Deutsche Bank and the herd mentality on capital adequacy


About a month ago Deutsche Bank experienced one of its most difficult moments since the financial crisis of 2008-2009. In a matter of days, its share price dropped precipitously, nearly 30% down, rumours sprung that the German lender was in dire financial condition (given the threat of a large fine in the US) and some big instiutional clients started fleeing threating to trigger  a run on the bank.

The heart of the problem was whether Deutsche had enough capital.

It is remarkable that while many observers opined that Deutsche Banks’s capital was inadequate, still many others, including Deutsche’s own management, claimed that the run that was about to start was irrational since the bank had considerably more capital than a decade ago. FT’s , even quantified it at around three to four times as much capital as what the bank previously had.

Yet investors remained unconvinced. They compared Deutsche’s capital to that of other similar European banks, noted that Dutsche was the laggard and reached the conclusion that capital was insufficient under realistic scenarios, given the impending DoJ fine and despite the large legal provisions made by Deutsche.

Why did the market react that way? Couldn’t market simply say, oh ah, despite all adversities Deutsche Bank has way more capital than it ever had in the last ten years, even assuming a large fine from the SEC, so why worry too much?

Apparently not, as the market instead panicked, albeit for a brief period. The underlying question here is what is adequate capital for a bank. As Marcia Stigum very aptly explains, “since the whole question of capital adequacy boils down to asking how much capital a bank needs to ensure its survival under unknown future conditions” it is not surprising that neither regulators nor banks themselves have ever found a definitive answer to that question. We live in a world of radical uncertainty so who can confidently predict what condition would prevail in financial markets in future or how a specific portfolio of loans and securities will fare.

In those circumstances what banks do is they stay with the herd. In other words each bank compares its position to that of the other banks and aims to stay in line with its peers. This behaviour is rational from banks’ point of view given that both regulators, investors and clients are ready penalise a bank that steps too much out of line.

So to come back to the question about Deutsche, the reason for the panic was not necessarily the objective lack of sufficient capital buffers but rather the tendency of the investors to penalise banks when they deviate from the herd.

Just as with many other issues in the economics of bubbles and panics, the question of Deutsche’s capital adequacy and the panic surrounding it, all boiled down to herd mentality and self-fulfilling behaviour.

Money and Credit, how does it work?

Money can be confusing. In the past it used to be in the form of gold. But what is money nowadays? It is more like very liquid and abstract credit. And since it is credit, it is also debt. This is very confusing because we are used ot think of money as “something”. To think that every unit of money is somebody’s asset and at the same time somebody else’s liability is not easy for the untrained observer.

Here is a “fairy-tale” attempt to explain this in a way that can build intuition on how this works and how money is linked to the underlying concrete transactions which we like to call the “real” economy. This fairy tale is based on chapter 6 of John Hicks’ book “A Market Theory of Money” and is inspired by Professor Mehrling’s Money and Banking course at Coursera.

The Tale of Money and the roots of the Money Alchemy
We could imagine a pre-money society. I am a producer of apples and you want to buy some in exchange of pears. But you expect your pears to ripen two months from now. We could agree that you get the apples now and I wait for the pears to be delivered later. That would be inter-temporal trade with a normal contractual relations. But you could also offer me a paper which says “[Your name] promises to deliver 10kg of pears to the bearer of this note on [date]”. That would be something like a negotiable instrument. I am not sure these kind of things ever existed. The point is that once I get this paper I could trade with it. I accepted it because I trust you will deliver. I could pass it on to anybody else who equally trusts you.

How can I use the paper to trade with people who don’t trust you? I have to use the services of a third party that is “universally” trusted. That party should be willing to take my paper and issue its own liability, again let’s imagine in the form of paper. Here we better introduce some measure of value and say that the third party issues a paper worth 10 Guldens (the name has nothing to do with gold). This third party will have, of course, discounted my “pear paper” (i.e. with those 10 guldens I will be able to buy less than 10kg of pears). Now that I have the liability of the third party I can trade with anybody in the community, or at least with a wider circle of people than with the “pear paper”.

The third party is trusted “universally” because it is doing this transformation of debts professionally and is supposed to pick up the good promises that are unlikely to go unfulfilled. It’s trusted also because it holds a portfolio of these. So even if one of the “papers” remains unpaid the others will be and given that it discounts them at the appropriate rate all should be fine.

We can call this third party a bank…

Although this is not representing accurately what banks do, or have ever done, they do something close to that. And what central banks do is similar too. Instead of promises to pay apples/pears they usually obtain short-term government debt (but also other things like MBS recently in the US) and issue central bank reserves or banknotes in exchange.

