For both institutional and contextual reasons, Deutsche Bank is unlikely to provoke the 2016 version of a Lehman moment.
Yes, there are questions about the bank's balance sheets, including the complicated valuations of "level 3" assets. But Deutsche Bank's sources of funding are much more diversified and its balance sheet is significantly more robust than Lehman's ever was. Also unlike Lehman, Deutsche Bank has access to emergency funding at a central bank, in this case, the European Central Bank.
And it has internal means of generating capital (including through asset disposals and even a rights issue), even though the more such methods are used, the less attractive they are to management and existing shareholders. Moreover, given its accumulated litigation reserves, the pressures would also lessen if, as was hinted at in some news reports at the end of last week, the bank reached a settlement with the U.S. Justice Department that required it to pay far less than the original fine of $14 billion.
The environment is quite different, too. Deutsche Bank is not part of a growing storm making its way through the global financial system. Although some European banks remain fragile, others around the world have notably strengthened their capital cushions, are deploying more prudent liquidity-management approaches, and have made significant progress in cleaning up their liabilities. Importantly in terms of systemic effects, this is particularly the case for U.S. banks.
But even if Deutsche Bank doesn't threaten a Lehman moment, that doesn't mean its troubles couldn't have any systemic effects. There are at least four factors that should be kept in mind.
- The saga deals yet another blow to the already frail reputation of the banking system. Understandably, it fuels the politics of anger, enticing some politicians to make statements that could undermine trust in the financial intermediation process.
- By highlighting remaining gaps in the macro-prudential architecture – that is, the regulatory and supervisory structure aimed at ensuring the safety and soundness of the financial system -- Deutsche Bank's travails also put central banks and regulators on the spot, yet again. This exposes them to greater threat of political interference at a time when there are already lots of questions and growing irritation at the ECB’s use of negative policy interest rates and its balance sheet for large-scale asset purchases.
- Renewed concerns about European banks are likely to be yet another headwind to the region's already-tentative growth prospects. Expect European financial institutions to become more prudent as they place balance-sheet robustness ahead of making loans, especially when it comes to lending to small- and medium-sized enterprises. History shows that such shifts cannot be easily compensated for by central banks and governments.
- Because of the inherent interconnectivity of banking operations, the risk of equity and bond market contagion is greater than for most other sectors. In combination with the spread of hybrid securities, such as contingent convertible bonds that initially act as internal amplifiers, Deutsche Bank's difficulties transmits volatility to other banks' capital structure, potentially enlarging the group of institutions that attract short-sellers. In turn, this raises the possibility of broader market instability.
The benefits of stabilizing Deutsche Bank extend well beyond one institution that is being forced to redefine its business model by internal and external challenges . Fortunately, there still are tools for restoring stability. And while a Lehman moment is unlikely, time is running short for Europe and the banking sector to contain and minimize the risk of other collateral damage and unintended consequences.
By Mohamed A. El-Erian, originally published in Bloomberg View on 10/03/16. Reprinted with permission. The opinions expressed are those of the author.