February 16,2016

If you had to pick the moment when European banking reached the point of no return, which would you choose? The July day in 2012 when Bob Diamondresigned as Barclays’s chief executive officer amid the Libor rigging scandal? Or the fall morning later that year when UBS announced it was pulling out of fixed income and firing 10,000 employees? How about Sept. 12, 2010, when Basel III’s raft of costly capital requirements started upending the economics of global finance?

All signature events, to be sure. But try May 21, 2015. That’s when Deutsche Bank stockholders filed into the dome-shaped Festhalle arena in Frankfurt to take part in one of the most venerated and, let’s be honest, boring rituals in corporate life: casting a vote on management’s strategy and performance. It wasn’t dull this time. Almost 40 percent of the bank’s investors gave co-CEOs Anshu Jain and Jürgen Fitschen a big thumbs down. While winning six out of 10 votes is a landslide in politics, it’s a crushing blow at a publicly traded company. By the end of June, Jain was out and Fitschen had agreed to leave the company by May of this year.

Investors are running out of patience with European bank chieftains, and no wonder. Since the fall of Lehman Brothers in September 2008, eight of Europe’s biggest banks have announced layoffs adding up to about 100,000 employees, paid $63 billion in legal penalties, and lost $420 billion in market value. In 2015, Deutsche Bank lost a record €6.8 billion ($7.6 billion). In mid-February the industry suffered an epic selloff as subzero interest rates, China’s slowdown, the oil crash, and looming regulatory and litigation costs triggered an outbreak of fear not seen since the fall of 2008. Just last year new CEOs took over at Barclays, Credit Suisse, Deutsche Bank, and Standard Chartered. Now they have to find a way to prosper in a marketplace that’s being reshaped simultaneously by strict new capital regulations and myriad financial technology startups that don’t have to abide by them.

While American banks appear to have turned the corner since that gut-churning autumn nearly eight years ago, European institutions are girding yet again for another round of restructuring. So much so that analysts in London call them “building sites,” Bloomberg Markets magazine reports in its forthcoming issue. Credit Suisse’s new CEO, Tidjane Thiam, is “right-sizing” the investment bank and pushing for a 61 percent jump in pretax income from his international wealth management unit over the next two years. At Barclays, Jes Staley wasted no time cutting 1,200 investment banking jobs and closing offices in Asia and Australia after taking charge in December. Meanwhile, John Cryan, the British executive who replaced the India-born Jain, is pursuing an unprecedented overhaul of Deutsche Bank’s entire information technology infrastructure to shore up shaky risk-management systems.

No event crystallizes the forces at work in European finance more than Jain’s exit and Cryan’s entry. Jain, 53, a fixed-income maestro who excelled on the trading floor and the sales side, did as much as anyone to build Deutsche into an investment banking powerhouse with operations in 70 countries. No surprise, then, that when it came time for him to draft a five-year plan to confront the forces buffeting the institution, he balked at a fundamental reorganization along the lines, say, of what Sergio Ermotti did at UBS in 2012. In April 2015, Jain and Fitschen vowed to divest Deutsche’s shares in the German retail lender Postbank and retreat from more than a half-dozen countries as part of a €3.5 billion cost-cutting plan. Even so, as Jain put it, Deutsche Bank would “remain global … remain universal.” He said in a Bloomberg TV interview at the time, “There was quite a bit of speculation that we might have done something even grander, even more radical. It really became a case of not altering the core DNA.”

That wasn’t what investors wanted to hear, and Deutsche shares skidded almost 10 percent over the next week. Analysts griped about the bank’s soaring litigation costs. That month, Deutsche agreed to pay $2.5 billion in penalties to U.S. and U.K. authorities for its role in the Libor rate rigging. (No current or former member of the bank’s management board was implicated.) But something deeper was at work, too. European banks aren’t going through a stormy phase that will eventually clear and permit them to claim a new golden age.The industry is undergoing a metamorphosis that will demand a thorough and radical alteration of its core operating model.

Since the late ’90s, lenders on both sides of the Atlantic have sought strength through consolidation. They became financial supermarkets, cross-selling products and services to as many clients as they could reach. Theirs was a belief system built on the promise of efficiency and growth; in the end, the regime failed to deliver either in a sustainable way. Now universal banks in Europe are unbundling. “To play the game, a bank had to be integrated,” says Clayton Christensen, a Harvard Business School professor who wrote a landmark 1997 treatise on industrial-scale disruption, The Innovator’s Dilemma. “What’s happening in their world is that it’s becoming more modular. More services can be provided by independents. Little by little, customers will move away from the old and into the new.”

