Deutsche: Why the Turmoil and Concern?

Is Deutsche Bank the next Lehman? Shouldn't new rules avert the next Lehman-like crisis?

For a moment or so, some wondered whether we were headed down another 2008-like path, as if investors, traders, and lenders in capital markets are resigned to a recurrence of the financial crisis. This time, it's not Lehman, Bear Stearns, Washington Mutual or Countrywide.

Deutsche Bank is the target this month, the subject of widespread concern about which large financial institution could be the next to fail--even after politicians and regulators had imposed new rules, stress tests and capital requirements to minimize another Lehman-like implosion.

What explains this concern?

Much of it followed the U.S. Government's announcement that it intends to fine the bank $14 billion for mortgage-crisis improprieties.  Can a bank with equity capital of about $70 billion absorb such a substantial payout? Does it have enough leverage to negotiate a much-lower settlement? These are similar to the big penalty payments other big banks have paid in the wake of the problems mortgage securities contributed to the mid-2000's crisis.

Now there is anxiety about the bank's health. Some gauge it might not be able to manage fine payouts or at least convince the Government to reduce the penalty and settle for something less.

In the world of financial institutions, concern about the solvency of an important player, counterparty or market participant often leads to anxiety and often unsubstantiated rumors that could be true or may not be.  For the institutions that trade with it, lend it money, deposit funds  or clear and process its securities, they prefer not to be caught off guard.  They flee.  And when they flee en masse, the institution singled out struggles to survive.  When the run is on, days of survival can be counted. They end up getting acquired or winding down.

But Deutsche Bank, a Germany-based powerhouse tightly interwoven into the global financial system and in such size that the numbers are unthinkably large?

In the years since the crisis, legislators and regulators implemented layers of rules to eliminate the occurrence of another Lehman, to reduce the likelihood of runs on banks, and minimize the impact of unexpected market and credit losses. As if the current rules aren't enough, more rules are in draft and will come later.  Think capital requirements, liquidity rules, stable-funding requirements, long-term-funding requirements, stress tests and orderly-wind-down scenario runs--all to ensure big institutions like, yes, Deutsche will survive every conceivable banking scenario.

So why are respectable hedge funds and other large institutions running scared, pulling funds out, canceling securities-trading arrangements, and withdrawing? Why is its stock price plummeting?

Wouldn't the capital and leverage ratios have hinted at certain risks? Wasn't the bank (or at least its U.S. operations) required to pass tests related to market, liquidity and credit risks and smooth liquidations?

And wouldn't regulators, who normally park themselves on floors of big banks for extended periods, not be aware of specific risks that could jeopardize the bank's existence?

What do the numbers suggest?

They tell part of the story. The bank meets most the standard regulatory requirements, but in some instances, barely.

In 2016, the bank is not losing money. But with returns on equity (ROE) less than 2% this year, it's not making enough money to justify the enormous risks the bank takes and the leverage it uses to support risk-taking activity. Some shareholders are justified in dumping shares (on that basis).

The bank conducts an array of activities with a $2 trillion of assets on the balance sheet (and similar amounts off balance sheet). Yet it does so with about a third of the amount equity capital as some of its U.S. peers (JPMorgan Chase, Citi, Bank of America, e.g.), which have similar-size balance sheets with different risk content. 

A glance at the details of the balance sheets shows a bank less involved in deposit-taking and loan-making and more involved operating a large derivatives-market-making machine.  Its loan book is almost half the size of peers (including Chase, Citi and also-under-watch Wells Fargo).  Its derivatives activities, at least what appears on the balance sheet, exceeds some peers by almost 10 times. 

In essence, annual reports and public statements may tell the story of one kind of bank. The financials suggest a bank with an ironclad strategy to generate profits and returns from seizing the role of market-making in derivatives (swaps of all kinds, currencies, options, forwards, futures, etc.). While capital has dipped in recent periods (partly because of losses last year), derivatives activity explains as much as a third of its balance sheet.  Earnings from the same haven't contributed in the same proportions, as bank profits still rely on net-interest from lending and other areas to overcome mediocre results on the trading side.

So wouldn't a bank with such leverage, with significant trading risks, and flat levels of capital have trouble meeting regulators' strenuous requirements for minimum capital and maximum leverage?

It should, but it doesn't.  The bank follows the rules and benefits from some of the relief the rules permit (hedging, collateral, netting agreements with counterparties, e.g.), which soften some of the blow of hefty balance-sheet leverage.  It appears to have taken baby steps to increase long-term stable funding (steady increases in long-term debt to offset reliance on short-term, fickle funding), something regulators are encouraging.

The irony is the bank could arrange to pay out $14 billion and still be just above minimum capital requirements and meet most regulatory tests (likely coming in right on the button for leverage tests). (Some equity analysts argue the maximum it can pay out without threat to solvency is about $4 billion.

The reality, nonetheless, is that it would thereafter have no more room for error--no room for further losses, no room to increase the balance sheet or risk levels. It would be a bank that survives, complies with rules, but forced to wrestle with whether or not its role as a global bank with a too-big-to-fail trading role is the right strategy for the years ahead.

The solution?  Big boosts in capital (and all the funding sources that get counted as "bank capital").

Tracy Williams

See also:

CFN:  MF Global:  Too Small to Save, 2011
CFN:  Dark Days at Knight Capital, 2012
CFN:  Basel III Becoming Real, 2013
CFN:  Jefferies: Comfortable in its Niche, 2012