U.S. Authorities Starting to Worry about Deutsche Bank’s Mountain of Derivatives

We know, since last year, that Deutsche Bank has become the bank with the most exposure to derivatives in the world, slightly ahead of JP Morgan. The total amount of the German bank’s derivatives is astounding: 55 Trillion euros, a sum equal to 20 times Germany’s GDP, or five times the Euro zone’s GDP. Obviously, the bank could not face any hard depreciation of those products, since they represent 100 times its clients’ deposits, or 150 times its own funds...

What’s new is that financial authorities are starting to worry. Well, it’s about time! Even though, as we would have thought or hoped, these worries are not emanating from German or European authorities, but from U.S. authorities. In a letter to Deutsche Bank, in fact, the New York Fed states an “important operational risk”, and goes on to say that financial reports from the bank concerning derivatives “are of a low quality, imprecise and unreliable. The sheer size and scope of errors strongly suggest that the whole regulatory reporting structure of the bank should be thoroughly revised.” The New York Fed also deplores that, despite its former warnings, it has not noted any improvement. And, as confirmation of this scary picture, KPMG, Deutsche Bank’s auditor, has also noted some “deficiencies” in the bank’s financial reporting. 

A spokesperson for Deutsche Bank replied that “we are working diligently to reinforce our control systems and are striving to achieve best-in-class status.” To that avail, 1,300 people will be hired, 500 of which in the United States, for conformity, risk and technology. And how, may we ask, is this statement supposed to be reassuring? If they need to hire 1,300 more people in order to manage this mountain of derivatives, doesn’t it mean that we should be worried about the situation?

The usual reply we get from banks regarding their derivatives exposure is that their different positions are compensated and that, at the end, their net exposure is only a few billion dollars. Well, yes, but where do they buy those derivatives? From other banks, of course. Hence if only one of those banks goes under, the domino effect will have an impact on the other ones. This almost happened with AIG’s bankruptcy: AIG was counterparty to several financial institutions, in September of 2008, and it was bailed out at the last moment by the American state. So, calculating net exposure is purely theoretical and one must calculate real exposure.

It’s a good thing that the Americans are doing (a little) the work that the ECB and the national regulation agencies should be doing. In truth, in its preceding stress tests, already very lax, the ECB wasn’t even taking into account the amount of the banks’ derivatives, and it will likely be the case again in the upcoming ones. Refusing to see is much worse than being blind. Beyond Deutsche Bank, we must understand that the large banks of the world are holding inordinate amounts of derivatives, beside which their own funds are ridiculously low. And this constitutes an endemic risk that is largely underestimated by the shareholders, as well as the depositors.