The intensification of banking crisis signals at the end of September has created tumultuous conditions for the stability of the global economy. Deutsche Bank's predicaments, with its worldwide interconnectedness and operational linkages are aggravating the global financial imbalances and threatening the market toward a disorderly resolution. Expressing concerns about the precarious state of the European banking sector that stems from leveraging their equity capital since the inception of euro, in some cases by forty to one or more, we wrote on July 2015 that:
The stability of the system has only been maintained by a rather artificial prolonged surge in global financial markets since 2013, emanating from an extraordinary loose monetary policies in advanced economies. In the words of a December 2014 BIS report, “ample monetary stimulus fueled investors' risk appetite and boosted a search for higher-yielding assets”.
Then on February this year, after the global bank stocks crushed amid a selloff that erased more than $4 trillion from global equities, with shares of Goldman Sachs and Morgan Stanley dropping by close to 10 per cent below their tangible book value, French and German banks like Société Générale and Deutsche Bank seeing their shares fall by more than 10 per cent , Italian and Greek banks by 31 per cent and 60 per cent and Japanese banks by 36 per cent we argued that the legacy of sovereign debt crisis is still haunting the banking sector and wrote:
For much of the last few years various central banks have been performing an extensive set of “stress testing” their balance sheets against a chain of purportedly worst-case economic scenarios, in order to identify which banks do not have sufficient capital to meet the hypothetical shocks, gauging the amount of recapitalisation the banks require. However, policy makers are well aware that no bank can survive these tests when confidence in the banking system has been shattered. As well, nobody knows how the structural parameters of the underlying models for these tests have changed in response to unconventional policies such as negative interest rates. In other words the results of these tests are at best unreliable.
Indeed, share price of Deutsche Bank that has had three massive re-capitalisations since the financial crisis of 2008-09, and had passed the ECB's stress test this July, underwent a highly volatile session on September 30th, when its shares crashed by more than 7 per cent in the US and Germany in the early hours of trading, after reports that some hedge funds were trimming their exposure to the bank. This was after Deutsche's share price had plummeted close to 30-year lows earlier in that week, when reports surfaced that the US Department of Justice intended to impose a $14 billion fine for mortgage-backed toxic security in the run-up to the financial crisis. However, after an Agence France-Presse report that the bank was nearing a deal with the U.S. authorities, to reduce its fine to $5.4 billion its share was partly recovered, trimming its year-to-date loss to a still-sizable 46 per cent.
Nevertheless, the volatility was a clear sign that market anxiety about European economy has reached its critical limit. This is in the context of a very fragile global economy, where the distortionary impacts of QEs and negative interest rates together with costly Basel-III regulations have reduced financial institutions earning prospects in a market where competitions by highly agile and low-cost fintech companies are becoming more aggressive.
Deutsche Bank is the 12th largest bank in the world (8th largest non-Chinese bank) with a market valuation of about €67 billion, which operates in 70 countries. However, its balance sheet is contaminated by a massive amount of toxic assets, particularly concentrated in its investment banking unit, which constituted much of its earnings before the financial crisis of 2008-09. The negative interest rate and financial regulations have fundamentally overturned its traditional business model. The bank as a balance-sheet lender tended to be heavily reliant on net interest income, but its net interest margins have been severely slashed as a result of ECB's negative interest rate policies, while at the same time the bank has been under pressure to recapitalize in order to build a larger financial buffer. In a low growth environment with limited investment opportunities the bank, like other European banks, has seen its profit margins being plummeted to a record low.
More specifically, Deutsche Bank's $1.75 billion 6 per cent Additional Tier 1 bonds (AT1), known as contingent convertible capital instruments or CoCo bonds, callable in 2022 became under severe downward pressure when were bided at 69.55 cents on the euro, and when the US Department of Justice asked Deutsche to pay the aforementioned massive fine to settle an investigation into its selling of toxic mortgage-backed securities. This was lower than February's sell-off low of 70.2 cents on the euro -- 83 cents earlier in September.
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| CoCo bonds with 6 per cent coupon |
Chief executive of Deutsche Bank, John Cryan, who two days earlier in an interview with the German tabloid Bild had stated that a capital increase was "currently not an issue" was forced to issue an statement on September 30th, highlighting the bank's resilient financial position, emphasizing that it has an "extremely comfortable buffer" when it comes to liquidity. “There are forces now under way in the markets that want to weaken confidence in us,” he wrote. “Our job now is to ensure that this distorted perception does not more strongly influence our day-to-day business,” Cryan added. "At no time in the last two decades has Deutsche Bank been as safe as it is today," reporting that the bank's liquidity reserves amounted to more than 215 billion euros. As well, in a brief to journalists, Deutsche Bank pointed out that most of it's 200 derivatives-clearing clients had stayed with the bank, and that its recent risk management efforts only affected the bank's sales and trading operations, and not areas such as corporate finance or transaction banking. Felix Hufeld, the head of Germany's financial regulator Bafin, told the Sunday edition of the "Frankfurter Allgemeine" newspaper: "I warn people not to let themselves be drawn into a kind of downward spiral of negative perception."
