## _cr14336 - EXECUTIVE SUMMARY ## Source details **Canonical URL:** [_cr14336 - EXECUTIVE SUMMARY](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14336.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14336.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14336.pdf.json) --- ### Major findings on system resilience and risks - Authorities’ actions to improve resilience: - Strengthened financial regulation and supervision. - New bank resolution framework including bail-in of creditors; deployed to resolve small and medium-sized banks. - Institutional framework for macroprudential policy. - Legislation requiring maturity extension of covered bonds in stress to reduce refinancing risk in mortgage finance. - Stress test conclusion: - Stress tests indicate financial stability risks are contained in baseline severe scenarios; solvency levels at large banks and MCIs remain well above regulatory requirements due to high current capital ratios. - Caveat: stress tests may underestimate contagion risks because they cannot fully capture second-round and non-linear effects; the large size and interconnectedness of Denmark’s financial system make such contagion risks material. - Priority: given centrality of covered bonds backed by mortgage loans, reducing risks in mortgage finance is a priority. ### Key vulnerabilities and structural characteristics - Size and interconnectedness (selected figures): - Financial system assets exceed 650 percent of GDP. - Banking sector (95 banks and MCIs) accounts for two thirds of financial sector assets. - Six D-SIFIs dominate; Danske Bank Group has assets of about 180 percent of GDP. - Insurance sector assets are 130 percent of GDP. - Household pension claims on life insurers and pension funds represent 140 percent of GDP. - Covered bonds market is 150 percent of GDP. - Lending by banks and MCIs to households amounts to 130 percent of GDP. - Household sector: - High household gross debt; large share of household assets illiquid (housing and pension savings); limited liquid buffers. - Household deleveraging has negatively affected private consumption. - Household arrears generally low; DN household-level stress tests suggest limited impact of an interest rate increase on NPLs. - Nonfinancial corporates: - Nonfinancial corporate sector debt stabilized at 110 percent of GDP after rapid rise during boom years. - Corporate defaults remain higher than before the crisis and profitability recovery has been slow. - Cross-border exposures: - Strong ties with Nordic and Baltic countries. - Danske Bank’s lending and deposit market shares range from 5–10 percent in other Nordic and Baltic countries (except Latvia). - Nordea (Swedish) is the second-largest bank in Denmark with important deposit and lending market shares. ### Crisis response and legacy - During the global crisis: - Commercial banks faced severe liquidity strains from excessive reliance on short-term wholesale funding. - Danmarks Nationalbank (DN) provided extraordinary liquidity support and large-scale government guarantees ensured access to funding. - Banks recorded loan write downs equivalent to about 8½ percent of GDP (2008–2011), significantly eroding profitability. - 2010: authorities distinguished viable banks (supported by guarantees and capital injections) from weak banks (resolved via private solutions or closed). - Government adopted six rounds of measures (the “Bank Packages”). - Large banks were explicitly excluded from the new resolution scheme, highlighting the need for an effective resolution regime for D-SIFIs. ### Financial Soundness Indicators (selected figures, 2006–2013) - Regulatory capital to risk-weighted assets: 13.8 (2006), 12.3 (2007), 14.1 (2008), 17.9 (2009), 17.9 (2010), 20.1 (2011), 22.1 (2012), 22.3 (2013). - Regulatory Tier I capital to risk-weighted assets: 10.9 (2006), 9.2 (2007), 10.7 (2008), 14.6 (2009), 15.1 (2010), 17.2 (2011), 19.2 (2012), 19.5 (2013). - Core / Common Equity Tier 1 capital to risk-weighted assets: N/A (2006), 8.7 (2007), 10.0 (2008), 11.8 (2009), 12.2 (2010), 14.4 (2011), 16.3 (2012), 16.7 (2013). - Nonperforming loans net of provisions to capital: 4.5 (2006), 5.0 (2007), 18.0 (2008), 20.6 (2009), 22.9 (2010), 22.0 (2011), 22.9 (2012), 22.4 (2013). - Bank provisions to Nonperforming loans: 51.7 (2006), 45.6 (2007), 42.1 (2008), 53.7 (2009), 55.2 (2010), 50.2 (2011), 50.8 (2012), 51.0 (2013). - Nonperforming loans to total gross loans: 1.5 (2006), 1.2 (2007), 3.8 (2008), 7.0 (2009), 7.9 (2010), 7.9 (2011), 8.3 (2012), 8.7 (2013). - Sectoral distribution of loans to total loans — Nonfinancial corporation: 71.2 (2006), 69.5 (2007), 72.8 (2008), 69.4 (2009), 66.7 (2010), 64.2 (2011), 64.4 (2012), 65.2 (2013). - Sectoral distribution of loans to total loans — Households (including individual firms): 26.7 (2006), 28.0 (2007), 24.9 (2008), 28.3 (2009), 31.1 (2010), 32.5 (2011), 33.1 (2012), 32.0 (2013). - ROA (aggregated parent-company basis): 1.2 (2006), 0.9 (2007), -0.1 (2008), -0.4 (2009), 0.1 (2010), 0.1 (2011), 0.2 (2012), 0.4 (2013). - ROE (aggregated parent-company basis): 19.7 (2006), 16.2 (2007), -2.9 (2008), -6.4 (2009), 1.7 (2010), 1.3 (2011), 2.7 (2012), 5.7 (2013). - Interest margin to gross income: 71.8 (2006), 78.1 (2007), 87.4 (2008), 78.5 (2009), 70.1 (2010), 73.4 (2011), 67.0 (2012), 64.2 (2013). - Noninterest expenses to gross income: 25.8 (2006), 23.4 (2007), 25.9 (2008), 36.0 (2009), 42.7 (2010), 43.8 (2011), 44.9 (2012), 47.2 (2013). - Liquid assets to total assets: 24.5 (2006), 21.3 (2007), 19.9 (2008), 28.4 (2009), 27.8 (2010), 23.6 (2011), 27.0 (2012), 30.9 (2013). - Liquid assets to short-term liabilities: 34.8 (2006), 31.6 (2007), 30.3 (2008), 44.3 (2009), 45.6 (2010), 37.3 (2011), 45.4 (2012), 49.8 (2013). - Foreign currency position: N/A (2006), 9.6 (2007), 6.4 (2008), 3.3 (2009), 3.4 (2010), 2.8 (2011), 1.4 (2012), 1.2 (2013). ### Key policy recommendations (priorities indicated) - Mortgage finance (Short term): - Reduce refinancing risk by encouraging longer bond maturities (DFSA, MOBG). - Limit impact of eventual normalization of interest rates by ensuring credit risk is taken into account in loan pricing and approvals (DFSA, MOBG). - Increase buffers in IO loans by lowering LTV limits for such loans, requiring amortization to a lower ceiling, and/or imposing higher capital charges or credit loss provisions until IO periods expire (DFSA, MOBG). - The proposed prudential limits on MCIs’ higher-risk activities are welcome. - Prudential supervision: - Reduce length of examination cycles for banks and insurance companies (DFSA) — requires additional supervisory resources (MOBG) (Short term). - Ensure operational independence of the DFSA by establishing supervisory imperatives within the Director General’s authority, lengthening Board members’ terms, and establishing a formal vetting process (MOBG) (Medium term). - Bank supervision: broaden routine reporting on operational and market risk (DFSA) and ensure systematic review of Pillar III disclosures (DFSA) (Short term/Medium term). - Insurance supervision: enhance supervision of conduct of business, fraud, and AML/CFT (DFSA); establish a solvency level below which companies may not operate (DFSA); require risk, compliance, internal audit, and actuarial functions in all insurers and better integrate qualitative governance assessments with off-site analysis (DFSA) (Short term/Medium term). - Macroprudential policy: - Develop instruments to address time-varying systemic risk, such as limits on LTV and DSTI ratios (DN, DFSA) (Short term). - Expand analytical tools to identify and monitor systemic risk (DN) (Medium term). - Crisis management and bank resolution: - Establish early resolution triggers and strengthen funding arrangements and the resolution toolkit (MOBG, FSC, DFSA) (Short term). - Prepare resolution plans and resolvability assessments (FSC, DFSA) (Short term). - Enhance the DGS by removing mandatory offsetting, strengthening back-stop arrangements, and introducing depositor preference (MOBG) (Medium term). - Stress testing: - Intensify cooperation between DFSA and DN to exploit synergies between micro- and macroprudential stress testing (Medium term). - Develop a macroprudential stress testing framework for the insurance sector (DFSA) (Medium term). - Expand financial stability analyses to include insurance and pension funds (DN) (Medium term). ### Supervisory and institutional priorities - Strengthen DFSA capacity and operational independence; increase onsite inspection frequency, including AML/CFT supervision. - Broaden routine reporting on operational and market risk; implement systemic review of Pillar III disclosures. - Insurance supervision: set a minimum solvency level; require key internal functions across insurers; enhance governance, market conduct, fraud, and AML/CFT supervision. - Macroprudential framework development: - SRC creation, imminent D-SIFI capital surcharges, and forthcoming CCB framework are important steps. - Authorities encouraged to expand systemic risk identification capacity, develop time-varying instruments (LTV, DSTI), and establish higher risk weights for specific sectors. - Review institutional arrangements to ensure independence, particularly the government’s role as the designated authority for most macroprudential instruments. ### Regional cooperation - Given strong financial links with other Nordic countries (Danske Bank’s regional presence and Nordea’s role in Denmark), continue strengthening cooperation on macroprudential policy and harmonize resolution frameworks at a regional level for institutions with potential regional spillovers. --- ### Box 1. Denmark: Government Measures to Strengthen Financial Stability ### Government bank packages and resolution tools (selected measures) - Bank Package 1 (October 2008): temporary state guarantee for all claims of depositors and other unsecured creditors; financial sector covering losses up to DKK 35 billion (2 percent of GDP); created the Financial Stability Company (FSC). - Bank Package 2 (January 2009): temporary facilities for state-guaranteed senior funding and solvency support; banks drew DKK 46 billion (2.6 percent of GDP) in solvency support and DKK 193 billion (11 percent of GDP) in state-guaranteed debt instruments. - Bank Package 3 (October 2010): scheme for orderly resolution of (non-systemic) distressed financial firms with bail-in of unsecured creditors including deposits above DKK 750,000 (EUR 100,000); FSC has taken over loans and guarantees equivalent to about 5½ percent of GDP. - Bank Package 4 (September 2011): incentives for viable institutions to acquire assets of distressed firms; strengthened funding structure