Deutsche Bank, Germany’s largest bank, is facing its biggest crisis since the global financial meltdown in 2008. A couple of weeks ago we learned that US regulators were seeking to fine the company $14 billion — not just a large sum of money but actually enough to fundamentally threaten the viability of the bank. And that was only the latest in a series of setbacks that have cost the company’s stock more than half its value over the past year:
- A year ago, the company announced plans to lay off 35,000 people shortly after announcing a $7 billion quarterly loss.
- In November, the bank agreed to pay a $258 million fine for violating US sanctions laws.
- In June, it failed a US regulatory “stress test” designed to predict whether it would survive a major economic downturn (more about this later).
And now Deutsche Bank is facing a multibillion-dollar fine.
Things have gotten so bad that people have started to worry about the bank’s solvency. Last week, Bloomberg reported that a few of the bank’s clients had curtailed their business with Deutsche Bank due to fears about its financial health. That led to chatter that the bank’s failure could trigger a broader 2008-style crisis.
At the same time, regulators and banks have made a lot of changes since 2008 to prevent another crisis. European officials say that thanks to these reforms, Deutsche Bank — and other major European banks — is in a better position to weather future financial problems.
But those precautions have never been fully put to the test, and for years critics have worried that they may be insufficient. If Europe experiences an economic downturn, it could threaten the financial health of the continent’s banks — with Deutsche Bank one of the most at risk. And strict new anti-bailout rules passed as part of a backlash could hamper German leaders’ ability to respond effectively to a new crisis.
Regulators have been “stress testing” banks to prevent another meltdown
The 2008 financial crisis occurred because banks (as well as insurance companies and some other financial institutions) were making big, risky bets with borrowed money. Bank shareholders didn’t have very much of their own cash on the line, so when their bets went bad, shareholders could get wiped out quickly.
And because many banks owed money to each other, the failure of one institution threatened the solvency of others. That created the danger of a domino effect that could cripple the global financial system. In the fall of 2008, US and European regulators stepped in to rescue the banks before this could happen.
Since then, regulators have taken a number of steps to prevent this from happening again. One of the most important is to require bank shareholders to put more of their own money on the line. That way, if a bank’s bets don’t pay off, the costs will be eaten by shareholders rather than the bank’s creditors or (ultimately) the government.
European and American regulators have performed a series of “stress tests” to try to predict how banks will fare in the event of another economic downturn. If banks fail these tests, they’re required to beef up their reserves.
Deutsche Bank has been one of the worst performers in these tests, and last year it was forced to suspend dividend payouts to shareholders to allow it to build up its cash reserves.
At the same time, regulators have punished banks for their role in the 2008 crisis. The Obama administration has sought a series of stiff fines against banks that allegedly sold bundles of low-quality mortgages without fully informing customers of the associated risk. Deutsche Bank faces one of the biggest fines — $14 billion. But the bank is widely expected to negotiate a settlement that will require it to pay a fraction of that amount — as little as $5.4 billion, according to one report.
To a large extent, these two regulatory efforts work at cross purposes. On the one hand, regulators are pushing banks to build up a bigger financial cushion to help them weather future economic downturns. But levying multibillion-dollar fines erodes that cushion, making banks more likely to become insolvent if they hit an economic rough patch.
Deutsche Bank doesn’t seem to be on the verge of collapse
It’s inevitable that a big, struggling bank will invite comparisons to 2008. And there are some obvious parallels. But the two situations also differ in some important ways.
In a financial crisis, it’s important for banks to have liquidity — cash or assets like government bonds that they can easily sell to raise cash. The Wall Street Journal’s James Mackintosh notes that Deutsche Bank’s liquid assets are about 12 percent of its total assets. For comparison, Lehman’s liquidity was just 7.5 percent of total assets a month before it collapsed.
The 2008 crisis occurred because Lehman Brothers, AIG, and other financial institutions had loaded up with “toxic assets” — complex financial instruments assembled using a lot of low-quality mortgages. Deutsche has about €37 billion of assets on its balance sheet that are not easy to price, which has created concerns that it’s in a similar situation.
Is it? It’s hard to say. As the Financial Times puts it: “The equity stakes and loans could be to thriving companies or businesses in deep trouble. The debt could be ‘distressed’ or in the form of high-grade private placements that are only illiquid because they were sold to family offices and institutions that tend to hold investments to maturity.”
Nobody outside Deutsche Bank knows for sure, which is one reason the bank’s stock price has been battered in recent months. Some traders are assuming the worst. At the same time, these assets represent a small fraction of the bank’s overall €1.8 trillion balance sheet. And the fact that some of these assets could be bad doesn’t mean they are bad.
Angela Merkel has vowed not to bail out Deutsche Bank
The 2008 financial crisis happened after US officials refused to organize a bailout of Lehman Brothers, starting a chain reaction that brought down other companies that had been heavily exposed to the mortgage market. Ever since then, policymakers in both the US and Europe have been trying to change the rules to make another bailout unlikely.
In an acute crisis, Deutsche Bank and others could count on getting short-term loans from the European Central Bank. But if a bank winds up insolvent, European rules prohibit national governments from providing a no-strings-attached bailout. Instead, the rules require governments to first “bail in” a failing bank’s creditors — forcing them to accept that they’ll be repaid less than 100 cents on the euro.
This approach seems reasonable in principle, but it can lead to practical problems. In Italy, for example, banks’ creditors are not always large, sophisticated financial institutions. According to Bloomberg, 45 percent of Italian bank debt is held by ordinary Italians. That means complying with the EU rules could mean some Italians lose a big chunk of their life savings.
Italian Prime Minister Matteo Renzi got a taste of the potential backlash back in December, when the Italian government rescued four banks in accordance with EU rules. Creditors took losses in the process, and one of them was an Italian man who lost $110,000 he had invested in bonds issued by one of the failing banks. The man killed himself, leaving a suicide note criticizing his bank.
Earlier this year, Renzi was lobbying other European leaders for permission to inject taxpayer money into Italian banks to prevent a repeat of this fiasco. But German Chancellor Angela Merkel said no, insisting on strict adherence to the eurozone’s no-bailout rules. And she’s been consistent at home, with a German magazine reporting that Merkel has privately vowed not to use German taxpayer money to rescue Deutsche Bank.
That position is good politics, as bank bailouts are unpopular among German voters. But if Deutsche Bank were to actually fail, Merkel’s resolve would be tested. The losses from a Deutsche Bank failure could be felt widely across the German economy. And there’s always a risk that the failure of one big German bank could be the first domino that leads to a larger financial crisis.