Deutsche Bank, which is Europe’s largest investment bank, and one of the largest of the world, has attracted a lot of attention from regulators, analysts and media lately. News have not been good. In June the Fed announced the firm’s U.S. operation failed — twice in a row — the Fed’s stress test. An IMF research report awarded it the title of “the biggest contributor of systemic risk”. Impact of Brexit was predicted to take a material toll on its investment bank, headquartered in London. As a result, Deutsche’s stock has been in a tear, with the market capitalization falling below EUR18bn, a quarter of its book value. Since early 2016 its credit default swaps (a measure of its credit risk) has sharply grown and has been trading in 200 to 250bps range. This is close to Unicredit’s levels, another battered European firm. Financial blog posts (well, some of which also fall for conspiracy theories) predicting the firm’s demise abound. Obviously all is not well, yet how bad is it remains a matter of speculation. The biggest concern seems to be not the loan book and securities portfolios, which are somewhat easier to comprehend, but the more obscure “derivative portfolio” that has grown to staggering proportions. The press attaches various numbers to it but these are generally between 50 to 70 trillion (yes, trillion) dollars or Euro. This sounds quite worrisome indeed. Let’s look into the matter more closely and draw some initial conclusions.
As this article revolves around derivatives, let’s give a simple explanation. A derivative contract has two parties, which make payments to each other. The payments of at least one of the parties are linked to the price of some traded asset (e.g. stock price). Very simplistically, the value of such contract for the parties is linked not to the level of the stock price, but to its rate of change. It bears some similarity to derivatives in calculus, i.e. the rate of change of the value of a function. Derivatives’ value is therefore significantly more volatile than the price of the underlying assets. Derivatives are designed to be used as an insurance against volatility in asset prices, but in reality are often used for speculation. We provide a bit more detailed explanation in a short Derivatives Refresher in the appendix.
So, Will Deutsche Bank Go Under?
In short, most likely not. But there is a longer story. Deutsche’s financial stance has been concerning the market for years. The firm is a complex beast. It has strived to and largely succeed in developing a world-class investment banking arm, aspiring for the top spot in advisory, sales and trading businesses. It has developed a significant financial derivatives franchise, especially in rates and foreign exchange. It is somewhat ironic that in the late 1990s it expanded its north American franchise via the acquisition of Bankers Trust, a firm that found both its success and its demise in the world of financial derivatives. Also, guided by the consolidation trends of the past 10-15 years Deutsche has also expanded into more mundane universal banking business with substantial deposit-taking operations, apparently to get more solid capital and deposit base. Whatever the justification at the time, the addition of retail arms like Deutsche Postbank has proved to be a poor fit. Deutsche may indeed have strived to be akin to Goldman Sachs. Having acquired Deutsche Postbank in 2010 however it to an extent resembles Citigroup, the U.S. financial conglomerate with a history of financial woes. Citigroup was also created from the merger of a universal bank (Citibank) with an insurance company (Traveller’s) and then with a bulge bracket Wall Street firm (Salomon Brothers). It ventured into synthetic mortgage securities (CDOs), keeping a large hold of super-senior tranches, which under market turbulence proved to be not quite risk-free as it was thought. Despite a hectic capital raising effort, Citi found itself insolvent and had to accept a USD 40 billion bailout from the government, largely wiping out existing shareholders.
While Deutsche has been quite aggressive in its risk-taking, its strong risk management culture made sure that its transactions were typically assessed, structured, and managed in a proper fashion. While succeeding at individual transaction level, the bank has failed strategically. Figuratively speaking, it committed the capital sin of banking: shortage of capital. Indeed, Deutsche has long had a very risky and undercapitalized balance sheet. Why is capital important? It is a crucial loss absorber, in case part of the loans assets go bad, or marketable assets (e.g. stocks, bonds, but also derivatives) decline in value. And they may, regardless of risk management efforts. Let’s take a quick look at Deutsche’s capital position. It entered the financial crisis in a precarious financial position, with EUR 2 trillion in assets but less than EUR30 billion in Tier 1 equity (the most powerful risk-absorbing sort). In other words, about 1.5% decline in assets could have wiped out the existing equity cushion. Paradoxically, it was in the crisis eve, in mid-2007, when Deutsche’s market cap was the highest, at above EUR60bn. Its stock was trading at 1.6x the book value (and above 2.1x tangible book value), suggesting great confidence in the strength of its business and prospects.
Since then, Deutsche has put good efforts in shrinking its risk assets while boosting its capital base, especially Tier 1. Thus, at end-2015 it emerged with EUR 1.7 trillion in assets and EUR 49 billion in Tier 1 capital (out of total EUR 67 billion total equity). Thus Deutsche’s leverage position significantly improved, although it lags behind all its major international rivals, especially the north American ones. The firm still falls short of its capitalization targets yet the management (recently appointed CEO John Cryan) is confident it will meet them without the need to tap the market for any new capital. The plan is to dispose of non-core assets (the most important of these being Postbank), as per the updated strategy concluding mass retail banking is a poor fit for the rest of the firm.
