Angela Merkel's Deutsche Bank dilemma - is there a way out?

As crisis engulfs Deutsche Bank, its management and the German government are tying to tough it out and play for time in the hope that the institution can fix itself.

Chancellor Angela Merkel’s decision to play hardball by making it clear that she will not step in will play well with a German electorate appalled (as it should be) at the prospect of the state being called upon to back, and perhaps to bail out, another financial institution. Especially after all those cries of “never again” that were heard at the end of the financial crisis.

In saying he’s fine with that, and can trade through it, Deutsche Bank’s British chief executive John Cryan hopes that the markets will believe him. He says he won’t pay the $14bn (£11bn) American regulators want to settle charges that the bank packaged up and sold dodgy mortgages in the run up to the financial crisis. The implication is that he will negotiate it down, just as Goldman Sachs did when it settled similar charges.

With a more palatable deal in his pocket, Mr Cryan ought to be able to tap his shareholders for the cash to pay up before moving on with a leaner, meaner, and more prudent business.

It all sounds good in theory. Quite possibly too good to be true.

We have, after all, been here before. We’ve heard banking executives voice reassurances only to subsequently fall flat on their faces. When organisations such as the International Monetary Fund say that an institution “poses the greatest risk to the global financial system”, it’s no wonder markets draw their own conclusions and run a mile. Right now there is momentum behind a dark, developing story. A lot of smart money is betting on the worst, adding to that momentum.

Deutsche Bank has an enormous balance sheet, especially when compared with the capital it holds, and a dizzying array of derivatives on its books. It is one of the world’s most interconnected financial institutions. Were it to fail, it would make the Lehman Brothers collapse look like an unexpectedly high credit-card bill and Brexit like a lovers’ tiff at the end of a long week.

That’s the problem with all the regulatory reforms introduced after the financial crisis: they didn’t go far enough.

The problem with playing for time is that while things might get better, they might also get worse.

There is a way to spoil the party for the hedge funds that are gambling on that happening. Were Angela Merkel to say that Germany would stand behind Deutsche Bank, the bombed-out share price would stabilise and then bounce back. That would give Mr Cryan the option of going to big shareholders, such as insurer Allianz, to ask them to back a rights issue. They would likely agree to bite the bullet, and others would fall in line behind them.

In showing a willingness to commit state funds now, there shouldn’t be any need for them to be deployed.

However, that is an irony with the bitter taste of moral hazard even if it is one that would solve a very nasty problem that could easily be exacerbated by sitting and waiting until the German elections are over and Ms Merkel has more room to manoeuvre.

Ultimately, Ms Merkel is right. The German state shouldn’t be faced with such a Hobson’s choice. That doesn’t change the fact that Deutsche Bank is a problem that needs fixing.