Roy C Smith and Brad Hintz
16 February 2015, eFinancial News: Issue 936
It’s long well past time for Deutsche Bank’s long-suffering shareholders to challenge the holy writ of universal banking. The bank’s strategic challenges were made clear in late January when its fourth-quarter results showed return on equity of 2.6%, about 20% of its cost of equity capital. Management said the performance was “encouraging” – but the equity market continues to value the bank’s shares at only half book value.
Jürgen Fitschen and Anshu Jain, Deutsche’s co-chief executives, say they are committed to preserving the bank’s traditional “universal banking” strategy and determined to remain among the top five investment banks. But their “Strategy 2015+,” announced soon after they took over in 2012, now looks hopeless. Goals of a cost/income ratio of 65% and an after-tax return on equity of 15% by 2015 seem truly out of reach.
Yet, Deutsche Bank has been a relative winner, as other banks such as UBS, Morgan Stanley and Barclays have cut back their investment banking or trading activities. In 2014, Deutsche’s investment banking unit ranked third in both global debt underwriting and loan syndication revenue, according to Dealogic. Fitschen said: “We see good opportunities to win market share… when some of our competitors are pulling back from investment banking.”
But after four years of disappointing performance, it is time to recognize that shareholders have not profited from the bank’s gains in market share, nor are its unrealized expense aspirations the same as bottom-line performance. The massive regulatory changes since the 2008 crisis have severely affected the universal banking business model, bringing its viability into question. Constraints on the capital markets businesses continue to tighten as regulators pursue a goal of transforming the largest global banks into low-growth, but bulletproof, public utilities. There are now capital surcharges for systemically important financial institutions: “special” national capital buffers, leverage limits, liquidity standards, operating prohibitions against excessive risk-taking as well as proposals for new financial transactions taxes. All of these changes add costs and lower the return on equity of capital markets activities. Among the large banks, only Goldman Sachs has been able to generate returns near its cost of capital and that is because of a sharp reduction in compensation and continued liquidation of a legacy merchant banking portfolio.
And, there has been a tsunami of politically popular, punitive litigation that has stripped all of the universals of precious capital just as they need to increase it.
Deutsche Bank’s strategy of profiting from a war of attrition in investment banking cannot succeed. The firm still faces cost and margin issues, poor trading returns, continued demand for additional capital as well as cultural challenges in its London-based banking unit. Fitschen and Jain have promised a strategy update sometime in the second quarter. Rumors suggest this may involve the sale of recently acquired Deutsche Postbank. But, it is not Postbank that is hurting the bank, it’s the investment bank.
There is one successful example of a spin-off. After more than a decade building itself into a broad-based financial services company, American Express in 1994 reversed course. New CEO Harvey Golub decided to shed the Shearson Lehman investment banking and brokerage units, whose performance had seriously undermined the parent’s stock price. The brokerage business was sold to Smith Barney, and the investment bank, Lehman Brothers, was spun off to shareholders.
While these were controversial moves when announced, it is now clear that American Express shareholders benefited from the restructuring and that operating performance improved significantly, not only at Amex but also the companies it jettisoned.
Since then, however, the capital markets business has become more complex, and separating out trading and market-making from a modern universal bank would have major repercussions. Certain capital advantages related to portfolio risk analysis and netting of positions would be lost. The cost of funding for an independent trading entity would rise as the funding base shifted towards more long-term debt and institutional deposits. The marketing synergies between commercial lending and investment banking would be severed, which would be likely to erode market share. The shared technology and staff support costs of the universal banking structure would end.
Further, the newly independent investment bank would need to maintain sufficient capital and liquidity to meet regulatory requirements and to qualify for Baa/BBB credit ratings. For this to be achieved, the parent would probably have to take back some preferred stock or contingent convertible loans, as American Express did when Lehman was spun off, or third-party investors would have to be brought in.
Change is good
It would not be easy, but it could be done.
And it might create entirely new value. Determined managers of a newly independent investment bank would be forced to rethink their business model and accelerate the glacial rate of change in capital markets dominated for years by the universal banks. On the cost side, compensation ratios would fall, organizational structures would flatten, headcount would be reduced, back offices automated and support staff outsourced.
On the revenue side, an independent firm with limited financial resources would be forced to pursue the highest margin banking businesses and reduce commoditized products, while improving balance sheet turnover and returns on trading assets – all good for investors. After spinning off its investment banking activities, a smaller and de-risked Deutsche Bank, retaining some wholesale lending business, would still be a world-class commercial lender, a leader in serving mid-size industrial companies in Europe, a large and growing wealth manager and a powerful transaction services provider.
Its strong positions in the admittedly over-banked German and Italian retail markets still generate low-cost retail deposits that enable a profitable lending and investment portfolio. And without the siren song of investment banking and its maddening, constant fire-fighting demands on management, Deutsche Bank could focus on improving the banking and distribution businesses it knows best.
Most important, however, is the almost certain increase in shareholder value than would result from a break-up. The combination of the various individual business units might be valued on a stand-alone basis at as much as €55 billion. With today’s market value of €37 billion, reflecting investors’ grim view of the bank’s future, there is a lot of room for creating value through a restructuring. Spinning off the investment bank might be the best way to capture that value.
Roy C Smith is a finance professor at NYU Stern School of Business and former partner at Goldman Sachs. Brad Hintz is an adjunct finance professor at NYU Stern and former CFO at Lehman Brothers and top-ranked banks analyst with Sanford Bernstein