of Danish Guarantee Fund for Depositors and Investors. - Bank Package 5 (March 2012): allocated resources to finance economic growth and exports. - Bank Package 6 (October 2013): introduced more stringent solvency requirements for D-SIFIs. ### Broad financial system developments and macro context - Deleveraging and credit: - Ratio of private credit to GDP declined from about 205 percent at end-2009 to about 185 percent at end-2013. - Cross-border exposures and domestic credit have declined. - House prices fell sharply during 2007–12; recently started to rise gradually and are now estimated to be not far from fundamentals, with a valuation gap of less than 10 percent. - Macroeconomic policy and outlook: - Tight peg to the euro has kept inflation anchored. - Fiscal policy generally countercyclical; gross government debt remains relatively low, supporting the sovereign’s triple-A credit rating. - Denmark’s external position is strong; current account surplus expected to remain at above 6 percent of GDP. - Output growth forecast at 1½–2¼ percent in 2015 and beyond. ### Commercial banks: capital, funding, and risks - Capitalization and funding improvements since the crisis; several banks raised capital through share issuance. - DFSA imposes additional Pillar 2 capital requirements, publicly disclosed. - Reliance on wholesale short-term funding has decreased; deposit-to-loan ratio increased; liquidity improved. - Profitability under pressure from low lending volumes and interest margins. - All large commercial banks (87 percent of sector’s assets) returned to profitability in 2012; ROE in other banks remains very weak. - Impaired loans ratio increased from 1.2 percent in 2007 to 8.7 percent in 2013. - Commercial real estate prices remain weak; some medium-sized non-systemic banks may need consolidation or resolution if weak earnings persist. - Basel III/CRD IV implementation underway. ### Mortgage Credit Institutions (MCIs): structure, risks, and legislation - Structural features: - 75 percent of total mortgage debt at end-2013 are adjustable and variable rate loans. - Such loans financed mainly by short-term bonds, most rolled over annually; increases borrower interest rate risk. - Interest-only (IO) periods of ten years common; many IO periods will expire over next several years. - Increase in LTV ratios due to 2007–12 house price decline may preclude refinancing for many borrowers. - Performance and vulnerabilities: - MCIs experienced low impairment charges, better ROEs than commercial banks, and maintained stable capitalization. - Covered bond market remained relatively liquid during the crisis. - Many borrowers could face payment shocks when interest rates return to historical norms, which are 3–4 percentage points above current levels. - A rise in interest rates could put downward pressure on house prices, increasing LTVs and requiring additional collateralization for outstanding covered bonds. - Scheduled expiry of IO periods could lead to additional loan impairments, though DN and MOBG household-level analyses indicate most affected could continue servicing debts. - Legislative response to refinancing risk: - New legislation requires extension of covered bond maturities in event of an auction failure; defines a failed auction as bids not sufficient to cover bonds on offer or bids requiring an increase in interest rate on the bonds of more than 5 percentage points. - New law limits increase in interest rates of extended bonds to 5 percentage points. - New legislation estimated to have increased covered bond spreads by only about 5–10 basis points. ### Insurance companies and pension funds - Insurance sector: - Mostly positive but low premium growth since 2010. - Solvency levels increased, especially among life insurers, reflecting good investment returns during 2009-12. - Profitability declined recently but remains relatively high in non-life. - Non-life companies face growing claims from more frequent weather-related events. - Life insurers and pensions: - Challenge of prolonged low interest rates for life insurers. - Shift from guaranteed products into non-guaranteed and unit-linked business. - Legacy portfolio of contracts with annual guarantees of more than 4 percent is relatively large though declining. - Pension fund resilience: - ATP reserve indicator stable at 309 percent at end-2013. - Multi-employer pension funds and company pension funds recorded average solvency ratio of 591 percent at end-2013. ### Principal risks to financial system resilience (selected) - High likelihood — Protracted slower global growth: expected impact Medium; consequences include higher NPLs, lower profitability for banks, life insurers and pension funds stressed by low interest rates. - High likelihood — Surge in global financial market volatility: expected impact Medium; consequences include liquidity strains, asset valuation corrections, higher NPLs and impaired solvency. - Low likelihood — Drop in confidence in Danish covered bonds: expected impact High; consequences include retrenchment by investors, financing problems for MCIs, mark-downs hurting solvency of banks, life insurers, and pension funds. - Additional note: combination of protracted low euro area interest rates and domestic recovery could create overheating in housing markets. --- ### Stress testing framework, scenarios, and results ### Scope and methodology - Institutions covered: banks, MCIs, insurance companies, largest pension fund; integrated solvency stress test for Danske Group. - Stress test horizon: five years (2014Q1–2018Q4); separate estimate of full Basel III implementation (2019). - Methodology: constrained bottom-up (BU) using banks’ internal frameworks; top-down (TD) DN framework; parallel TD confirms BU results. - Data baseline: audited financial statements as of end 2013; bank-internal portfolio, income and balance sheet data. ### Scenarios analyzed - Baseline and two adverse scenarios: “protracted slow growth” and “severe stress”. - “Protracted slow growth”: five-year cumulative shock to real GDP growth of about one standard deviation. - “Severe stress”: two-year cumulative shock to GDP growth of 2½ standard deviations. - Severe Stress specifics: - Real GDP growth lower by -3.8 percentage points in 2014 and -1.6 percentage points in 2015 than baseline. - Adverse scenario equals a 5.4 percentage points two-year cumulative shock for 2014–15 compared to baseline. ### Banking sector solvency results - Overall conclusion: commercial banks and MCIs are in strong positions to withstand severe shocks given already high capital buffers. - Baseline: capital ratio would rise further as credit losses remain low; increased profitability would offset increases in risk weights and phase-out of hybrid capital. - Slow growth: profits lower and credit risk higher; capital ratio would remain roughly at current level. - Severe stress: capital ratio would fall sharply but all institutions in sample remain well above regulatory minima throughout forecasting horizon. - MCIs: greater exposure to housing market means larger contributions from loan losses and RWA increases; mitigants include high collateralization, lower LTVs than banks, and loan loss guarantees by commercial banks. ### Sensitivities and concentration - Covered bond spread shock: - 500 bps increase in covered bond spread would reduce aggregate CET1 ratio by 1.7 percentage points (taking into account profits). - Historical peak during global crisis was about 150 basis points. - Sovereign yield shock: - Two standard deviation sovereign yield shock results in only small reduction in CET1 ratio given low volatility of Danish sovereign bonds and small foreign sovereign exposures. - Concentration risk: has come down and is manageable. - Parallel TD tests confirm BU results. ### Liquidity risk and funding - LCR definition and results: - European Commission allows high-quality covered bonds meeting criteria as Level 1 HQLA up to a ceiling of 70 percent with a haircut of 7 percent. - On this definition, average bank in sample had an LCR of 95 percent as of end-2013. - Liquidity shortfalls: - DKK 17 billion (about 1 percent of GDP) shortfall for the 60 percent requirement applicable from October 2015. - DKK 82 billion (about 4½ percent of GDP) shortfall for the 100 percent requirement applicable from January 2018. - Of the DKK 82 billion shortfall, only DKK 6 billion (less than ½ percent of GDP) would remain if institutions switched current holdings of ineligible HQLA to eligible HQLA. - Funding ratio: With two exceptions, all banks have FRs below the regulatory ceiling of 100 percent. - Banks expected to meet phased-in LCR requirement including by exchanging some covered bonds for sovereign bonds. ### Insurance and pension stress tests - Methodology: BU solvency tests using same macro scenarios; market and underwriting risks detailed; total balance sheet approach applied to assets and liabilities. - Conservative assumptions: no discretionary management actions; no investment returns assumed from 2015 to 2018 apart from interest-driven valuation changes. - Results: - Adverse scenarios have large negative effects on insurers, mostly due to asset price and interest rate shocks. - Drop in stock prices and surge in corporate bond spreads lead to large declines in available capital, especially at life insurers. - Life insurers’ net income (low to begin with) does not recover under zero-investment-return assumption. - Non-life insurers break even in 2014 and recover quickly due to profitable underwriting and less reliance on investment returns. - Sensitivity: 500 bps increase in covered bond spread would cause insurers’ solvency ratios to fall sharply. - Catastrophic windstorm would reduce non-life insurers’ solvency ratios only a little due to reinsurance. - ATP: - ATP’s excess cover drops slightly under baseline and more in stress scenarios, but stays comfortably close to ATP’s internal targets. - Main driver of reduction in bonus potential is equity shock; corporate bond shock does not materially affect ATP. - Stress scenarios reduce ATP’s profits, turning them negative in both scenarios. ### Improving risk assessments — recommended enhancements - Intensify DFSA–DN cooperation to exploit synergies between micro- and macroprudential stress testing. - Strengthen analysis of insurance companies and pension funds and their inter-linkages with the financial system. - For insurance: complement micro-prudential stress testing with macroprudential stress testing that is severe but plausible, tailored to insurance specificities (e.g., concentrations in covered bond holdings), comprehensive, forward-looking, and based on a clear narrative. ### Interconnectedness