The danger of Deutsche Bank: Why its turnaround plan has to work

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The most dangerous bank in the world just got a bit more dangerous.

Deutsche Bank AG (DB), Germany's biggest lender and, until recently, one of the world's biggest banks, endured a week from hell that sent its shares tumbling to lows not seen in more than 30 years.

On Friday, in European trading, DB shares at one point fell 9 per cent, taking them under €10 ($14.75 Canadian) before reversing course to close up 6 per cent as reports surfaced that the U.S. Department of Justice might be willing to settle a probe into mortgage-backed securities for less than half of the initial demand of $14-billion (U.S.).

DB's plunge has rattled investors, clients, regulators and politicians. The bank, should it weaken or fail, could easily send shock waves across the world's financial markets, given the daunting size of its loan, bonds and derivatives books, and its globe-circling network of connections with other leading banks. In June, the International Monetary Fund said DB "appears to be the most important net contributor to systemic risks." In other words, it is potentially the world's riskiest bank.

The latest decline in the shares came amid talk that some hedge fund managers, evidently concerned about DB's stability, had withdrawn billions of dollars of listed derivatives holdings and other securities from the bank.

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Earlier in the week, chief executive officer John Cryan said in an interview with Bild, Germany's largest newspaper, that he had not used a recent meeting with Chancellor Angela Merkel to ask for a bailout. "At no point did I ask the Chancellor for support," he said, adding that government help is "out of the question for us."

Despite his assertions that DB could go it alone, another prominent newspaper, Die Zeit, reported that the German government has secret plans to prop up DB if the bank, equipped with a relatively thin capital cushion, can't muster the resources to pay the U.S. Justice fine.

The newspaper said the government would take a 25-per-cent stake in DB in a "worst-case scenario." The Merkel government claimed the report was incorrect, but DB investors apparently aren't taking any chances. They have been abandoning the company in droves, driving the shares down 57 per cent in the last year, with much of the decline coming in September.

But even if DB avoids the need for a government backstop, the blows taken by the bank have left it in survival mode as it tries to reinvent itself as a smaller bank and shed it status as a scandal machine. So far, Mr. Cryan's turnaround plan involves massive amounts of cost cutting. If the plan does succeed, what next? What will the bank look like once it has shed assets and culled armies of bonus-mad investment bankers? (Deutsche Bank did not respond to interview requests).

If the plan does not succeed, DB might have to be rescued to prevent it from becoming a grave threat to the German and European economies and the big banks with which it trades.

Deutsche Bank ranked among the world's biggest banks, as measured by the size of its balance sheet, only a few years ago. Its shares were trading at €100 and the bank seemed invincible, a formidable competitor to anything that Wall Street and the City of London could throw at it. In 2007, the year before the financial crisis, it earned a record €6.5-billion. Last year, the bank set another record, this time by losing €6.8-billion. Today, it doesn't crack the top 10 list of large banks.

The bank achieved star status after deciding that its traditional role of providing loans to finance Germany's postwar economic miracle – known as the Wirtschaftswunder – was dated and dull. Instead, DB would become a global investment bank that would compete with the likes of Goldman Sachs Group Inc. and JPMorgan Chase & Co. The effort started in earnest in 1989 with the purchase of the British investment bank Morgan, Grenfell & Co. It hit the big leagues a decade later, when it bought Bankers Trust Corp. in the United States.

As the investment bankers took over key positions, paid themselves lavish bonuses and took huge risks, the entire culture and profit profile of the bank changed, evidently for the worse. It also built a derivatives book whose notional value is about 20 times larger than Germany's gross domestic product (the bank reports its net derivatives exposure, after accounting for collateral, at €41-billion – still a hefty figure).

Bankers and bank consultants who did not want to be identified said DB's vast investment banking business, while apparently successful, made three mistakes that would ultimately damage the business. The first was focusing on the fixed-income market – during an era of rock-bottom interest rates – which required a lot of capital, hurting returns on equity; the second was going after the transactions business – M&A, initial public offerings, financings and other deals – which can be highly profitable but also highly sporadic in a market ruled by the big Wall Street beasts; the third was an outrageous bonus-payment structure. The German broadcaster Deutsche Welle says DB paid out as much as €50-billion in bonuses in the 15 years after the Bankers Trust purchase.

Then came the scandals, and lots of them.

Since 2014, DB has been bombarded with settlement claims. The timing could not have been worse because the bank was trying to shore up its capital at the time – it still is – and may have to dilute shareholders by raising new equity. In 2014, it failed the European banking system's "stress tests," which measure a bank's ability to overcome theoretical shocks such as a deep recession or bond-market collapse. DB fared better in the 2016 edition of the test, but was still among the 10 most vulnerable banks.

DB is under attack by about 7,000 lawsuits for a broad range of alleged sins. Since 2008, it has paid about $9-billion (U.S.) in settlements for its alleged roles in the Libor interest-rate rigging scandal, manipulating the price of gold, defrauding mortgage companies and violating sanctions imposed by the United States against Iran, Syria and other countries on the U.S.'s enemies list.

Other than the Justice Department's $14-billion penalty – an amount DB on Sept. 15 said it "has no intent" of settling "anywhere near the number cited" – the big unknown is the outcome of the investigation into DB for possible money laundering in Russia.

The investigation centres on the "mirror trades," the simultaneous purchase and sale, through DB's Moscow trading desk, of various big-name Russian stocks in different markets. According to an August report by Ed Caesar in the New Yorker magazine, such trades were used to spirit about $10-billion out of Russia. The New York State Department of Financial Services and regulators in Britain and Germany have also launched probes to determine if the trades constituted money laundering, and, if so, who was behind them.

