Coming from the position of the largest bank in Europe in the 1990s, Deutsche Bank can’t even make it to the top 15 anymore. The bank has been struggling since 2006 with its low profitability – its return on equity has lagged below the cost of capital for many years, meaning the shareholder’s value is effectively beyond destroyed – but the recent demand from the US Department of Justice to settle a $14bn probe into mis-selling of mortgage securities has left the bank’s shares trading at the lowest level in three decades (see below) and exposing the need to raise more capital. Last Thursday, it was reported that major hedge funds and investors are pulling capital out of DB, leading to even greater concerns about its stability. Although we’re already seeing signs that the fine with the DoJ will be settled for a much smaller amount, there are still many outstanding risks for the banking sector. The question is, what are the implications for the euro?

dbbp1

The crisis in DB exposes not only the German bank, but the whole European banking sector. A significant proportion of a bank’s profitability is determined by the interest rates, as they normally make money from the difference between short-term and long-term rates, and therefore struggle when rates are flat or negative. In the current scenario of negative interest rates, it’s virtually impossible to increase profitability. In a document required by Basel III regulations, JPMorgan, for example, reported that a 100 basis-point rise in interest rates would add $2.8bn to its net interest income. We could spend hours debating whether the ultra-loose Central Banks’ monetary policies are the responsible for this crisis or whether they have just responded to the current market environment of increasing global savings rate and slow growth, but the fact is that the banking sector is suffering and there are almost no signs of upcoming relief (out of the major Central Banks, the Fed is the only one giving sign that a rate hike may be on the way).

It may look like a hopeless situation, but interestingly the DB crisis may have positive results for the European banking system and the euro. First, we’re talking about Germany’s biggest lender, and its importance to the global economy tells us that it’s very unlikely that officials will let it fail. Angela Merkel, less than a year away from a general election and under a lot of criticism on the back of her decision to allow a large number of immigrants into the country, is in a difficult situation, as any attempts to rescue DB would trigger a crisis with countries such as Italy, which have been under pressure from Germany and prevented from rescuing their own banks. This situation, however, increases the chances that the ECB will turn to a tighter (or, at least, not looser) monetary policy in an attempt to avoid a generalized crisis in the European banking sector, which in turn is positive for the euro.

Second, let’s not forget that the euro is still seen as a safe-haven asset, which means it should benefit from a scenario of increasing risk. In fact, looking at the trade-weighted index, we can see that the euro was not the one who’s suffered with the DB crisis, quite the contrary (see chart below).

dbbp2

Deutsche’s and the European banks’ problems are far from being resolved. However, as long as the increasing regulations prove to have prepared banks for crisis scenarios better than ever (as all bankers like to say) and we don’t see a generalized failure, the consequences for the euro may surprise us to the positive side, as counterintuitive as it may sound.

Author: Marilia Shewchenko