It looks like Deutsche Bank is heading toward failure. Why might we be concerned?
The problem is that Deutsche is too big to fail — more precisely, that the new Basel III bank resolution procedures now in place are unlikely to be adequate if it defaults.
Let’s review recent developments. In June 2013 FDIC Vice Chairman Thomas M. Hoenig lambasted Deutsche in a Reuters interview. “Its horrible, I mean they’re horribly undercapitalized,” he said. They have no margin of error.” A little over a year later, it was revealed that the New York Fed had issued a stiff letter to Deutsche’s U.S. arm warning that the bank was suffering from a litany of problems that amounted to a “systemic breakdown” in its risk controls and reporting. Deutsche’s operational problems led it to fail the next CCAR — the Comprehensive Capital Analysis and Review aka the Fed’s stress tests – in March 2015.
Major senior management changes were made throughout 2015 and Deutsche was retrenching sharply with plans to cut its workforce by 35,000. This retrenchment failed to reassure the markets. Between January 1st and February 9th this year, the bank’s share price fell 41 percent and the prices of Deutsche’s CoCos (or Contingent Convertible bonds) were down to 70 cents on the euro. Co-Chair John Cryan responded with an open letter to reassure employees: “Deutsche Bank remains absolutely rock-solid, given our strong capital and risk position,” he wrote. The situation was sufficiently serious that the German finance minister Wolfgang Schäuble felt obliged to explain that he “had no concerns” about Deutsche. Finance ministers never need to provide reassurances about strong banks.
On February 12th, Deutsche launched an audacious counter-attack: it would buy back $5.4 billion of its own bonds. The prices of its bonds — and especially of its CoCos — rallied and the immediate danger receded.
Fast forward to the day after the June 23rd Brexit vote and Deutsche’s share price plunged 14 percent. Deutsche then took three further hits at the end of June. First, spreads on Credit Default Swaps (CDSs) spiked sharply to 230 basis points, up from 95 basis points at the start of the year. These spreads indicate the market’s odds on a default. Second, Deutsche flunked the CCAR again. Then the latest IMF Country Report stated that “Deutsche Bank appears to be the most important net contributor to systemic risks” in the world financial system and warned the German authorities to urgently (re)examine their bank resolution procedures.
Less than a week later, Deutsche’s CoCos had collapsed again, trading at 75 cents on the euro. The Italian Prime Minister, Matteo Renzi, then put his boot in, suggesting that the difficulties facing Italian banks over their well-publicised bad loans were minuscule compared to the problems that other European banks had with their derivatives. To quote:
If this nonperforming loan problem is worth one, the question of derivatives at other banks, big banks, is worth one hundred. This is the ratio: one to one hundred.
He was referring to the enormous size of Deutsche’s derivatives book.
In this post I take a look at Deutsche’s financial position using information drawn mainly from its last Annual Report. I wish to make two points. The first is that although there are problems with the lack of transparency of Deutsche’s derivatives positions, their size alone is not the concern. Instead, the main concern is the bank’s leverage ratio — the size of its ‘risk cushion’ relative to its exposure or amount at risk — which is low and falling fast.
Deutsche’s derivatives positions
On p. 157 of its 2015 Annual Report: Passion to Perform, Deutsche reports that the total notional amount of its derivatives book as of 31 December 2015 was just over €41.9 trillion, equivalent to about $46 trillion, over twice U.S. GDP. This number is large, but is largely a scare number. What matters is not the size of Deutsche’s notional derivatives book but the size of its derivatives exposure, i.e., how much does Deutsche stand to lose?
There can be little question that this exposure will be nowhere near the notional value and may only be a small fraction of it. One reason is that the notional value of some derivatives – such as some swaps – can bear no relationship to any sensible notion of exposure. A second reason is that many of these derivatives will have offsetting exposures, so that losses on one position will be offset by gains on others.
On the same page, Deutsche reports the net market value of its derivatives book: €18.3 billion, only 0.04 percent of its notional amount. However, this figure is almost certainly an under-estimate of Deutsche’s derivatives exposure.
It is unreliable because many of its derivatives are valued using unreliable methods. Like many banks, Deutsche uses a three-level hierarchy to report the fair values of its assets. The most reliable, Level 1, applies to traded assets and fair-values them at their market prices. Level 2 assets (such as mortgage-backed securities) are not traded on open markets and are fair-valued using models calibrated to observable inputs such as other market prices. The murkiest, Level 3, applies to the most esoteric instruments (such as the more complex/illiquid Credit Default Swaps and Collateralized Debt Obligations) that are fair-valued using models not calibrated to market data – in practice, mark-to-myth. The scope for error and abuse is too obvious to need spelling out. P. 296 of the Annual Report values its Level 2 assets at €709.1 billion and its Level 3 assets at €31.5 billion, or 1,456 percent and 65 percent respectively of its preferred core capital measure, Tier 1 capital. There is no way for outsiders to check these valuations, leaving analysts with no choice but to work with these numbers while doubtful of their reliability.
