Denmark: Financial System Stability Assessment; Press Release; and Statement by the Executive Director for Denmark
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International Monetary Fund. Monetary and Capital Markets Department
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Publication Date:
12 Aug 2020
eISBN:
9781513552965
Language:
English
Keywords:
ISCR; CR; th e DFSA; stress test endeavour; FSAP solvency stress test analysis; Danish authorities; financial system; Stress testing; Insurance companies; Systemically important financial institutions; Covered bonds; Insurance; Global; Baltics; mortgage loan; banking sector; parent company; credit risk; unemployment rate
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Financial System Stability Assessment-Press Release; and Statement by the Executive Director for Denmark

Abstract

Financial System Stability Assessment-Press Release; and Statement by the Executive Director for Denmark

Executive Summary

Much of the work of the FSAP was conducted prior to the COVID-19 pandemic. Given the FSAP’s focus on medium-term challenges and vulnerabilities, however, many of its findings and recommendations for strengthening policy and institutional frameworks remain pertinent. This report reflects key developments and policy changes since the FSAP mission work was completed, and includes illustrative scenarios to quantify the possible implications of the COVID-19 shock on the solvency of systemically important financial institutions (SIFIs).

Prior to the COVID-19 pandemic, the Danish authorities had taken important steps to improve financial system resilience. The authorities had actively used macroprudential tools to bolster the robustness of the financial system. The supervision of the banking and insurance sectors had improved. Likewise, recent legislation enables enhanced anti-money laundering and combating the financing of terrorism (AML/CFT) supervision, including by strengthening monitoring and enforcement powers and stiffening certain non-compliance penalties. Major reforms such as a new bank resolution framework had also considerably improved Denmark’s financial safety net and crisis management frameworks.

Stress tests indicate that the COVID-19 shock is expected to have a large impact on SIFIs’ capitalization ratios, though all would continue to meet minimum capital requirements. Stress tests were conducted using illustrative scenarios that attempt to capture the adverse growth and unemployment implications of the COVID-19 shock on the solvency of SIFIs. Although the adverse macroeconomic conditions associated with the COVID-19 pandemic have a significant impact on capitalization ratios, all SIFIs would meet their minimum capital requirements. However, the impact is differentiated across SIFIs, and, in some cases, a few SIFIs would need to partially use their capital conservation and/or SIFI buffers. Importantly, given the unprecedented nature of the ongoing pandemic, these scenarios, and their implications for SIFIs, are subject to considerable uncertainty and downside risks: A further deterioration of economic prospects relative to those assumed under the scenarios, or tighter financial conditions, could bring about a situation where some SIFIs breach their minimum capital requirements. The financial stability risks stemming from the insurance sector appear contained for now; in the stress tests, life insurers would be significantly hit by market shocks but most remain well above the regulatory solvency thresholds, while occupational pension funds and non-life firms are more resilient. At present, bank liquidity appears adequate and tests suggest that banks can withstand more significant funding pressures than those observed in March 2020. MCIs play a central role in the domestic interbank system and can generate significant contagion effects across a financial system which is densely linked by covered bond exposures.

Danmarks Nationalbank (DN) promptly provided liquidity support in response to the intensification of the crisis. In particular, DN has launched extraordinary liquidity facilities and reactivated bilateral swap lines with the ECB and the Federal Reserve. Looking ahead, DN should continue to refine its operational preparedness for nonstandard liquidity support. Specifically, domestic interagency collaboration should be improved and the framework for accepting credit claims as nonstandard collateral should be further automated.

The financial safety net and crisis management framework has been considerably enhanced, yet operational readiness is an area where further improvements are warranted. Notwithstanding ongoing efforts, the resolution planning process for systemically important financial institutions (SIFIs) should be expedited. The authorities still need to define strategies for liquidity assistance to institutions in resolution. To strengthen the autonomy of the resolution authority, the government should be involved in resolution decisions only when fiscal support is needed. A national crisis management plan, including a crisis communication strategy, should be developed and tested.

Prudential supervision is generally sound, but there is scope for further improvement. The DFSA’s risk-based supervisory approach focuses on traditional financial risks; in particular credit risk in banking and market risks and asset-liability management in insurance. However, its strong traditional focus needs to be complemented with equal rigor in other areas such as governance and risk culture as risks arising in these fields have the capacity to undermine banking soundness rapidly. Insurance supervision should be further strengthened by increasing on-site inspection frequency, completing a solid risk assessment framework, and enhancing the oversight of cross-border business. The DFSA’s operational independence should be safeguarded and it would benefit from a further increase in resources.

Denmark should build upon its recent reforms so as to maintain its momentum in strengthening AML/CFT supervision in the banking sector. The DFSA should finalize its new institutional risk assessment model and incorporate the results into its on-site inspection schedule. Moreover, the DFSA should intensify (that is, significantly lengthen and deepen) its on-site inspections of higher-risk financial institutions as a matter of priority and demonstrate the effective use of its new monitoring and enforcement powers when appropriate. The Government should consider next-stage options for the integration/consolidation of AML/CFT supervision at the sub-regional or EU levels and pursue the selected option(s).

It is important to continue to strengthen the macroprudential policy framework going forward. In particular, the institutional arrangements can be improved by streamlining the decision-making process to reduce inaction bias and further enhancing accountability on macroprudential policy. If elevated vulnerabilities in the housing sector remain after the COVID-19 pandemic, additional macroprudential actions could be warranted over the medium term, in form of tighter loan-to-value limits and binding income-based measures on borrowers. Coordinated policies are also needed to reduce debt bias, simplify rental regulations, and relax supply constraints on housing. Data gaps in the CRE sector limit the assessment of vulnerabilities and should be closed, especially given the rising risks in this sector. Systemic risk monitoring should more actively cover the nonbank sector.

Danish banks are more exposed to physical risk from climate change, especially flood-related disasters, than to transition risk. Although 1½ percent of mortgage assets serving as collateral are currently at risk of flooding, this share could increase to 13 percent. Banks have limited exposure to the high carbon-emitting industries. Non-life insurers are mainly exposed to windstorms and cloudbursts, but these risks are largely transferred to reinsurers.

Table 1.

Denmark: Key Recommendations

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ST: Short term (1–3 years); MT: Medium Term (3–5 years).

