Karen Shaw Petrou’s memorandum to the Federal Financial Analytics clients  on “The Sovereign Doom Loop: Deutsche Bank Edition.”

TO: Federal Financial Analytics Clients

FROM: Karen Shaw Petrou

DATE: September 30, 2016

The Sovereign Doom Loop: Deutsche Bank Edition

Earlier this week, The Wall Street Journal blamed Deutsche Bank’s problems on the Justice Department’s belated efforts to show that it can be tough on big banks. It might better have blamed the problem on German officials who side-tracked Eurozone efforts to craft an effective, practical resolution regime in their efforts to make it not just one that ensured resolution, but also revenge. At the same time, Germany fought stringent stress tests and some of the other standards that have worked so well in the U.S. Had Germany not been so tough on the rest of the Eurozone and so indulgent towards it largest bank, Deutsche Bank would not now be bringing the global financial system back to the brink.

[drizzle]Deutsche Bank

Why has one German bank, big though it is, done so much so fast to send systemic jitters across the globe? Deutsche Bank’s problems are reputational – not the traditional solvency and liquidity ones at which the post-crisis rules are aimed. DB in fact has respectable capital and liquidity with which to withstand anything but a crisis of confidence caused by reputational damage exacerbated by market uncertainty. In banking, reputation counts more than dollars and Euros as a bulwark against run-risk. The right way to deal with this most fundamental of all of the risks to which giant banks are heir thus is to ensure that reputation risk is prevented and resolution is certain without systemic risk. On both these reputation-risk and resolution-protocol counts, global regulators still fall very, very short.

Earlier this week, FedFin released a new paper on operational risk and how to ensure it doesn’t turn terminal for troubled banks. This paper argues strongly against Basel’s pending standardized approach to operational-risk capital in favor of capital requirements aligned with risk-reduction and mitigation incentives. Basel’s proposal premises operational-risk capital on a percentage of a bank’s gross income – stated simply, this would mean that the more money a bank rakes in, the higher its capital requirement would grow regardless of whether risk in any way correlated with revenue. Perversely, banks that take the costly, prudent steps to curtail operational risk would face the highest operational-risk capital costs because their earnings would be double-taxed for risk mitigation – once through a charge against gross income and then again through the cost to earnings resulting from these risk controls and buffers.

Would Deutsche Bank be better off with more operational-risk capital? Certainly, but conditionally, (the Basel proposal doesn’t count litigation reserves as it should) but it would be far better off had it had better operational-risk controls in place to ensure effective risk management and compliance in the vulnerable high-return, high-risk areas now causing it so much grief. Prudential supervision of DB – admittedly here in the U.S. as well as in Germany – fell very short.

DB would be in far better shape today with these operational-risk controls – demonstrable buffers, mitigants and reserves. Assume, though, that panic grips DB’s counterparties and stress turns into a confidence rout. Here’s where the second failing of global financial regulation since the crisis counts for so much – Deutsche Bank’s problems are magnified by continuing uncertainty over whether the German government will give it aid and comfort, what the U.S. and U.K. might do in any such eventuality, and what would happen if no one stepped in.

In short, market fears about one bank are powered up into a frenzy by market uncertainty, uncertainty that leads each counterparty and creditor not unreasonably to try to save itself. For whatever reason – does no one listen to what Wolfgang Schäuble says – markets thought the German government would bail out Deutsche Bank. Now it’s not so sure.

Whip-sawed like this, banks are not subject to market discipline when it would do them good and are pilloried by market fears when they have no power to resist. In 2012, FedFin wrote another paper arguing that regulators can pile capital rules atop liquidity ones and circle back again to make them tougher without making a dent in systemic risk if tough prudential standards are not matched by meaningful, clear orderly-resolution ones. Four years later, and we see the sorry proof of this prediction.