Make simplicity a priority in banking And still the revelations come. At the height of the financial crisis Deutsche Bank, once the great banker to German industry, now deeply involved in global investment banking, appears to have sailed closer to the wind of insolvency than previously thought. According to a Financial Times investigation, three whistleblowers have separately complained to regulators including the Securities and Exchange Commission that the bank failed to recognise up to $12bn of losses on a huge position in derivatives structures known as leveraged super senior trades. The suggestion is that if Deutsche had accounted realistically for the decline in the value of this position, with a notional value of $130bn, its regulatory capital would have been so badly dented as to necessitate a government bailout. The transactions concerned, which related to synthetic collateralised debt obligations, are fiendishly complicated for mere mortals to grasp. Yet the principles were simple enough. The bank wanted to insure against default by companies generally regarded as among the safest. It sought insurance from investors who were desperate for income in a world where yields had plunged to extraordinarily low levels. In exchange for posting very modest collateral with the bank, they were paid an income stream equivalent to an insurance premium. Because the spread between this income and the investors" cost of funding was narrow, leverage, or borrowing, was introduced into the transaction to juice up the return. This was deemed safe because the likelihood of default at the insured companies was thought remote. In the crisis, markets took a more alarmist view. The possibility that investors might not be able to post more collateral in deteriorating conditions became pressing. So while the value of Deutsche's insurance policy was rising, so generating mark to market gains, the risk of its counterparties walking away from transactions was increasing. There was thus a need for marking down as well as up. The whistleblowers are suggesting that the accounting approaches adopted by Deutsche to address this risk were inadequate. It is too early to make judgments on the rights and wrongs of the case. Yet a number of points about the nature of the risks run in a modern financial system are worth making. First, $12bn was a huge sum in relation to Deutsche's capital, amounting to a quarter of its net equity in 2007. Note, too, that the balance sheet leverage at that time was vast, with net equity amounting to just under 2 per cent of total assets. Put bluntly a mere 2 per cent fall in the value of the assets would have wiped out the bank. Yet its Tier One core capital under the Basel risk weighted capital adequacy regime was 8.6 per cent, putting a gloss on a parlous situation. These two different measures diverged at the end of 2008 after the Lehman collapse, with the leverage ratio falling to 1.4 per cent, while the tier one capital rose to 10.1 per cent. That Basel is situated in cloud cuckoo land is underlined by the fact that there is substantial discretion in the calculation of risk weights and a longstanding suspicion that in a capital-stretched German banking system discretion prettifies the ratio. This serves to underline an iron law of financial markets that states that leverage always turns out to have been greater than was assumed before a financial crisis erupts. It has also become more opaque because leverage is built into the structure of complex financial instruments, in the sense that small market movements can bring large swings in value. This does not show up in accounts as straight borrowing does. A striking feature of the Deutsche case is just how big a risk it was taking in just one of the many complex markets in which it operates. This tends to reinforce the case of those who argue that a far greater capital cushion will be necessary to address the next financial crisis. The saga also lends strength to the arguments of Andrew Haldane of the Bank of England, who argued at the central bankers" talkfest at Jackson Hole in August that simple leverage ratios have been better predictors of default at big, complex banks than risk-weighted alternatives. For my money the fact that Deutsche's leverage ratio stood at only 2.6 per cent in the third quarter of this year is a great deal more interesting than its Tier One ratio of 10.7 per cent. Simplicity should take precedence.