Could Deutsche Bank become the first victim of the United Kingdom’s withdrawal from the European Union?
Deutsche Bank: a problem too big to solve?
The once formidable German bank has seen better days. Its share price on the New York Stock Exchange (NYSE) has declined by 25.5 per cent since the United Kingdom voted in favour of ‘Brexit’ on June 24. However, it would be misleading to solely attribute its struggles to the British referendum. This is a bank clouded in controversy and poor decision-making. Its recent struggles have been more than a decade in the making.
As of Friday its share price was $US13.95, or almost 89 per cent below its adjusted peak of $US124.23 in May 2007. It is down 42 per cent from the end of last year. You don’t need to be an expert in technical analysis to realise that there is nothing good to be found in the graph below.
In late June, the International Monetary Fund declared that Deutsche Bank was the riskiest 'globally significant' bank. According to the IMF, Deutsche Bank “appears to be the most important net contributor to systemic risks, followed by HSBC and Credit Suisse”. Deutsche Bank may be too big to fail, in the sense that it is too dangerous to let it fail, but it appears increasingly likely to follow in the footsteps of Bear Stearns and Lehman Brothers.
The report from the IMF coincides with the Deutsche Bank Trust Corporation failing the Federal Reserve’s annual stress test of financial institutions, which tests a bank’s capacity to withstand a financial crisis. It was the second consecutive year that Deutsche Bank failed the test.
We shouldn’t use comparisons to Lehman Brothers lightly. With hindsight we now know that Lehman Brothers triggered an once-in-a-lifetime financial crisis; the reverberations of which are still being felt to this day. Deutsche Bank faces an existential threat, that much is clear, but I’d steer clear of predicting a financial crisis if they do go under.
Deutsche Bank’s price-to-book value ratio – which compares the market value of their assets against their recorded book value – currently sits at just 0.3. That’s well below its competitors, such as Barclays (0.4) and Credit Suisse (0.6), and some investors might interpret that as a buying opportunity.
If – and this is a big if – Deutsche Bank can increase its capital base and sell off some of its underperforming assets, then those investors may prove to be correct. Making progress on this front, though, has been difficult after the bank recorded a €6.8 billion loss in 2015, with the bank’s core tier one capital ratio remaining well below its main competitors.
More capital needs to be raised but, with Deutsche Bank’s bonds effectively considered junk, attracting investors is not as easy as it once was. The credit default swap, or insurance, on Deutsche Bank subordinated debt, which is the debt least likely to be paid in the case of default, is now at a record high.
It’s a remarkable situation for an investment bank that was considered among the top three investment banks in the world during the initial aftermath of the global financial crisis.
Systemically important financial institutions
Most readers will not have direct exposure to Deutsche Bank. That doesn’t necessarily mean that you are out of the woods. Since Deutsche Bank is a systemically significant financial institution, almost every investor has indirect exposure to Deutsche Bank.
As the IMF acknowledges, “the largest German banks and insurance companies are highly interconnected”. Deutsche Bank is a key source of inward spillovers between, for example, German banks and insurers but also outward spillovers to banks and financial institutions abroad.
The threat of spillovers or contagion is where the real risk lies for global investors, including Australians. Financial stress for Deutsche Bank would almost certainly translate into increased pressure on the likes of HSBC and Credit Suisse.
There are already existing concerns about the capitalisation of several Italian banks. These banks continue to suffer under the weight of Italy’s atrocious economic performance. Economic activity in Italy is at roughly the same level as it was at the turn of the century.
It was enough for Deutsche Bank chief economist David Folkerts-Landau to recently suggest that European banks need a €150 billion bailout program to deal with the combination of excessive debt, lacklustre growth and low inflation.
“Europe is extremely sick and must start dealing with its problems extremely quickly, or else there may be an accident,” Folkerts-Landau said.
Now there may be a little self-interest there given Deutsche’s current plight but the simple fact that this has been mentioned speaks volumes about financial conditions across the euro area.
The main problem is that a bailout of this nature would breach European Commission rules. Under existing EU rules, a bank’s creditors are expected to suffer losses before the taxpayer is asked to step in. As a result, Deutsche Bank is both too big to fail and the existing rules may make it too difficult to save.
How might this affect Australia banks?
This is clearly the key question for Australian investors. It is one thing to discuss the risks associated with a German bank but what we really care about is whether it will affect the four major banks that dominate the portfolios of so many Australian investors.
There is obviously a direct risk in that financial stress or the collapse of one foreign bank will typically hit the share price of most major banks. This tends to occur even if the bank doesn’t have a great deal of exposure to the institution that's under pressure. Co-movement between bank stocks and bonds is one example of the contagion that I mentioned earlier.
From our perspective, though, the main risk for our major banks is that they have become increasingly reliant on offshore borrowing to keep their books ticking over. Cheap foreign money has been great for short-term profitability and the share price of the major banks, but such activity carries its fair share of risks.
The business model for Australian banks is remarkably simple: more loans equal greater revenue and profits. As long as a bank can issue more loans than they did the year before they will almost always record a higher profit. However, the banks face one simple snag: Australia is too small a market to fund this business model. That’s why the major banks have come to rely on offshore funding.
Offshore funding to Australian banks currently stands at 51 per cent of nominal GDP, or around $835 billion. Total foreign liabilities for Australian banks currently sits at around $1.23 trillion. Over the past two decades, there has been a significant shift towards offshore borrowing to offset the fact that Australia has a relatively small population and deposit growth can only take a bank so far.
This money is then funnelled into Australia’s housing market. The million-dollar homes common in Sydney and Melbourne are largely a product of cheap foreign debt.
Financial disruption from abroad, whether it be Deutsche Bank or the dysfunctional Italian banking system or ‘Brexit, will translate into higher funding costs for Australian banks. These costs will inevitably be passed on to consumers in the form of higher interest rates.
Higher funding costs and higher interest rates are hardly ideal for a business model which relies on the ability to issue more loans than the year before. It’s also far from ideal for Australia’s $5.9 trillion housing market since prices are determined by the amount of money banks are willing and able to lend. A credit squeeze would likely lead to a fall in house prices or at the very least not a lot of growth.
At the extreme end – where credit markets freeze and credit is highly rationed – Australia might face a recession. Since Australia runs a current account deficit of around 5 per cent we are susceptible to any financial shock that reduces out capacity to borrow from abroad. That scenario though is unlikely given central banks have become far more proactive since the beginning of the global financial crisis.
Any financial shock would be met by looser monetary policy, in the form of lower interest rates, quantitative easing or even negative interest rate policy, which would help to contain some of these risks. Intervention from central banks actually makes it very difficult to assess both the likelihood that Deutsche Bank collapses and the market response.
How you approach this issue really depends on what type of investor you are. If you are a 'sit and hold' investor then you may simply decide to ride out any turbulence. More active investors, though, may want to hedge their risk by reducing their exposure to bank shares or property funds. That’s quite difficult in Australia because after excluding the banks, and assuming you aren’t all that keen on mining, you are left with very few reliable domestic stocks.
At the very least investors should be paying close attention to financial news regarding Deutsche Bank. It doesn’t get a lot of coverage in Australian publications but it soon will as it teeters on the brink of collapse. Central banks may once again come to the rescue but until then investors must recognise that this once great German bank represents a considerable risk to global financial markets, with spillovers that will likely hit domestic investors as well.