and spillovers - Domestic: - Large inter-sector exposures; largest exposures include households’ claims on insurers/pension funds, ROW claims on banking sector, and banking sector claims on households. - Danske Bank: - VAR analysis shows Danske tends to be recipient rather than source of spillovers; Danske’s credit spread rises in case of distress in economy, corporate sector, and sovereign. - Cross-bank and cross-border: - Conditional probabilities indicate asymmetric distress dependence among Danske, Jyske, Sydbank, Nordea parent. - Network analysis shows close interconnection with Nordic and Baltic countries; Denmark vulnerable to extreme shocks in Norway, Sweden, Finland, United Kingdom, and United States. - An extreme credit and funding shock in Denmark would have significant regional impact. --- ### Financial oversight framework: policy measures and institutional design ### Mortgage finance measures - Mitigate risks from product innovations; opportunity to lengthen covered bond maturities at minimal cost to borrowers. - Possible measures: - Incentivize reduced maturity mismatch and refinancing risk; consider regulatory restrictions or additional capital (Pillar II or systemic risk buffer); consider modifying balance principle to require overcollateralization for refinancing risk. - Encourage lenders to increase administrative margins for variable/adjustable rate loans; supervisors require stressed DSTI criteria; stress tests could be more severe. - Discourage new IO loans via higher credit loss provisions, ending/reducing tax deductibility of interest on IO loans, or requiring lower LTV ratios for IO loans. - Authorities’ measures under consideration: - Proposed Supervisory Diamond for MCIs covering lending growth, short-term funding, borrower interest-rate risk, IO loans, and large exposures. - Home buyers required to make down payment of at least 5 percent. - Commercial properties required to generate positive cash flow before financing. ### Prudential supervision enhancements - Institutional strengthening: - DFSA granted additional powers and staffing increased by about half. - Strong risk-based approach; offsite tools include Supervisory Diamond for banks and traffic light system for insurers. - Governance/internal controls: - Recommend keeping supervisory imperatives within Director General’s authority, lengthening Board members’ terms, strict fit and proper criteria, and establishing internal audit function. - Resource needs: - Increase supervisory resources to raise frequency of onsite inspections and enhance AML/CFT supervision. - Banking supervision specifics: - Shorten supervisory cycle for smaller institutions; improve onsite follow-up for large institutions. - Expand data used in offsite supervision, including market and operational risk monitoring. - Ensure systematic review of Pillar 3 disclosures and broaden related-party monitoring. - Insurance supervision specifics: - Increase onsite work; inspect large life insurers every two years; require risk management, compliance, actuarial and internal audit functions across insurers. - Formalize macroprudential surveillance for insurers; set minimum capital level below which insurer must close or transfer business. - Enhance market conduct and policyholder protection; underpin DFSA work with explicit statutory objective of policyholder protection. ### Macroprudential policy recommendations - Analytical tool expansion: - Continue broad risk dashboard; add risk heat maps and measures of interconnectedness across institutions and sectors. - New instruments: - Develop limits on LTV and DSTI ratios; framework for higher risk weights on lending to particular sectors. - Improve data collection on LTV/DSTI distributions by loan type, property, borrower category, and over time. - Institutional review: - Assess risks from designating the government as the designated authority for most macroprudential instruments; note that decision-making power lies with MOBG. ### D-SIFI surcharges and CCB - D-SIFIs to be subject to higher capital requirements phased-in gradually from 2015 to 2019 ranging from 1–3 percent of RWA depending on systemic importance. - Framework for countercyclical capital buffer (CCB) to be phased-in starting in 2015. ### AML/CFT and upcoming assessment - Progress since 2006 assessment; DFSA developed risk-based on-site AML/CFT program and expert supervising task force. - Remaining deficiencies: - DFSA lacks adequate resources and powers for AML/CFT supervision. - Low levels of suspicious transaction reporting. - FIU legal limitations on obtaining additional information without court order persist. - Upcoming FATF assessment scheduled late 2015 with detailed report finalized October 2016; authorities encouraged to implement revised FATF standard. ### Safety nets, bank resolution, and crisis management recommendations - Designate and empower a resolution authority with robust mandate, governance, operational independence, and broad resolution powers; clarify roles and coordination among DFSA, FSC, DN, DGS, and MOBG. - Legal amendments recommended: - Powers for forced mergers, recapitalization, bail-in, appointment of special administrators, override shareholder rights, stay on contractual rights, and qualitative/quantitative resolution triggers. - Mandate preparation of resolution plans for D-SIFIs; powers to require changes to improve resolvability. - Cross-border resolution: - Further harmonize regimes, establish crisis management groups and firm-specific cooperation agreements, introduce mechanisms to give effect to foreign resolution measures, and ensure foreign firms’ active participation in crisis management groups. - Emergency liquidity assistance (ELA): - Formalize ELA framework and internal guidelines; set clear eligibility criteria and conditions; formalize DN–DFSA coordination. - DGS enhancements to consider: - Remove industry representatives from DGS board; introduce shorter payout period; enhance funding via risk-based premiums and government backstop; introduce depositor preference; limit offsetting of depositor claims to overdue financial obligations. --- *Executive Summary of the IMF Financial Sector Assessment for Denmark (content unit: _cr14336 - EXECUTIVE SUMMARY).* ### EXECUTIVE SUMMARY __________________________________________________________________________ 5 ### _cr14336 - EXECUTIVE SUMMARY ### Major findings on system resilience and risks - The Danish authorities have taken important steps to improve financial system resilience, including: - Strengthened financial regulation and supervision. - A new bank resolution framework that includes bail-in of creditors and has been deployed to resolve small and medium-sized banks. - An institutional framework for macroprudential policy. - Legislation requiring maturity extension of covered bonds in stress situations to reduce refinancing risk in the mortgage finance system. - Stress tests indicate financial stability risks are contained in baseline severe scenarios, with solvency levels at large banks and mortgage credit institutions (MCIs) remaining well above regulatory requirements due to high current capital ratios. - Caveat: stress tests may underestimate contagion risks because they cannot fully capture second-round and non-linear effects; the large size and interconnectedness of Denmark’s financial system make such contagion risks material. - Given the centrality of covered bonds backed by mortgage loans, reducing risks in mortgage finance is a priority. ### Key vulnerabilities and structural characteristics - Size and interconnectedness: - Financial system assets exceed 650 percent of GDP. - Banking sector (95 banks and MCIs) accounts for two thirds of financial sector assets. - Six D-SIFIs dominate the sector; Danske Bank Group has assets of about 180 percent of GDP. - Insurance sector assets are 130 percent of GDP; household pension claims on life insurers and pension funds represent 140 percent of GDP. - Covered bonds market is 150 percent of GDP (four times the size of the government debt market). - Lending by banks and MCIs to households amounts to 130 percent of GDP. - Household sector: - High household gross debt is an underlying vulnerability. - Large share of household assets is illiquid (housing and pension savings); limited liquid buffers. - Household deleveraging has negatively affected private consumption. - Household arrears generally low; DN household-level stress tests suggest limited impact of an interest rate increase on NPLs. - Nonfinancial corporates: - Nonfinancial corporate sector debt stabilized at 110 percent of GDP after rapid rise during boom years. - Corporate defaults remain higher than before the crisis and profitability recovery has been slow. - Cross-border exposures: - Banks have strong ties with Nordic and Baltic countries. - Danske Bank’s lending and deposit market shares range from 5–10 percent in other Nordic and Baltic countries (except Latvia). - Nordea (Swedish) is the second-largest bank in Denmark with important deposit and lending market shares. ### Crisis response and legacy - During the global crisis: - Commercial banks faced severe liquidity strains from excessive reliance on short-term wholesale funding. - Danmarks Nationalbank (DN) provided extraordinary liquidity support and large-scale government guarantees ensured access to funding. - Banks recorded loan write downs equivalent to about 8½ percent of GDP (2008–2011), significantly eroding profitability. - In 2010 authorities distinguished viable banks (supported by guarantees and capital injections) from weak banks (resolved via private solutions or closed). - The government adopted six rounds of measures (the “Bank Packages”). - Large banks were explicitly excluded from the new resolution scheme, highlighting the need for an effective resolution regime for D-SIFIs. ### Financial Soundness Indicators (selected figures, 2006–2013) - Regulatory capital to risk-weighted assets: 13.8 (2006), 12.3 (2007), 14.1 (2008), 17.9 (2009), 17.9 (2010), 20.1 (2011), 22.1 (2012), 22.3 (2013). - Regulatory Tier I capital to risk-weighted assets: 10.9 (2006), 9.2 (2007), 10.7 (2008), 14.6 (2009), 15.1 (2010), 17.2 (2011), 19.2 (2012), 19.5 (2013). - Core / Common Equity Tier 1 capital to risk-weighted assets: N/A (2006), 8.7 (2007), 10.0 (2008), 11.8 (2009), 12.2 (2010), 14.4 (2011), 16.3 (2012), 16.7 (2013). - Nonperforming loans net of provisions to capital: 4.5 (2006), 5.0 (2007), 18.0 (2008), 20.6 (2009), 22.9 (2010), 22.0 (2011), 22.9 (2012), 22.4 (2013). - Bank provisions to Nonperforming loans: 51.7 (2006), 45.6 (2007), 42.1 (2008), 53.7 (2009), 55.2 (2010), 50.2 (2011), 50.8 (2012), 51.0 (2013). - Nonperforming loans to total gross loans: 1.5 (2006), 1.2 (2007), 3.8 (2008), 7.0 (2009), 7.9 (2010), 7.9 (2011), 8.3 (2012), 8.7 (2013). - Sectoral distribution of loans to total loans — Nonfinancial corporation: 71.2 (2006), 69.5 (2007), 72.8 (2008), 69.4 (2009), 66.7 (2010), 64.2 (2011), 64.4 (2012), 65.2 (2013). - Sectoral distribution of loans to total loans — Households (including individual firms): 26.7 (2006), 28.0 (2007), 24.9 (2008), 28.3 (2009), 31.1 (2010), 32.5 (2011), 33.1 (2012), 32.0 (2013). - ROA (aggregated parent-company basis): 1.2 (2006), 0.9 (2007), -0.1 (2008), -0.4 (2009), 0.1 (2010), 0.1 (2011), 0.2 (2012), 0.4 (2013). - ROE (aggregated parent-company basis): 19.7 (2006), 16.2 (2007), -2.9 (2008), -6.4 (2009), 1.7 (2010), 1.3 (2011), 2.7 (2012), 5.7 (2013). - Interest margin to gross income: 71.8 (2006), 78.1 (2007), 87.4 (2008), 78.5 (2009), 70.1 (2010), 73.4 (2011), 67.0 (2012), 64.2 (2013). - Noninterest expenses to gross income: 25.8 (2006), 23.4 (2007), 25.9 (2008), 36.0 (2009), 42.7 (2010), 43.8 (2011), 44.9 (2012), 47.2 (2013). - Liquid assets to total assets: 24.5 (2006), 21.3 (2007), 19.9 (2008), 28.4 (2009), 27.8 (2010), 23.6 (2011), 27.0 (2012), 30.9 (2013). - Liquid assets to short-term liabilities: 34.8 (2006), 31.6 (2007), 30.3 (2008), 44.3 (2009), 45.6 (2010), 37.3 (2011), 45.4 (2012), 49.8 (2013). - Foreign currency position: N/A (2006), 9.6 (2007), 6.4 (2008), 3.3 (2009), 3.4 (2010), 2.8 (2011), 1.4 (2012), 1.2 (2013). ### Key policy recommendations (Table 1, priorities indicated) - Mortgage finance (Short term): - Reduce refinancing risk by encouraging longer bond maturities (DFSA, MOBG). - Limit impact of eventual normalization of interest rates by ensuring credit risk is adequately taken into account in loan pricing and approvals (DFSA, MOBG). - Increase buffers in loans with interest-only (IO) periods by lowering LTV limits for such loans, requiring amortization to a lower ceiling, and/or imposing higher capital charges or credit loss provisions until IO periods expire (DFSA, MOBG). - The proposed prudential limits on MCIs’ higher-risk activities are welcome. - Prudential supervision: - Reduce the length of examination cycles for banks and insurance companies (DFSA) — requires additional supervisory resources (MOBG) (Short term). - Ensure operational independence of the DFSA by establishing supervisory imperatives within the Director General’s authority, lengthening Board members’ terms, and establishing a formal vetting process (MOBG) (Medium term). - Bank supervision: broaden routine reporting on operational and market risk (DFSA) and ensure systematic review of Pillar III disclosures (DFSA) (Short term/Medium term). - Insurance supervision: enhance supervision of conduct of business, fraud, and AML/CFT (DFSA); establish a solvency level below which companies may not operate (DFSA); require risk, compliance, internal audit, and actuarial functions in all insurers and better integrate qualitative governance assessments with off-site analysis (DFSA) (Short term/Medium term). - Macroprudential policy: - Develop instruments to address time-varying systemic risk, such as limits on LTV and DSTI ratios (DN, DFSA) (Short term). - Expand analytical tools to identify and monitor systemic risk (DN) (Medium term). - Crisis management and bank resolution: - Establish early resolution triggers and strengthen funding arrangements and the resolution toolkit (MOBG, FSC, DFSA) (Short term). - Prepare resolution plans and resolvability assessments (FSC, DFSA) (Short term). - Enhance the DGS by removing mandatory offsetting, strengthening back-stop arrangements, and introducing depositor preference (MOBG) (Medium term). - Stress testing: - Intensify cooperation to exploit synergies between micro- and macroprudential stress testing (DFSA, DN) (Medium term). - Develop a macroprudential stress testing framework for the insurance sector (DFSA) (Medium term). - Expand financial stability analyses to include insurance and pension funds (DN) (Medium term). ### Supervisory and institutional priorities - Strengthen DFSA capacity and operational independence; increase onsite inspection frequency, including AML/CFT supervision. - Broaden routine reporting on operational and market risk; implement systemic review of Pillar III disclosures. - In insurance supervision, set a minimum solvency level, require key internal functions across insurers, and enhance governance, market conduct, fraud, and AML/CFT supervision. - Further develop macroprudential framework given high interconnectedness and limits on monetary policy under the fixed exchange rate: - SRC creation, imminent D-SIFI capital surcharges, and forthcoming CCB framework are important steps. - Authorities encouraged to expand systemic risk identification capacity, develop time-varying instruments (LTV, DSTI), and establish higher risk weights for specific sectors. - Review institutional arrangements to ensure independence, particularly the government’s role as the designated authority for most macroprudential instruments. ### Regional cooperation - Given strong financial links with other Nordic countries (Danske Bank’s regional presence and Nordea’s role in Denmark), continue strengthening cooperation on macroprudential policy and harmonize resolution frameworks at a regional level for institutions with potential regional spillovers. *Executive Summary of the IMF Financial Sector Assessment for Denmark (content unit: _cr14336 - EXECUTIVE SUMMARY).* ### Box 1. Denmark: Government Measures to Strengthen Financial Stability ### Box 1. Denmark: Government Measures to Strengthen Financial Stability ### Government bank packages and resolution tools - Bank Package 1 (October 2008): Established a temporary state guarantee for all claims of depositors and other unsecured creditors, with the financial sector covering losses up to DKK 35 billion (2 percent of GDP). Created the Financial Stability Company (FSC) to wind up failing financial firms. - Bank Package 2 (January 2009): Established temporary facilities for state-guaranteed senior funding and solvency support (hybrid Tier 1 capital instruments). Banks drew DKK 46 billion (2.6 percent of GDP) in solvency support and DKK 193 billion (11 percent of GDP) in state-guaranteed debt instruments. Almost all guaranteed bonds issued and solvency support drawn in 2009–10 have been redeemed. - Bank Package 3 (October 2010): Created a scheme for orderly resolution of (non-systemic) distressed financial firms allocating losses to the private sector. Provides transfer of a distressed firm’s assets and part of its liabilities to the FSC or a third party, with the residual bank in ordinary liquidation. All unsecured (and uninsured) creditors are subjected to a haircut (bail-in), including deposits above DKK 750,000 (EUR 100,000). FSC has taken over loans and guarantees from several distressed institutions equivalent to about 5½ percent of GDP, much of which has already been wound up. - Bank Package 4 (September 2011): Created greater incentives for viable financial institutions to acquire assets of distressed firms, either directly or via the FSC. Strengthened funding structure of the Danish Guarantee Fund for Depositors and Investors via introduction of annual fixed payments. - Bank Package 5 (March 2012): Allocated resources to finance economic growth and exports. - Bank Package 6 (October 2013): Introduced more stringent solvency requirements for D-SIFIs. ### Broad financial system developments and macro context - Deleveraging and credit: - Ratio of private credit to GDP declined from about 205 percent at end-2009 to about 185 percent at end-2013. - Cross-border exposures and domestic credit have declined. - House prices fell sharply during 2007–12; recently started to rise gradually and are now estimated to be not far from fundamentals, with a valuation gap of less than 10 percent. - Macroeconomic policy and outlook: - Longstanding tight peg to the euro has kept inflation anchored. - Fiscal policy has been generally countercyclical; gross government debt remains relatively low, supporting the sovereign’s triple-A credit rating. - Denmark’s external position is strong; current account surplus expected to remain at above 6 percent of GDP. - Output growth forecast at 1½–2¼ percent in 2015 and beyond. ### Commercial banks: capital, funding, and risks - Capitalization and funding: - Commercial banks’ capitalization and funding have improved significantly since the global crisis. - Several banks raised capital through share issuance. - DFSA actively imposes additional Pillar 2 capital requirements, which are publicly disclosed. - Reliance on wholesale short-term funding has decreased; deposit-to-loan ratio has increased; liquidity has improved. - Profitability and asset quality: - Earnings are under pressure from low lending volumes and interest margins. - All large commercial banks (accounting for 87 percent of the sector’s assets) returned to profitability in 2012; ROE in other banks remains very weak. - Impaired loans ratio increased from 1.2 percent in 2007 to 8.7 percent in 2013. - Corporate failures remain high and commercial real estate prices remain weak. - Developments particularly worrisome in some medium-sized non-systemic banks (Group 2), where further consolidation or resolution may be necessary if weak earnings persist. - Regulatory developments: - Implementation of Basel III/CRD IV is underway; banks are adjusting portfolios and are generally expected to be able to meet stricter capital and liquidity requirements. ### Mortgage Credit Institutions (MCIs): structure, risks, and legislation - Structural features and innovations: - Rapid growth of adjustable and variable rate loans: 75 percent of total mortgage debt at end-2013. - Such loans are financed mainly by short-term bonds, most rolled over annually; increases interest rate pass-through to borrowers, creating borrower interest rate risk. - Interest-only (IO) periods of ten years have become common; many borrowers will face expiry of IO periods over the next several years. - Increase in LTV ratios due to 2007–12 house price decline may preclude refinancing for many borrowers. - Performance and vulnerabilities: - MCIs experienced low impairment charges, better ROEs than commercial banks, and maintained stable capitalization. - Danish covered bond market remained relatively liquid during the crisis, supporting lending volumes and profitability. - Many borrowers of adjustable and variable rate loans could face payment shocks when interest rates return to historical norms, which are 3–4 percentage points above current levels. - A rise in interest rates could put