Global Financial Crisis Act II – Deutsche Bank Part 2
Series: Global Financial Crisis Act II
With Brexit serving as the catalyst, Season 2 of the European banking crisis may be about to unfold.
The commercial break at the close of the opening act of the global financial crisis in 2008 is finished. Here comes Act 2 with the globe’s most risky bank as featured guest.
Part 2 of the series describes the sequence of a typical bank failure and explores the list of options available to Deutsche Bank and the likely outcomes.
In Part 1 of the series we re-capped the historical context of the first global financial crisis and the sequence of events leading to the next chapter of the crisis starring Deutsche Bank. We also articulated why a failing Deutsche Bank is a big deal to the financial world beyond the Euro zone.
Sequence of a Bank Collapse
At this juncture it is instructive to paint a rough sequence of events leading to a bank collapse.
First of all, take it as a given that the public – yes, I am talking about you – would be the last to find out and do so well after the collapse is unleashed in full force.
Secondly, if a bank fails, it fails not because it becomes insolvent or fails regulatory capital requirements. A bank can remain insolvent from an accounting point of view for an extended period of time and continue to operate as if it is healthy. Similarly, failing regulatory capital requirements does not mean the bank gets shut down.
When it does fail, it is invariably a case of said bank running out of liquidity – liquidity such as cash, credit lines or ability to do swaps with other financial entities. Just like a fair weather friend, liquidity comes plentiful when your financial well-being is great and you don’t need extra liquidity, but disappears into thin air when you most need it.
And what determines whether the weather is fair or not? Confidence. When counterparties think the bank is in good shape, liquidity is plentiful and free flowing. The minute they start to think the other bank is in trouble, liquidity gets pulled rather rapidly.
In turn, confidence, or loss thereof, does not take place in a linear fashion. For one, it takes a long time to grow confidence but a very short time to lose it. In addition, the erosion of confidence is a long drawn-out process and also takes place in a non-linear fashion.
Take for example a bank which has been in business for decades and has the trust of its customers and peers. When its financial situation starts to deteriorate, very few would notice and fewer still would be concerned. Confidence in that bank can continue to be maintained for a long time even as the financial situation of the bank continues to worsen well beyond the point where such confidence is warranted. And then something happens which triggers the awakening of the clients and peers. Once that critical threshold gets crossed, confidence quickly vaporizes. Instead of melting away like an ice cube under the hot summer sun – a fairly swift but gradual and steady process – it suddenly falls off a cliff. Death quickly follows.
In other words, when it comes to confidence, it does not matter until it matters. And when it does, it matters here and now. NOW.
With the above in mind, what is Deutsche’s liquidity position like, you might ask?
Here’s Goldman’s take on Deutsche’s funding position, courtesy of a repost by ZeroHedge: (link)
Here’s a high level breakdown:
Liquidity reserves — €223 billion, of which €125 billion is cash and cash equivalents.
Funding position breakdown:
- lowest volatility funding: €564 billion or 57% including retail deposits, transaction banking balances;
- low volatility funding: €146 billion or 15%, including debt securities;
- other customers: €71 billion or 7%, including margin/prime brokerage cash balances; and
- other remaining funding: €212 billion, including unsecured wholesale and secured funding, etc.
Remember the last of the latest headlines above about hedge funds pulling cash from Deutsche? Their action resulted in the bank’s share price nose-diving 6% on that day. A look at the funding position above indicates that the cash involved was part of the €71 billion which belongs to the ‘other customers’ bucket. Even if the entire amount got pulled, it would cause a big dent in Deutsche’s €223 billion liquidity reserves, but the blow would probably not be fatal.
However, a far bigger concern for Deutsche is its €564 billion depositor base (€307 billion of that is retail deposits). When the institutional panic spreads to the depositor base, the consequence would be far, far more serious and swift.
However, as noted above, the biggest threat to DB is not so much its hedge fund client base, whose damage potential is limited, but the depositor base. Again: while Lehman failed, it did so as a result of its corporate counterparties suffocating the bank by rapidly pulling out their liquidity lines. Lehman, however, was lucky in that it didn’t have retail depositors: it [sic] death would have likely come far faster as the capital panic was not limited to institutions but also included a retail depositor bank run.
This is where Deutsche Bank is very different from Lehman, and far riskier, because if the institutional panic spreads to the depositor base, which as the table below shows amounts to some €566 billion in total, and €307 billion in retail deposits… then all bets are off.
Which is why both the bank and the authorities are desperately trying to keep DB’s share price above single digit, a psychological threshold which retail depositors typically equate with a bank’s viability.
The lower the price drops, the faster they will pull their deposits, the quicker DB’s liquidity hits zero, the faster the self-fulfilling prophecy of Deutsche Bank’s death is confirmed.
Decision Paths Ahead and Likely Outcome
Below we explore the choices of action available to the bank and the authorities. None of them are pleasant. By this far down the road from where the can has been kicked, there are no longer good choices left, only bad choices and worse ones.
- Jawboning – By default, the authorities will pull out all the stops to maintain a surface calm and not to fuel further panic in the market. Hopefully, jawboning the market works and the bank survives to fight some other crisis another day. Can kicked further down the road.
- Germany bails out the ailing bank – this would be toxic medicine to take. Not only would such an unpopular move mean almost certain defeat of Merkel’s government in the upcoming election next year, the Bundesbank, ECB and other authorities would lose all authority and ability to rule, now that it is in plain sight for the whole world to see that there is a set of rules for the lesser, deposable countries like Greece and Cyprus and another set of rules for ruling countries like Germany and France. This is an unlikely option from a political point of view.
- Germany bails in the bank’s creditors – when country-wide bank-runs break out as depositors start to flee any and all suspect banks before bail-ins get imposed, the EU will experience first hand how the ill conceived bail-in regime would backfire. As such, this is also an unlikely option. A partial bail-in – bailing in a selective class of creditors while leaving the depositors alone – for now – is a viable and likely option, however.
- Let the chips fall where they may – doing nothing is not an option. Thanks to the massive interconnections and even bigger derivatives exposure, the tsunami of cascading failures resulting from Deutsche’s uncontrolled collapse would make the 2008 crisis feel like a walk in the park. These banks are called too big to fail for a reason.
- Public bailout by another name – in all likelihood, the country as well as the ECB would come up with a loophole which would allow public money to bail out the bank, without calling it a bailout, and get around the bail-in rule. To convince the public this is the preferred option, the authorities might first let the market descend further into chaos until white-eye fear is induced in the public before announcing a bailout by a different name. This is the most likely action.
Given the possible set of actions above, here’s a list of possible outcomes:
- The market stabilizes without major interventions after the authorities come out and jawbone the market. This is the most ideal outcome. (Somewhat likely)
- The ECB and Germany uses a backdoor loophole to bail out the bank. Market calm returns and the can gets kicked further down the road. (Likely)
- A bail-in occurs involving depositors (Not likely) and other creditors (Likely) and the bank is saved for the day.
- No bail-in or bailout; the bank is allowed to sink or swim on its own, and the financial system descends into chaos. (Unlikely)
Ironically, the combatant Renzi must be glad that Deutsche and Germany are now taking over the spotlight. Whichever decision chosen for Deutsche – at this stage there are only unpleasant ones which would require a great deal of selling to the angry citizens – the Germans will be bushwhacking a PR trail in front of the Italians.
We certainly live in interesting times.