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Deutsche Bank's Big Gamble (Int'l Edition)


International -- Cover Story

DEUTSCHE BANK'S BIG GAMBLE (int'l edition)

Will its lavish move into global investment banking pay off?

Wind River Systems Inc. couldn't have picked a worse week for a stock offering. The Silicon Valley software company was scheduled to issue 3.3 million new shares on July 11--right in the middle of a market correction in which technology stocks took their hardest beating in years. Nearly two dozen technology deals expected during the week were delayed or killed. Yet on that tense Thursday, Wind River's investment bank was able to place every share. The bank made money on the deal, too.

A miracle pulled off by one of Wall Street's wizards? No, this was the formidable Deutsche Bank, sweating out its first job as lead manager for a new technology issue in the U.S. The deal was a watershed for Frank P. Quattrone, the technology guru Deutsche had lured from Morgan Stanley & Co. just three months earlier with a multimillion-dollar pay package.

OBSOLETE HAUSBANK. Deutsche Bank will need many more such victories. After resisting change for most of its 126-year history, the august Frankfurt institution is attempting a revolution in its major businesses, from domestic retail banking to dealmaking. Just as the changing world economy is forcing Germany itself to rethink its approach to everything from wages to welfare, competition is driving Deutsche to take radical steps. Under the leadership of Chairman Hilmar Kopper, Deutsche is trying to forge a new identity as a global contender in the cutthroat field of investment banking.

It's a strategy that Kopper and his colleagues call inevitable. It's also the riskiest one the bank has pursued since its postwar reconstruction. Conservative to a fault, the $471 billion-asset Deutsche Bank built its franchise in the cozy world of relationship banking, lending to German companies in which it also often held shares. Management, whose straitlaced hierarchy was patterned on the Prussian army, cherry-picked its customers and eschewed risk. It kept its decisions--and details of the bank's true profitability and reserves--strictly to itself.

Now, Deutsche Bank, along with its Continental rivals, knows that the old banking culture is doomed. Heavyweights from Wall Street and the City of London are muscling in on European privatizations and mergers. And the European banks can no longer rely on collecting fat fees from thousands of midsize companies by acting as their personal lender, or Hausbank. Says Kopper: "The Hausbank is dead."

So Kopper is leading Deutsche into global investment banking. He launched the attack 15 months ago by merging the bank's worldwide investment activities into a retitled Deutsche Morgan Grenfell (DMG), based in London, and more acquisitions may be ahead. Kopper spelled out his goals to BUSINESS WEEK: "To retain and widen our position as No.1 in investment banking in Germany, to become the top European investment bank, and at the same time to become a member of the group of global players."

UNFAVORABLE ODDS. To accomplish these goals, Deutsche is fighting on many fronts. At home, Kopper is slashing costs of domestic operations while taking on giant, Munich-based insurer Allianz for domination of the German financial-services industry. In Asia, the bank is pitting new talent against old-line British banks with former colonial connections, as well as burgeoning Chinese banks, the Japanese, and the Americans. In the U.S., Kopper is trying to break the run of bad luck that other European banks have had in cracking the "bulge bracket," or top rank of Wall Street firms. The odds seem stacked against Deutsche. A Japanese assault on the U.S. banking market in the 1980s cost the newcomers billions as they tried to win new business by accepting paper-thin margins. For all their below-market pricing, the Japanese never made a dent. No European bank has ever fared better on its own.

In addition, controlling a global investment bank is a lot tougher than keeping tabs on a staid commercial bank. Last month, Deutsche had to cough up $280 million to make good on losses in two mutual funds run by DMG's Morgan Grenfell Asset Management unit in London. And on Sept. 25, the debt-rating agency Moody's put Deutsche's AAA rating under review, citing "business and balance-sheet risks resulting from the group's aggressive global expansion strategy."

Such scrutiny makes cutting costs in domestic retail banking even more urgent. Deutsche is the least efficient of Germany's Big Three banks, with costs that run about 70% of net income. Its return on capital is around 9%, compared with an average of more than 20% for U.S. banks. Investment banking is far from paying its way, especially as Deutsche continues to offer outsize compensation.

The hiring binge is drawing criticism from rivals around the world. Established equity houses in the U.S. and Asia gripe that the juicy packages Deutsche has used to lure new talent are driving up costs for the entire industry. Competitors also claim Deutsche is "buying" deals, Japanese-style, by severely underpricing its services. DMG Chairman Michael Dobson admits that, like competitors, the bank will sacrifice margins to clinch a landmark privatization, for example. But he says Deutsche is also frequently undercut.

Indeed, the bank in 1995 ranked No. 11 in European initial public offerings, after Morgan Stanley and Merrill Lynch & Co. Meanwhile, as the bank spends billions on its transformation, its shareholders have watched Deutsche Bank stock bump along sideways even during a blazing bull market (charts).

