According to JPMorgan, This Is the Biggest Risk Facing Deutsche Bank at This Point

Deutsche Bank uncertainties were added to concerns about BoJ tapering spooking global equity markets over the past week. Widespread press reports about Deutsche Bank clients and counterparties reducing their financial exposure to the bank, including their derivatives exposures, alarmed market participants.

At the same time, JPMorgan warns, the amount borrowed by euro-area banks at the ECB’s USD auction this week spiked to $6.35bn raising fears about funding.

We need to wait for next week to see if this elevated dollar borrowing by euro area banks persists beyond quarter-end. But as JPMorgan’s Nikolaos Panigirtoglou warns,

In our opinion it is not so much funding issues but rather derivatives exposures that more likely to trouble markets going forward if Deutsche Bank concerns continue.

This is especially true if these concerns propagate into a confidence crisis inducing more rapid unwinding of derivative contracts.

As we have detailed previously, Deutsche has the world’s largest so-called derivatives book—its portfolio of financial contracts based on the value of other assets. As Forbes notes, it peaked at over $75 trillion, about 20 times German GDP, but had shrunk to around $46 trillion by the end of last year. That’s around 12% of the total notional value of derivatives outstanding worldwide ($384 trillion), according to the Bank for International Settlements.

As a reminder, if the liquidity run forces DB to start unwinding or being forced to novate derivatives, it could get ugly.

JPMorgan bank analysts confirm the size of DB’s book, and note that BIS data provide an alternative but indirect way to gauge the size of derivatives exposures. According to BIS data the exposure of foreign banks to German counterparties via derivatives contracts stood at $312bn as of Q1 2016.

Source: BIS

This is significantly lower than the $408bn reported for Q1 2015, suggesting that foreign banks have cut their derivatives exposures to German counterparties significantly over the past year.

But at $312bn this exposure is still large even if Deutsche Bank accounts for a fraction of this.

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As we have noted previously, Deutsche Bank has around EUR 560 billion in deposits (for now) and so theoretically they do not have a funding issue.

But as we have seen numerous times in Deutsche’s history above (and obviously in many other banks), when the runs start, they seldom end peacefully (and funding sources disappear very quickly). Which perhaps explains this from Germany’s financial regulator…

The head of Germany’s financial regulator warned on Saturday of “negative perceptions that could lead to downward spirals on the markets”, at the end of a week that saw Deutsche Bank shares battered by a crisis of confidence.

In an interview with the Frankfurter Allgemeine Sonntagszeitung newspaper due to be published on Sunday, the head of Bafin, Felix Hufeld, declined to comment specifically on Deutsche Bank, Germany’s biggest bank.

But he said: “I warn people not to let themselves be drawn into a kind of downward spiral of negative perception. Not every nervous market reaction is backed by objective facts.”

Roughly translated as “Don’t panic, we have everything contained.” Now where have we heard that before?

One thing is clear: Friday’s desperate rumor-driven ramp saved some of that deposit base as going out at record lows into a long-weekend would not have been confidence-inspiring for the deposit base.

But, as JPMorgan makes clear – and we have reiterated numerous times, it’s the derivatives that matter and as the chart below shows, counterparties were piling into protection en masse – even as speculators bid up the stock on a quiet Friday afternoon.

Remember how many times investors were told that Lehman had no liquidity or funding problems?

However, as noted previously, Lehman failed as a result of its corporate counterparties suffocating the bank by rapidly pulling out their liquidity lines. Lehman, however, was lucky in that it didn’t have retail depositors: it’s death would have likely come far faster as the capital panic was not limited to institutions but also included a retail depositor bank run.

This is where Deutsche Bank is very different from Lehman, and far riskier, because if the institutional panic spreads to the depositor base, which as the table below shows amounts to some €566 billion in total, and €307 billion in retail deposits…

… then all bets are off.

Which is why it is so critical for Angela Merkel to halt the plunging stock price, an indicator DB’s retail clients, simplistically (and not erroneously) now equate with the bank’s viability, and the lower the price drops, the faster they will pull their deposits, the quicker DB’s liquidity hits zero, the faster the self-fulfilling prophecy of Deutsche Bank’s death is confirmed.

Which ultimately means that DB really has four options: raise capital (sell equity, convert CoCos, which may results in an even bigger drop in the stock price due to dilution or concerns the liquidity raise may not be sufficient), approach the ECB for a liquidity bridge (this may also backfire as counterparties scramble to flee a central bank-backstopped institution), appeal for a state bailout (Merkel has so far said “Nein”) or implement a bail-in, eliminating billions in unsecured claims (and deposits) and leading to a full-blown systemic bank run as depositors everywhere rush to withdraw their savings, leading to a collapse of the fractional reserve banking mode (in which there is only 10 cents in physical deliverable cash for every dollar in depositor claims). 

Which of the four choices Deutsche Bank will pick should become clear in the coming days. Until it does, it will keep the market on edge and quite volatile, because as Jeff Gundlach explained today, a “do nothing” scenario is no longer an option for CEO John Cryan as the market will keep pushing the price of DB lower until it either fails, or is bailed out.