The View | Bad banks, even German ones, should be allowed to fail
Deutsche Bank’s situation illustrates the enormous weaknesses and destabilising outcomes of the current ‘too big to fail’ regulatory and economic models
Smart traders will say the biggest risks you run are those you are unaware of. And that explains the market’s worries about the numerous risks swirling around Deutsche Bank. Its shares reversed a sharp fall last Friday, coming back from a new 33-year low.
Deutsche is negotiating a settlement for a $14 billion penalty by the US Department of Justice for mis-selling mortgage backed securities nine years ago. Never mind that the bank has US$18 billion market capitalisation. Regulatory woes are the least of its problems. It raises serious questions about the usefulness and relevance of regulatory enforcement policy since the 2008 financial crisis.
The German government says it won’t provide a bail out. Even if Germany wanted to let Deutsche Bank fail it would risk systemic collapse. Any rescue is complicated by Eurozone rules that require a mandatory bail in (forcing discounts on deposits and lenders) – sounds smart in theory, but that could precipitate a bank run as depositors flee once it is announced or even rumoured.
Deutsche arguably runs Europe’s most risky balance sheet. The market doubts its asset quality and most of all, the valuations of its large derivative positions. Its assets amount to more than half of Germany’s total annual gross domestic product. It is also a large deposit holder with about €600 billion.
About half of its €1.8 trillion in assets are connected to its trading business with about €28.8 billion classified as ‘level three’ assets, which are more opaque and difficult to value. Unfortunately, the model of leveraged asset growth of the balance sheet, which was the source of the 2008 financial crisis remains a threat to financial stability.
It takes a rare combination of banking regulators and central bankers to come up with a true economic disaster. Economists have never understood that their models are perverted by the regulatory framework in which they attempt to function. Mispriced money and inadequate regulation in the EU has allowed the European bank sector to increase and misprice their risk exposure.
Everyone knows what an insolvent bank looks like. But determining if a solvent bank faces impending illiquidity is an entirely different and tricky exercise. The market may be assuming the worst case scenario where the bank’s level three assets are all completely worthless even though this is probably not the case.