downward pressure on house prices, increasing LTVs and requiring additional collateralization for outstanding covered bonds. - Scheduled expiry of IO periods could lead to additional loan impairments, though DN and MOBG household-level analyses indicate most affected would be able to continue servicing debts. - Box 2 — Balance Principle in MCIs: - MCIs limited by law to granting mortgage loans funded by issuance of covered bonds from specific capital centers segregated from the general balance sheet. - Small margin over covered bond cost, currently around 65–85 basis points, charged to cover administrative costs, risk, and profit. - MCIs do not accept deposits and have little or no unsecured debt. - Balance principle requires overcollateralization of each capital center to cover retained interest rate, foreign exchange, volatility and liquidity risk; interest rate risk determined by stress tests and may not exceed a small percentage of the overcollateralization. - Balance principle passes most noncredit risks, including prepayment risk, on to bond investors, but does not address refinancing risk. - Since 2007 commercial banks also allowed to issue covered bonds for certain loans; risk allowances under balance principle less restrictive for commercial banks; commercial banks account for a small share of mortgage lending and covered bond issuance. - Legislative response to refinancing risk: - New legislation requires extension of covered bond maturities in the event of an auction failure; defines a failed auction as bids not sufficient to cover bonds on offer or bids requiring an increase in interest rate on the bonds of more than 5 percentage points. - New law limits increase in interest rates of extended bonds to 5 percentage points. - Risks inherent in maturity mismatch between adjustable rate loans and their financing are passed to bond investors, adding complexity and potential for greater pro-cyclicality in the covered bond market. - Interest rates on underlying mortgage loans would be raised to reflect higher bond rates, resulting in larger loan payments. - New legislation estimated to have increased covered bond spreads by only about 5–10 basis points. ### Insurance companies and pension funds - Insurance sector performance: - Insurance companies recorded mostly positive but low premium growth since 2010. - Solvency levels have increased, especially among life insurers, mainly reflecting good investment returns during 2009-12. - Profitability has declined recently but remains relatively high in the non-life sector, reflecting favorable underwriting results and relatively low expense ratios. - Non-life companies face growing claims from more frequent weather-related events. - Life insurers and pension challenges: - Investing in prolonged low interest rates is a challenge for life insurers. - Large share of occupational pension contracts contributes to more stability than in other European countries. - Within traditional life insurance business, shift from guaranteed products into non-guaranteed and unit-linked business. - Legacy portfolio of contracts with annual guarantees of more than 4 percent is relatively large though declining. - Attracting new business in low interest environment mainly limited to unit-linked products. - Pension fund resilience: - Reserve indicator of Arbejdsmarkedets Tillægspension (ATP) stable at 309 percent at end-2013. - Multi-employer pension funds and company pension funds recorded average solvency ratio of 591 percent at end-2013. - Note: ATP is not subject to a regulatory solvency regime but calculates capital requirement broadly in line with Solvency II. ### Principal risks to financial system resilience - Three principal risks (see Risk Assessment Matrix in Appendix II): - A protracted period of slower global growth could lead to weaker GDP growth and higher unemployment in Denmark, reducing asset quality and financial sector profitability. - A surge in global financial market volatility could cause liquidity strains, a broad-based correction in asset valuations, and sharply lower output and employment, increasing nonperforming loans and loan impairment charges. - An increase in Denmark-specific risk (a reassessment of household credit quality) could lead to higher spreads in the covered bond market. - Additional risk note: - Combination of protracted low euro area interest rates and an economic recovery in Denmark could create overheating pressures in asset markets, particularly in the housing market. *Source: _cr14336 - Box 1. Denmark: Government Measures to Strengthen Financial Stability* ### 19. The impact of these risks on the financial system was assessed through comprehensive ### _cr14336 - 19. The impact of these risks on the financial system was assessed through comprehensive ### Scope of assessment - The impact of these risks on the financial system was assessed through comprehensive stress tests of: - banks - MCIs - insurance companies - the largest pension fund (Figure 8 and Appendix III) - An integrated solvency stress test for a financial conglomerate (Danske Group) was also conducted. ### References within the unit - Figures and appendices cited: Figure 8 and Appendix III. - Footnotes cited: 6 and 7. *Source: _cr14336 - 19. The impact of these risks on the financial system was assessed through comprehensive* ### 20. In the solvency tests, a baseline and two adverse scenarios were analyzed (Figure 9). ### _cr14336 - 20. In the solvency tests, a baseline and two adverse scenarios were analyzed (Figure 9). ### Solvency tests — scenarios - Two adverse scenarios analyzed alongside a baseline: “protracted slow growth” and “severe stress”. - “Protracted slow growth” scenario: assumes a five-year cumulative shock to real GDP growth of about one standard deviation. - “Severe stress” scenario: assumes a two-year cumulative shock to GDP growth of 2½ standard deviations. - The same macroeconomic scenarios were applied to the insurance and banking arms of Danske Group; losses were consolidated according to existing accounting standards. Results for banking groups include results from the conglomerate stress test; results cannot be shown separately due to confidentiality. ### A. Banking Sector Stress Tests — Solvency risk (commercial banks and MCIs) - Overall conclusion: commercial banks and MCIs are in strong positions to withstand severe shocks given already high capital buffers (Figure 10). - Baseline scenario: - Capital ratio would rise further as credit losses remain low. - Increase in profitability due to higher GDP growth would more than offset impact of increases in risk weights and the phase-out of hybrid capital instruments due to implementation of the new EU Capital Requirements Directive. - Slow growth scenario: - Profits would be lower and credit risk higher. - Capital ratio would remain at roughly its current level. - Severe stress scenario: - Capital ratio would fall sharply, driven mainly by a rise in risk weights, loan losses, and lower gross profits. - Further house price shock would reduce collateral values and thus raise effective loss rates. - MCIs: greater exposure to the housing market means contribution of loan losses and increases in RWA to changes in capital ratios would be somewhat larger than at commercial banks. - Loan losses at MCIs would be mitigated by high collateralization, lower LTV ratios than commercial banks, and loan loss guarantees provided by commercial banks. - All institutions in the sample remain well above regulatory minima throughout the forecasting time-horizon. ### A. Banking Sector Stress Tests — Sensitivity and concentration - Sensitivity to covered bond spread shocks: - An extreme shock to the covered bond spread of 500 bps would reduce the aggregate CET1 ratio by just 1.7 percentage points (taking into account profits), as the increase in funding costs would be mostly passed on to borrowers. - Historical context: During the global financial crisis, the covered bond spread peaked at about 150 basis points, suggesting that a 500 bps shock is an extremely low-probability tail event. - Sovereign yield shock: - A two standard deviation sovereign yield shock would result in only a small reduction in the CET1 ratio because volatility of Danish sovereign bonds has been low and exposures to foreign sovereign bonds are small. - If the entire sovereign debt holdings were marked-to-market, the impact would increase only marginally. - Concentration risk: - Concentration risk has come down in recent years as a result of supervisory actions and is currently at a manageable level. - Parallel testing: - Parallel top-down (TD) stress tests confirm results of the constrained bottom-up (BU) test. ### A. Banking Sector Stress Tests — Liquidity risk and funding - Liquidity Coverage Ratio (LCR): - The European Commission allows high-quality covered bonds meeting certain criteria to be classified as Level 1 HQLA up to a ceiling of 70 percent with a haircut of 7 percent. - On this definition, the average bank in the sample had an LCR of 95 percent as of end-2013. - The sample shows slightly stronger liquidity positions in Group 1 banks and stand-alone MCIs than in Group 2 (medium-sized) banks. - Liquidity shortfalls: - DKK 17 billion (about 1 percent of GDP) shortfall for the 60 percent requirement applicable from October 2015. - DKK 82 billion (about 4½ percent of GDP) shortfall for the 100 percent requirement applicable from January 2018. - Of the DKK 82 billion shortfall, only DKK 6 billion (less than ½ percent of GDP) would remain if institutions switched current holdings of ineligible HQLA to eligible HQLA. - Banks are expected to meet the phased-in LCR requirement in the EU, including by exchanging some covered bonds for sovereign bonds. - Funding ratio (FR): - With two exceptions, all banks have FRs below the regulatory ceiling of 100 percent. - BU and TD liquidity testing: - Due to data confidentiality, DFSA organized the BU liquidity stress test with banks and performed TD analyses; methodologies and scenarios were agreed with the FSAP team. ### B. Insurance and Pension Sectors Stress Tests - Methodology: - Bottom-up solvency stress tests used same macrofinancial scenarios as banking tests. - Market and underwriting risks specified in more detail. - Asset price shocks were front-loaded; interest rates assumed to change every year. - Additional shock: higher rate of policyholders surrendering life insurance policies in the first year. - All shocks applied to both assets and liabilities consistent with the “total balance sheet approach” of Danish regulatory regime and forthcoming Solvency II regime. - Conservative assumptions in stress tests: - No discretionary