Background

A. Macrofinancial Context

1. Steady growth in recent years was abruptly interrupted by the COVID-19 pandemic.

  • During the 2008–2009 global financial crisis, the economy underwent a sharp downturn which was exacerbated by the burst of the domestic real estate bubble. The combination of the sharp fall in house prices and the high level of household debt dampened private consumption growth, resulting in a recovery which trailed that of regional peers. During the past few years however, in an environment characterized by negative policy rates, the unemployment rate was at a 10-year low, and despite a positive output gap, structural reforms and the krone’s tight peg to the euro has kept inflation low and stable (Figure 1, Figure 2, Table 2).

  • The outbreak of the pandemic has led to a sudden stop in economic activity and a sharp deterioration of short-term economic prospects reflecting in part the necessary containment measures. Likewise, after a long period of accommodation, financial conditions tightened sharply in March 2020, before easing again more recently (Figure 3). The timing and the shape of a future recovery remain highly uncertain, and risks are to the downside. In particular, there is a concern that a further tightening of financial conditions or a second pandemic wave could expose financial vulnerabilities.

Figure 1.
Figure 1.

Denmark: Macroeconomic Developments

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: OECD, Haver, BIS, Statistics Denmark, IMF staff calculations, Danmarks Nationalbank.Note: In panel 5, overall PMI and production index is shown. In panel 6, consumer confidence is based on the general economy over the next 12 months.
Figure 2.
Figure 2.

Denmark: Monetary Policy, Operations, and FX Markets

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: Haver, Danmarks Nationalbank, ECB, IMF staff calculations.Notes: In panel 1, the market rate is in DKK/Euro and the FX Interventions is in DKK billion. In panel 3 international reserves are in DKK billions and interest rates are in percent.
Figure 3.
Figure 3.

Denmark: Monetary and Financial Conditions

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: Bloomberg, Haver, IMF staff calculations.
Table 2.

Denmark: Selected Economic Indicators, 2016–2021 (As of April 2020)

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Sources: Danmarks Nationalbank, Eurostat, IMF World Economic Outlook, Statistics Denmark, and Fund staff calculations.

Contribution to GDP growth.

Based on Eurostat definition.

General government.

Overall balance net of interest.

Cyclically-adjusted balance net of temporary fluctuations in some revenues (e.g., North Sea revenue, pension yield tax revenue) and one-offs.

2. The past track record of sound macroeconomic management enabled a prompt and decisive response to the crisis. Prudent fiscal policies and government debt at 30 percent of GDP have underpinned the sovereign’s triple-A rating. Past current account surpluses have resulted in a sizeable stock of foreign assets. With such buffers, the authorities were able to rapidly implement a range of measures to contain the spread of COVID-19 and to support the economy (Box 1). Specifically, in addition to the countercyclical support that is expected to come through Denmark’s strong automatic stabilizers, the authorities have provided discretionary fiscal support of approximately DKK 126 billion (5½ percent of 2019 GDP). Moreover, Danmarks Nationalbank (DN) has introduced an extraordinary lending facility and has reestablished swap lines; the countercyclical capital buffer (CCyB) was released.

3. The 2014 FSAP found that financial stability risks were broadly contained, but called for additional measures to further enhance systemic resilience. Existing vulnerabilities, such as the financial system’s large size and interconnectedness, have been compounded by newer threats including signs of greater risk taking following a long period of persistently low interest rates, particularly in the commercial real estate (CRE) sector. Although policy arrangements have evolved, several weaknesses identified in the previous FSAP have yet to be fully addressed (Table 3). Notably, the Danske Bank money laundering (ML) case drew attention to what had been longstanding supervisory deficiencies (Box 2).

Table 3.

Denmark: FSAP Update: Status of Main Recommendations

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4. Much of the work of the 2020 FSAP was conducted prior to the COVID-19 outbreak. Nevertheless, this report has been updated to reflect key developments and policy changes since the work on the FSAP was completed, and includes illustrative scenarios to quantify the possible implications of the COVID-19 shock on the solvency of systemically important financial institutions (SIFI)s. Note that these illustrative scenarios focus on the growth and unemployment implications of the COVID-19 shock. These COVID-19 scenarios do not entail an abrupt tightening of financial conditions or a real estate downturn, though these shocks are part of a third scenario with more severe market shocks but less severe economic shocks. The possible amplification of the COVID-19 shocks for banking liquidity or potential system-wide contagion risks have also not been assessed.

B. Structure of the Financial System

5. Denmark’s financial system is large, with assets over 630 percent of GDP (Table 4). The banking sector—comprising 77 banks and mortgage credit institutions (MCIs)—accounts for 55 percent of financial sector assets and is large in comparison with other countries. The banking sector is dominated by seven domestic SIFIs; the largest is the Danske Bank Group (with assets of about 170 percent of GDP). Insurance companies and pension funds (ICPFs) are also large relative to European peers (190 percent of GDP) partly due to the fact that life insurers are major providers of occupational pension plans. ATP is the dominant provider of pension savings outside the insurance sector.

Table 4.

Denmark: Structure of the Financial System

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Source: Statistics Denmark, Danish Financial Supervisory Authority. Note: ATP is a compulsory pension scheme for employees; related schemes also included in this group.

6. The large size of the financial system reflects in part the high level of interconnectedness between financial institutions, households, and corporates (Figure 4). Household assets (housing and pension savings) and liabilities (mortgages) as shares of GDP are among the highest in the world. MCIs fund household mortgages by issuing covered bonds which are held by banks, ICPFs, and, increasingly, foreign institutional investors. ICPFs hold covered bonds as assets against their insurance and pension liabilities to households. The covered bond market is about 130 percent of GDP (almost five times the size of the government debt market) and the world’s largest in relative and absolute terms (Figure 5).

Figure 4.
Figure 4.

Denmark: Cross-Sectoral Interconnectedness

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Note: Node size reflects the magnitude of total assets for each sector, line thickness is proportional to the normalized size of bilateral links with respect to total system assets, and line color represents exposure direction, where it matches the color of the exposed sector for a given link. NFC, CB, CI, FUND, OFI, INS, PEN, GOV, HH, and ROW denote the nonfinancial corporate sector, central bank, credit intermediaries (including banks and mortgage credit institutions), investment funds, other financial institution, insurance companies, pension funds, public sector, household sector, and the rest of the world, respectively.
Figure 5.
Figure 5.

