Strategic challenge facing European banks

Posted on September 30, 2016

The logo of Germany's biggest lender Deutsche Bank can be seen during the company's annual shareholders' meeting in Frankfurt am Main, western Germany, on May 19, 2016. / AFP / DANIEL ROLAND (Photo credit should read DANIEL ROLAND/AFP/Getty Images)©AFP

It has been a torrid week in Europe’s banking sector. Deutsche Bank, the focus of investors’ anxiety, saw its shares drop to levels not seen since the 1980s, after a $14bn demand from US regulators led to new concern over its capital position. Talk of a government rescue plan, which Berlin has denied, is premature. Indeed, rumours of a deal with regulators fuelled a rally in the shares on Friday. However, John Cryan, the bank’s chief executive, cannot simply batten down the hatches and wait for the storm to pass. He has to convince investors that the bank has a business model worth backing. Moreover, Deutsche Bank is merely the most prominent victim of structural problems afflicting many eurozone banks.

Germany’s biggest bank should be at little risk of an acute funding crisis. Its capital position is stronger than during the global financial crisis and well above the regulatory minimum. It has an ample cushion of liquidity.

    In extremis, it could turn to the European Central Bank. A bail-in of bondholders would risk repercussions in a fragile eurozone financial sector, and the German government, conscious of the demands it has made of Rome in dealing with Italian banks, insists there will be no bailout by taxpayers. Yet few believe that Berlin would ultimately allow Deutsche Bank to fail.

    It is not enough for Mr Cryan to blame
    nebulous “forces in the market” for creating a “distorted reality”. The initial $14bn demand from the US Department of Justice may well be reduced to a manageable penalty, judging by the settlements other banks have reached in similar cases. Yet it is likely to remain a sizeable problem; this week’s turbulence could result in damage to Deutsche’s business if it causes clients and counterparties to go elsewhere. Moreover, the justice department demand was merely the trigger for the latest sell-off. The underlying issue is that investors are not convinced by Deutsche’s strategy.

    Deutsche Bank’s ambitions as a leading European investment bank, seeking growth in markets such as Greece and Italy, took a severe knock after the global crisis. Rivals such as Barclays, facing similar challenges, have been able to fall back on a reasonably solid retail business. Yet Deutsche’s home market is not an attractive one.

    Large German companies, the bedrock of its business, are flooded with cash, able to borrow cheaply in bond markets and see limited opportunities to invest at home. Germany’s ageing population is more inclined to save than to borrow. The profitability of the country’s banks suffers from the fragmentation of the sector, which has more than 1,500 lenders, many of them small, municipally owned savings banks. The ECB’s ultra-loose monetary policy merely compounds these problems.

    There are several steps Deutsche Bank could consider to improve its capital position, ranging from asset sales to more speculative ideas such as bonus clawbacks. The German government is right to intimate that it should solve its own problems. However, Deutsche will struggle to raise fresh capital until it can present a convincing long-term plan.

    The bigger question is whether Germany’s banking sector still has a business model. Indeed, Mario Draghi, ECB president, argued last week that one of the chief problems afflicting eurozone banks was that the sector had become too big relative to the needs of the economy. Individual institutions are under pressure to adapt to changed conditions.

    Policymakers may need to recognise the need for the sector to shrink.

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