The failure of New York-listed Lehman Brothers showed the world that no financial services group is too big to collapse. The Lehman Brothers bankruptcy set off a global financial crisis in 2008 that affected not only shareholders in similar stocks, but economies around the world for many years. With the troubles at Deutsche Bank looking eerily similar to those that presaged the end of Lehman, it is understandable that it is not only stock market investors who are keeping a close eye on how things are being managed at the German-headquartered multinational. It’s a tricky situation for Germany authorities, too, who will be reluctant to come to the rescue – as this will risk setting a precedent or creating an outcry that only larger organisations in the EU are protected. Helping to make sense of the Deutsche Bank woes and what they mean for the world is respected analyst Eamonn Walsh of University College Dublin. The accountancy professor unpacks the numbers and the issues, with a warning that there could be significant economic and political difficulties over the next few weeks. At best, he says, the Deutsche Bank crisis will create a sense of urgency to address EU banking sector challenges. Even bottom-feeders are unlikely to find Deutsche Bank attractive in its current state. – Jackie Cameron
By Eamonn Walsh*
Deutsche Bank is in the news for all the wrong reasons. Some speculators believe that it will be the 2008 Lehman Brothers collapse all over again. Shares in the bank were briefly driven down to single digits. They seem to have stabilised around €10 but this remains well below the €30 just over a year ago and €100 a share in 2007. And the bank’s future is uncertain.
Clearly investors are worried and there is an absence of people who believe even €10 would be a sensible investment. At €10 per share, an investor has a right to €48 of equity. But the problem is whether that €10 will ever be returned to you – let alone with gains. Like many other banks though, Deutsche Bank faces a number of headwinds, which have knocked its profits in recent years.
Deutsche Bank: Three structural issues
New regulation since the financial crisis requires that banks must accumulate their profits to create a greater cushion against the risks that became apparent in 2008. This means that the profits that Deutsche will earn over the next few years will be used to increase the size of that cushion rather than being returned to shareholders. Relief is unlikely, as the IMF has identified Deutsche as “the most important net contributor to systemic risks in the global financial system”.
Large well-established banks have a second problem. They have become fat with too many employees juggling outdated, disparate and often dysfunctional IT systems. Deutsche has more than 100,000 employees. Its retail branches – a number of which have been cut this year – are labour intensive and add to these problems.
Dealing with this problem requires reinvesting some of its profits in restructuring its activities – which again means less money for shareholders in the short-run. Failure to do so, however, will create opportunities for new entrants to the banking market such as alternative finance and new fintech operations.
We cannot tolerate, whether it’s Deutsche Bank, Wells Fargo or Bank of America, the kind of fraudulent activity that we've seen for so long.
— Bernie Sanders (@SenSanders) October 2, 2016
The European Central Bank’s negative interest rate policy is compounding problems. Historically, banks benefited from retail depositor inertia – depositors that park their money in accounts and don’t act upon earning little or no interest. A healthy deposit base ensured a source of zero or low-cost funds that could be lent elsewhere. But the benefit of depositor inertia disappears when interest rates go negative as it costs money to service these customers with extensive retail networks. Imposing user fees is unpopular with customers.
Crisis catalyst and management
These structural issues are well known. The catalyst for the recent action is a US$14 billion fine from the US Department of Justice for mis-selling mortgage bonds a decade ago. Deutsche is looking to negotiate a smaller figure, but if the $14 billion fine sticks the bank could need to raise another €9 billion of equity. At current prices, hapless investors would need to subscribe an additional 60% of their investment to simply hang on to the share of future profits that they expected to receive prior to the fine.
While Deutsche talks confidently of lowering its fine, it is unlikely to attract buyers for its stock. Meanwhile, speculators betting on a decrease in the share price are pushing an open door. Plus, given the dysfunctional nature of eurozone financial regulation, the high political costs of German government intervention and risk of signalling that larger eurozone members play by a different set of rules – the German government will be slow to intervene.
Talks between Deutsche Bank, DOJ continue but details in flux; no deal yet presented to senior decision makers on either side – Dow Jones
— CNBC (@CNBC) October 2, 2016
Adding to this complexity, the fine from the US government comes just days after the US$13 billion fine the EU hit Apple with, making some suspicious that there is an element of revenge at play. True or not, the uncertain outcome during the lengthy appeals process will only increase the perceived risks of an investment in Deutsche Bank.
From the sidelines, one would be sympathetic to the CEO’s statement that Deutsche is a strong bank that is being targeted by “forces that want to weaken us”. The bank has assets of more than €1.8 trillion and equity of €67 billion.
As a large, complex entity, it is easy for outsiders to speculate that the bank may be weak, further eroding investor and customer confidence in both the bank and European bank regulation. The coming days will largely determine whether the negative feedback loop between confidence and the stock price can be broken. At worst, the outcome will be significant economic and political difficulties in the coming weeks. At best, it may create a sense of urgency within the eurozone to comprehensively address the banking sector issues that have festered for the past eight years.
- Eamonn Walsh is Professor of Accounting, University College Dublin. This article first appeared at The Conversation.