Pity the German taxpayer.

Recent weeks have brought a slew of bad news in terms of contingent liabilities for the German state -- meaning that taxpayers are potentially on the hook for increasing amounts. Two weeks ago, European Central Bank President Mario Draghi affirmed his willingness to commit the ECB -- partly owned by Germany -- to take on added sovereign-debt risk. And last week the German constitutional court confirmed that the European Stability Mechanism is consistent with German law, allowing further fiscal transfers to the euro-area periphery.

And most recently, Deutsche Bank AG unveiled its revamped strategy, with a new vision for its organization and growth. The German taxpayer should be very worried.

Deutsche Bank cannot fail -- in the sense of experiencing a Lehman Brothers-type bankruptcy. The German government wouldn’t allow it. With a balance sheet equivalent to about 80 percent of Germany’s gross domestic product, Deutsche Bank is too big to fail both in terms of its direct involvement with the national economy and the potential knock-on effect on confidence in German industry.

But the bank can fail in the sense that it could require future taxpayer assistance. To determine how likely this is -- and the scale of potential losses at any bank -- you need to answer three questions.

Equity Financing

First and foremost, how much capital does the bank have? In this context, capital is a synonym for equity financing, so the right question is: How much is the bank financed with shareholder equity rather than any form of debt? Sometimes people speak of a bank “holding” capital, but this is the wrong verb; it implies that capital is a type of asset, when it is actually a form of liability.

As taxpayers view banks, equity capital is critically important because it is the buffer that absorbs losses. If losses exceed the value of equity, the bank is insolvent and -- assuming there is a rescue -- the difference becomes a taxpayer responsibility.

Seen in this light, Deutsche Bank has long been a worry because it is one of the more thinly capitalized global megabanks.

Its official capital ratios might seem respectable to a casual observer: At the end of the second quarter, it reported a core Tier 1 capital ratio (a regulatory measure of equity) of 10.2 percent of total assets.

The problem with this measure is that it uses risk-weighted assets. In other words, if a bank can convince itself and its regulators that it can apply lower risk weights to a given portfolio, its capital ratio will look higher.

What is considered to be a low-risk asset in the context of European banks? Typically, the sovereign debt of euro-area countries has been regarded as very low risk. But Draghi is being forced into extraordinary measures and the German constitutional court is being asked to rule on the ESM and other bailout measures precisely because sovereign debt for some euro countries has become so risky. And if you think there is a non-zero probability of the euro area breaking up, then risk-free assets have become a meaningless concept in Europe.

To evaluate any global bank today, it is much more advisable to look at its leverage ratio, the total size of its balance sheet relative to its equity, without any risk adjustments.

At the end of the second quarter, Deutsche Bank had total assets of 2.241 trillion euros ($2.93 trillion). Its total shareholder equity capital was 55.75 billion euros -- a little less than 2.5 percent of total assets. That is a lot of leverage. Bloomberg News reported that this is the least equity (and most leverage) “among the 24 biggest European banks.”

Risk Management

Second, does the bank have a good grip on risk management? None of the recent statements from the new co-chief executive officers, Juergen Fitschen and Anshu Jain, are reassuring, primarily because they don’t address the issue of Deutsche Bank’s very high leverage. If you believe a global $2.9 trillion portfolio cannot suffer more than 3 percent losses, I have some U.S. mortgage-backed securities, euro-periphery debt, and Chinese bridges to nowhere to sell you. Or you can talk to the people at UBS AG who lost their jobs for this kind of hubris.

Third, does management have a convincing vision for staying out of trouble? The really worrying issue in this regard is that Fitschen and Jain remain focused on hitting a return-on-equity target.

They have set a target of a 12 percent after-tax return, a headline number that the bank says is comparable to the 25 percent pretax target set when Josef Ackermann was CEO, but may end up being sharply lower. But as Anat Admati of Stanford University and her colleagues have explained at length in recent years, ROE is a completely flawed target for banks, precisely because it doesn’t capture the associated risks.

“Since investors must be compensated for bearing risk, higher leverage increases the required, or expected, return on equity. To judge whether a manager has created value, one cannot simply look at the return on equity; one must adjust for risk,” Admati wrote in the New York Times. “A bank manager can attempt to reach a ‘target return on equity’ by taking on more risk and by using more leverage, but this, in and of itself, does not create value. It does, however, increase fragility and systemic risk.”

If you invest in banks and haven’t followed this debate, you really need to catch up. The full set of Admati papers is here.

Germany has deep pockets, and many people lined up to put their hands in. But the wealth and the patience of the German people is limited. The country’s gross general government debt is already almost 80 percent of GDP while net debt is 54 percent of GDP, according to the International Monetary Fund’s spring 2012 fiscal monitor. German GDP is 2.65 trillion euros.

Euro Rescue

The even bigger threat is to Germany’s influence in the escalating intra-European struggle over how to save the euro area and who will pay that bill. In the next round -- the argument about potential conditionality that may be attached to ECB and ESM support -- expect Spanish Prime Minister Mariano Rajoy to make the point that reckless German banks, including state-backed Landesbanken, contributed to the debt mess on the periphery. Northern lenders, pursuing foolish ROE targets, were not careful and pushed cheap credit on real-estate developers and governments alike.

Allowing German banks to lend recklessly within the euro area will prove to be a costly mistake, no matter who pays the final bill. Why go down the road again of pursuing high return on equity while mismeasuring credit risk?

Deutsche Bank should be instructed to raise more capital, exactly as UBS and Credit Suisse Group AG have been recently compelled to do. The Swiss authorities recognized that to act otherwise would be fiscally irresponsible. German taxpayers should be clamoring for their government to come to the same realization.

(Simon Johnson, a professor at the MIT Sloan School of Management as well as a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)

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To contact the writer of this article: Simon Johnson at sjohnson@mit.edu

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net