By
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.”
Disappointing
returns
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
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