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Deutsche Bank will live to see a new day, but a darker one

Deutsche Bank’s decline in profitability culminating with a gargantuan 2015 loss and a US Department of Justice fine of $14 billion levied in September have been making headlines of late. These two coincidental events have put the bank’s future in question.

It seems that many were caught off guard by this development in the wake of Brexit, the Italian banking crisis, and OPEC negotiations.

To others still, this could have been viewed as imminent: bank profitability throughout Europe has been squeezed by low or negative interest rates, major bank balance sheets are fraught with bad debt, capital requirements are higher and technology is transforming the modern banking model as we know it into a highly competitive battle for profitability. China’s slowdown, oil prices, and Brexit’s potential fallout are making it harder to drive revenues.

An unfortunate series of events

Part 1: Painful Restructuring

But what happened in 2015 for Deutsche seemed especially distressing. In January this year, CEO John Cryan announced a $6.8 billion dollar loss for 2015, citing revenue declines in corporate banking and securities (specifically sales and trading where margins are heavily squeezed, and advisory where deal flow has cooled and Deutsche may be losing market share). Costs have been elevated by an extended restructuring process, as Deutsche attempts to bolster its core equity ratio, called the Core Tier 1. Cryan has targeted 12.5% for this ratio by 2019. This ratio is used by regulators to help determine systematic risk, and during “stress tests” on European banks in June and July, it became apparent that Deutsche bank was the worst performer by this metric. This ratio currently stands at 10.8% for Deutsche, and that gap translates to €7 billion.

To fill this gap, Deutsche is streamlining the business and selling off units left and right. Among them: Hua Xia, a Chinese bank in which Deutsche held a $3.9 billion stake, and Deutsche’s insurance unit, Abbey Life, which will go for $1.2 billion. Atop that, the bank will be laying off 9000 staff globally.

Part 2: Stock in Freefall

The announcement of last year’s loss kicked off a long decline in Deutsche bank shares and after the Department of Justice fine was confirmed on September 16th, shares slipped 8%, currently trading at 56% below their 52-week high, languishing in the $10-$15 range. They re-stabilised near the end of September when multiple parties assured investors that the size of the fine could be talked down considerably. When negotiations reached an impasse on October 10th, the stock slid again.

Part 3: DOJ Stakes a claim

Since the 2008 financial crisis that sparked the Great Recession, the US Department of Justice has levied fines against all of the major banks and reached settlements between $3.2B and $16.7B for each of them. Deutsche Bank is now facing a fine for its role in the sale of mortgage securities with risk misinformation. Cryan assured investors on the day of the fine’s announcement that negotiations were “just beginning,” and a lower settlement would occur. The DOJ has a history of levying inflated fines and settling for much lower. Most analysts expect the bill to end up being under $6 billion. The days before October 10th saw a renewed optimism as it came to light that Cryan was in Washington DC and many were hopeful of an early settlement. However, it soon became apparent that these negotiations had reached an impasse.

What not to expect

Here is what not to expect: a bailout. And for good reasons.

First, German Chancellor Merkel cannot afford it politically. She is the antithesis of forgiving when it comes to risky players in the system. When that player was Greece, she fought vehemently against a bailout unless there were significant austerity measures. When it was the Italian banks, she took a similarly hard stance. With her polls declining in Germany, putting the Deutsche Bank pain on the shoulders of taxpayers would “kill Merkel politically” said one group of analysts.

The second reason is more important: Deutsche bank will not need a bailout. No one expects that the bank will pay the full $14 billion, and in all likelihood it will pay less than half. This will most certainly make it extremely difficult to reach targets for the Core Tier 1. Deutsche has set aside $5.5 billion in litigation costs as probes pile up, which could have been used to fill the majority of the reserve deficit. If the finalized settlement is more than this rainy day fund of sorts, Deutsche will be able to tap funds raised from sell-offs of its business units. If a deficit still remains, Deutsche can raise debt, albeit on very undesirable terms.

Deutsche Bank should get out alive of this crisis though not with both arms. The 12.5% Core Tier 1 target will be very difficult to reach and much will depend on the outcome of negotiations over the settlement.

But when the storm is over, Deutsche Bank will have to face an unfortunate fact: banking itself, and especially German banking, is in a low-profitability era.

A saturated system

In the EU, there are an average of 166 customers per bank employee. In Germany, there are 127. The reason, in large part, is increased regulatory scrutiny. German banking rules ensure hard lines between private banks, co-operative banks, and public savings banks, so consolidation is prevented and cost duplicities therefore exist. This heightened competition is also bad for margins.

Technology like high-frequency trading has caused margins to converge to record low levels. Post-crisis regulation has coerced banks into lowering their risk profile.

Finally, there’s what has really kept bankers up at night: low or negative interest rates. The ECB currently charges negative interest to banks using the ECB deposit facility and ECB president Mario Draghi announced on October 7th that rates are to stay low until growth picks up “convincingly”. However, borrowing has proved largely insensitive to this rate environment so real economic growth has been sluggish.

Deutsche Bank’s troubles are therefore not to be viewed as stand-alone bank failure, but rather a painful transition into an inherently lower-risk, lower-margin era. Events like the DOJ fine remind us of the age that global policy makers unanimously agree we need to part from: an age of ingenious risk-disguising and of behavior not unlike gambling. And following the ongoing restructuring phase, Deutsche bank will be positioned to make the most of it.

The most of it just won’t be so great anymore.




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