There is a ticking time bomb in the heart of Europe. Deutsche Bank, the largest bank in Europe, needs to be recapitalized. But neither the German government nor the European Central Bank (ECB) wants to fund it. This is leading to an unsafe and unstable situation. It could even trigger another global financial crisis.

The US Department of Justice (DoJ) recently levied a fine on Deutsche Bank (DB) in the amount of $14 billion. But the bank does not have the money to pay the fine.

Deutsche Bank

There are three options:

  1. The bank could issue equity. This is a bail-in.
  2. The government could bail out the bank by giving money to it.
  3. A third party could buy into the bank as an investor. This is also a bailout but a “friendly” one.

With option #1, the highly leveraged, low-profit firm would be issuing equity as the stock price is close to record lows. This bail-in would convert equity and subordinated debt to new equity. If that happens, the fragility of the entire European banking system will be obvious.

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Global financial markets are hoping for option #3—an investor-friendly solution to the problem. They want a white knight in the form of a bailout from a deep-pockets third party like China.

The truth is that any solution to the DB issue outside of this “friendly bailout” will be perceived as systemic weakness. And that carries the risk of contagion to the rest of the European banking system.

If a white knight does not ride to the rescue soon, Germany and the ECB may have to step in with a bailout. This option #2, however, is only slightly less pleasant than option #1, a bail-in. It would set a precedent and lead to demand for a huge round of bailouts for troubled banks throughout the euro area.

The Deutsche Bank Problem

Europe is currently fraught with many risks, both financial and geopolitical. The last thing its leaders should do is allow anyone to sense that the continent’s biggest bank is in trouble. However, politics always trumps (no pun intended) common sense.

And that is the problem here. The already-wobbly Merkel government has staunchly resisted other bank bailouts in the past. So, spending a big chunk of taxpayer money to bail out DB would be de facto political suicide.

Almost every financial analyst is saying the same thing: DB is credit-starved and barely profitable. What the firm needs is a couple of years to sell off low-performing units. This would allow them to reorganize into a more efficient and profitable firm. But DB does not have the luxury of time to deal with its problems.

Deutsche Bank

DB was limping along but was not in immediate trouble until the $14 billion DoJ fine came down. The balance sheet shows the bank could scrape up only about $6 billion on its own.

People started to question where the money for the fine was going to come from. Of course DB’s stock price started to tumble as this situation became clear.

What it boils down to is that Deutsche Bank is not an attractive investment. DB’s position today is marginal at best. The firm is undercapitalized. It will not become more profitable without reorganization.

DB is the world’s largest derivatives trader and the biggest bank on the continent. It is four times the size Lehman Brothers was. Any possibility of an unexpected failure is an unacceptable risk.

Bail-In or Bailout for Deutsche Bank

Unless the US DoJ relents and drops its fine to $6 billion, DB must raise capital soon. It needs cash for more than just the relatively small-peanuts DoJ settlement. The bank also needs to buy breathing room for a much-needed reorganization. But will the recap of DB be a bailout or a bail-in?

A bailout is the more straightforward option. The question is, who wants to take a stake in a highly leveraged, low-profit megabank in today’s risk-filled environment? With time, the German government may figure out a better way to recap DB than using taxpayer dollars.

At this point, though, that seems like a long shot.

Both China and the new Turkish wealth fund have been mentioned as possible white knights. But politics could be an obstacle in either case.

With a bail-in type solution, the bank should be declared nonviable and all equity and subordinated debt written off. This process would convert 63.1% of long-term senior debt to new equity. This would increase the institution’s leverage ratio to a solid 9%. Bailed-in senior debt holders should receive a recovery of around 94% of their current position.

An IPO Solution for Deutsche Bank

If the bail-in was undertaken as an IPO, then management would have three months to develop and present a new strategy to potential investors. This process would also provide the newly issued equity holders a way to sell their shares. This kind of bail-in allows debt holders to recoup at least some of their losses.

A bail-in solution, however, would not be embraced by the financial markets. This could likely lead to a major downdraft in global equity markets. Investors might flee other banks as well. That would likely cause a European banking crisis.

A bailout by China perhaps makes the most sense. The People’s Bank of China (PBOC) has more than $600 billion in euro reserves. That money is drawing negative interest rates. The Chinese government would be glad to become a major stakeholder in the largest bank in Europe. Even DB’s meager 1%–2% annual profits are better than negative rates.

A Solution for DB Problem Must Be Found Soon to Avoid Contagion

Geopolitical analyst George Friedman and others have recently pointed out that risk has been increasing throughout the world over the last few years. Europe has often been at the center of emerging geopolitical storms. The present problem is just one more instance of this.

The euro-area economy remains in the doldrums. Greece needs major debt forgiveness. Several Italian banks are teetering and will almost certainly need to be bailed out. And all of this is happening in the backdrop of the biggest wave of immigration to Europe in generations.

The German government and the ECB continue to play chicken. An unexpected collapse of Deutsche Bank or even a bungled bailout attempt could end up being the “Lehman Moment” of 2016. Europe’s already fragile economy would certainly be pummeled. The “risk off” contagion of this type of event could even trigger another global financial crisis.

Back in 2008–2009, the US Treasury and Federal Reserve took decisive actions during the financial crisis to make for a better end than might have been. EU financial regulators, however, cannot make such quick, unilateral decisions in a crisis. This notably boosts the odds of a “risk off” event. So, it is important for the regulators to have plans in place ahead of time and to watch what develops.

A well thought-out fix to the DB problem must be a high priority. A failure in this puts the entire global economy at risk.

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Article by Olivier Garret, Garret/Galland Research

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