Deutsche Danger

A reckless business strategy and poor regulation have weakened Germany’s largest bank. It is a risk to the world economy

is less than a decade since the western banking system collapsed under a cascade of bad debts. The global economy has never fully escaped that crisis. Ominously, the problems that caused it have not gone away. They are exemplified in the condition of Deutsche Bank, the largest German commercial bank and until recently one of the top three global investment banks.

The International Monetary Fund has referred to Deutsche as “appear[ing] to be the most important net contributor to systemic risks” — bureaucratese for a balance sheet so huge that it poses a danger to the system. Deutsche’s malaise raises urgent questions about how to regulate banks so that they do not get into trouble and how to insulate the economy from the damage that an enfeebled banking sector can wreak.

Deutsche has inadequate capital reserves and faces a potential fine of $14 billion (£10.8 billion) imposed by the US Department of Justice for mis-selling complex mortgage-based securities before the crash. Worries about the bank’s capital position have caused dramatic weakness in its share price, which has halved this year. That reflects in part a risk that the bank may have to call on shareholders for fresh capital.

The assets of Deutsche are valued at some €1.8 trillion. That is roughly half the size of the entire German economy. And Deutsche epitomises the disastrous strategy that banks adopted in the long business expansion of the late 1990s and 2000s. The stock market then prized companies that delivered high returns on equity. It made a perverse sort of sense for banks to undertake rapid expansion while depleting their capital reserves. Deutsche did so with gusto. It became a dominant player in securities markets with a very thin base of equity. As a business strategy this was a failure and its legacy is clear. Deutsche’s balance sheet is too big, its costs are too high and the low global interest rates have weakened its interest income.

In any industry the costs to shareholders and employees of such risk-taking would be heavy. In banking the costs potentially extend much further. Governments had to inject huge sums of taxpayers’ money to support the banking system from 2007 to 2009 because the economy would have otherwise collapsed.

Deutsche Bank is not as vulnerable now as the failed banks of the last crisis were in 2007. There are steps it can take, such as issuing new shares, before a rescue plan has to be devised. But EU constraints on state aid rule out a government bailout and the fact that such a large and poorly run institution sits at the heart of Europe’s economy is a serious and enduring weakness. Germany’s banking problems are one more danger — along with China’s slowdown and threats to the world trading system — facing the world economy.

There are three broad lessons for European and British policymakers. First, tight European integration is a misguided utopian project. Europe’s banks are tied together in a euro-denominated wholesale lending market that has contributed to the weakness of the banking system in much the same way that securitisation spread risks in the last crisis.

Second, some European banks remain “too big to fail” and regulators need to find ways of cutting them down to size. If banks’ functions are not clearly separated between high-risk proprietary trading and more conventional retail banking, then the costs of big losses will fall on taxpayers rather than shareholders.

Third, financial crises always, at some level, come down to too much debt. That lesson is all the more important for Britain as Theresa May’s government eases its inherited plans for austerity in the light of Brexit. Market confidence in governments, as in companies, depends on a reputation for prudent financial management.