Deutsche Bank: The Canary in the Coalmine?

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Markets are sensitive to bank problems, given the scenario that transpired in 2008. Deutsche Bank is currently shaking up its operations, one of the largest bank restructurings since the financial crisis.

So, there are all the natural questions that would emanate from the Deutsche scenario:

1) Will they go under?

2) Does this mean the economy is close to a recession?

3) What will happen if they do go under?

The answer is that we don’t really know yet. It will depend on a combination of internal restructuring efforts and external policy response.

How deep is Deutsche willing to go to exit unprofitable franchises? What will the ECB do to help backstop major banks if their economic viability is in question?

Deutsche is putting €80 billion of assets into what’s been deemed “Bad Bank”. This is €30 billion more than what was originally planned in June and is approximately five times DB’s market cap.

Obviously, banks depend heavily on the ability to lend profitably. European banks largely rise and fall based on yields of the European Union’s primary reserve asset, which is the German bund.

This DB’s stock price in comparison to the 10-year German bund yield:

deutsche bank

If we look at this within the context of the ECB’s upcoming policy response, this is negative for DB. The ECB is driven by a single statutory mandate, which is inflation. Inflation and inflation expectations are falling. This means that the ECB will ease policy and this is bad for banks, holding all else equal.

In September, the ECB is expected to roll out a new batch of stimulus measures. This comes despite the ECB’s already theoretically limited policy arsenal, with its main refinancing rate at zero and its deposit rate at minus-40 basis points.

The set of policies likely to be rolled out in September include:

– A 10-basis point cut in the deposit rate (from minus-40bps to minus-50bps)

– €30bn per month in net asset purchases (a resumption of quantitative easing)

– Forward guidance will change, with the expectation that rates will be at the same levels or lower going forward

– The issuer limit* is likely to be increased from 33% to 49%

(*The issuer limit denotes how much of any given issuer’s outstanding securities the ECB is legally permitted to buy. Increasing the issuer limit will allow the ECB to become a larger player in each individual security market in which it can buy assets. This will help to increase the prices of these assets and drive down their yields. (Prices move inversely to yields.) This helps lower credit costs to encourage credit creation and improve debt servicing.)

Deutsche’s core problem is not an overleveraged balance sheet, which reduces its risk of failing quickly. Rather, its issues are heavily characterized by its ongoing revenue losses caused by high costs and the difficulties associated with its operational restructuring program.

Revenue has shrunk because Deutsche has been cutting back its headcount and the financing it can offer its investment banking clients. Before the financial crisis, Deutsche’s financing costs were a material competitive advantage. Now, the bank is not competitive with other banks. These costs show up in the high costs of Deutsche’s credit default swaps, or the cost associated with protecting its bonds from default.

Deutsche has considered mergers (notably with Commerzbank, with talks collapsing in April 2019). Now they’re separating assets into a separate legal entity and going heavier on restructuring to cut costs and restore credibility to clients and investors. Yields are going lower, which is expected to hurt the business moving forward.

Deutsche Bank within the Context of the EU

Deutsche’s issues are symptomatic of a broader structural predicament within the euro zone itself. The euro area doesn’t have a common fiscal policy. Accordingly, monetary policy is the primary channel used to fight an economic slowdown. This means most European countries are tied together by the euro currency. Under a quasi-pegged currency system, this leaves the currency too strong from some (notably the periphery – Italy, Spain, Portugal, Greece) and too weak for others (Germany and, to a lesser extent, France).

Further quantitative easing (asset buying) by the ECB is difficult given spreads in the yield curve are virtually absent. When there is no spread left to chase, then QE has little stimulative power in getting investors into higher-yielding assets. Increasing the value of financial assets is intended to create a “wealth effect” which will flow into spending and job creation (in theory). But many sovereign debt markets see a yield curve where 10-year maturities are at zero or negative – e.g., Germany, France, Austria, Belgium, Denmark, Finland, and the Netherlands.

Many anticipate more corporate bond buying from the ECB and investors are front-running that move by piling in. Negative rates are a very real thing despite the counterintuitive nature of them (lenders paying people to take their money or borrowers getting paid to borrow).

The nomination of IMF head Christine Lagarde to take over for Mario Draghi as the President of the ECB makes sense within the context of the immediate future of the euro zone. Lagarde has been vocal about negative rates, believing them to be beneficial to an economy. Moreover, she has experience delving into fiscal stimulus and fiscal reforms in her various national-level projects overseen with the IMF.

Deutsche is the most high-profile example of a troubled European bank, but others, including Credit Suisse and UBS, have similar problems with bad asset portfolios and disintermediation issues from the effects of zero or negative rates.

In theory, because many of DB’s assets in “Bad Bank” are of shorter maturity, this means that many of them should mature without DB having to sell them. Nonetheless, the volume of assets (as mentioned, 5x the equity value of DB) creates unease.

To become economically sustainable again, DB’s expense cutting will need to be radical. The current plan may not be adequate enough. For example, DB may need to exit New York altogether, abandoning their 60 Wall St location. (People that I personally know fear that this office will be closed entirely.) They may also need to exit most forms of trading.

Deutsche Bank established its roots lending to larger corporations in Germany and other European countries. It may need to refocus on its most foundational business.

Ultimately, if Deutsche’s plan doesn’t work in paring itself down to a much leaner, sustainable version, then the ECB is likely to step in in some form.

The US had a financial crisis over a decade ago – a function of an overleveraged banking sector, poor bank risk management, and bad monetary policy. In that instance, we had government programs, such as TARP and new legal structures (Maiden Lane) to keep the banks and other financial institutions running (or at least those that hadn’t already failed) with debt guarantees and new equity infusions. New legal entities were formed to facilitate transactions between financial institutions while keeping the effects on market conditions to a minimum.

The sovereign bonds market and banking system is much more complex and fragmented in the euro zone than in other developed markets, such as Japan, Denmark, and Switzerland. Those countries have negative rates and tiered deposit systems. In the euro area, the complexity is enormous given the banks of various sizes, in different countries and markets, and in entirely different states of health.

The euro zone is heading toward negative / more negative rates, which is bearish for banks. The question for the ECB is how to stimulate the economy with negative rates while minimizing the influence of bank intermediation with a tiering / exemption system.

We know that a tiering multiple of 4x to 5x the reserve requirement would drain the entirely of the excess reserves out of the banking system of the European periphery (Italy, Greece, Portugal, and nearly Spain). This would cause rates to rise in their short-dated sovereign debt.

The ECB’s challenge is to get excess reserves moving from the “core” countries (Germany and France) into the periphery, in particular the smaller periphery banks. But there’s no guarantee this will happen because of regulation, country risk, and so forth.

Is Deutsche Bank the Canary in the Coalmine?

Deutsche Bank is not emblematic of a failing euro zone economy or an overleveraged banking sector. Having any bank fail is not of interest to European policymakers, but DB is not at risk of failing quickly because it’s primary problem is its falling revenue growth rather than overleveraging.

It is partially reflective of the structural issues within the EU of having many countries tied to each other with very different states of condition. While Germany could use tighter monetary policy, which would in turn theoretically help an institution like Deutsche Bank, countries like Italy could use easier monetary policy. But given they’re essentially wedded together through the euro, neither can be achieved.