Measure U.S. Banks' Credit Exposure to Deutsche Now

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Deutsche Bank, which is interconnected with the world's largest financial institutions and corporations, continues to experience massive problems that have led to multiple fines and layoffs. It is incredible that the credit rating agencies have not downgraded the globally systemically important bank's debt ratings this month. Plenty of signals already exist for the rating agencies to act on an accident waiting to happen.

Twice this year, the International Monetary Fund has stated that the almost $2 trillion-asset institution is of systemic importance and concern. The bank's market capitalization has declined a little more than 50% in twelve months, according to Bloomberg data. The credit default swap market, which is a highly watched indicator to determine the credit quality of an issue, shows that trading referencing "Deutsche Bank bonds" surged to a six-month high at the end of September. And according to the Depositors Trust Clearing Corp., there are about a net $3.78 billion of credit swaps outstanding on Deutsche Bank — the most for referencing any bank. Moreover, the German bank had to pay 290 basis points above Treasuries in a bond that it recently issued.

The market, as always, has been quicker than any rating agency to show that it believes that Deutsche is in trouble. The conundrum for Deutsche is very difficult to escape. The more that Deutsche's troubles increase, the more expensive it will be for it to borrow, further increasing its woes.

In an email to employees on Sept. 30, Deutsche Bank Chief Executive John Cryan said that the bank is complying with "all current capital requirements."

However, the key word is "current." Presently, we are not in a banking crisis.

And, in fact, the European Banking Authority's stress test exercise found Deutsche placed second to last, only coming in ahead of Italy's Monte dei Paschi di Siena. It is also of no comfort that the only reason that Deutsche passed the European Central Bank's stress tests was because the ECB allowed Deutsche to include a potential sale as part of its capital. This special treatment is egregious not only because it calls into question the fairness and uniformity in how the ECB runs its stress tests, but also because market participants rely on stress tests to learn about a bank's financial health in a period of stress.

It is also very important to remember that as a globally systemically important bank, Deutsche has significant flexibility in determining its risk-weighted assets. Under the Basel Committee for Banking Supervision's international uniform regulatory capital standards, Deutsche is allowed to use its own data and models to determine the probability of default of its assets. It can also design its own models to measure its market and operational risk exposures. No internal auditor or bank examiners are allowed a level of granularity to see how robust the models are or whether the ratios are correct.

As Deutsche is notorious for having old technological systems, it makes it hard to believe that its risk-data-aggregation processes are strong enough to make the bank's capital, liquidity and leverage ratios credible. Any investor in, or counterparty to, Deutsche should be seriously questioning the firm's ability to sustain unexpected losses.

Even if one could believe Deutsche's ratios as credible, how long can the bank stay well-capitalized if the U.S. Department of Justice ends up fining it $14 billion related to the way it sells residential mortgage-backed securities? Indeed, negotiations on a settlement with the department began in September, and the final cost of litigation remains difficult to predict.

Even smaller fines, such as the $9.5 million that Deutsche Bank Securities agreed to pay to settle the Securities and Exchange Commission charges, are mounting for a bank that has already coughed up a lot of money in fines and settlements.

Since 2008, The New Yorker wrote in an August article, Deutsche "has paid more than nine billion dollars in fines and settlements for such improprieties as conspiring to manipulate the price of gold and silver, defrauding mortgage companies, and violating U.S. sanctions by trading in Iran, Syria, Libya, Myanmar and Sudan."

Deutsche may be a foreign word, but Deutsche Bank in the U.S. is as American as apple pie. Through its banking entities, broker-dealers, asset management firms and special purpose vehicles in the U.S., Deutsche is very interconnected with banks, hedge funds, private-equity firms, insurance companies, pension funds, corporations, municipalities and individuals.

Deutsche Bank legal entities in the U.S. failed the stress tests mandated by the Dodd-Frank Act's Title I. In other words, in the event of significant market or credit stress, Deutsche in the U.S. would be insufficiently capitalized to withstand unexpected losses. If Deutsche were to fail in the U.S., the Federal Deposit Insurance Corp. would be responsible for resolving Deutsche's U.S. legal entities.

All this to say it is especially imperative that U.S. bank regulators ask the 25 largest U.S. banks to measure their credit exposure to Deutsche. It is not only our eight globally systemically important banks that are engaged in a wide range of transactions with Deutsche in the U.S. or abroad. Indeed, even regional banks hold derivatives and repurchasing agreements with Deutsche. All 25 banks invest in Deutsche's bonds and stocks and provide all kinds of short- and long-term liquidity and credit facilities to the German giant. 

Neither the bank regulators nor banks' risk managers can afford to wait until rating agencies downgrade Deutsche before understanding the level of exposure to the bank giant. Let us not forget that Lehman Brothers was rated "A" on Sept.15, 2008.

Mayra Rodríguez Valladares is managing principal of MRV Associates.

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