By Ismail Ertürk - The Banking Expert at Alliance Manchester Business School, The University of Manchester.
In the introduction to my co-edited book on Banking Regulation and Reform (https://www.routledge.com/The-Routledge-Companion-to-Banking-Regulation-and-Reform/Erturk-Gabor/p/book/9780415855938) that came out of Routledge two weeks ago I gave the example of Deutsche Bank to argue that, almost a decade after the 2007 banking crisis, the banking system is still not safe and the financial system in general does not work in the interests of the economy and the society. During the last couple of days the news of Deutsche Bank's fragile financial health has resurfaced with greater seriousness, high probability of Deutsche Bank needing a government bail-out being widely considered in the markets.
Deutsche Bank has never fully recovered since the 2007 financial crisis because its business model that relied on a type of investment banking, where trading of complex and high-risk securities of all types was the driving force of its extraordinary revenues, was no longer economically valid and socially acceptable. This kind of investment banking was based on generating revenues from opaque highly leveraged and risky transactions between financial institutions rather than from realistic and sustainable profits that are based on serving the corporate and investment banking needs of productive economy. Consequently before the crisis Deutsche Bank was constantly generating return on equity at dizzying heights of about 25% that could not be sustained by moderate growth rates in productive economy. And consecutive promises by various CEOs since the crisis to get the ROE back to at least 15% levels were kept being broken.
But it was not very clear to the public and even to the financial community how these super profits at Deutsche Bank had been created prior to the financial crisis. Such high levels of profitability, like in most investment banking at the time including the likes of Lehman Brothers, Goldman Sachs, Barclays, UBS etc., were a black box to most observers. But now, like in the case of Deutsche Bank, we learn that the sources of such profitability relied great extent on creating and trading financial securities that were derivatives of subprime loans in the U.S. with very poor credit risk. And what’s more the U.S. Department of Justice is planning to fine Deutche Bank for a significant sum of $14 billion for mis-selling such derivatives called mortgage-backed securities to the U.S. financial institutions.
The share price of Deutsche Bank has already suffered badly at the beginning of the year falling to about €13 per share in February from a height of about €28 in November 2015. The news of the possible fine of $14 billion for mis-selling securities pushed the price further down to about €10. At this price the fine will almost wipe out the full market value of Deutsche Bank threatening its solvency and hence requiring possible government bail-out. Against such risks to create market confidence and to boost its capital base Deutsche Bank sold a couple of days ago its subsidiary Abbey Life to raise $1 billion. Of course this is only a minuscule injection of capital for a giant bank like Deutsche.
It is almost unbelievable that the management of Deutsche and the European Central Bank have not reacted much earlier, back in January and February of this year, to the alarm bells of worsening financial health of Deutsche. As a result financial markets now face great uncertainty regarding the soundness of a systemically important bank although the stress tests of European Central Banks have not picked up and warned the investors and depositors against such risks.
Banking is still far from being reformed successfully to serve economic growth both in Europe and the U.S. Furthermore the regulators are still unsure about how much and what kind of capital can make banks safe. Direct and indirect state subsidies to the private banks continue almost everywhere in core capitalist countries. Only back in January this year Sir John Vickers, the architect of the U.K. structural reform in banking, which ring-fenced retail banking from the risky investment banking in banking conglomerates, publicly criticised the regulators at the Bank of England for not following his advice in setting higher capital buffers for banks. Another regulator across the Atlantic, Neel Kashgari, the president of the Federal Reserve Bank of Minneapolis, who was one of the architects of the U.S. bail-out of banks when he was working at the U.S. Treasury at the time, announced that the problem is the size and complexity of banks not the levels of capital calling for radical splitting up of banks into utilities which both the Dodd-Frank Act in the U.S. and the Vickers Report in the U.K. had ruled out.
The 2007 crisis required a multi-disciplinary analysis of what went wrong. Although the failure of mainstream economics and finance has been universally acknowledged alternative approaches have not been accommodated intellectually in policy circles and in some academic research. The current sad and dangerous state of Deutsche Bank is a consequence of knowledge failure by regulators. Regulators and politicians have not learned the expensive lessons of the 2007 crisis. Europe lives in dark ages of finance and banking.
Ismail Ertürk - The Banking Expert at Alliance Manchester Business School, The University of Manchester.
Ismail is a regular commentator in the broadcast and print media. He has taught corporate finance, bank financial management and international finance on both the School’s MBA and Executive Centre programmes. His research interests are in financialisation and financial innovation.