By Thomas Atkins and Kathrin Jones
FRANKFURT (Reuters) - Deutsche Bank's (DBKGn.DE) determination to be the last European in the upper echelons of global investment banking is an expensive waiting game for investors.
Germany's flagship lender is holding its ground against U.S. leaders such as JP Morgan (JPM.N) and Goldman Sachs (GS.N) in revenues, but its returns are trailing because it was not as quick to restructure and recapitalise in the wake of the financial crisis.
European rivals such as UBS (UBSN.VX) and Barclays (BARC.L) have seen their revenues fall as they have shrunk their bond trading desks, but their returns are in better shape.
Deutsche bets that its strategy, which is to vacuum up activities abandoned by retreating European competitors, will pay off when bond trading rebounds.
With interest rates set to remain at record lows for some time in Europe and a risk that litigation costs and regulatory scrutiny could eat up capital, it could be a long wait.
Investors are frustrated. They have seen returns diluted by a $12 billion rights issue this year as Deutsche restocked its balance sheet ahead of European stress tests.
Deutsche's return on equity of less than 3 percent in the first nine months of this year was far below the 12 percent it aims to reach in 2016 and a far cry from the 20 percent returns enjoyed before the crisis.
All banks are aiming for double digit returns given that the industry's cost of equity is around 10-12 percent.
Deutsche Bank has said it is sticking with the 2016 goal. Privately, some investors say that looks unachievable, but since its shares are already among the cheapest in Europe, they say it makes more sense to wait and see than to turn their backs now.
"You just have to hang in there," said one top 10 investor.
Even with this year's rights issue, there are question marks over whether Deutsche will have enough capital to grow the investment banking business given potential litigation costs and new rules which make it far more expensive to trade.
The bank's leverage ratio, or stock of capital to total assets, is 3.3 percent, close to the 3 percent minimum required globally, although it aims to increase that to 3.5 percent by the end of 2015.
A review by global regulators of trading books could yet require more capital, while ongoing investigations, including into alleged interest rate and forex pricing irregularities, could result in billions of euros in new penalties, despite Deutsche Bank already spending over six billion euros on fines and settlements since 2012.
A spokesman for Deutsche, which passed this year's European stress tests even before its rights issue was taken into account, said the bank had enough capital to fund its investment banking plans, citing its core capital ratio of 11.5 percent, which compares to 10.2 percent for Britain's Barclays. But European players who have abandoned their attempts to be full-service investment banks, such as Barclays and Switzerland's UBS, are reaping earlier rewards.
Switzerland's largest bank, which has largely exited bond trading, reported a return on equity of around 7 percent in the first nine months of the year.
UBS and other banks that have tempered their global investment banking ambitions now rely less on trading and more on other businesses such as private banking and retail business for their earnings.
At Deutsche Bank, investment banking accounted for around half of its adjusted pretax profits in the first nine months of the year, which the bank said gave it a balanced portfolio.
Andrea Williams, a fund manager with Royal London Asset Management, said she preferred UBS and Credit Suisse.
"The reason I am differentiating them over Deutsche is because of the wealth management and private banking side, which Deutsche does not really have," said Williams. "Deutsche still has a lot of litigation issues and it still needs capital."
Washington's swift recapitalisation of its banks in the heat of the crisis gave U.S. banks a head start in getting their balance sheets ready for a world of tighter regulation.
JP Morgan is one of the few banks that now earns more now than it did before the crisis and it comfortably leads the revenue rankings, coming top of the Thomson Reuters league table for global investment banking fees every year since 2008.
JP Morgan's return on equity was 10 percent in the first nine months of 2014.
Deutsche has retained its No 6 Thomson Reuters ranking this year and is tagged at No 3 for fixed income, currencies and commodities, which generates around half its investment banking revenue, according to data compiled by consultancy Coalition.
But Coalition predicts that the investment banking market, in terms of revenue, will fall to $257 billion in 2014, down 4 percent from 2013 and down 27 percent from their peak in 2009.
To try and generate better returns from a smaller pie, Deutsche has been adding staff and expanding into riskier areas.
“Our redeployment has paid off and if you look at Europe in particular, the trend towards greater investor interest in risk assets such as equities, financing, and high yield credits will continue in the low interest rate environment - all areas where we are a top provider,” Deutsche Bank’s investment bank chief Colin Fan told Reuters.
But expanding into new areas is expensive: costs in the investment bank rose 10 percent in the third quarter versus a year ago and the introduction of a bonus cap for bankers in the European Union, starting next year, is expected to raise European banks' fixed costs.
Deutsche is cutting back activities that cost too much in capital, including pulling out of part of the credit derivatives market this year. It has also appointed Stefan Krause, its outgoing chief financial officer, to a new board role focused on strategy to help plot its future course.
With few signs of a major upswing in trading and lingering uncertainty over litigation and regulation, more cuts are in store, not just at Deutsche Bank but in the European investment banking industry as a whole.
“There still needs to be more efficiency, more reshaping, more careful capital allocation. More banks need to be more selective about where they can compete and play to their strengths,” said Ted Moynihan, global head of corporate banking at consultancy Oliver Wyman. “There is room for a European at the top table.”
(Additional reporting by Steve Slater and Carolyn Cohn in London; writing by Carmel Crimmins; editing by Philippa Fletcher)