by Bill O’Grady and Kaisa Stucke

[Posted: 9:30 AM EDT] The market’s focus continues to center on the banking system, with Deutsche Bank (DB, $11.48, -0.82) being the most market relevant, although the travails of bankers testifying before Congress hasn’t helped the sector.  Deutsche Bank is the bigger issue because it raises fears of systemic problems.  The heart of the matter is that no bank can really absorb a bank run.  The whole premise of banking is term conversion—they take our deposits, which are short term in nature, and turn them into long-term assets in the form of loans.  The famous scene in It’s a Wonderful Life when the hero, George Bailey, is faced with a bank run is a good portrayal of the problem.  When confronted with frightened depositors, he explains, “Your money isn’t here, it’s in the homes of your friends and neighbors.”  When a handful of hedge funds announced they were pulling their business from Deutsche Bank, it raised fears of a broader run against the bank.

The reality is that all banks are potentially subject to runs.  What prevents them from occurring?  In a word, confidence.  If depositors (which are lenders to the bank) are confident the bank is well run and that their deposits (which are really loans to the bank) are safe, then they don’t run to the bank to redeem their deposits and claim their cash.  So, is Deutsche Bank at risk?  Yes, but not in an extraordinary manner.  All banks are at risk.

Thus, all banks are potentially at risk for a run and, once a run starts, idiosyncratic risk can become systemic risk.  Governments are aware of this issue and therefore create backstops to lessen the perception of risk and support financial system confidence.  This is what regulation and deposit insurance provide.  The goal isn’t to necessarily protect all banks but to ensure that a single bank problem doesn’t trigger system-wide problems, which is the entire issue behind “too big to fail.”  If a bank becomes a systemic risk by itself due to its size, it creates conditions of moral hazard, where the too big to fail bank takes large risks, knowing that the government can’t let it collapse or it would face a systemic meltdown.

So, the real question isn’t about the financial conditions of Deutsche Bank, but rather market confidence in the German government’s support for the bank.  At first glance, this appears to be a no-brainer; the Merkel government would be profoundly inept if it failed to bail out Deutsche Bank if it faces a run.  That’s economics…unfortunately, there is a political element to this issue as well.  First, the rapidly rising right-wing AfD party would use a bailout of Deutsche Bank as a cudgel against the Merkel coalition, portraying the move as either incompetence or cronyism.  According to EU rules, bank creditors would be first in line to take losses (the “bail-in” clause), followed by state support.  However, it would not go over well to have the largest bank in your nation converting bank bonds to equity and, if the run became fully developed, creditor bail-in would probably be inadequate.  The need to inject state money would be difficult to avoid and very unpopular.  Second, if Germany uses state money to bail out its banks, it will be hard to tell Italy that it can’t do the same.[1]  Once governments begin bailing out banks, fiscal profligacy could easily follow and that notion worries Germany, fearing that excessive fiscal spending will weaken the EUR and bring inflation.

Thus, the risk is that the Merkel government, already prone to deliberate actions, may wait too long to step into a deteriorating situation with Deutsche Bank due to high political costs and cause more market turmoil than necessary.  It is important to remember that the Bush administration’s decision not to support Lehman Brothers was ultimately a political calculation.  The concern among policymakers was that continuing to bail out banks created a moral hazard and led the banks to increase their risky behavior, confident in ultimate government support.  The decision to try to stop that process was defensible, but it’s hard to fully account for all the risks.  The same is true with the Deutsche Bank situation.  It is no doubt true that the bank has significant resources to weather the storm (assuming the storm remains manageable), but concerns that a government backstop may not be as solid as one would expect given the bank’s size and position in the German economy remains the key issue.  Therein lies the risk.

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[1] http://www.reuters.com/article/us-eurozone-banks-italy-boi-idUSKCN1200KD?il=0