After the fall of Lehman Brothers 10 years ago, there was a public debate about how the leading American banks had grown “too big to fail”. But that debate overlooked the larger story, about how the global markets where stocks, bonds and other financial assets are traded had grown worrisomely large. By the eve of the 2008 crisis, global financial markets dwarfed the global economy. Those markets had tripled over the previous three decades to 347% of the world’s gross economic output, driven up by easy money pouring out of central banks. That is one major reason that the ripple effects of Lehman’s fall were large enough to cause the worst downtown since the Great Depression.
Three days before Lehman Brothers filed for bankruptcy in September 2008, Bob Diamond was ushered into a conference room with “buyer” handwritten on the door of the New York Federal Reserve Bank in Manhattan. As the Barclays boss closed on a deal for Lehman, Mr. Diamond says the opportunity looked “wonderful”- even if he remains frustrated he could not reach agreement before it collapsed which may have averted the worst of the financial crisis in our opinion. In the end, Barclays bought much of Lehman’s US operations out of bankruptcy. At that time, Barclays was among the European banks viding high even as the US banking system went into meltdown, with ambitions to be among those left to pick over what was left after the subprime mortgage crisis had run its course. A few months earlier, Royal Bank of Scotland had become the world’s biggest bank by assets by outbidding Barclays to acquire Dutch rival ABN Amro. But as shares in the biggest US banks were being pounded by waves of panic about which might collapse next, few could imagine then how the implosion of the debt-fuelled housing bubble would result in the US financial sector surging back stronger than ever. During the next decade, the biggest groups on Wall Street would go on to establish a seemingly unshakeable dominance in global corporate and investment banking.
European banks, meanwhile, have been forced into a steady retreat-weakened by the subsequent eurozone debt crisis and overtaken in the global ranking by resurgent US rivals as well as the even faster growing Chinese state-owned banks.
According to collected figures, HSBC, RBS, BNP Paribas, Barclays and Deutsche Bank, the top five European banks, made close to 60 billion US-Dollar of combined net profits in 2007. This was a fifth higher than the earnings of JP Morgan Chase, Bank of America, Citigroup, Morgan Stanley and Goldman Sachs, their main US rivals. By 2017, the picture had changed drastically. The net profits of European groups had than two – thirds to 17.5 billion US-Dollar, more than a quarter below the 24.4 billion US-Dollar that JP Morgan earned on its own last year. Indeed, JP Morgan’s 380 billion US-Dollar market capitalization exceeds that of its five European rivals combined. Between 2006 and 2016, the top five US banks gained 6 percentage points of market share in global wholesale banking revenue, while the top five European have lost 4 percentage points, according to research by Oliver Wyman and Morgan Stanley. Senior bankers trace the contrasting fortunes back to the different responses to the crisis on each side of the Atlantic. The US, under the direction of Hank Paulson, Treasury secretary, forced its banks to go on a crash diet by forcibly injecting government funds and barring them from repaying it – or from paying dividends and bonuses – until they passed a stress test. “It totally stabilized the US system”, says Paul Achleitner, Deutsche Bank’s chairman and a former colleague of Mr. Paulson of Goldman. “It allowed them to radically write off all kinds of stuff that they had there, and yes, they replenished. Over here in Europe, you couldn’t possibly do any of the above.”
Bankers such as Mr. Diamond and Mr. Achleitner say Europe is making a big strategic mistake by leaving itself exposed to increasingly blatant US economic nationalism, particularly under Donald Trump’s presidency.” As American banks have shown through history, they go hot and cold on commitment to markets outside the US”, says Bill Winters, the former JP Morgan executive now running Standard Chartered, the emerging markets lender. So we at Calvin • Farel certainly think that it would be imprudent for Europe to find itself in a position where their conduits to international capital markets are entirely companies that do not have a vested interest in the local economy. Others share the mounting concerns that US banks will retreat in the next crisis, leaving European companies with less access to funding. For the European industry to have to rely on American banks for the raising of capital, for mergers and acquisitions, for intermediation of equity and investment is geopolitically somewhat quiet challenging in our opinion, which has retrenched significantly since the crisis. We describe UBS for example currently as a “little” David against Goliath. David can win but your challenge is a little bit steeper.