management actions allowed (only existing hedge positions assumed to roll over). - No investment returns were assumed from 2015 to 2018, apart from changes in value of fixed-income instruments driven by interest rate changes. - Stress tests did not consider some mitigating factors from Solvency II (e.g., the volatility adjustment). - Results and sensitivities: - Adverse scenarios have large negative effects on insurance companies, mostly due to asset price and interest rate shocks. - Drop in stock prices and surge in corporate bond spreads lead to large declines in available capital, especially at life insurers. - Life insurers rely on interest rate derivatives to reduce asset-liability mismatch; roll-over risks become relevant. - Net income of life insurers (low to begin with) does not recover, reflecting assumption of zero investment returns. - Non-life insurers would break even in 2014, then quickly recover to pre-stress levels due to profitable underwriting business and less reliance on investment returns. - Sensitivity to covered bond spread: - A 500 bps increase in the covered bond spread would cause insurers’ solvency ratios to fall sharply. - Catastrophic events: - A severe windstorm would reduce solvency ratios of non-life insurers only a little, reflecting large use of reinsurance. - ATP (largest domestic pension fund): - ATP’s excess cover (relative to its individual reserve requirement) drops slightly under the baseline and by a bit more in the two stress scenarios, but stays comfortably close to ATP’s internal targets. - ATP’s discounting framework allows for a nearly complete offsetting of changes in the value of bond holdings in valuation of technical provisions. - Main driver of reduction in bonus potential is the equity shock; the corporate bond shock does not materially affect ATP. - Stress scenarios reduce ATP’s profits, which would turn negative in both scenarios. ### C. Improving Risk Assessments — recommendations - Intensify cooperation between DFSA and DN to exploit synergies between micro- and macroprudential stress testing. - Strengthen analysis of insurance companies and pension funds and their inter-linkages with other parts of the financial system. - For insurance companies, DFSA should complement micro-prudential stress testing with macroprudential stress testing that is: - Severe but plausible. - Tailored to insurance sector specificities (e.g., concentrations in covered bond holdings). - Comprehensive (including risk factors beyond Solvency II, such as changes in the ultimate forward rate). - Forward-looking and based on a clear narrative. ### D. Interconnectedness and Spillovers - Domestic interconnectedness: - Macro-financial system characterized by large inter-sector exposures; banking sector and corporate sector are the largest lenders and borrowers. - Largest exposures across sectors: households’ claims on insurance and pension funds; rest of the world’s claims on the banking sector; banking sector’s claims on households. - Danske Bank spillovers: - A global Vector Auto Regression applied to measures of financial stress shows Danske Bank tends to be recipient (rather than source) of spillover effects from other sectors. - Danske’s credit spread rises appreciably in case of distress in the economy, corporate sector, and sovereign. - Larger impact of corporate distress on credit growth (compared to bank distress) suggests credit growth may be more constrained by demand rather than supply factors. - Cross-bank spillovers: - Distress dependence estimated for four banks (Danske, Jyske, Sydbank, Nordea parent). - Conditional probabilities of default for other banks given that Danske is in distress are slightly higher than conditional probabilities of default for Danske given other banks in stress, with the exception of Nordea. - If Nordea is in distress, there is a much higher probability of Danske being in distress compared to the opposite situation. - Cross-border spillovers: - Network analysis shows Denmark’s banking system is closely interconnected with Nordic and Baltic countries. - Danish banking system vulnerable to extreme credit and funding shocks to banks in Norway, Sweden, and Finland. - Shocks in the United Kingdom and United States would also have large impact on Denmark’s banking sector stability. - An extreme credit and funding shock in Denmark would have significant regional impact on Nordic and Baltic banking systems. ### Financial Oversight Framework — A. Mortgage Finance (policy measures) - Risks from product innovations in mortgage finance should be mitigated; low interest rates and flat yield curve present an opportunity to lengthen maturity of covered bonds at minimal cost to borrowers. - Possible measures include: - Provide incentives to reduce maturity mismatch and refinancing risk; consider adapting regulation to directly restrict maturity mismatch or require additional capital (e.g., Pillar II reviews or systemic risk buffer); consider modifying balance principle to require some overcollateralization for this risk. - Limit potential adverse effect on credit risk of an increase in interest rates: - Encourage lenders to increase administrative margins for variable and adjustable rate loans. - Supervisors already require MCIs to employ stressed DSTI criteria; stress test could be made more severe. - Discourage new loans with interest only (IO) periods: - IO loans could be discouraged by requiring higher credit loss provisions for loans with longer IO periods, ending or reducing tax deductibility of interest payments on loans with IO periods, or requiring lower LTV ratios for loans with IO periods. - Authorities’ measures under consideration: - Proposed Supervisory Diamond for MCIs to provide supervisory guidance on lending growth, loans with short term funding, borrower’s interest-rate risk, interest-only loans, and large exposures. - Home buyers would need to make a down payment of at least 5 percent when purchasing a home. - Commercial properties would be required to generate a positive cash flow before they can be financed. ### Financial Oversight Framework — B. Prudential Supervision - Institutional strengthening: - DFSA has been granted additional powers and staffing has increased by about half. - Strong risk-based approach focused on credit risk in banking and investment risk in life insurance. - Offsite analytical tools: Supervisory Diamond for banks and traffic light system for insurance companies. - DFSA publishes summaries of onsite inspection reports and breaches of offsite monitoring systems. - Governance and internal controls: - BCP and ICP assessments emphasize protecting DFSA operational independence. - Recent governing body changes removed active industry representatives casting votes on supervisory policy actions. - Recommended governance changes: - Keep certain supervisory imperatives (provisioning policy and inspection schedule) wholly within authority of Director General. - Lengthen terms of Board members. - Introduce strict fit and proper appointment criteria. - Establish an internal audit function within DFSA. - Resource needs: - Increase supervisory resources to raise frequency of regular onsite inspections and enhance ability to respond with additional onsite work. - For insurance supervision, additional resources and powers needed for onsite inspection of brokers and effective regulation/supervision in market conduct and fraud prevention. - In both banking and insurance, additional resources and powers needed for AML/CFT supervision. - Banking supervision — suggested enhancements: - Shorten supervisory cycle for smaller institutions and improve onsite follow-up for large institutions. - Expand depth and breadth of data used in offsite supervision, including better monitoring of market risk and expanded reporting of operational risk. - Ensure systematic review of Pillar 3 disclosures; internal policies should assess completeness and accuracy of filings. - Enhance regulatory definition and monitoring of related parties to include minority shareholders and key risk takers; require more detailed reporting and more frequent analysis. - Insurance supervision — suggested enhancements: - Increase regular onsite work; large life insurers to be inspected every two years; small life insurers should be inspected more often than once every six years. - Enhance approach to assessing and recording risk judgments; require functions responsible for risk management, compliance, actuarial and internal audit across insurers. - Cross-firm/thematic work to benchmark major companies and provide feedback on practices. - Develop enhanced risk-based framework integrating offsite analysis with governance, management and controls, fraud prevention, AML/CFT, and market conduct. - Formalize macroprudential surveillance with a regular process to consider macroprudential issues and review potential systemic significance of large insurers. - Strengthen capital adequacy requirements: - Establish a minimum capital level below which an insurer is regarded as no longer viable and must close or have business transferred. - Set explicit requirements for prior approval of internal model use. - Increase focus on market conduct and policyholder protection: - Tailor proportionate governance expectations for broker intermediaries. - Give closer attention to product disclosure requirements. - Underpin DFSA’s work with an explicit statutory objective of policyholder protection. ### Financial Oversight Framework — C. Macroprudential Policy - Institutional framework: - Adoption in 2013 of an institutional framework for macroprudential policy is welcome. - Systemic Risk Council (SRC) includes DN, DFSA, relevant ministries, and independent experts. - Chair: Chairman of DN’s Board of Governors; central bank hosts secretariat; DFSA and relevant ministries participate in secretariat. - SRC tasks: identify and monitor systemic financial risks and issue observations, warnings, and recommendations to DFSA and Government. - Transparency and accountability: “comply or explain” rule and abstention rule for government representatives and DFSA on recommendations to the government. - Decision-making power on most macroprudential instruments lies with the MOBG, appointed as designated authority. - D-SIFI identification and capital surcharges: - Six largest banking groups designated as D-SIFIs in June: Danske Bank, Nordea Bank Denmark, Nykredit, Jyske Bank, Sydbank, and DLR Kredit. *Source: IMF staff calculations and Danish authorities as presented in the IMF FSAP chapter.