Deutsche’s reported 3.5 percent leverage ratio
Recall that the number to focus on when gauging a bank’s risk exposure is its leverage ratio. Traditionally, the term ‘leverage’ (or sometimes ‘leverage ratio’) was used to describe the ratio of a bank’s total assets to its core capital. However, under the Basel III capital rules, that same term ‘leverage ratio’ is now used to describe the ratio of a bank’s core capital to a new measure known as its leverage exposure. Basel III uses leverage exposure instead of total assets because the former measure takes account of some of the off-balance-sheet risks that the latter fails to include. However, there is usually not much difference between the total asset and leverage exposure numbers in practice. We can therefore think of the Basel III leverage ratio as being (approximately) the inverse of the traditional leverage (ratio) measure.
Armed with these definitions, let’s look at the numbers. On pp. 31, 130 and 137 of its 2015 Annual Report, Deutsche reports that at the end of 2015, its Basel III-defined leverage ratio, the ratio of its Tier 1 capital (€48.7 billion) to its leverage exposure (€1,395 billion) was 3.5 percent. This leverage ratio implies that a loss of only 3.5 percent on its leverage exposure (or approximately, on its total assets) would be enough to wipe out all its Tier 1 capital.
If you think that 3.5 percent is a low capital buffer, you would be right. Deutsche’s 3.5 percent leverage ratio is also lower than that of any of its competitors and about half that of major U.S. banks.
There are also reasons to believe that the reported 3.5 percent figure overstates the bank’s ‘true’ leverage ratio. Leaving aside the incentives on the bank’s part to overstate the bank’s financial strength, which I touched upon earlier, the first points to note here are that Deutsche uses Tier 1 capital as the numerator, and that €48.7 billion is a small capital cushion for a systemically important bank.
The numerator in the leverage ratio: core capital
So let’s consider the numerator further, and then the denominator.
You might recall that I described the numerator in the leverage ratio as ‘core’ capital. Now the point of core capital is that it is the ‘fire resistant’ capital can be counted on to support the bank in the heat of a crisis. The acid test of a core capital instrument is simple: if the bank were to fail tomorrow, would the capital instrument be worth anything? If the answer is Yes, the capital instrument is core; if the answer is No, then it is not.
Examples of capital instruments that would fail this test but are still commonly but incorrectly included in core capital measures are goodwill and Deferred Tax Assets (DTAs), which allow a bank to claim back tax on incurred losses if/when the bank subsequently returns to profitability.
Deutsche also reports (p. 130) a more conservative capital measure, Core Equity Tier 1 (CET1), equal to €44.1 billion. This CET1 measure would have been more appropriate because it excludes softer non-core capital instruments – Additional Tier Capital – that are included in the Tier 1 measure.
If one now replaces Tier 1 capital with CET1, one gets a leverage ratio of 44.1/1,395 = 3.16 percent.
Even CET1 overstates the bank’s core capital, however. One reason for this overstatement is that the regulatory definition of CET1 includes a ‘sin bucket’ of up to 15 percent of non-CET1 (i.e., softer) capital instruments, including DTAs, Mortgage Servicing Rights,and the capital instruments of other financial institutions. The consequence is that Basel III-approved CET1 can overstate the ‘true’ CET1 by up to 1/0.85 -1 = 17.5 percent.
The denominator in the leverage ratio: leverage exposure vs. total assets, both too low
Market-value vs. book-value leverage ratios
So what’s next for the world’s most systemically dangerous bank?
At the risk of having to eat my words, I can’t see Deutsche continuing to operate for much longer without some intervention: chronic has become acute. Besides its balance sheet problems, there is a cost of funding that exceeds its return on assets, its poor risk management, its antiquated IT legacy infrastructure, its inability to manage its own complexity and its collapsing profits — and the peak pain is still to hit. Deutsche reminds me of nothing more than a boxer on the ropes: one more blow could knock him out.
If am I correct, there are only three policy possibilities. #1 Deutsche will be allowed to fail, #2 it will be bailed-in and #3 it will be bailed-out.
We can rule out #1: the German/ECB authorities allowing Deutsche to go into bankruptcy. They would be worried that that would trigger a collapse of the European financial system and they can’t afford to take the risk. Deutsche is too-big-to-fail.
Their preferred option would be #2, a bail-in, the only resolution procedure allowed under EU rules, but this won’t work. Authorities would be afraid to upset bail-in-able investors and there isn’t enough bail-in-able capital anyway.
Which consideration leads to the policy option of last resort — a good-old bad-old taxpayer-financed bail-out. Never mind that EU rules don’t allow it and never mind that we were promised never again. Never mind, whatever it takes.
Full article: Is Deutsche Bank Kaputt? (CATO Institute)