Europe’s banking sector is back in the spotlight – and, once again, it is for less than positive reasons. Unlike earlier episodes, however, the focus is not on the periphery of the region but its heartland. Obviously, we are talking about Deutsche Bank (DB), the largest investment bank in the EU, whose share price has taken a battering over the past several weeks (indeed, months). For a financial institution of this scale and global interconnectedness this is a worrying development for many. Indeed, some commentators have drawn comparisons with Lehman Brothers whose failure in September 2008 contributed, in no small way, to putting the Great in Great Recession.
The trigger for the latest slump in DB’s share price was the recent announcement by the US Justice Department that it intends to fine the German bank USD 14bn for alleged missselling of mortgage-backed securities. This fine was much higher than widely expected [1] and, coming so soon after the EU announced it was fining US tech giant Apple EUR 13bn [2], one has to wonder whether international politics had any bearing on the amount in question.
Given politics is primarily about the art of comprise, there is likely to be some room for negotiating the amount down; Deutsche Bank’s CEO certainly thinks so. Indeed, the Justice Department has indicated as much by saying that the fine could be lowered in return for “co-operation”. That said, while a reduced penalty would be positive for DB, we consider the magnitude of the fine to be relatively unimportant.
What is clear from examining the trends in crowd-sourced sentiment indicators is that concerns about DB are hardly new and certainly pre-date the announcement of the fine. As can be seen in the exhibits below, the crowd view on DB has been negative for quite some time. Sentiment has been consistently below zero since July last year (when DB’s share price was trading three times higher than its current market price) and, aside from a fleeting move into positive territory back in May, the same is also true for Optimism [3].
Exhibit 1: Crowd-sourced Sentiments – Deutsche Bank
Source: www.Amareos.com
In addition, crowd-sourced measures of Stress and Fear – both negative sentiments- towards DB have been on an oscillating, but consistent, uptrend since May 2015. This is further confirmation that the crowd has been increasingly negative towards Germany’s leading bank for many months, with the main area of concern relating to the degree of leverage in the balance sheet, which at EUR 1.4tr utterly dwarfs DB’s EUR 15bn market capitalization [4]. The significance of the fine, in our judgement, is that simply brought this longstanding concern back to the forefront of investors’ minds.
Exhibit 2: Fear & Stress Sentiments – Deutsche Bank
Source: www.Amareos.com
As we have outlined in previous insights [5], the ability of the “many over the few” to outperform is hindered (crowd fail in our lexicon) when there is a high degree of correlation between individual views whether it takes the form of elevated bullishness or bearishness. Given the confluence of low Sentiment/Optimism and high Stress/Fear readings, and a stock price at multi-decade lows, it is tempting to make the case for a contrarian bullish argument for Deutsche Bank’s stock price. In our judgment, such temptations are to be resisted.
Commercial banks are different from almost any other type of private company in one very important respect. For a bank, even one the size of DB, confidence its greatest and most critical asset. And, just like trust, confidence is nebulous, fickle and asymmetric; that is to say, hard to acquire but quickly lost. As former BoE governor King famously noted, and as the Lehman episode validated,
“…it may not be rational to start a bank run, but it is rational to participate in one once it had started.”
For the avoidance of doubt, we are not suggesting or anticipating such an escalation in the case of DB. Actually, let us go further and state unequivocally that Deutsche Bank will not go the way of Lehman Brothers and any suggestion belies a misunderstanding of the issues at hand.
Rather, we are emphasizing the highly non-linear nature of banking sector crises. A non-linearity that stems from the fact that behaviour at such times is dominated by psychology, something the crowd-sourced sentiment indicators we track at Amareos are ideally suited to monitor.
As testimony to the importance of confidence, DB CEO John Cryan last week publicly stated that he sees no need for any state support because the institution is “comfortably equipped with free liquidity”. Unfortunately, the optics of this are not great especially because, as has been noted by some commentators [6], Lehman’s CEO Dick Fuld made similar public statements in the months prior to its failure [7].
One would think that the obvious course of action would be for the German government to step in and support DB, as other governments stepped in to support their banks during the Great Recession. Yet, Chancellor Merkel has been reported as saying that there would be “no bailout” of Deutsche Bank [8].
