Deutsche crisis shows failure of German corporate governance model, says Professor John Kay

Leading economist calls for banking giant to be broken up

You know you’re in trouble when Professor John Kay is on your case.

The respected economist says the collapse of investor confidence in Deutsche Bank, which has seen its shares plummet to multi-decade lows, reflects a failure of the German corporate governance model which is incapable of dealing with the “arrogant management” of large businesses.

Kay, whose UK-government commissioned Kay Review looked into the practices of short-termism in the UK capital markets, said that while the German corporate governance model had worked well for small and medium companies, recent corporate governance scandals had shown that this model did not work for larger businesses like Deutsche and Volkswagen (VW).

“The way corporate governance works in Germany has strengthened the position of incumbent management, and this has worked very well for small and medium companies who have that freedom to develop effectively.

“But the very same system has shown that it is not capable of dealing with the arrogant management of large businesses. We have seen that at VW and we are now seeing that with Deutsche,” he told RI in an interview.

Shares in Germany’s largest lender went into freefall on news that the US Department of Justice is seeking up to $14bn to settle claims that Deutsche mis-sold US mortgage-backed securities before the financial crisis. The stock has rallied in recent days on reports that the bank was close to agreeing a much lower figure of $5.4 billion.

Although the current loss of investor confidence has brought the bank’s precarious financial position into sharp focus, investor misgivings over failings at the bank’s management and supervisory board have a longer history.
Earlier this year, Deutsche shareholders very narrowly lost a vote to carry out a special audit of its management and supervisory boards, showing the depth of investor concern.
At the bank’s AGM in May, several high-profile pension funds including US pension giants CalPERS and CalSTRS, the Canadian Pension Plan Investment Board and Dutch state pension fund APG, supported a shareholder proposal for an independent audit of the bank’s management and supervisory board. In the end, however, it was narrowly defeated, with 53.6% of shares voting ‘no’.“There have been worries about Deutsche and its approach for a little while now,” said one UK institutional investor who declined to be named.

“But the bank had not really addressed investor concerns over its level of transparency and disclosure. So they never really gave investors the confidence when the sun was shining, so to speak, and as a result they are in a much weaker position with investors as the storm is coming,” the person added.

The investor added that with a reduced fine, the bank should try and draw a line under its current woes. Future steps could include a board renewal and increased transparency.

Kay said that one way forward would be to break up the bank, to make it a smaller, more specialist institution.

“We don’t really need these diverse financial institutions. We might find that if Deutsche is broken up, some of its bits will not be able to survive while some others may become viable financial businesses,” he added.

Kay noted that with its level of leverage, Deutsche worked like a very large hedge fund that also had a retail and commercial bank attached to it. With the total volume of derivatives exposures estimated at $600-700trn globally, Deutsche Bank and JP Morgan account for 10% each of that total exposure, he said.

Deutsche shares have lost 50% of their value this year, and last week plunged to a 30-year low, at one point below the key 10-euro level. Shares are now trading at 11.50 euros.

There have been reports of hedge funds shorting the stock and indeed the percentage of shares out on loan — from institutional investors — has spiked to its highest level this year at 5.6% on October 3, up from 5.3% on September 30, according to the latest data from Markit.

Kay said: “I think this is a very rational evaluation of the stock in a modern capital market from an institutional investor point of view – although this has come about a bit belatedly – which is ‘I don’t know what’s going on, so I am not going anywhere near that stock’.”

However, there may be more pain ahead for Deutsche investors. Credit Suisse analyst John Peace said that even if the US litigation is settled at reasonable levels, other cases (including Russia and FX) could create “additional headline risks and will weigh on core capital generation” up to 2018.

He added: “Even with no dividend in 2016/2017 and benefits from recent disposals we still think the bank will struggle to meet its capital targets organically.”

The next scheduled event for Deutsche is its third quarter earnings report on October 27, which should make interesting reading.