## An Overview of the Danish Covered Bond Market

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### Introduction
- Denmark’s nonbank financial institutions (NBFI) sector has tripled in size since the Global Financial Crisis (GFC).
- The NBFI sector now accounts for almost 300 percent of GDP.
- The share of NBFIs in the total assets of the financial system increased from less than 30 percent in 2007 to almost 45 percent in 2023.
- Drivers of the increase: significant gains from investment returns and valuation, increased household assets, a search for yield, and tighter regulations for banks.

### Key vulnerabilities and risks
- Primary vulnerabilities to monitor: asset prices, leverage, liquidity, and interconnectedness.
- Market Risk:
  - Elevated, albeit declining, market risk for global and European markets due to potential disorderly falls in asset prices.
  - High exposure of Danish NBFIs to market risk and significant domestic and cross-border interconnectedness could translate into market stress.
  - Commercial real estate (CRE) cycle may not yet have turned and could experience further stress.
  - Two recent stress episodes tested resilience: the GFC and sharp monetary policy tightening in 2022, which resulted in significant NBFI losses; the system proved resilient.
- Credit Risk:
  - Corporate credit risks remain elevated; higher interest rates made servicing debt more challenging for some Danish corporates, notably in industry, construction, trade, and real estate.
  - Corporate credit risk parameters, including probability of default and loss given default, indicate stress (EBA, 2024).
- Macro-Financial Risk:
  - Denmark could be prone to a significant wealth effect due to very large household assets combined with high household debt.
  - Under an adverse scenario involving household wealth losses, Denmark is estimated to be markedly impacted in terms of private consumption.
  - Historical precedent: household consumption in Denmark dropped by more than 6 percent in 2008 during the GFC.
- Leverage:
  - Leverage has increased since the GFC but does not appear excessive relative to the EA average.
  - For insurance companies, leverage measured as debt to assets suggests an increase but remains lower compared to the EA average.
  - For pension and investment funds, gross leverage is assets under management to net asset values; adjusted leverage excludes derivatives. These measures show leverage increased but only slightly above the EA average.
- Liquidity:
  - Liquidity buffers proxied as liquidity 1 (cash, deposits, and debt securities, including covered bonds) and liquidity 2 (cash and deposits).
  - Liquidity 1 indicates: pension funds’ buffer is above the EA average; investment funds’ buffer is at par with the EA average; insurance companies’ buffer is below the EA average.
  - Liquidity 2 indicates lower buffers compared to the EA average, especially for investment funds, but convergence to EA average levels across segments.
- Interconnectedness:
  - High degree of domestic and cross-border interconnectedness.
  - Domestic: insurers and pension funds significantly interdependent with investment funds; Danish NBFIs more interconnected with banks through holdings of covered bonds compared to the EA average.
  - Cross-border: substantial cross-border allocations in equities and debt securities, with large exposures to a few countries including the U.S., the UK, Luxembourg, and Ireland.

### Market size, currency composition, and instrument types
- Outstanding issuance: €436 billion (about 123 percent of GDP) as of end-2023.
- Currency composition:
  - Danish Krone (DKK): 96.8 percent of total outstanding.
  - Euro (EUR): 1.6 percent.
  - Swedish Krona (SEK): 1.6 percent.
- Instrument types: callable bonds, bullet bonds, and floaters with or without a cap.
- Market structure: high number of securities, but market value concentrated in a few large series and the majority issued by three large banks.

### Legal framework, pass-through feature, and risk characteristics
- Danish match funding forms the basis of Danish covered bond legislation and distinguishes the system from other European mortgage systems.
- Legislation complies with European standards and is described as among the most stringent, especially regarding asset liability management risk.
- Mortgage banks offer pass-through products, eliminating the credit and market risk for mortgage banks.
- Pass-through principle and borrower option:
  - Borrowers may terminate their loans by buying back the mortgage bonds that fund their loans in the bond market and delivering them to their mortgage bank.
  - This option is known as the delivery option or the buyback option and applies to all mortgage bonds, whether callable or non-callable.
- Credit ratings and safety:
  - Credit ratings of covered bonds have generally been stable.
  - Over 90 percent of issuers maintained a stable or positive rating outlook.
  - Additional notches provide buffers against potential downgrades of the issuer’s credit rating.
  - Covered bonds are structured to minimize risk through dual recourse and are generally well-rated, but their safety is not absolute and is closely tied to issuers’ financial health and credit rating.
  - Danish covered bonds have never defaulted.

### Asset pool composition and collateral standards
- Asset pool: both residential and commercial real estate.
- Maximum loan-to-value limits:
  - Residential real estate: 80 percent.
  - Commercial real estate: 60 percent.
- Overcollateralization exceeds the ECBC’s minimum requirement of 2 percent.
- No official limit on commercial real estate assets in the asset pool.

