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As I’ve mentioned, the European banking system is a key risk, and Deutsche Bank—one of the largest banks in Germany and Europe—is catching headlines over its troubles. There’s been a great deal of speculation about what this means for the U.S. and world economies and for stock markets. Some have even suggested this might be a “Lehman moment” that could trigger another financial crisis. I asked our international analyst, Anu Gaggar, to take a look and report back on what she found. — Brad
All the negative news coverage and commentary on Deutsche Bank is certainly disturbing, as is the company’s plummeting stock price. The stock, however, seems to be trading on headline risk and not necessarily on changing fundamentals. Is it possible there's more smoke than fire here?
Most of the damage may already be done
The immediate risk, and the one that has provoked the headlines, is the potential fine imposed on Deutsche Bank by the U.S. Department of Justice. This has rattled markets, and justifiably so. But the initial fine doesn’t necessarily reflect the final fine, which in the past has ranged from 30 percent to 70 percent of the amount originally quoted. If that’s any indication, the fine is likely to be around $7 billion or so.
The good news is that Deutsche Bank has already reserved $6.5 billion for fines, which means that the damage, at least in financial terms, has largely already been accounted for. Given this, could the U.S. fine on Deutsche Bank bring on the next financial crisis? Most likely not, for the simple reason that most of the possible financial damage appears to have been baked into the bank’s accounts. And much of the reputational risks are already reflected in the share prices.
On a larger scale, the current media tumult is actually a good thing. This kind of coverage means that other financial institutions are fully aware of the risks and actively working to reduce their exposure. Part of what made the Lehman crisis so damaging was that it came out of the blue. No one can say they weren’t warned about this one.
A closer look at the risks
None of this is to say there won’t be costs and risks. There will, and they need to be watched.
The short term: The reality is that Deutsche Bank’s balance sheet is much stronger today than it was during the last financial crisis. The bank isn’t out of the woods yet, having failed the Fed’s stress test for the second year in a row, but it did fare better in the tests earlier this summer. The bank has nearly $250 billion in liquid assets and, as mentioned, has set aside $6.5 billion in reserves for fines, which could come close to covering the final amount. The bank’s CEO, John Cryan, is reportedly in talks with the DOJ to negotiate a final settlement. In all, the risk posed by the fine looks likely to be short term.
The longer term: Although the immediate risks are probably overstated, the longer term risks are very real.
Effects on European banking system. We are concerned about the bank’s derivatives book and income statement, and what they imply for the rest of the European banking system. In many ways, Deutsche Bank is the poster child of all the ills that plague Europe's banking sector. Negative interest rates coupled with stricter regulations mean that there are fewer avenues for banks to generate income, which stands to damage the system over time. Regulatory restrictions that limit what banks are allowed to do to restructure and cut costs exacerbate the problem. This doesn’t bode well for the economic growth of European economies, possibly keeping them in the vicious cycle of negative interest rates and slow growth for even longer.
Limited exposure for mutual fund investors. For U.S. investors, particularly in Deutsche Bank mutual funds, there is another concern—the health of that business. Deutsche Asset and Wealth Management accounts for nearly 5.5 percent of the company’s assets but generates nearly 16 percent of its revenues. Given its disproportionate contribution to profits, Deutsche Bank’s funds unit should continue to be a priority.
As far as custody risk, the funds of the asset management company are held separately from the parent, with individual teams maintaining their own balance sheets. The company has been proactive in reassuring the asset management teams that their bonus pools won’t be impacted by what happens at the parent company. Employee morale could be low in such an environment, however, and turnover is something to watch. The company is also consolidating some of its nonstrategic lines of business, and we expect that to continue.
Challenges, yes, but catastrophe unlikely
Deutsche Bank faces significant challenges, to be sure, but the immediate concern seems exaggerated and unlikely to lead to a systemic crisis. For U.S. investors in the bank’s mutual funds, there is a clear legal and operational separation between the parent company and the asset management company, meaning that fund investors are not directly exposed.
That said, this is an evolving situation, and investors would do well to keep watching, just as we here at Commonwealth will be.