European politicians, however, mostly seem untroubled, showing little sympathy for the coming and continuing struggles of regional banks that are still considered politically toxic. Even the companies that rely on bank finance seem unfazed. Corporate treasures point out banks is queuing in Europe to provide access to cheap funding.
Multinational companies typically have a stable of at least a dozen banks a mix of local and international lenders that can support global operations to meet financing needs. “European banks have retrenched but others have stepped in to pick up the slack,” says Sarah Boyce of the UK’s Association of Corporate Treasurers.
In the past decade, the five European banks have shrunk their revenues by 20%, their assets by 15% and their workforce by almost 30% according to our datas. Meanwhile, their fire Wall Street rivals have increased their revenues 12% and their assets by 10%, while their headcount has shrunk by less than 10%. There are some who believe that Europe’s shrinking banks should be celebrated. In our opinion we had in effect a huge tax-payer-backed subsidy for risk-taking and that ended in tears. So pulling back from that is directionally a good thing. The banks’ balance sheets got so overblown with a lot of activities which we believe we’re completely unproductive so there is no social loss or economic loss in their disappearance. RBS remains the most extreme example of a European bank in retreat. For a spell in 2008, it was the world’s biggest by assets until being bailed out by Gordon Brown’s Labor government a month after Lehman collapsed. Since then RBS has been engaged in a drawn-out restructuring, shedding over 60% of its assets and 70% of staff. Even Stevenson, finance director at RBS, says the European corporate and investment banking market suffers from “an excess of capacity” that drags the profitability of most banks in the region down below their cost of capital – meaning they are destroying value. So it is a concern in our opinion, but it is also a multi-faceted problem that we don’t think would get solved just by insisting that European investment banks continue to exist at scale.
As well as being slower to flush toxic assets out of their balance sheets, European banks have suffered from the political stigma around the sector in the aftermath of the crisis. “Across much of Europe you saw almost the application of biblical justice, which is if you’re a bank, you’re bad, so let’s penalize you, as opposed to let’s make you healthy again,” says Mr. Diamond, who was pushed out by regulators as Barclays chief executive in 2012 and now runs private equity funds that buy assets from banks. Since the crisis, most European countries have introduced bank-specific taxes and laws, such as the bonus cap and the Mifid II investor protection rules, which do not apply in the US.
The US government is unwinding parts of its past-crisis financial regulation, such as the Volcker rule restricting proprietary trading by banks. There are structural reasons for the outperformance of US banks, which benefit from a dominant position in a homogeneous market that boasts the world’s largest investment banking fee pool. Europe has no truly pan – European banks, its economic growth remains sluggish, and the eurozone banking union is unfinished. Added to that, Brexit now looks set to further fragment the market. Frédéric Oudéa, chief executive of Société Générale, points out that US banks can charge treble the fees for an initial public offering and 30% more for bond issues than in Europe. “I would not call it an oligopoly but it is not far off,” he says.
At a time when the US is using sanctions against countries such as Russia, Iran and Turkey as a way to harness the dominance of the dollar in international trade and achieve its foreign policy goals, some argue that strong, global banks are more important than ever for Europe, we argue that alternative have to be found and implemented.
Mr. Ackleitner says he has been asking politicians in Berlin if they are happy leaving the US to be the world’s financial policeman since he became chairman of Deutsche Bank six years ago. His questions grew louder when the US panicked investors in 2016 by threatening Germany’s biggest bank with a 14 billion US-Dollar fine for alleged mortgage securities mis-selling before the crisis. “Six years ago they were quite indifferent to the question if we need big international banks in Germany”, says Deutsche Bank chairman.” In the current political environment this position has changed fundamentally.” For 60 years, most Europeans have assumed their strategic interests are aligned with the US, but Mr. Ackleitner says this is now changing. “The hard – nosed fact is there may be elements where it deviates and they just become much more accentuated under the current US president,” he says.
But also Deutsche Bank has made huge strategical mistakes in the past, especially with the German family – owned business “Mittlestand”.
