Deutsche Bank’s downward slide: financial crisis 2.0 on the cards?

Written by: Nic Haussamer

Yesterday, US-listed equity in Deutsche Bank hit all-time lows. Why is this important? Because Deutsche Bank is one of the most significant firms in the global financial system, and it appears to be in a precarious position.

The stock decline came off the back of the news that 10 hedge funds are withdrawing cash from Deutsche Bank and moving some of their listed derivative holdings to other firms. The bank, which has faced major problems over the last couple of years, now has a market cap lower than that of Twitter. In other words, Twitter (about which I have written before for Rational Standard) is a more valuable company – according to the market – than Deutsche Bank.

On top of this, financial markets have shown growing concerns over the health of Deutsche Bank. Over recent months, the prices for 1-year credit default swaps (CDSs) for Deutsche Bank’s debt have increased dramatically. For the uninitiated, CDSs are financial instruments which act like insurance for investors who hold debt. In this instance, investors who have loaned money to Deutsche Bank through corporate bonds have to pay more to ‘insure’ that debt.

In addition to the increase in 1-year CDS prices, the 5-year CDSs for Deutsche Bank debt have spiked in an (arguably) even more dramatic way. All of this points to the higher likelihood that the bank will not be able to repay its debts in future. Moreover, it seems that a large quantity of put options on Deutsche Bank is being sold, indicating that the financial markets are preparing for further declines in the company’s value.

Context: what’s wrong with Deutsche Bank?

In the post-financial crisis world, European banks on the whole have been struggling. Deutsche Bank is no exception. It seems that the artificially-low interest rate environment in Europe is taking its toll, as Deutsche Bank has undertaken a number of measures to restructure its business and will continue to do so in future – that is, if it remains a going concern.

Part of the problem has been Deutsche Bank’s run-ins with the ‘law’. In 2015, Deutsche Bank was slapped with a massive $2.5 billion fine by regulators in the US and UK for its role in the Libor scandal, which contributed to its net loss of €6.5 billion for the year. More recently, the US Department of Justice has issued a fine of $14 billion to the bank, as a result of an investigation into its mortgage-backed securities dealings prior to the financial crisis.

In response to some of its problems, Deutsche Bank has raised additional capital on several occasions over the last few years. Nonetheless, the bank failed US stress tests in June of this year, and barely scraped through European stress tests around a month later. These stress tests are used to determine how well banks can cope with adverse experience, such as particular market events, large losses, fines, and so on. Even by regulators’ (arguably low) standards, the bank appears to be in a very weak position.

What’s next?

Earlier this year, the IMF said that “among the G-SIBs (global systemically important banks), Deutsche Bank appears to be the most important net contributor to systematic risks…” In other words, the global consequences of Deutsche Bank faltering or failing would likely be worse than those following the failure of any other bank. This is largely because of how banks are inter-connected. The following diagram from an IMF report illustrates this point by showing how connected Deutsche Bank is to other European (blue), American (purple) and Asian (green) banks:

This inter-connectedness is partly a problem because of Deutsche Bank’s massive derivative exposure: $51 trillion on a notional basis. Discerning what that actually means in concrete terms is more difficult without knowing exactly what the bank is exposed to and what the net effect of unfavourable derivative performance on the bank would be; an educated guess may say that the bank could lose hundreds of billions of dollars if those derivative contracts performed poorly.

The primary concern at Deutsche Bank right now is probably its liquidity position – basically, how much cash it does or can have available when needed. Zero Hedge notes that the bank could manage a nightmare scenario in which its brokerage clients all withdraw their funds. But if its depositors want to take their money out of the bank en masse, it could be game over.

Banks are remarkably fragile institutions. Astoundingly, this is a direct result of the way that monetary and banking laws and regulations are designed. As such, banks can be thought of as inverted financial pyramids held up by weak, buckling supports: one unexpected nudge can shatter the support structures and send the pyramid toppling over. And, of course, all of these pyramids are stacked within centimetres of each other – one collapse will almost certainly bring down the others.

One of the biggest problems with the current banking system is that the supports holding up those inverted pyramids are confidence. But confidence is a volatile and emotionally-laden human element. During 2007/2008, for example, the major losses of two of Bear Sterns’ hedge funds made investors panic. The subsequent withdrawal of funds just about depleted the firm’s liquidity capital (i.e. cash), and the crisis lead to a bailout by the Federal Reserve and takeover by JP Morgan Chase.

The lack of confidence about Bear Sterns’ liquidity position ironically led to a substantial worsening of its liquidity position, and ultimately, its failure. Irrespective of the actual health of Deutsche Bank, it’s no wonder that it has referred to the withdrawal of the 10 aforementioned hedge funds as being part of normal operations.

What if Deutsche Bank fails?

Some commentators have been invoking the name “Lehman Brothers” in trying to explain how significant a Deutsche Bank failure could be. Of course, that’s not an entirely accurate comparison: if Deutsche Bank were to fail, it could happen far faster and possibly be far more calamitous than the failure of Lehman Brothers – the effects of which were felt worldwide.

Naturally, it is difficult to predict what could actually happen in future. This exercise is not made easier by the lack of clarity around whether the German government would bail out Deutsche Bank if it were deemed necessary.

Regardless, one thing is for certain: bank failures will continue to threaten the global economy, and our livelihoods, so long as governments keep propping up banks – making them ‘too big to fail’ – and maintain this pernicious debt-based fiat monetary system. Nothing is quite as conceited as the belief of bureaucrats and central bankers that they can enable and sustain this hyper-fragile banking system without disastrous consequences. Sadly, they don’t seem to learn from experience, either.

Nic Haussamer is a Rational Standard contributor.