Despite this soothing recapitalization narrative, Deutsche stock is now trading at record lows, at just over a quarter of book value. This suggest the investors are worried that potential losses may debase the capital cushion, and by induction, that they may be forced to accept massive dilution of their equity interest in Deutsche. This is also exactly the logic why the management is resisting the temptation to tap investors for additional capital. This high-risk approach is thus understandable although not commendable. This was also the logic why other firms, most notably Lehman Brothers, have resisted getting a helpline at conditions that were perceived as dilutive and generally unfavorable. And they have paid for this.
Deutsche’s financial position — and especially its huge financial derivative exposure — is something to worry by about. At the end-2015 the aggregate notional of outstanding derivative contracts on its books was EUR42 trillion. To put the number in perspective, it is 14 times higher than Germany’s GDP and 3 times higher than EU’s combined GDP. Indeed, notional value of contracts is not necessarily the best indicator of the underlying risks. The risk value of a derivative contract may be lower than notional value by orders of magnitude (e.g. tens or even hundreds times lower). About four fifths of the exposure consists of interest rate derivatives, whose risk value is typically a lower fraction of notional. Just over half of the derivative contracts on Deutsche’s books are cleared through a clearing house (central counterparty or CCP), which materially mitigates the credit risk in the individual transactions.
Judging by Deutsche’s financial reports, its derivative exposure is carefully managed at both individual transaction and at firm level. The contracts are typically offset with matching contracts with opposite sign, negating the derivative exposure. Thus changes in derivative assets are fully, in theory at least, offset by equal changes in derivative liabilities. In addition, the derivative transactions involve collateral and credit support arrangements to manage the risk of the respective counterparties. Above half of Deutsche’s entire derivative portfolio is cleared through central counterparties, additionally minimizing counterparty exposure. Judging by this explanation, Deutsche’s derivative book is almost “perfectly hedged” and does not entail material risk, right?
Unfortunately, no. Our universe does not know perfect hedges. Indeed, many of the contracts are hedged not with identical contracts but with combination of instruments that should work in the same way. (Doing this is quite a complex affair. The reason to do it is simple though: if a firm hedges a contract with identical contract with the opposite sign and takes perfect security, it will never make any money.) Sometimes, especially during periods of market strain, they simply don’t (enter basis risk!). In this situation gaps may open between derivative asset and liability position. While positive gaps (i.e. marked-to-market profit) is welcome, a negative gap has the potential to destroy much of the equity value. In addition, in times of crisis weaker counterparties may fail to deliver, and the respective credit safeguards may also fail to perform. In addition to the credit loss, the resultant naked (i.e. un-hedged) derivative position has the potential to generate significant losses in case of adverse price developments.
The worry here is the sheer size of Deutsche Bank’s derivative portfolio, with tens of trillions of Euro notional. A reduction in the net value of just 0.15% of the notional would wipe Deutsche’s entire capital, leaving it insolvent. Such reduction is not unconceivable even though the net exposure — represented with the dotted line on the chart — has been remarkably stable at around EUR20bn in recent years. The variation in net market value of the derivative portfolio has been remarkably low — to the tune of a hundredth of a percent of the notional value. Such extremely low variation suggests near perfect hedging indeed… This structure may work just fine under steady market conditions. Yet who knows how it would behave under extreme turbulence and high degree of asset price correlation, i.e. when diversification and proxy hedging strategies cease to work. The best safeguard against portfolio gyrations wiping out capital is actually quite simple: build up capital. This is something that Deutsche is yet to complete.
This realization is probably the reason behind the current exceptionally low valuation of Deutsche’s stock. The investors dread a scenario when the capital (of which they hold shares) is wiped out, while the firm is forced to accept a highly dilutive capital increase by investors, bail-in (i.e. converting bondholders into shareholders) or even a government bail-out. Yes, at current levels (price-to-book ratio of 0.27x) Deutsche’s stock is quite probably oversold, especially given management to recapitalize the firm only via asset disposals. It may be a good (even great) trade but…go long Deutsche at your peril.
Deutsche’s Systemic Importance in the Derivatives World
The firm runs one of the largest individual derivative books in the world. At the end of 2015 the global notional of all outstanding derivative trades totaled a shade below U.S.$ 500 trillion (about EUR 450 trillion). Deutsche’s book made up about 9% of that. The aggregate market value (positive and negative exposures combined) of all of Deutsche’s trades exceeds a trillion U.S. dollars, or about 8% of the global total. This is extreme concentration for an undercapitalized market participant, however sophisticated risk management it employs. The consequences of Deutsche Bank failing to make good on its trades would be undoubtedly disastrous. Enter systemic risk. Deutsche has a central role on the derivatives market but also on the interbank market of other instruments. Its failure to honor any of its trades would propagate like a wildfire through the market. Deutsche’s deficient capital combined with the massive degree of “interconnectedness” with other firms, especially European ones, made the IMF conclude that the firm is the biggest contributor to global systemic risk.
