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Eurozone authorities need to tackle bank contagion fears

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Deutsche Bank paved the way for a share rally when it expressed confidence in its financial soundness. But so far, the German government has denied it intended to provide support for the bank.

London

THE financial scare surrounding Deutsche Bank, and to a lesser extent Commerzbank, is a wake-up call for the Eurozone authorities even though their shares rallied sharply on Friday.

The rally was the result of unconfirmed reports that the US Justice Department intended to slash Deutsche Bank's mortgage security fine from US$14 billion to US$5.5 billion. Analysts caution, however, that a reduction in the fine would not put the bank in the clear due to poor profitability and other regulatory and legal issues.

Due to its reserves and its large- scale retail banking business, Deutsche Bank cannot be compared to the US investment bank Lehman Brothers which collapsed in 2008. Nevertheless a marked reduction in confidence is a worry. Such were the fears of a bank meltdown last week that the market believed that the German government and European Central Bank had no alternative but to act and support the bank.

As a first step it was widely expected that the US Department of Justice would slash the fine to counter worries that Deutsche Bank and Commerzbank bank crises could have a knock-on effect on the European and global banking sector. So far the German government has denied that it intended to provide support for Deutsche Bank and possibly Commerzbank which is also at risk. Instead, Deutsche Bank chief executive John Cryan paved the way for a share rally when he expressed confidence in the financial soundness of the bank.

In an email to employees on Friday, Mr Cryan stressed that "Deutsche Bank has strong fundamentals" and "fulfills capital requirements", while the disposal of the British insurer Abbey Life and soon-to- be-sold stake in the Chinese Hua Xia Bank "will further improve our capital ratio".

"We have significantly decreased our market and credit risk in recent years. At no point in the last two decades has the balance sheet of Deutsche Bank been as stable as it is today," he said in the email. "Despite low interest rates and a difficult environment we posted a pre-tax profit of about 1 billion euros (S$1.53 billion) in the first half of 2016". Liquidity reserves amount to more than 215 billion euros - "an extremely comfortable buffer".

 "Trust is the foundation of banking. Some forces in the markets are currently trying to damage this trust," he maintained.

Despite these assertions Deutsche Bank and other banks rely on confidence, and reports that hedge funds were withdrawing funds from Deutsche Bank's problematic investment bank, which has wide exposure to the derivatives market, were disturbing. The sharp share rally indicates that hedge fund and other bears were covering short positions and the rally could peter out this week.

Illustrating the volatility, Deutsche Bank shares plunged by 10.8 per cent to a low of 9.75 euros early Friday on news of hedge fund deposit withdrawals, before soaring by 20 per cent to 11.70 euros later in the day following reports of a deal with the US Justice Department. Commerzbank also slumped on Friday morning but then rallied in an intra-day swing of 18 per cent. To put the Friday rallies in perspective, however, Deutsche Bank is still 64 per cent below mid-2015 levels, and in the same time frame Commerzbank has slumped by 58 per cent.

The concern is the extent of contagion in a Eurozone which is heavily populated by zombie banks. Fifteen Italian, Portuguese, Spanish and Irish banks have lost more than 40 per cent of their share values in the past 52 weeks. These include nine banks which slid by more than 60 per cent.

"The fear evident in the marketplace is that this could be the start of a European banking crisis and that the German government has no good options," says Brendan Brown of MUFG Securities EMEA.  "All the regulation of recent years has not in fact reduced the danger of contagion especially given still weak equity capital positions."

 In its April 2016 financial stability report, the International Monetary Fund (IMF) warned that "problems of excess capacity, high levels of non-performing loans, and poorly adapted business models continue to depress (European) bank profitability, which could erode bank resilience over time".

"These legacy problems became more apparent in late 2015 and early 2016 as sharp downward pressures on bank equity and debt prices drove valuations down to levels that could impair their ability to tap capital markets ... The hardest hit banking systems within the euro area in February have been those of Greece, Italy, and to a lesser extent, Portugal, along with some large German banks," added the IMF, estimating that Euro area banks had a whopping 900 billion euros of non-performing loans.

"The expansion of European Central Bank quantitative easing and other powerful credit and funding easing measures announced in March will help address and contain systemic concerns (of Deutsche Bank and others), but it is not a full solution," concluded the IMF.

Adding to Deutsche Bank woes, The Wall Street Journal reported on Saturday that a Milan judge charged 13 former and current executives at Italian bank,  Banca Monte dei Paschi di Siena, Deutsche Bank and Nomura International plc with a number of alleged financial crimes. Quoting "people familiar with the matter", the newspaper said that the decision by judge Livio Cristofano followed an investigation lasting more than one and a half years by Milan prosecutors into two complex financial transactions that Monte dei Paschi arranged with Nomura and Deutsche Bank.

Monte dei Paschi and Nomura spokesmen had no comment, and a Deutsche Bank spokesman said, "We will put forward our defense in court", declining further comment. Lawyers for the individuals either declined to comment or didn't respond to requests for comment.

In February, Milan prosecutors said that they were seeking the indictment of the executives after they had found evidence of the manipulation of Monte dei Paschi's stock and falsification of its accounting, and some of the executives' obstruction of the supervisory activity of Italian authorities, according to court documents seen by The Wall Street Journal.