Systemic Implications of Problems at a Major European Bank

William Cline

No PB16-19, Policy Briefs from Peterson Institute for International Economics

Abstract: Deutsche Bank's recent troubles, including a fine by the US Department of Justice for allegedly misleading investors in the sale of mortgage-backed securities, have led to a decline in the bank's share price. The bank, however, is not insolvent and would not be even if the full $14 billion fine were levied. Its problems, nonetheless, should prompt policymakers to focus on whether banking sector reform after the financial crisis is on track. The new shocks from large legal fines add to concerns about capital adequacy. Low stock market prices may further reflect doubts about asset valuations, especially for derivatives, and about risk weightings using internal models. Cline notes that the decline in the bank's share price in both January–February and September was prompted by the specter of losses to additional tier 1 (AT1) bonds that count toward the bank's total loss-absorbing capacity (TLAC) imposed by the Basel III regulatory reforms. He concludes that the bank's difficulties provide further support for additional bank capital beyond Basel III targets. Higher equity capital provides a larger cushion against insolvency in the face of shocks. With equity a larger share of the TLAC target of 18 percent of risk-weighted assets under Basel III, an additional benefit would be the resulting reduction in the need for contingent (AT1) capital, which has proven to be a source of market instability when investors fear writedowns on (or conversions of) such obligations. Low market valuations mean that banks would need to raise additional equity over time through retained earnings rather than immediately through new issuance when share prices are depressed. This problem is currently more severe for large banks in Europe than for those in the United States. Banks may also need to change their basic business models and downsize their balance sheets gradually until share prices rise toward book values.

Date: 2016-10
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