Deutsche Bank (DB) has been in the news recently as being the next possible Lehman or AIG (AIG) that will bring down financial markets in a scenario like that of the financial crisis. While the current DB situation has brought back fears from the depths of the financial crisis, it has also demonstrated how the regulations that were put in place since the crisis do indeed work and have significantly reduced systemic risk.
Going back to the fall of 2008 when Lehman went bankrupt and AIG had to be bailed out, the major risk from these situations was called "counterparty risk" (CP). CP risk refers to the possibility that a participant in a trade will not be able to cover their obligations. The failure of a CP in a trade leaves the other participants with not only a worthless trade, but also a much more serious situation of having positions that are now unhedged if they were relying on that now-failed CP.
Until the financial crisis, the derivatives market was designed in a way that all trades were executed and then remained as contracts between the executing parties for the life of the trade, thus creating significant CP risk. The Lehman bankruptcy was manageable because Wall Street was able to take all the trades in which Lehman was a CP and essentially replace Lehman with another bank in order to keep the trades alive. Basically, the Street shared in the pain of the reallocation of all Lehman's trades.
However, when it came to AIG, the situation was not manageable by the Street. The problem with AIG was that it was basically the foundation of the credit default swap (CDS) market. A CDS, in essence was supposed to act like insurance for a bond going into default. Since AIG was in the insurance business, it wasn't much of a stretch for it to sell "insurance" on corporate bonds. Unfortunately, AIG had sold so much of this insurance, and didn't understand the risk involved with these contracts, that when the crisis hit, AIG had no way of making good on all the insurance it had sold to all of Wall Street, who in turn had sold the insurance to its clients. That's why, If AIG had not been bailed out, it would have left Wall Street with several "Lehman moments."
Since Wall Street did almost implode during the crisis, the government had to step in and take some serious steps to change the system. In January 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law and Wall Street has not been the same since. Dodd-Frank contained sweeping reform that included a timeline that would force banks to create a central counterparty clearing platform for derivatives markets that would dramatically reduce CP risk. Now, when derivative trades are executed, they are restructured so that all parties involved face an exchange and not each other for all future cash settlements. Aside from CP risk, central clearing has also dramatically reduced the amount trades and notional (risk) outstanding. Since the exchanges are able to see all the transactions, they can eliminate offsetting ones, which results in less capital being used by participants. For example, at the end of 2007, there was $62.2 trillion in CDS notional outstanding, whereas today we are down to $12 trillion.
Also inside of Dodd-Frank was another set of rules called "Volcker Rules." They were created by the esteemed former Fed Chair Paul Volcker, who served in the Carter and Reagan administrations and famously "broke the back" of inflation in the 1980s when inflation was running in the double digits. Well, Volcker basically broke the back of Wall Street with his aggressive new rules that eliminated proprietary trading by banks and severely limited the types of investments that banks could hold. The downside to the Volcker Rules are that they reduced trading desk liquidity, especially in fixed income, which has led to an increase in volatility. The bottom line here is, systemic risk has been reduced.
It's because of Dodd-Frank and Volcker Rules that we can see a massive bank like DB face a fine from the government that is almost equal to its equity market capitalization, and markets not go into a tailspin. The moral of the story here is that Wall Street has unwillingly learned a lesson and that things actually are different this time.