The collapse of Lehman Brothers in 2008 threatened the world's financial system and created one of the greatest financial crises in modern history. The fallout from the bankruptcy threatened to bring down the world's financial system and led to the Great Recession. Taxpayer-funded bailouts of banks and massive monetary stimulus combined to rescue the banking system and prop up the economy. On June 29, 2016, International Monetary Fund (IMF) announced that Deutsche Bank poses the greatest risk to the global financial system.
As of June 2016, no other major global financial institutions of Lehman Brothers' stature have declared bankruptcy. Many observers credit regulatory reforms such as the Volcker Rule, higher capital requirements and stress tests for stabilizing financial institutions in the United States, while similar rules stabilized European banks. However, the balance sheet of Deutsche Bank AG (NYSE: DB) shows excessive risk-taking by the bank.
Perhaps the biggest problem Deutsche Bank faces is excessive leverage on its balance sheet. According to Berenberg Bank's James Chappell, Deutsche Bank faces insurmountable challenges from poor-performing core businesses and a lack of capital. On May 16, 2016, Chappell cut his rating on the bank from hold to sell and lowered his price target on the shares, citing the vicious cycle the company faces to shore up its balance sheet and shed unprofitable businesses as rationale. He noted that the company has cut its dividend and pledged to cut employees and sell unprofitable businesses. However, he believes the company ultimately must raise more equity capital to solve its leverage problems. Deutsche Bank's valuation highlights the market's pessimism. As of June 15, 2016, the bank traded at 27% of tangible book value, which means the company is worth less than its liquidation value.
Need to Raise Capital
On June 9, 2016, Barclays PLC (NYSE: BCS) banking analysts downgraded shares of Deutsche Bank. The analysts cited the bank's need to raise additional capital to pay settlements arising from its sales of mortgage-backed securities (MBS) prior to the financial crisis. The analysts estimated that the settlements could cost the bank up to $4.5 billion. They also noted that Deutsche Bank is below the Common Equity Tier 1 targets set by U.S. and European regulators. The risk, they concluded, is that raising additional capital may be difficult and will dilute shareholders. The bank has raised 21.7 billion euros on three separate occasions since the financial crisis.
Massive Derivatives Risk
According to the Bank for International Settlements, the total notional value of derivatives contracts outstanding equaled $550 trillion in 2015. Deutsche Bank reported in its April 29, 2016 earnings announcement that it had notional derivatives exposure of $72.8 trillion, or about 13% of the total global amount. As of June 15, 2016, the total derivatives exposure equates to about 3,600 times the bank's market cap of $20.26 billion.
Deutsche Bank is unlikely to face losses equal to its notional derivatives exposure, since its contracts are netted out with different counterparties. However, the last financial crisis showed that counterparty risks can snowball and create a chain effect. In 2008, failures at Lehman Brothers and American International Group Inc. (NYSE: AIG) led to a run on banks and imperiled the financial system. Similarly, a failure at Deutsche Bank could have catastrophic consequences for the banking system in 2016.