New Regulations to Force a Lowering of Leverage Ratios
We recently wrote about the problems regarding what can only be termed 'opaque accounting' at Deutsche Bank. While the particular practice discussed follows the letter of the law, it nonetheless makes it more difficult for outside observers to assess the risks the bank is exposed to. This is of concern mainly because German banks in general and Deutsche Bank in particular are known to be highly leveraged.
The high degree of bank leverage in Europe has inter alia evolved due to an underdeveloped corporate bond market: compared to the US, far more lending to the corporate sector is performed by banks rather than by investors in Europe. The risks and weaknesses associated with this practice have been amply demonstrated in the euro area debt crisis.
There are currently attempts underway to force banks to reduce their risks, mainly via the so-called Basel 3 framework, which essentially demands the institution of higher capital ratios. It should be noted here that the practice of fractional reserve banking as such has not been touched at all – it hasn't even been discussed. Nevertheless, Basel 3 and associated regulations recently formulated by the Fed for banks operating in the US, imply that the banking sector overall will have to curtail its leverage, which is inherently deflationary. Almost €3.8 trillion of uncovered money substitutes exist in the euro area's banking system (if the EU 27 were considered, then the addition of uncovered money substitutes issued by UK banks alone would raise this figure by another € 1 trillion).
How can banks attain these lower leverage ratios? They either have to reduce their asset base, increase their capital, or both. They can achieve this by selling assets, reducing outstanding credit on their books by calling back loans, issuing additional share capital and retaining earnings. In many cases a combination of all these will be pursued. However, the issuance of new share capital is largely the province of the truly desperate. All other banks will likely try to avoid angering their shareholders by diluting their stakes further.
Selling assets is not going to have an effect on the money supply, but but it should be pointed out that the banking system as a whole can not sell its outstanding loans so easily: who is going to buy these loans if not other banks? However, since the banks are all trying to reduce leverage at the same time, most won't be eager to acquire the loans of other banks.
Retaining earnings – if there actually are earnings – won't be sufficient in most cases. The effect of retained earnings on leverage ratios can be improved by concurrently slowing down the issuance of new credit, up to the point where more credit is paid back than is extended. The latter is deflationary, as extant uncovered money substitutes will shrink if this course is pursued (absent an active inflationary policy by the central bank that is aimed at creating new deposits).
We have no problem with that, but most politicians and economists will likely regard it as one. If indeed the amount of fiduciary media in the euro area is set to shrink, one long term effect will be (ceteris paribus) a strengthening of the euro's purchasing power. This would be excellent news for consumers, savers and all those depending on fixed income (retirees, widows, orphans…) – precisely the groups that are punished the most by inflationary policy. It would be bad news for all those whose economic activities depend on easy money, as well as for all those who have accumulated very large unproductive debts, including governments. There would be long term gain, but considerable short term pain. Since short term pain is politically unpopular, reining in the banks is a difficult balancing act from a political perspective.
The euro area's true money supply, via Michael Pollaro. Base money (currency and covered money substitutes) and fiduciary media (uncovered money substitutes) in the euro area. Uncovered money substitutes amount to nearly € 3.8 trillion – click to enlarge.
Deutsche Bank – A Vast Balance Sheet Needs to be Brought to Heel
As reported in the FT, the aforementioned Deutsche Bank will need to shrink its balance sheet by about 20% to comply with the new leverage ratio regulations. A few excerpts:
“Deutsche Bank plans to shrink its vast balance sheet by as much as a fifth in order to comply with incoming stricter rules for financial soundness.
In a big strategic step by Germany’s largest lender by assets, Deutsche is expected to tell investors that it aims to achieve a minimum 3 per cent ratio of overall equity to loans by the end of 2015, people briefed on the plans said.
[…]
The German lender’s estimated ratio of equity to assets stood at 2.1 per cent at the end of the first quarter, the second-lowest of 18 banks ranked by Morgan Stanley analysts.
European regulation based on the Basel III global rule book calls for the minimum ratio of 3 per cent to be achieved only in five years’ time. But the topic has risen on investors’ agenda after UK, Swiss and US regulators have drawn up plans for either stricter timetables or higher ratios.
Deutsche Bank aims to trim its balance sheet by up to 20 per cent to about €1tn under US accounting rules in the next two and a half years. The bank believes the measures it is planning would have a very small impact on earnings.
Its strategy to achieve the minimum ratio includes the application of new regulatory rules for the accounting of derivatives, reducing its vast cash pile of €240bn and shrinking the €90bn of assets in its so-called non-core unit, mostly non-performing loans.