In the event of non-performance, the rush to liquidate collateral may trigger market selloff, or exacerbate a selloff already underway. It quickly escalates in a vicious circle, otherwise known as positive feedback loop. A good albeit extreme illustration of positive feedback loop is the nuclear chain reaction. The selloff causes sharp reduction in market prices, e.g. fixed income instruments but also equity, credit default swaps (use to hedge credit risks), etc. The liquidation of collateral catalyzes selloff, which further depresses prices, driving more transactions in the red and requiring more margin calls and liquidation. Ultimately it may trigger price collapse across markets, way below their intrinsic valuation.
We have seen such dynamics a few times in recent history. More relevant ones are LTCM failure in 1998 and the Lehman Brothers’ collapse in 2008. (We don’t suggest a next round would be in 2018, but we don’t rule it out either). The current market situation is characterized by significant nervousness of the market participants, due to fundamental economic factors — China, European banking crisis — but also due to geopolitical tensions — Brexit, South China Sea, North Korea, Russia, Syria, now Turkey. This nervousness may result in price swings triggering liquidation of contracts, but also deepen the price collapse after the crisis starts. The ample market liquidity provided by central banks buoys the markets but it can only do so much in case of panic.
The Doomsday That Wasn’t
The scenario described above sounds downright scary, and is undoubtedly possible. We have seen developments like that in the past and certainly will see them again. Yet it does not make sense to be alarmist about it. How the disaster can (and probably will) be averted?
First of all, the derivative contracts typically include collateral and credit support arrangements to manage (and mitigate) the performance risk of the counterparties. Deutsche is on both sides of such contracts and is both recipient of and provider of collateral and credit support. Thus, it is protected from failure of its counterparties to deliver as it can tap the collateral. The counterparties are also protected in the same way from Deutsche’s failure and can resort to the collateral and credit support posted in their favor. Bilateral arrangements, i.e. when two counterparties transact directly under bespoke documents, are typically less reliable and may not be fully effective in preventing any party’s failure.
That’s why market regulators have consistently pushed for clearing the trades through a central counterparty (CCP), i.e. a clearing house that stands between the two counterparties in a trade. Pursuant to recent U.S. and EU legislation it will be mandatory to clear certain derivative transactions via CCP starting in mid-2016. In addition, also from 2016 the collateral requirements for bilateral (i.e. non-CCP cleared) derivative transactions will also be enhanced. The CCP standardizes and automates the marking the derivative positions to market, posting collateral, and performing under a trade. CCP also centralizes reporting and contributes to market transparency. Overall, CCPs do not eliminate credit risk but manage it and mitigate it to a significant extent. At market-wide level, CCPs to a certain extent reduce systemic risk. Figuratively speaking, while bilateral collateral arrangements can extinguish only small fires, CCPs can also deal with larger fires. But could CCPs can make the entire system fireproof? Unlikely.
Currently, about half of Deutsche’s derivative trades are CCP cleared. This is below the average proportion on the market, which is stands at 60% – 80% depending on type of derivative. Starting from 2016 Deutsche like the other professional market participants will need to comply with the legislation and switch to CCP clearing for much more of its trades.
Second, let’s also have a look at Deutsche’s financial strengths in recent years. The firm survived the massacre of the 2008 crisis with much less of a capital cushion and with similarly large exposure to derivatives and other assets. It entered the 2008 crisis with Tier 1 equity at mere 1.4% of its assets, while today it stands at 3.5%. True, the management may well be over-confident in its recapitalization plans. But in case of a threat of systemic failure, German and European authorities may force a solid capital increase upon Deutsche, very much the way the U.S. government forced a U.S.$ 40 billion bail-out upon Citigroup and wiped out the existing stockholders. The central banks, led by the ECB will also keep on pumping liquidity in the markets, to forestall free fall in prices, but also to ensure banks can make good on their promises. It won’t cure the system altogether but may prevent its sudden death. That kind of investor reasoning may explain the current combination of paltry equity valuation (for fearing that a forced bailout may wipe existing stockholders) but with credit ratings within the investment-grade zone. Deutsche’s credit default swap (i.e. insurance against default) is expensive but not at disastrous levels.
So we wouldn’t recommend betting against Deutsche’s failing to deliver on its obligations, derivative or otherwise. Or wouldn’t we? It may make a nice contrarian bet.
Deutsche’s CDS, anyone?
