Deutsche Bank Is Not the Next Credit Suisse

After the collapse of Switzerland’s second-largest bank, Credit Suisse, investors looking for the next bank failure fixed their eyes on Deutsche Bank, Germany’s largest bank.

The tell-tale signs of blood in the water appear in a bank’s share price and the cost of its credit-default swaps (CDS). Equity investors last week sold off Deutsche Bank shares as credit investors drove up the price of its CDS, which are insurance contracts against a default on its debt. And in today’s market, when investors get spooked, depositors are quick to follow.

Like America’s Federal Reserve, the European Central Bank (ECB) is also hiking interest rates in an attempt to tame runaway inflation, after years of forcing interest rates down near zero and buying up bonds to drive up lending, spending and asset values. And like in the United States, European investors and depositors are rushing away from any banks that show signs of weakness—leading to the failure of Switzerland’s second-largest bank, Credit Suisse, on March 20.

But some analysts say that Deutsche Bank, a global giant that at its height in 2007 was worth $75 billion but has now fallen to $21 billion in market capitalization, is no Credit Suisse and that it can weather the current crisis.

“We have no concerns about Deutsche’s viability or asset marks,” wrote research analysts Stuart Graham and Leona Li, of Autonomous Research, a subsidiary of AllianceBernstein. “To be crystal clear – Deutsche is NOT the next Credit Suisse.”

German Chancellor Olaf Scholz stated at a news conference on March 24 that Deutsche Bank had “thoroughly reorganized and modernized its business model and is a very profitable bank.” Scholz said he saw no reason to believe that the bank was in jeopardy.

A March 24 research report from JPMorgan stated: “We are not concerned today about counterparty [or] liquidity issues” with Deutsche Bank. Analysts believe the sharp sell-off in Deutsche’s shares is the result of concerns about its relatively large holdings of commercial real estate assets, as well as its exposure to complex financial instruments called derivatives, but they predict these problems are manageable and will not take the bank down.

Dark Clouds in Europe

While European and American banks are both struggling to cope with rising interest rates, Europe has some additional, unique problems. While American banks like SVB and Signature Bank were taken down by their exposure to market risk as their portfolios of fixed-rate assets fell in price amidst rising interest rates, credit risk was not a factor. U.S. banks’ holdings of Treasury bonds and mortgage backed securities were not seen to have a risk of default.

However, sovereign and corporate debt in Europe is coming under increasing pressure, and credit risk may become a concern. Following the 2008 mortgage crisis, European debtor nations like Greece appeared likely at the time to default on the bonds they issued. The crisis spread throughout the banking system, because many banks had invested in sovereign bonds, considering them risk-free from a credit perspective.

In 2012, amidst speculation that the euro itself would collapse, the ECB stepped in and bought up the sovereign bonds, with then-ECB President Mario Draghi famously declaring that he would “do whatever it takes” to defend the euro. The ECB sharply accelerated its purchases of bonds during the pandemic, with its balance sheet ballooning to 8.5 trillion euros (about $9.3 trillion). Now the ECB has declared its intention to reduce its balance sheet, which will likely drive down the value of European debt.

On March 1, the ECB declared a policy of “quantitative tightening” (QT), or reducing its portfolio of bonds, after eight years of balance sheet expansion. Its balance sheet is currently about 7.9 trillion euros.

In addition to the effects of monetary policy, many companies in Europe are now facing sharply escalating costs from shortages of oil and gas as the embargo of Russia, its main supplier, together with a poorly performing transition to wind and solar power, take their toll on Europe’s economy.

A History of Risk Management Failures

One thing Deutsche Bank shares with Credit Suisse is a recent history of risk-management failures.

Founded in 1870, Deutsche Bank was Germany’s first international bank at a time when German companies had to rely on British or French banks if they wanted to do business overseas. The bank developed into a major player in global finance, employing 65,000 people in 74 countries today. It is a universal bank, offering consumer banking, corporate banking and investment banking.

