Monday, November 21, 2011

Regulators as source of financial instability: Deutsche Bank could transfer contagion

In his Bloomberg column, Simon Johnson examines how Deutsche Bank could transfer contagion between the US and Eurozone.

Unintentionally, he highlights one of the key ways that regulators are a source of financial instability:  reliance on each country's regulator to properly assess the banking operation of each bank doing business in its country.

Clearly, this reliance is misplaced.  Some regulators are just not as capable as others.  For example, in the run-up to the financial crisis in the US, firms that could choose their regulator choose the Office of Thrift Supervision.

In the case of Deutsche Bank, it is clear that the regulators in all the countries that the bank does business in do not have access to the all the useful, relevant information for doing their job.

In describing the mother of all financial databases, I have consistently said the database must be global and include all of a bank's current asset, liability and off-balance sheet exposure detail.

With this data, regulators can assess what is going on both locally and globally.

You’ve probably never heard of Taunus Corp., but according to the Federal Reserve, it’s the U.S.’s eighth-largest bank holding company. Taunus, it turns out, is the North American subsidiary of Germany’s Deutsche Bank AG (DBK), with assets of just over $380 billion. 
Deutsche Bank holds a large amount of European government and bank debt; it also has considerable exposure to lingering real estate problems in the U.S. The bank, therefore, could become a conduit for risk between the two economies. But which way is Deutsche Bank more likely to transmit danger -- to or from the U.S.?...
The German bank, however, is thinly capitalized. Its total equity at the end of the third quarter was only 51.9 billion euros, implying a leverage ratio (total assets divided by equity) of almost 44. This is up from the second quarter, when leverage was about 36 (assets were 1.849 trillion euros and capital was 51.678 euros.)... 
Globally, Deutsche’s capital ratios are relatively healthy, judging by the banking industry’s standard measures. At the end of the third quarter, its Tier 1 capital ratio was 13.8 percent (up from 12.3 percent at the end of 2010) and its core Tier 1, which excludes hybrid debt that can convert into equity, was 10.1 percent. 
How does such a highly leveraged bank become “well- capitalized”? The answer is that “risk-weighted assets” were 337.6 billion euros as of Sept. 30. But what is a low risk- weight asset in the European context today? Incredibly, it is sovereign debt, which of course is far from riskless at the moment. 
Perhaps Deutsche Bank holds mostly German government debt, which still has safe-haven value. But it’s likely that Deutsche also holds a significant amount of Italian and French government bonds.
The answer to this and similar questions requires current detail data.
Still, the bigger risks are probably in the U.S. Deutsche Bank is a significant trustee for mortgages, having been heavily involved in the issuance and distribution of mortgage-backed securities during the housing bubble.... Many questions on whether paperwork was done properly and whether the rights of investors have been protected hang over these trusts. 
Let’s take a look just at Taunus Corp.,... The latest figures (from the Fed data, using the consolidated financial statement at the end of the third quarter) show Taunus with total equity capital of just $4.876 billion. This implies an eye-popping leverage ratio of around 78. 
Why would the Federal Reserve and the new council of regulators known as the Financial Stability Oversight Council allow Deutsche Bank to operate in the U.S. with sky-high leverage -- with its huge implied risk to the rest of the financial system? 
Presumably, in the past, U.S. authorities have taken the view that Deutsche Bank had a strong enough balance sheet worldwide that more capital could be provided to its American subsidiary, if needed.

Such a presumption now seems questionable, at best. Earlier this year, Bloomberg News reported that Taunus needed almost $20 billion of additional funds to meet U.S. capital standards, and that Deutsche Bank was trying to declassify Taunus as a bank- holding company to avoid capital requirements entirely. It’s unclear where this process now stands, but it’s also not obvious how declassification would help U.S. or global financial stability.... 
All of this raises troubling questions. 
Have U.S. bank supervisors really satisfied themselves, through onsite inspections, that Deutsche Bank’s risk weights accurately reflect market conditions and the increasing structural weakness of the euro area? 
Can U.S. regulators document their satisfaction beyond the materials produced for the European Banking Authority, which earlier this year oversaw stress tests that pronounced now-collapsed Dexia as well-capitalized? (Actually, Dexia had stronger capital ratios than Deutsche Bank.) 
Why should market participants be dependent on the regulators for analysis?  If ultra transparency was made available through the mother of all financial databases, market participants could do the analysis for themselves.

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