Denmark: Covered Bond Market

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: Danmarks Nationalbank.

7. Major SIFI’s group structures include a commercial bank and an MCI (Table 5). Within groups, commercial banks are financed with deposits, provide loans to non-financial firms, and serve as the point of contract for customers of the group. MCIs serve as (capitalized) vehicles that issue covered bonds to finance the mortgage portfolios originated by the commercial bank (Box 3). These differentiated business models within the groups are reflected in the composition of assets and liabilities across banks and MCIs (Figure 6).

Figure 6.
Figure 6.

Denmark: Assets and Liabilities of MFIs

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: Statistics Denmark.Notes: Total assets and liabilities are calculated by summing the components, and not taken directly from the reported total MCI.
Table 5.

Denmark: Structure of the Systemically Important Financial Institutions—A Summary

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Source: Danish Financial Supervisory Authority. Note: Total assets reported are for 2018. Nordea Bank Group is headquartered in Finland. Total Assets for Nykredit RealKredit A/S include those of Totalkredit A/S.

8. The banking system has strong linkages with other Nordic countries (Figure 7). The operations and exposures of major Nordic banks are concentrated in the Nordic-Baltic region through complex cross-border business arrangements. In particular, banking groups conduct mortgage lending operations in foreign countries via MCIs, which are structured as subsidiaries to facilitate compliance with differing local covered bond regulations; in contrast, other foreign banking operations are conducted using branches. In Denmark, the Finland-headquartered Nordea operates a large branch while other Nordic banks have only a small domestic presence. Danske Bank has significant operations across the Nordic region via its MCI subsidiaries and commercial banking branches. The exposure of Denmark’s banking groups to the Baltic region is now negligible, following Danske’s retrenchment from the region in the aftermath of the ML case.

Figure 7.
Figure 7.

Denmark: Cross-border Holdings of Bank Claims

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: Bank for International Settlements.Notes: This figure depicts the share of total liabilities of Denmark at banks located in other BIS-LBS reporting countries. The countries with the ten highest shares in 2017 are included. Non-BIS-LBS reporting countries’ liabilities are not included in this calculation (non-reporting countries including Estonia, Latvia, Lithuania, and Russia). Denmark reports claims and liabilities to other countries in the publicly available BIS-LBS data. Total outstanding liabilities of Denmark in other countries are aggregated based on the location or residence of banks and their subsidiaries and offices, irrespective of the location of the headquarter of the parent bank. For example: If a bank in Denmark holds deposits at the subsidiary of a Swedish bank in Finland, the liabilities will be included as liabilities of Denmark in Finland.

9. Banking groups exhibited high capitalization and liquidity ratios before the COVID-19 shock (Table 6). The aggregate risk-weighted capital ratio stood at 22.5 percent at end-2019 and all SIFIs met the minimum leverage ratio requirement of three percent. Moreover, during the six months prior to the crisis, SIFI’s aggregate common equity tier 1 (CET1) ratio increased by over a full percentage point to 18.3 percent in 2020 Q1. Most SIFIs have also recently announced plans to cancel dividend payments and cancel their share buyback programs which would help bolster their capital buffers. Due to relatively low risk-weighted (mortgage) asset (RWA) densities, however, the introduction of risk weighted assets floors (under the finalized Basel III) may have significant implications for the four Danish banks using IRB models by lowering their regulatory capitalization ratios (Figure 8). All banks exceeded the minimum required Liquidity Coverage Ratio (LCR) of 100 percent by a comfortable margin—as of April 2020, the median LCR across systemic banks was 198 percent. Although the nonperforming loan (NPL) ratio has trended downward to a value of 1.7 percent at end-2019, there is a risk that asset quality would deteriorate owing to the aftereffects of the COVID-19 outbreak.

Figure 8.
Figure 8.

Denmark: Comparison of Selected Financial Indicators

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: IMF FSI. Note: latest available.
Table 6.

Denmark: Financial Soundness Indicators, 2012–2019

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Source: IMF Financial Soundness Indicators.

10. Bank profitability was adversely affected following the intensification of the COVID-19 pandemic. Despite the downtrend in net interest margins following a long period of low interest rates prior to the outbreak, the aggregate return on equity (ROE) of banks had been about 11½ percent on average over the last four years supported by low impairment charges not seen in over a decade and a wave of mortgage refinancing-related fee income (Figure 9). However, more recently, bank’s ROE in 2020 Q1 fell to -2.7 percent, one of the lowest levels in recent years, owing to a sharp rise in loan impairment charges. Lending by banks and MCIs to the household and the nonfinancial corporate sectors has declined.

Figure 9.
Figure 9.

Denmark: Performance Indicators for Financial Institutions

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: IMF Financial Soundness Indicator database (which covers up to 67 deposit-taking institutions) and Danmarks Nationalbank.

11. To mitigate the erosion of net interest income, banks are offering negative rates to depositors. The share of corporate deposits earning negative interest rates in systemic banks has risen from about 40 to 60 percent over 2017–19. Also, many SIFIs have begun passing on the negative policy rates to households with deposits over DKK 750,000 (€100,000) which is equivalent to the current level of deposit insurance. However, this strategy has its own limitations and risks: it cannot fully offset the decline in net interest income if interest rates remain persistently low and it could destabilize the funding base.

12. The prolonged period of low interest rates has been challenging for life insurance companies, and the first quarter of 2020 brought substantial investment losses. Even before the COVID-19 shock, the profitability in the life insurance sector was modest and was being dragged down by a relatively large (though declining) legacy portfolio of contracts with guaranteed rates of return of more than three percent which are notably above market interest rates (Figure 10). Low interest rates, longer life expectations, and the resulting change in product offering continue to be a key challenge for life companies, while market risks are increasingly borne by policyholders via unit-linked contracts. Covered bond exposures, which account for 60 percent of all fixed-income assets, are almost entirely domestic. Non-life insurance has been characterized by favorable underwriting results and relatively low expense ratios. Solvency ratios have been broadly stable, hovering around 280 percent in both the life and non-life segments, well above the regulatory threshold of 100 percent.

Figure 10.
Figure 10.

Denmark: Insurance and Pension Fund Sector

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: EIOPA, DFSA, Eurostat.