In 2008, as a major arranger of collateralized debt obligations (CDOs), Deutsche Bank took a hit during mortgage crisis, with subsequent investigations revealing a senior executive calling some of the bonds it sold “crap” and “pigs” in emails to colleagues. In 2014, it paid a $1.93 billion fine in a settlement over misconduct with mortgage-backed securities, the first in a series of scandals and fines.

In 2015, Deutsche Bank was fined $2.5 billion by U.S. and UK regulators over a LIBOR-fixing scandal. That same year, it was fined an additional $258 million for doing business with Iran, Libya and other Middle Eastern countries that were under U.S. sanctions. The bank posted a $7.4 billion loss that year.

Soon thereafter, the bank was in trouble again, charged and fined $425 million for money laundering for Russian criminal gangs. The operation, dubbed “Global Laundromat,” featured a complex international network of accounts and as much as $80 billion in illegal funds.

In 2018, the bank appointed a new CEO, Christian Sewing, who set about restructuring, downsizing and reforming the company. Looking back today, many analysts believe he has succeeded and that the bank is on stronger footing going into the current crisis.

In 2022, Deutsche Bank generated 5.66 billion euros in profits, its best year since 2007. At the same time, the bank’s equity cushion increased, with its tier 1 equity ratio at 13.4 percent, which is generally considered a healthy level for banks. The Autonomous Research report stated that Deutsche Bank is now solidly profitable with its most solid capital ratios in decades, with lower interest-rate risk than many U.S. regional banks.

Will Credit Risk Add to Banks’ Problems?

To date, banks have largely faced only interest rate and liquidity issues. Credit problems, or defaults within their asset portfolios, have yet to be a factor, though they may be coming.

European countries and companies are under pressure, both from energy shortages and the price inflation that has resulted from that, and from rising interest rates. While European countries tied to the euro have succeeded recently in reducing their debt levels, a number of countries are still highly leveraged.

A report by Eurostat, the statistical office of the European Union, found that EU sovereign debt had on average declined from 90 percent of GDP to 85 percent between 2021 and 2022. However, more leveraged countries included Greece debt at nearly 180 percent of GDP, Italy at nearly 150 percent, and Portugal at 120 percent. Spain, France and Belgium had debt levels that were about 115 percent of their GDP.

U.S. federal debt, similarly, increased from 64 percent of GDP at the beginning of 2008 to about 100 percent through 2019; in 2020, it shot up to 135 percent. As of year-end 2022, U.S. debt was 120 percent of GDP.

During the COVID pandemic, European banks bought more than $218 billion of European sovereign bonds, bringing their total exposure to $1.75 trillion in 2020. Germany’s national debt is about 70 percent of GDP, indicating relative safety, at least from a credit perspective.

While the market risk of owning fixed rate assets against bank deposits was clearly demonstrated when Silicon Valley Bank (SVB) failed for this very reason, analysts say that Deutsche Bank’s assets are more diversified and its liquidity is significantly stronger. JP Morgan Chase reports that Deutsche Bank’s liquidity coverage ratio, which measures its ability to repay depositors, was 142 percent at year-end 2020, including 219 billion euros in high-quality liquid assets, which is a 64 billion euro surplus above requirements.

The report further notes that the bank’s liquidity reserves are above regulatory limits, at 25 percent of its balance sheet. Furthermore, during the previous bank crisis of 2015-2018, Deutsche Bank lost only 3 percent of its depositors and it would likely benefit from any flight to quality, if depositors start fleeing from weaker banks.

Like the U.S., European debtors will now be forced to pay significantly more in interest as the ECG hikes rates to fight inflation. And while the recent unusually warm winter has reduced energy demand and allowed Europe to dodge a bullet regarding restrictions on the supply of oil and gas from Russia, European companies may not be so lucky in the year to come.

In addition, Europe has ventured even farther than the United States into government-directed industrial policy, regulating and subsidizing a transition from fossil fuel energy to wind and solar and from internal combustion engine cars to electric vehicles (EVs). An example is a contemplated European Union ban on new gasoline-fueled cars by 2035, which would impact car manufacturers that employ more than 3 million people in Germany and make up 12 percent of its industrial base.