So, after taking up everyone’s time and bandwidth for four months, the Deutsche/Commerzbank merger talks have broken down. The market reaction is pretty clear; Deutsche’s share price is up 2% at the time of writing. This most likely partly reflects the fact that it had become obvious that any Commerzbank deal would involve a substantial capital issue, but it may also indicate that the market now recognises that Deutsche is going to have to look its problems in the face.
The rationale for the Commerzbank deal was always questionable. It gave size, but not any real benefits of scale in any business line. And it presented a formidable operational task of integration to two banks which were individually famous for their acquisition-related IT problems. To most outside observers, it had a strong flavour of “we’ve tried everything else” to it.
But had Deutsche really tried everything else? The bank is on its fifth CEO or co-CEO of the last ten years, and has presented the market with a similar number of “New Deutsche” business plans. Each one has been individually uninspiring. Taken together, they look like a ladder of diminishing expectations, as the bank suggests further incremental retreats from investment banking business lines, with associated cost cuts that seem to be always promised but never delivered. And the ongoing project to improve the reporting and control systems is now in year seven, with major regulators still unconvinced.
A large part of the problem is that Deutsche is a bank that has been cleverly optimised for an environment which no longer exists. Its legacy asset portfolio (the “fatberg” of mortgage bonds and their associated swaps and hedges) made great business sense in a world in which too-big-to-fail banks could fund themselves at term for only a fine spread over government bonds. In a world of 3% policy rates, the global transactions business was a huge cash cow and its deposit float a massive asset. And back in the days before “CDO” was a dirty word, Deutsche could fairly claim to be “the Goldman Sachs of Europe” with its top-quality mathematical modelling teams.
But those days are gone. And Deutsche needs to face up to reality. The temptation is always to go for a radical “Plan B” (actually more like “Plan J” when you consider how many things have been tried) and cut the investment bank, either in its entirety or in North America. But this is a counsel of despair; the German domestic business is no more profitable and the transaction bank would be a much less attractive proposition if it couldn’t offer ancillary services.
In a note out today, JPMorgan's banking analyst Kian Abouhossein offers Deutsche's CEO Christian Sewing a few ideas. With the corporate and investment bank (CIB) consuming two thirds of Deutsche's capital and generating a return on equity of just 1%, Abouhossein says the time has come for more dramatic restructuring and cost cutting in this particular unit. The U.S. equities business looks first in line - JPMorgan estimates that it loses €200mn-300mn each year, but even if those losses were absent, Deutsche's return on tangible equity would only rise by 0.4%. Something more needs to be done. But what?
Fundamentally, Deutsche needs to look at what it could do better. For all the poor performance of the U.S. equities operation, Deutsche has a no-worse franchise in equities than Credit Suisse, which seems to have transformed the profitability of that business line. It still has dominant market share in forex, so it needs to keep investing in capacity and technology. Its IBD and capital markets franchise was once a solid second-tier player and could be again (although its recent behaviour in hiring and firing means that it will need to pay up for talent in the short term). Taking revenue as a given and concentrating on costs is a form of denial for Deutsche Bank. – As JPMorgan's analysts also note, Deutsche needs to do better on the revenue side. This will mean yet another reorganization of the franchise, but if you're in a non-capital intensive business with growth potential, you could be in luck.
Of course, an effective reorganization will require effective management. And Deutsche Bank's management issues go right to the top. Why has Deutsche gone through so many CEOs? Why has it failed to keep heads of division like Rob Rankin and Colin Fan? Why does it have so little to show for decades of costly acquisitions in the asset management industry? Why do so many people think that this company is run from the supervisory board rather than the executive board? Paul Achleitner was apparently the architect of the Commerzbank deal, and now that it has collapsed, he needs to do some serious thinking about his own role in bringing Deutsche Bank to where it is today.
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