Why are German banks causing such worry?

After several years of fretting about Spanish, Italian and French banks as the eurozone economy staggered onwards, the financial markets became nervous about the health of the German powerhouse Deutsche Bank and its smaller competitors at the start of this year.

Deutsche posted its first full-year loss since 2008 in January due to a variety of problems including a €5.2bn provision for fines and lawsuits, sending its shares careering lower and pushing its new bonds into a tailspin.

The crash in its €4.6bn tranche of contingent-convertible bonds,known as cocos, was particularly alarming because they are designed to wipe out investors in a crisis, therefore avoiding a state bailout – but so far no bank has put this safety valve to the test.

Deutsche Bank has not even come close to converting its bonds yet, but the firm has come back into sharp focus because of a $14bn fine proposed by the US Department of Justice last week for mis-selling mortgage-backed securities in the heady days before the financial crisis.

Shares in Deutsche have lost more than half their value so far this year. The IMF hasn’t helped matters, saying in June that the bank is the greatest contributor to systemic risk in the world’s biggest lenders.

Commerzbank is also preying on investors’ minds, after reporting another round of job cuts that will see one in five positions axed.

What is Deutsche Bank doing to address its problems?

John Cryan, the Briton who became chief executive last summer, hasset out a five-year restructuring plan that will cut about 15,000 of Deutsche’s 101,000-strong workforce. The bank’s dividend has been suspended for two years, and Cryan expects to close dozens of overseas sites from Argentina to New Zealand. It sold Abbey Life, its old portfolio of British life insurance products, for €1bn earlier this week.

The bank has insisted that its immediate problem, the $14bn fine from the States, can be paid without resorting to a state rescue – and in any case, as Cryan told Bild this week, the bank can probably follow the example of several US banks and negotiate the penalty down to a more manageable figure.

Some analysts, such as Kian Abouhossein at JP Morgan, think even a $4bn settlement “would put questions around [its] capital position”.

Will the German government bail out Deutsche Bank?

Not right now. The finance ministry, not wanting to alarm anyone, has fiercely denied that it is preparing any contingency plan if Deutsche cannot cope with the US fine. Cryan has said that capital needs are “currently not an issue”.

But it would be absurd to think that the German government has not put any thought into the flagging fortunes of the country’s biggest bank. Not least because there are strict rules in place in Europe that prevent state aid in most circumstances, which might need to be circumvented at some point.

What else can the bank do to turn around its fortunes?

Rumours surfaced over the summer of a possible merger between Deutsche and Commerzbank, its next biggest competitor, and more recently the idea of another multibillion-euro rights issue has been floated. Again, these reports have been played down by the bank.

Deutsche also has the option to “switch off” regular coupon payments on its coco bonds, providing a small amount of breathing space. Credit analysts led by Miguel Hernandez at BNP Paribas have said that a fine of more than $6bn could lead to coupon deferrals, according to Bloomberg.

Analysts at Autonomous have also suggested that the bank could save €2.8bn by not paying staff bonuses. 

What does this mean for British finance?

Deutsche Bank employs about 8,000 people in the UK, so at a basic level it means more job cuts in its offices in London, Birmingham and Bournemouth.

The slump in Deutsche’s shares risks dampening appetite for banking stocks across the board, leaving RBS even further adrift of its hopes that its shares will reach 73.5p – the level at which the UK government could sell off its stake for a profit.

If Deutsche decided to scale back its investment banking arm, this could be beneficial to rival outfits in the City – although the resulting gloom about the eurozone’s biggest economy would probably take the shine off the extra work.

Is this another Lehman Brothers?

Steady on, that kind of reckless talk could bring down the bank. Deutsche still has numerous tools at its disposal, painful though they may be, to shore up its capital levels using the financial markets. But they only succeed if investors have enough faith in the future of the organisation to support them.

Since Lehmans went bust in September 2008, international authorities have tried to create new structures that allow banks to fail while leaving the rest of the financial system relatively unharmed.

This is why Deutsche has coco bonds that it can write off in times of trouble, and why any German state rescue would be based on the new strict rules on bailouts, which have already this year prevented a rescuefor Italy’s Monte dei Pasci.

Hans Michelbach, a conservative politician in Bavaria, said it was “unimaginable” that the government would carry out a 2008-style bailout.

But the fact that people are prepared to put Deutsche in the same sentence as Lehman, even if it’s to deny their similarities, has inflamed concerns.

First appeared at The Telegraph