What Deutsche Bank’s Troubles Tell Us about the Health of Europe’s Banking System*

September 30, 2016 4:30 PM

The stock of Germany’s largest bank, Deutsche Bank, is currently trading at multi-decade lows and the bank is edging closer to suffering a general crisis of confidence, which could see investors pull their business from the bank and even depositors wanting their money out. We are not there yet, however, despite rapidly increasing rumors to the contrary. Whatever its outcome, the recent debacle will mean dramatic changes at the bank itself and could well stress test the new euro area single supervisory mechanism (SSM).

Recent events have underlined the basic fact that Deutsche Bank’s current business model is unsustainable—it simply cannot be allowed to continue to operate with a trillion-and-a-half-euro ($1.69 trillion) balance sheet and just a few tens of billions of euros in equity. Leverage ratios of 30, 40, or even 50 must be a thing of the past in the euro area banking system, and the opaqueness of Deutsche Bank’s balance sheet with its abundance of so-called level 3 assets with unobservable prices must end. The true value of Deutsche Bank’s balance sheet is simply too uncertain, so the bank either reduces and simplifies its balance sheet or raises a lot more equity capital to support it.

But make no mistake: This is not another Lehman Brothers moment about to happen, as it is simply not credible to think that Deutsche Bank, which has access to essentially unlimited liquidity from the European Central Bank, could run out of cash to repay counterparties anytime soon. At the same time, the bank’s sheer size makes it overwhelmingly likely that a deep-pocketed German government could, if required, support Deutsche under the new EU Bank Recovery and Resolution Directive rules Article 32.4 (d), which states that:

(d) extraordinary public financial support is required except when, in order to remedy a serious disturbance in the economy of a Member State and preserve financial stability, the extraordinary public financial support takes any of the following forms;

(i) a State guarantee to back liquidity facilities provided by central banks according to the central banks’ conditions;

(ii) a State guarantee of newly issued liabilities; or

(iii) an injection of own funds or purchase of capital instruments at prices and on terms that do not confer an advantage upon the institution, where neither the circumstances referred to in point (a), (b) or (c) of this paragraph nor the circumstances referred to in Article 59(3) are present at the time the public support is granted.

Given that a collapse of Germany’s largest bank would surely lead to a “serious disturbance in the economy of a Member State,” Berlin could issue guarantees for new Deutsche Bank bonds or inject equity capital into the bank, provided it did so under current market conditions. As Germany’s largest bank, there is absolutely no doubt that the government would stand behind it. Given that 10-year government bonds currently offer a negative yield, the country might actually get paid by investors for the trouble of injecting its own funds into Deutsche. In short, there is no real risk of a sudden collapse that might thrust the eurozone’s banking system back to the acute crisis of 2012.

Following the lead of its smaller German rival Commerzbank, which earlier this week launched a far reaching restructuring plan, Deutsche Bank’s management should be compelled by existing shareholders, and if need be European bank supervisors, to soon launch a voluntary and far reaching restructuring of the bank. Recent events have proven that the bank is simply not up to snuff as a large global investment bank, and any restructuring would likely result in material reductions in its investment bank operations.

At the same time, Deutsche’s market route will serve as a kind of stress test of the new SSM. If the situation  deteriorates and Deutsche Bank does at some point in the near future require public capital support, it would—coming just after Deutsche Bank passed the latest EU stress tests—be a serious blow to the credibility of the SSM. That Deutsche has been allowed to operate with a balance sheet this vulnerable should serve as a broader warning sign about the need for the SSM to strengthen its supervision of the largest euro area bank balance sheets.

There is also a clear transatlantic dimension to the bank’s troubles, in the form of the looming up to $14 billion settlement with the US Department of Justice (DoJ), related to the so-called misselling of mortgage-backed securities before the financial crisis. European observers should recall that the large US banks have already paid billion-dollar settlements with the DoJ, and Deutsche is hence not being singled out for its nationality any more than Apple was a few weeks ago by the European Commission over its dodgy tax practices.

At the same time, while the Apple claim will in no way jeopardize the financial health of the company, the full $14 billion fine for Deutsche might just be the last straw for the bank’s viability. If that is the case, the DoJ better have an ironclad case for pursuing the full fine (the latest news though mention a likely $5.4 billion settlement, which should not really trouble Deutsche), as the political ramifications for transatlantic relations would otherwise be very significant. The political optics of an American DoJ pushing Germany’s largest bank into bankruptcy would look very bad.

The performance of Deutsche’s so-called CoCo bonds, debt that at a certain threshold of financial stress for the bank converts automatically to equity to help shore up the bank’s balance sheet, is a broader issue. Some will argue that the recent rapid decline in the price of these bonds have fanned the flames of Deutsche’s crisis, rather than helping stabilize it. In the end CoCos may make German taxpayers sleep a little easier, but at the price of many more sleepless nights for Deutsche Bank’s employees and investors.

Lastly the bank’s travails reinforce the idea that banking sector weakness is not the providence of the euro area periphery but is also very much present in Germany. This will invariably lead to a great deal of schadenfreude, especially Italy. But Italian leaders would be wise to bite their tongues a little longer—at least until a battered Banca Monti dei Paschi has managed to raise the envisioned five billion euros in new capital it needs from market sources at the end of the year.

Reform is coming to Deutsche Bank no matter what, and the bank may well have to raise new capital. But that doesn’t make it any easier for Italian banks to raise new needed capital themselves in the coming months. Quite the contrary.

*Deutsche Bank is a supporter of the Peterson Institute.