Commerzbank - Kohlhaussen's big gamble

Is he mad, bad or just recklessly confident? Few investment bankers would be as candid as Mehmet Dalman.

"It worries me that things are going so well," says Dalman, Commerzbank's head of equities, who last month also took over fixed income. "We couldn't have planned that."

"So it's a fluke?"

"Well, yes."

Dalman makes it clear he has little time for his commercial banking bosses. His real hero is John Meriwether, fallen angel of Salomon Brothers and Long-Term Capital Management.

Mehmet Dalman

Ennui turned to amusement as Dalman used enormous persuasive powers plus a generous portion of good looks and charm to attract experienced professionals jaded by the culture of huge investment banks and keen to make a fresh start at what he terms a "start-up operation". Dalman tends to ignore the fact that Commerzbank already had a substantial German equities business.

During the expensive preparatory phase, Dalman generated enormous publicity for his venture. The 41-year-old Englishman of Cypriot origin - his family are wealthy ship-owners - rivets listeners with tantalizing details about the bank's top management and appears to be driven by genuine intellectual fervour as well as ambition.

By setting head-counts during the recruitment drive, he gained an early reputation as a free-spending expansionist. In November 1998, after 18 months of preparation, Commerzbank Global Equities opened for business. It has hired over 600 front-office staff. In recognition of this effort, Extel gave its analysts last year's "best newcomer" award.

Its research team is 130-strong. Research is organized entirely by sector, rather than by country and sector as at many other banks. Fund managers receive short, punchy reports, while detailed analysis is aimed at buy-side analysts who have the time to read it. During 2000, says Richard Greer, head of equity research, Commerzbank will move towards providing "customized" research for specific clients. All research contains some quantitative analysis and data, since he believes that clients want it. Yet the bank has not yet proved that its research has won greater esteem with investors; rumours based on internal surveys suggest the opposite.

The freedom available to managers in this start-up phase is clearly a big attraction. Mark Eban, head of equity capital markets, enthuses about "building something rather than fitting into an established organization. Everyone is very direct with everyone else and people are told what they need to know. They are kept happy." Part of that, of course, is the payment of huge salaries with guaranteed bonuses.

After just one year, Dalman is asking the market to believe that he has already achieved substantial success. Earnings from equities have been so strong, he says, that they will fund the bank's ambitious new venture into European M&A as well as its expansion in credit products - both now under by Dalman. In October, Dalman took control of the fixed-income division and wrested M&A out of corporate finance.

Commerzbank's figures for the first nine months of 1999 (the most recent figures available) show that equities contributed e229 million ($229 million) to proprietary-trading profits against e188 million from fixed income and e103 million from treasury and forex.

These numbers appear to justify Dalman's claim that Commerzbank is now "an equities house" with a few other businesses attached.

But on closer inspection, it seems that Commerzbank Global Equities has not even been put to a proper test, let alone succeeded against the odds.

Klaus Patig, the Commerzbank board member in charge of investment banking, admits that the real test for the equities business is yet to come. "Quite frankly, it was an easy year," he says of 1999, admitting that this had everything to do with the bull markets - and luck that the bank had not got around to expanding into emerging markets - and very little to do with the bank's own brilliance.

But it was an expensive year as costs increased: Commerzbank's personnel costs climbed by 13%, mostly in international investment banking. The cost-income ratio in investment banking rose from 49.5% in the first half of 1999 to 64.9% in the third quarter. The figure for equities was over 70%. There is no information about how the bank will reduce that figure to the target of 65% in 2000 (the bank's overall target is 60%).

Dalman argues that he can earn more from trading a volatile market than the bull market of the past year. "My strategy would be badly hit if the market went illiquid," he says.

Yet this is not an operation built on the back of own-account trading - a strategy that failed disastrously for Rabobank in 1998 and 1999 and for others before.

Klaus Patig

Perils of market neutrality

"Market-neutral trading is like taking out an expensive insurance policy," says a competitor in German banking who knows Commerzbank well. "The decisions are based on a value-at-risk model. They can try to reduce that risk to zero, but it works better in theory than in practice."

If Commerzbank is running a market-neutral book (some senior managers like to call it "risk-free"), it is hard to see how equities or fixed-income could have earned anything on their own account.

In fact, it is impossible to tell whether Commerzbank Global Equities is making money at all. Under German accounting rules, banks have a variety of opportunities to defer tax on start-up assets, write down future losses and net off costs against revenues. Commerzbank's investment-bank earnings figures (drawn up under German rules rather than the more familiar IAS or US-GAAP) are breathtakingly vague. Equities, fixed income, forex, derivatives, asset-liability management and asset management are all represented by a single profit figure: e518 million pre-tax.

