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Affluent Investor | April 28, 2017

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Deutsche Bank – The Snowflake That Could Trigger an Avalance

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Avalanches build up one special snowflake at a time. The last snowflake launches the avalanche. Financial avalanche specialists are wondering if the troubled Deutsche Bank will earn the honor of being that last special snowflake, the Lehman Brothers of the latest recession.

After Brexit, the IMF warned that the bank was the most significant contributor to systemic risks. Experts have expressed fears about its undercapitalized state for several years. Alt-M’s Keven Dowd confirmed that those fears are justified in his post “Is Deutsche Bank Kaputt?” He wrote that the bank claimed a leverage ratio of 3.5 percent in its 2015 annual report:

One can also compare Deutsche’s reported 3.5 percent leverage ratio to regulatory standards. Under the Basel III rules, the absolute minimum required (Tier 1) leverage ratio is 3 percent. Under the U.S. Prompt Corrective Action (PCA) framework, a bank is regarded as ‘well-capitalized’ if it has a leverage ratio of at least 5 percent, ‘adequately capitalized’ if that ratio is at least 4 percent, ‘undercapitalized’ if that ratio is less than 4 percent, ‘significantly undercapitalized’ if that ratio is less than 3 percent, and ‘critically undercapitalized’ if its tangible equity to total assets ratio is less than or equal to 2 percent.

The Federal Reserve is in the process of imposing a 5 percent minimum leverage ratio requirement on the 8 U.S. G-SIB (Globally Systemically Important Bank) holding companies and a 6 percent minimum leverage ratio on their federally insured subsidiaries, effective 1 January 2018.

The bank estimated its exposure to derivatives at €18 billion, but Dowd explains why that is far too low. And the author cuts through opaque bank accounting methods to reveal the true leverage ratio of Deutsche Bank:

One can obtain the market value estimate by multiplying the book-value leverage ratio by the bank’s price-to-book ratio, which was 44.4 percent at the end of 2015. Thus, the contemporary market-value estimate of Deutsche’s leverage ratio was 2.71 percent times 44.4 percent = 1.20 percent.

A leverage ratio of 1.20 percent means that losses on its loans of just 1.20 percent would wipe out its net worth. Dowd’s conclusion:

At the risk of having to eat my words, I can’t see Deutsche continuing to operate for much longer without some intervention: chronic has become acute. Besides its balance sheet problems, there is a cost of funding that exceeds its return on assets, its poor risk management, its antiquated IT legacy infrastructure, its inability to manage its own complexity and its collapsing profits — and the peak pain is still to hit. Deutsche reminds me of nothing more than a boxer on the ropes: one more blow could knock him out.

Collapse by Deutsche Bank would launch the financial avalanche because of the intricate interlocking of the crystals connecting all banks and financial institutions. Italian and French banks have been on the edge of the cliff for the last decade and failure by Deutsche would push them over the edge. The more than €18 billion in derivatives are essentially insurance policies that the bank has written for other banks and businesses. When the bank craters, those insurance policies will become worthless at the moment when the holders need them the most to help them recover from the crisis.

The stock market has weathered a lot of bad economic and financial news, including five quarters of declining profits with a sixth expected. It may not be able to survive the avalanche that Deutsche Bank causes.

 

Originally published on ABCT Investing.

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