Deutsche Bank: Is a bailout inevitable?

October 3, 2016
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FACULTY Q&A

Deutsche Bank, one of the largest banks in the world, has seen its shares and ratings plunge in recent months. This week, CEO John Cryan is expected to be in the U.S. to negotiate a settlement for misselling mortgage-backed securities.

Amiyatosh Purnanandam, professor of finance at the University of Michigan’s Ross School of Business and expert on corporate finance, banking, credit risk and the subprime mortgage crisis, discusses the recent free fall of Deutsche Bank’s bonds and stock, a possible bailout and the effects it could have in the world financial systems.

Q: Last Friday, Deutsche Bank saw a break from the freefall it’s been experiencing on reports of a possible agreement with the U.S. Department of Justice to reduce it’s fine on mortgage-backed securities from $14 billion to $5.4 billion. Would this deal be enough to provide stability to the bank in the long term?

A: This break helps but I do not think it is going to be enough. Deutsche Bank has some structural problems that it needs to address. They need to take a hard look at their aggressive risk-taking behavior, both on the asset side and on the liability side. On the asset side, they need to be more prudent in their risk-taking, and be more transparent in risk-disclosure. On the liability side, they need to strengthen their capital base. Anything short of that is only going to give them temporary respite, not long-term stability.

Q: As Deutsche stock continued to fall, hedge funds investors were cashing in. Will the Deutsche Bank go into bankruptcy?

A: If the German government does not intervene, then it is possible. But I cannot imagine that the German government will not provide a helping hand to Deutsche Bank if the situation deteriorates further. Also, Deutsche Bank has a good amount of cash and liquid assets on hand. So, it can sustain some withdrawal from its counterparties even without any government support. The combination of higher liquidity and likely government support makes it unlikely that Deutsche Bank will get into bankruptcy.

Q: Do you think we will see a bailout?

A: That possibility is becoming more likely by the day. Deutsche Bank has struggled to keep a healthy capital cushion. It has always been one of the most aggressive banks in terms of leverage ratios. Even today, it has relatively lower equity capital compared to several other comparable money-centric banks. So yes, I do think we are getting closer to a bailout situation. What remains unclear is the kind of bailout—sometimes just a verbal commitment of a bailout is good enough to restore market confidence, even without an actual capital injection by the government.

Q: What effect has this uncertainty had in the rest of Europe’s financial markets (especially after the Brexit vote)? Will other European institutions come to Deutsche Bank’s rescue?

A: The most important capital a bank has is trust, even more important than its financial capital. Clearly, investor’s trust in Deutsche Bank has taken a beating. Given its central role in the world banking system—one of the largest banks with very active counterparty linkages with banks in Europe and around the world—if investor confidence in Deutsche Bank weakens, so does it in other banks. Hence the entire banking sector is likely to experience a lot of ups and downs in the coming weeks. It will be a volatile period ahead for banks in Europe and in the U.S. But the rescue package is most likely to come from the Germans in my opinion, not other institutions.