If anyone has the experience to steer Deutsche Bank through the storm, it is John Cryan. Rarely has the appointment of a banking CEO looked more fortuitous.
Prior to becoming CEO of Deutsche in July last year, Cryan was first an accountant and then a financial institutions group (FIG) banker (who helped banks raise money) and then the chief financial officer (CFO) of UBS. He was global head of UBS’s FIG business during the financial crisis and he was instrumental in UBS’s $3.5bn share sale in 2009. Cryan’s hands are therefore about as safe as they come. Cryan was “one of the best FIG bankers on the Street,” Dan Davies, senior research advisor at Frontline Analysts and a former banking analyst at Cazenove, Credit Suisse and BNP, said yesterday. He’s, “run more rescue bank capital issues than I’ve had bonuses”.
While Cryan’s email to employees this morning suggests that he doesn’t intend to raise additional capital (“We fulfil all current capital requirements and our restructuring is well on track”), Davies is therefore among those predicting that Cryan will do the right thing and that a capital injection in the region of €5bn will be announced early next week.
This isn’t because Deutsche is facing 2008-style liquidity issues: it isn’t. J.P. Morgan points out that Deutsche has €123bn in cash and central bank balances and a liquidity coverage ratio (assets on hand to cover short-term funding requirements vs. those short-term funding requirements) of 124%. If a fire breaks out, the ECB is also standing by with a large hose. However, as Cryan admitted, it’s all about perception and a capital injection now would help put an end to hedge funds’ new habit of shorting Deutsche’s stock.
Unfortunately for Deutsche’s bankers, the general consensus seems to be that at least some of the increased capital will need to come from bonuses. Echoing this week’s note from Autonomous Research, Davies suggests Deutsche can raise €2.5bn+ by informing staff that this year’s bonus pool will be paid entirely in, “new issued stock or capital instruments”, and the forced forfeiture of payments from previous years. He advises that a further €3bn should be raised in one fell swoop from a sovereign wealth fund or other “large bank investor”.
If Deutsche announces an injection of €5.5bn of capital before markets open on Monday, Davies says there could be some “interesting” movements in the share price. On the other hand, if the DOJ does indeed cut Deutsche’s $14bn fine to $5bn, Cryan’s strategy of doing nothing may be vindicated.
J.P. Morgan says pay in Deutsche’s investment bank has been protected for too long
Whether the fine is cut or not, Deutsche will still come under pressure to cut pay in the investment bank and Cryan (who has a reputation for parsimony) is likely to be only to happy to oblige. J.P. Morgan’s banking analysts think some serious curtailment of compensation is overdue. As their chart below shows, compensation spending at Deutsche Bank has remained stable at around €13bn since 2011, even as the bank’s return on equity has collapsed. In the combined corporate banking and securities unit (CB&S) and the non-core operations unit (NCOU), profit before tax has turned negative in the past five years, while spending on pay has faithfully hovered around €4.8bn.
How pay at Deutsche persisted as profits declined:
Source: J.P. Morgan
In light of recent events, J.P. Morgan’s analysts suggest Deutsche needs to be far more aggressive in terms of cost cutting. Like Davies and Autonomous, they think Deutsche could raise capital by cutting bonuses (there’s “€1.0bn in deferred expense from previous years to be expensed in 2016” and an estimated “current year bonus pool” of €1bn”). However, they’re also cautious about the consequences, suggesting Deutsche could lose its “best talent” if it’s too harsh.
Something needs to be done though. JPM’s analysts also note that Cryan’s cost target of €26.5bn for 2016 is flat compared to 2015. In global markets and the corporate and investment bank (CIB), they think that 90% of the cost base is fixed. As the chart below shows, this means that falling revenues rapidly eat away at profits. If 2016 revenues decline by more than a third, the investment bank will become loss making.
How profits in Deutsche’s investment bank respond to declining revenues:
Source: J.P. Morgan
Deutsche’s investment bankers could be about to discover the downside to their high salaries
High fixed costs in Deutsche’s investment bank are partly due to the bank’s heavy investment in ‘control functions’ and technology. They’re also partly due to the European Union’s CRD IV legislation, under which bonuses have been restricted to 200% of total pay and salaries have increased accordingly. In 2014, prior to Cryan’s arrival, Deutsche increased salaries for its highest paid 1,700 bankers by a combined €300m – an average of €176k per head.
As a result, headhunters say some heads of business at Deutsche’s investment bank in London are now on salaries of $2m (£1.5m), while plenty more are on salaries of $1m. Last year’s compensation report reveals that 70% of the pay in Deutsche’s corporate and investment bank was fixed in 2015. Even Deutsche’s 1,781 ‘material risk takers’, received 54% of their compensation in the form of salaries, with only 30% of their compensation in the form of deferred (and plummeting) stock.
Like it or not, therefore, Deutsche’s most senior staff are therefore comparatively sheltered from the bank’s declining share price. Junior and mid-ranking staff have been shielded too: we understand that most of their bonuses are comprised of deferred cash, which vests over four years.
There is a downside to this though. As Cryan seeks to cut costs in response to what may be a very difficult third quarter, his eye could well fall upon salaries. Fixed pay totalled €3.4bn across the non-core unit and investment bank last year. Needless to say, however, cutting salaries means cutting heads, something Deutsche has resisted in the past. Last year, front office headcount in Deutsche’s global markets business declined by a mere 155 people to 4,828, while front office headcount in corporate banking and IBD rose by 70 people to 7,305. This could be about to change.
If Cryan wants an example of what really paring back an investment bank looks like, he can always look to Commerzbank. Deutsche’s German counterpart is ahead of the curve: it cut 80% of its front office London investment bankers between 2009 and 2013, has shunted most of its London fixed income traders to Frankfurt, and announced a whole new round of investment banking job cuts only today. This is what harsh looks like.
Deutsche as a whole will survive this current crisis. It’s senior bankers, though, could be in for a shock.