Deutsche Bank's 'pimple on the backside'

There were few surprised faces when Deutsche Bank last month announced a major restructuring. A radical reboot has been on the cards for a while after Europe's fourth-largest lender was rocked by one scandal after another and reported four consecutive years of losses.

After struggling to recover from the 2008/9 financial crisis, the bank finally admitted it could no longer compete with major American rivals like JPMorgan Chase, Bank of America or Citigroup. The shakeup, it said, would see it pull out of the US and include the closure of its investment banking division.

Announcing 18,000 job losses, Deutsche Bank also said it would set up a "bad bank" to wind down €74 billion ($83.2 billion) of its most toxic assets related to its investment bank — mostly long-dated interest rate and derivative trades.

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More bad debt?

The Frankfurt-based lender has long faced accusations that it is hiding much higher levels of bad debt, and that many of its illiquid assets are overvalued, which the bank furiously denies.

Although financial markets appear to have welcomed the bad bank proposal, for now, much skepticism remains that Deutsche Bank has found a solution for enough of its troubled assets.

"It is merely a pimple on the backside," Gordon Kerr from the London-based financial consultancy Cobden Partners told DW of the bad bank, noting that Deutsche has reported total assets of €1.34 trillion (2018).

German bank restructuring expert Cordelius Ilgmann is hopeful that the Capital Release Unit, as the bad bank is known, will allow Deutsche Bank's management to focus on the turning around of the troubled lender.

"While the bank is in crisis mode, it is tough for management to work through all these impaired assets, while at the same time, concentrating on the profitable side of the business," he told DW.

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Aids global equities pullout

Ilgmann said the creation of a bad bank makes sense when Deutsche is shutting down entire business areas — in this case, investment banking.

Despite receiving very little media coverage, bad banks are nothing new. The US, Germany, Britain, Sweden and several other European and Asian countries have created similar structures, to isolate a troubled bank's riskiest assets that threaten the solvency of a lender.

Many of them benefitted from taxpayer bailouts, which the European Central Bank has tried to curtail since the financial crisis.

For Deutsche, this will be its second bad bank. The first was created in 2012 to run down €125 billion of risk-weighted assets linked to the Great Recession that included a $4.3 billion Las Vegas casino whose owner had defaulted. Although the first was a success, the unit faced almost €14 billion in losses from the firesale of those assets.

Bad banks are risky as they force banks to admit that large swathes of their business have gone bad. They often prompt a significant revaluation of the assets being hived off.

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Bargain hunters await

In Deutsche's case, its new bad bank may struggle to sell off its troubled asset book. There may be few buyers for the most illiquid assets, and now that the bank's woes have been widely reported, purchasers would likely drive a hard bargain.

Ilgmann told DW that pricing of the riskiest assets at their real market value would prompt a "huge write down that could even lead to the insolvency of the good bank," — Deutsche Bank itself.

Kerr, meanwhile, noted that regulators now require banks to "take a realistic view of their assets" and speculated that Deutsche Bank's €74 billion might have already been written down considerably.

More woes on horizon

While Deutsche Bank's CEO Christian Sewing says he is confident the bad bank will help him to right the ship, Ilgmann thinks the lender's problems go far beyond those of impaired assets.

"It first has a reputational risk; secondly, nobody knows what additional legal risks are embedded in the business they are divesting; and thirdly, if they really want to become a German corporate bank again they will need to change their whole business culture," he told DW.

IIgmann added that the bank would need to throw off its aggressive and sometimes arrogant Anglo-Saxon approach to banking and bring back a bit of good 'ole German pragmatism.

Success in turning around Deutsche Bank at this time is critical as storms clouds gather over the global economy again and due to the large German lender's pivotal role in stabilizing the global banking system.

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Putting off a bailout?

The International Monetary Fund concluded in 2016 that Deutsche Bank posed a more significant threat to global financial stability than any other bank. That statement spiked speculation that the lender would at some point need to be bailed out.

Kerr, whose consultancy specializes in helping nations whose banking systems are in great difficulty, concluded that the German government would, at some point, have to step in.

"The only way for the bank to be turned around is with a massive injection of new equity which could only come from the taxpayer and credible management," he told DW.

Ilgmann, however, noted that the state aid rules currently prevent Berlin from using taxpayer funds while the bad bank is still on Deutsche's balance sheet.

"The worst-case scenario would be a government bailout, similar to those in the US and Britain, which would give the German government an impossible choice," he added.

"Either they bend the rules, creating moral hazard, or they risk a systemic event not only in Germany but also in Europe as a whole."