— Other Liabilities

41 trillion euros concealed in Deutsche Bank’s balance sheet

Lehman Brothers’ bankruptcy in September 2008 had disastorus effects for the global economy.

Now another financial giant is posing a great risk for to the financial markets.

As the DoJ’s plans to issue a 14bn fine to Deutsche Bank for selling toxic assets during the subprime mortgage boom hit the markets, Deutsche Bank’s ability to pay this amount started to be scrutinized.

Deutsche Bank’s shares have tumbled after the announcement which came just a week after EU’s 14 bn demand from US tech giant Apple for gaming EU tax system.

Market cap of Deutsche Bank, which has an asset size of 2 trillion dollars fell below 16bn dollars due to its stumbling share price.

Markets seem to be relieved with the expectation that settlement amount might be around 5.5 bn dollars. However problems with Deutsche Bank is not limited to the settlement fee it might have to pay.

How solvent is Deutsche Bank?

According to the 2016Q2 financial results, Deutsche Bank made a 5.5 bn provision for its potential legal costs which might stem from the alleged case.

Any amount exceeding that will cause an unexpected cash outflow for the bank, meaning further deterioration for the balance sheet and ratios which the bank has to compile as per Basel III regulations.

Despite it’s fragile balance sheet Deutsche Bank is very unlikely to default due to its systemic role. Yet, Deutsche Bank investors and financial sector might take another strong hit with any further deterioration on its balance sheet.

However, the main issue underlying Deutsche Bank’s problems is its undercapitalised balance sheet rather than the amount of settlement it’ll have to face.

Deutsche Bank’s latest financial results are in line with Basel III regulations. For example; leverage ratio, which is calculated as ‘common equity/assets’ must not fall below 3 percent according to Basel III. Where Deutsche Bank has a leverage ratio of 3.4.

Concerning the ‘CET1’ (Common Equity Tier1 ratio), which is calculated as ‘(paid in capital+retained earnings)/risk weighted assets’; Deutsche Bank has a ratio of 10.8 percent which is higher than the minimum CET1 ratio of 4.5 percent, and 7 percent which is the CET1 ratio a bank must satisfy to be able to pay dividends.

But complexity of Deutsche Bank’s balance sheet obscures the matters, since the great amount of derivatives in its balance sheet puts authenticity of these ratios in question.

How to value derivatives?

Balance sheet of public companies aims inform investors and public about the financial situation of the company.

Audit companies perform their due diligence in line with international accounting principles; namely International Financial Reporting System (IFRS).

Assets such as cash held in bank accounts, cash receivables/payables are relatively to easy to value since they can be tracked with counter-parties. Therefore, under normal circumstances these type of assets do not perform strong fluctuations.

Assets like derivatives however, are highly complex and valued with much more opaque methods, also much more prone to fluctuations.

Derivatives are valued in three different classes according to IFRS 13, which regulates handling of such assets.

Assets classified as ‘Level 1’ are actively traded in markets and therefore their value is quiet transparent. (Assets such as equity, sovereign bonds etc.)

Level 2’ assets are not traded on indexes, however there are similar assets traded in indexes and their value is deducted from these similar type of assets.

Enter the ‘Level 3’ and things get much complicated. This class comprises of assets that have no liquid market and have unique features as they are traded ‘over the counter’. Therefore their value is calculated by assumptions of the firm’s estimations on how much the market participants are willing to pay to acquire these assets.

Concentration in Level 2 and Level 3 assets

Basel III regulations require off balance sheet exposures such as derivatives to be added to the balance sheet assets for leverage calculations.

Kevin Dowd an author from Cato Institute has raised this particular issue with Deutsche Bank’s balance sheet in his August 2, 2016 dated post.

According to its 2015 YE financials, Deutsche Bank states that it’s derivative holdings which has a notional amount of 41 trillion euro fairly valued at 193 billion.

Potential future exposure stemming from this holdings has been claimed as 215 billion euro. (2015YE report, page 157)

Deutsche Bank’s risk weighted assets (size of assets after low risk assets such as sovereign bonds are deducted from the total assets) assumed to be around 1.4 trillion euro, with a slightly little contribution of 193 bn euro, stemming from derivative risks.(2016Q2 report, page 52)

The risk here is that if the potential future exposure from derivatives turns out to be more than 193 billion, both the leverage and CET1 ratios declared in financial reports will turn out to be insignificant.

Although not the full amount of 41 trillion is going to be a risk factor since it also includes derivative contracts cancelling each other out, the fact that no one knows how the models beneath the balance sheet work to calculate the potential risk is quite concerning.

Another clue about how accurate these valuations actually can again be found in the annual report of Deutsche Bank. (2016Q2 report, page 94)

Over-The-Counter Derivative Financial Instruments:[…] More complex instruments are modeled using more sophisticated modeling techniques specific for the instrument and are calibrated to available market prices. Where the model output value does not calibrate to a relevant market reference then valuation adjustments are made to the model output value to adjust for any difference. In less active markets, data is obtained from less frequent market transactions, broker quotes and through extrapolation and interpolation techniques. Where observable prices or inputs are not available, management judgment is required to determine fair values by assessing other relevant sources of information such as historical data, fundamental analysis of the economics of the transaction and proxy information from similar transactions.’

Considering financial institutions usual reluctance to sharing bad news about their derivative holdings, unfortunately we have to rely on time to tell us how sound these assumptions are.

Is it really possible for Deutsche Bank to go bankrupt?

Any kind of cash outflow like settlement fees or losses from derivatives will stress Deutsche Bank’s balance further. These cases have the potential to cause run on the bank.

However balance sheet is not the leading factor on determining solvency of a bank. Liquidity is.

Unless Deutsche Bank finds itself in a case where it has no longer access to the capital markets, which triggered the collapse of Lehman Brothers in 2008, bankruptcy does not seem very likely.

Even in the case of a perfect storm, German government and EU will have the last say on the case.

This article originally appeared on diken.com.tr on 08/10/2016