Deutsche may be the new Lehmans, but at least it will force decisive action
The US acted promptly after the collapse of Lehmans – unlike eurozone politicians, says Colm McCarthy
THE latest leg of the long-running eurozone banking crisis is playing out — not in Greece or in Italy, but in Germany, home to the headquarters of Deutsche Bank, whose share price has collapsed and which may shortly require support from the authorities. Comparisons are being made with the failure of Lehman Brothers on September 15, 2008, which triggered the freeze-up of world financial markets.
Deutsche has total liabilities of about €1,800bn, making it one of the largest international banks. According to its published balance sheet, Deutsche’s assets exceed liabilities by about €60bn, a thin margin of equity capital: for every €100 owed by Deutsche there is (supposedly) just €3.30 that can absorb losses if things go wrong. The stock market delivers a judgement on the value of this €60 billion every day, and the shares are now trading at only one-quarter of this book value.
Deutsche Bank’s equity is valued at just €15bn, comparable to the market capitalisation of strong companies like CRH or Ryanair, which have no exposure to these enormous short-term liabilities. The market thinks that Deutsche’s true capital is worth less than 1pc of liabilities.
Within weeks of the Lehman’s collapse, the US authorities insisted on injecting capital into all of the largest American banks. This included banks that were in serious trouble but also several which insisted that they were OK and did not need the extra support.
As things transpired, some of them did not need the extra capital, others needed more help later, but the authorities did not hang about to let the chips fall. The outgoing Republican administration swallowed its reluctance to assume (partial) ownership of the banking system and forced all of the large banks to take public capital.
The central bank, the Federal Reserve, took various actions to ensure the financial system had liquid funds as well as ability to absorb losses. When regulators came to release stress test results for the US banks in May 2009, the positive verdicts were credible. Many banks proceeded to raise more private capital and the worst of the financial panic was over.
Nothing so decisive has ever been undertaken in the eurozone. Politicians in France and Germany, and European Central Bank (ECB) officials, initially denied that Europe had a banking crisis at all, insisting it was an American problem. When financial crisis became undeniable in Europe, it was blamed on the failures of peripheral countries in budget policy, even though some of the countries targeted had been running surpluses pre-crisis and had low debt levels. Individual member states were left to deal with their own banking problems in an uncoordinated fash- ion and the ECB frequently went missing as lender of last resort. There have been three rounds of unconvincing stress tests and the banks remain undercapitalised. The US banking system has been functioning smoothly for several years now, the Federal Reserve has concluded its emergency measures and is seeking to raise interest rates to more normal levels.
But eight years into the crisis, the eurozone banking system remains fragile and untrusted by financial markets. Weak banks abound, the ECB policy stance is still in emergency mode and the risk of a renewed shock to the broader economy has not been eliminated.
Banks are vulnerable to a loss of market confidence because their assets cannot quickly be turned into cash to redeem liabilities that can walk. Yet they are permitted to operate with a very thin cover of equity capital. It is a dangerous gamble that Europe’s major banks have not been required to recapitalise adequately over the eight long years since the financial crisis erupted in the final months of 2008.
Deutsche Bank’s immediate problems include the threat of a large fine from US authorities over the mis-selling of mortgage-backed securities in its American unit. The current low interest rate environment does not help bank profitability generally, but Deutsche has deeper problems. It does extensive business in derivatives, is a major player in what might be called the casino end of the international banking business and has been unable to translate risk-taking into profit. Deutsche’s extensive business in derivatives means its counterparties require collateral and confidence that the bank is sound. Some New York hedge fund clients were reported on Thursday as having cut their credit to Deutsche, an ominous development.
According to Bloomberg, some others have been short-selling the shares, now trading at a 30-year low and at half their value of a year ago, despite a modest recovery on Friday. This pattern is eerily reminiscent of what hap- pened to Lehmans and other failing banks and brought forth robust declarations from Deutsche management that all is well, the bank has adequate capital and tons of liquidity.
Surprisingly, the German finance ministry issued a denial that it was working on a possible rescue plan for Deutsche Bank. This is not to be believed: the German authorities have had a Plan B for Deutsche for many years, and would be failing in their responsibilities otherwise. They also have a Plan B for Commerzbank, the next biggest German bank, where the government already owns a 15pc stake. Plan A for both is to wait for the problem to go away.
If Deutsche keeps losing the confidence of market counterparties, they will drain away liquidity. This will be replenished, so long as Deutsche has eligible collateral, by the ECB, conveniently located a few kilometres away in central Frankfurt. It would take a sustained run to use up both Deutsche’s existing liquidity and ECB-eligible collateral and it may never happen. Even if it does, the troubled bank would have weaker collateral to offer for loans from Germany’s national central bank, the Bundesbank, headquartered in Frankfurt’s northern suburbs.
The ECB imposed penal conditions on the provision of this form of support, called emergency liquidity assistance, when banks in Ireland and elsewhere required lastditch help. It will be interesting to see what rules apply between the Frankfurt trio should the need arise. But Deutsche is too big to fail and will be rescued if the trouble gets serious. The rules, including the EU’s Bank Recovery and Resolution Directive, will be re-interpreted on the hoof.
Since the crisis broke in 2008, Germany has resisted any moves towards a comprehensive solution to the European banking mess, initially denying there was a problem at all. The ECB had to overcome German opposition to introduce its programme of bond purchases, designed to ease borrowing costs for governments and businesses. The ECB is buying €80bn worth of debt securities per month with central bank money, and interest rates on government and corporate bonds have been driven to very low levels.
‘Deutsche is too big to fail and will be rescued if the trouble gets serious. The rules will be re-interpreted’
If a fraction of this had been devoted to injecting public money, in exchange for ownership stakes, into Europe’s fragile lenders, the festering eurozone banking crisis could have been brought to an early conclusion. This was done quickly in the US when the crisis broke in 2008 — and it worked.
There should be no temptation to Schadenfreude (joy in the misfortune of others) over Germany’s banking crisis. There could even be a silver lining if it encourages decisive action to finally face the music.