13. As the role of investment funds grows, related vulnerabilities merit deeper analysis. Investments funds, which have been expanding appreciably owing to net inflows and rising valuations, account for about 91 percent of GDP and have sizeable linkages with ICPFs, banks, and nonfinancial firms. A more granular breakdown of the investment funds and their linkages with other sectors is becoming increasingly important for a comprehensive monitoring and appraisal of risks.

Systemic Risk Analysis

A. Macrofinancial Vulnerabilities

14. On the eve of the COVID-19 pandemic, key financial vulnerabilities were associated with the housing market and mortgage financing:

  • Household debt: Notwithstanding a gradual downtrend, Denmark’s high level of household (gross) debt remains an important vulnerability (Figure 11). Household net wealth is relatively high, but a large share of households’ assets is illiquid (housing and pension savings), limiting buffers to deal with shocks. This large stock of debt renders household consumption more susceptible to a confluence of adverse interest rate, asset price, and income shocks, which could reinforce macrofinancial feedback loops in a highly interconnected economy. Estimates suggest that although greater household leverage could stimulate near-term growth, it would also raise the chances of a slowdown over the medium term (Figure 12).

  • Real estate prices: Nationwide house prices had stabilized in response to prudential measures and appeared to be broadly in line with fundamentals. By contrast, house prices in urban areas remained elevated through 2019. In fact, the downside risks to house prices associated with larger house price misalignments appear to be greater in Copenhagen relative to the national market (Figure 13).

  • Mortgage loans: Despite improvements, the still high share of variable-rate mortgages (60 percent of the stock, of which 36 percent are non-amortizing) leave households sensitive to interest rate hikes (Figure 14).1

Figure 11.
Figure 11.

Denmark: Household-Sector Vulnerabilities

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: Danmarks Nationalbank, Association of Danish Mortgage Banks, Statistics Denmark, Eurostat, IMF staff calculations. Notes: Real property prices are calcualted using CPI as the deflator. National averages is the weighted average of owner-occupied flats and one-family houses nationally. The housing cost overburden refers to the percentage of the population living in a household where total housing costs (net of housing allowances) and represents more than 40% of the total disposable household income (net of housing allowances); DNK, LVA, and HUN are 2018 data, and ISL is 2015 data.
Figure 12.
Figure 12.

Denmark: Growth-at-Risk

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: IMF staff calculations.Notes: Short- and long-term refer to 4 and 12 quarters ahead, respectively; one standard deviation shocks are simulated.
Figure 13.
Figure 13.

Denmark: House Prices at Risk

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Figure 14.
Figure 14.

Denmark: Housing Finance-Related Vulnerabilities

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: Danmarks Nationalbank.

15. Indications of greater risk taking by financial intermediaries and nonfinancial firms, the changing risk profile of the commercial real estate and covered bond markets, and the incomplete implementation of risk-based AML/CFT supervision represent additional financial stability concerns:

  • Risk taking: There was evidence of greater risk taking across segments of the banking and insurance sectors. Given persistently low interest rates and the attendant pressure on profitability, some medium-sized banks were aggressively extending credit to households with high loan-to-income ratios as they tried to further increase their market share in major urban areas (Copenhagen, Aarhus). Likewise, insurers had been searching for yield by increasingly investing in riskier assets, thereby increasingly exposing themselves to liquidity risks. The greater shift towards unit-linked products is supporting insurance companies’ profitability, but transfers more risk to policyholders. This shift may reduce risk management incentives by insurers and would raise consumer protection concerns.

  • Nonfinancial corporate (NFC) sector and CRE: Despite an overall decline before the COVID-19 shock, there was evidence of rising leverage in cyclically-oriented firms which were already indebted against a backdrop of loosening credit standards for the NFC sector (Figure 15). In particular, the CRE market was characterized by rising prices, a large share of foreign investors, and there were concerns regarding the income generating capacity of CRE (Figure 16). At the same time, CRE was among the most leveraged corporate sectors and where debt had grown the fastest in recent years. Firm-level analysis, conducted before the onset of the pandemic, indicated that the CRE sector, accounting for about 30 percent of the total corporate debt, was especially vulnerable. In particular, the analysis revealed a six-fold jump in debt-at-risk for the CRE sector in an adverse scenario—far greater than other sectors (Figure 17). Such fragilities, which are now more acute in light of the COVID-19 shock, are concerning because banks have sizeable exposures to the CRE market which in turn has significant interconnections with the rest of the financial system.2

  • Covered bond market: Given the strong reliance on market-based funding, the increasing share of foreign investors confers diversification benefits, but at the same time increases the sensitivity of a regionally interconnected financial system to global investor sentiment. Although the Danish covered bond framework mitigates funding risks (Box 3), there are substantial holdings of covered bonds across domestic financial institutions.

  • AML/CFT: Despite continuing, critical reforms to Denmark’s AML/CFT regime, the recent money laundering case has affected both the reputation of, and confidence in, the financial system, such that financial stability could be impacted should foreign authorities issue significantly larger-than-expected fines or other, similar cases come to light. Indeed, bond spreads and equity prices were adversely affected by the news of the Danske Bank case, elevating Danske’s own funding costs and to a lesser extent those of other financial institutions for much of 2019.

Figure 15.
Figure 15.

Denmark: Debt of Non-financial Corporations (NFCs)

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: Danmarks Nationalbank, BIS.
Figure 16.
Figure 16.

Denmark: Commercial Real Estate

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: Danmarks Nationalbank.
Figure 17.
Figure 17.

Denmark: Pre-COVID Default Risk Analysis: Nonfinancial Corporate Sector

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: Danmarks Nationalbank, IMF staff calculations.Note: Estimated firm-level PDs are based on sector-specific default probability models. In panels 3 and 4, debt-at-risk (firms-at-risk) is calculated by aggregating debt of firms (number of firms) with projected PDs above 1.5 percent.

B. Risks

16. These vulnerabilities and the macroeconomic situation define the main risks faced by the Danish financial system. These risks, which could be mutually reinforcing given the high degree of sectoral and cross-border interconnectedness and financial vulnerabilities, are presented in the Risk Assessment Matrix (RAM, Table 7) and summarized as follows:

  • Prolonged Covid-19 outbreak. Containment measures could remain in place (or in some places intensify or need to be re-introduced) through early 2021.

