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Deutsche Bank as Next Lehman Brothers: Far-Fetched but Not Unthinkable
All it took was the threat of a $14 billion fine against Deutsche Bank for the word "contagion" to rear its ugly head.
Global markets have been shaken up in recent weeks over fears that Deutsche Bank, a symbol of German financial might and Europe's fourth-largest biggest bank by assets, cannot absorb a fine of that magnitude. The German government said flatly that it would not bail out the bank, leading to what some called market "panic" that Deutsche Bank could face a messy Lehman Brothers-style collapse and set off a global financial crisis.
Among investor concerns are the high amount of borrowing the bank uses to support its asset base, the difficulty in valuing many of the assets that make up its capital cushion, and the high-risk trading strategies embraced by some of its clients.
Those fears seem wildly overblown. "The bottom line is, I think the Deutsche Bank issues will be resolved and there won't be any contagion episode," said Hal S. Scott, a professor at Harvard Law School and the author of the recent book "Connectedness and Contagion." "But it's a wake-up call. Are we prepared if this ever happens again? The answer is 'no.'"
Professor Scott defines "contagion" as "an indiscriminate run by short-term creditors of financial institutions that can render otherwise solvent institutions insolvent because of the fire sale of assets that are necessary to fund withdrawals and the resulting decline in asset prices triggered by such sales." He calls such contagion "the most virulent and systemic risk still facing the financial system today."
The latest spasm in global markets began last month when The Wall Street Journal reported that the Justice Department was demanding $14 billion to resolve accusations of fraud in Deutsche Bank's packaging and sale of mortgage-backed securities before the financial crisis.
Deutsche Bank issued a statement confirming the $14 billion figure but stated it had no intention of paying such a large sum. Renee Calabro, a spokeswoman for Deutsche Bank, declined to comment further.
But the unexpectedly large number, coupled with other outstanding potential liabilities and what many investors view as a weak balance sheet, set off a chain reaction that brought back memories of the dark days before Lehman Brothers collapsed in September 2008.
Deutsche Bank shares dropped over 8 percent the day the news broke, and shares in other European banks, many with even more fragile balance sheets, also plunged.
Deutsche Bank shares were trading in New York at over $30 a year ago. By the end of September, they had dropped below $12 before recovering slightly. In an ominous reminder of the loss of confidence that plagued Lehman Brothers before its demise, some hedge funds pulled billions in assets from the bank and moved their trading activities to rivals. (The bank noted that this represented a tiny fraction of its more than 20 million clients.)
John Cryan, Deutsche Bank's chief executive, issued one of his "dear colleagues" letters — never a good sign — warning that the bank was the victim of rampant "speculation." "Trust is the foundation of banking," he wrote. "Some forces in the markets are currently trying to damage this trust."
It didn't help that widespread investor skepticism remained about the health of the European banking system, where many banks are still exposed to high concentrations of sovereign debt from Europe's weakest economies, or that Deutsche Bank is just the first of several large European banks facing a day of reckoning with the Justice Department.
Barclays, Credit Suisse, Royal Bank of Scotland, UBS and HSBC are all awaiting their turn.
For United States banks, the problems are largely behind them: They have paid over $56 billion since 2010 to settle similar suits.
In his letter, Mr. Cryan emphasized that the bank's balance sheet was more "stable" than it had been "in decades," and pointed to the bank's liquidity reserves of 215 billion euros, about $241 billion. Deutsche Bank has already set aside €5.5 billion for potential settlements and is expected to add a billion or more from the proceeds of sales of the British insurer Abbey Life and its stake in a large Chinese bank.
JPMorgan Chase analysts issued a report concluding that Deutsche Bank could absorb a fine of up to $4 billion without raising concerns about its capital position. Despite the department's tough opening offer, a fine of under $4 billion doesn't seem all that outlandish. Citibank paid a fine of $4 billion to settle similar accusations by the Justice Department, and Morgan Stanley paid just $2.6 billion. Citibank and Deutsche Bank had similar market shares in the mortgage-backed securities market, while Morgan Stanley's was nearly twice as large. Other factors in setting a fine include how much Deutsche Bank has cooperated in the investigation, and how egregious the conduct may have been, facts known only by the bank and the government.
Even if the Justice Department has an exceptionally strong case, it would surely pause before demanding a fine that imperils the viability of Deutsche Bank, let alone the fragile European banking system, which would surely spill over into global markets and the United States economy. Deutsche Bank is far larger and more systemically important than Lehman Brothers was.
"The goal really shouldn't be to destroy financial institutions," said Brandon L. Garrett, a law professor at the University of Virginia and author of "Too Big to Jail." "It should be to reform them. The proper way to punish corporations is to hold the individuals and executives responsible. Huge fines just punish the shareholders even more and won't stop the recidivism we've seen at Deutsche Bank."
(Deutsche Bank has already paid more than $9 billion in fines since the onset of the financial crisis.)
The Justice Department has not said whether it is looking at potential individual defendants at Deutsche Bank in connection with the mortgage-backed securities cases, but it did charge two former traders at the bank with manipulating the benchmark London interbank offered rate, or Libor. Another former Deutsche Bank executive pleaded guilty and is cooperating with prosecutors.
"I think the Justice Department could afford to be a little more lenient with the fine as long as individuals are held accountable," Mr. Garrett said.
A spokesman for the Justice Department declined to comment.
Even if the United States maintains an aggressive posture, few think the German government would allow Deutsche Bank to fail, even though it has ruled out any bailout.
"I agree it may be too fragile" to withstand a huge fine, Professor Scott said. "Does the Justice Department understand the risk of contagion? It reminds me of Arthur Andersen," the defunct accounting firm. "No one thought an enforcement action would force it into bankruptcy."
Should Deutsche Bank precipitate a financial crisis, it's not clear how it would be resolved. It's a European bank, so the Federal Reserve's powers would be limited.
"I hope there's a global game plan," Professor Scott said, "because that's what it would take. If Deutsche Bank set off contagion, it would start in Europe. Who would be next? This would require global coordination."
Should such a crisis spread to American nonbank institutions, like money market funds, the government has even fewer tools at its disposal than it did after Lehman Brothers failed, thanks to congressional efforts to limit future bailouts. In his book, Professor Scott argues that Congress should give the Fed and other regulators more — not less — power to stop runs at banks and nonbanks alike by coming to their assistance and extending deposit guarantees, if necessary, as they did after Lehman Brothers.
Despite widespread nervousness about Deutsche Bank's ultimate fate, nothing so dire seems imminent — yet.
"I don't think this will develop into anything serious," Professor Scott said, "but we need a deal for Deutsche Bank that's $5 billion or less and not $14 billion, and we need this to happen within a short time frame. The longer this goes on, the more uncertainty there is, and the more nervous the markets get."
[Source: By James B. Stewart, International New York Times, 06Oct16]
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