Deutsche Bank and the Nonstop Bleeding of Europes Lenders

Its been more than eight years since the financial crisis. Shouldnt the No.1 bank in Europes biggest economy have found its footing by now?

Germanys Deutsche Bank has investors rattled, policymakers muddled, and anyone else whos paying attention feeling a little queasy. The trigger was news in September that the bank could be hit with a $14 billion penalty for alleged misdeeds during the U.S. mortgage boom. Fearing Deutsche Bank would have to raise capitalselling stock and diluting per-share valueor even find itself in need of a state bailout, investors sent its shares tumbling to a record low on Sept. 26.

While Deutsche Banks shares have since stabilized amid hopes it can negotiate a smaller bill with the U.S. Department of Justice, theyre still down 43 percent this year. Its clear that one of Europes too-big-to-fail institutions is struggling to adapt to a post-crisis world defined by more aggressive regulation and fewer ways for banks to make money.

The European banking model may be broken, says Peter Hahn, a professor at the London Institute of Banking & Finance. The existing system isnt working with low growth and zero-to-negative interest rates. Rock-bottom rates have lowered banks cost of borrowing but also mean they are paid less on loans and investments.

The health of Deutsche Bank has implications far beyond Europe. With 1.8 trillion ($2 trillion) in assets, it raises capital and trades securities for clients in dozens of nations, including the U.S. In June the International Monetary Fund flagged Deutsche Bank as the biggest contributor to systemic risk among global banks.

For the past three weeks, Chief Executive Officer John Cryan, a Briton who speaks fluent German, has been reassuring the market. He told the German press that seeking state aid was out of the question. In a memo to the banks 101,000 employees, he said the bank was stronger than it was before the 2008 crash. Its Tier 1 capital ratioone measure of financial strengthwill improve to 11.2 percent from 10.8 percent following the sale of its stake in a Chinese bank.

Cryan cited heavy speculation for the falling share price. That drew the ire of German Vice Chancellor Sigmar Gabriel, who told reporters on Oct. 2, I dont know whether to laugh or be angry that the bank that declared speculation to be its business model now declares itself the victim of speculators.

Once a sleepy adjunct of German industry, Deutsche Bank spent the first decade of the 2000s expanding its investment banking operations in a bid for growth. In the years following the financial crisis, it chose to largely preserve its investment banking franchise even though regulators were forcing the industry to curtail risk-taking. Deutsche Bank had fewer options to fall back on than its rivalsUBS and Credit Suisse possessed asset management businesses that generated lucrative fees, and American giants such as Citigroup could rely on deep reservoirs of retail deposits.

Even as its rivals shuttered underperforming units and eliminated tens of thousands of jobs, Deutsche Banks head count has actually climbed 29 percent since 2007. When Cryan took charge in October 2015, he vowed to make the bank simpler, less risky, and more efficient. The five-year plan included cutting 9,000 jobs and slashing 3.8 billion in costs.

But Deutsche Bank is still dealing with an overhang of legal issues. In 2015 it paid $2.5 billion to settle claims over its role in rigging the bellwether London interbank offered rate. The bank has set aside 5.5 billion to cover litigation costs, which it may have to drain even if it reaches a lighter settlement with the U.S. on mortgages. Meanwhile, authorities in the U.S. and the U.K. are investigating whether Deutsche Bank helped clients move money out of Russia in violation of money laundering rules.

Cutting costs and settling legal bills wont solve Deutsche Banks most pressing problem. It needs to generate ample profits to reinvest in the business and to continue to shore up capital. In the second quarter of 2016, Deutsche Banks net income dropped to 18 million from 796 million a year earlier as it absorbed restructuring costs. Last year it lost 6.8 billion, which was worse than the 3.9 billion loss it recorded in 2008.

Deutsche Bank has to restore confidence in itself, and to do that you have to produce sustainable profitability, says Gary Jenkins, the head of Swordfish Research, a credit analysis firm. Thats really tough to do when you need an industrywide restructuring.

This drama couldnt come at a worse time for German Chancellor Angela Merkel, whos girding for a general election in the second half of 2017. The last thing she wants to deal with is saving Deutsche Bank, especially after her government led the push in recent years to largely bar taxpayer-funded bailouts in the European Union. In a process dubbed a bail-in, troubled lenders must force losses on their shareholders and some creditors before state aid can be considered.

Cryans allies are pushing back on the idea that the bank needs such a radical remedy. On Oct. 4, Jamie Dimon, the CEO and chairman of JPMorgan Chase, told CNBC that Deutsche Bank had plenty of capital and would overcome its challenges. The chieftains of German companies such as Allianz, Siemens, and Munich RE have been rallying around the bank in statements to German media. But it will take more than supportive comments to nurse this 146-year-old institution back to health. Whether its raising capital, merging with another lender like the struggling Commerzbank, or in the worst-case scenario turning to a reluctant Berlin for help, the most obvious options are painful.

The bottom line: Even if Deutsche Bank doesnt end up having to pay $14 billion for its alleged role in the mortgage mess, it still has big problems.

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