  • Longer containment and uncertainties about the intensity and the duration of the outbreak could reduce supply and domestic and external demand. A more protracted economic contraction in global growth would have a sustained negative impact on Danish exports, investment, and consumption. These risks could be exacerbated by pandemic-prompted protectionist actions as Denmark is a small open economy with many sectors—including shipping—deeply integrated in global value chains. Corporate-sector losses would be accompanied by further increases in unemployment, NPLs, and loan loss impairments weighing on bank profitability, possibly aggravated by tighter credit conditions, and adverse Nordic spillovers.

  • Deteriorating economic fundamentals and the associated decline in risk appetite could result in a second wave of financial tightening (amplified as latent fragilities are unmasked). A protracted and correlated decline in asset prices would adversely affect the internationally exposed portfolios of ICPFs, erode household wealth, and weigh on consumption growth. Second-round effects are likely to be significant given the high degree of Nordic financial integration and ensuing adverse macrofinancial feedback loops given the extent of domestic interlinkages and elevated household indebtedness.

  • Sharp house price correction: The trigger could be associated with the global shocks discussed above or could be more regional or domestic in nature. Given close financial linkages, a Nordic real estate correction could quickly spark regional spillovers. Domestically, the shock could be triggered by a reassessment of fundamentals that sets a vicious cycle in motion, whereby tighter financial conditions and depressed economic activity amplify the impact of the initial shock.

Table 7.

Denmark: Risk Assessment Matrix (As of April 2020)

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C. Systemic Risk Assessment and Stress Testing

17. The impact of these risks on the financial system was assessed through stress tests of banks, MCIs, and insurance companies (Appendix I and II). The analysis covered all seven SIFIs (representing 77 percent of assets of credit institutions). The tests of banks and MCIs were performed at the (consolidated) group-level as well as on individual banks and MCIs, some of which operate within the groups. Insurance stress tests covers five life insurers, six occupational pension funds, and five non-life insurers, accounting for more than 70 percent in each sector. ATP was also included.

18. The resilience of banks and MCIs was assessed under illustrative five-year scenarios. Importantly, these illustrative scenarios are not meant to be forecasts, and are associated with considerable uncertainty and downside risks (Figure 18):

  • The first scenario, “COVID central,” attempts to capture the abrupt deterioration of short-term economic prospects owing to the COVID-19 pandemic.3 It envisages a sharp fall in GDP of 8 percent in 2020 (reflecting in part the containment measures), followed by a rebound of 6 percent in 2021. At the same time, the unemployment rate rises to 6.8 percent in 2020, before gradually declining. Note that this scenario focuses on the growth and unemployment implications of the COVID-19 shock, and does not entail an abrupt tightening of financial conditions (including a sharp rise in risk premia) or a real estate downturn (see Figure 18 for the scenario assumptions).

  • To reflect the considerable downside risks associated with longer containment measures, a second scenario with a more prolonged recession is considered (“COVID prolonged”). In this scenario, growth declines by 8 percent in 2020, but, instead of a rebound in 2021, the economy continues to contract (by 2.1 percent in 2021) before the recovery ensues in 2022. The protracted economic contraction is accompanied by a large increase in the unemployment rate which rises to 11.8 percent in 2022 before steadily falling. This scenario also assumes that there is no sharp tightening in financial conditions or a decline in house prices.

  • A third scenario, with more severe market shocks but less severe economic shocks, is also considered (“market shocks”). In particular, there is a sharp rise in asset risk premia (which adversely affects banks’ funding costs) combined with a prolonged downturn in the domestic real estate market. These large market risk shocks occur amid a protracted recession (which is less severe in the short-term relative to the other two scenarios).4

Figure 18.
Figure 18.

Denmark: Macroeconomic Scenarios for Stress Testing

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: IMF staff calculationsNote: Rate reflects overall cost of funding—calculated as a weighted average of retail and wholesale sources across all maturities. These scenarios are not meant to be forecasts and are associated with considerable uncertainty and downside risks.

Solvency Stress Tests

19. The solvency tests focused on SIFIs consolidated at the group-level. In particular, seven SIFIs (three financial groups, two banks, and two MCIs) are considered. For the three financial groups, the tests were performed on individual banks and MCIs and then consolidated by taking into account of intra-group holdings. Regarding banks, the economic downturns in the scenarios are expected to increase loan loss rates, but with significant variations across economic sectors and therefore banks. In addition, cost of funding shocks, which can only be partially passed on to bank borrowers, would aggravate the erosion of net interest income. Regarding MCIs, the stress tests assessed their capacity to withstand the effects of adverse shocks that generate losses through three main channels: (i) credit losses triggered by mortgage defaults, (ii) losses from the downward repricing of securities held in capital centers, and (iii) the loss of net interest income from the issuance of higher-cost junior bonds needed to shore up the collateral of their capital centers. Importantly, note that the tests assume that within-group guarantees and those provided by banks outside of the stress testing perimeter are available to cushion the impact of loan defaults on MCIs’ capitalization ratios.

20. The illustrative scenarios reveal a large impact on capital which varies across SIFIs:

  • Under the COVID central scenario, the aggregate CET1 ratio declines from 18.3 percent in 2019 to a low point of 13.4 percent in 2020, while the aggregate leverage ratio declines to 3.6 percent (Figure 19). The materialization of credit risk, which is predominantly influenced by GDP growth and the unemployment rate, is the main driver of the losses. All SIFIs meet their minimum capital requirements (a 4.5 percent CET1 ratio) under this scenario, however, the impact on capital varies. Specifically, one out of the seven SIFIs must partially tap into its capital conservation buffer (CCB) to fully absorb the losses under stress. The leverage ratio (which is currently planned for implementation in mid-2021) for one SIFI falls below the three percent threshold.

  • In the context of the COVID prolonged scenario, the aggregate CET1 ratio falls to a low point of 12.4 percent in 2022, reflecting the more protracted nature of the economic contraction. The aggregate leverage ratio would decline to 3.0 in 2024. Under this scenario, while all SIFIs still meet their minimum capital requirements, the impact on capital is more differentiated and subject to even greater uncertainty. While one SIFI makes partial use of its CCB, another SIFI needs to partially use its SIFI buffer. Likewise, the leverage ratios of a few SIFIs fall below three percent.

