The European banking system has been in a bit of a crisis in the last few years. Major European banks have not recovered from the low valuations that they received during the 2008-09 banking crisis in the United States.

American banks seem to have recovered from the shock and are close to their previous valuations. However, the valuations of European banks have been down by as much as 70%. Major German banks such as Deutsche Bank and Commerzbank are the ones that have been hit the worst.

At the present moment, the market capitalization of Deutsche Bank is a mere 15% of what it was during its peak. The case with Commerzbank is also the same. Deutsche Bank is a German institution which is considered to be systemically important by many. Its existence goes to about 150 years in the past, and the bank has never faced an existential crisis like it is facing now.

The Scale Of Deutsche Bank’s Operations

The problem with European banks is that they have very large balance sheets and exposure to a lot of risky assets. European banks in total hold about 31 trillion euros in debt. This sum is close to three times the GDP of Europe. The problem is that it is a known fact that these banks are carrying over 900 billion in bad loans on their books. This amount is greater than 30% of the market capitalization of these banks.

This is also the case with Deutsche Bank. This balance sheet of Deutsche bank accounts for more than 45% of the German GDP. This is a dangerous situation to be in from a risk mitigation point of view. Since Deutsche bank is so large in size, the government will not have an option but to bail out the bank. If Deutsche Bank is in crisis, it means the entire German economy is in crisis.

The Reasons Behind Deutsche Bank’s Poor Performance

European banks have been performing very poorly in general. Deutsche Bank is a perfect case in point for the malaise that has spread through the system.

• Firstly, Deutsche bank has a problem earning money from its conventional sources. This is because the interest rates in Europe are near zero. As a result, the net interest margin is not very high. This is because corporates can borrow money from the bond market directly at rock bottom prices
• This has spurred banks like Deutsche bank to get heavily involved in derivatives. Deutsche Bank has a very large and opaque exposure to derivatives trading. A lot of these transactions have reflected in the past profit and loss statements as losses. This is the reason why investors are wary about buying Deutsche bank stock since the real extent of derivatives exposure is not really known.
• Deutsche Bank has been making highly leveraged investments. The Basel -3 norms stipulate that banks must have a leverage ratio of at least 3%. The Deutsche Bank leverage ratio is below that. This means that Deutsche bank does not comply with global norms. Also, the leverage ratio present in Deutsche bank is comparable to what was present in Bear Sterns when the bank got wiped out by an adverse market movement. Since then, the Americans seemed to have learned their lesson.

  American regulators have stipulated a 5% leverage ratio, which is much higher than the Basel norms. It is high time that the German regulators prevented a systemically important institution from making leveraged bets.

Why Bailing Out Deutsche Bank Will Be Difficult?

• Germany has been preaching about the demerits of bailouts to other countries. In such a scenario, bailing out Deutsche bank will make Germany look hypocritical, and it will be a major blow to German leadership.

  Angela Merkel has personally criticized other European leaders for using taxpayer money to bailout private banks. Now, it seems like Angela Merkel will have no option but to bail out the failing Deutsche bank. However, both Merkel and the German parliament will try to avoid such a bailout as long as they can. This is because such a bailout is against the German principles

• Private shareholders will not be willing to purchase the equity shares of Deutsche Bank. This is because the bank is so highly leveraged that any capital infused into the system will benefit the creditors and depositors. Equity shares, on the other hand, are at the risk of losing their entire investment. This is called “debt overhang.” It is a situation in which excessive debt that a company already has prevents it from raising any more equity.

The root cause of the entire situation is the lack of action taken by the European regulators. American banks were facing the same problems. However, after the 2008 crisis, the American regulators forced banks to raise more equity by raising the capital requirements. On the other hand, the European regulator listened to the bankers and eased the capital requirement norms. The end result of the situation is clearly visible. American banks are now on a sound footing whereas German behemoths like Deutsche bank face a risk of total collapse.

The bottom line is that bailouts do NOT make an economic system stable. Instead, it is a reasonably high capital requirement which leads to long-term stability of financial institutions like Deutsche Bank.