Can Cryan halt Deutsche Bank's decline?

By:
Peter Lee
Published on:

Deutsche Bank has come to the end of an era. The question is whether or not it is approaching the end of its empire as well? Respected across the industry for his intelligence and integrity, John Cryan needs plenty of both to restructure Deutsche. It succeeded for years in building too large a version of exactly the wrong sort of investment bank for today’s markets. A bank that once had a clear identity in global finance is struggling to present a vision of what it will be in the future.

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John Cryan, Deutsche Bank’s co-chief executive, may have the toughest job in banking today. He has to restructure a very large and complicated bank with no cash cow division providing a cushion of steady earnings and generating capital to fall back on. 

Making the job even tougher, the investment bank that his predecessors built and that still dominates the group is exactly the wrong sort of investment bank for today’s heavily regulated markets. This is the business on which, over the 20 years leading up to the financial crisis, Deutsche grew from a fading European commercial bank into a global giant. The still unfolding regulatory response to the financial crisis has set out to crush precisely the Deutsche Bank model of investment banking. 

One former senior Deutsche executive says: "Everything was built with a derivatives mind-set: retain ultimate flexibility, offer your private and business clients bespoke solutions, not realizing that you would soon need an army of compliance and operations staff to stick with that model."

Cryan’s predecessor Anshu Jain, who he replaced nine months ago, gambled that as others got out, Deutsche Bank could both grow market share and benefit from fatter margins. He resisted voices on his own board urging him to cut back until he was forced out.

Cryan cannot pare back as far in investment banking as others have, notably UBS, because that is the bank’s core business. But he has to build a new model of an investment bank.

Many of Deutsche’s rivals have already slimmed investment banking down and relied on other businesses to cushion the cost of disposing of redundant staff and redundant risk-weighted assets. At UBS the business is wealth management; UK retail banking and credit cards at Barclays; retail at BNP Paribas; global transaction banking at Citi. Deutsche’s base is more troublesome.

"In Deutsche Bank’s case, its core business is investment banking, which represents 50% of equity, 75% of leverage assets and 50% of profits," points out James Chappell, analyst at Berenberg. "However, investment banking is in structural decline." 

The panic about Deutsche Bank last month that saw its stock price collapse, its AT1 bonds fall to 70% of face value, its CDS spreads widen to crisis-era highs and its senior bonds trade at a discount, is a distraction, albeit a painful one. 

Deutsche is not going to miss its AT1 coupons, nor is it going to breach its AT1 capital triggers any time soon. It could buy back its entire stock of outstanding senior debt out of liquid reserves if it chose to.

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Its short-term prospects are fine: it is the medium- and long-term outlook that investors should be worrying about. And the most worrying aspect of Deutsche’s results announcement at the end of January was the severe drop-off in underlying investment banking revenues in the last two quarters. At a time when it needs its core business to produce profit and generate the capital buffer to shrink its balance sheet, the trajectory suggests that revenues might fall faster than costs, producing not profits but losses that eat into capital.

Here is where Deutsche’s biggest problem lies. Not only is Deutsche the last big bank to begin restructuring its investment bank; not only is the type of investment bank it had built – a leader in many trading segments and a top six or seven capital markets firm – the wrong type for today’s regulation; it is not clear what Deutsche Bank should aim to be. The only thing that is clear is that cannot continue as it is. 

Restructuring

Jain and his team had built the plain-vanilla flow-monster capability in rates and foreign exchange that might yet sustain it in future, but at its heart Deutsche Bank was a derivatives-focused, principal trading firm: a hedge fund in essence, which also had many other US and UK hedge funds as its core institutional client base.

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A senior executive at the firm tells Euromoney: "If a real-money client came to Deutsche Bank wanting to sell a block of shares, the typical Deutsche response would be to bid for those shares as principal, take them on balance sheet, hedge them, manage the delta and work the position out over a long period. It’s the derivatives and principal trading mentality, aiming for a big pay-off. Its instinct would not be to cross that block against countervailing customer orders and take a quick and easy agency commission. But that is what market businesses today are all about."

Cryan has to do more than carefully dismantle the bank’s old investment bank without torching its balance sheet. That is hard enough. But he also has to build a new core business for Deutsche on modest foundations, with limited capital, while long-ignored IT problems mount in the back office and the threat of big fines for past misdoings is ever-present.