  • Under the market shocks scenario, the capitalization ratios reach their respective troughs at the end of the stress testing horizon: the aggregate CET1 ratio decreases to 13.4 percent in 2024; the aggregate leverage decreases to 3.4 percent. Although this scenario assumes significantly more severe market shocks and a lasting domestic real estate downturn, the results are primarily driven by the protracted nature of the envisaged downturn. In this case, a few SIFIs make partial use of their CCBs and a few SIFIs’ leverage ratios dip slightly below three percent.

Figure 19.
Figure 19.

Denmark: Solvency Stress Tests for Banking Groups

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Source: IMF staff calculations.

21. These stress testing results should be interpreted with caution. In addition to the large uncertainty associated with these scenarios, several limitations need to be recognized. In the analysis, the relationship between growth and capitalization is non-linear, implying that deeper recessions have potentially disproportionate impacts on capital. Some second-round and non-linear effects, which are not fully captured in the analysis, could imply an underestimation of losses.5 Importantly, the analysis suggests that a further deterioration of economic prospects and tighter financial conditions, relative to those assumed under the scenarios, could bring about a situation where SIFIs breach their minimum capital requirements.

Liquidity Stress Tests

22. The analysis suggests that the banking system could withstand significant withdrawals of short-term funding.6 The cash-flow based tests assessed the resilience of individual banks to severe shocks to their cash inflows and outflows combined with asset liquidations subject to valuation haircuts. The assumed shocks in the liquidity stress tests were significantly larger than those that have materialized in 2020 Q1. Banks can counterbalance negative funding gaps by using their cash and by liquidating securities both in the markets and at the central bank (via standard monetary operations). The tests reveal that all five banks would be able to survive extreme liquidity pressures without external support for longer than three months.7 Tighter financial conditions relative to those assumed in the tests could affect bank’s access to liquidity and funding costs unevenly and may result in acute liquidity strains for some banks.

Insurance Stress Tests

23. The resilience of insurance companies was assessed through a top-down (TD) and bottom-up (BU) solvency stress tests implemented before the onset of the COVID-19 pandemic. These tests build on the narrative and severity of the market shocks adverse scenario and are also subject to uncertainty and downside risks. Note that these tests encompassed several market shocks which resulted in a combined stress scenario that was considerably more severe than what was observed in 2020 Q1 (Appendix II). Importantly, in contrast to banks where credit risk is critical, market shocks are the main risk factor relevant for the insurance sector, especially for the life insurance segment.

24. Under the adverse scenario, although regulatory solvency requirements are met in aggregate, the life insurance sector is significantly impacted. The BU tests indicated that although the industry is able to withstand severe asset price shocks, most of the solvency impact would be attributed to the increase in domestic sovereign and covered bond yields. After stress, the median solvency capital requirement (SCR) ratio in the life sector dropped from 188 to 127 percent, while in the non-life sector the ratio declined from 233 to 207 percent (Figure 20). One life company drops below a solvency ratio of 100 percent, and the capital needed to restore a full coverage of solvency requirements would only be a moderate fraction of the sample’s aggregate capital. The TD tests broadly confirmed these results. Resurgent financial market turbulence associated with even more severe shocks relative to those assumed under the adverse scenario could impair insurers’ solvency positions and profitability to a greater extent.

Figure 20.
Figure 20.

Denmark: Pre-COVID Insurance Stress Test Results

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: IMF staff calculations based on company submissions.Note: In panel 4, TPs denote technical provisions, and LAC_TP the loss-absorbing capacity of technical provisions. Sensitivity analyses covered only the relevant sectors, i.e. longevity in the life and pension sectors, windstorm in the non-life sector, and the banking counterparty default in all sectors.

25. Over the medium-term, insurers will face declining investment returns as their higher-coupon bond holdings expire. In aggregate, the Danish life insurance sector still records positive spreads of investment returns over guaranteed interest rates, and is also expected to regain profitability after the materialization of the adverse scenario, but significant differences exist across companies. While insurers which are more active in non-life and unit-linked life business are less affected by the current low-yield environment, companies with a high legacy stock of guarantees on their policies are likely to experience a drain on their profitability.

26. The insurance sector appeared capable to withstand the losses simulated under the adverse scenario without materially amplifying market risks. In response to the stress conditions, life insurers would consider gradually divesting riskier holdings (equities, non-investment grade bonds) and increase their investments in sovereign and covered bonds. Likewise, non-life companies would also rebalance their portfolios and may even expand their investments in equities and real estate. In sum, the surveys from the BU test suggested that insurers reactions under the adverse scenario may mitigate the impact of the shocks on financial markets as they try to shore up their capital buffers.

27. Sensitivity tests point to longevity risks and the resilience of non-life companies to climate-related catastrophic events:8

  • A strong increase in life expectancy would reduce the median SCR of life insurers and occupational pension funds to 210 percent. Higher mortality rates however, including temporarily stemming from a severe epidemic, would decrease annuity payments, while coverage for sickness pay and hospitalization are only moderate.

  • In terms of climate-related risks, non-life insurers are mainly exposed to windstorms and cloudbursts, of which the latter occur more frequently, but remain local events with moderate losses per event. A repetition of windstorm Anatol, which hit Denmark in 1999 would result in a reduction of non-life insurers’ own funds of only one percent as risks are largely ceded to reinsurers (see also Box 4).

28. ATP displays a considerable degree of resilience in the stress test.9 Its individual reserve requirement remains covered by a significant margin. The stress reduces ATP’s profits, which would turn negative in the first year of the projection horizon, and remain flat in the following two years assuming that asset prices would not recover. At the same time, wider spreads and a sharper decline in asset prices relative to those assumed under the market shocks adverse scenario could reduce ATP’s bonus potential (free reserves) to a larger degree.

Interconnectedness and Contagion Analysis

29. MCIs play a central role in the domestic interbank system. The interconnectedness analysis, which is more structural in nature, was conducted with a novel multi-layer contagion model that can distinguish the transmission of shocks across eight different exposure types based on the newly released credit registry database. Focusing initially on the domestic banking system illustrates that MCIs take center stage in the network linking systemic and non-systemic banks through a dense network of covered bond exposures (Figure 21). The full network highlights the strong connections between the Danish banking system and the domestic corporate (in particular, CRE) and household sectors (via loans) and domestic institutional investors, which include ICPFs and investment funds, (via securities). Cross-border exposures are especially strong with the Nordic region and the euro area financial system.

Figure 21.
Figure 21.