Thomas Mayer, founding director of Germany's Flossbach von Storch Research Institute and DB's former European economist, said that all European banks, DB included, are saddled with dying business models. Negative interest rates are killing loan profit margins and the new era of stringent regulations and high capital requirements is damaging overall returns. "The banks are basically suffering from cancer," he said.

On Wednesday, Credit Suisse Group AG CEO Tidjane Thiam made the grim observation that, eight years after the financial crisis, the banking industry's woes are still intact. At a Bloomberg conference in London, he said the sector is "not really investable" and is in a "very fragile condition." He went on to say that "Risk is everywhere. … In life you should only worry about bad outcomes. If you raise capital and you're wrong, it's okay. If you don't raise capital and you're wrong, you die."

The next day, as if on cue, Germany's Commerzbank AG, DB's main domestic rival, announced that it was suspending its dividend and eliminating 9,600 jobs, about a fifth of its work force.

So while DB is not alone in Europe in is miseries, its dire shape will make its reinvention exceedingly difficult to achieve, which raises the question: Is Mr. Cryan the fix-it man or man or the man who will break up the bank and sell it off?

John Cryan is famous, or infamous, for his blunt approach.

Last November, four months after he became co-CEO – he was appointed sole CEO in May – the British banker made it painfully clear that the days of lavish pay were over. "I think people in banking are paid too much," he said at a conference in Frankfurt, home of DB's headquarters. "Many people in the sector still believe they should be paid entrepreneurial wages for turning up to work with a regular salary, a pension and probably a health-care scheme and playing with other people's money."

Since then, the banking market has been flooded with the résumés of DB investment bankers, mostly those employed in fixed income, currencies and commodities (FICC). They had been ousted or were trying to get out before Mr. Cryan swung his axe again. His restructuring plan would, by 2020, eliminate 9,000 jobs, equivalent to almost 10 per cent of the bank's global work force. DB's investment banking arm seems especially vulnerable. Its business is dropping at an alarming rate and the game plan, evidently, is to attempt to cut costs faster than the fall in revenues.

Mr. Cryan cannot be shocked by DB's deterioration. He became a member of the bank's supervisory board in 2013, giving him an insider's view. At the same time, his insider status made him an odd choice for the CEO job. In many dire corporate situations, where fast and vicious turnaround plans are needed, directors often recruit bosses who have no association with the company; all the better to ensure the new man or woman has no sacred cows.

He was born in Harrogate, in England's northeast, in 1960, and studied physics at Cambridge, where Stephen Hawking was among his teachers. He began his career as a chartered accountant at Arthur Andersen in London. During the late 1980s and 1990s, he climbed the ladder at SG Warburg and UBS, in corporate finance and client advisory roles, and became UBS's chief financial officer in 2008. He had a short stint as the European man for Temasek Holdings, Singapore's investment fund, before he became DB's top executive.

Handelsblatt, Germany's biggest business newspaper, says he is known among investment bankers as "Mr. Grumpy" because of his dour, no-nonsense style. Out went the private jet used by Josef Ackermann, the imperial Swiss banker who led DB from 2002 to 2012. In came the message that DB's free-spending days are over.

His challenge is not just fixing DB, but adapting whatever emerges from the overhaul to a rapidly changing banking market.

DB's official goal is ambitious, if rather mundane. It appears to leave the notion of a universal bank – all things to all people – largely intact and will rely on cost-cutting and slimming-down exercises to boost regulatory capital and improve return on equity. The plan is to crunch annual costs by a third, to €22-billion, by 2018 (the dividend was suspended last year).

The figure, however, excludes severance, restructuring and – the big wild card – litigation expenses. Like all banks in flat-lining Europe, the DB's fortunes also rest on EU growth (or lack thereof), the success of the European Central Bank's quantitative easing program and the duration of negative interest rates, which are squeezing all banks' profit margins on credit creation.

So far, DB has been a short-seller's dream. David Neuhauser, managing director of Livermore Partners of Northbrook, Ill., shorted the shares when they traded at €20 – they closed Friday at €11.57 – for a tidy little profit. He thinks they remain risky, "given that they will require more capital, but [DB] doesn't seem in need of a bailout any time soon."

What it does need, in the short term, is a strategy to overcome the waning confidence in it. In the medium to long term, it needs a strategy to cope with a market under ever-rising stress, especially in Germany, where competition is fierce because the banking landscape is cluttered with almost 2,000 private, savings and co-operative banks of all sizes. Mr. Cryan obviously wants to shrink the investment bank, but what business will rise to make up for it? "You can't just take a whack on the revenue side and call that a strategy," said a London banker who knows Mr. Cryan.

Mr. Mayer, the former DB European economist, thinks any bank with a presence in investment banking will have to reconsider the wisdom of reducing or exiting the business. That's because fee and trading income would have to replace lost loan income as negative interest rates persist. "This [negative rates] is making the life of credit-extension banks unbearable," he said.

Ultimately, DB and other weak banks will probably have to find merger partners, so they can reduce overhead costs, and concentrate on business areas where they can create scale to ensure market clout. DB, however, is hardly in position to buy another bank. Equally, its relatively low capital buffer and enormous potential litigation settlement costs do not make it an attractive takeover target.

DB wants to be a turnaround story in the making, but that effort took severe blows in recent weeks. It could also be a disaster in the making if confidence in the bank evaporates and the litigation settlements prevent it from raising capital, sending it rushing to Berlin for a bailout.

Mr. Cryan on Friday blamed the share selloff on a "distorted perception from the outside" and "some forces at play in the market that want to weaken this trust in us." He said the bank was strong. Investors will remember that Lehman Brothers Inc.'s boss gave similar assurances shortly before the Wall Street bank collapsed in 2008.