Did the European tremors of the banking crisis end with Credit Suisse? Overnight, investors asked themselves that question about Deutsche Bank — and clearly thought otherwise. A big spike in credit default swaps shows at least heightened concern about the viability of this financial giant, and has stock markets worried that the worst may not yet be over:

Deutsche Bank shares fell by more than 14% on Friday following a spike in credit default swaps Thursday night, as concerns about the stability of European banks persisted.

The German lender’s Frankfurt-listed shares retreated for a third consecutive day and have now lost more than a fifth of their value so far this month. Credit default swaps — a form of insurance for a company’s bondholders against its default — leapt to 173 basis points Thursday night from 142 basis points the previous day.

The emergency rescue of Credit Suisse by UBS, in the wake of the collapse of U.S.-based Silicon Valley Bank, has triggered contagion concern among investors, which was deepened by further monetary policy tightening from the U.S. Federal Reserve on Wednesday.

Is this an overreaction? The Wall Street Journal’s Caitlin McCabe seems to think so. Credit Suisse had viability issues before the collapse of Silicon Valley Bank and Signature Bank sent investors and regulators scrambling, while Deutsche Bank has more firm capitalization and profitability. They do have an inordinate exposure to American bond issues, however:

• Deutsche Bank is one of the more exposed European banks to U.S. commercial property. But the analysts said this was manageable. “We believe Deutsche is proactively managing the risks in this key portfolio,” they wrote.
• The bank’s capital ratios are “at their strongest levels since 1997,” they wrote.
• This isn’t the bank’s first crisis of confidence. When its shares sold off in early 2016, liquidity “remained strong throughout that very tough quarter” and there were few deposit outflows, the analysts wrote.
• “Our underperform rating on the stock is simply driven by our view that there are more attractive equity stories elsewhere in the sector,” they said.

Well, maybe, but investors certainly see some issues at DB, or those credit default swap prices wouldn’t have spiked. Those issues are being exacerbated by the Federal Reserve’s rate hikes, which has made bonds held by these banks less valuable, which in some cases has resulted in capitalization crises as those declines get factored into their balance sheets.

The problem is that there is no clear end to that cycle, as banks moved hard into these bonds in the wake of the pandemic and stimulus cycles. As deposits soared and businesses shuttered, James Surowiecki explained at The Atlantic yesterday, banks had to do something with massive amounts of cash flooding into the system, which reached a peak of $4.4 trillion by the end of 2021 over the levels two years previously.

“Lulled into a false sense of security by years of low inflation and near-zero interest rates,” banks around the world made the choice to start “binging on bonds.” But when Congress the Biden administration triggered a massive demand wave in the middle of a supply-chain crisis in March 2021 and set inflation soaring, banks got left stuck with upside-down assets — and a new crisis:

This was not an especially lucrative strategy, but it seemed like the best of banks’ not-good options. As the subheading of that same article noted, banks “have little choice but to buy up government debt, even if it means skimpy profits.”

The strategy had one obvious downside: It exposed banks to a huge amount of what economists call “interest-rate risk.” When interest rates rise, the value of bonds falls. If inflation—and therefore interest rates—spiked, all of those low-interest government bonds and mortgage-backed securities were going to be worth a lot less than the banks had paid for them. But in 2020, and even in early 2021, that outcome seemed to almost everyone, including the Federal Reserve itself, very unlikely.

Banks, you might say, had been lulled into a false sense of security by years of low inflation and near-zero interest rates: They were operating on the assumption that, for many years to come, inflation would remain quiescent, and interest rates would stay low. Accordingly, banks made what now seems like an obviously foolish decision: taking hundreds of billions of dollars in deposits and putting them into long-term bonds yielding only a couple of percentage points. Now that inflation has returned and the Fed has jacked up interest rates, banks find themselves sitting on piles of bonds that are worth far less than they once were. As a result, their balance sheets are much weaker than they had previously appeared to be.

Surowiecki points out that banks haven’t actually lost money yet, and that the value of the bonds will bear out as they mature. That’s true, but it’s incomplete. Banks are measured on their asset-to-liability ratios on an ongoing basis, so this is not like individuals who can simply go along for the ride if their house mortgage ends up underwater for a period of time. If banks’ bond portfolios tip over from assets to liabilities, it means that their ability to cover their deposits comes into question — and the credit default swap prices shows that investors are figuring that out.

The only real good news is that the Fed may have gotten the message. In his press conference this week about the 25-basis-point increase in the Fed’s interest rate, Powell predicted that more intervention may not be necessary. The pressure on capitalization created by the rapid increase in lending rates will make banks on the edge much less likely to lend to all but the most secure borrowers. That would have the same impact as further hikes in the Fed rate, although it might take longer for that to cool demand.

The better way out of this mess would be supply-side regulatory and tax policies to incentivize production to meet the higher demand. Had we pursued that, especially in energy, the Fed could have pursued a more leisurely return to historic interest-rate levels and curtailed inflation with much less damage to the banking system. We missed that opportunity, but that doesn’t mean we wouldn’t benefit from that significant change in policy now. Joe Biden and his administration, however, care more about climate-change activism and DEI than they do about the stability of the banking system and the economic health of the country. Or of the world, as it turns out.