The Deutsche Bank Legal Crisis

    In the wake of the 2008 financial crisis, governments and central banks around the world have kept a closer eye on the capital reserves and risk exposure of systemically important banks. Legislation such as Dodd-Frank has ensured that banks operate more safely by including elements like the elimination of trading with huge leverage. While most banks have abided by these requirements, Germany’s Deutsche Bank has not been so receptive to the new financial norms. The bank’s stock price has halved since a year ago amid concerns about its capital reserves and huge derivatives portfolio. The IMF also declared it “the most important net contributor to systemic risks" to the global financial system (1). In a shock to many, Deutsche also failed the “stress test” conducted by the Federal Reserve this past June. While its capital requirements were within the federal guidelines, its system for capital planning was not.  This  caused concern that the company could be exposed to excess risk in the future (2).
 
     As the largest bank in Germany and one of the largest in Europe, Deutsche Bank is systemically important. Additionally, as the largest foreign bank in the United States, Deutsche Bank has its U.S. employees and clients worried. As the bank’s legal expenses pile up due to compliance issues, it needs to cut costs in some way. 
 
     Just last month, the U.S. Justice Department requested $14 billion from the bank due to an investigation into its residential mortgage-backed securities—an area in which many are sensitive just eight years removed from the 2008 crisis. While the bank initially refused to pay, investors sold shares in droves upon the announcement. In addition, Deutsche set aside $5.5 billion in June just for legal expenses (3).
In order to pay for these exorbitant costs, Deutsche is considering scaling back its operations in the United States. Because the U.S. Department of Justice requires a certain percentage of capital to be dedicated strictly to U.S. business, shrinking its presence in America would lower that requirement. But despite being headquartered in Europe, Deutsche employs 10,842 people in the United States, or around 10% of its employees (4). If the bank decides to scale back its operations, this decision would affect thousands of American workers.
 
     The state of the American banking industry is very uncertain. With rock-bottom interest rates and increased regulation, banks are finding it harder to turn a profit in all of their departments. Traders can’t use as much leverage as they once could, low interest rates result in decreased revenue from loans, and increased reserve requirements restrict banks from making money on already low-performing loans. In short, the American banking system is just not what it used to be.
 
     But shockingly, it’s even worse in Europe. In the wake of Brexit, the United Kingdom’s (UK) economy is on very shaky ground, and threatens to take the entire European economy down with it. Since the UK left the European Union, the legitimacy of the EU itself has been brought into question, and many member nations asking why they should be a part of the group. In addition, the Greek bailout is still looming over the continent, and the Italian banking system continues to struggle under the weight of bad loans. If the state of the U.S. banking system is uncertain, the state of the European one is dour. There is uncertainty across the continent, along with low interest rates and increased regulation, that is threatening the profitability of all banks.
    
     Having said all that, scaling back operations in the United States will definitely hurt the top line. After Germany, the U.S. accounts for the most revenues for Deutsche Bank of any country in the world (5). Banking across the world is just not as profitable as it used to be, and despite the low rates and increased regulation, the United States is still one of the best places for banks. It will be a tough decision if Deutsche decides to leave the country with the world’s biggest capital market and one of the most profitable investment banking industries (6).
    
     This leaves investors in a tough spot. While all logical investors understand that the company needs to cut costs, shrinking its presence in the U.S. will be a tough pill to swallow. CEO John Cryan has already suspended dividends and bonuses as well as cut risky assets, but these represent just the low-hanging fruit of costs. Increased cost-cuts will have to be made, and the firm doesn’t have many good options.
    
     Government aid is one option, but it would be unpopular among German taxpayers, and is unlikely to happen. Deutsche is not yet in a desperate situation that would require government support, but it seems to be heading down that path. If the bank were to receive a bailout at some point, it would almost certainly come with specific provisions from the German government that would dampen investors’ expectations of future profitability.
 
     It seems that the only choice Deutsche has is to shrink, which will be a painful process. The German bank would be the first of the large global banks to shrink its operations after 2008, and it could set off a chain reaction of banks doing the same thing. 
 
     Taxpayers across the globe are fed up with “systemically important” banks that they have to bail out. In just about every other industry, failing companies are allowed to go bankrupt, while the best companies are allowed to thrive. This competition ensures that customers are provided the best products or services at the lowest prices. In order to get to that level of competition in the financial services industry, the big banks need to get a lot smaller. Prior to 2008, banks knew they could take as many risks as they wanted with trades and loans, because they knew they would be bailed out by taxpayers if they failed. In this way, the risk was transferred from the banks to the taxpayers. In order to transfer, as well as localize, the risk back to themselves, banks need to become smaller, and that seems to be where Deutsche is headed. Because of its many divisions, Deutsche has many ways in which it could reinvent itself, but the fact remains: it cannot keep growing at its current size and in the current economic environment.
 
     The shrinking of Deutsche is definitely not what shareholders want to hear, at least in the short term. Unless the company is able to sell off large chunks of its business at high premiums, or significant financial engineering takes place, shareholders are sure to see their investment drop in value if the firm shrinks.
Deutsche Bank first needs to clear itself of the 7,000 lawsuits and billions of dollars in owed fees (7). To pay for that, it needs to cut costs somehow, and shrinking its operations in the United States might be the best way to do so. This would put many Americans out of work and cause the already-low stock price to drop even further. However, if Deutsche is able to shrink somewhat seamlessly, the process could provide an opportunity for value investors to buy shares of the bank at a very depressed price. However, the company is in dire straits right now, and it looks like the only option is to shrink itself, which will be a painful process for all involved.


(1) Chang, Evelyn. "Deutsche Bank Crisis, Explained - Cnbc.com." CNBC, 28 Sept. 2016. Web. 25 Oct. 2016.
 
(2) Ibid.
 
(3) Forester, Jan-Henrik, and Aaron Kirchfeld. "Deutsche Bank Said to Explore Shrinking U.S. Operations ..." Bloomberg.com. Bloomberg, 16 Oct. 2016. Web. 25 Oct. 2016.
 
(4) Ibid.
 
(5) Ibid.
 
(6) "M&A Statistics By Countries." IMAA Institute. IMAA, n.d. Web. 24 Oct. 2016.
 
(7) Iskyan, Kim. "Here Are the Signs That Deutsche Bank Is in Big Trouble ..." thestreet.com. The Street, 25 Aug. 2016. Web. 25 Oct. 2016.


Image: © Anna Martynova | Dreamstime.com - Deutsche Bank building