Photogrpah by Luke MacGregor — Reuters
By Shawn Tully
June 10, 2015

If any doubt lingers that traditional securities trading has faded from a fabulously profitable, glamorous enterprise to a shadow of its former self, the latest news from Deutsche Bank makes this new reality all too clear.

On June 7, Germany’s largest lender announced that its co-CEOs, Anshu Jain and Jurgen Fitschen, would resign from their posts. The new CEO (who technically will share the job with Fitschen until he departs next May) will be John Cryan, a member of the Deutsche Bank (DB) supervisory board and former CFO of rival UBS.

What’s remarkable about the shift is that while Deutsche Bank’s leadership will change, the board intends to follow the same basic strategy that failed under the previous regime: bolstering, one might even say doubling down, on investment banking, its primary pillar and Cryan’s area of expertise. Within investment banking, deutsche is wagering heavily on an antiquated area where modernization isn’t its friend: fixed income trading.

Appointed in 2012 to succeed the legendary Josef Ackermann, co-CEOs Jain and Fitschen set ambitious financial goals, and missed all of the big ones by a spectacular margin. In April, the duo unveiled a strategic overhaul with significantly reduced goals. At Deutsche Bank’s annual meeting in May, investors expressed deep disappointment with the plan; only 61% of shareholders endorsed it in a non-binding vote, which clearly shocked the board into action.

Two main factors account for Deutsche Bank’s chronically poor results. First, since the end of the financial crisis, a series of fines, settlements, and restructurings have inflicted billions upon billions of euros in charges on the bank. Those charges were far bigger than the bank’s leaders, analysts, or almost anyone else expected. In the past three years, the bank has paid a total of around $9 billion to settle a Libor-rigging action and lawsuits over its underwriting of mortgage-backed securities, as well as its role in the collapse of the Kirch media empire in 2002. It also dumped troubled portfolios of commercial real estate loans inherited in the acquisition of government-owned lender Postbank in 2008.

The new Basel III capital rules triggered additional losses. Once profitable swaps and assorted derivatives contracts sprung losses when new rules mandated that banks back those volatile contracts with heavy reserves. The tighter regulations forced Deutsche Bank to sell derivatives portfolios at heavy losses.

Similar travails afflicted most big banks in the post-2008 financial order. But Jain and Fitschen wouldn’t have whiffed so badly if Deutsche Bank’s basic operating businesses had posted strong results. Instead, they performed poorly, exploding the forecasts. In 2012, the co-CEOs announced three goals for 2015. First, they promised to achieve a 12% return on “book equity,” as stated on the balance sheet. Second, Jain and Fitschen pledged to reach an impressive ratio of operating costs to revenues of 65%. The third target: Hiking its regulatory capital level to 10% by the end of the three-year window, without raising any new capital.

As for return on equity, Deutsche Bank was faring so poorly in April that the co-CEOs lowered the goal in a big way. The new target is 10% on tangible equity, a lower number since it excludes goodwill. It’s the equivalent of 8% on book equity, four points below the previous bogey. Further infuriating shareholders, they pushed back the deadline to achieve this easier target by five years, to 2020. So far, progress is nowhere in sight. In 2014, Deutsche Bank posted a return on equity of 2.3%. “It will probably be in the low-single digits for 2015 as well,” says Dirk Becker, an analyst with Kepler Cheuvreux in Frankfurt. On the second objective, the expense ratio is now running not in the 60% range as planned, but in the 80s.

The duo did achieve a capital ratio of 10%. But they flopped again, since getting there required raising around $13 billion in new equity capital, diluting shareholders, who’ve fled the stock. Since 2007, Deutsche Bank’s share price has dropped from $150 to $33, erasing $100 billion in market value.

The poor performance of investment banking, and growing doubts that this will change any time soon, most seriously calls the bank’s current strategy into question.

Deutsche Bank relies far more heavily on investment banking than most of its peers. In recent years, it has placed even greater weight on that franchise. Deutsche Bank’s remarkable rise to the summit in investment banking began in 1990, when it purchased Britain’s Morgan Grenfell, followed by the acquisition of Bankers Trust eight years later. Thereafter, the investment bank thrived––Ackerman, followed by Jain, were principal architects of its success––rising to the top echelon alongside Goldman Sachs and Morgan Stanley.

Deutsche Bank’s greatest strength is its fixed income arm, especially, trading. In its best years, the bank was generating fantastic 40% ROEs in its bond business. Even in 2009, in the wake of the financial crisis, it enjoyed great success in trading. Investors were desperate to exit securities at any price, providing huge “spreads,” or margins, for the bank. At the same time, many of Deutsche Bank’s biggest competitors were reducing their bond trading or closing their fixed income desks altogether. So in 2009, Deutsche Bank profited handsomely by bucking the trend, and it maintained its signature franchise.

Jain-Fitschen decided to rely on their bastion of profitability, bond trading. Their plan was twofold. First, they believed that the retrenchment of many big players, including UBS and Credit Suisse, would put their bank in a far more powerful position. The idea was that the reduced competition would both raise both their market share and trading margins. They also figured that the ultra-tight capital restrictions would gradually loosen, so that banks could once again expand their trading books without huge increases in reserves.

Neither of those predictions worked out as planned.

To make matters worse, the flush, pre-financial crisis time, reprised in 2009, didn’t return. For the past half-decade, fixed income markets have been relatively placid. New regulations have forced the banks to substantially shrink the size of their inventories of bonds for sale. Most customers are in no hurry to sell their bonds and buy new ones at today’s rates, so turnover is low. “They keep waiting for the trends they predicted to happen, and they haven’t happened,” says Becker.

In announcing the changes at the top, the Deutsche Bank board stressed that it’s adhering to the investment banking-first strategy. The bank does have a substantial retail business, boasting around $220 billion in deposits at its branches. But it pledges to shrink that franchise by selling Postbank, which offers banking services in post offices throughout Germany and accounts for half of Deutsche Bank’s deposits.

If it’s well run, retail banking has a strong future because deposits provide big pools of money that’s pretty much interest-free. As rates on loans and securities inevitably rise, those cheap deposits become highly profitable.

The future isn’t nearly as predictable for bond trading. Electronic platforms are now matching big owners, the Fidelities and Vanguards, directly with one another, bypassing the banks and lowering costs in the process. We may be on the brink of a sister revolution to the one that modernized the equity markets and ominously squeezed most of the profit out of stock trading.

It’s usually safe to bet that, after a crisis, businesses can return to a state of normalcy. But it’s not always so, especially not in the outdated, bank-dominated bond business. The world has changed. The question is whether it will change back. For Deutsche Bank, planning on a reprise of the good old days may be a losing wager.

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