Finance

Lionel Laurent is a Bloomberg Gadfly columnist covering finance and markets. He previously worked at Reuters and Forbes.

Duncan Mavin is a former Bloomberg Gadfly columnist.

The turmoil that hit Deutsche Bank's shares and bonds this week was never entirely about the bank. And it may strike again in other markets, and soon.

Fundamentally, nothing has changed for the lender. Concerns about the future profitability of the bank are as valid now as they were last week. That didn't stop the stock oscillating wildly.

What changed in the credit market was investors' perception of risk. Trades that offered a little extra yield in an era when interest rates were kept at artificial lows by central banks are now being unwound -- as Deutsche Bank found out.

Investors have grown nervous about China, energy markets and the global economy, and are re-pricing assets wherever they can.

The process started late last year with high-yield debt, then turned to energy assets broadly, and this month it focused on bank debt in Europe.

Confidence Shaken
The cost of insuring Deutsche Bank bonds against default has more than doubled
Source: Bloomberg

Concerns about the banks stem from their exposure to losses from loans to the oil and gas industry, their vulnerability to a slowdown in China's economy, as well as regulations that are forcing banks to exit previously profitable businesses. In Deutsche Bank's case, add worries about the potential for costly penalties related to legacy conduct issues to that list.

These factors weigh on expectations about future profit -- but they're unlikely to push a bank to miss a coupon payment. Nor is there a lack of liquidity at the banks -- Mario Draghi and the European Central Bank have seen to that.

One reason bank debt became the lightning rod was that in Europe, the central bank's massive purchases of sovereign debt prevent the market from letting off steam there. Instead, the banks are in some ways a proxy for broad worries about the economy.

Also, the specific bank securities most under a cloud right now -- Additional Tier One capital -- are a relatively new asset class. Banks, under pressure from regulators to bolster their balance sheets, issued 91 billion euros of the securities since April 2013. Investors were drawn to average coupons of 6.6 percent, roughly twice the interest payment on banks' senior bonds, and saw the risk that the AT1s would be converted into equity as remote.

Capital Problem
Deutsche Bank has little room for maneuver, based on its CET1 ratio
Source: Bloomberg Intelligence

But it's plausible some buyers didn't fully understand how to price the risks when they bought the securities. This has made AT1 a wobbly block on which to build out bank capital after the financial crisis. Investors piled into AT1 for the extra yield over regular bank debt. Now they want more on top of that.

A further irony is that the banks' own retrenchment from some business lines is contributing to the depth of the sell-off. The pressure of new regulations has pushed banks to scale back credit trading, leaving markets less liquid than they used to be. When investors want to sell their AT1 holdings, the bank trading desks are not there to make a market.

None of which does much to ease the worries of the bankers. The possibility that sentiment turns even more negatively against another lender is real -- as is the chance traders start reassessing their positions in other asset classes. Investors are already keeping a close eye on markets that have boomed in recent years - think securitized corporate debt or U.S. commercial real estate loans. Banks are unlikely to be the last to be battered in this storm.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the authors of this story:
Lionel Laurent in London at llaurent2@bloomberg.net
Duncan Mavin in London at dmavin@bloomberg.net

To contact the editor responsible for this story:
Edward Evans at eevans3@bloomberg.net