Watching the related financial dramas of China’s HNA Group and Germany’s Deutsche Bank AG, we are reminded that purposeful design and order imposed from above by experts and regulators is largely an illusion. The world is filled with ill-considered strategies, especially at the intersection of public policy and corporate governance.
So what is the problem for Deutsche Bank?
Banks are facing higher funding costs in the short term because of central bank tightening, while having no assets with a yield to buy in the long term. Banks are constrained by the dual impact of restrictions on lending due to regulation and a dearth of quality assets, due to a decade of central banks buying them up during their easing spree.
In an already difficult market environment, the less well-managed institutions are first to get into trouble. This is why Deutsche Bank had to raise $9.6 billion last year through an equity issue, resulting in Chinese conglomerate HNA becoming its biggest shareholder.
Deutsche Bank searched for years and in vain for a new shareholder prior to the arrival of HNA. When the shadowy Chinese group started to accumulate Deutsche Bank shares in February 2017, the situation at the bank was grave—and had been for years.
Fear of Contagion
To illustrate how grave the situation must be at Deutsche Bank, consider the fact that EU and U.S. regulators have not taken any action to investigate the unknown parties behind HNA—again, Deutsche Bank’s largest shareholder.According to the Financial Times, the HNA investment in Deutsche Bank suggests the possibility “of an additional undisclosed shareholder behind one of the HNA entities.” This is a remarkable revelation. Yet note that regulators on both sides of the Atlantic have taken no action—at least in public—for fear of toppling over the sagging Deutsche Bank.
Normally when you hide the identity of the beneficial owner of a U.S. bank, the primary regulator begins an enforcement action and sends out referrals to the U.S. Attorney and other law enforcement agencies. The parties involved start thinking about jail time.
After a $50 billion deal spree, much of it fueled by debt, HNA has cut a wide swath of value destruction through the world of banking, aviation, lodging, real estate, and other sectors. Just how did HNA get the approval of EU regulators for this investment, despite being denied in other cases?
The government of New Zealand shot down an HNA Group investment in a bank, and this indicated big problems. The Overseas Investment Office (OIO) blocked an attempt by China’s HNA Group to buy a motor vehicle finance firm, in part due to doubts about the debt-saddled conglomerate’s financial stability, Reuters reports. The OIO apparently disliked the HNA practice of pledging equity investments in group companies as collateral on loans.
Were U.S. regulators consulted or even aware of the HNA share purchases in Deutsche Bank last year? Deutsche Bank operates a mostly securities business in the United States, but the German bank does have a $55 billion trust company in New York. Deutsche Bank Trust Corporation is regulated by the Fed and the state of New York, and is a significant player in the market for commercial mortgage-backed securities.
Yet in the strange case of Deutsche Bank and HNA, exactly nothing is happening. The regulatory community has been caught completely off base over the past year and cannot do much for fear of financial contagion. Indeed, the festering mess at Deutsche Bank shows that “too big to fail” is alive and well and global regulators are powerless.
The key issue for investors is to understand that precisely no one is in charge when it comes to the twin systemic risks posed by Deutsche Bank and HNA. If HNA is forced to unwind its leveraged investment in Deutsche Bank, then the German bank will be worse off than before. It will have wasted more than a year engaged with a surreal investor who has disappeared into the mist like a character in a bad Chinese martial arts film.
Fire Sale
Of note, one possible permutation of the Deutsche Bank saga back in Germany is the sale of the U.S. banking business. JPMorgan weighed in on the Deutsche Bank debate several weeks back with the publication of a research report for clients saying Deutsche should shrink its U.S. business “to create shareholder value.” But since German Chancellor Angela Merkel threw the German bank under the bus several years ago, the remaining value of Deutsche Bank is questionable.Reports that former Merrill Lynch CEO John Thain is being nominated to the supervisory board of Deutsche Bank is certainly good news. Thain is a veteran operator, but sadly he is not the CEO. More than anything else, Deutsche Bank needs to tell investors and regulators why this bank should continue to exist. If, in fact, Deutsche Bank moves forward with the sale of its U.S. unit, then the entire business could be in play.
But should the bank stumble in a way that surprises Europe’s distracted politicians, look for a very hastily planned merger. Our candidates for the first zombie merger of this decade: Deutsche Bank and Citigroup. Neither bank has a particularly strong domestic banking business or funding base, but there are some interesting asymmetries. Financially it would be a disaster for shareholders, but from a regulatory perspective, it makes all the sense in the world.
