Uncle Sam May Tip Deutsche Bank Over The Edge by Justin Murray, Mises Institute
On September 16, 2016, the US Justice Department threatened Deutsche Bank with a $14 billion fine for bond sales practices from before the 2007 Financial Crisis. Predictably, the share price immediately collapsed 8% and the financial markets went into a tizzy over equity holders losing value. This also rippled into other parts of the banking sector, for example hitting share prices of the Royal Bank of Scotland by 4%. For reference, the total market valuation as of this writing, September 29, 2016, for Deutsche Bank is 16 billion Euros, meaning the penalty the Justice Department is seeking is 88% of the total valuation of the bank and the announcement has wiped out 20% of the market value since the beginning of September.
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
While the financial markets and media outlets are lamenting the loss of share valuation, there is a major stakeholder in this whole operation that is outright ignored. Because of the practice of fractional reserve banking, Deutsche Bank has managed to maneuver itself into a position where the leverage ratio is 3.5%. What this means is that, effectively, Deutsche Bank only has enough high quality assets to cover 3.5% of their liabilities. From a pure depositor standpoint, the FY2015 Annual Report shows that there are 567 billion Euros deposited in Deutsche Bank accounts but just 97 billion Euros of cash and central bank deposits to cover this. If this announcement were to cause just 18% of the deposits to be withdrawn, this would effectively cripple Deutsche Bank. Depositors aren’t the only risk, either, as hedge funds are also asking the bank to return their assets. Roughly 1.3 trillion Euros of assets is tied up in various loans, derivatives and investments. What this essentially means is that Deutsche Bank has only 97 billion in Euros as cash to cover 1.8 trillion Euros of promises to various entities. To put this in perspective, the entire GDP of Germany is 3.8 trillion Euros. On top of this, those existing revenue-generating assets are insufficient to cover the operating costs of the bank, so the justice Department’s fine creates a financial double-whammy that will almost certainly cause its collapse in the absence of some sort of bailout.
This math should already raise significant questions. While Deutsche Bank has 67 billion Euros in equity using the accrual method of accounting, the market has already decided that the equity is really only worth 18 billion.
While this isn’t exactly how market valuations work, we were to imagine Deutsche Bank unloading all of its various investment asset holdings in a fire sale, they would be lucky to recoup a quarter of it in actual cash. One can see how this is a problem when attempting to pay any kind of fine. Since the US Justice Department wouldn’t want to be paid in a horse trade with derivative instruments, Deutsche Bank can either dip into that 97 billion Euro stockpile or attempt to liquidate a large volume of holdings. Since dipping into that stockpile will cause the bank to run foul of Basel III rules to not leverage beyond 3%, there is little choice but to liquidate other assets or face further fines and penalties the bank can ill afford. However, if we consider the liquidation of those assets would get pennies on the Euro, the bank essentially owns nothing; any payment to the US Justice Department has to be taken away from that very cash stockpile it can’t afford to lose. This places Deutsche Bank between two conflicting regulatory bodies. Pay up the cash and run afoul of EU banking regulators, or liquidate revenue-generating assets and amplify the bank’s already unsustainable loss position.
Fractional reserve banking and the quest of the public sector to collect fines for the coffers have run into each other. Because of this practice, the US Justice Department is telling Germany’s citizenry that they’ll need to divert their tax money to the United States because of the short-sighted policies of both the private banks and central banks. With banking being such a fragile animal because of fractional reserve banking, governments have set up implicit bailout guarantees, which Germany is already considering. Due to a system of depositor insurance schemes set up by national governments, this cost ends up getting kicked off to the taxpayers in the end. In this case, the German taxpayers are funneling money into the coffers of the US Treasury.
Given Deutsche Bank’s major role in financing fragile Southern European nations and is considered so systematically important, some are speculating that a Deutsche Bank failure would lead to the total collapse of the Euro as a currency and with it, the Euro Zone itself. So not only would German taxpayers be on the hook — if Germany doesn’t bail out the bank — the EU Central Bank will be on the hook too, which further spreads the cost of the Justice Department’s fine over all the EU member states.
The entire Deutsche Bank fiasco is fully avoidable. The government facilitated the widespread use of fractional reserve banking, attempted to regulate the inevitable instability then contributed to the instability through various actions such as destroying bank profitability through artificially low interest rates and then pushing banks into financial collapse through devastating fines, which are the only tool governments utilize to enforce regulatory decrees on organizations.
In the end, the only losers are the taxpayers who end up backstopping the loss through various government banking insurance schemes or direct bailouts. Deutsche Bank, as a banking institution will continue on with a large infusion of taxes extracted from the general public and the printing of new currency by the ECB to keep the bank stable. Banks, and the politicians who created the regulatory and policy morass who truly caused the mess, are not only insulated from the pain but also are able to twist it to their favor by promoting further regulatory action and claim a moral high ground.
This cycle will continue until the entire central banking edifice is unwound. This is not a painless or even remotely easy path, but it is the only one to avoid the perpetual cycle of fines, collapses and bailouts which accomplish little more than siphoning money off the general public and into the hands of public coffers and special interests.
Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.