The Danish banking sector is adapting to new requirements that mean it must hold more capital and conform to yet more rules. While few in the industry doubt that the system must be more robust, concerns are increasingly being voiced that the country’s banks are having to adjust to more stringent regulations than their EU counterparts, and at a faster pace. 

As regulators across the globe take measures to ensure the safety of their banking systems, Danish bankers worry that their regulator is getting ahead of the curve and that they could be disadvantaged against their European competitors.

Denmark’s banking sector is large relative to its economy with assets of about three times that of its gross domestic product (GDP) and it had a fairly difficult financial crisis with a number of small bank failures. The authorities responded with a mixture of guarantees, funding and ultimately tougher regulations.

Going too fast?

Danish bankers agree that the system needs to be more robust and that taxpayers should not be liable in the event of a bank failure. But they are worried about their ability to make decent returns in a slow market while at the same time being asked to hold more capital and conform to new rules.

In particular they are anxious about the impact of Denmark’s new resolution scheme which has led to downgrades by Moody’s on the basis that sovereign support has been removed. On top of this they are being subjected to much tougher provisioning requirements and Denmark was one of the first countries to introduce a supervisory diamond in 2010 which monitors banks through five key measures – the funding ratio, large exposures, commercial property exposure, lending growth and excess liquidity coverage.

With such a strong response from the Danish financial services authority, it is easy to conclude that the Danish banks have nothing left to fear about the onset of Basel III. In fact there are still lingering concerns that Danish covered bonds could be excluded from the list of allowable assets under the proposed liquidity coverage ratio (LCR) even though the market is more liquid than that for Danish treasuries and no Danish covered bond has defaulted since their introduction in 1797.

Evind Kolding, chairman of the executive board of Danske Bank, says: “Our main concern is whether Denmark follows in the EU regulatory track and at the same speed. We should not go overboard with additional requirements or go faster than the EU. The first level of defence for a bank is a sound profit and we mustn’t jeopardise that by focusing solely on the second level of defence, which is capital. Yes we need to meet higher capital requirements but let’s do it in a phased way.”

Resolution scheme criticism

Like most Danish bankers Mr Kolding reserves his harshest criticisms for the country’s new resolution scheme under which two banks have already been allowed to fail with investors taking a hit but not taxpayers.

“Denmark has got a bit ahead of itself by introducing this scheme,” says Mr Kolding. “The problem is that Moody’s has seen it as a lack of systemic support in Denmark. We disagree with that view and we believe that Danske would receive the same level of support as equivalent banks in Sweden, Norway, Germany and other places. As it is today we have a two-notch disadvantage for being headquartered in Copenhagen rather than Stockholm.”

Over time, if the system worked it could alleviate the need for extra capital buffers and so in the end would not result in a net increase in funding costs

Urs Rohner

The resolution scheme raises the funding costs of Danish banks by closing off certain classes of investors and depositors such as those in the US commercial paper market.

Denmark’s experience with its resolution scheme is of huge interest since resolution, and particularly cross-border resolution, is arguably the most difficult regulatory issue still to be worked out in the current wave of rule making.

In June, the European Commission adopted proposals for EU-wide rules for bank recovery and resolution and at the Institute of International Finance’s (IIF) meeting earlier in 2012 – appropriately held in Copenhagen in the same month – the association released a report on cross-border resolution frameworks.

At an IIF press conference a number of questions were asked about cross-border resolution, including as to whether it would raise funding costs. IIF board director Urs Rohner, who is the chairman of Credit Suisse, said: “Over time, if the system worked it could alleviate the need for extra capital buffers and so in the end would not result in a net increase in funding costs.”

New IIF chairman Douglas Flint (replacing Josef Ackermann), who is HSBC’s group chairman, said: “There is an argument for a large part of the marketplace that if the system going forward is better capitalised, better supported and the infrastructure and institutions around it are better able to deal with recovery and resolution, then for a large number of institutions their funding costs should reduce.” Mr Flint did concede, however, that it could lead to bifurcation of the market with weaker banks facing higher costs. The IIF has not conducted a study on the impact of new resolution proposals on funding costs.

First-mover disadvantages

Danske Bank’s Mr Kolding is anticipating that in Denmark it could be the resolution scheme itself that bifurcates rather than the market. “When the SIFI [systemically important financial institutions] comes into play, this would mean adding capital for the larger banks and it could allow the resolution scheme to be adjusted, so there could be one for the systemically important institutions and one for the smaller banks,” he says.

