausen’s wishes to push into global investment banking by buying Morgan Grenfell of the UK. Sadly, Herrhausen didn’t survive to see it though; he was assassinated by a roadside bomb on his way to his office a few days after announcing the deal. And although he’d bemoaned the organisational divide that typically existed between commercial and investment banking, calling it “a big mistake, which results from our having developed the habit of thinking along the lines of a split banking system,” a decision was nevertheless made to leave Morgan Grenfell alone for five years to operate as an autonomous entity.
Integrating Morgan Grenfell into Deutsche Bank wouldn’t be a smooth process. Some on the management board recoiled at the prospect of a London-based investment bank undermining Deutsche's heritage as a German universal bank. On the other side, investment bankers feared that integration would erode their culture. John Craven, chairman of Morgan Grenfell, had previously worked in a senior role at Credit Suisse and had seen it all before – a radical restructuring there, aimed at integration, had “the result that the entire top team in London left within 18 months”.
It wasn’t until 1998 that Morgan Grenfell was fully subsumed into Deutsche Bank. Along the way, the group operated under a variety of matrix structures, with business oversight pushed back and forth between London and Frankfurt. In charge of the new Global Corporates and Institutions segment was a Swiss banker recently hired from Credit Suisse, Josef Ackermann.
Under Josef Ackermann, Deutsche Bank fully embraced the global investment banking strategy. His biggest division was Global Markets (principally, fixed income) run by Edson Mitchell, an ambitious trader recruited from Merrill Lynch. John Craven hadn’t wanted them, but the foreign exchange and money market activities that flowed from Deutsche’s branches worldwide nestled well within the investment bank’s fixed income division. “I have just been given the keys to the kingdom at Deutsche Bank,” Mitchell told a colleague. “We can do whatever we want.”
Group revenues increasingly skewed towards investment banking. In 1998, over a third of group revenue came from Global Corporates and Institutions, although the profit contribution was lower because of the higher costs associated with the business (“2,500 people in 18 months – it has never been done since,” Mitchell’s colleague later recounted).
Nevertheless, management decided they needed to make a further acquisition to bolster their position in the US, the world’s largest capital market. Credit Suisse would look to expand there in 2000 by buying DLJ but one year earlier, Deutsche Bank filled its own gap with the acquisition of Bankers Trust. The deal enhanced Deutsche’s position in Global Markets and US equity issuance. But, at 2.4 times book value, it was expensive. And it gave birth to an enormous balance sheet – the largest bank balance sheet in the world at the time, at $850 billion.
Although Deutsche strived to extract synergies from the deal more quickly than it had in the case of Morgan Grenfell, they were difficult to parse at the group level. In 1999 the group reported a 3% return on equity and although profitability improved in 2001 (to 7.5%) returns then collapsed to 3-4% over the next two years.
But at least the bank had (finally) cracked its ambition to be a global investment bank. “At the end of the 1990s, more than 20 banks around the globe wanted to advance to be one of the five best investment banks in the world,” Josef Ackermann told shareholders on his retirement in 2012. “Deutsche Bank is the only non-US financial institution to have achieved this objective.” (Chew on that, Credit Suisse.)
Just as Alfred Herrhausen never got to see the integration of Morgan Grenfell into Deutsche Bank, Edson Mitchell didn’t get to see the full integration of Bankers Trust. In December 2000, en route to his holiday home in Maine, his plane crashed, killing him and his pilot. Ackermann promoted Anshu Jain to take his place.
Under Anshu Jain, the Global Markets business continued to thrive. In the first half of 2002, Deutsche Bank ranked second in the world in debt sales and trading, behind Citigroup and ahead of JPMorgan (Credit Suisse languished in sixth place). A few years earlier an analyst at JPMorgan branded Deutsche a “Flow Monster” for the role it played in intermediating client fixed income flows. It was a name Anshu Jain grew proud of.
The Global Hausbank
While the tailwind of buoyant markets helped propel Deutsche Bank over the next few years, what really helped was the leverage it was allowed to assume. In 2002, Josef Ackermann took over as CEO of the entire group and promoted a 25% return on equity target. One way to achieve that was to run with as little equity as possible relative to assets. On the eve of the financial crisis, the group just about got there, but most of that was due to leverage. On a capital footing more consistent with current norms, return on equity averaged around 8.5% over the two years 2005 and 2006, higher than in prior years but not as exciting as the headline figures suggested. The beneficiaries were employees, who saw compensation soar to €13 billion.
