Did Deutsche Bank Just Default?

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Deutsche Bank has announced that it is cancelling its global equity business and laying off 18 thousand workers by 2022.  The bank has long been rumored to have troubles with its outsize derivative portfolio and maintaining profits. But the latest moves looks an awful lot like a restructuring we have seen in the not so distant past.

Deutsche Bank Layoff
Image Courtesy NY Times

Many remember the $7.2 billion in fines the bank paid in 2017 as a result of its role in the 2008-9 financial crisis. The bank plans to restructure operations to the tune of $8.3 billion, about 1/3 of its entire market cap. Where is the bank going to find that money to finance the restructuring? Reports are that the bank doesn’t need to raise capital to pay for the employee cuts, which some employees have said amounts to one month’s severance pay. The bank does intend to create a ‘bad bank’ entity to wind down $83 billion of risk weighted assets. Exactly how the company expects to do this remains to be seen, but ratings agencies are skeptical.

Rating agency Moody’s said there were “significant challenges” to executing the plan swiftly, adding it would keep its negative outlook.

Does This Sound Like Lehman?

Lehman’s collapse left 30,000 employees in New York jobless. Deutsche employees being let go are worried they will be able to find jobs in their field, or if they will have to retrain into new sectors of the economy. This is, by all accounts, the largest layoff of bankers since Lehman during the financial crisis. Overall, Wall Street banks have never recovered all of the employees they lost during the last crisis, and that was before the Deutsche Bank announcement.

Many Wall Street players have said the plan is “very deep, radical, and challenging”. JP Morgan notes that risks to DB’s plan include a general slowdown in the world economy resulting in weaker credit quality and revenues. Barclays wonders if the bank can execute the plan without substantial impact to its revenues. RBC Capital Markets remarked that they believe executing the plan will lead to deterioration and probably require the bank to raise capital.

In other words, the market is not too sure that Deutsche Bank is going to survive going forward. If the bank folds, it will send reverberations around the world. That is perhaps why regulators in Europe are working closely with DB to monitor and assist in the plan. The European banking sector cannot let a global giant such as this one to fail. In fact, given the interconnections of all of the credit markets, the world cannot afford to let it fail either. Despite the plans; however, success looks doubtful.

Chinese Banks are Suffering More Losses

Elsewhere, China’s banking system also appears to be in trouble. Per the Wall Street Journal,

Chinese officials have been adamant that last month’s regulatory takeover of Baoshang Bank, a small lender in northern China, was an isolated case and not indicative of broader problems at small banks. Markets, eyeing some obvious signs of trouble, don’t agree.

Since the problems with Baoshang Bank, COD rates have risen to attract new capital into the system, but issuance of them have at the same time fallen. China recently had to settle down problems with another of it’s banks, Bank of Jinzhou, by issuing a credit risk mitigation warrant, an instrument similar to a credit default swap. If the bank defaults, a state-owned issuer will pay up. Essentially, the government is backstopping the banking system to prevent a run of failures. As many as 19 small banks have delayed releasing their 2018 annual reports, perhaps to delay more bad news spooking the Chinese banking sector.

Chinese banks ended the 2018 year with $420 billion in bad loans. Banks are having to allocate more money to loan loss provisions. Analysts think the bad loan figures being reported may be low due to the recent amounts of defaulted debt and because bad debt definitions are very liberal. This may allow Chinese banks to hide loans going bad for some time until they have to report them. Bad banks, known as AMCs, are becoming more common. As a result, the Chinese market is becoming more capital restrained and may not survive unless public assistance is provided.

What This Means for World Banking

The banking sector in major manufacturing sectors such as Germany and China are beginning to show serious cracks. Further, intervention by government authorities may be glossing over just how bad the issues are. There is no telling how quickly the bad loan contagion may begin to spread to other major markets, such as the US. given how much capital is invested among the banking sector, banking defaults in major economies like the ones discussed could spread risk all over the rest of the world.

Given the data that we have been tracking in consumer spending and production across the world, it certainly appears that the recessionary pressures in the world economy are starting to be noticed in the banking sector. That should give Europeans and Americans pause on how much to trust their banks to store their money, assets in safe deposits, and how much of their retirement funds they want exposed to the financial sector. At the very least caution is advised as we see how far the banking sector woes spread while the world economy slows. If past recessions are any indication, we should expect multiple bank failures and possibly even widespread bank holidays.

Certainly, we should not hide our heads in the sand and pretend there are no problems. Rather, we will continue to watch the world economy moving forward and examine the risks that further slowdown may raise.

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