Deutsche Bank’s plunging share price raised fears of a new financial crisis on the order of 2008 in the United States or 2011 in Europe. Deutsche, Germany’s largest lender, lost slightly over half its market value this year, and declined by 30% since Sept. 9. German media quoted unnamed Berlin officials warning that there would be no bailout for Deutsche Bank, and the stock price fell sharply this morning. That’s the bad news, and very bad news indeed if you are unfortunate enough to own the stock. But it’s not that bad for the rest of us.
The catalyst for Deutsche’s price collapse was the American government’s demand for a $14 billion penalty for Deutsche’s alleged chicanery in mortgage-backed securities during the financial crisis. The bank would have to raise new capital at a fabulously expensive price in order to pay a fine of that size. But the bank’s legal problems have exacerbated fears about its financial condition and viability.
The bad news is that Europe’s banking system has two kinds of problems: banks with enormous amounts of non-performing loans, and banks with vast amounts of opaque derivatives exposure (listed on their financial reports as “off-balance sheet obligations.”) The good news is that we know precisely who the sick men of European banking are, and there aren’t that many of them. There are just two banks that list off-balance sheet obligations in excess of a quarter of their assets — Deutsche Bank and its fellow underperformer, Credit Suisse (full disclosure: I was a Managing Director at Credit Suisse from 1998 to 2002). Barclay’s Bank also has a big off-balance sheet book but is considered more conservative by the market.
By the same token, there are a group of banks with so many bad loans that they are in effect insolvent. The good news is that all of them are in Italy, and the total cost of a government bailout under the most extreme of circumstances would add less than 5% to Italy’s national debt. Worst among these is the Monte de Paschi Bank, or what local wits dub the Monty de Python Bank (as in, “This parrot is dead”). I wrote about Italy’s bank crisis in this space last March .
Italy’s banks have bad loans equivalent to about a fifth of their total loans, and they have capital equivalent to about a tenth of their total loans. The loans in question are overwhelming small business loans, and Italy’s surreal bankruptcy system takes eight to ten years on average to wind up the affairs of a bankrupt borrower. That gives deadbeat borrowers more time to empty their businesses of assets. The regulators are trying to get banks to sell off their bad assets, but it is hard to sell a loan whose likelihood of eventual collection is so poor. The bank situation is hopeless, but not serious; the comic opera of Italian finance has a few more acts to go.
There may be nothing nefarious in Deutsche’s off-balance sheet exposure, to be sure. We simply don’t know. Back in 2008, Lehman Brothers had huge off-balance sheet exposure; among other things, it had written price guarantees on some parts of the collateralized debt obligations it had issued over the preceding several years. As the market for these complex derivative products vaporized, Lehman didn’t know how much money it owned, and couldn’t find out. That’s one reason its affairs had to be wound up.
In the case of Deutsche Bank, though, there may or may not be anything to fear from its off-balance-sheet obligations. In the past, Deutsche used accounting tricks (legal ones) to keep some of its loans off the balance sheet in order to save on the cost of capital. It has an enormous derivatives book, but this consists of matched positions. If one of its counterparties were to default in a big way, Deutsche would be at risk, to be sure, but that sort of event is easy for central banks to preempt. If Deutsche were (very hypothetically) to suffer an unexpected loss large enough to threaten its survival, there would not be a German government “bailout.” Junior bondholders would lose some of their money, depositors would be protected, the derivatives book would be ring-fenced, and the bank’s functions would be farmed out to its competitors.
At the peak of the market bubble in 2008, the gross market value of credit default swaps outstanding (after netting for matching positions) was around $5 trillion. It’s shrunk to about $420 billion as of the end of 2015, according to the Bank for International Settlements. The hot air has been leaving the system, and the few pockets of it left, for example in Deutsche Bank’s balance sheet, aren’t big enough to create another conflagration.
Europe’s banks need to merge into larger institutions with a lower cost base, and far fewer employees. That is a political problem in a high-unemployment country like Italy, but less so in Germany, where labor is scarce. Europe’s economy will remain depressed and its banks will contribute little enough to growth. But a new crisis is most unlikely.