Shareholders paid the price during the financial crisis when Deutsche Bank lost €5.7 billion in 2008 before tax. But, compared with other banks, that wasn’t so bad. Like Credit Suisse, Deutsche Bank had a relatively good crisis. Neither bank was forced to take financial assistance from its respective government, each turning to private investors to help shore up its capital needs. In the month after the collapse of Lehman Brothers, Ackermann went on an investor roadshow. “Deutsche Bank remains a relative winner through the crisis,” his slides declared.
We’ve posited it before in the case of Credit Suisse, but this relative success likely inured the bank to the structural changes flowing through the industry. Neither bank changed its senior management through the crisis and when Ackermann finally retired in 2012, he was replaced with Anshu Jain, whose view – like that of the CEO of Credit Suisse – was that the bank’s previous business model could be restored with some cost-cutting. In mid-2010, for example, he reported that “Global Markets gained best market share ever” and that Deutsche Bank “was well positioned for returning markets”.
But serious underlying problems soon became apparent, including the fallout from unethical and illegal activity that the bank had been engaged in during the boom of the 2000s. Alongside some banks, Deutsche was implicated in the Libor scandal and agreed to $2.5 billion of fines in 2015. Alongside others, it was subject to penalties linked to its sale and pooling of toxic mortgage securities during the crisis. With yet others, it was accused of US sanctions violations and of money laundering. It was even involved in an espionage scandal years before Credit Suisse suffered one of its own. It seemed that whatever the misconduct case, Deutsche was involved: #ItsAlwaysDeutsche.
In early 2017, Deutsche Bank’s new CEO, John Cryan, bowed to a public apology. “It was generally the misconduct of a relatively small number of individuals pursuing their own short-term interests that jeopardised Deutsche Bank’s most valuable asset: its reputation.”
Such reputational damage fed back into Deutsche’s franchise. At the same time, stricter capital regulations meant the bank could no longer deploy leverage to squeeze out returns. The bank soon found itself in a downward spiral of trying to cut costs and staff while trying to compete in global markets and keep customers. Underpinning the challenge were problems in IT systems that proved unfit for the bank’s purpose, making it even more difficult to cut costs. A former Chief Operating Officer of the group called Deutsche “the most dysfunctional company” for which she had worked.
In 2015, Deutsche Bank lost more money than at the height of the financial crisis in 2008. It would go on to lose money in four of the next five years, worse than Credit Suisse which lost money in three of those years.
Like Credit Suisse, Deutsche embarked on a series of rolling restructuring exercises. It launched six plans between September 2012 and July 2019, characterised by big cost cuts (typically 15-20%), swingeing asset reductions and higher capital, mostly fashioned around a 10% return on equity target.
When Christian Sewing was appointed CEO in 2018, he took a sharper knife to the investment banking business, exiting equity sales and trading to focus on fixed income, transaction banking and corporate banking. Deutsche’s advantage over Credit Suisse is that while both suffered deteriorating performance in their investment banking businesses, misconduct did not infect Deutsche’s other businesses to the same extent it did at Credit Suisse. So while Deutsche’s retail and private banking businesses struggled to become profitable, their franchise was not impacted.
Sewing seems also to have got a grip on controls. He invested in enhanced control functions rather than squeeze them for costs, investing €3 billion in the years between 2019 and 2002. Culture is slow to change but the evidence so far is that the investment in systems and in behavioural change is paying off. When Archegos collapsed, Deutsche was not affected; nor was it anywhere near Greensill. At the end of March, the bank held €1.2 billion of litigation provisions in reserve and a further €1.9 billion of contingent legal liabilities, down from a combined €9.9 billion at the end of 2016.
Having lost share through the restructuring programs, Deutsche also seems to be winning it back in fixed income. It slipped outside the top five in fixed income sales and trading at the end of 2019, its market share falling from 14% at peak to 7%. But its share is back to around 10%. James von Moltke recently cautioned that fixed income revenues could be down 15-20% in the current quarter versus the same period last year, but Sewing anticipates that they will pick up again through the remainder of the year.
Deutsche Bank’s latest return on equity target of 10% for 2025 is not the most exciting hurdle for a shareholder to behold. But, on constant leverage, it is high relative to the bank’s history and if it can be achieved consistently, it marks a huge improvement.
Management is all too aware of its past troubles – a lot of the detail in this piece comes from an epic history Deutsche Bank commissioned for its 150th anniversary in 2020. Such longevity also lends perspective. “The more we execute on our strategy, the more we deliver sustainable profitability,” said James von Moltke in April. “But also the more we put historical issues around control failures and other events in the past. I hope that what some call muscle memory will fade in the market and the sort of the beta nature of Deutsche Bank will fade.”
It’s too early for that, but the next time a bank fails, investors might not be so quick to turn to Deutsche.