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10 August, 2016

The transformation and decline of Deutsche Bank

Shares of Deutsche Bank and Credit Suisse have been dropped from the prestigious Stoxx Europe 50 share index. Is European banking in decline? And if so, what are the factors that led to its current parlous state?

Remember the days when bankers were bankers, not "investment bankers," and thought of as sober-suited, cautious accountant types, risk-averse to the point of being thought rather dull and unimaginative?

Back in those days, business was still based on long-term relationships, not just on quarterly results. A handshake was worth as much as a written contract. In terms of public prestige, senior bankers were on a par with leading university professors, or the sort of senior physicians who head up medical clinics. In Germany, during the years of the Wirtschaftswunder (post-war economic miracle), Deutsche Bank in particular was a deeply respected, almost sacred institution.

But that was before the events which an article in "Zeit Online," a leading German news website, called the "inside-job robbery" of Deutsche Bank. That started 27 years ago, in 1989, as Deutsche's executive team under then-CEO Alfred Herrhausen bought British investment bank Morgan Grenfell and made it a unit of Deutsche. Suddenly, hundreds of financial markets experts and securities dealers flooded into Germany's biggest private bank. This ended up fundamentally changing its culture and character.

What had once been a staid, solid institution that made its money by extending credit to industrial companies looking to expand their production lines increasingly became a casino more and more focused on making bets in the financial markets on its own account.

Ten years later, in 1999, Deutsche Bank also bought up the big American investment bank Bankers Trust. As a result, Deutsche temporarily achieved a new status as the largest bank in the world, measured by the size of its balance sheet. More importantly, the takeover of Bankers Trust completed the transformation of Deutsche. The investment bankers dominated the fused entity.

Bank robbery from inside

In contrast to the bank's directors, Deutsche's investment bankers weren't legally liable for their deals. They took - and still take - far higher risks than the Deutsche Bank of the pre-Morgan Grenfell, pre-Bankers Trust days, and they rake in huge bonuses - estimated to have amounted to a total of 40 to 50 billion euros ($44 to $55 billion) within a span of just 15 years.

That's despite the fact that Deutsche's investment banking arm may not have actually booked any profits, on a net basis, over that time frame. By the end of the period, Deutsche had dropped from number one to somewhere in the 40s in terms of balance-sheet size. Its share price crashed by two-thirds within the past year, from 33 euros a share to 11, and valuable, long-held shareholdings of major industrial companies were sold in an effort to shore up the bottom line. Those measures were ultimately the price Deutsche paid for the 40 or 50 billion euros in bonus payouts. That's what critics mean by "bank robbery from the inside."

The investment bankers changed the corporate culture of Frankfurt's biggest banking house into one that seemed to scorn ethical and legal norms. Worldwide, more than 7,000 lawsuits are underway against Deutsche, alleging a long list of financial crimes, including large-scale money laundering, interest rate manipulation, and tax evasion. Deutsche presently has 5.4 billion euros set aside in a special fund to pay for litigation costs. Last year, fines, settlements and litigation costs weighed on the bank's bottom line to such an extent that it reported a record loss of 6.8 billion euros.

Provisional nadir

The low point in the bank's reputation - to date, at any rate - came this spring, when CEO John Cryan and CFO Marcus Schenck felt compelled to reassure investors that Deutsche would continue to be able to pay interest on its bonds, now seen as high-risk. When a corporate CEO comes out saying that sort of thing, it's often because his company is at the brink of insolvency.

Even if that appears not to be the case with Deutsche, it's not a reassuring signal. Investors such as pension funds, which are mandated to put their money into safe, long-term investments, have been pulling their money out of Deutsche Bank shares. Moody's, the US-based ratings agency, has adjusted Deutsche's rating accordingly; it's now just two notches above "junk" status. That, in turn, is driving up the bank's refinancing costs.

Meanwhile, things don't seem to be going much better for other European banks. On the Tuesday afternoon a couple of business days after the European Banking Authority's stress-test results of the 51 biggest European banks were released, bank shares all over Europe took a dive. Italy's Unicredit, which owns the German bank Hypo-Vereinsbank as a subsidiary, lost 7.2 percent, followed by Spain's Santander, down 5.3 percent, and BBVA, down 4.9 percent. The Netherlands' ING Group, parent of Germany's ING Diba bank, lost 4.6 percent.

The long descent

The balance sheets of many European banks are still weighed down from the fallout of the global financial crisis of 2007-8. Hundreds of billions of euros in nonperforming loans are still on their books. The most recent stress-tests show that some big banks - including Germany's two biggest private banks, Deutsche Bank and Commerzbank - still have a rather thin core capital ratio, the cushion of paid-in shareholders' money and retained earnings that's meant to absorb any losses during a downturn. And all the banks are suffering from a sustained reduction in profitability resulting from very low interest rates, which are now all the more likely to stay low in the wake of Brexit.

The weakening of the big European banks is now making itself evident in one of the continent's most important stock indices, the Stoxx Europe 50. Deutsche Bank and the Swiss giant Credit Suisse were dropped from the Europe Stoxx50 index, which includes Europe's most important companies, as of today. If the two banks were football teams, this would be like dropping from the Premier League down into the second division.

The future doesn't look particularly rosy. Thomas Mayer, formerly chief economist of Deutsche Bank and today a professor at the University of Witten-Herdeke, a year ago prophesied the "downfall of the traditional banks." His prognosis suggested that their business model could become obsolete as a result of several developments: technical developments in finance, or "fintech," allowing new players to enter the market, more stringent new regulations, and the near-zero interest rate policy imposed by central banks will combine to squeeze banks' margins.

Future dangers

Central banks' low-interest rate policy, Mayer argues, will hit profit margins of banks in the traditional business of granting credit to borrowers, "and the longer the low-interest-rate phase lasts, the more will banks have to give up on this core business."

Increasing government regulation tends to squeeze margins, according to Mayer, who has argued that "the supplemental equity capital requirements for systemically important banks, and the obligation to be able to wind up a bank that enters insolvency without any recourse to taxpayers' money, will make the business model of global universal banks obsolete."

But the banks' biggest enemy, Mayer says, is technological progress - because it could lead to banks' losing their core payments and credit-brokerage businesses to 'fintech' companies. Payments "could in future increasingly be made via novel electronic payments systems, in which information technology companies have technical advantages."

Classic credit brokerage activities could also be threatened by new competitors, Mayer warns: "The rise of crowd funding shows that social enterprises can bring together savers and investors with borrowers."

The traditional banks are responding, however, by monitoring the fintech startups closely and in some cases teaming up with them or investing in them.

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