Berlin is trying to distance itself from Deutsche Bank and the threat of a $14 billion U.S. fine that would likely force the bank to raise capital.
This makes sense politically ahead of an election year. It also, effectively, calls the U.S. authorities' bluff: if the fine is too big, German taxpayers won't step in to help.
But the danger is that deepening investor concerns over the health of the country's No. 1 bank spiral out of control -- and circle right back to Berlin.
As unpalatable as it may be politically, the market sees Germany and Deutsche as joined at the hip.
You can see it in Deutsche Bank's share price: it plumbed a record low on Monday after Focus magazine has reported Chancellor Angela Merkel ruled out state aid for the lender ahead of next year's elections.
You can also see it in the lender's credit-default swaps: both the German five-year sovereign CDS and Deutsche Banks's five-year CDS have risen in tandem over past weeks.
Even Deutsche Bank's own executives have commented on it. It's almost a year to the day since Stefan Krause, then a member of the bank's management board, noted how investors confused the lender with the Bundesbank and therefore saw ``there was always an implicit state guarantee'' when giving the bank funding.
Deutsche Bank is a truly systemic bank with about $2 trillion in assets, about two-thirds of Germany's entire annual output. The weaker it becomes, the more investors will expect its home country to be on the hook.
Deutsche Bank said it's determined to manage on its own and a capital increase isn't currently on its agenda. Merkel's government is attempting to stay out of the fray. On Monday, her chief spokesman said there were "no grounds" for speculation over state funding.
This is politically expedient: the last thing Merkel would want in the run-up to an election is to acknowledge that the country's biggest bank may need taxpayer aid.
Remember also that the U.S. authorities know full well that Deutsche Bank can't easily pay $14 billion -- but that Germany very well could. That helps to explain why Merkel's spokesman also reiterated the hope for a "fair treatment" by the Justice Department.
But this is a game of brinksmanship that could get very dangerous very quickly. If Deutsche Bank is backed into a corner and forced to pay a steeper-than-expected fine, the concern is that it will be forced to skip coupons on some debt instruments and take a bigger hit on already painful asset sales.
The threat of a downward spiral involving credit downgrades isn't here yet -- but Germany should beware of stoking this kind of concern. The larger any eventual capital-raising, the likelier it is that Berlin would have to step in and support it.
This is a political impasse with a political solution -- but the sheer uncertainty ahead risks making markets increasingly jumpy.
It's hard to see market sentiment on Germany decoupling itself from market sentiment on Deutsche Bank; Berlin will have to bear that in mind when picking its negotiating position.
Fitch Ratings last week affirmed Germany's sovereign credit rating at AAA. One of the factors Fitch cited in its decision was that the country's banks were stable and bolstering capital. But among the risks it cited was Deutsche Bank's exposure to legal penalties.
One bank's self-help looks a lot like national self-harm.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
(Corrects data for German sovereign CDS in second chart.)
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