### Market stress episodes and central bank intervention
- Global Financial Crisis (GFC) 2008:
  - Experienced a sudden liquidity dry-up.
  - Danmarks Nationalbank intervened to ensure market continuity.
  - Empirical finding: Buchholst, Gyntelberg, and Sangill (2010) show that, despite the liquidity shock, covered bonds behaved similar to government bonds in turmoil periods.
- Covid pandemic onset 2020:
  - Covered bonds experienced a widening of spreads, indicating reduced liquidity and trading.
  - The market recovered rapidly.

### Investor base and ownership changes since the GFC
- Domestic holdings as of March 2024: about DKK 2.8 billion, returning to GFC levels.
- Changes in sectoral composition of domestic holdings (2009 to 2024):
  - Banks (MFI): decreased from 58 percent in 2009 to 34 percent in 2024.
  - Insurance companies and pension funds (ICPF): increased from 21 to 35 percent.
  - Investment funds: increased from 9 to 13 percent.
- Foreign ownership:
  - Share of foreign holdings rose from 9 percent in 2008 to 25 percent of total outstanding Danish covered bonds as of end-2023.
  - Peak foreign share: 33 percent of total covered bonds in 2020 and 2021.
  - Euro Area countries constitute about 56 percent of foreign holdings, with largest investments from Germany, Luxembourg, Ireland, Italy and Finland as of end-2023.
  - Asian countries, in particular Japan, have also increased their holdings.
- Currency mismatch risk: considered low because about 96 percent of covered bonds are denominated in DKK, implying foreign holdings are mostly DKK-denominated.

### Monitoring and policy implications
- Danish covered bond market remains stable but with changing underlying dynamics.
- Key vulnerabilities and risks to monitor:
  - Interconnectedness risk between covered bond issuers and the broader financial system.
  - Ongoing review of the macroprudential policy stance to contain systemic risk and safeguard the financial system.

### Policy options and recommendations (system-wide NBFI context)
- Strengthen systemic risk assessment and policy framework for NBFIs:
  - Consider developing a comprehensive systemic risk assessment framework that covers both banking and nonbanking institutions.
  - Consider developing a system-wide stress testing framework combining banking and nonbanking institutions.
- Systemic Risk Assessment practices and precedents:
  - Financial stability reviews in several central banks now routinely include systemic risk assessments for NBFIs (examples cited: Central Bank of Ireland, Bank of England, Bank of Canada).
  - In countries with sizable NBFI sectors (Netherlands, Sweden), central banks explicitly discuss emerging NBFI risks.
  - The FSB (2021) framework uses indicators covering asset prices, leverage, liquidity, and domestic and cross-border interconnectedness.
- Stress Testing practices and precedents:
  - ESMA (2019, 2020) provides guidelines for liquidity stress-testing frameworks for investment funds.
  - ECB (2024) has begun explicit quantitative assessments of NBFI risks in systemic risk assessments.
  - Bank of England (BoE, 2023) launched a stress test combining banks and NBFIs to analyze behaviors, interactions, and amplification mechanisms in stress, carried out with microprudential supervisors.
- EU-level initiatives:
  - Ongoing policy initiatives to develop a macroprudential policy toolkit for NBFIs at the EU level (EC, 2024).
  - EIOPA proposals for Solvency II include dividend restriction or suspension, powers to reinforce liquidity, temporary redemption rights for policy holders, capital surcharges for systemic risk, and concentration thresholds.
  - Proposals for investment funds aim to address liquidity mismatches and leverage through activity-based measures, entity-based measures, and liquidity management tools.
  - Ongoing efforts to address risks associated with margining practices and central counterparties (EC, 2022).

*Prepared by Burcu Hacibedel and Mariusz Jarmuzek; August 22, 2024.*

### 1.   An Overview of the Danish Covered Bond Market  ____________________________________ 12

### 1.   An Overview of the Danish Covered Bond Market

### Introduction
- Denmark’s nonbank financial institutions (NBFI) sector has tripled in size since the Global Financial Crisis (GFC).
- The NBFI sector now accounts for almost 300 percent of GDP.
- The share of NBFIs in the total assets of the financial system increased from less than 30 percent in 2007 to almost 45 percent in 2023.
- Drivers of the increase: significant gains from investment returns and valuation, increased household assets, a search for yield, and tighter regulations for banks.