 That amount is not unprecedented. The large U.S. banks, J.P. Morgan, Citi, Goldman Sachs, BofA, and Morgan Stanley, all have derivative books of similar or larger magnitude. Still, they are better capitalized and (with the exception of Citi in 2012 and 2014 and the conditional approval of Morgan Stanley this year) pass the stress tests.
 Of course, as a highly rated counterparty, Deutsche is usually obliged to post collateral only upon exceeding certain transaction thresholds, as well as in case of deterioration of its credit quality.
 An alternative view holds it that CCP failure (which is not impossible) can propagate market risk to a much greater extent than a failure of individual albeit large counterparties.
Appendix: A Refresher on Financial Derivatives
Derivatives may look complex but their basic substance hardly is. A derivative contract has (typically) two parties. The parties exchange payments (or assets) from time to time, e.g. in the beginning, during, or at the end of the contract in a pre-set manner. Usually at least one of the parties’ deliveries are linked to the observable market price of a specified asset, be it currency, interest rate, stock, commodity, etc. For example, the parties agree that at the end of each month, party A pays to party B the market price of gold; and party B simultaneously pays $1,200 to party A. In other structures, both parties’ payments may be linked to market prices. For example, at the end of each month party A pays the then market interest rate in US dollars, and party B simultaneously pays the market interest rate in Euro. These arrangements are “swaps” in the jargon, for flows of value being swapped.
A simpler derivative contract gives a party the option, but not the obligation, within a pre-agreed period to buy (or sell) a traded asset at a set price. Say party A pays now $7 to party B for the option to buy 1,000 Euro for 1,100 US dollars within the next week. After party A makes this $7 initial payment only party B remains obligated to deliver, and therefore only party A remains exposed to credit risk. Let’s note here that the notional value, i.e. the value of the underlying asset of this contract is $1,100 (or EUR1,000). The value of the contract for party A however, i.e. the amount it has at risk, at least initially, is just $7, which party A paid for this option. We must distinguish between market value and notional value of a derivative – they may and usually do differ by orders of magnitude. The value of an option for the buyer (Party A) is always non-negative. The swaps however can take positive or negative values depending on the prevailing market prices. Options are often combined in more (and often very) complex structures aimed to address specific needs, real or imagined. In theory, every financial contract can be constructed from, or broken down to, financial options.
The primary use of derivatives is very much like insurance from a particular financial risk. For instance, a firm, which borrows at LIBOR may use an interest rate swap to fix the amount of interest it pays, never mind a change in LIBOR. Or, a German car exporter may use derivatives to make sure a billion dollars it will receive in the next months from overseas sales are converted to Euro at a rate between say 1.10 and 1.12. The sophisticated market participants (banks, hedge funds, etc.) use derivatives for both risk management and for speculation, and trade them en masse. Banks also sell derivatives to end-users, like the German car exporter, to insure (or “hedge”) them from currency, interest rate, commodity and other risks.
Why are derivatives risky? Because of the variation in prices of the underlying assets, and because of the uncertainty if the parties will keep on delivering. Let’s suppose that, when gold traded at $1,200, we agreed to pay $1,200 each month and to receive one ounce of gold (or its market price). But then the price of gold grows to $1,500. We now make $300 profit per month. But, if our counterparty fails to deliver, we would lose these $300, i.e. this is our credit risk. It goes further than that. Even if the gold price stays at $1,200, it still has the potential to grow higher, and we would then have potential risk of loss. Conversely, our counterparty would face the potential risk to lose its profit, in the case the gold price falls below $1,200. And here probabilities come into play.
Derivatives are typically traded under a contractual framework (under the acronym ISDA) that the market has accepted as standard. The master agreement is consistent in standardization of operational terms and concepts, but is also remarkably flexible. It also lays out a sound risk framework. To manage their risk, parties typically exchange collateral and guarantees, and agree to net out amounts they owe to each other. For example, if the gold price rose to $1,500 — and per above party A runs $300 credit risk on party B — then party B must post $300 collateral to party A. It’s all very simple and logical. Yet such derivatives sometimes bankrupt gold mines exactly when the price of gold is growing! No wonder Warren Buffet once called derivatives “financial weapons of mass destruction”. Derivatives are mostly useful — like a chainsaw is useful — but better not leave them in the hands of your kid.
While all this sounds simple, derivatives’ complexity runs big. Too great is the variety of assets underlying the contracts as well as the delivery terms. And too many and hard to come by are the probabilistic variables governing asset prices. Market players, like banks and hedge funds, use complex math and quantitative models to estimate derivatives’ value and risk, and yet they still fail. We all saw stark recent failures, like the crisis of 2008 but also the LTCM debacle ten years earlier. Their repercussions, as we remember, were truly global. Today, the total notional value of all outstanding derivative contracts is about 500 trillion US dollars, 7.5 times the world GDP.
By Vassil Chakarov