Deutsche Bank (DB) has been making headlines and causing tremors in the markets. With flashbacks of the Lehman fiasco and concerns over contagion, investors are justifiably anxious.
We thought we would wade through some of the noise and share our thoughts on the situation.
Base case scenario
Typically, the Department of Justice (DoJ) floats a very large fine, the banks negotiate and eventually pay a much lower number (single digit billions). The initial number from the DoJ was $14bn, but rumours surfaced on Friday that the DoJ and DB could be agreeing to a $5.4bn fine. If this turns out to be true it should relieve the pressure on DB. We believe it is possible that the German and American governments are having backroom discussions to expedite the process in hopes of avoiding a major problem.
Ironically, the post-crisis regulations intended to make banks safer might just be making the situation worse. Firstly, European regulation prevents a government bailout until creditors have been hit with losses equal to 8% of liabilities. In DB’s case, this could be €139bn which could significantly damage confidence in the financial system. Furthermore, Germany hasn’t been particularly sympathetic towards Italy’s bank problems, making it difficult for Chancellor Merkel to skirt the rules.
Secondly, the increased transparency and reporting of the leverage ratio can cause a negative spiral. There are some signs of creditors shying away from lending to DB, which makes it more difficult for them to maintain their leverage ratio (unless they aggressively sell assets). If lenders see a deterioration in the ratio some may decide not to lend and so on. The problem is that banks still rely heavily on short term funding and typically maintain only 30 days of liquidity, so this downward spiral can get out of hand quickly.
We have been reducing risk as Deutsche adds to other concerns that will affect the market in October such as the US election and continued worries over the Fed. In particular, we have reduced exposure to bank debt to provide flexibility should the opportunity to re-establish positions present itself.
We continue to watch closely as the situation develops and are holding a modest risk profile until we have further clarity on DB’s outlook.