Europe’s QE: will it work, what the market thinks?

This week James Mackintosh of the Financial Times wrote that the market reaction to the prospects of QE in Europe suggests that QE will happen but it will not work. Mackintosh’s arguments run along the following lines. In the US quantitative easing worked mostly as a confidence boost. When the Fed started bond purchases the bond yields went up. On a purely demand and supply level of analysis this made no sense. Increased demand should have brought the bonds’ prices up and their yields down. But because QE did work its miracle in the US (i.e. it did boost investor confidence) money flowed into stocks and other assets and bond prices decreased.

In Europe, however, as Mackintosh points out, German bond prices were going up while yields dropped on 27 November to a record low of 0.7%. Mackintosh reasoned that this implies that the market believes there will be QE in the eurozone but it will fail to boost confidence, and therefore the simple demand and supply logic is playing out. Hence German bonds price went up and yield reached lower.

Two things contradict this theory.

First, the short term market reaction is almost certainly driven by traders front running of the asset purchases. Mackintosh did acknowledge this effect and he even mentioned that this also initially happened in the US. What he seemed to have missed is that the traders cannot be equated to the market. Traders react quickly to news of economic significance or to changes in supply and demand. But traders’ moves are not necessarily indicative of the broad market’s perception of the fundamentals that drive the economy. Traders have a short-term outlook. To be sure they do react to the moves by the longer-term minded big institutional investors. But “fundamental” investors’ reaction may be slower than the daily volatility created by traders. The transmission mechanism between the “fundamental” investors and the traders can take some time. Ultimately it is the slower reaction of the big “fundamental” investors that will shift the market and show whether QE worked. At this stage we are yet to see the “fundamental” investors’ reactions. From this perspective it is premature to judge whether the market “believes” that QE will work in Europe. (One of the weird things here is that QE will work if investors believe that it will work. But this is another story to be examined separately.)

Second, Mackintosh only focused on the reaction of the price of yields of German 10-year bonds. On the exact same day, 27 November, when German bond yields were reaching record low, the German DAX index was rising for an 11th day in a row, telling another story – investors’ confidence was on the rise.

The two points above do not clearly point to any conclusion on whether the prospective QE in Europe will inspire market confidence. But they show that it is premature to reliably gauge the market sentiment on QE’s fortunes. We still need to see more data as the events unfold.

Investment goes up in response to higher interest rates? Really?

In fact, investment often rises when interest rates go up and volatility increases.

Obviously this defies conventional wisdom. Yet so wrote the Economist in their latest issue trying to debunk monetary policy as irrelevant and useless (and arguing instead for lower taxes and less onerous regulation).

This statement defies logic and seems to come from mixing up cause and effect. Of course if one studies historical data it will turn out that investment is highest at the top of an overheated cycle when businesses and investors get overexcited. That is precisely when interest rates go up because 1) demand for credit increases and so the price, i.e. interest rates go up and 2) central banks start worrying about over investment and try to discourage it by tightening in the form of increased interest rates. Yet that by no means demonstrates that in a recession a central bank can encourage investment by increasing interest rates.

To be completely fair, the Economist is merely presenting an academic opinion expressed by Mr Kothari of Sloan School of Management. It also does not explicitly state that higher interest rates cause increased investment but from the overall context of the article that is what follows.

The talk about a 10% correction

Last week many analysts predicted that we are in for a 10% correction and that it is almost imminent. But that already meant there would not be a 10% correction. If most people expects a 10% “correction” that means people estimate that stocks will drop by 10%, reach a bottom and a fair value, and then slowly start moving upwards. Logically if they expected that after a 10% drop there will be further downward movement towards what they estimate to be the fair value (or the technical floor) they would be predicting something more than a 10% correction, perhaps a 12% correction, or 15% correction, etc. Implicitly the broad market was considering anything more than a 10% as a clear oversell territory that would be highly unlikely and possibly a strong buy.

So in this situation the logic of anticipating what the others expect (the market is all about anticipating the anticipations based in turn on anticipations) would dictate that once stocks fall by around 7-8% traders will start buying. After all, why wait for the 10% percent when everybody else, knowing others’ expectations, would start buying. Is it not better to stay ahead of the market and buy on the cheap before everybody else.

This is not to say that volatility will not come back. It certainly will and possibly will freak out a lot of traders and investors. But there will not be a 10% correction when everybody expects a 10% correction.