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

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...

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Deutsche bankYesterday, 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.

SEE ALSO: Negative real interest rates: Officially a reality by Christiaan van Huyssteen

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:

IMF Deutsche Bank links

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?

Lehman abandoned
Depiction of abandoned Lehman Brothers offices in “The Big Short”

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.

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  1. Harald Sitta Reply

    Dear Nic, Grim but clear. Reasons as you said: Why should they reform if they get bailed out anyway? A cunning and devious attitude towards rules. Megalomania of global “players”. The politics of the central banks ( very low or zero interest >> has anyone studied von Mises on low interest rates ? , liberty to acquire public obligations). Derivative and fancy instruments which are wagers without any substance. If that ‘instruments’ go into trillions as you said I may ask if a lot of bankers had gone mad. We will need good nerves..

    1. Nic Haussamer Reply

      The point on the politics of central banks (as you call it) is a good one. I think, unfortunately, the implicit guarantee/bailout that exists as a result of having central banks standing by as ‘lenders of last resort’ greatly distorts the working of the financial sector.

      I would note that many of the types of derivative contracts that exist are genuinely brilliant and incredibly useful in certain contexts; and I would say the same thing for the mortgage-backed securities that were created and traded from the 1970s up until the financial crisis. However, it’s that implicit guarantee that encourages banks to take as much risk as they do. I think the fundamental problem in banking is poor risk management. Another problem is that, because of the legal barriers to entry, there are relatively few players, so risks are concentrated in relatively few firms, and these have mostly become inter-linked (as I notes in the article).

      1. Harald Sitta Reply

        Derivatives might be useful but it seems to me that they gain a “life of their own” – like the sub-prime securities ( Fanny Mae etc) which had until 2007 been traded recklessly. My personal experience from investment workshops is that bankers do not understand their own creations.

        Would in your opinion a return to the Gold standard help?

        1. Nic Haussamer Reply

          “it seems to me that they gain a “life of their own””
          -> I think this is true of most financial assets/contracts – not just derivatives, MBSs, etc. – largely because of the influence of cheap money and, as we’ve been discussing, the risky behaviour that results from the moral hazard created by central banks especially. As I was trying to say earlier, it’s not these financial instruments that are problems themselves; it’s the environment that enables them to be used in a reckless manner.

          Even if banks aren’t totally bailed-out by central banks/governments (ie. their solvency issues aren’t helped out by these institutions), I think a big problem is the line of credit available through central banks. It means that if banks are in a tough situation, they can quickly phone up the central bank, get a whole bunch of money that they need now, and only deal with the underlying problem much later. In the case of Deutsche Bank, I know that the ECB has a number of credit facilities available (post-financial crisis) that enables exactly this sort of thing.

          I haven’t thought through it thoroughly, but I suspect the overall situation would be better under a gold standard. [Of course, this depends on what is meant by a “gold standard”, because there have been some monetary regimes (eg. Bretton Woods up until the 1970s) where the US dollar was still loosely tied to gold, but all of the other mechanisms of the current monetary system were in place, including the ‘lender of last resort’.]

          I don’t think that a government-enforced gold standard would be much good in this regard (the 20th century shows why; if you haven’t already read it, I recommend Rothbard’s “What has government done to our money?”). This is not to say that the use of gold as money, which has been done for thousands of years, would not be a good idea – it’s just a matter about how we approach it, ie. does the government enforce and set the “standard”, or is it determined by market participants? Rothbard argues in The Mystery of Banking that if the legal tender and fractional reserve banking laws and regulations were repealed, banks would be compelled to tread carefully because they’d have to ensure their own survival.

          Sorry for the long comment – just put down everything that occurred to me now.

          1. Harald Sitta

            Thank you. Very instructive. And very discomforting if we go through the present situation as these limitless credit facilities must come to an end. A “perpetuum mobile” cannot exist, also not a financial p.m. The result of socialism is really that in the end we all have the remaining.Nothing.

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