22 July 2016

Deutsche bank’s share price has fallen by more than half in the last year. For some insight into the background see these two extracts from Other People’s Money, published in September 2015 (and available from the shop in paperback or hardback). My return on equity is bigger than yours In the years before the global financial crisis, bank CEOs competed like schoolboys to demonstrate that ‘my return on equity is larger than yours’. The display was led by Josef Ackermann, chief executive of Deutsche Bank from 2002 and chairman from 2006 to 2012, who announced a target of 25 per cent return on equity. In 2008, as the global financial crisis broke around him, he proudly announced that this target had been achieved. Return on equity (RoE) is a ratio of profit to shareholders’ funds, and there are two ways to increase a ratio. You can raise the numerator – the profit – or you can reduce the denominator – the equity capital. Reducing equity is easier. RoE is a seriously misleading measure of profitability. For businesses that are not very capital-intensive – such as asset management, or other professional service firms such as accountants – high returns on equity are achievable because the capital requirement is so small. Capital-intensive businesses – in the modern economy they are principally banks, utilities and resource companies – can achieve high returns on equity only through extreme leverage, as Deutsche Bank did. Even as the thinly capitalised Deutsche Bank was benefiting from state guarantees of its liabilities, it was buying back its own shares to reduce its capital base. And whatever return on equity was claimed by the financial officers of Deutsche Bank, the shareholder returns told a different, and more enlightening, story: the average annual total return on its shares (in US dollars with dividends re-invested) over the period May 2002 to May 2012 (Ackermann’s tenure as chief executive of the bank) was around minus 2 per cent. RoE is an inappropriate performance metric for any company, but especially for a bank, and it is bizarre that its use should have been championed by people who profess particular expertise in financial and risk management. Banks still proclaim return on equity targets: less ambitious, but nevertheless fanciful. In recent discussions of the implications of imposing more extensive capital requirements on banks, a figure of 15 per cent has been proposed and endorsed as a measure of the cost of equity capital to conglomerate banks.28 If these companies were really likely to earn 15 per cent rates of return for the benefit of their shareholders, there would be long queues of investors seeking these attractive returns. In practice, most European and some American banks are unable to raise any capital at all from investors, and the new capital which has been needed to restore bank balance sheets following the losses of 2008 has principally been supplied by governments or by customers. Modern financial conglomerates are not so much engines generating large profits as institutions that survive as a result of public subsidy. The accounts of major banks are lengthy and impenetrable. No one really knows the profitability of banks, year by year, business segment by business segment, or in aggregate. The proliferation of poorly understood complexity in the financial sector was intentional: complex products were a source of profit, and these products would have been less rewarding for the sellers if they had been better understood by the buyers. But this complexity would in the end overwhelm the management of financial institutions, as the requirements of oversight increased faster than the capabilities of executives and regulators entrusted with that oversight. The key to a high return on equity is to have little equity in your capital base – to have very high leverage – and Deutsche Bank achieved this to more dramatic effect than any large company in history. At the onset of the global financial crisis equity represented less than 2 per cent of the liabilities of Germany’s largest bank. How could anyone suppose that a trading entity with liabilities twenty, thirty, even fifty times its capital would remain stable, far less be an appropriate repository for the savings of individuals and the credit system of a nation? No other industry operates on such a thin capital base, and no financial institution would lend to a non-financial institution whose finances were so insecure. But Deutsche Bank was thought to be impregnable, like Citigroup and AIG – and, thanks to the German government and European Central Bank, it is. When government stands behind you, it is not necessary to be profitable to be politically and economically powerful – or well placed to provide handsome rewards to senior employees.   Weapons of Mass Destruction The search for high returns on equity, led by Deutsche Bank, encouraged banks to build these very large balance sheets based on positions in FICC. At Deutsche, the pursuit of return on equity produced a balance sheet in which shareholders’ equity amounted to less than 2 per cent of total assets and liabilities – a leverage ratio of over fifty to one. The risk capital available to Deutsche Bank – with shareholders’ equity of €54 billion in 2012 – is not much greater than the funds available to the largest hedge funds. In 2014 Renaissance had funds under management of $38 billion and Paulson $24 billion. (J.P. Morgan and Citigroup, with shareholder funds over $200 billion, are way ahead of any hedge fund, although these banks, like Deutsche Bank, are engaged in many activities other than trading.) But banks with large retail deposit bases have significant competitive advantages in trading, as a result of the size of the collateral they offer and the implicit or explicit government guarantee of their liabilities. The scale of their activities is altogether different – and with it the potential consequences of trading losses. However this fifty-to-one ratio actually substantially understates the leverage at Deutsche Bank, because derivative contracts create leverage. Suppose that, instead of