At a Glance
- Our Investment Grade team is always looking to invest in credible turnaround stories
- The German bank had a culture problem, but when it appointed a new CEO and began to embark on a period of restructuring, we were interested
- Things are now looking brighter for the bank, but is further progress likely to be achieved?
A great German thinker once said: “We rarely find people who achieve great things without first going astray1.”
Back in 2018 the analyst team at Columbia Threadneedle Investments considered Deutsche Bank2 to be an example of a culture problem. The old joke was that it was better to be an employee of the bank than a shareholder. From 1995, when it began building the investment bank, to 2018 total shareholder returns were negative €13 billion, while staff bonuses over the period were €79 billion3!
That year, under new leadership, the bank embarked on a period of restructuring. We were initially skeptical – Deutsche Bank’s previous track record of change was poor – but we took note when CEO Christian Sewing began hitting his targets. On Columbia Threadneedle’s Investment Grade Credit team we invest in credible turnaround stories. As a company improves, borrowing costs fall, bond prices rise and our clients reap the benefits. In this instance we talked to management, reviewed the numbers and decided it represented an investment opportunity.
Slowly, things started to change at Deutsche Bank. Over a six-year period the cost-to-income ratio (a measure of efficiency) fell by more than 15 percentage points and the return on equity (measure of profitability) improved from zero to around 6%4. What’s more, the culture around risk management and governance and the approach to society and the environment was overhauled.
Things are now looking brighter in Frankfurt, and credit markets have taken note. Deutsche Bank’s cost of borrowing is currently around the same level as Barclays or Société Générale – companies which have demonstrated greater stability and predictability of cashflows over the years.
So, what now for the new Deutsche Bank? We felt further progress would be harder to come by. Let’s look at why:
The investment bank
Deutsche’s investment bank performed well from 2000-06, but only because it was leveraged around 50x! In fact, when we look back and apply recent leverage levels of 18-20x, the investment bank didn’t meet its cost of capital at any point until Sewing arrived in the CEO role. By focussing on efficiencies and exiting underperforming businesses, Deutsche has since been punching its weight relative to peers such as Citi and Bank of America. While that is impressive, we thought further gains would require increased market share – which we thought unlikely. Deutsche Bank didn’t have a particular edge in this business relative to the big US players.
Asset quality
The new management team improved transparency and tightened lending standards. The CFO and CRO led “investor deep dives” into the darker corners of the balance sheet and the company avoided some of the embarrassing mistakes that caught out its peers (for example, Archegos and Signa). Credit risk had been well managed to-date and bad debt numbers had come through on expectations.
Domestic competition
Germany is a tough banking market. It consists of the private banks (mainly Deutsche and Commerzbank), the public sector banks (the Landesbanken and Sparkassen) and the credit cooperatives (the Volksbanken and Raiffeisenbanken). The public and cooperative sectors have a combined market share of about 50% and are not-for-profit institutions. They don’t have shareholders or profitability targets so can lend at lower margins. Put simply: the competition can offer the same product at a better price.
However, a couple of years into Deutsche’s turnaround, the European Central Bank (ECB) started to hike rates and profitability became easier to achieve. The German system is awash with deposits. “Deposit beta” – the percentage of an ECB rate hike which gets passed through to depositors – is around 30%. This rising rate effect helped to add more than 20% to net interest income between 2021 and 20236.We felt the timing was fortuitous. Interest rates have been the tide that has lifted all ships in banking. As rates fall over the next couple of years, our view was that profitability growth would be much harder to come by.
Conclusion
Deutsche is no longer astray. Sewing and his team have steered things on to a better path. The credit market has adjusted its perceptions. Valuations are close to those of peer companies, which didn’t stray as far. However, we felt it would be a tall order for the bank to continue this trajectory of improvement. As such, it was time for us to say “auf Wiedersehen” and move on to the next turnaround opportunity.