As the IMF annual review of the German financial industry published over the summer made clear DB is one of two “globally systemically important financial institutions” [9] in the country, with DB considered “to be the most important net contributor to systemic risks”. The size and global interconnectedness of DB – a direct consequence of its large balance sheet – is the very definition of an institution “Too Big To Fail”. This simple fact means that recent comments from Chancellor Merkel that there would be “no bailout” (if required) is a vacuous promise.
Nevertheless, her publicly stated position is understandable when one considers the political backdrop she is facing. German elections are, at most, just over a year away [10] and Merkel is already under considerable pressure because of the increase in support for the right-wing AfD party amid widespread criticism of her immigration policy. Naturally, therefore, she would prefer not to become embroiled in a bailout of the country’s largest bank at this point in time, particularly as the introduction of new EU legislation [11] in relation to banks makes burden-sharing (ie, private sector bail-in) a prerequisite for state-aid (ie. government bail-out).
A recent ruling [12] by the European Court of Justice, which made clear the bail-in legislation is compliant with EU law, does allow for exceptions in the event that it “endangers financial stability”. However, given the strong opposition from the German government [13] to PM Renzi’s efforts earlier this year to circumnavigate the bail-in clause and provide official support to Italy’s beleaguered banking sector [14], it is extremely difficult to imagine that the rest of the EU would acquiesce to any bail-in exemption for Germany.
Hence, a German government bailout of DB – if, of course, one is required – would almost certainly imply a bailing-in of the private sector (including equity holders, unsecured bond holders and potentially even depositors); not a politically palatable move.
Merkel’s strategy is best described as one of hope. If DB is able to weather the current storm, raise sufficient funds – again, if needed – under its own steam, either by capital raising or asset disposals, such that her government does not have to announce a bail-out/bail-in, all well and good. Unfortunately, shoring up a balance sheet by asset disposals and/or capital raising is always much more challenging when it occurs under duress as is presently the case [15].
If, instead, this proves not to be possible then the German government, reluctant as it may well be, will be forced to step in and backstop DB because the consequences of it not doing so would be catastrophic – not just for Germany but the entire globe [16]. Such action would avoid a repeat of the Lehman episode, but because it would necessarily involve some private sector burden-sharing, it is unlikely to lead to a strong rebound in DB’s share price [17].
At the risk of sounding like a zen mantra, given such risk-rewards the prudent course of action is one of inaction. That is until such time as crowd sentiment towards DB shows signs of a sustained pick-up, indicating that the all-important confidence factor is returning[18]. While this may sound easy (or even boring) it is worth recalling the words of David Tepper, the hedge fund manager who specializes in investing in distressed assets, and hence knows a thing or two about such situations:
“Sometimes the hardest thing to do is to do nothing.”
He ain’t wrong.
*Sentiment Analytics are based on MarketPsych indices.
[1] The same was also true of the Apple fine.
[2] A topic we covered in an earlier post see: https://amareos.com/blog/appletax/
[3] As a reminder to readers Sentiment is a measure of contemporaneous net positivity (ie positive minus negative) whereas Optimism is a measure of future net positivity.
[4] DB’s capital ratio, which also takes into account assets convertible into equity, stands at 11% – low by comparison with its peers but above the 7% minimum threshold.
[7] A cottage-industry has sprung up squeezing price charts so that the descent of Lehman’s stock price in the months prior to its bankruptcy mirrors the recent fall in Deutsche Bank’s stock price: eye-catching for genetically-predisposed pattern-seeking homo sapiens that we are but statistically lame.
[10] German law stipulates that a federal election must be held by 22 October 2017 at the latest.
[11] Formally known as the Bank Recovery and Resolution Directive.
[12] The ruling cannot be appealed.
[13] German Finance Minister Schäuble was a strong advocate of the bail-in legislation.
[15] Deutsche Bank announced this week that it had sold the UK unit Abbey Life Assurance Co for USD 1.2bn. The sale, while raising its Common Equity Tier 1 ratio by 10bp, will generate a pre-tax loss of EUR 800mn.
[16] It would certainly eclipse the Great Recession.
[17] A bank’s solvency and its share price are not the same thing – something many pundits fail to appreciate.
[18] As a reminder daily sentiment data on Deutsche Bank (plus 9,000 other assets) are available to view both on our web portal and on the Amareos App available on the Eikon Studio.
