Hidden Risks at German Banks

Deutsche Bank's Accounting Raises Questions

Regarding the risks in Germany's banking system, it should be pointed out that large German Banks are among the most highly leveraged in Europe relative to their net tangible capital. This is when the known risks are considered, but it has recently turned out that there are also hitherto unknown, hidden risks. Consider in this context the recent revelation that Deutsche Bank has kept loans to Brazil and Italy off the books, as well as loans to Greek banks and other dubious debtors such as Dexia, in spite of the fact that it remains fully exposed to the associated credit risks. Mind, DB apparently did nothing illegal here – but this accounting practice does mask the extent of risk the bank is exposed to.

“Between 2008 and 2011 Deutsche Bank AG, the largest bank in Germany and one of the largest in the world, made loans to Italian bank Banca Monte dei Paschi di Siena SpA and Brazilian bank Banco do Brasil SA totaling $3.3 billion but did not include these transactions in financial reports sent to investors. Similar loans were made to Dexia SA, TT Hellenic Postbank SA, National Bank of Greece, and Qatari bank Al Khaliji.

These loans are part of $395.5 billion in liabilities that Deutsche Bank AG has offset with other liabilities, an amount equal to 19 percent of the company’s total reported assets. Deutsche Bank spokesperson Kathryn Hanes says that these accounting practices are proscribed by law and that Deutsche Bank’s actions are in line with the letter and intention of financial regulations. She also claims that this information does not impact the company’s financial health or key financial ratios.”

(emphasis added)

Nothing to see here, move right on! Until one considers the finer details of these 'netting' transactions that is:

“Secured loans usually entail a company providing collateral in exchange for cash that a bank has on hand, and the collateral is held until the loan is repaid in full. Instead, Deutsche Bank AG sold its collateral, government bonds in this case, to come up with the cash to make the loan, leaving it with an obligation to return the bonds.

Under the terms of the agreement Deutsche Bank AG was only obligated to return the ‘cheapest-to-deliver’ equivalent of the bonds, protecting it from devaluation but leaving the bank exposed to default. This maneuver effectively put a short on the government bonds, exposing Deutsche Bank to greater risk than if it had simply held the bonds for the duration of the loans. Deutsche Bank then sold credit-default insurance to investors, recording an immediate €60 million profit at the outset of the Monte Paschi deal.”

(emphasis added)

In other words, these 'secured' loans are not really secured, unless one considers what is effectively a short position on the bonds that were provided as collateral to represent adequate security. In addition, DB apparently 'spiced' the deals up by writing credit default swaps, exposing it to even more credit risk.

As Bloomberg further reports, this isn't the first time DB has obscured its true financial position by means of accounting practices that are not necessarily illegal, but certainly raise questions about how to properly evaluate the risks the bank is exposed to.

Meanwhile, the banks that have received the loans in question were able to continue to report ownership of the bonds DB has sold, allowing them to misrepresent their own financial health as well. In fact, that appears to have been the true reason for the odd accounting treatment of these transactions. While Deutsche's hands are considered legally clean, those of e.g. Monte Dei Paschi apparently are not:

“Monte Paschi is currently being investigated by Italian prosecutors for using the loan to hide losses, and both Banca Monte dei Paschi di Siena SpA and Banco do Brasil SA continued to report ownership of the bonds that were used as collateral since they were due to receive them back. Prosecutors have not alleged any wrongdoing on the part of Deutsche Bank AG in this case.

However, analysts say that netting makes it difficult to accurately gauge the company’s financial health and that it goes against the spirit of financial regulations by hiding the real amount of risk that Deutsche Bank has on its books.

This isn’t the first time Deutsche Bank AG has been accused of obscuring financial information this year. In the aftermath of the Libor scandal the bank was previously investigated for possibly hiding $12 billion in losses by incorrectly valuing its derivative portfolio.”

(emphasis added)

We're not sure at this point what, if anything, came of the above mentioned investigation into derivatives accounting, but would note that derivatives open a great many possibilities for 'obscuring' balance sheet information.

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