Yes, Martha, Another Bank Crisis

The CEO of Deutsche Bank (DB) has a message for you: The balance sheet is strong, liquidity is good and there is no need of an equity infusion. He may be right but it absolutely does not matter. Once a bank loses confidence, the worst fears are always realized. Your stock falls, your bonds drop, depositors leave, other banks refuse to do business with you, and down you go. That’s the reality of a fractional banking system whose assets are long term and illiquid, leaving the bank dependent on overnight access to funds to meet daily requirements.

Lehman Brothers did not seem to be in that much trouble in 2008 but rumours started, shorts attacked its stock and debt and market confidence was lost. JP Morgan pulled the plug on key banking lines and seized Lehman’s available collateral which it had on deposit. The Fed refused to bail it out, so the end only took a few days. That was it.

So, you say, obviously the German Government will bail out DB; surely they won’t let the world’s 11th largest bank trigger another Lehman-like disaster. Not so fast. If the Germans break all their own rules, how can they continue to say no to Italy, whose banking system is in far worse shape (see my post of September 19). And while you are at it, Spain and Portugal also have some very serious banking issues to confront. If Germany steps in, all discipline within the EU is lost. Therefore, expect the EU to require a bail-in as well as a bail-out, where large depositors and creditors share in the pain, not just tax-payers. The bail-in provisions are in place and they were test-driven in Cyprus in 2012-13. Expect that to hit the euro currency hard as investors flee to the dollar.

Now, is DB all that important? Yes. Simply, it’s one of the world’s most systemically important banks and the proverbial “canary in the coalmine” for Europe. What happens to DB reflects the health of the entire system. DB is perched atop the largest derivatives book in Europe, a $61 Trillion pile of who knows what, which is 20 times the size of the German economy. DB has ties to almost every major financial institution in the region. The EU banking system is $46 Trillion in size, THREE TIMES larger than the US banking system which nearly took down the world’s financial system in 2008. And the EU banking system as a whole is leveraged at a ridiculous 26 to 1, more than twice the US. A 4% loss on assets wipes out the banking system’s capital. For reference, Lehman was leveraged at about 30 to 1.

The fact that this is a systemic problem is clear from the stock performance of the major EU banks. Below is DB, now trading at all-time lows:

gpc-db

Credit Suisse (CS) is trading BELOW its 2012 banking crisis lows.

gpc-credit-suisse

So is Barclays (BCS)

gpc-barclays

So here is my guess dear reader.

  • Bank runs will begin in several major EU banks as depositors are spooked.
  • Germany will be forced to bail out DB. This will involve key elements of a bail-in including haircuts for depositors and creditors as well as government/EU/ECB funding.
  • The EU will then have to co-ordinate combined bail-outs/bail-ins for most of the rest of the European banking system.
  • Angela Merkel will lose her job as Chancellor.
  • The euro will collapse.

Hopefully I’m wrong and it isn’t that bad. But it could easily go there in a surprise chain of events not unlike the 2008 banking crisis which almost no one saw coming.