Yet the 61-year-old Kopper, who joined the bank as an apprentice at 19 and must retire in less than four years, claims the bank has no alternative to taking drastic steps, no matter how expensive or controversial. Like the other Continental "universal" banks, which unlike their Anglo-Saxon counterparts do both merchant and commercial banking, Deutsche Bank risks becoming dangerously unprofitable if it continues to rely mainly on its commercial business.

A COMMON DEVIL. The same devil is driving them all. Europe is wildly overbanked: There are 9,500 different banks in the European Union, 40% of them in Germany alone. Margins are slipping, and corporate clients--even small ones--are increasingly savvy at exploiting the competition, crossing the street to shave a couple of basis points off loan interest charges.

Although Kopper is generally considered less of a visionary than his predecessor, Alfred Herrhausen, who was assassinated in 1989, he has spent a lifetime preparing for this challenge. Colleagues consider him one of the most "Anglo-Saxon" of Germany's top bankers. He spent part of his apprenticeship at New York investment bank J. Henry Schroder Wagg. While Herrhausen was still alive, Kopper masterminded Deutsche's acquisition of old-line British merchant bank Morgan Grenfell for about $1.4 billion in 1989.

After a long lull, in which he left Morgan Grenfell alone while he concentrated on rebuilding Deutsche's clout in eastern Germany after unification, he is again digging into Deutsche's deep pockets. In the two years through the end of 1996, he will have spent an estimated $730 million--about half of last year's $1.4 billion consolidated net profit--to hire staff and install high-priced technology, such as state-of-the-art trading rooms in offices throughout Europe and Asia.

Making this costly bet pay off will be a Herculean task. In the U.S., says Carter McClelland, chairman of Deutsche Bank North America, investment banking revenues will be up substantially this year from a "very modest" base in 1995. Yet a former New York executive estimates that North America is losing $100 million per year, before adding back earnings from pre-existing businesses and the commercial finance unit acquired from ITT Corp. All the new operations, he claims, "haven't done a damn thing but add costs."

Kopper's problem is that the huge hiring costs at the investment bank are swallowing up the savings on domestic cutbacks. Even as the bank pursues a new and risky global business, it is restructuring domestically from top to toe. By the end of this year, Kopper will have shed 20% of the 52,600 German employees it had at the end of 1992. About half its 18 regional superbranches, classic baronies in the old Deutsche, will soon close. Back-office work for all branches has already been concentrated in just four regional technology centers.

To signal his seriousness about maintaining Deutsche's position at home, Kopper on July 10 announced that the bank has taken a 5.2% stake in Munich-based Bayerische Vereinsbank, Germany's fifth-largest. The ploy gives Deutsche a decisive voice in how the widely anticipated consolidation of Germany's banking industry will unfold. Vereinsbank and Deutsche are a logical fit. BV's branches are concentrated in southern Germany, where Deutsche is weaker, and it has business strengths that Deutsche lacks. For example, it is a European market leader in real estate finance. The relationship "makes a lot of sense," says Manfred Piontke, banking analyst at Bank Julius Baer in Frankfurt.

SPRINGBOARDS. Better yet, the gambit ups the ante in the long-running war of nerves between Deutsche and Munich-based insurance giant Allianz for dominance of Germany's financial services industry. Kopper could have bought a 4.9% stake in BV and kept it quiet. But he wanted to send a signal that Deutsche intends to stay leader of the pack. "It's the big dog barking," he laughs. In 1989, Deutsche tweaked Allianz by rejecting a partnership and later plunging into life insurance alone. Its Deutscher Herold unit is now Germany's fifth-biggest insurer, with nearly $2.5 billion in premium income, compared with Allianz's $8.6 billion in life premiums.

While Kopper consolidates Deutsche's position on the Continent, he's waiting for his far-flung new investment banking talent to start delivering real results. His hired guns at DMG, from London's Dobson to Quattrone's DMG Technology Group in Menlo Park, Calif., have racked up some respectable deals. DMG is a global book runner, responsible for selling shares directly and through other banks, for Deutsche Telekom's partial $10 billion privatization. It is also advising the French Treasury on France Telecom's forthcoming sell-off to the private sector. Deutsche advised French retailer Auchan in its $3.7 billion hostile takeover of Docks de France, the country's largest buyout ever. And it structured Italy's biggest LBO, by Texas Pacific Corp. of motorbike maker Ducati Meccanica for $330 million.

ASIAN HIRING SPREE. The bank is pushing hard in Asia, too. It had a powerful springboard there, with 40 branches in 17 countries. But when Simon Murray, the Asia-Pacific regional chairman, arrived in Hong Kong three years ago, Deutsche didn't have much of an investment banking presence. It did mainly stockbrokering and low-margin project advisory work. After considering an acquisition, Deutsche instead hired nearly 600 people into investment banking in just 18 months.

