By James Gorrie
The story is a familiar one: A large bank with a critical influence on the economy finds itself in a liquidity crunch and then its troubles soon drag down other big banks around the world with it.
In 2007, British bank Northern Rock was the first bank to run out of money, but it wouldn’t be the last in what was to become the Global Financial Crisis of 2008-09. Even though it issued one in every five mortgages in Britain, Northern Rock was strapped for cash. Its business model relied on selling very low-interest rate mortgages and then bundling them into quarterly bond offerings. That model worked well until there were no more buyers for the increasingly risky bonds.
But as the world quickly discovered, Northern Rock wasn’t the only well-regarded bank in a very compromised position. Other banks held subprime U.S. real estate bonds and were also under stress. The global financial system became increasingly choked on bad debt of risky, under-performing collateralized mortgage portfolios.
Eurozone Economic Weakness
Today, just as it was then, the key factor is weakness within a bank’s business model, and of course, whether that weakness is shared by other banks, either by practice or exposure. That’s where Germany’s Deutsche Bank, and indeed, other European banks find themselves today. The weakness isn’t so much from issuing and selling risky mortgages as much as from larger, systemic and business practice issues.
At the macro level, a weak European economy is a big factor. As the economy slows down, banking activity slows down as well. What’s more, the European economy isn’t immune from the trade tensions of the world. As much of Europe struggles with low or zero growth, falling demand from China and different European economies, the pressure on banking business models increases.
This recession pressure is seen in the low and even negative interest rates European banks charge for borrowing money. Though banks make money on fees, they also gain from interest rate spreads on lending. Subdued economic activity means a loss of lending business for banks. Low and negative interest rates, in turn, are intended to spur economic investment through business borrowing.
But economic growth and business expansion aren’t driven simply by cheap money. Consumer demand is also a big part of the economic equation. Without rising consumer demand in the Eurozone, business expansion becomes an added risk, not an economic remedy.
Brexit Adds to Economic Uncertainty
This challenge to the European economy and its banking system is magnified by the ongoing drama of the Brexit question. As one-fifth of the Eurozone’s economy, Britain’s exit, whether “hard” or “soft” will have a significant, yet not completely understood impact on European banking. That political uncertainty is beyond banking’s ability to control.
At the business level, many European banks have created many of their own problems. According to a recent report by Moody’s Investor Service, prominent European banks have been violating trade sanction and anti-money laundering practices for many years. The report reveals that since 2012, European banks have been fined “over $16 billion” for these violations.
Shady Practices Cost Banks
As bad as that sounds there’s more trouble ahead for European banks. The Moody’s report states that “(European) Banks face financial, operational, and reputational risks as more investigations take place.” And notably, although 75 percent of the current fines have been levied by U.S. authorities, European banking regulators are becoming more aggressive, raising their fines and penalties against European banks engaged in illegal activities. For example, in September 2018, Dutch regulators fined ING Groep $915 million.
Fines and penalties not only cost banks capital, but also reputational damage that can lead to additional losses in customers and revenues. That’s a downward spiral that already weakened banks don’t need.
But that’s not all. There are also the costs of remediation. These troubled institutions are forced to engage is more capital investments on technology, compliance oversight as well as deepening auditing procedures to prove their compliance to regulatory authorities. These additional costs, in turn, lead to personnel layoffs, which further damages their financial health as well as negatively impacting the overall European economy.
Deutsche Bank in Rough Shape
Among European financial institution in the worst shape is German financial giant Deutsche Bank. The flagship German bank is in a major restructuring effort that will eliminate its equity trading operations, trim investment banking and perhaps isolate its more toxic assets. It will also cut out 18,000 jobs. Some expert observers fear that these actions will actually make the global megabank weaker and less solvent than it is today.
How serious are the German bank’s problems?
They’re formidable. In addition to its sickly balance sheet, Deutsche Bank is being investigated for its key position in the Danske Bank scandal, one of Europe’s most egregious money laundering schemes. As the scandal continues to unfold and its health continues to come into question, expectations for its ongoing survival fall.
The greater concern, however, is the effect that Deutsche Bank’s eventual or even imminent demise could have. It could be the first domino to fall, in what could be a replay of the Northern Rock collapse and its global implications.
US Exposure too Big to Ignore
Unfortunately, as in 2008, the interconnected global financial system results in major banks and financial institutions have exposure to financial risk in multiple markets. A whopping 41 percent of American banks’ foreign balance sheet exposure is to European banks.
That’s too big to ignore or to avoid. Problems that begin with Deutsche Bank will certainly be problematic for the Europe and America, which will, of course, impact the health of the entire global financial system.
James Gorrie is a writer and speaker based in Southern California. He is the author of “The China Crisis.”