Deutsche bank robbery: the makings of a financial disaster, a bank morphs into a hedge fund.

Author:Engelen, Klaus C.

Worries about the fragile state of the largest lender in both Germany and Europe, Deutsche Bank AG, dominated the unofficial agenda when bankers and finance officials from all parts of the world came to the annual meetings of International Monetary Fund, the World Bank, and the Institute of International Finance in Washington this October.

At the time, the headlines in the financial press on the smoldering Deutsche Bank crisis were indeed scary. On September 26, 2016, The Telegraph came out with the dire prediction: "The Deutsche Bank crisis could take Angela Merkel down--and the Euro." A day later, Bloomberg headlined, "Deutsche Bank Returns to Haunt Merkel in an Election Year."

During the IMF/World Bank meetings, Deutsche Bank's domestic rival Commerzbank--which still carries a large government rescue debt--kept up the tradition and invited the German financial community in attendance to a buffet cruise on the Potomac river aboard the Cherry Blossom. On the same day, EurActiv warned in its cover piece, "Financial expert: Deutsche Bank collapse 'would probably trigger new global financial crisis.'" On CNBC, U.S. Attorney General Loretta Lynch was confronted with the accusation, "How U.S. regulators may be creating panic around Deutsche Bank."

From IMF veteran Mohamed El-Erian, who ran the huge investment fund P1MCO and who still advises Allianz AG, came an explanation of why Deutsche Bank and other banks still have a confidence problem with the markets. "This uncertainty and especially the uncertainty around Level 3 assets [for which market pricing is lacking] causes people to price in a very high risk premia in the banking sector," he told Bloomberg. "It shows you Europe has been well behind the U.S. in strengthening its banking system."

At the IMF/World Bank meetings, Germany's official delegation headed by Finance Minister Wolfgang Schauble and Bundesbank President Jens Weidmann strictly followed a no-comment strategy on the Deutsche Bank crisis, with other German bankers going into hiding on the haunting issue. Earlier this year, Schauble made clear that he considered Deutsche Bank as "rock solid."

This year's Deutsche Bank presence at the Washington bankers' summit contrasted with those illustrious IIF gatherings in previous years. From 2006 to 2012, Deutsche Bank's head Josef Ackermann dominated the stage as chairman of the influential Institute of International Finance, the global association of the financial industry with nearly five hundred members from seventy countries. This year, however, current Deutsche Bank CEO John Cryan was not in sight. He did, however, attend a reception at the German Embassy where he spoke to his German banker colleagues about his dilemma. On the one hand, Deutsche Bank has been and is a major lender to the Trump real estate empire with a volume of loans of $2.5 billion since 1998 and outstanding loans to Trump entities of well over $300 million, the Wall Street Journal estimates. On the other hand, there is considerable uncertainty over whether the old or the new U.S. administration will eventually decide on Deutsche Bank's pending U.S. Department of Justice penalty claim of $14 billion.

The crisis currently engulfing Deutsche Bank as the dominant financial institution at the helm of what used to be the economically powerful "Deutschland AG" is one that has taken many people outside the financial community by surprise. But experts and market pundits saw Deutsche's disaster coming for many years.


In June 2016, the International Monetary Fund, as part of its Financial Sector Assessment Program report on Germany, expressed the dire warning: "Both Deutsche Bank and Commerzbank are the source of outward spillovers [of systemic risk] to most other publicly listed banks and insurers. Among the global systemically important banks, Deutsche Bank appears to be the most important net contributor to systemic risks, followed by HSBC and Credit Suisse. In its report the IMF presented a chart showing the key linkages of the world's riskiest banks and warned, "The relative importance of Deutsche Bank underscores the importance of risk management and intense supervision of G-SIBs [globally significant banks] and the close monitoring of their cross-border exposures."

In reaction to the IMF paper, Simon Jack, the BBC's business editor, reminded his audience that Deutsche Bank's U.S. unit "was one of only two of thirty-three big banks to fail tests of financial strength set

by the U.S. central bank earlier this year. (The other was Santander of Spain).

At the center of market concerns about Deutsche Bank is its huge derivative exposure and its extremely high amount of Level 3 assets. As follow-up to the IMF labeling Deutsche Bank as the most dangerous bank in terms of systemic risks, major magazines and newspapers have tried toassess the danger of the bank's huge derivatives exposure and Level 3 volume.

Fortune concluded in its September 27, 2016, piece "5 Things You Should Know About the Deutsche Bank Train Wreck" that Deutsche "has an inconceivably huge derivatives portfolio."

"Deutsche has the world's largest so-called derivatives book--its portfolio of financial contracts based on the value of other assets--in the world. It peaked at over $75 trillion, about twenty times German GDP, but had shrunk to around $46 trillion by the end of last year," said Fortune writer Geoffrey Smith. He added, "How scary is that? Less than it sounds. The overwhelming majority of those exposures are hedged against other trades, resulting in a far lower net exposure."

Fortune, however, remains worried that Deutsche Bank is too interconnected to fail, not very well capitalized, already in the Fed's bad books, and is struggling because of weak earnings.

Mike Bird of the Wall Street Journal presented a very balanced perspective in his October 5, 2016, article on Deutsche Bank's derivatives book. On Deutsche Bank's exposure to derivatives, Bird argued that the "raw size can be misleading, since it...

To continue reading