The breakdown is not publicly disclosed, but Euromoneyhas learnt that equities contributed only 7% of that figure, while fixed income, a far smaller operation, contributed 12.5%. The lion's share of the division's earnings was generated by treasury/forex and asset management, which accounted for 40% each.

Furthermore, sources inside the bank say Dalman's earnings figures are net only of "direct" costs such as salaries, bonuses and operating expenditure. "Indirect" costs such as IT spending, back-office and legal costs were allocated to the corporate centre - a non-business organization whose P&L is a permanent "red hole", as James Hyde, banking analyst at Merrill Lynch puts it.

The fog thickens with the cross-subsidy between divisions of Commerzbank. Much of the profit booked by equities or derivatives is allocated to the traditional commercial banking businesses. This is to give an incentive to corporate relationship managers depressed by vanishing margins and to preserve the illusion that the German universal banking model is alive and well.

In January, a new internal accounting system introduced a parallel universe of "shadow" revenues, so that investment bankers, who do the business but see their revenues allocated to relationship managers on the corporate-banking side, still get a reward, and vice-versa. In theory, shadow revenues will count the same as real revenues when the board assesses performance and sets bonuses. In practice, everyone will continue fighting for the largest possible real revenue and against allowing his business to be booked in the shadow accounts.

One division head in the investment bank gapes at the publicly disclosed earnings figures for the first nine months of 1999 as if he's never seen them before. "That figure looks very odd to me," he finally comments. Another division head describes the disclosed figures as meaningless.

Says Hyde of Merrill Lynch: "Divisional and product line accounting can be humbug. We take all their figures with a very large pinch of salt."

Surely Commerzbank's own head of equity research will be able to interpret the figures. It seems not. "You'll just have to believe us," says Greer, grumbling about German accounting standards. When pressed for an interpretation of the opaque figures, Greer can only offer his own speculative argument: surely Dalman would not have been asked to take over fixed income too if he had been unsuccessful with equities?

Dalman clearly has the full support of Commerzbank's board. This is the first time a single manager below board level has been put in charge of equities and fixed income, at any major bank. "No other bank does it, and that's the reason I'm sceptical," says one of Dalman's internal critics.

Commerzbank's bond business has been in turmoil for two years, ever since its former head, Jürgen Karcher, was thrown out overnight because of his huge trading losses on the Asian markets.

Karcher's successor was derivatives trader Fraisse, one of the surviving recruits from SocGen who started up Commerz Financial Products six years ago. Because Dalman was investing in equities, there was no money available for Fraisse to do the same in bonds.

So the fixed-income division, originally the powerhouse of Commerzbank's capital markets effort, became the weaker partner. According to Patig, Fraisse also put too much emphasis on derivatives and failed to build up the weak cash business.

Patig acknowledges his strategy was completely different for each of the two divisions. "I watched over time, then I asked myself who was more successful: Regis with his niche strategy or Dalman with his global strategy."

If earnings had been any guide, the winner would have been obvious. Fixed income exceeded its target earnings in the first nine months of 1999 by 30%, while Dalman fell short of his far more modest target. Patig himself says that fixed income achieved return on equity of over 20% in the first three quarters of 1999 compared with 19.5% for equities. But Dalman evidently won on style.

During the autumn, a rumour was started that Fraisse had lost his commitment and was thinking of leaving banking altogether. In reality, the Frenchman was forced into leaving Commerzbank after being outmanoeuvred by Dalman and then dropped by Patig.

Ever since 1997 Dalman had been talking about "complete integration" of the investment bank, with fixed income and equities in a single organization (ie, under his control). Early on he had wrested equity capital markets from the corporate finance division; now his aim was to take over all of fixed income too.

In late October Fraisse was given a weekend to draw up a business plan for the partial integration of fixed income and equities. His scheme included combining the trading of convertible bonds and repackaging, reducing costs by merging credit research and equity research, and combining high-yield origination for all products. It stopped short of combining benchmark trading and sales or the capital-markets desks.

By the time Fraisse submitted his plan on November 2, Patig had already changed his mind: now he wanted complete integration, or a merger of the two divisions. According to insiders, Patig summoned the Frenchman and told him of the decision: "Mr Dalman is in charge. Work out the details with him."

October was a good month for Dalman, who also wrested the M&A business from David Savage, head of corporate finance, who arrived from Deutsche Bank three years ago. Savage, a quiet-spoken American, had been trying for several years to persuade the board to build up a proper M&A business. Patig took Savage's advice, but gave no reward. At a divisional-heads meeting, with rival managers looking on, Savage was brusquely informed that Dalman had won the day.

