Could Deutsche Bank Fine Spark a New Crisis?

SMITH BRAIN TRUST — Deutsche Bank is facing a $14 billion fine from U.S. regulators for its alleged role in propping up the housing market in the lead-up to the Great Recession, igniting some fears that the unprecedented sanction poses a new set of risks for the Frankfurt-based bank and the global financial system.

Finance professor Clifford Rossi at the University of Maryland's Robert H. Smith School of Business says there isn't a strong likelihood that the struggles of the highly interconnected Deutsche Bank could spark an unraveling of the global economy. Nonetheless, he says New York University's systemic risk index has Deutsche Bank ranked No. 1 in terms of its potential systemic risk to the financial system.

"Brace yourselves. Sooner or later, history repeats itself, and the banks will fail again," writes Smith School professor of international business Peter Morici. "Virtually all European banks are suffering from slow-growing economies and ultralow interest rates that make moving bad loans off their books tough and earning profits on new loans even tougher." About 17 percent of loans held by Italian banks are underwater, he says, compared to 5 percent of loans held by U.S. banks at the height of the financial crisis. "The picture is pretty bleak elsewhere on the continent, too," he adds.

Shareholder Jeopardy … And Panic?

"In the end, Deutsche Bank may have to resort to a 'bail-in,' as recent European bank reforms more generally require — namely forcing bondholders to accept much-depreciated stock to replace their claims and take huge losses in the bargain," Morici says. "As panic spreads among bondholders elsewhere in Europe — and don’t think it can’t — the potential for economic collapse is enormous."

"In Italy, ordinary depositors have been encouraged to purchase bonds in the manner that Americans invest in certificates of deposits," Morici adds. "Similar bail-ins there would impose huge losses of savings and purchasing power, and a contagious recession that could easily undo Europe's fragile welfare state economy once and for all."

Smith finance professor David Kass notes that the bank’s common stock has been under pressure. It  currently trades at about $13 per share, down from a 12-month high of $30. "With continuing cost cuts," Kass said, "Deutsche Bank currently represents a high-risk investment that may earn a commensurate return over the long run." 

The bank's shares are being dragged down in part because of the scale of its investment banking business, which focuses on complicated derivatives trading and is highly leveraged. Deutsche Bank also maintains a significant amount of illiquid assets on its balance sheet. Meanwhile, for all global banks, Rossi says, "the current, unusually low interest rate environment and bouts of market volatility — think Brexit — have created a drag on earnings."

Sketchy Business Model

Deutsche Bank failed the 2016 stress test imposed by the Federal Reserve. Rossi, who will moderate a discussion on regulaton on Oct. 28, 2016, at the Smith Business School Summit, says the failure reflects the bank's poor risk management before, during and after the financial crisis, but also reflects a flurry of market headwinds and "a supercharged regulatory environment." 

The Department of Justice's "large expected fine of the bank is just another catalyst in a string of problems the bank has been unable to extract itself from," Morici says. Additionally, he says, the bank "keeps dodgy books and has wide interconnections that threaten other banks in Europe and around the globe — including in the United States."

To draw an analogy, Morici says, "German banks are run as U.S. auto companies were run before the crisis." (He told NPR in 2008 that then-struggling "General Motors brings product to market too slowly at too high a cost, and its production costs are too high.")

Ultimately the bank's fate, says Rossi, is one more unfortunate example of how aggressive business strategies coupled with underwhelming risk management governance and practices can pose devastating effects for banks and the system at-large.

Regarding European bank practices more broadly, Morici says "fraud may be endemic as German bank executives appear intent on exporting their bogus practices."

"For example, former and sitting Deutsche Bank executives were recently indicted by Italian prosecutors for helping Banca Monte dei Paschi, the world's oldest bank, grossly overstate 2008 to 2012 profits, he says. "In the United States, new regulations require big banks to write living wills that specify how they would sell off assets in a crisis and to build up capital to help cushion the process. But like Deutsche Bank and U.S. banks in 2008-09, most of their assets and capital would prove unmarketable and nearly worthless should the economy turn south."

A settlement even one-third of the size of the one proposed by the U.S. Justice Department would require the Frankfurt-based bank to sell stock to replace lost capital, and it is not well positioned to do so, Morici warns.

Rossi says the European Central Bank would likely require Germany to extend a lifeline to Deutsche Bank "to shore up its capital position or maintain sufficient liquidity."

However, such a lifeline contributes to the risk facing the global economy. "We are told over and over again, Deutsche Bank is no Lehman Brothers," Morici says. "It can’t pull down the global financial system because the European Central Bank stands ready to lend virtually unlimited amounts of cash against the bank's assets."