* ### 2014. D-SIFIs will be subject to higher capital requirements—which will be phased-in gradually from ### _cr14336 - 2014. D-SIFIs will be subject to higher capital requirements—which will be phased-in gradually from ### Higher capital requirements and countercyclical buffer - D-SIFIs will be subject to higher capital requirements—which will be phased-in gradually from 2015 to 2019—ranging from 1–3 percent of RWA, depending on their systemic importance. - The framework for the countercyclical capital buffer (CCB) will be phased-in starting in 2015. ### Macroprudential policy framework — findings and recommendations - Expand the range of analytical tools used to identify and monitor systemic risk: - Continue broad assessment of risks using indicators in a risk dashboard and notes on specific topics. - Add risk heat maps (based on thresholds for various indicators) and measures of interconnectedness (across various financial institutions, including insurance companies and pension funds, and economic sectors). - Develop new policy instruments capable of addressing time-varying systemic risk: - Develop limits on LTV ratios and DSTI ratios and a framework to apply higher risk weights on lending to particular sectors. - Improve data collection on the distribution of LTVs and DSTIs across loans, types of property, categories of borrowers, and over time to inform calibration and activation of such instruments. - Review institutional arrangements for macroprudential decision-making: - Assess risks from designating the government as the designated authority for most macroprudential instruments, given decision-making power lies with the government rather than an institution with operational independence. - Note: Denmark is one of three countries in Europe where the designated authority is the government. ### Cross-border cooperation - Denmark participates actively in European and regional fora on financial stability and systemic risk: - DFSA hosts the supervisory college for Danske Bank since 2009 and participates in other supervisory colleges for Nordic-Baltic banks as a host supervisor. - Cross-border coordination is guided by the Nordic-Baltic cooperation agreement on cross-border financial stability, crisis management, and resolution. - DN and DFSA are part of the European Systemic Risk Board (ESRB) and participate in pan-European macroprudential discussions. - The Nordic-Baltic countries have established a Macroprudential Forum; a task force is examining implementation differences and reciprocity approaches. - Considerations on Banking Union: - Denmark has not yet decided whether to opt in to the EU Banking Union. - Potential benefits of joining: harmonized supervisory standards and resolution practices and a common backstop. - Potential costs: giving up national standards and practices and possible contributions to legacy costs (mitigated by the ECB’s comprehensive assessment of euro area banks). - Denmark’s decision will depend on a thorough assessment of benefits and costs currently under way. ### AML/CFT — progress and shortcomings - Steps taken since the Fund-led AML/CFT assessment in 2006; FATF progress report in 2010 recognized significant progress on many technical deficiencies. - DFSA actions: - Developed a risk-based on-site examination program to inspect banks’ compliance with AML/CFT. - Established an expert supervising task force to conduct onsite and offsite AML/CFT inspections. - Remaining deficiencies: - DFSA still does not have adequate resources and powers to supervise compliance with AML/CFT and anti-fraud requirements, including within the banking and insurance sectors. - Levels of suspicious transaction reporting remain low. - No change in legal position regarding FIU’s ability to obtain additional information from reporting entities without a court order. - No changes to requirements ensuring reporting entities have adequate screening procedures for hiring employees. - Upcoming assessment: - An AML/CFT assessment will be conducted by the FATF in late 2015, with a detailed assessment report finalized in October 2016. - Authorities are encouraged to effectively implement the revised FATF standard, particularly regarding regulation and supervision of financial institutions, politically exposed persons, freezing of terrorist assets, and by conducting a money laundering/terrorist financing national risk assessment. ### Safety nets, bank resolution, and crisis management — recommendations - Designate and empower a resolution authority and clarify roles and coordination with other agencies: - Current institutional set-up involves DFSA, FSC, DN, DGS, and MOBG. - DFSA initiates resolution via enforcement of minimum capital requirements; transfer to the FSC depends on a decision by bank management with alternatives being liquidation or private sector solutions. - The designated resolution authority should have: - A robust mandate and governance structure, well-defined accountability, and a broad suite of resolution powers. - Operational independence and protection against liability for discharging duties in good faith. - Unimpeded access to firms for resolution planning and execution. - Legal amendments to enhance resolution scheme (including for D-SIFIs): - Provide the resolution authority with powers to effect forced mergers and recapitalization, implement bail-in, and appoint special administrators. - Expand powers to override shareholders, notably to effect recapitalizations or other restructuring measures. - Introduce powers to temporarily stay the exercise of contractual rights such as acceleration, early termination, set-off and netting rights. - Provide for qualitative and quantitative resolution triggers to allow use of resolution powers before balance-sheet insolvency and before all equity is fully wiped out. - Mandate preparation of resolution plans, at least for D-SIFIs; give competent authorities powers to require changes to firms’ business practices, structures or organizations to improve resolvability. - Eliminate obstacles to implementation of measures taken by resolution authorities within their legal powers and in good faith. - Cross-border resolution enhancements: - Further harmonize national resolution regimes (e.g. application of bail-in requirements). - Establish crisis management groups and firm-specific cooperation agreements for systemically important firms with cross-border activities; establish institution-specific crisis management groups to coordinate resolution strategies and resolvability assessments, and to address regional spillovers. - Introduce mechanisms to give effect to foreign resolution measures. - Ensure active participation in crisis management groups by foreign firms with material presence in Denmark (notably Nordea). - Emergency liquidity assistance (ELA): - Formalize the framework for emergency liquidity support; prepare (internal) policy guidelines. - Guidelines should outline clear eligibility criteria (temporarily illiquid but otherwise solvent firms) and provide conditions for support (collateral, pricing and maturity, and other requirements imposed on recipients). - Formalize coordination arrangements between DN and DFSA for providing ELA. - Deposit Guarantee Scheme (DGS) enhancements to consider: - Remove industry representatives from the DGS board. - Introduce a shorter payout period. - Enhance funding arrangements via risk-based premiums and an explicit funding backstop provided by the government. - Introduce depositor preference. - Limit offsetting of depositor claims to overdue financial obligations to avoid imposing unnecessary hardship on insured depositors. ### Appendix I — Selected implementation status of 2006 FSAP recommendations - Supervisory capital and monitoring: - Supervision became more intrusive following the crisis; DFSA regularly monitors risk weights and makes active use of Pillar 2 capital requirements. - Housing market monitoring and consumer information: - DFSA’s real estate valuation unit monitors housing market development (offsite and onsite). - New rules on risk labeling for loans secured with real property were introduced into Danish legislation in 2013. - The SRC analyzes housing market developments and can issue macroprudential recommendations. - DFSA organization, resources, and fit-and-proper: - Powers and responsibilities of DFSA established in the Financial Business Act (FBA); no formal legal reorganization. - Resources of DFSA have been increased significantly since 2006, though the budget still follows the same approval procedures. - As of 2010, DFSA assesses every member of the BoD and senior management; law updated in 2010. - Liquidity stress testing and contingency planning: - DFSA introduced monthly liquidity stress testing requirements for Group 1 and 2 institutions and standardized stress tests for remaining institutions; all institutions required to have contingency funding plans. - Inspections and oversight enhancements across payments, securities settlement, insurance, and AML/CFT: - KRONOS contingency planning and Sumclearing measures being modernized (projects expected complete by end 2014); contingency measures tested regularly. - VP conducts annual tests of contingency plans (most recently August 2013) and adapts plans per FSB and CPSS-IOSCO recommendations in 2014. - DFSA issued a binding Executive Order on Management and Control of Banks, Insurance Companies. - Larger life companies subject to full inspections at least every fourth years; DFSA performs yearly risk assessments. - STRs subjected to initial analysis in the FIU upon intake; formal reporting requirements introduced since 2012. ### Appendix II — Risk Assessment Matrix (selected risks and impacts) - High likelihood — Protracted period of slower global growth in advanced and emerging economies: - Expected impact: Medium. - Consequences: Weaker GDP growth and higher unemployment would increase nonperforming loans and loan loss impairments, weighing on banks’ profitability; life insurers and pension funds would face difficulties attracting long-term savings in an environment of low interest rates, and servicing guaranteed-interest contracts would weigh on profitability. - Note: This risk has been analyzed in a macrofinancial scenario. - High likelihood — Surge in global financial market volatility: - Expected impact: Medium. - Consequences: Further increase in NPLs and higher loss rates due to real estate collateral devaluation; pressure on loan generation and banks’ and MCIs’ profitability; MCIs constrained in posting additional collateral to maintain bonds’ cover ratios; insurers and pension funds face market-value losses endangering solvency and lowering investment income. - Note: This risk has been analyzed in a macrofinancial scenario. - Low likelihood — A drop in confidence in Danish covered bonds: - Expected impact: