Why
Deutsche Bank is on the ropes
Once
the markets start pummeling a banking behemoth, all bets are off.
By FRANCESCO
GUERRERA 9/30/16, 6:28 PM CET
Investors and
regulators are engaged in a boxing match over the fate of Deutsche
Bank.
So far, the markets
have the upper hand, and Europe’s largest bank is reeling from
their blows. The final outcome will determine whether the world’s
financial system is about to experience another heart-stopping
moment, or just another bump in a tortuous road to safety.
In one corner of the
Deutsche bout stands the complex regulatory infrastructure built to
avoid a repeat of the taxpayer bailouts of banks seen in the 2008
global financial crisis. It has many bells and whistles designed to
address the weaknesses exposed by the ruinous events of eight years
ago: “stress tests” of banks’ health; higher capital buffers; a
new type of securities designed to create additional protection when
things get really bad; and stricter oversight of risk-taking by
traders and bankers.
In the other corner
stand investors wracked with nerves. On the face of it, the fears of
hedge funds, pension funds, and bond wizards over Deutsche’s
ability to pay a possible $14 billion (€12.5 billion) fine to U.S.
regulators don’t sound like enough to bring into question the
future of such a financial behemoth.
“Trust
is the foundation of banking. Some forces in the markets are
currently trying to damage this trust” — Deutsche CEO John Cryan
But the rapid
disappearance of market confidence has done in many big financial
firms, as shown by the demise of Bear Stearns, Lehman Brothers, and
AIG in 2008.
“It is not a
matter of available liquidity, at least for now, but of irreversible
damage to confidence in the bank,” wrote BNP Paribas’ analysts
Geoffroy de Pellegars, Miguel Hernandez, and Marco Busin to clients
on Friday. “Past experience shows that customer trust can disappear
quickly and, past a certain point, liquidity reserves can be fast
depleted.”
To be clear,
Deutsche is not in a similar desperate situation as Lehman and the
others. And even the mooted $14 billion penalty for the alleged
mis-selling of mortgage-backed securities stemming from the 2008
crisis is only an opening bid by the U.S. Department of Justice and
could be reduced as the two sides negotiate a settlement.
Air of optimism
Berlin, Brussels,
and Frankfurt were all projecting an air of optimism on Friday, while
Deutsche CEO John Cryan told staff in an internal memo that the
bank’s balance sheet is safer than at any point in the past two
decades.
But the last few
days have shown how tough the going can get for big banks, once
markets start losing faith in their financial health in spite of
their sturdier balance sheets and more solid regulatory
infrastructure.
On early Friday,
Deutsche’s shares fell below €10 apiece for the first-time ever
after reports that hedge funds were reducing their exposure to the
German lender in a clear sign of mushrooming market fear. The stock
rebounded later in the day partly because of Cryan’s intervention,
but it has lost more than half its value this year. Deutsche’s
riskiest bonds have also fallen sharply in price, while the cost of
insuring against a default has spiked.
“Trust is the
foundation of banking. Some forces in the markets are currently
trying to damage this trust,” Cryan wrote in the staff memo,
stealing a page from past CEOs of other troubled institutions,
including Lehman and Citigroup, with his ominous but vague warning
about dark market forces conspiring against the bank.
In theory, Europe
should be prepared for a crisis such as this. All the regulatory
energy since the collapse of Lehman in September 2008 — undone by
its own risky trades, thin capital, and the bursting of the U.S.
housing bubble, as well as by the U.S. authorities’ inability or
unwillingness to save it — has been focused on reducing the need
for taxpayers to bail out banks.
Besides more
stringent stress tests and much higher capital requirements, two
innovations stand out in Europe: Cocos and the Single Resolution
Board.
Cocos, short for
“contingent convertibles” are bonds that turn into stock once a
bank’s capital fall below a set threshold. They are designed to
provide an automatic safety net to boost the capital reserves of a
troubled lender.
Investors like them
because they pay very high interest rates, partly because of the risk
that they could be converted to stock in bad times. But since no
major bank has been in trouble so far, investors have not been
spooked by cocos, aside from a brief blip when Deutsche’s bonds
came under pressure earlier this year.
Too big to fail?
Meanwhile, the
Brussels-based SRB is Europe’s answer to the issue of
“too-big-to-fail”: the obligation by governments to rescue big
banks with public money because of their crucial importance to the
economy. The SRB, armed with a fund that will be equal to 1 percent
of all eurozone banks’ deposits by 2023, should alleviate that
problem by intervening when banks are on the brink.
Ironically, its boss
is Elke König, who was Deutsche’s primary regulator as head of
Germany’s Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin)
between 2012 and 2015. When POLITICO asked König in July if the SRB
was ready to deal with a failing bank, she answered: “Of course,
yes,” before adding, “I am very confident that if a bank is
failing, we have now the rules in place, we have the tools at hand to
get this sorted out.”
Unlike Lehman, Bear,
and AIG, Deutsche has some €600 billion in customer deposit — a
huge reserve against a cash crunch — more than €200 billion in
liquid assets, and full access to the European Central Bank’s
emergency loans. And it has a fraction of the debt Lehman carried on
its balance sheet — a key factor in its demise.
Then why are
investors worried? That depends on whom you ask.
At the end of a wild
trading session on Friday, Deutsche shares roared back into positive
territory on reports that the DoJ may settle for just a $5.4 billion
fine.
Shareholders are
fretting because they fear Deutsche will have to sell shares to raise
money to pay for the DoJ fine, thus reducing the value of their
stocks. Kian Abouhossein, head of European banks’ research at J.P.
Morgan, calculates that Deutsche has about €4 billion in reserve to
pay the U.S. bill — way short of $14 billion.
The concerns of
bondholders and clients are more fundamental. They are worried that a
stiff U.S. fine would make it difficult for Deutsche to both pay its
debt and continue to do business with them.
“The financial
system remains fragile … Not surprisingly confidence is less than
solid,” notes Robert Jenkins, a senior fellow at Better Markets and
a former member of the Bank of England’s Financial Policy
Committee.
As often in finance,
the political dimension is not too far away and not in this case,
either.
Deutsche’s current
predicament was caused by reports of the DoJ’s proposed fine, not
by some market event. Many insiders on both sides of the Atlantic now
expect the German and EU authorities to put pressure on the Americans
to be more lenient.
That request,
though, might be met with a cold shoulder, not least because of the
recent decision by the Commission to hit the American corporate icon
Apple for €13 billion in allegedly unpaid taxes.
At the end of a wild
trading session on Friday, Deutsche shares roared back into positive
territory on reports that the DoJ may settle for just a $5.4 billion
fine.
But as markets go
silent for the weekend, regulators and politicians have plenty of
chance to reflect on the latest example of fragility in the global
financial markets.
Silvia Sciorilli
Borrelli and Bjarke Smith-Meyer contributed reporting to this
article.
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