But the banking industry is becoming more febrile as Cryan, Thiam, and their peers struggle to re-engineer their firms in the face of an unforgiving market and a stalled European economy. On Feb. 8, Deutsche Bank shares nose-dived almost 10 percent and the price of credit default swaps backstopping its debt soared to its highest level since 2011, according to data compiled by Bloomberg. The cause? A warning from credit analysts in London to clients that Deutsche may be unable to service some of its riskiest bonds next year. Cryan wasted no time in telling the marketplace that the bank was “rock solid” and would not miss bond payments. Still, it was an ominous flashback to the months leading up to the 2008 crash when one bank boss after another assured investors that their firms weren’t sliding into a capital crunch.

At the same time, peer-to-peer lending, mobile banking, and the advent of the blockchain, the software powering bitcoin, are mounting a challenge to banks—simplifying finance by making it easier to manage money and send payments overseas. Banks are racing to catch up by establishing accelerators to incubate startups, sometimes joining forces to pool expertise, and even patenting their own digital currencies. More than 100 startups are now attacking the core services of retail banking in the U.S. and U.K., according to CB Insights, a New York research firm. “The intimacy and distributed power of a smartphone in the hands of a person is so different than anything we’ve faced in our business careers,” Brian Moynihan, CEO of Bank of America, mused during a roundtable discussion at the World Economic Forum in Davos in January.

For all the changes imposed by policymakers, it’s the propellerheads in London, New York, and Silicon Valley who may truly rewire the business of banking. Venture capitalists, angel investors, and bankers themselves have plowed more than $24 billion into fintech startups worldwide in the last two years, according to Innovate Finance, a London-based trade group. “There’s a fundamental change taking place in banks,” says Sam Hocking, who was once co-head of global sales at BNP Paribas’s prime brokerage unit. “They see the unbelievable costs in their technology, and if there are ways to bring them down by working with outside firms, that’s got to be meaningful.” Hocking now runs AltX, a San Francisco-based startup that produces portfolio analytics for hedge fund managers and investors.

There’s no better place to get a feel for the fintech moment than the 39th floor of One Canada Square, a pyramid-topped tower in the heart of the Canary Wharf complex in London’s East End. Three years ago, Claire Cockerton and Eric Van der Kleij, entrepreneurs who specialize in developing startups, set out to buildLevel39, the biggest accelerator for this new breed of startups in Europe. It’s owned by Canary Wharf Group, the property developer that’s long been the London landlord for the world’s biggest banks. Having been whipsawed in the crash, Canary Wharf concluded it might not be wise to depend on banks for its future growth. It’s literally constructing the future on the eastern edge of its land: a cluster of towers that one day will lease space to fintech startups, some of them incubated practically in-house.

On any given weekday, Level39 is buzzing as entrepreneurs attend conferences and commiserate with investors in a lounge-workspace with views of skyscrapers bearing the logos of Citigroup, Credit Suisse, and HSBC. UBS has been running experiments on issuing “smartbonds” in its blockchain lab here. Dopay, a startup based here that enables companies to pay their employees via an app, has joined forces with Barclays. “After the crash, everyone thought it was going to be tough for a while and there would be layoffs but then sentiment would return,” Van der Kleij says. “What no one expected was fintech.”

If there’s one chief executive who’s hip to this epic moment, it’s Cryan. As UBS’s chief financial officer from 2008 to 2011, he helped steady the Swiss bank as it lost billions on toxic subprime mortgages and related debt. Now he’s charged with fixing 146-year-old Deutsche Bank—a task that requires him to live up to his reputation, in the words of a German newspaper, as “the ice-cold housecleaner.” A better moniker might be: teller of uncomfortable truths. At a banking conference in Frankfurt on Nov. 23, the 55-year-old CEO took on therich paydays for investment bankers: “Many people in the sector still believe they should be paid entrepreneurial wages for turning up to work with a regular salary, a pension, and probably a health-care scheme and playing with other people’s money.” On Jan. 28 he slashed bonus pools at the bank “as a matter of justice.”