Back then, labour-intensive, long term relationships with unlisted, family-owned companies in the German heartland appeared dull and parochial, compared with the lavish returns generated by flamboyant traders in London and New York. Germany’s biggest bank holds a market share of only 12% to 16% among corporate clients with 15 million – 100 million Euro in revenue, according to data from Credit reform, a financial service provider. The market is controlled by municipal – owned Sparkassen, cooperative banks, and Deutsche Bank listed rival Commerzbank. In these days Deutsche Bank’s investment bank is suffering from failing revenues and bloated costs. Chief executive Christian Sewing is trying to rebalance the lender. By 2020, he wants to generate 65% of earnings in stable, non-trading activities, compared with an average of 56% over the past decade. Winning a larger market share among Germany’s prosperous Mittlestand is a pillar in that strategy. Even before becoming chief executive in April, Mr. Sewing started to prioritize domestic SMEs. “We regard Germany’s Mittlestand as one of our most important client groups”, he said in March, when co-heading Deutsche Bank private and commercial bank. In September 2015, he appointed Mr. Bender to lead the push. “We want to grow – and we want to grow our revenue faster than our costs,” Mr. Bender said. The snag is that Deutsche Bank rivals from Sparkassen to state-owned Landesbanken, listed peer Commerzbank, and foreign competitors such as BNP-all have similar plans.
“There is no lender in Germany which doesn’t want to grow in corporate banking,” said Jens Sträter, a partner at German banking consultancy Zeb. All are lured by Germany’s globally successful companies, a sound and stable macroeconomic environment, and a large revenue pool, which strategy 8, a PWC-owned consultancy, estimates is 20 billion Euro. The market is tough, with banks’ margins under pressure and credit covenants becoming more lenient. Burnt by its past lax behaviour during dashes for growth, Deutsche Bank is not able or willing to undercut the competition. “Deutsche Bank is still relatively uncompromising when it comes to lower lending standards,” said a consultant on condition of anonymity. In our opinion this does make it much more difficult to meet growth ambitions. As Deutsche Bank’s biggest asset in wooing the country’s Mittlestand is its global network – why not merging Deutsche Bank with its rival Commerzbank.
In our opinion a tie-up between Deutsche Bank and Commerzbank is not seen as a question of it, but when. The prevailing view among the cognoscenti is that the country’s two largest listed lenders are very likely to merge eventually. The common opinion, backed by large investors in Deutsche Bank, is that the bank has to integrate Postbank and restructure its ailing investment bank division before it can do a deal with Commerzbank. “Still-lumping together two sick men don’t create a healthy one”, said once Calvin • Farel’s chairman.
Two scenarios might accelerate the potential merger. One is that Deutsche Bank realizes it is unable to turn itself round under its own stream; the other is that a foreign peer tables a bid for Commerzbank, forcing Deutsche Bank chief Christian Sewing to make a counter-offer.
Assuming a 35% premium on Commerzbank’s market capitalization, Deutsche Bank would have to pay 14 billion Euro for its smaller rival. As per our experience there are different ways to structure this deal, but it surely would not be in cash. The fact that US private equity group Cerberus has taken minority stakes in both Deutsche Bank and Commerzbank, and been hired as an adviser by Mr. Sewing, has also fuelled merger speculation. Behind closed doors, some bankers in Frankfurt are even encouraging Mr. Sewing to act quickly. A possible merger as per our analysts should be done sooner rather than later as both lenders needed the synergies created by a merger to earn their cost of capital. With 1.9 trillion Euro in assets, a merged Deutsche – Commerzbank would be the third – largest European bank after HSBC and BNP Paribas.
Another Frankfurt – based banker known to us working for a different global lender acknowledged that “there is no structural or technical reason why the deal could not be done within three to six months”. He did not think that was a very likely scenario, because both persuading shareholders and executing a deal were significant tasks. Based on the experience from previous banking mergers, Amit Goel, analyst at Barclays, estimates that both lenders can squeeze just under 2 billion Euro in annual costs, or 27% of Commerzbank’s cost base. By 2020, this would push the enlarged bank’s return on tangible equity to about 9%. On a standalone basis, Mr. Goel expects that Deutsche Bank will eke out less than 2% in the same year.