Fanning out from Singapore and Japan, the investment bankers are beginning to make inroads. "We bump up against them in many markets--and they have real dynamism," says the Asia boss of a rival based in Singapore. A 40-strong project finance team has bankrolled two oil refineries in Thailand, the $3 billion north-south highway in Malaysia, and several telecommunications projects in the region. Deutsche recently floated $158 million worth of new shares for Tingyi, the top maker of premium instant noodles in China, and was lead manager for a $350 million convertible bond offering for Bangkok Bank Ltd. Says Murray: "We're not in the same league as the big U.S. banks yet. But we're on the ladder."

Deutsche's tactic of buying people has rivals howling that Kopper has begun a global bidding war for talent. For example, DMG not only beat the $5 million salary-and-bonus package Frank Quattrone had commanded at Morgan Stanley but also guaranteed it for two years and threw in an offer of profit-sharing thereafter. In May, Deutsche raided ING Barings Ltd.'s star Latin America research team with similar incentives. Gripes one London-based top executive at a large European investment bank: "This is indiscriminate hiring. They are not a competitor, they are a destructive force in the marketplace."

Kopper and his lieutenants stand squarely behind their strategy. He insists DMG is paying compensation only 3% above market averages. Says North America's McClelland, who has pumped up the U.S. head count by 600 this year, to 1,800: "It's far cheaper to build than buy." Nevertheless, recurrent industry gossip has it that Deutsche may soon target a major U.S. house, such as Lehman Brothers or Salomon Brothers, or even a smaller, more specialized outfit such as Kidder Peabody.

Kopper responds: "I would not exclude it, but it's not for this century. It'll take three years to get DMG up and running fully." Dobson agrees: "We are taking a three-to-five-year view of this expansion, but we do expect improving bottom-line results. We are trying to have our cake and eat it, too."

Yet critics wonder whether Kopper's recruiting strategy is opening a cultural Pandora's box. "Deutsche Bank's approach is flawed," charges a senior executive at a top French bank. "If you are building a business, the key is having a culture where people are working for you because they want to, not because they are being paid a lot to." Banking scuttlebutt has it that some of DMG's top-dollar hires from Wall Street have kept their families and houses in the U.S., ready to head back from London once their bonus guarantees run out.

But there's also fear that in DMG, Kopper has built a new entity dangerously outside Deutsche's control. Just last month, British regulators started investigations at DMG's asset management subsidiary into the activities of mutual-fund manager Peter Young. One of the funds he ran, for instance, owned 34% of the outstanding shares in a highly speculative, unlisted security. That's more than triple the amount allowed by British rules unless the stock is due to be listed within 12 months.

When internal supervision picked up on it, Young, who was fired and is now being investigated by Britain's Serious Fraud Office, allegedly kept the stocks against orders by switching them into vehicles he said were "to be listed" in Luxembourg. Deutsche moved fast to limit the damage to its $270 billion asset management business, buying the stocks from the funds and putting them onto its own books. "[It cost] about one-tenth of 1% of our asset management volume," sniffs Kopper. But it raised questions about accountability in London. No one has been charged or arrested in connection with the losses.

The asset-management embarrassment wasn't Deutsche's first. In 1994, the bank was left holding the bag when real estate mogul Jurgen Schneider fled Germany, leaving behind more than $2.3 billion worth of bad debt with 60 different banks. Deutsche Bank booked losses of $267 million. The previous year, metals and trading company Metallgesellschaft, in which Deutsche now has a 16.6% stake, turned up trading losses of $1.3 billion from oil futures and other instruments it had allegedly hidden from Deutsche's board of directors. Kopper claims that "we didn't lose a penny" in the rescue operation. But the incident spawned a flurry of lawsuits that have yet to be resolved.

VISE. Deutsche Bank can't afford many such mistakes. New revenues take time to build: six months to a year in capital markets and a year or two in other lines, according to North America's McClelland. Kopper is caught in an uncomfortable vise between fast-rising costs and revenues that are improving slowly at best. One Hong Kong rival puts it bluntly: "How long are they going to be willing to run at a loss out here? And what kinds of events will cause them to rethink their approach?"

None so far. DMG will dive back into British securities trading starting Nov. 1. It also plans a global push into equity underwriting in the next 12 months, initially picking a couple of sectors from a list that includes telecommunications, media, utilities, financials, and metals and mining.

With only a few years left before retirement, Hilmar Kopper is understandably in a hurry to make his mark on the bank and on Germany Inc. Despite the high risks, he maintains--with perhaps a hint of the old Deutsche arrogance--that his strategy can succeed. Already, he has prodded old-line companies in which Deutsche holds stakes, such as Daimler-Benz, to trim down, open their books, and become more accountable to investors. If he can make the same changes at his bank, he will be remembered as one of the architects of 21st century Germany.By John Templeman in Frankfurt, with Dave Lindorff in Hong Kong, Stanley Reed in London, and Joan Warner in New YorkReturn to top


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