Anyone who can answer this question definitively can make a fortune in the markets—and major stock markets across the world, in an period of abundant liquidity, got their first taste of serious volatility last week over this issue. Let us examine it as rationally as possible.
The International Monetary Fund (IMF) had forewarned that Deutsche Bank presents “the world’s most important net contributor to systemic risk in the global banking system” in 2016. Its capital concerns are well known as are its exposure to the energy sector in a period of collapsing oil prices. Fortunately, it has a favourable balance sheet and its short-term liquidity is still strong, with a liquid coverage ratio of 120% and liquidity reserves of $246 billion. This is quite comfortable under a stress test scenario. Besides, the bank has high quality liquid assets (HQLA) coverage of 94% of its liquidity reserves, based on the last published results. HQLA signify assets which can be liquidated within 30 days without haircuts.
So, were the global markets roiled so significantly last week merely due to the department of justice (DoJ) ruling for misconduct fines of $14 billion? After all, Deutsche Bank has litigation reserves of $6 billion and, if past compromises with DoJ are any indication, this claim can potentially be settled within this figure. In my opinion, the markets were reacting to three fundamental factors arising out of this situation: fundamental business model challenges of Deutsche Bank and not short-term liquidity concerns, deepening fragility of the entire pan-European banking system and the lack of satisfactory political response from chancellor Angela Merkel to the intensifying crisis.
Business model challenges in Deutsche Bank, and indeed the entire banking sector, is quite significant. Deutsche Bank revenues were down 21% as were profits by 94%. In an era of ultra low interest rates, it is highly unlikely that traditional commercial banking will be a profitable business and that too when capital raising is necessary after debt write-offs necessitated after the 2008 financial crisis. Capital growth either through earnings or infusion from private investors is difficult. Additionally, the discriminatory BASEL IV norms which are weighted against the European banks makes matters quite bleak for the entire financial system in the Continent and the UK. To make matters worse, the challenge by the fintech revolution is disrupting the incumbents’ business model quite significantly. In this context, the stated position of Angela Merkel of no bailouts for the banking system with taxpayer money, whilst being politically popular and perhaps a principled position, has aggravated the uncertainty manifold. Germany is due for elections soon and the Hobson’s Choice before Merkel is sacrificing her career or providing the assurance of a bailout to Deutsche Bank if matters come to a head. This, of course, has huge implications for the recapitalization of the eurozone banks, especially in Italy, where bailouts have been blocked by the Merkel-influenced European Central Bank; Italian banks/investors are currently in a wait and watch mode for the outcome of the Deutsche Bank crisis and, more importantly, Merkel’s response to it.
Such uncertainty is the perfect recipe for a speculative attack by the likes of George Soros and it adds heightened volatility to the markets due to the systemic risk posed by Deutsche Bank to the global financial system. IMF is correct in its assessment of this risk and had listed 35-odd banks across the world where the effects of a potential contagion could spread, based on the highly sophisticated Diebold and Yilmaz methodology as correlated to daily equity returns since 2007.
While it is not my base case that this is another Lehman Brothers in the making, I find it amusing when parallels are drawn by television anchors and market pundits in a desperate bid to compare this with the 2008 crisis, and write off the risks pronouncing that adequate liquidity exists in the global system. I would like to argue that while enough has been done to stem the credit freeze aspect of the last financial crisis, history bears testimony that no two crises are quite the same and it is foolish to provide a judgement based on a highly superficial comparison with the last one. This one is quite different —brought about by excessive regulation and monetary easing instead of the highly leveraged, reckless banking and minimal regulation scenario of 2008. It is still a debt bubble though, but brought about by central bank-sponsored liquidity, so taking us back once again to an impudent leverage play though in a different avatar! And fundamentally, the banking crisis this time is essentially one of profitability unlike liquidity driven as in 2008. Given its return on equity (RoE) of just 3.4% against European banks which are cumulatively at 6.8% and US banks at 10.6%, the business model challenges for Deutsche Bank are clear.
Deutsche Bank’s market cap has dwindled from a high of $50 billion to $16 billion last week; it has failed the stress test in the US and narrowly scraped through the ECB tests; S&P has lowered its outlook and its common equity tier 1 ratio is below the 12.25% European Central Bank-mandated minimum, as per calculations by Credit Suisse. CEO John Cryan maintained that the bank was “rock solid” in February, and still maintains it now, despite the events of the last seven months—quite similar to the utterances of Jeff Skilling before Enron and Dick Fuld before Lehmann imploded! The good news is that Germany is solvent enough to support it provided it can overcome the political embarrassment which will come with it: though I must add that it will lead to a contraction in the balance sheet which could in itself trigger recessionary trends in Europe. A very fluid scenario at the very least!
Trust and credibility are the cornerstones of the financial system and, as we saw in 2008, it takes very little time to unravel once broken: unfortunately, that is on a precipice at this moment. A few hedge fund withdrawals was all it took to bring Deutsche Bank to its knees and the global markets with it. A swift speculative attack can be the proverbial trigger to a potential implosion, especially when the global financial system is sitting on a debt time bomb with, unlike 2008, limited policy options before the central bankers in the US, Europe, Japan and China.
The perfect storm is brewing in the face of significant global events: US and German elections, DoJ’s giant omnibus fine and a settlement involving a basket of large European banks (Credit Suisse, Barclays Plc., Royal Bank of Scotland) next month, resolution of the DB issue, recapitalization of Italian banks. The changing geo-political risk environment in India too cannot be wished away. In my view, it is time to be tactical in the markets and strategic outcomes can be given a pass till matters clear up in the next few months. Despite all the euphoria in the TV media led by the sharp rebound in the markets on Monday, it is time to be risk averse, avoid all forms of leverage and be nimble.
The next few months could be stormy!
Prabal Basu Roy is a Sloan Fellow from the London Business School and a Chartered Accountant: the writer presently manages a PE fund and has formerly been a Director and Group CFO in various companies.