Deutsche Bank: not Lehman Brothers

Germany's most important bank has become a mainstay in the headlines, and rarely in a good way these days. A record loss in the last year, rock-bottom share prices, every fourth branch shut down, and rumors of a split. The Deutsche Bank is more "zombie than champion", according to "The Economist."

As if that weren't bad enough, the International Monetary Fund labeled the bank the most dangerous bank in the world, because of all the systemic risk it brought to the international banking system - more than HSBC.

"Whether the German Bank is more dangerous than competitors like Goldman Sachs, HSBC, Morgan Stanley or Barclays, that's hard to say," said Martin Hellmich, a professor for risk management at the Frankfurt School of Finance & Management.

Too little capital

But a glance at Deutsche Bank's balance sheet shows it has less capital than its competitors, he said.

"Looking at this combination - very strong linkage via a huge commercial business to a large number of clients worldwide, but very tight capital - then one can see how the IMF came to its assessment."

Now Deutsche Bank is being compared with Lehman Brothers, the investment bank whose bankruptcy in 2008 sparked a global financial crisis. Especially alarming is the mountain of derivatives. Those are financial products, with which exporters use to hedge against currency effects, and investors use to insure against interest rate fluctuations.

But there are derivatives that bet on specific outcomes and have no connection to real trade. Because these types of derivatives played such a key role in the US, such products have fallen into disrepute.

"Deutsche Bank has a very complex investment department with massive trade in derivatives," said veteran banker Christopher Wheeler, who analyzes banks for London-based Atlantic Equities. "And it's not clear, how big the risks are in this portfolio."

42 trillion in derivatives

According to the bank's latest financial statement, its derivatives were worth an impressive 42 trillion euros, that's one of the biggest positions in the global finance industry. In comparison, Germany's annual GDP is worth around 3 trillion euros.

The vast sum is computed simply by adding together the values of all derivatives contracts, even as some of those contracts effectively cancel each other out. Risk management specialist Hellmich cites interest rate swaps as an example. If an investor buys such a contract for 100 million euros to hedge against rising interest, and another client hedges against declining interest for the same sum, then the interest rate risk at the bank would be zero.

Still, trading in derivatives inherently carries what's called the counterparty risk. That's when the other party to a contract defaults on the obligation and is unable to deliver his or her side of the deal. In a long chain of derivatives trading, one bank going bankrupt can drag down many other institutions with them in the sort of domino effect seen during the financial crisis of 2008 and 2009.

But these days, derivatives are more strictly regulated, and banks have to set aside more capital to trade in them.

"That Deutsche Bank has a lot of activity in the area of derivatives means there are also high capital requirements," said Hellmich. "That's another reason why the bank is under pressure."

Who passes the stress test?

In June, Deutsche Bank failed the stress test in the US for the second time. But it's unlikely to fail the upcoming test by the European Banking Authority (EBA) on July 29, said analyst Wheeler. But that has less to do with the bank than the test itself.

"The EBA's stress test is going to produce a big mix of numbers that are hard to understand," said Wheeler.

He added that one of the problems was the difference in how bad credit was dealt with across Europe - in Italy, it's done very differently than in Germany, for example. The US stress tests are clearer and more informative.

Special attention will be paid to the results of Italian banks this time around. Because they lack capital, the Italian government has asked for aid, which isn't allowed under eurozone rules. It's possible that an exception will be made, should the country's third- biggest bank, Monte dei Paschi di Siena, fail the stress test.

Threat from Italy

The chief economist of Deutsche Bank, David Folkerts-Landau, has also called for a European rescue fund worth 150 billion euros to stabilize the banks.

"When Europe's banks come under pressure, that affects other banks," said Hellmich, "especially the banks with significant trading activities". Like the Deutsche Bank.

But Hellmich still doesn't believe that Deutsche Bank would need rescuing with tax money, or that it faces bankruptcy. What he sees is a long and painful restructuring effort.

"That can extend as far as dividing the bank into different business areas."

London-based analyst Christopher Wheeler is certain that the bank will be able to come out of its predicament on its own steam, or in a pinch, get a fresh cash infusion from capital markets. But when push comes to shove, Deutsche Bank is unlikely to fail. "It's all in the name: Deutsche Bank," said Wheeler. "Germany would do everything to help its bank solve its problems."