Deutsche Bank is the tip of the Iceberg

Deutsche Bank’s shares hit record lows yesterday. Its market cap has fallen by 75%since the start of 2014. Is this Lehman Brothers all over again? There’s no doubt the rest of the Too-Big-to-Fail banks are still dominoes waiting to fall.

It’s no surprise that Deutsche is in so much trouble – at least not to UKIP in Parliament.

Our study on Europe’s financial sector, published late last year, found Deutsche to be the least capitalised of any major European bank, with the lowest leverage ratio, and the worst performance under a hypothetical stress test.

But Europe’s other big banks – including the UK’s – are scarcely any better capitalised, or less vulnerable. So if Deutsche goes down, it’s taking the rest of the financial sector with it. As the IMF – in a rare moment of lucidity – warned three months ago.

The question is: why is this happening at all?

After the financial crisis, billions of pounds have been pumped into the world’s biggest banks to keep them afloat. New regulations – from Dodd-Frank to Basel III – are supposed to have made sure they couldn’t collapse again. The global financial sector is meant to be fixed.

But it’s all a sham.

Public subsidies for banks – whether QE, low interest rates, deposit insurance, or direct state bailouts – have only encouraged them to take more risks, in the sure knowledge taxpayers will pick up the tab.

New capitalisation rules haven’t raised banks’ leverage ratios (core capital vs. liabilities) any higher than they were before. The margin of error is still far too thin. In fact, the biggest banks are the most exposed to risk.

Official stress tests, meanwhile, invariably overstate the big banks’ strength. But then why wouldn’t they? They’re carried out by the same central bankers who are supposed to have reformed the system. Regulators can’t admit there’s a problem without confessing their own negligence.

The left tends to blame financial instability on corporate greed. Unfortunately, it’s much worse than that. The real problem is systemic: fractional reserve banking.

Banks that lend against deposits dozens of times over are inevitably unstable. They’re bound to be vulnerable to shocks and bank runs because they never had the capital to cover all their liabilities in the first place.

In a free market, bad banks would fail. Fractional reserve banking would be unsustainable in the long term. Why? Because the only thing sustaining it now is state subsidy.

Overleveraged banks like Deutsche are too big to survive. Fixing them requires tackling the excesses of fractional reserve banking. How? I proposed one way to do it in After Osbrown.