Deutsche Bank and the herd mentality on capital adequacy

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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.

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