Europe’s Deutsche Bank remains on course for a crash

Quite suddenly, or so it seems, the fears of a rerun of the Lehman Brothers crash have returned. But this time the institution in the firing line, Deutsche Bank, is in Europe and is much larger than Lehman. For many people this will sound both extraordinary and troubling. Weren’t all the actions taken by the authorities supposed to lead to a safer banking system? Wasn’t it a problem in the US, particularly in housing finance, that led to the crash, not events or practices in Europe? And isn’t Deutsche Bank a solid commercial bank, not one of those “casino banking” institutions?

Some of the answers to these questions are easy. Yes, banking in general is safer now, but continental Europe has been slower than the US at recapitalising its banks, preferring to maintain that the problems were not as serious on this side of the Atlantic. Paradoxically, it is a concern that Deutsche will have difficulty raising more capital, partly to pay fines imposed by the US authorities, that has triggered these latest fears. Actually European banks were just as damaged as American ones; governments on the continent just didn’t want to admit it. More troubling still, banking weakness matters more in Europe than in the US because banks here are more important in providing corporate finance than they are there, as US capital markets are more developed. Despite all the rhetoric about casino banking, it has mostly been bad commercial lending, often on property, that has brought the banks to their knees. Look what happened in Ireland.

But is it really as bad as Lehman? I think not for one reason only. We have already had the experience of a systemic banking collapse, and that experience will stop it happening again. So if it is necessary to do so, the German government will rescue it. Angela Merkel has said she won’t, but she will. The costs of not rescuing are much greater than the costs of rescuing. It is as simple as that. There is a general consensus building now that the failure to rescue Lehman was a huge mistake.

I don’t know whether Deutsche Bank will need a formal rescue — it may squeak by without it. There are however three other weaknesses in the European financial system which have grave long-term implications for the economy.

The first is that this is not just a German banking problem — other banks look to be under even greater pressure. It is an open discussion that several Italian banks need to be rescued, and the debate is how this burden should be shared. Will it fall entirely on the Italian government, which already has the largest debt-to-GDP ratio in Europe? Or will other eurozone governments be forced to join in? One of the reasons why Germany has been so reluctant to help Deutsche Bank is that it is worried about setting a precedent for other countries.

The second implication stems from this. European banks are constrained in their new lending because they are carrying so many duff loans on their books. The European Central Bank has tried a string of devices, most recently negative interest rates, to try to put pressure on banks to lend more, but the results have been disappointing.

This is particularly serious because, as noted above, the capital markets are less developed than in the US and UK. So raising investment funds will be difficult for European business as a whole for the next few years, which will in turn constrain growth. Eventually Europe’s banks will recover.

The third implication is that banking weakness means that Europe is likely to remain a slow-growth, low inflation region — rather like Japan, which also failed to reform its banking system. That failure is associated with economic stagnation, though it is not the sole cause of it as demography is equally important. But there is a twist, and it is that Japan is a single country. Regional tensions do exist in Japan, but there is nothing on the scale of the tensions between the northern members of the eurozone and the Club Med. Europe’s banks will be kept going. I cannot see any depositors losing money, and that includes large depositors with funds far greater than the legal guarantee of €100,000 in Europe or £75,000 in the UK. But quite which set of taxpayers will foot the bill, should the worst happen, is hard to see.

To be clear. This is all manageable. The problem is that it has not been managed yet.