On Friday, the shares of Deutsche Bank took a record hit. So much so that the German chancellor himself had to step up and speak up for the bank and declare that it is a fundamentally solid bank.But still its share prices continues to fall. So here comes the question, what exactly is wrong with it? Well, nothing. Yes. There is absolutely nothing wrong with Deutsche Bank. It just happens to be another scapegoat of the global banking crisis and the tremendous deregulation at the American Banks. Deutsche Bank continues to fall pulling down other major European Banks.
Why are investors dumping their shares? Because they are panicked. There is a new model which is often considered in sentiment analysis. It is hyper panic model. News spreads. It spreads fast. Bad news spreads twice as fast as good news. Now, this is the classic case of a hot hand fallacy. Just in a negative sense. A hot hand fallacy is, a basketball player makes a few consecutive shots, so everybody just draws a line and assumes that the player is going to make the next shot as well. Basically, connect the dots linearly. After much drama of the past few weeks, and fall of two major US banks SVB and Signature Bank, also the UBS & Credit Suisse merger people are expecting Deutsche to fall. They are panicked. Somebody started dumping their shares, it got reflected on the prices. The news spread on social media. So another guy thinks he must know something I don't let's just trust him. So he also stars dumping his shares and this process continues and takes the form of a domino effect. So either everyone is equally smart or everyone is equally dumb.
Next let's understand, what is a credit default swap or CDS?
Lets say there is a rich guy called Greg. Greg has a lot of money. He decides to use it for lending and earning some interest on it. Paul approaches Greg for a loan. But, Greg doesn't know him. So, he turned to one of his trusted guys John to take a report on Paul. John says, Paul can be fairly trustworthy with money, I will rate him BB. But, Greg only wants to loan someone who he knows will pay back for sure. Now, Harvey steps into the game. He is know to Paul John and Greg. John has rated Harvey AA in terms of money handling and all that. Harvey says, I will insure your loan against a default, just pay me a part of the interest as insurance premium. So, this is a credit default swap. Somebody defaults, somebody else pays.
Greg is happy and passes the loan. Paul does not default and all of them walk away with a lot of money.
To contextualise, Greg is any entity with money to invest. Be it a hedge fund an investment bank or whatever. Now, Paul is any company or entity who is taking the loan. John is a ratings agency like Moody's. Lastly Harvey is an insurance company like AIG who sells these insurances.
During the 2008 crisis, what banks started doing was they combined these loans together and got a CDS for them collectively. Now they started trading these CDS in the open market. The underlying asset value of each CDS is still the loan which has the underlying asset value, the house or the mortgage which is backing this loan. Eventually, the price of a CDS goes up so high in the open market that it becomes costlier than that of the house. So the insurance is costlier than the very thing it is insuring. Eventually people started defaulting on their loans and finally the value of the CDS went down.
Deutsche Bank is very solid in terms of liquidity and assets. It has enough money to fund its operations and handle withdrawals. It has a rock solid business and profits soared a record high in 2022 after a long time. But, some major issues with the bank are:
- Deutsche Bank saw a spike in the cost of insuring its bonds against default, which rose to 220 basis points on March 24, 2023, from 142 basis points two days earlier. This indicates that the market perceives a higher risk of the bank failing to repay its debts.
- Deutsche Bank's troubles were part of a wider contagion that affected other major European banks, such as Credit Suisse, UBS, Societe Generale and Barclays. The banking crisis was sparked by the collapse of several U.S. banks, such as Silicon Valley Bank, First Republic Bank and Signature Bank, which were unable to cope with the impact of higher interest rates on their assets and liabilities.
- Higher interest rates were driven by the monetary policy tightening of global central banks, including the U.S. Federal Reserve, which raised its benchmark rate by a quarter point on March 22, 2023, to combat inflation. Higher interest rates increase the cost of borrowing for banks and their customers, and reduce the value of their bond holdings if they have to sell them to meet liquidity needs.
- The banking crisis also coincided with a global economic slowdown, which reduced the demand for loans and increased the risk of defaults and bad debts. The economic slowdown was caused by various factors, such as trade tensions, supply chain disruptions, energy shortages and pandemic-related restrictions.
Now, Deutsche bank has been facing some issues due to this very same thing.
- CDS can reflect the market's perception of the creditworthiness of a bank, as well as its exposure to other troubled banks. A higher CDS spread means that investors are demanding a higher premium to insure against the risk of default by the bank. For example, Deutsche Bank's five-year CDS spread jumped 24 basis points to 193 basis points on March 24, 2023, indicating that investors were more worried about its ability to repay its debts.
- CDS can also affect the liquidity and solvency of a bank, as well as its access to funding. A higher CDS spread can make it more expensive for a bank to borrow money or issue bonds, as well as trigger margin calls or collateral requirements from its counterparties. For example, Deutsche Bank's additional tier-one bonds, which are a type of hybrid debt that can be converted into equity if its capital ratio falls below a certain level, saw their yields surge to around 27% on March 24, 2023, reflecting their higher risk and lower price.
- CDS can also create contagion and systemic risk in the banking system, as well as amplify market volatility and uncertainty. A spike in CDS spreads can signal distress or default by a bank, which can affect other banks that have exposure or linkages to it. It can also trigger panic selling or buying of CDS contracts or other assets by investors who want to hedge or speculate on the situation. For example, Deutsche Bank's CDS spike was part of a wider sell-off of European bank stocks and bonds on March 24, 2023, following the collapse of Credit Suisse and other U.S. regional banks earlier this month.
This is a high time regulators and central banks around the world steps in to the scenario to take control.
Central banks can provide liquidity and emergency funding to banks that face cash crunches or solvency issues, as well as coordinate with other central banks to ensure cross-border stability. For example, the Swiss National Bank provided $54 billion to Credit Suisse, and the U.S. Federal Reserve injected $30 billion into First Republic Bank, but mostly through other banks.
Central banks can also adjust their monetary policy to support the economy and the financial system, by raising or lowering interest rates, buying or selling bonds, or providing forward guidance. For example, the U.S. Federal Reserve raised its benchmark rate by a quarter point on March 22, 2023, to combat inflation, but also signalled that it would be flexible and data-dependent in its future decisions.
Regulators can supervise and monitor the banking sector to ensure compliance with prudential norms, capital requirements, risk management and governance standards. They can also intervene to resolve failing banks or broker mergers or acquisitions with healthier ones. For example, the Swiss government brokered a deal for UBS to take over Credit Suisse, and the Hong Kong Monetary Authority oversaw the transfer of SVB Bank’s UK business to HSBC.
Regulators can also coordinate with other regulators and authorities to share information, harmonize rules and address cross-border issues. They can also communicate with the public and the markets to provide transparency, clarity and confidence. For example, the Financial Stability Board issued a statement on March 23, 2023, reassuring that it was closely monitoring the situation and working with its members to address any spillovers or systemic risks.
It is evident that central banks and regulators have vital functions in addressing the global banking crisis and preventing it from escalating into a full-blown financial crisis.
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