Deutsche Bank’s woes make a mockery of Basel rules

The Australian 12:00am October 3, 2016

Adam Creighton

Whether the German government feels obliged ultimately to help Deutsche Bank or not, heightened fears about the bank’s viability last week have underscored the failure of so-called tough new bank regulations, known as Basel III, to stabilise the financial system, reassure investors and protect taxpayers.

Consider this. Here is a bank — among the largest in the world, with €1.8 trillion ($1.47 trillion) in assets, three times the size of the Commonwealth Bank — that satisfies the new regulatory standards yet which is being actively canvassed as a potential recipient of state aid.

Deutsche Bank’s second quarter results show the bank has a risk-weighted capital ratio of 10.8 per cent, well above the minimum. Its leverage ratio, a simpler measure that indicates equity as a share of total assets, was 3.4 per cent at the end of June, again well above the Basel III minimum of 3 per cent.

This problem isn’t unique to Deutsche. Practically all Europe’s banking behemoths, especially those in Italy and France, pass the new standards yet remain precariously vulnerable to crises of confidence.

Out of naive devotion to their “national champions”, European governments have failed to force their banks to raise equity or even stop them paying out dividends, putting the interests of their elites above their economies and citizens.

Concerns about Deutsche Bank’s viability are nothing new. Its share price trajectory over the past year looks like a slinky going down a staircase. Investors have been taking an increasingly dim view of its massive, highly leveraged and opaque balance sheet. In a year global regulators have been meeting in Switzerland to put the finishing touches to Basel III, Deutsche’s stock price has dropped almost 50 per cent to €12.

What makes last week’s turmoil interesting is the cause: reports in the media that the German government would not be bailing Deutsche out. Nothing new emerged about the bank’s financial position. Senior managing director at Kroll Bond Rating Agency, Christopher Whalen, says Deutsche has plenty of liquidity and remains an “investment grade” credit. Indeed, news that the US Department of Justice was seeking $US14bn ($18bn) from Deutsche for alleged fraud over selling of mortgage backed securities in 2008 emerged weeks ago.

Were too-big-to-fail subsidies a thing of the past, such media reports would have made no difference to Deutsche’s stock price. Yet the prospect that German taxpayers wouldn’t ensure Deutsche remained a going concern under all circumstances knocked almost 10 per cent off its value. That is remarkable. The movement in the stock price doesn’t even capture the (much larger) benefit such subsidies provide to Deutsche’s creditors.

The idea the world’s mega banks face the chill winds of capitalism, as practically every other business does, has long been a joke. The beefed up banking rules agreed in 2010, known as Basel III, were supposed to protect taxpayers from future bailouts by forcing banks to maintain more capital, in other words to use more of their own rather than borrowed money to fund their activities.

They have helped a bit. In Deutsche’s case, for instance, balance sheet leverage has fallen from around 60 to less than 30 times. But that is still enormous; think about the wisdom of a $US34,000 deposit for a $US1m house. Moreover, Deutsche is party to around €42 trillion of derivative contracts, around 18 times Germany’s GDP. For it, taking deposits and making loans is more of a side business.

The new regulatory standards ignore market values. Deutsche’s market value is currently less than 30 per cent of its book value. In August, before the latest bout of uncertainty, Cato Institute scholar Kevin Dowd calculated Deutsche was leveraged more than 100 times based on market values, which incorporate what investors thought its assets were worth.

Polls over the weekend showed around 70 per cent of Germans opposed any state aid for Deutsche Bank. Indeed, if Angela Merkel’s government does help Deutsche — an institution that pays hundreds of millions of euros in “bonuses” annually despite producing returns on equity and assets of less than 1 per cent — she will surely lose the next election, and lay the ground work for more extremist politics.

On the other hand, if Deutsche collapsed it could unleash another financial crisis and recession. The most likely outcome is what Europe excels at — muddling through. The European Central Bank will provide unlimited cheap financing to ensure the giant casino remains open for business