Every confident prediction from Dodd-Frank boosters that “too big to fail” is a thing of the past must contend with what happened to Deutsche Bank this week.
When the company faced a potential inability to repay its debts, elites floated the theory that the German government would never let such a thing occur. And investors responded by sending the stock soaring.
How Deutsche Bank got into trouble is an interesting story. But the assumption that their government would find a way to help them out of it suggests that the largest global banking institutions remain dependent on taxpayer support. And the best way to fix that is to make giant banks a thing of the past.
Deutsche Bank’s suffering has roots in the recent global market turmoil, which has particularly affected bank stocks. Deutsche Bank’s share price has fallen over 40 percent since the beginning of the year, as commodity prices and emerging market woes made for a brutal start to 2016. The market plunge comes right when the firm is reorganizing its investment banking unit, and lower returns make that costly. Continued litigation over various incidents — mortgage-backed securities fraud, foreign exchange rate manipulation, money laundering — also hampers Deutsche’s outlook.
On Monday, the company released a short statement insisting that it would be able pay 350 million euros of contingent convertible capital (known as CoCo) interest payments by April 30. Since nobody was really asking the firm whether it would have the capacity to pay those debts, the insistence signaled significant nervousness.
CoCo bonds actually grew out of the financial crisis. European regulators created them to give banks flexibility in times of trouble. The bonds convert into common equity, or get written down, if a bank doesn’t have enough capital on hand to satisfy the interest payments. This way, investors take some of the haircut, rather than getting paid in full after government bailouts.
Despite the logic, no bank has skipped CoCo payments before. And the experience of Deutsche Bank suggests that banks don’t want to, probably because failure to pay would signal disastrously low capital levels, leading to a panicked run on their funding sources. That’s especially true because CoCos have become a prolific asset class, with 91 billion euros invested since mid-2013 (Deutsche Bank itself was issuing new CoCo bonds as recently as last October). Until this market stress on banks, they produced a healthy return, higher than the current low-yield environment. But now much of that return has been wiped out.
So Deutsche went to great lengths to try and restore market confidence. Their co-CEO called the firm “absolutely rock solid” in a memo to employees a day after the assurance on the CoCo payments. Investors didn’t get the message until word leaked that Deutsche would consider buying back bonds to reduce debt and make their capital ratio look better, thus ensuring the CoCo payments. The bank announced Friday morning that it would buy back $5.4 billion in debt. In response, its stock price shot up more than 11 percent. As Bloomberg View’s Matt Levine pointed out before the move was announced, it's kind of crazy that Deutsche Bank’s plan — including using euros to buy back bonds, thereby reducing liquidity or the ability to immediately pay back debts — would relieve investor concerns.
Maybe investors were thinking something more akin to what John Mack, the former CEO of Morgan Stanley, had to say on Bloomberg on Wednesday. “This idea that I heard yesterday, the possibility of not making their interest payments, it’s just absurd,” Mack said. “The government will not let that happen.”
That’s basically a straight-up case for too big to fail, from the former leader of one of America’s too-big-to-fail banks. And Mack posited that Germany would never abandon its largest bank. “The bank’s name is Deutsche Bank. It’s the German bank,” he concluded. “Politically, they will stand up, if they need a safety net, and give it to them.”
That backstop — the idea that governments would never let a major bank fail — was supposed to be dissolved in this round of financial regulation. And you can point to many studies and analyses claiming that it’s gone. But those facts and figures only mean something in a moment of crisis. And at least for Deutsche Bank, we’re in that moment.
In fact, this is not just a Deutsche problem. It’s become a symbol in recent days for a more generalized stress in bank stocks. That stands to reason, because the financial system remains hopelessly interconnected, and damage at Deutsche Bank is sure to produce collateral damage in the U.S.
The threat of tougher sledding for the global economy makes more interest rate hikes unlikely, which hurts banks. And the oil price collapse is causing a wave of energy-related defaults on bank loans. But the counter-party risks from Deutsche Bank and its European colleagues are real. And if Europe is in another “doom-loop,” with bank stress and government debt stress playing off each other, that can bleed out to the American economy.
If the CoCo bonds that European regulators set up to tamp down panics aren’t working, the parties involved are forced to look at alternatives. And sitting out there, as whispered by John Mack, is the potential of a bailout. This is supposed to be impossible under new European banking rules, but maybe the chaos of a run on Deutsche Bank is seen as more impossible. And that picture is broadly similar in the United States.
The banking industry remains extremely profitable. And the rules put in place to try to make the system more stable and secure may work to a certain extent. But the only way to truly know about their strength is when they’re tested, not in theories and postulates but in the real world. The Deutsche Bank lesson suggests that the only way to truly ensure that a bank isn’t too big to fail is not to let banks become too big.
This article was updated to reflect Deutsche Bank's debt buyback announcement.