How the net tightened around Deutsche

The consequences of new regulation have exacerbated Deutsche’s problems, and may make its survival very messy.

The European banks aren’t being helped by the EBC’s monetary policy and negative interest rates. Picture: Krisztian Bocsi/Bloomberg

It is inconceivable that Deutsche Bank could fail. The post-crisis banking reforms are designed to ensure that it can’t. The unintended consequences of those regulatory reforms, however, could make its survival messy and costly.

This week’s spike in the markets’ fears about the giant investment bank’s stability, ostensibly because of the US Department of Justice’s $US14 billion ambit claim for its role in the residential mortgage securities market meltdown that precipitated the financial crisis, is the latest of a wave of fears about Deutsche’s financial strength.

In February this year Deutsche was forced to reassure investors it could meet the interest payments on its bonds after announcing a €6.9 billion loss for 2015 in January.

There was another bout of turmoil in July after the group, dubbed the riskiest bank in the global financial system by the International Monetary Fund, reported a near-total wipe-out of its earnings for the June quarter. It’s lost nearly two-thirds of its market capitalisation – which, at about $US16 billion, is only marginally greater than the amount sought by the DoJ -- in the past year.

There is renewed nervousness about the group – hedge funds are shifting their business elsewhere, the short sellers are more active, its bonds are being sold off and the cost of credit default swaps is spiking – even though it is awash in liquidity (€223 billion) and has made it clear it has no intention of handing $US14billion over to the DoJ.

Deutsche probably can’t raise fresh equity in the current environment, without German Government help – help that the European banking rules prohibit and which the government has ruled out. It isn’t profitable and has been barely profitable over the best part of a decade and therefore has no sales pitch with which to attract new equity.

It is essentially a giant global investment bank, with massive market exposures – it has gross derivative exposures of about €46 trillion, hence the IMF’s label – in an era where markets-facing businesses have been struggling. It does, however, have assets and businesses, most notably its asset management business, that it could sell in extremis.

Its predicament, however, does tend to illustrate how well-intentioned policies can have adverse and unintended consequences under real-world stress.

The thrust of the post-crisis banking reforms has been to require banks to hold more and higher-quality capital and for more of that capital to be “loss-absorbing.” The global banking regulators have also required them to hold more and higher-quality (but lower-yielding) liquidity and to reduce the amount of leverage in their balance sheets.

In Europe, there have been particular measures as the European Central Bank tries put in place a eurozone banking union, including a prohibition on “bail-outs.”

The Germans have been most strident in their opposition to any use of public monies to rescue banks although, if Deutsche were truly on the brink, no-one would allow the world’s riskiest – and most connected – bank to fail. The post-crisis rule books would be torn up.

While, one way or another, Deutsche would be bailed out as a last resort, that doesn’t mean that the bank’s ability to achieve stability and ultimately reorganise around a profitable and less-risky model is going to be straightforward.

In February, when concerns about Deutsche flared and generated turmoil in global markets, an under-current in the influences behind that sell-off related to the regulatory reforms that require banks to hold more loss-absorbing capital.

By 2019 the 30 big global banks (which includes Deutsche) regarded as “too big to fail” have to hold at least 16 per cent of their risk-weighted capital in “loss-absorbing” capital. By 2022 the requirement rises to 18 per cent.

That’s capital that would be “bailed in,” either absorbing losses or being forcibly converted to equity, in a crisis. Germany last year changed its banking laws to reclassify all senior unsecured debt as loss-absorbing capital.

Investors loved the high yields on the contingent convertible capital instruments (CoCo bonds) but they are a pro-cyclical form of securities, given that any threat of a forced conversion because of a crisis in the issuing institution would trigger a frenetic scramble for the exits by investors. Deutsche has both CoCo bonds on issue and unsecured senior debt. The CoCo bonds are trading at about 75 per cent of their face value.

The European banks, and others, face a steady ratcheting up of the requirement for total loss-absorbing capital over the next few years as well as the introduction by the regulators of standardised (as opposed to internally modelled) risk-weightings and a simple leverage ceiling.

Despite most of the banks passing the ECB’s latest stress tests earlier this year, there is enormous cynicism about the strength of European bank balance sheets.

That cynicism was buttressed this week the EU’s financial regulation chief, Valdis Dombrovskis, said the EU wouldn’t accept any reforms that led to a significant increase in the capital requirements for Europe’s banks. The current reforms needed work in a number of areas, he said.

The European banks aren’t, of course, being helped by the EBC’s monetary policy and negative interest rates, which drain their profitability and ability to internally generate capital.

For Deutsche, rising capital requirements under the current regulatory regime are emerging even as its ability to raise new capital has diminished to the point of being non-existent. The protection for taxpayers of loss-absorbing capital provides an incentive for debt-providers to flee and potential debt-providers to stay clear. The prohibition on state-funded bail-outs adds to equity and debt holder insecurities.

In the longer term, more capital and liquidity and less leverage should make banks somewhat safer.

The length of the lead times for banks to comply with the new regime – the European banks are well behind their counterparts in North America and Australia in terms of strengthening their balance sheets – does mean, however, that a banking crisis in Europe today would find some of its banks very poorly-positioned and vulnerable.

It might also expose some of the unintended consequences of measures supposed to shore up the system, not destabilise it.