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Categorized | Banks

Deutsche Bank offers a tough lesson in risk

Posted on October 4, 2016

James Ferguson©James Ferguson

All banks are weak, but some banks are weaker than others. This is the chief lesson of the market turmoil surrounding Deutsche Bank. Yet there is also a host of further lessons: the approach taken to punishing banks for their failings is more like firing a blunderbuss than a rifle; and it is still hard to recapitalise banks without public money. Above all, more than nine years after the start of the global financial crisis, worries over the health of the financial system remain significant, especially in Europe. This should not be surprising. But it should be disturbing.

The proximate cause of Deutsche Bank’s weakness has been the demand by the US Department of Justice for a settlement of $14bn of its case against the bank over its alleged mis-selling of mortgage-backed securities in America.

    But the bank is structurally weak. Its name is also misleading: lacking a solid retail base in Germany’s highly fragmented banking system, it is mainly a global investment bank and so similar to Goldman Sachs. In an effort to retain high profitability, Deutsche Bank is highly leveraged by the standards of its peers. Roughly half of its €1.8tn in assets are linked to its trading activities, with a significant proportion of those assets (€28.8bn, in total) without market prices. Even by the standards of its peers, it is a highly-leveraged bank with a doubtful business and opaque assets.

    So what does all this turmoil tell us?

    A first lesson is that banks remain highly fragile businesses. By their nature, banks are highly leveraged entities with ultra-liquid liabilities and far more illiquid assets. The balance sheets of many banks are also huge. Customers view the liquid liabilities of banks as utterly reliable stores of value and means of payment. Banks are also highly interconnected, directly, via their transactions with one another and, indirectly, via euphoria and panic.

    The high pre-crisis returns on equity promised by banks depended on their ultra-high leverage and so on the taxpayer support in the resulting crash. Even strong banks benefit from post-crisis support to their weaker brethren, because that helps keep their counterparties and so the system upright. As public institutions have been dragged into the industry as insurers of its liquidity and solvency, they have also been forced to impose ever tighter regulation. The recent market turmoil reminds us of all this.

    A second lesson is that the way in which all the regulators have gone about punishing banks for their many wrongdoings is unsatisfactory. It is indeed reasonable to punish shareholders for the misdeeds of the banks whose shares they own. Yet it must be doubted whether it makes sense to impose a penalty so large that it imperils the survival of an institution. Far more important, the idea that shareholders control banks is a myth. It is management that is responsible. What remains disheartening is that shareholders and a few small fry among the employees have been punished, but the decision makers who ran these institutions have escaped more or less unscathed. Indeed, that is one explanation for the rise of Donald Trump. The sheer size of the envisaged penalty upon Deutsche Bank’s shareholders highlights this anomaly.

    A third lesson is that banks are still undercapitalised, relative to the scale of their balance sheets, as Anat Admati and Martin Hellwig have pointed out. More immediately, we lack reliable means of rectifying this. So, while governments insist bailouts are ruled out, few believe this, particularly in the case of a bank of Deutsche’s importance. The European Central Bank has proposed temporary bailouts as an option. But it is hard to believe such bailouts would ever be reversed. In practice, private creditors would flee and the government would end up as the owner of the bank in question.

    Adam Lerrick of the American Enterprise Institute has, instead, proposed a mirror-image: a temporary bail-in of private creditors. His plan starts from the need to avoid further government rescues. A temporary bail-in of creditors would raise the bank’s capital to adequate levels. If the bank were subject to just temporary panic, it would raise fresh equity once those worries had faded. The creditors’ claims might then be reconverted into debt, at par. If it were to prove impossible to raise equity in future, because the capital shortfall was structural, the bail-in would be permanent. To protect small creditors, only the excess of each investor’s holdings above, say, €200,000 would be converted into equity. The probability of such a bail-in and the chance that it would become permanent, would affect the price of debt, as it should.

    In sum, the problem of banks has not disappeared. A fundamental part of the danger is that these are inherently fragile institutions. It is also likely that the balance sheets they inherited from the excesses of the pre-crisis period are insufficiently profitable and so will need to shrink. Most important of all could be the impact of new information technologies and business models on the health of the historic banking industry, particularly given the damage done to its reputation for competence and probity. Many would add to all this the impact on profitability of central banks’ ultra-loose monetary policies.

    Yet, against this, note that these reflect the post-crisis economic malaise. If monetary policy were tighter and so economies weaker than they are today, the banking sector — ultimately a leveraged and so volatile play on the economy as a whole — would be weaker, too.

    A little while ago the focus was on the Italian banks. Today, it is on Deutsche Bank. In all probability, even the latter will not trigger a big crisis. But risks in banking remain. The solution is to ensure adequate capital at all times and, in its absence, sufficient bail-in-able debt. In the absence of either, banking remains an accident waiting to happen.