Denmark: Topology of the Financial System

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: IMF and Danmarks Nationalbank staff.Notes: Based on September 2019 data. The network graphs in the top panel comprises 21 credit institutions, classified as systemic banks and non-systemic banks as well as mortgage credit institutions (MCIs). The bottom panel includes other individual financial institutions in Denmark and sector-level aggregates of non-financial sectors in Denmark and sector-level aggregates for cross-border exposures. Line thickness is proportional to exposure-to-capital ratio, and in the top panel matches the color of the exposed entity. Node size is proportional to weighted out degree (number of exposures weighted by exposure-to-capital ratio). In other words, thicker lines indicate higher degree of concentration vis-à-vis a counterparty normalized by exposed entity’s capital and larger nodes indicate higher degree of potential vulnerability as measured jointly by the total number of exposures for each node and the strength of those connections. Exposures that are less than 10 and 5 percent of exposed entity’s capital are excluded in top panel and bottom panel, respectively.

30. The analysis revealed that Danish credit institutions are mostly exposed to shocks from within the banking system:

  • MCIs are a key source of outward spillovers and induce the highest levels of contagion losses through unlisted shares (reflecting complex group structures) and covered bond exposures (Figure 22). Contagion is transmitted predominantly through credit losses.

  • Systemic banks, on average, are more vulnerable to inward spillovers owing to their covered bond holdings. More generally, the domestic banking system is susceptible to cross-border financial spillovers from the Nordic region and the euro area (including via interbank loans and deposits). Taken together, given their high contagion and vulnerability scores, the analysis identifies four financial institutions with the ability to amplify spillovers across the financial system.

  • Overall, while losses from unlisted shares occur mostly within group structures, potential contagion from covered bond exposures can be more widespread.

Figure 22.
Figure 22.

Denmark: Contagion Analysis Results

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Sources: IMF and Danmarks Nationalbank staffNotes: Based on September 2019 data. Banks with * indicate systemic banks; NOR represents Nordic Region countries. Contagion index (CI) is the average losses to the core network comprising 21 credit institutions normalized by their capital. For example, the hypothetical default of the most contagious individual entity, MCI3, results in the average losses to the other 20 entities of around 12 percent of their capital. The most vulnerable bank as measured by Vulnerability Index (VI), MC1, incurs average losses of about 4.5 percent of its capital across all independent simulations, following the hypothetical default of each core entity in the network. Systemic Risk Map plots the normalized CI and VI (between 0 and 1) of each entity indicating where the tipping points might be in the network. For example, all the entities in the dark-shaded quadrant are relatively both more contagious and more vulnerable than the rest in the network.

Financial Sector Oversight

A. Macroprudential Policy

31. Denmark’s atypical institutional set up for macroprudential policy remains unchanged since the last FSAP. The macroprudential authority is the Systemic Risk Council (SRC) which is chaired by the chairman of the Board of Governors of the DN. The SRC only has an advisory role and can issue observations, warning, and recommendations with an explicit “comply-or-explain” mechanism. The ultimate decision-making power however lies with the minister of industry, business and financial affairs, which is rare in international comparison. In practice, the minister will need the support of the economic committee to make a decision and hence implicitly the hard powers for macroprudential authority lies with the government.10

32. DN plays an important role in systemic risk monitoring with the SRC providing an enabling environment for coordination on risk assessment and policy formulation. The SRC secretariat, housed in the DN, is responsible for preparing the materials for the SRC’s quarterly discussions.11 While the secretariat has worked on several thematic issues these are seldom published, notably due to resource constraints. The SRC would benefit from more frequent publications on selected issues to enhance communication and create awareness about macroprudential policies and the role of SRC in Denmark. This may require increasing resources devoted to systemic risk monitoring within the DN.

33. The Danish authorities have undertaken several measures to address household vulnerabilities since the 2014 FSAP. These include a mandatory down-payment requirement and other demand side measures (targeting loan origination and amortization) to bolster the resilience of borrowers in the mortgage market including by limiting lending via interest-only and floating rate mortgages to highly indebted households. The active implementation of such policies, in combination with other measures (such as property tax reforms and easing supply constraints), seem to have helped arrest the rapid increase in property prices.

34. After increasing the countercyclical capital buffer (CCyB) to two percent (effective December 2020), the authorities fully released it following the onset of the COVID-19 pandemic. It is important that the credit institutions use the provided flexibility to extend their lending capacity and not to pay additional dividends or conduct share buybacks.

35. Notwithstanding these policy initiatives, some elements of the framework render the system vulnerable to inaction bias. In particular:

  • The legal framework for the SRC prescribes that it should strive for consensus in decision-making. Procedurally, the SRC secretariat is responsible for drafting macroprudential policy proposals that are then discussed in the SRC. However, the secretariat starts working on draft recommendations only after receiving a mandate from the SRC, which often follows a phase of consensus building within SRC meetings.12 While there are merits to consensus building, in its extreme form implies that each member has an implicit veto power. The institutional arrangement should foster consensus building without letting it hold up decision-making. Delayed activation of CCyB and household sector tools despite signs of building vulnerabilities are two examples where consensus building may have limited action.

  • Another reason for inaction bias is the limited powers of the SRC. The SRC does not have hard powers over macroprudential tools. In fact, the MIBFA did not comply with SRC’s recommendation regarding risks related to deferred amortization loans in 2014 and only partially complied with the recommendation targeting similar risks in 2017. This limited ability to act has resulted in inaction bias wherein (i) macroprudential action is either not taken or delayed, and (ii) when action is taken, second-best policy options are chosen in some cases, which internalize political feasibility.

36. Over time, a further tightening of borrower-based measures may be warranted to help address residual risks related to household vulnerabilities (Figure 15). Micro data suggests that households’ NPLs respond non-linearly with LTVs. Relatedly, the mandatory down-payment requirement of five percent (an effective LTV limit of 95 percent) in Denmark is loose when compared to other countries. Further, the macroprudential toolkit to address household sector risk is incomplete because there is no legal basis to introduce binding borrower-based macroprudential measures. Therefore, several demand side measures have been introduced as guidelines under the consumer protection legislation rather than binding macroprudential measures, which may affect both the transparency and the impact of these measure. While the rules implemented in 2018 to limit lending via interest-only and floating-rate mortgages to highly indebted households is a move in the right direction, pockets of vulnerability remain. Further tightening measures should however be data dependent and take into consideration the uncertainty associated with the recovery from the COVID-19 shock.

