The Are Two Big Problems With Deutsche Bank Failing The Fed's Stress Test

There are two big problems with Deutsche Bank failing the Fed's stress test as the WSJ just reported it would.

This is what the WSJ reported moments ago:

Large European banks including Deutsche Bank AG and Banco Santander SA are likely to fail the U.S. Federal Reserve’s stress test over shortcomings in how they measure and predict potential losses and risks, according to people familiar with the matter. Failing the stress tests would likely subject the U.S. units of Deutsche Bank and Banco Santander to restrictions on paying dividends to their European parent companies or other shareholders.

Why is this an issue?

Well, the first problem is that Deutsche Bank recently passed the ECB stress test with flying colors. Then again, since that was a "test" which not even in its worst-case scenario modeled for deflation (as a reminder, Europe just suffered its record worst deflation in history on par with the Great financial crisis), one can now roundly dismiss any and all current or future analytical, regulatory and executive tasks conducted by the ECB. We will ignore the fact that the world's biggest bond buying program is currently being undertaken by precisely said clueless central bank. We will also ignore the other fact, that the bank of the former FDIC-head Sheila Bair, Santander - a bank which is currently the biggest subprime auto loan lender - will also fail the stress test: to dwell too much on that particular irony would give us a headache.

The WSJ did provide a token explanation for this particular "oversight" by the ECB:

Deutsche Bank Trust Corp. is expected to be found adequately capitalized by the Fed but will likely receive a warning on qualitative shortcomings, according to people familiar with the matter.

 

Both Deutsche Bank and Santander passed European Central Bank stress tests in October. Those tests focused on whether the banks had enough capital to withstand a two-year recession but didn't assess such things as governance, risk management, and other more subjective factors like the Fed’s test.

Actually, the explanation that Deutsche Bank is lacking in its "risk management" department should be enough to give one a chill, especially when one considers the second big problem. Then again technically it not just a second problem: it is some 62.2 trillion problems, which is what the gross notional exposure of all derivatives on the Deutsche Bank balance sheet is pre-netting (and as Lehman showed us, netting only works in a perfect world in which there isn't one single counterparty failure: if there is, there is no netting and gross instantly becomes net, simple as that).

 

So a bank which has €54.7 trillion, or a little over $62 trillion at today's exchange rate, in derivatives - a number that is 20 times greater than the GDP of Germany -  just failed a central bank stress test due to lacking governance and risk management controls and, just maybe, has insufficient capital? What can possibly go wrong.