The View
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Bad banks, even German ones, should be allowed to fail

Deutsche Bank’s situation illustrates the enormous weaknesses and destabilising outcomes of the current ‘too big to fail’ regulatory and economic models

PUBLISHED : Thursday, 06 October, 2016, 8:25am
UPDATED : Thursday, 06 October, 2016, 10:41pm

Smart traders will say the biggest risks you run are those you are unaware of. And that explains the market’s worries about the numerous risks swirling around Deutsche Bank. Its shares reversed a sharp fall last Friday, coming back from a new 33-year low.

Deutsche is negotiating a settlement for a $14 billion penalty by the US Department of Justice for mis-selling mortgage backed securities nine years ago. Never mind that the bank has US$18 billion market capitalisation. Regulatory woes are the least of its problems. It raises serious questions about the usefulness and relevance of regulatory enforcement policy since the 2008 financial crisis.

The German government says it won’t provide a bail out. Even if Germany wanted to let Deutsche Bank fail it would risk systemic collapse. Any rescue is complicated by Eurozone rules that require a mandatory bail in (forcing discounts on deposits and lenders) – sounds smart in theory, but that could precipitate a bank run as depositors flee once it is announced or even rumoured.

Deutsche arguably runs Europe’s most risky balance sheet. The market doubts its asset quality and most of all, the valuations of its large derivative positions. Its assets amount to more than half of Germany’s total annual gross domestic product. It is also a large deposit holder with about 600 billion.

About half of its 1.8 trillion in assets are connected to its trading business with about 28.8 billion classified as ‘level three’ assets, which are more opaque and difficult to value. Unfortunately, the model of leveraged asset growth of the balance sheet, which was the source of the 2008 financial crisis remains a threat to financial stability.

It takes a rare combination of banking regulators and central bankers to come up with a true economic disaster. Economists have never understood that their models are perverted by the regulatory framework in which they attempt to function. Mispriced money and inadequate regulation in the EU has allowed the European bank sector to increase and misprice their risk exposure.

Everyone knows what an insolvent bank looks like. But determining if a solvent bank faces impending illiquidity is an entirely different and tricky exercise. The market may be assuming the worst case scenario where the bank’s level three assets are all completely worthless even though this is probably not the case.

Deutsche may have missed their best opportunity for raising equity. Confusion and worry have overtaken Deutsche’s equity story

The valuation methods for these illiquid instruments, which include long dated interest rate swaps, equity stakes in companies and exotic sovereign debt are monitored by regulators and auditors. Lack of transparency about what these instruments actually represent explains some of the worries that drive sharp movements in value. It leads to suspicions of “marking to myth” rather than “marking to market.”

Deutsche Bank may steer clear of insolvency, but it needs to raise a large amount of capital and change its business culture in order to survive. EU banks are undercapitalised compared to UK and US banks. But, Deutsche may have missed their best opportunity for raising equity. Confusion and worry have overtaken Deutsche’s equity story.

Although the German government has disavowed any bailout, the bank’s counterparties are conducting business on the basis that it is inconceivable that Germany would not rescue ‘Germany’s bank’.

And if this parallel universe prevails right up to a crisis then counterparties will desert it by following their golden trading rule: do unto others as they would do unto you, but do it first.

Arbitrarily saving bad or overvalued assets through political interference destroys any opportunity for constructive destruction and market clearing.

Regulators and Deutsche’s management will be sorely tested when its bonus pool is announced in the coming months. The Deutsche Bank dividend was suspended in 2015, but the bank managed to find US$2.7 billion to pay staff bonuses in a year the bank lost over US$7 billion.

The 2015 bonus pool was €2.4 billion, down 17 per cent year-on-year. If the 2016 bonus pool is not substantially lower it will be a clear sign that management is putting their own interests over the bank’s future and shareholder’s best interests.

Deutsche Bank’s situation illustrates the enormous weaknesses and destabilising outcomes of the current ‘too big to fail’ regulatory and economic models. It concentrates banking power in the hands of management and passes the consequences onto taxpayers and shareholders. It only incentivises the big banks and their managers to defend the status quo instead of innovating or changing their ways.

Peter Guy is a financial writer and former international banker

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