Discounted at 10 percent, and after tax, the cost synergies alone would be north of 13 billion Euro, or about a third of the current combined market cap, in today’s money. Making the synergies happen will inquire closing hundreds of branches and sacking thousands of bankers. “You’d really have to be radical here, otherwise such a deal would not work, “said one of our Frankfurt-based M & A business associate. While the woes of Germany’s listed lenders are partly due to poor management, they have structural roots. “German retail and commercial banking is the most competitive market in Europe, if not the world, “wrote Andrew Coombs, Citi analyst, in a note to clients.
Apart from cutting costs, teaming up with Commerzbank might make sense strategically for Deutsche Bank. The lender is overly dependent on its investment banking division, which ties up a lot of equity and generates volatile returns. Commerzbank’s 13 million retail customers could also give Deutsche Bank the scale necessary to make retail banking profitable, Commerzbank is already a leading lender to the Mittlestand. That is the market where Mr. Sewing wants to expand, complementing Deutsche Bank’s strength among German blue chips. In 2016, both lenders already briefly explored a tie-up in informal talks, but the discussions came to nothing. “Deutsche Bank’s unresolved legacy issues were a key stumbling block,“ said a person familiar with the talks. But over the past two years, Deutsche Bank settled three-quarters of its legal headaches, removing an obstacle. A remaining counter-argument is that Deutsche Bank’s own restructuring is very much work in progress and might be derailed by the complex task of integrating Commerzbank. Another argument for Deutsche Bank is to wait for its fortunes to improve. During the leadership crisis earlier this year, and disappointing results, its stock fell to all-time lows and has only recovered slightly. If Mr. Sewing successfully delivers on his turnround pledges, its shares may rise, meaning Deutsche Bank could get control of Commerzbank more cheaply. However, a deal could not happen without political support, People familiar with the thinking of Europe’s banking watchdog say the ECB’s Single Supervisory Mechanism is in favour of banking consolidation. But the bigger a lender, the higher the risks it creates for stability and the larger the potential capital surcharges. “The regulator could shoot down the deal with the stroke of a pen” said another Frankfurt-based associate, adding that policy makers do have wide discretion. A lot would hinge on the view of the chancellery and finance ministry. Since bailing out Commerzbank a decade ago, Berlin has been a shareholder, and holds a 15 percent stake. Olaf Scholz, the finance minister, has stressed that the country needs a strong, globally competitive financial sector.
One policymaker points to the market cap of Germany’s two listed lenders as evidence for the sector’s weakness. “The smallest of the four big French banks has a higher market capitalization that the two largest listed German banks,” our analysts said. Yet the future of the taxpayer’s stake in Commerzbank has not been the subject of public political debate. “The fact that we don’t talk about this in public doesn’t mean we don’t think about this a lot; a political person said, adding there might be options other than a Deutsche-Commerzbank deal. Another detail in Berlin’s attitude to a potential bid by a rival such as UniCredit or BNP, because such a deal might further weaken Deutsche Bank’s position and put one of the Mittlestand lenders in foreign hands.
Policy makers in Berlin traditionally have been highly reluctant to conduct aggressive industrial politics that tries to create national champions. “But in the current political climate, which is shaped by trade conflicts and a return of protectionism, the attitude in Berlin may change,” said another business associate.
Another aspect to consider is that such a merger is easier to execute in good times with smooth running operations than under tougher market condition or even in a recession. Over the past decade, the world’s largest central banks – in the United States, Europe, China and Japan – have expanded their balance sheets from less than 5 trillion US-Dollar to more than 17 trillion US-Dollar in an effort to promote the recovery. Much of that newly printed money has found its way into the financial markets, where it often follows the path of least regulation. Central bankers and other regulators have largely succeeded in containing the practice that caused disaster in 2008: risky mortgage lending by big banks. But with so much easy money sloshing around in global markets, new threats were bound to emerge – in places the regulators aren’t watching as closely.
