Wednesday, April 29, 2015

Deutsche Bank's Wrong Call

By Brad Hintz and Roy C. Smith

(from Financial News, April 29, 2015)


On Monday’s investor call, Deutsche Bank’s Co-CEO Anshu Jain explained that “Strategy 2015+,” the most recent remake of the firm, had not met all of its targets, but it did meet some. It achieved its >10% Basel III core tier 1 ratio, and profitability, excluding litigation, was improved by the downsizing of the capital market business.  And its plan to spin off Postbank made sense because the ever-changing EU regulatory environment, which has constrained the ability of Deutsche to use retail deposits for institutional funding, doomed the economics of the earlier €6 billion acquisition.

But the bank has fallen very far short of its 12% return on equity target. And management has acknowledged that maintaining “optionality in our business model” (i.e., the capability to deliver a broad range of capital markets and banking products across all major markets) has proved to be a costly mistake for the bank.

Unlike Strategy 2015+, which focused on optimizing the risk adjusted balance sheet and achieving Basel capital targets, the new plan calls for a “profound deleveraging …of the CB&S balance sheet.”  Low return, low risk assets (such as matched book repo, the prime brokerage balance sheet, credit trading and bilateral derivatives) will all shrink. The institutional client base will be triaged to constrain the asset demand of low return clients, while continuing to support the bank’s high ROE client relationships.

Management is also attempting to boost margins and returns. Legacy retail branches will be closed, certain institutional product lines will be de-emphasized, back office activities streamlined and the international footprint reduced. Savings of €3.5 billion are targeted that should deliver a cost income ratio of 65% and a better, but still insufficient return on tangible assets of 10%.

Overall the bank aims to maintain a leading position in fixed income and commercial banking and to fortify relationships with corporations, and to capture more of the high margin equities and mergers business from legacy client relationships.

Mathematically, Deutsche Bank’s plan is sound – cut low return activities and grow high return units.

Unfortunately, all capital markets products and services are linked together. Institutional clients continue to demand full-service offerings. Issuers demand money market placement as well as low-margin DCM as quid pro quo for high-margin engagements. These inter-business connections make downsizing key units challenging for any bank – there is no bright line down the center of a fixed income floor that says ‘cut here’.

Deutsche Bank’s strategy of limiting low return balance sheet positions is neither radical nor new. UBS and Morgan Stanley announced long ago their intentions to reduce reliance on capital markets businesses but retain their investment banking franchises. Barclays is constraining its fixed income unit. Credit Suisse has been pruning around the edges of trading businesses, and under new management this summer may cut further. Goldman and JP Morgan Chase have already cut back sufficiently to deliver returns near their cost capital.

However, so far none of the legacy capital market banks has been willing to throw in the towel and so the war of attrition between them is likely to continue and a quick rebound in capital markets ROEs for any of them is unlikely.
But, not all of these firms have the managerial capability to be able to compete effectively in this race. So far, Deutsche Bank has proven to be a laggard. Publishing a wish list is not the same as convincing the market that the bank is capable of turning its latest strategy (which really is the same strategy as everyone else) into a winner.

The unspoken alternative to this latest of Deutsche Bank’s strategic announcements, is to have spun off the investment bank altogether into a separate company.   Given the difficulties it must face to make a full recovery and the continuing skepticism regarding capital markets, that would have been a better move.

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