### Key Vulnerabilities
- Primary vulnerabilities to monitor: asset prices, leverage, liquidity, and interconnectedness.
- Asset price exposure:
  - High exposure to debt securities and equities increases susceptibility to market risk.
  - Significant asset allocation to covered bonds issued by mortgage credit institutions indirectly exposes NBFIs to real estate market fluctuations, while direct property holdings remain relatively small.
  - Insurance companies and pension funds have exposures to investment funds; investment funds are increasingly exposed to each other.
- Leverage:
  - Leverage has increased since the GFC but does not appear excessive relative to the EA average.
  - For insurance companies, leverage measured as debt to assets suggests an increase but remains lower compared to the EA average.
  - For pension and investment funds, gross leverage is assets under management to net asset values; adjusted leverage excludes derivatives. These measures show leverage increased but only slightly above the EA average.
- Liquidity:
  - Liquidity buffers proxied as liquidity 1 (cash, deposits, and debt securities, including covered bonds) and liquidity 2 (cash and deposits).
  - Liquidity 1 indicates: pension funds’ buffer is above the EA average; investment funds’ buffer is at par with the EA average; insurance companies’ buffer is below the EA average.
  - Liquidity 2 indicates lower buffers compared to the EA average, especially for investment funds, but convergence to EA average levels across segments.
- Interconnectedness:
  - High degree of domestic and cross-border interconnectedness.
  - Domestic: insurers and pension funds significantly interdependent with investment funds; Danish NBFIs more interconnected with banks through holdings of covered bonds compared to the EA average.
  - Cross-border: substantial cross-border allocations in equities and debt securities, with large exposures to a few countries including the U.S., the UK, Luxembourg, and Ireland.

### Risks
- Market Risk:
  - Elevated, albeit declining, market risk for global and European markets due to potential disorderly falls in asset prices.
  - High exposure of Danish NBFIs to market risk and significant domestic and cross-border interconnectedness could translate into market stress.
  - Commercial real estate (CRE) cycle may not yet have turned and could experience further stress.
  - Two recent stress episodes tested resilience: the GFC and sharp monetary policy tightening in 2022, which resulted in significant NBFI losses; the system proved resilient.
- Credit Risk:
  - Corporate credit risks remain elevated; higher interest rates made servicing debt more challenging for some Danish corporates, notably in industry, construction, trade, and real estate.
  - Corporate credit risk parameters, including probability of default and loss given default, indicate stress (EBA, 2024).
  - Deterioration in corporate sector conditions could exert downward pressure on equity markets and adversely affect equities held by Danish NBFIs.
- Macro-Financial Risk:
  - Denmark could be prone to a significant wealth effect due to very large household assets combined with high household debt.
  - Under an adverse scenario involving household wealth losses, Denmark is estimated to be markedly impacted in terms of private consumption.
  - Historical precedent: household consumption in Denmark dropped by more than 6 percent in 2008 during the GFC.

### Mitigating Factors
- Pension companies hold about 50 percent of total liabilities in non-guaranteed market-return products, mitigating solvency and liquidity impact from market and credit risk.
- Significant exposure to real estate is mainly indirect through covered bonds, which have shown considerable resilience in stress episodes.
- Covered bonds’ resilience supports investment funds’ liquidity risk management given their sizable holding of covered bonds.
- NBFIs provide limited direct credit extension, with credit provision accounting for only around 10 percent of GDP.

### Policy Options and Recommendations
- Strengthen systemic risk assessment and policy framework for NBFIs:
  - Consider developing a comprehensive systemic risk assessment framework that covers both banking and nonbanking institutions.
  - Consider developing a system-wide stress testing framework combining banking and nonbanking institutions.
- Systemic Risk Assessment practices and precedents:
  - Financial stability reviews in several central banks now routinely include systemic risk assessments for NBFIs (examples cited: Central Bank of Ireland, Bank of England, Bank of Canada).
  - In countries with sizable NBFI sectors (Netherlands, Sweden), central banks explicitly discuss emerging NBFI risks.
  - The FSB (2021) framework uses indicators covering asset prices, leverage, liquidity, and domestic and cross-border interconnectedness.
- Stress Testing practices and precedents:
  - ESMA (2019, 2020) provides guidelines for liquidity stress-testing frameworks for investment funds.
  - ECB (2024) has begun explicit quantitative assessments of NBFI risks in systemic risk assessments.
  - Bank of England (BoE, 2023) launched a stress test combining banks and NBFIs to analyze behaviors, interactions, and amplification mechanisms in stress, carried out with microprudential supervisors.
- EU-level initiatives:
  - Ongoing policy initiatives to develop a macroprudential policy toolkit for NBFIs at the EU level (EC, 2024).
  - EIOPA proposals for Solvency II include dividend restriction or suspension, powers to reinforce liquidity, temporary redemption rights for policy holders, capital surcharges for systemic risk, and concentration thresholds.
  - Proposals for investment funds aim to address liquidity mismatches and leverage through activity-based measures, entity-based measures, and liquidity management tools.
  - Ongoing efforts to address risks associated with margining practices and central counterparties (EC, 2022).