High. - Consequences: Investors, especially foreigners, would retrench from the Danish covered bond market creating financing problems, especially for mortgage credit institutions; mark-downs of covered bonds would hurt solvency of banks, life insurance companies, and pension funds. - Note: This risk has been analyzed in a sensitivity test. *Source: _cr14336 - 2014. D-SIFIs will be subject to higher capital requirements—which will be phased-in gradually from* ### Appendix III. Stress Test Matrix (STeM) for the Banking Sector ### Appendix III. Stress Test Matrix (STeM) for the Banking Sector ### Institutional perimeter and data - Institutions included: - 6 banking groups: Danske Bank Group, Nykredit Realkredit Group, Nordea Bank Danmark Group, Jyske Bank Group, Sydbank Group, BRFkredit Group. - 5 commercial banks (unconsolidated): Danske Bank A/S, Nykredit Bank (subgroup), Nordea Bank Danmark A/S, Jyske Bank (group level), Sydbank (group level). - 5 mortgage credit institutions (unconsolidated): Realkredit Danmark A/S, Nykredit Realkredit A/S, Totalkredit A/S, Nordea Kredit, BRFkredit. - 5 commercial banks (unconsolidated): Danske Bank A/S, Nykredit Bank A/S, Nordea Bank Danmark A/S, Jyske Bank A/S, Sydbank A/S. - Market share: - 95 percent of mortgage credit sector’s and 87 percent of commercial banks’ total assets. - 87 percent of commercial banks’ total assets. - Data and baseline date: - Data: bank-internal portfolio, income and balance sheet data; audited financial statements as of end 2013. - Exposure coverage: (i) all credit risk-sensitive exposures, (ii) all market risk-sensitive exposures, including Danish and foreign sovereign exposures in the held-to-maturity portfolio of the banking book; (iii) cash-flow based funding liquidity data. - Top-down: Bank-by-bank supervisory data from year end 2013; audited financial statements as of end 2013; exposure coverage includes sovereign exposures as part of gross bond holdings. - N/A entries retained where specified. ### Methodology and channels of risk propagation - Methodology: - Constrained bottom-up stress test using participating banks’ and mortgage credit institutions’ internal risk management frameworks. - DN top-down stress testing framework (balance sheet-based regulatory approach). - Top-down (FSAP Team): N/A. - Satellite models / macro-financial linkages: - Bottom-Up: - Credit risk: Banks’ Internal Ratings Based (IRB) models and internal models for portfolios under the Standardized Approach; Basel III regulatory framework for calculating capital requirements. Direct and indirect credit risk covered. - Market risk: banks internal risk management models; Basel III regulatory framework including stressed Value-at-Risk (VaR) effects on RWA. - Pre-impairment income: bank internal risk management models. - Liquidity risk: Section 152 Danish Financial Business Act requirements (Funding Ratio, Excess Liquidity Coverage (ELC)); and CRD IV Liquidity Coverage Ratio. Estimates include contractual and behavioral cash-flows, as well as market liquidity shocks. - Credit growth: scenario-dependent, dynamic balance sheet assumption (unconstrained). - Top-Down (DN, IMF FSAP team): - Credit risk: Sectoral credit risk factor model (Abildgren and Damgaard, 2012); linear and static regression model with regressors including unemployment rate, real long- and short-term interest rates, real growth in house prices. Parameter estimates recalibrated based on expert judgment; direct and indirect credit risk covered. - Market risk: Repricing of market-risk sensitive exposures, excluding sovereign debt holdings. - Pre-impairment income: Main income and expenses balance sheet items estimated from linear regression models, with institute-specific add-on estimated from past performance. - Credit growth: Endogenous growth modeling depending on profitability. - No tests for market and funding liquidity risks. - Top-Down (FSAP Team): N/A. - Stress test horizon: - Five years (2014Q1–2018Q4); plus separate estimate of impact under full Basel III implementation (2019). - Top-down entries: N/A. ### Scenarios, tail shocks, and sensitivity analysis - Scenario generation and baseline: - Stress scenarios generated by the IMF’s EUROMOD model. - Baseline scenario: IMF World Economic Outlook (WEO), October 2013. - Scenario descriptions: - Protracted Slow Growth scenario: - Euro area growth deteriorates gradually but persistently. - Real GDP growth would be lower each year by about 0.5 percentage points than in the baseline scenario. - Five-year cumulative shock corresponds to a little over one standard deviation move in annual GDP growth relative to the baseline. - Effects: depressed collateral prices, slower GDP growth, increased NPLs, weaker profit-generation capacity. - Severe Stress scenario: - Causes: Surge in global financial market volatility due to geopolitical tensions, revised expectations about UMP exit in the United States, or concerns about fundamentals in emerging economies. - Real GDP growth would be lower by -3.8 percentage points in 2014 and -1.6 percentage points in 2015 than in the baseline scenario. - The adverse scenario constitutes a 2½ standard deviation shock (5.4 percentage points) to the two-year cumulative real GDP growth rate for 2014–15 compared to the baseline. - Effects: depressed collateral prices, higher unemployment, lower GDP growth, negative impact on banks’ profitability and asset quality. - Sensitivity analyses: - Sovereign risk: country-specific yield shocks, including on own sovereign; including and excluding held-to-maturity portfolio of the banking book. - Hike in Danish covered bond spreads by 100 and 500 basis points. - Credit concentration and counterparty credit risk: simultaneous default of largest 1, 3, 5, and 10 largest single exposures (paragraph 145, Art. V Danish Financial Business Act (DFBA)); simultaneous default of 1, 3, 5, 10, and all Large Exposures (defined according to paragraph 145, Art. IV DFBA). - Assumptions for concentration tests: All off-balance sheet exposures covered (not only the 75 percent via the Credit Conversion Factor); conservative LGD assumption of 45 percent (for all banks and all tests); group-internal exposures excluded; losses calculated after deduction of eligible collateral (up to certain limits e.g. on housing collateral). - Impact measure: Change in capital ratio with and without gross profits as first line of defense. - Top-down (FSAP Team): N/A where specified. ### Risks assessed, behavioral adjustments, and buffers - Risks/factors assessed (Bottom-Up): - Credit risk, direct and indirect. - Credit concentration and counterparty default risk. - Market risk (incl. sovereign risk). - Market liquidity risk. - Funding liquidity risk. - Funding cost risk. - Risks/factors assessed (Top-Down DN): - Credit risk, direct and indirect. - Market risk (excl. sovereign risk). - Funding cost risk. - Behavioral adjustments and management actions: - Bottom-Up: Dynamic balance sheet assumption, bank-specific. - No capital increases assumed. - Outflow of capital due to CRD4 phasing-out and redemptions of AT1/T2 capital (where relevant). - Tax assumed at 25 percent of profits before tax. - Dividend payout assumed at 25 percent of profits after tax before dividends. - No management intervention assumed in asset disposal, lending standards or portfolio allocation. - Top-Down: Depending on result and contractual obligations; constant portfolio allocation/composition; no management actions. - Top-Down (DN): Balance sheet growth modeled endogenously, conditional on profitability. The risk-weights reported by banks under the bottom-up test were applied in the top-down test. The risk-weights are kept constant for the remaining period. - Top-Down (FSAP Team): N/A. - Buffers and absorption: - Regulatory phase-in arrangements and buffers included: CRD IV phase-in arrangements for CET1, Tier 1, and Total Capital; Capital Conservation Buffer (CCB), SIFI buffer, as well as bank-specific Pillar 2 add-ons. - Accounting: IAS 39 accounting standards. - RWA behave dynamically according to changes in credit and market risk parameters. ### Regulatory and market-based calibration - Calibration of risk parameters: - Credit risk: (PD and LGD): point-in-time parameters for Expected Loss estimation; through-the-cycle and point-in-time for capital requirements (Bottom-Up). - Top-Down: Point-in-time “impairment rates” (i.e., loss rates) modeled directly (no explicit modeling of PD, LGD). - Market risk: scenario parameters provided in terms of haircuts. - Regulatory/Accounting and Market-Based Standards: - CRD IV phase-in arrangements for CET1, Tier 1, and Total Capital; includes CCB, SIFI buffer, and bank-specific Pillar 2 add-ons. - IAS 39 accounting standards. - Section 152 DFBA and Supervisory Diamond referenced for liquidity-related regulatory standards. ### Reporting format and output presentation - Solvency risk outputs: - Evolution of capital ratios. - Solvency test result drivers. - System-wide capital shortfall. - Percentage of assets below regulatory minimum. - Capital shortfall; percentage and distribution measures. - Liquidity risk scope and outputs: - Institutional perimeter: - Excess liquidity coverage test: 81 banks. - LCR: 16 banks and MCIs. - Funding ratio: 85 banks. - Market share: 100 percent in terms of assets. - Data and baseline date: Institutions internal and supervisory data as of March 2014. Unconsolidated data for excess liquidity coverage test and funding ratio; consolidated data for LCR. - Methodology: - Coverage ratios (Excess Liquidity Coverage and CRD IV Liquidity Coverage Ratio). - Structural maturity mismatch ratio: Cash-flow-based using maturity buckets (Funding Ratio). - Risks and buffers: - Multi-factor scenarios comprising funding liquidity shocks and market liquidity shocks. - Buffers: Counterbalancing capacity. - Tail shocks (size of the shock): - Dry-up of wholesale funding markets, loss in deposit funding; shocks to market values of liquid assets; downgrades of financial institutions. - Detailed parameterization referenced for Excess Liquidity Coverage and CRD IV LCR. - Regulatory standards: - Section 152 DFBA and Supervisory Diamond. - CRD IV (final version). - Output presentation: - Excess Liquidity Coverage, Liquidity Coverage Ratio, and Funding Ratio for the full sample and, separately, for different size buckets. - Number of banks that do not pass stress test; liquidity shortfall; potential to close shortfall. - Distribution measures of individual results. *Appendix III. Stress Test Matrix (STeM) for the Banking Sector — content as provided in the source PDF.* --- _Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2014/_cr14336.pdf_