The largest German bank, Deutsche Bank, has lately faced trouble as world markets have undergone handwringing over massive fines the bank needs to pay the U.S. Department of Justice (DOJ) for claims relating to mortgage-backed securities from the financial crisis of 2008.
The DOJ previously announced it wanted Deutsche Bank to pay a colossal $14 billion settlement. This was much more than the bank had set aside for penalties relating to the crisis. In fact, it was said that this sum could affect the bank’s liquidity, which in turn could trigger hedge funds to pull their assets from the bank.
There was a worry that this could have the effect of causing a spiral of other companies and individuals pulling their money out of the institution as well, leading to a run on the bank that could cause a catastrophic collapse, similar to what happened to ill-fated Lehman Brothers in the U.S. in the Fall of 2008.
Fears of this eventuality subsided slightly as weekend market rumors indicated the DOJ might be willing to settle for a lesser amount than $14 billion — possibly less $6 billion, according to some online sources. But market jitters persisted, as Deutsche Bank is not necessarily capitalized to the degree that some regulatory institutions would like it to be.
The bank has $2.2 trillion in assets and is currently one of the world’s largest lenders. But in the last decade or so, the business model for the bank has been to earn the bulk of its profits by speculating in capital markets, exposing itself to more risk on a regular basis than most banks and attracting critiques of its practices among its peers.
In particular, the bank has some $60 trillion worth of derivatives on its balance sheets. Worries about the bank’s derivatives balances have grown over the years.
According to Michael Lewitt, the editor of Credit Strategist Letter, “This sum represents the gross exposure of the bank’s contracts, many of which are long positions that would be offset by short exposures, resulting in a much smaller net [cash] position. That’s in a perfect world. If in a financial crisis, counterparties can’t meet their obligations, this netting of positions won’t occur. In any case, DB’s net exposures are sufficiently large to blow up the [global] financial system.”
The most recent market concerns over the DOJ settlement have led to anxiety that a Deutsche Bank failure could lead to a crisis of the caliber of the 2008 failure of Lehman, when the U.S. Federal Reserve had to intervene and get the heads of all the major banks into one room to implement a solution before contagion from the debacle infected the world’s financial markets, causing a global meltdown.
In effect, a similar happening at Deutsche Bank could be the European equivalent of Lehman if market conditions continue to devolve. Unlike Lehman, Deutsche Bank also has retail operations, with more than $307 billion in deposits — deposits that could prove fatal to the bank if they were to flee in a panic.
Prior to the most recent DOJ negotiations, the German government had signaled that it would not bail out Deutsche Bank, or at least, not before things got a lot worse. German Economic Minister Sigmar Gabriel had no sympathy for the company, saying “I do not know if I should laugh or cry that the bank that made speculation a business model is now saying it’s a victim of speculators.”
At the same time, like all European banks, Deutsche Bank does have access to roughly $200 billion in short-term emergency funds from the European Central Bank (ECB), but the very accessing of those funds could potentially set off a crisis of confidence that could lead to a run on the bank as mentioned previously.
A recent study by Harvard Ph.D. Natasha Sarin and former U.S. Treasury Secretary Larry Summers showed that bank volatility levels have not fallen much from 2008, despite increased levels of capital on hand.
It’s also widely acknowledged that Deutsche Bank does not have as high a ratio of available capital as some other banks. A recent study by Citigroup said that its current leverage ratio was 3.4 percent — lower than the bank’s own target of 4.5 percent by 2018.
The firm’s stock price is already down more than 50 percent in the last 12 months and 70 percent in the last three years. In recent weeks, it fell 25 percent to a low of $10.25 on September 29 when 10 hedge funds moved their derivative holdings out of the bank.
Deutsche Bank is now trading at roughly 22 percent of book value, a record low since Thomson Reuters began tracking those numbers in 1980.
Many say this is the result of speculators selling the company’s stock short. “Trust is the foundation of banking,” wrote Deutsche Bank CEO John Cryan in a staff memo. “Some forces in the markets are currently trying to damage this trust.”
There are concerns that the bank may never be able to be profitable long-term because of newly lower trading income, lower asset-management fees, flatter yield curves, negative interest rates and a tougher regulatory environment.
Much of these concerns have to do with globalization, which, instead of creating new channels of profit for large international banks such as Deutsche Bank, has given rise to new avenues for contagion in cases of crisis such as this one.
Globalization means that capital now flows to places where interest rates are lowest and wages are stagnant. Profitability is reduced, and for Deutsche Bank, which once was protected by an insulated German market in which it had more control over inflation, these are negative factors which will not be receding anytime soon. This, in turn, has led investors away from the bank in search of better opportunities elsewhere.
Deutsche Bank had attempted to boost its profitability by making a strong commitment to the American market, where it set up a massive subsidiary. It operated aggressively, trying to carve out a large chunk of the market for itself.
It also tried to ease political pressure on itself along the way; it reportedly gave at least $1 million to Bill and Hillary Clinton in speaking fees and donations. But in the end, Deutsche was one of the last banks to see a new era of tight regulation approaching, limiting its scope and ambition.
In Germany, Deutsche Bank’s largest rival Commerzbank announced it would be cutting its workforce by 20 percent and would deliver a return on equity of only 6 percent between now and 2020.
Pressure will be on Deutsche Bank to sell off its own low-margin businesses and shrink its balance sheet. But this is easier said than done; selling off assets and unwinding affiliated companies can bring unwanted high costs that can further depress returns.
For now, the main challenge confronting Deutsche Bank will be to keep its stock price from falling further. Additional drops in the price will only speed capital outflows from the bank, which in turn will drive the stock down more, precipitating a death spiral.
For now, Deutsche Bank has been able to forestall such an event, but as the days and weeks wear on, only time will tell if and how the bank is able to prevent such a development.
Regards,
Ethan Warrick
Editor
Wealth Autority