Power without revolution

Dalman now has complete control of equities, fixed income and parts of corporate finance, but it seems unlikely he will create a revolution. All the signs are that Dalman will implement Fraisse's business plan for 2000, which includes a twelve-fold expansion in the credit business. It fits in perfectly with Dalman's main business idea: to increase volumes as much as possible and thus reduce unit costs. In return for additional power, Dalman has promised to achieve economies of scale.

Because of the board's confidence in Dalman, most investment capital is earmarked for his businesses. Meanwhile corporate finance is set for more gradual expansion. "Dalman has to get his volumes up in the equities business," says Savage. "Equities needs to be big because of the substantial fixed cost base. I don't have the same leverage potential. In my business we're not talking about the same zero-sum game because corporate finance is far less concentrated among a small group of players."

Despite the flamboyant veneer, building an investment bank is a defensive move by Commerzbank: it's protecting its share of the domestic market from slicker investment banks and sexier retail banks. Commerzbank is still struggling to leverage its main business with German corporates and branch customers and prevent them from drifting away. "Customers had got fed up with Commerzbank," says Dalman. "Meanwhile our competitors had wonderful ideas but no relationships."

Even if Dalman at the start didn't care about the commercial bank, he certainly endorses it now, chatting enthusiastically about his visit to local relationship managers at Commerzbank Hamburg. By helping the commercial bankers and sharing revenues with them, Dalman has made himself even more indispensable to the board.

Internal critics say the board have lost the ability to criticize Dalman because they are so beguiled by his ability to achieve change and generate enormous personal loyalty. ("He has brought the investment bank into the twentieth century," says a source close to Kohlhaussen).

Patig is overjoyed to see that the fixed-income division has been receiving lots of unsolicited job applications since it became known that Dalman would take over.

As Dalman becomes more powerful, Commerzbank officials try in vain to dispel the impression that he's indispensable.

And Dalman seems to enjoy this - daring them to prove otherwise. He's patronizing about his boss Patig, a 56-year-old lawyer who has spent his entire career at the bank. Patig had no experience in investment banking before being appointed to the board and
lacks the specialist knowledge to control Dalman.

"Patig's learning curve has been very steep," says Dalman. "A year ago he didn't know what a Sharpe ratio was, and he's not afraid to ask really stupid questions." But Patig seems diffident: he won't meet Euromoneywithout his protégé being present.

Dalman appears to be daring the board to call his bluff, knowing that the bank is staking on him its entire reputation in the capital markets - perhaps even its entire long-term business.

Kohlhaussen's only chance

Kohlhaussen, who retires in 18 months, has no time left to launch another new start. Dalman represents his only chance to save the commercial bankers from losing their market and to go out with glory.

Not surprisingly, Dalman is deeply resented by his peers, particularly in the investment bank. Some senior managers use studied indifference to conceal their dislike. They resent his ability to extract influence and big budgets out of the board, and they also complain he is unable to argue in depth.

Dalman is "an actor who would be lost without his lines", says one insider, recalling how Dalman was about to leave for Dublin for a reception to celebrate Commerzbank's membership of the Irish stock exchange when he discovered he had no speech with him. "Where's my script?" he rushed around shouting. "How can I do this without a script?"

Yet the market continues to be impressed. In July at an investor relations event Dalman was able to reassure fund managers and analysts who expressed concerns about Commerzbank's vaulting ambitions in investment banking. "That calmed a lot of hyperbolic fears," says Hyde of Merrill Lynch. "He had been portrayed in the media as a madman, but he gave a very erudite and level-headed presentation."

So Dalman has won over the board of Commerzbank, has captured the loyalty of his staff, supported the bank's commercial business and even impressed analysts. What next for the upwardly mobile Englishman?

"He wants Patig's job and then Kohlhaussen's," opines one of his internal critics. "His strategy won't be new, but it will be expressed in a way that will amaze everyone."

In the meantime, Commerzbank's global venture remains a gamble. Why should Commerzbank succeed where other start-up investment banks failed?

"No-one has proved that internal growth is a successful strategy," Patig admits. Indeed, he only agreed to Dalman's scheme after failing to take over Smith New Court and then spending months considering less ambitious internal growth strategies.

"We have to make sure that success doesn't make us relaxed," says Patig. "We still have to prove that our strategy is sustainable."

Cuts in Dalman: "We don't want to be a one-year wonder."

So what's unique about Commerzbank?

"Absolutely nothing," says Dalman in his jokey, forthright style.

Should one take that literally?

"You should," he replies, showing a perfect set of teeth.