Cryan has even pined for the stability of American banking. “The bank I would love to run at the moment is Wells Fargo,” he said in a press conference on Jan. 28. “I would love to make 400 basis points in retail banking and have a relatively easy life.” The San Francisco-based lender, which recorded $23 billion in profit in 2015, recently became the world’s most valuable bank. Cryan’s envy is understandable. With most of their legal bills paid and Dodd-Frank’s rules written and implemented, U.S. lenders are getting back to business. JPMorgan Chase hauled in a record $24.4 billion in earnings last year in a near-zero interest rate environment. The S&P 500 Financials Index outperformed its European counterpart, the Euro Stoxx Banks Index, by 14 percentage points in the 12 months ended Feb. 12.

Forced to balance different political, cultural, and financial rules in a multitude of nations, the euro zone’s leaders didn’t manage to put together a banking union until 2013. “If you realize how dependent we are on the banking system, you also realize how foolish we were to deal with the banks late,” said Jeroen Dijsselbloem, the Netherlands’ minister of finance, during a panel discussion in Davos. “The U.S. dealt with the banks very quickly, made them recapitalize, made them take their losses, and it took us three, four, five years more.”

Steve Schwarzman, the chairman and CEO of private equity giant Blackstone, suggested in the same discussion that regulators were stifling economic recovery in Europe by leaning too hard on banks. “Regulation has made the world more dangerous,” Schwarzman said. “Please don’t say that we have overregulated the banks,” said Dijsselbloem, who also serves as the president of the Eurogroup, which is made up of the euro area’s finance ministers. “We still have a number of issues to deal with to make the banks able to support economic growth again. Rather than saying regulatory regimes put in place are smothering economic activity, I think it’s actually the opposite. What’s smothering economic recovery in Europe is the effects of a financial crisis. That wasn’t caused by overregulation.”

Just because banks are welcoming innovation doesn’t mean they can control it. Startups are reinventing the business of retail banking. London-based Funding Circle has arranged more than $1.5 billion in loans to small businesses in Germany, the Netherlands, Spain, the U.S., and the U.K. since 2010, delivering an average annual return of 7 percent to lenders. The startup is still tiny compared even with midsize banks. By matching borrowers and lenders on its website, it doesn’t have to use its own balance sheet to make loans. Plus, it gains an enormous cost advantage by not maintaining a branch network or a mountain of money to comply with capital ratios. “If you could invent a bank today, would you?” asks Samir Desai, Funding Circle’s CEO and co-founder.

Funding Circle and its ilk, of course, have yet to be tested in an economic crisis, and investors clearly aren’t sold on the revolution they promise: Shares in LendingClub, the No. 1 online lender in the U.S., plunged 68 percent in the 12 months ended Feb. 12. And banks could just acquire fintech companies and try to fold them into their operations. But Christensen says no large organization in any industry has ever been successful in building disruptive technology on its own. There’s too much legacy in their operations, culture, and management practices to make such a leap. Christensen says he found JPMorgan Chase’s recent decision to distribute small-business loans through On Deck Capital, a New York-based online lender, groundbreaking. The bank is essentially telling the marketplace that it trusts On Deck’s methodology for managing risk. That’s huge for the burgeoning peer-to-peer industry.

Yet Christensen urges JPMorgan Chase not to bring the tie-up inside the castle walls and risk smothering the innovation. “They have to set up these things separately and keep them separate so they can grow in a new space,” he says. “Then one by one the customers of the traditional bank will leave and do more of their banking in these new structures. So you won’t take the new technology and integrate it into the old bank. You’ll take the customers out of the old bank and integrate them into the new one.”

Pretty radical, right? At Davos, Cryan surprised his fellow VIPs by embracing the gauziest fintech dream of all—a cashless society. “Cash in 10 years’ time probably won’t exist,” he said. The quote made headlines across Germany. Last October, Cryan dispatched Chief Operating Officer Henry Ritchotte to set up a digital bank. “We’re currently building an attacker whose only job will be to attack Deutsche Bank,” Paul Achleitner, chairman of the bank’s supervisory board, said at the time. “It’s exciting.”

In the end, the banking industry’s troubles can be traced back to one thing: the cost of complexity. From the moment banks went global in the late ’90s, skeptics decried these behemoths as too big to manage, let alone too big to fail. But the institutions thrived on the very creation of complexity in their products and in the markets. Now, to paraphrase what former Deutsche Bank CEO Josef Ackermann said then, there’s once again a flight to simplicity. That’s what regulators are demanding. And that’s what legions of customers are expecting as startups deliver financial services at the tap of an app. The unbundling of banking is undoubtedly complicated and perhaps even fraught with unseen dangers. And yet it’s really all about getting back to basics. —With Nicholas Comfort, Ambereen Choudhury, and Jeffrey Voegeli