Within the 290 trillion US-Dollar global financial markets, there are hundreds of new risks, pools of potentially troubled debt. Among the most troubling: corporate borrowers and so-called non-bank lenders all over the world. As bank lending dried up after the financial crisis, more and more companies began raising money by selling bonds, and many of those bonds are now held by these non-bank lenders – mainly money managers such as bond funds, pension funds, insurance companies or large corporations like Apple. Among corporations listed on the S8P 500 index, debt has tripled since 2010 to one and a half times annual earnings – near the historic peaks reached during the recessions of the early 1990s and 2000s. And in some parts of the bond markets, debt loads are much higher.
One of the big corporate risks is developing largely beyond regulatory oversight. Some United States companies that were publicly traded in 2008 have since gone private, often precisely in order to avoid intensified scrutiny from regulators. Many of those companies were purchased by private equity firms, in deals that leave the companies saddled with huge debts and high leverage. Right now the typical American company owned by private equity firm has debt six times higher than its annual earnings – or twice the level that a public ratings agency would consider high – risk or “junk”. At a time when central banks are holding interest rates at record lows, the return from holding plain vanilla corporate bonds is negligible, so investors are more willing to buy junk, for the higher yields. And this hunt for higher returns has been playing out worldwide as asset managers chase higher returns anywhere they can be found, whether in United States private equity or in the bond market of Europe and emerging economics like Argentina and Turkey.
The biggest risks outside the United States are in China, which has printed by far the most money and issued by far the most debt of any country since 2008, and where regulators have had less success reining in borrowers and lenders. Easy money over the last decade has fueled bubbles in everything from stocks and bonds to property in China, and it’s hard to see how or when these bubbles might set off a major crisis in an opaque market where most of the borrowers and lenders are backed by the state. But if and when Beijing reaches the point where it can’t print money any more, the bottom could fall out of the economy.
More broadly, the trigger to watch is the United States Federal Reserve, since many other central banks in the world tend to follow the Fed’s lead in setting interest rates. Over the last 50 years, every time the Fed has reined in easy money by raising interest rates, a downturn in the markets or the economy has followed eventually. It may take a while, but trouble almost inevitably does come as per our experience.
Many doomsayers worried that the Fed tightening that began in 2004 would help prompt a recession – and it eventually did in 2008. Though rates are still historically low in the United States, the Federal Reserve began to raise them more than two years ago and is expected to continue tightening them into next year. The Fed’s tightening is already rattling emerging markets. When the American markets start feeling it, the results are likely be very different from 2008 – corporate meltdowns rather than mortgage defaults, and bond and pension funds affected before big investment banks.
If a downturn follows, it is more likely to be a normal recession than another 100-year storm, like in 2008 in our opinion. Most economists put the probability of such a recession hitting before the end of 2020 of less than 20%. But as per our experience economists are more often wrong than right. Professional forecasters have missed every recession since such records were first kept in 1968, and one of many reasons for this is “recency bias”: using economic forecasting models that tend to give too much weight to recent events. They see, for example, that big banks are in much better shape than in 2008, and households are less encumbered by mortgage debt, and so play down the likelihood of another recession. But they are, in effect preparing to fight the last war.
To have any chance of anticipating and preventing the next downturn, regulators must look for threats that have emerged since 2008. They need to recognize that the markets now play an outsized role in the economy, and their attempts to micromanage this fast sea of money have only pushed the risks away from big American banks and toward new lenders outside the banking system, particularly in the United States and China. Markets have grown so large in part because every time they stumbled, central bankers recued them with easy money. When markets rose sharply – as they have in recent years – the authorities stood by, saying they are not in the business of popping bubbles. Now, in our opinion, the markets are so large it is hard to see how policymakers can lower the risks they pose without participating a sharp decline that is bound to damage the economy. It’s a familiar problem: Like the big banks in 2008, the global markets have grown “too big to fail”.
Having said all of this, we at Calvin • Farel have come up with our own conclusion and we will focus more and more on the 4th Industrial Revolution, blockchain technology and start-up companies in these fields as we believe that such companies will be less affected in a possible economical and financial downturn.
