Europe: Systemic risks posed by Deutsche Bank - BBH

Research Team at BBH, notes that the European investors are particularly concerned about the systemic risks posed by Deutsche Bank.  

Key Quotes

“Reports suggest that the gross notional value of its derivatives book is 46 trillion euros.  Many have warned of a potential Lehman-like event.  Contributing to this sense was a sudden jump in the demand for dollar funding.  Since the financial crisis, several central banks have been auctioning dollars, and there is quasi-permanent swap line between the Federal Reserve and five central banks (ECB, BOJ, BOE, BOC, and SNB).  

These swap lines remain largely dormant.  Last week, the ECB tapped the line for a $29 mln (paying 0.95%).  The BOJ took one million dollars.  Earlier this year the BOJ had doubled the size of its dollar auctions.  Last week, a dozen European banks borrowed $6.35 bln at the ECB's dollar auction.  This is the most in four years.  Unconfirmed reports indicated that none of the banks were German.  

The implications seem exaggerated by the investors' sensitivity and the some media accounts.  First, the average of dollar borrowing per bank at the ECB has been higher.  Even the cumulative amount is not indicative of a crisis.  Second, the borrowings cover quarter-end.  There was an increase in borrowings and participation in June as well, just on a smaller magnitude.  

Third, part of the demand for dollar funding may be a function of the dislocation being caused by the new rules regarding US money markets.  The preference for funds that invest solely in government securities appears to have driven up LIBOR yields.  In turn, this is exacerbating extreme pricing in the commonly used cross-currency swap market, where the cost of transferring liquidity or hedging euro and yen exposure into dollar has risen dramatically.  

The new money market rules come into effect in the middle of October.  The risk is that a previous buyer of short-term paper, US money markets, will have a considerably lower appetite.  A new source of demand has yet to materialize.  This warns that LIBOR rates may stay elevated in both absolute terms and relative to T-bills (TED spread).  Traditionally, the TED spread was a function of credit risk as T-bills have the backing of the US government while Eurodollars bear the credit risk of the depository institution.”