28 septembre 2016

Deutsche Bank: What if…?

Over recent months, Deutsche Bank (DB) has been in dire straits. Its share price has plummeted (-52% year-to-date); its CDS have skyrocketed (see figures 1 and 2). At the beginning of this week, German politicians even intervened by assuring that a bailout would neither be needed nor granted (if needed). Like in the world of sports, the news unnerved investors. For declarations of allegiance often occur just prior to a coach being fired. Investors also shifted their focus to a more fundamental question, « What if Deutsche Bank fails? »

Please note that we do not know if DB may fail or survive. However, investors obviously worry about the bank much more than about its competitors (see figure 3).

Moreover, we can to some extent imagine what may happen immediately after DB were to collapse:

  • Credit Contagion: Investors might quickly lose faith in other institutions, too, as the extent of their financial ties is opaque. A look at the common behavior of global banks’ credit spreads shows that DB is closely related to the network’s most connected nod, Commerzbank (see figure 4). This helps to understand the potential pattern of contagion. In a first round, the failure of DB would rattle Commerzbank, Germany’s second largest lender. In a second round, the shock may then be forwarded to Goldman Sachs, Credit Suisse, Société Générale and Unicredit. This means that the stability of the global banking system hinges to a large extent on the capacity to avoid second-round contagion. Therefore, any rapprochement between DB and Commerzbank would increase the risk of contagion because it would make credit markets more vulnerable.
  • Derivatives: As argued last week, at the end of 2015, DB had derivatives with a notional value of EUR 42tn on its books (see figure 5), most of them opaque OTC trades. Accordingly, in the case of bankruptcy, DB’s OTC counterparties stand to lose some portion of this amount, even if the ultimate financial impact is certainly mitigated by collateral holdings. What makes matters worse is that according to the IMF, DB seems to be the most interconnected global bank in terms of derivatives trades (see figure 6). Therefore, the bank’s demise may send shock waves into global derivatives markets thereby hurting other financial institutions.
  • ETF/ETN: Through its asset-management arm, DB is a big player in ETF and ETN products sold to retail and institutional investors alike. A particularity of DB’s ETF business is the « hybrid » replication method using derivatives rather than owning the underlying asset. Taking into account the bank’s strength in derivatives, DB is most likely a prominent counterparty to these derivative trades. Thus, « hybrid » ETF holders are exposed to the same derivatives risk described above. By contrast, ETNs are essentially a debt obligation with a complicated payment schedule. Whoever owns ETNs actually lends to DB and bears an implied risk on the bank.
  • Contingent Convertible debt: Although the Sub CDS of Deutsche Bank rose to an all-time high of 470 bps (see figure 7), contagion to other CoCo debt has been contained so far as illustrated by the mild correction of the Contingent Convertible European Banks index (see figure 8). Remember that holders of DB’s CoCo debt may be the ones to suffer like equity shareholders in case of default.
     
  • Bailout: Although German lawmakers seem eager to avoid their involvement before federal elections in 2017, a bailout is of course possible. The advantage of this approach is that, by construction, the bailout would transfer some of Germany’s creditworthiness to the bank thereby helping to stabilize Deutsche Bank solvency. In addition, second-round contagion effects may be contained to a minimum. The apparent disadvantage is that Germany’s capacity to financially support other struggling European countries would be hampered. Another political drawback is that the harsh stance of Germany towards the bailout of Italian banks would be undermined.

To sum up, the demise of DB might interrupt financial markets, most notably in the credit and derivatives markets. But ETFs and ETNs could also be harmed. The ultimate financial impact, however, considerably depends on potential second-round contagion. In this respect, there are two lessons to be learned. First, merging DB and Commerzbank would actually make credit markets more vulnerable to shocks. Second, a government bailout may allow to stabilize DB’s credit spread thereby preventing second-round effects altogether. Only time will tell.

 

Figure 1: Performance of selected banks

 

Figure 2: Credit spreads of selected banks


Figure 3: Risk aversion of selected banks


 

Figure 4: Network analysis of global banks relating its CDS to the closest neighbor according to a correlation based distance (the higher the correlation, the shorter the distance).


 

Figure 5: German GDP, EU GDP and Deutsche Bank’s Derivatives Book (in trillion EUR)


Figure 6: Systemic Risk among Global Systemically Important Banks (GSIB), from the IMF Country Report No 16/189, p. 31


 

Figure 7: CDS of Deutsche Bank Subordinated Debt.


Figure 8: Contingent Convertible European Banks Index