Nevertheless, the alarming situation was aggravated when the German finance ministry refuted a report on the weekly newspaper Die Zeit that suggested the German government was working on a contingency plan for Deutsche Bank, which could include taking a government stake in the bank. It is of note that bank made a loss of €6.8 billion in 2015 and is expected to show another €1.6 billion loss this year. According to Reuters a Milan judge had on October 1st charged 13 people over questionable past derivative transactions by the Banca Monte dei Paschi di Siena, which six of them were former managers of Deutsche Bank. It is noteworthy to recall that as we wrote, on August, Monte dei Paschi was the only bank this summer that was reported insolvent in the European Banking Authority(EBA)'stress test, with a common equity tier one (CET1) ratio of -2.44 per cent, requiring emergency recapitalisation. It too has a balance sheet contaminated with massive amount of toxic debt.
Will Deutsche Bank's crisis trigger a new global financial crisis? Can the new crisis be as severe as the 2008 that was triggered by the collapse Lehman Brothers which created a deep freeze in credit markets?
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Capital ratio versus regulator requirement (as of the second quarter '16)
Source: Credit Suisse, company data
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| Regional distribution of Deutsche Bank Share Ownership: in per cent year-end 2016 |
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Source: IMF. Staff calculations based on the Diebold and Yilmaz (2014) methodology and daily equity returns from Oct. 11, 2007, to Feb. 26, 2016. Groupe BPCE and the Agricultural Bank of China (ABC) not included due to lack of public traded data and short sample size.
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| Contagion of Bank Share Prices |
Reflecting the interconnectedness of banking sector, as the above chart indicates, there are strong correlations among the banks' share prices. In fact, Goldman Sachs share prices, despite the fact that has been benefiting from a relatively stronger U.S. economy, have been exhibiting somewhat strong correlations with those of Credit Suisse and Deutsche Bank since August 2015. One also needs to be reminded that Deutsche Bank's recent crisis hit bank shares across Europe with Lloyds Banking group, Barclays and Royal Bank of Scotland all falling by more than 4 per cent per cent at the start of trading in London. Commerzbank, Germany's second-biggest lender, was down by nearly 6 per cent. Swiss, French and Italian banks were down by about the same amount. Thus, should anxiety takes over, and investors dump holdings indiscriminately, this interconnectedness has the potential to generate a massive tsunami that would be impossible for the overstretched central banks to fight against. Such financial tsunami would slush the value of even non-toxic assets on bank balance sheets, devastating even the more robust financial institutions. As Deutsche Bank with its massive size rely less heavily on its deposit-taking activity and its earnings have been concentrated in its investment banking operations it is especially prone to reignite market anxiety.
The German officials , of course, have denied any attempt on a rescue plan to help Deutsche Bank, as new rules introduced to prevent misguided investments by large financial institutions prohibit taxpayer-financed bailouts. German authorities have been quite vocal in their oppositions to relax these regulations, spurning a recent rescue proposal by the Italian government, allowing them to inject public funds into the Italian banking system. Germans have been steadfast in criticizing southern Europeans for the euro-zone financial crisis and admonishing them for their lack of fiscal discipline. Thus, after so many non-German European banks being collapsed or drifted into insolvency because of unavailability of public funds, it would be politically perilous to relax the rules to rescue their own bank.
Even if Deutsche Bank would not be the bank that would trigger the next financial crisis, there are many other vulnerable banks that are also suffering from negative interest rates, high-cost regulations and competitions from fintech companies that could do so. Some of them like Barclays, Credit Suisse, Royal Bank of Scotland and UBS are also being investigated by the US Department of Justice for their roles in creating toxic residential mortgage-backed securities. Should a hefty fine be imposed on them that would affect their share prices and the resulting reverberations would almost certainly affects the share prices of those banks that have already agreed to pay a fine to settle allegations of misleading mortgage bond investors including Goldman Sachs (more than $5 billion ), Wells Fargo ( $1.2 billion), Bank of America ( almost $16.7 billion) and JPMorgan ($13 billion).
The seething financial crisis of course cannot be detached from the current tepid global productivity growth and lack of capital formation that have caused the global production possibility frontier to shrink. The deriving policy responses in the form of QEs and negative interest rates that have eroded the financial institutions profitability and altered the traditional behavioral relationships in the saving investment markets, have created a vicious circle. Governments facing a shrinking tax revenue and rising expenditures are becoming more and more dependent on the banks purchasing their debt, and the banks become reliant on government to earn returns. This is why recent Standard and Poor’s data show that banks across the EU have been investing more heavily in government debt, increasing their exposures. In fact, Western European banks have more than doubled their holdings of their own governments’ debt from a low of €355 billion in September 2008 to €791 billion today. Such a massive exposures between states and financial institutions adversely affects the health of both. Against this backdrop, a German bailout of its largest bank would only exacerbate such a tendency. Once again we repeat our suggested remedy.
The world urgently needs a global financial accord to cleanse the system of its toxic assets, realign currencies, and reestablish trade links.
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