Deutsche’s woes will prompt a long-overdue consolidation of banking system
By
David P. Goldman on September 29, 2016 in AT Top Writers,
David P. Goldman,
Spengler
At 12:30 pm Eastern Standard Time, the broad market found out what specialists had known for the past 48 hours: a number of major hedge funds were pulling their derivatives trades out of Deutsche Bank, and the cash they deposited against these trades. A Bloomberg News story reported, “A number of funds that clear derivatives trades with Deutsche Bank AG have withdrawn some excess cash and positions held at the lender, a sign of counterparties’ mounting concerns about doing business with Europe’s largest investment bank.” This was widely known on Tuesday to derivatives traders, but surprised most equity investors when the news hit the tape.
The Deutsche Bank headquarters in Frankfurt, Germany. REUTERS/Kai Pfaffenbach/File Photo
Nothing particularly exciting will happen. Trades that hedge funds used to book with Deutsche will migrate to its stronger competitors, and Deutsche’s business will shrink. Depending on how aggressively the US Justice Department pursues its proposed $14 billion fine on Deutsche Bank, it is possible that the institution will be subject to a shotgun merger–and even possible that some of its junior bondholders will lose money. There will be fewer banks and the ones who survive will make money. It doesn’t pay to be a bank stockholder and wait to find out whether you own one of the winners. This isn’t another Lehman Crisis, when everything went to pieces. But there’s no reason to own bank common shares.
Deutsche Bank’s shares had fallen by 6.5% as of mid-afternoon, followed by Credit Suisse, which lost 4.5%. JP Morgan had fallen by 1.5%. As I reported Sept. 26 in this space, Deutsche’s enormous derivatives book stands out like a sore thumb. Its off-balance sheet assets amount to a quarter of its total assets, a ratio matched only by Credit Suisse. Britain’s Barclay’s Bank is in third place. Derivatives have been a dirty word since the 2008 crisis, but the concept embraces quite different instruments. The “derivatives” that triggered the Lehman Brothers collapse in September 2008 were fraudulent by construction, synthetic bonds that bore a AAA rating but should have been considered junk. Deutsche’s derivatives book consists mainly of interest-rate, credit and foreign-exchange hedges that trade in reasonably liquid markets and whose behavior is quite predictable.
That’s a reasonable presumption, but the market doesn’t know that the portfolio is benign. Deutsche and Credit Suisse are being punished for opacity. Even nastier than today’s decline in Deutsche Bank’s already-cratered stock price is the fall in the price of its preferred stock. Preferred pays a fixed coupon like bonds but will be among the last obligations to be repaid in case of trouble. Deutsche Bank’s 6.55% preferred stock due 12/2049 has lost nearly 15% of its value, because it might become worthless in the case of a reorganization.
As I wrote earlier this week, this is not a banking crisis like 2008, when most of the banks held toxic waste securities with 60:1 leverage. Today we have just a few banks (Deutsche, Credit Suisse and Barclay’s) who have a big off-balance-sheet derivatives book, and just a few banks (mainly the Italians ) who can’t work their way out of their bad loan problems. Most of the banks act like boring public utilities.
There simply are too many banks and too little business for them. The bond markets have replaced a good deal of the commercial lending business. Financial technology reduces the number of loan officers, paper shufflers, and bank tellers. Deutsche’s competitor Commerzbank this morning announced 9,300 layoffs, or about a tenth of its workforce. That’s a good start. The European banking industry probably needs to reduce its headcount and number of branches by more than half. The return on equity to the Bloomberg European banks index stood at barely 3.3% in September. That’s not viable, and the solution is consolidation.
That probably explains why the German government has ruled out a bailout Deutsche Bank. In the case of a real run, to be sure, the government would protect depositors and counterparties to hedging transactions– but not stockholders or bondholders. On Sept. 27, a member of the German central bank’s supervisory board, Andreas Dombret, began a speech in Vienna with the question: “Are there too many banks?” He concluded with a blunt statement that “the banking sector’s share in economic activity has to shrink…How this is done is up to the market.”
That’s easier in Germany, which has a chronic labor shortage, than in France or Italy, which have chronic unemployment and where jobs are protected like heirlooms. The Bundesbank appears to have taken the initiative, and Deutsche Bank very well may lead the way.
