• Germany’s banks are a thorn in the side of the EU
  • German house prices and industry are crashing
  • Has the next global banking crisis already begun?

Believe it or not, one of the biggest obstacles to the harmonisation of EU rules and regulations is the peculiarities of the German banking system. German banks are just so different to the Anglo-Saxon type of financial institution that it would require a radical overhaul to bring them into line with the rest of Europe.

This obstacle has held back a large amount of other harmonisation the EU would like to pursue because establishing a banking union is required to bring other commercial regulations into the same system of rules. German banks don’t even follow the same accounting rules, let alone regulations and business model.

While other banking systems around Europe were forced to reform and modernise in response to one crisis after another, the Germans have managed to hold onto their strange system.

Even in the absence of a major systemic crisis in the German banking system, the German banks have been in plenty of trouble. Especially their only major international player Deutsche Bank, which is in the news regularly for one shemozzle or another.

But the German stock market’s bank stocks index is down from 700 points to just over 110 points since 2007. These days, it sits at the same levels it did during the height of the 2008 financial crisis. And that’s after doubling since 2020…

Today, I want to warn you that it may be about to get a whole lot worse. And not just for the German banks. I believe there is a possibility Germany’s banking system is on the precipice of causing the next major international banking crisis. The sort of thing which will be described as a “Black Swan” that “nobody saw coming”.

What has me so worried is a perfect storm scenario, with a long list of surmountable problems accumulating into something insurmountable…

First of all, you need to understand that the German banking system is not familiar with the sorts of chaos caused by loose monetary policy. They don’t know what a property bust looks like because they don’t know what an artificially induced property bubble looks like.

The Bundesbank, affectionately known as Buba, kept very tight monetary policy under the deutschmark. And so housing bubbles could never inflate, let alone pop.

But under the euro, the European Central Bank (ECB) inflates property bubbles by definition, as we looked into yesterday. When the euro came into being, the German economy was struggling and an artificially high interest rate was applied to its economy because of the booms going on in places like Spain, Greece and Ireland. After the 2008 financial crisis, the roles reversed. The German economy performed well while the periphery struggled in the aftermath of their housing bust. And that’s when the trouble started for the Germans…

Interest rates were kept too low for Germany, inflating a truly vast housing bubble in the country. German house prices went on their first real boom in living memory, financed by the ECB. Although specific cities leave the national figures in the dust, the national house price index doubled in less than ten years!

But the reckoning was always baked into the cake. Once interest rates soared after the pandemic, German house prices began to plunge. Germans are now living through the fastest house price crash in 60 years.

How does this impact banks? Well, their loan collateral is plunging in value. Negative equity must be spreading through the system. Borrowers who can’t repay face financial ruin. And those who can pay remain stuck in their homes because they cannot sell out and take a whopping loss. This seriously impedes economic growth and dynamism.

Houses are of course only one of the banks’ problems. In fact, German industry and business is famously reliant on its banking system for funding. Unlike in the US and to a lesser extent the UK, the Germans don’t use traded bonds to raise money as much as tapping their local banker.

But German industry is in the midst of an implosion. Headlines using the word “deindustrialisation” are everywhere. German factory output is down for the seventh consecutive month – longer than the record held by 2008. “Germany’s Days as an Industrial Superpower Are Coming to an End,” summarises a Bloomberg headline.

The source of this downturn is fairly well understood – energy prices. Specifically the energy-intensive industries are struggling the most, after all.

But I suspect the rout may well continue for quite some time yet because the ECB is more worried about inflation in Poland than Germany’s industrial implosion. Industry is booming in nuclear-powered France, after all.

Can German banks handle such a severe downturn in another one of their key lending markets?

As in 2008, the straw that breaks the banker’s back is coming out of the US. The German banks seems to have invested heavily in US commercial real estate, which is in a crisis of its own. One German bank even called it, “the greatest real estate crisis since the financial crisis.” The bank’s share price was down 40% in six months at the time.

In response to all this uncertainty, the interest rates German banks must pay to raise funds from investors are rising as they want to know what’s lurking on the banks’ books. This raises the costs of funding the bank – another potential crisis trigger.

Just as an amusing aside, it seems that the trouble for the German banks lending in the US has been related to Donald Trump’s practice of overvaluing real estate when borrowing. They are discovering the underlying asset is worth far less than borrowers had claimed when funding their purchase…

One source of stability that German banks could always rely on in times of crisis is rising German government bond prices. Each time there was a crash, German bunds rallied because they’re seen as a safe haven. This helped offset any losses elsewhere for German banks.

But this time, government bonds are another source of turmoil. German government bonds crashed in 2022. German bond ETFs lost about a fifth of their value, for example. This means the foundations that German banks rely on in times of trouble crumbled. If a German bank gets into financial trouble and tries to sell its government bond holdings, it may have to do so at a severe loss.

Like I said, it all amounts to the perfect storm. The last remaining ingredient is deposit flight – German households and companies pulling their money out of the banking system. This would defund the banks by the front door instead of just the back door and trigger the same sort of bank crisis we had in the US recently.

I believe that a German banking crisis needs to be firmly on your radar in 2024. But it’s far from the only thing. In fact, our upcoming issue of The Fleet Street Letter will be a compendium of surprising predictions for investors to be aware of in 2024.

Some would truly shock you. So get on the list now to find out what Nigel Farage, Eoin Treacy and I expect the year might have in store for you.

Until next time,

Nick Hubble
Editor, Fortune & Freedom