Will Deutsche Bank Boost Gold?

The standard scenario for the next recession assumes that the crisis will hit in China and spill over the whole world. However, there are growing concerns about the stability of Deutsche Bank. Could Germany’s biggest bank become the next Lehman Brothers? What does the banking situation in Europe imply for the gold market?

Deutsche Bank’s Problems

Remember Deutsche Bank? It is Germany’s largest bank, the fourth largest bank in Europe and the eleventh in the world. It was engaged heavily in the collateralized debt obligation market during the housing credit bubble from 2004 to 2008 and involved in the Libor scandal. Now, it is in the spotlight again. Yesterday, Deutsche Bank’s shares dropped more than 4 percent to lows not seen since 2009, after plunging 40 percent this year. Investors are clearly worried about the bank’s balance sheet. It should not be surprising because Deutsche Bank recorded losses of €6.8 billion for 2015. Thus, if the bank has any large unexpected costs (which is quite probable given that the bank is facing hundreds of litigation cases) it may be unable to meet its obligations and, for example, to pay interest on its contingent convertible bonds. The yield on those bonds surged, hitting 12 percent.

Chief executive John Cryer reassured the markets that the bank does not need to raise equity and it is absolutely rock-solid. German Finance Minister Wolfgang Schaeuble also said he was not worried about Deutsche Bank. However, investors are not convinced. Credit-default swaps (CDS) on the bank’s debt jumped to their highest level since 2012, the height of the European debt crisis. The rise in the price of CDSs indicates that investors are more worried about the Deutsche Bank’s stability since they are willing to pay more for protection against the bank’s bankruptcy. The cost of protecting the company’s subordinated debt from default for five years using credit-default swaps has more than doubled since the end of 2015.

The Deutsche Bank’s problems resulted from the fact that low margins in retail banking prompted the bank to engage in more lucrative, but risky activities. In fact, Deutsche Bank has the biggest derivative exposure in the world, amounting to about $75 trillion, more than Lehman Brothers had. It is gross derivative exposure, but still the risk is high.

European Banks Under Pressure

Other European Banks also suffered losses in the stock market. Generally, the European banking sector is rotten. While American banks have managed to deleverage at least to some extent, their European counterparts are still sitting on €1 trillion in non-performing loans. Moreover, European banks have significant exposure to China and the energy sector, while they have to continually raise capital ratios. According to analysts, Deutsche Bank would be the most sensitive bank to higher default rates in the oil and gas sector.

Conclusions

The take-home message is that investors are increasingly worried about the condition of Deutsche Bank. Rightly so, as the bank is facing important problems and is highly exposed to different risks. The possibly of bankruptcy would trigger a financial crisis, boosting the price of gold. However, it is perhaps too early to announce the collapse of the German giant. Moreover, Deutsche Bank would be probably considered too big to fail, so the EU and the ECB would provide support for the bank. On the one hand, it would depress the euro and strengthen the U.S. dollar, exerting downward pressure on gold. On the other hand, it would spur the safe-haven demand for gold. The rising fears about the condition of European banking and about the Brexit (another economic crisis in continental Europe should raise the odds for a British exit from the EU) should be supportive for the price of gold.