Analysts say investors will push for banks to reach the minimum ratio much earlier than the Basel III rules demand. “Our expectation is that most European banks will aim to meet requirements by 2015,” Kinner Lakhani, analyst at Citigroup, wrote in a note to clients.
The discussion around leverage ratios has brought Deutsche Bank’s capital position back into the spotlight only months after senior managers thought the issue had been taken off the table.
[…]
The focus on leverage ratios has drawn the ire of bank executives, who warned it would incentivize lenders to concentrate on riskier products and reduce cash holdings.
“A leverage ratio is undoubtedly important,” Anshu Jain, Deutsche Bank’s co-chief executive, said at a recent conference. “But [it] has significant flaws that could lead to perverse outcomes.”
(emphasis added)
We want to point out a small error in the FT's account. If Deutsche Bank (DB) were to shrink the size of its balance sheet to a mere €1 trillion, it would shrink it by 50%, not 20%. The reality of the matter is that DB not only sports scandalously high leverage of 50:1, but its balance sheet amounts to €2.03 trillion, approaching the size of the annual output of Germany's economy (Germany's GDP is about €2.7 trillion). Note as an aside here that the notional value of DB's derivatives book is about €1.3 trillion.
Obviously, when a bank is levered at a ratio of 50:1, there is 'no margin for error', as Thomas Hoenig, former Kansas Fed president and now vice chair of the FDIC, recently remarked. Hoenig incidentally is one of the scourges of TBTF banks, and has been repeatedly calling attention to the problem that they continue to exist and are in fact bigger than ever. Hoenig believes that Deutsche Bank is 'horribly undercapitalized'. He is correct. As things stand, the bank undoubtedly consitutes a large systemic risk factor. This has nothing to do with how well the bank may be managed otherwise: it is a simply a matter of mathematics. A bank with over € 2 trillion in assets that is leveraged 50:1 represents an immense potential threat to financial stability.
Deutsche asserts that it can shed € 300 billion plus worth of assets without impacting its earnings. This raises the not unreasonable question why it was holding them in the first place, as Christopher Wheeler (a London-based bank analyst with Mediobanca) has pointed out.
Jain's Groundless Objections
Lastly, let us briefly deal with the objections voiced by DB's co-CEO Anshu Jain. These are groundless. Essentially he is asserting: “If our ability to use other people's money to make profits for ourselves is somehow curtailed, we will take even bigger risks with the remaining funds.”
This is an indirect admission that shedding assets will indeed have an effect on earnings – otherwise, why would greater risks have to be taken post deleveraging? So Jain is implicitly threatening that banks – including DB one presumes – will create even bigger systemic risks if steps are taken to lower the risks they already pose.
We agree in principle with the sentiment that new regulations usually have a plethora of unintended consequences. However, the fact remains that the existence of a fractionally reserved banking system as such already represents a huge risk for the entire market economy. Because of this great risk, tax payers are generally expected to pick up the tab when a behemoth like DB gets into trouble. Fractional reserve banking is a legal privilege the existence of which can neither be justified by traditional legal principles, nor by economic theory (nor, we should add, is there any empirical evidence that would confirm that it actually 'helps' the economy to grow. On the contrary, as credit expansion is at the root of the boom-bust cycle, it tends to impoverish society at large). Since the banks have been given extraordinary license in expanding the issuance of fiduciary media due to being backstopped by central banks, anything that forces them to reduce leverage has to be seen as a step in the right direction.
Jain's objections sound as if he thinks that banks are entitled to a certain level of profitability and that their ability to extract such profits from the rest of the economy, already extraordinarily enhanced by the fractional reserve banking privilege, should not be subject to any limitations whatsoever. There exists no such entitlement.
If there were a truly free banking system in the context of an unhampered market economy in place, then there would be no regulatory meddling – but that is obviously not the case. We would furthermore posit that in such a free market and free banking environment, bank profits overall would likely be far smaller than they are today. The coddled and highly privileged banking cartel would be exposed to far greater competition and banks could no longer rely on a 'lender of last resort' keeping them out of trouble every time their speculations go wrong. Obviously Mr. Jain is not arguing in favor of free banking. He wants to keep things as they are, he only wants the banks to retain as many privileges as possible within the existing framework.
From left to right: Deutsche Bank chief financial officer Stefan Krause and the bank’s co-chief executives, Jürgen Fitschen and Anshu Jain.
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