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Here’s why the German government might not be able to help Deutsche Bank

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The problems surrounding Deutsche Bank are front and center in investors' minds, especially with the uncertainty surrounding the bank's $14 billion settlement negotiations with the U.S. Department of Justice. But while it is still unclear if the ailing German lender will need state aid to sail through this crisis, there is a regulation that could stop the German government from ending the misery by injecting equity into the bank.

The Banking Recovery and Resolution Directive (BRRD), that came into force earlier this year - requires an 8 percent bail-in of a bank's creditors, including very large foreign banks and hedge funds — be applied before taxpayers get put on the hook. The directive has a well-laid out structure for resolving a troubled or failing European bank, irrespective of whether it is a small lender in Italy or a national champion in Germany.

"The German government knows this," Dhaval Joshi, Senior Vice-President at BCA Research told CNBC via email. "The good news is that an individual bank failure, however large, should no longer constitute a systemic risk. BRRD forces the ECB, the Eurosystem, and governments to prioritise the protection of banks' critical functions and stakeholders, specifically: payment systems, taxpayers and depositors."

Volatility ahead?

But there is bad news too, Joshi said. 'The bad news for bank investors is that "other parts may be allowed to fail in the normal way' – meaning allocation of losses will follow the usual ranking of losses in insolvency."

Joshi further explained that , for Deutsche Bank, the biggest concern is the size of the fine. Shares in Deutsche Bank have been volatile as the German lender tries to cover itself from every corner. The bank's shares are down nearly 50 percent since the start of the year.

However, Joshi said that for other European bank investors, the worry is the size of the non-performing loans (NPLs) bogging down Europe's banks. The level of bad debts in Spain, is equal to nearly 30 percent of bank equity in Spain and 100 percent in Italy.

Italian policymakers and EU officials have been pondering how to improve Italy's fragile banking system, which has been bogged down by non-performing loans estimated to total around 360 billion euros ($401 billion).

This adds up to the bigger worry in the region for other European banks that have seen their stocks fall to all-time lows due to a number of factors such as uncertainty surrounding the U.K.'s vote to leave the European Union, weak earnings reports and low interest rate across the globe.

"European banks face three long-term headwinds that have impacted their performance over a period of time. These include the BRRD, Negative Interest Rate Policy, NPLs," BCA's Joshi said.

But that hasn't stopped equity investors to go overweight on European banks. Last week, Citi in a report said they were "overweight" on the European banking sector, suggesting that investor position is very light.

"Euro area, Europe ex-U.K. and U.K. banks are among the worst five performing region/sector combinations in the last 10 years out of 285 we track," the team, led by Jonathan Stubbs, said in the note. "European banks have been the lightning rod for all post-GFC (global financial crisis) macro risk," it added.

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