Nordea’s head of retail banking Michael Rasmussen, who is based in Copenhagen and also chairs the Danish Bankers Association, says: “The context of the resolution scheme is that individual banks need to solve their own problems with their own shareholders, debt holders and depositors. That is definitely the right thing to do. We at Nordea have paid out more than €650m for cleaning up other banks [through the deposit insurance scheme] and the stronger banks will have difficulties in doing more as it hurts their shareholders. However, it is true that Denmark was one of the first countries to adopt such a scheme and that this has hurt us. It’s important for us to be on a level playing field with other banks.”

Fitch says in an April 2012 report on the sovereign that the resolution scheme is, on balance, positive. “Some critics argue that while the bank resolution package may be positive from a sovereign perspective, from a banking system perspective it may restrict access to funding and create investor uncertainty in the short run... [But]… Fitch considers Denmark’s improving regulatory framework to be supportive of the stability and eventual robustness of its banking sector.”

Profit challenge

The challenge for Danish banks is to make profits in a stagnant market that has seen property prices fall 20% from their peak, in which margins are being squeezed and capital requirements are increasing.

Karsten Knudsen, group managing director of leading mortgage provider Nykredit, says that the regulator has come almost full circle with respect to provisioning requirements. He adds that Denmark’s system of dynamic provisioning was phased out between 2004 and 2007 amid concerns that banks were using it as a way of hiding profits and paying less tax. “Up to 2007, banks were forced to reduce their reserves. In the period since, we have been told to re-establish our reserves, but we are doing this in an economic downturn so it makes the income stream look awful,” he says.

Mr Knudsen says that Nykredit’s mortgage book used to expand by 10% a year up until 2008 but now growth rates are about 0.25%. The bank was always prudent on capital, holding double the amount stipulated by the regulator, but under new capital rules even a bank such as Nykredit will need to raise its capital. At the same time, says Mr Knudsen, it faces a battle with the competition authorities over its attempts to raise margins on existing loans.

Nordea’s Mr Rasmussen says that the Danish regulator’s change in mindset over provisioning revolves around focusing more on the 'for sale' price of the asset in question rather than its derived profitability and cash flow. He is, however, concerned about the timing of the changes. “The environment is very tough now and we will see in years to come if this was the correct timing [for increasing capital]. You could have your doubts,” he says.

Unlike most Danish banks, Nordea does not have a funding gap (with an excess of loans over deposits) and has seen an inflow of deposits during the crisis due to its perception as a safe haven.

A borrowing nation

One explanation for the Danish funding gap is that Danes borrow heavily – gross household debt was the highest in the Organisation for Economic Co-operation and Development countries in 2009 at 160% of GDP – for house purchase and then transfer excess funds into pension schemes. This means that these funds do not show up as deposits.

In any case, Danish mortgages have traditionally been funded by covered bonds rather than deposits, and a mortgagor even knows which particular bond has been issued in respect of his or her loan.

Banks hold the bonds for liquidity purposes, so suggestions that they might not qualify under the Basel III LCR have provoked real concern, especially as the Danish treasury market is too small to compensate. But most bankers feel that there will be more flexibility regarding this issue. A more pressing concern is the additional cost of adding collateral for covered bonds based on adjustable mortgages in a pool as property prices fall. Danish covered bond rules stipulate that loan to values for residential mortgages must not fall below 80%. The fall in property prices has forced banks to issue additional bonds to be used as additional collateral so adding to costs.

Danish banks are responding to these challenges by reducing costs through branch closures, lay-offs and other efficiencies.

Finally, for Danske Bank another challenge is dealing with the problems in its Irish operations. It bought both National Irish Bank in Ireland and Northern Bank in Northern Ireland in 2004.

Mr Kolding says: “Danske Bank has been through quite a difficult phase since the financial crisis and we are not completely out of it. Our problem child is Ireland. We expect future losses in Ireland to be in the range of DKr5bn [€673m] to DKr7bn on the assumption of continuing falls in the real estate market.”

The bad loans have been separated out so as to allow the good parts of both banks to continue without distractions, says Mr Kolding, while adding that the strategy is to stay in Ireland over the long term.


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