### Conclusions and Policy Considerations
- Systemic risk associated with NBFIs in Denmark appears contained but requires close monitoring.
- Supervisory focus should include leverage, liquidity buffers, and domestic and cross-border interconnectedness.
- Mitigating factors—high share of non-guaranteed market-return products, limited direct real estate exposure, and limited direct credit extension—reduce systemic risk stemming from NBFIs.
- Strengthening systemic risk assessment and developing system-wide stress testing that combines banks and NBFIs is warranted to better identify and manage system-wide vulnerabilities.

*Prepared by Burcu Hacibedel and Mariusz Jarmuzek; August 22, 2024.*

### Box 1. An Overview of the Danish Covered Bond Market

### Box 1. An Overview of the Danish Covered Bond Market

### Market size, currency composition, and instrument types
- Outstanding issuance: €436 billion (about 123 percent of GDP) as of end-2023.
- Currency composition:
  - Danish Krone (DKK): 96.8 percent of total outstanding.
  - Euro (EUR): 1.6 percent.
  - Swedish Krona (SEK): 1.6 percent.
- Instrument types: callable bonds, bullet bonds, and floaters with or without a cap.
- Market structure: high number of securities, but market value concentrated in a few large series and the majority issued by three large banks.

### Legal framework, pass-through feature, and risk characteristics
- Danish match funding forms the basis of Danish covered bond legislation and distinguishes the system from other European mortgage systems.
- Legislation complies with European standards and is described as among the most stringent, especially regarding asset liability management risk.
- Mortgage banks offer pass-through products, eliminating the credit and market risk for mortgage banks.
- Pass-through principle and borrower option:
  - Borrowers may terminate their loans by buying back the mortgage bonds that fund their loans in the bond market and delivering them to their mortgage bank.
  - This option is known as the delivery option or the buyback option and applies to all mortgage bonds, whether callable or non-callable.
- Credit ratings and safety:
  - Credit ratings of covered bonds have generally been stable.
  - Over 90 percent of issuers maintained a stable or positive rating outlook.
  - Additional notches provide buffers against potential downgrades of the issuer’s credit rating.
  - Covered bonds are structured to minimize risk through dual recourse and are generally well-rated, but their safety is not absolute and is closely tied to issuers’ financial health and credit rating.
  - Danish covered bonds have never defaulted.

### Asset pool composition and collateral standards
- Asset pool: both residential and commercial real estate.
- Maximum loan-to-value limits:
  - Residential real estate: 80 percent.
  - Commercial real estate: 60 percent.
- Overcollateralization exceeds the ECBC’s minimum requirement of 2 percent.
- No official limit on commercial real estate assets in the asset pool.

### Market stress episodes and central bank intervention
- Global Financial Crisis (GFC) 2008:
  - Experienced a sudden liquidity dry-up.
  - Danmarks Nationalbank intervened to ensure market continuity.
  - Empirical finding: Buchholst, Gyntelberg, and Sangill (2010) show that, despite the liquidity shock, covered bonds behaved similar to government bonds in turmoil periods.
- Covid pandemic onset 2020:
  - Covered bonds experienced a widening of spreads, indicating reduced liquidity and trading.
  - The market recovered rapidly.

### Investor base and ownership changes since the GFC
- Domestic holdings as of March 2024: about DKK 2.8 billion, returning to GFC levels.
- Changes in sectoral composition of domestic holdings (2009 to 2024):
  - Banks (MFI): decreased from 58 percent in 2009 to 34 percent in 2024.
  - Insurance companies and pension funds (ICPF): increased from 21 to 35 percent.
  - Investment funds: increased from 9 to 13 percent.
- Foreign ownership:
  - Share of foreign holdings rose from 9 percent in 2008 to 25 percent of total outstanding Danish covered bonds as of end-2023.
  - Peak foreign share: 33 percent of total covered bonds in 2020 and 2021.
  - Euro Area countries constitute about 56 percent of foreign holdings, with largest investments from Germany, Luxembourg, Ireland, Italy and Finland as of end-2023.
  - Asian countries, in particular Japan, have also increased their holdings.
- Currency mismatch risk: considered low because about 96 percent of covered bonds are denominated in DKK, implying foreign holdings are mostly DKK-denominated.

### Monitoring and policy implications
- Danish covered bond market remains stable but with changing underlying dynamics.
- Key vulnerabilities and risks to monitor:
  - Interconnectedness risk between covered bond issuers and the broader financial system.
  - Ongoing review of the macroprudential policy stance to contain systemic risk and safeguard the financial system.

*Source: sipea2024044 - Box 1. An Overview of the Danish Covered Bond Market*

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_Source: https://www.imf.org/-/media/files/publications/selected-issues-papers/2024/english/sipea2024044.pdf_