37. Structural factors creating distortions in the housing market should be addressed. These include: (i) favorable tax treatment of owner occupied housing compared to other saving vehicles; (ii) high mortgage interest deductibility (causing debt bias) alongside tax exemption on capital gains in owner occupied housing; and (iii) complex rental market regulations with rent caps across a significant share of apartment buildings in the major cities, which creates a lack of housing supply. The ministries participation in the SRC should assist in the complementary use of fiscal measures for both fiscal and macroprudential policy.

38. The SRC should closely monitor risks in CRE market and stand ready to act if vulnerabilities intensify. The coverage and quality of data in the CRE sector should be enhanced, including by a centralized collection of market data and more granular information on CRE financing to assess vulnerabilities in the CRE market. Further, if risks in the CRE sector continue to rise in coming years, the authorities should consider taking macroprudential measures, for example, increasing risk weights on CRE exposures or introducing a sectoral systemic risk buffer.

39. SRC’s systemic risk monitoring framework is largely focused on banks and MCIs and can be further enhanced. The SRC member institutions, in particular DN and DFSA, have strong analytical frameworks for systemic risk monitoring. The recent availability of credit registry database and interconnectedness analysis project which has been initiated (jointly with the FSAP team) would help in filling knowledge gaps. However, the monitoring framework can be further enhanced by: (i) more actively covering the nonbank sectors; (ii) developing truly macroprudential stress tests that take into account of macro-financial feedback loops; and (iii) building on the interconnectedness work, particularly given centrality of covered bonds in the system.

40. The macroprudential policy formulation in Denmark would benefit from a more streamlined decision-making process and an expansion of the policy toolkit. In particular:

  • Give the SRC chair the ability, enshrined in law, to make proposals for a recommendation—after due consultation with other SRC members—without the need to strive for consensus. This would limit the consensus building phase before the secretariat starts working on draft proposals. Over time, if inaction bias persists, the SRC could be given hard powers over capital tools under CRD/CRR legislation, that is, it is made the designated authority for macroprudential policy. Borrower-based tools, which have clear distributional implications, can remain with the MIBFA with the SRC having recommendation powers over them with a comply-or-explain mechanism.

  • Introduce national legislation to include borrower-based tools (limits on LTV, DTI, and DSTI) in the policy toolkit. This is essential to enhance legitimacy of macroprudential policy.

  • Over the medium term, introduce a stricter LTV limit (at least 90 percent) to safeguard against large house price shocks.

  • If the uptrend in house prices continues, consider introducing binding income-based limits, such as DTI restrictions for all loans, irrespective of their LTV ratios.

B. Banking and Insurance Regulation and Supervision Prudential Setting

41. The Danish Financial Supervisory Authority (DFSA) has improved standards in its oversight of banking and insurance since the last FSAP. The DFSA’s supervisory approach focuses on traditional financial risks; in particular credit risk in banking and market risks and asset-liability management in insurance. The DFSA benefits from and uses a suite of corrective and enforcement powers, which were further augmented through AML/CFT legislation (that entered into force in January 2020).

42. The DFSA’s operational independence is compromised, both through governance arrangements and through resource constraints. Risks to the industry, including with respect to money laundering, are better understood than they had been previously, though the supervisory skills and resources to mitigate those risks are still being built up as newly hired AML/CFT and insurance inspectors are still being trained. The funding structure, which levies fees on the industry but where the budget is set by the MIBFA (which has a non-voting representative on the Board), does not isolate the DFSA from the potential influence of government or industry. The MIBFA representative should be removed from the DFSA Board and the reasons for the dismissal of a Director General of the DFSA should be clearly stated in law and publicly disclosed.

43. The DFSA would benefit from a further increase in resources. There are concerns that the requirement that the DFSA operate on a “least cost” basis undermines the quality and needed further development of policy, processes, as well as the scope and execution of its tasks, notwithstanding its cadre of dedicated staff.

Banking Supervision

44. The DFSA has made a number of enhancements to its risk based supervisory approach since the last FSAP, acting on recommendations made. For example, the interval of the inspection cycle for sound and well-capitalized medium and smaller banks has been shortened from once every six to four years. A major project has recently been completed to document the DFSA’s business processes and needs to be complemented by a similar project to support consistency of analytical approaches and risk interpretations. Also, enhanced approaches to confirm explicitly the veracity of supervisory data received, as part of standardized reporting schemes, are needed.

45. Nonfinancial risks warrant greater prominence in the DFSA’s supervisory approach. The DFSA must complement its strong credit risk skills with equal rigor in other areas. Sharpening supervision of nonfinancial risks, including entities’ compliance, governance, conduct, compensation practices, and risk culture is necessary.

Insurance Supervision

46. Implementation of the Solvency II Directive—which harmonizes EU insurance regulation—has enhanced insurance supervision and improved the risk culture across the sector. Adoption of the Directive addresses many of the 2014 FSAP recommendations and has raised the level of observance with the Insurance Core Principles.

47. Insurance supervision should be further strengthened by increasing on-site inspection frequency and completing a solid risk assessment framework. Following a 2014 FSAP recommendation, the number of on-site inspections in the life sector has slightly increased, while those in the non-life sector remain too infrequent. The nascent risk assessment for individual companies needs to include non-financial risks, in particular governance-related risks. Two smaller non-life insurers, heavily engaged in cross-border business, failed in 2018 because of issues related to an insufficient level of reserves and an incorrect assessment of assets. Therefore, although a new supervisory standard is being developed which addresses previous gaps in licensing and supervisory monitoring, the supervision of cross-border business should be strengthened.

Financial Integrity

48. Following the 2019 Article IV Consultation, the authorities have completed or initiated a number of reforms, including with respect to AML/CFT supervision. That Consultation included a targeted analysis to evaluate the ability of Denmark’s AML/CFT supervisory framework to mitigate cross-border ML risks. Motivated in part by the Danske Bank case, recent legislation has significantly strengthened the AML/CFT monitoring and enforcement powers of the DFSA—most notably by allowing it to levy administrative fine notices and stiffening the existing penalties for non-compliance with certain AML/CFT obligations. Since June 2019, the DFSA’s AML Division has expanded considerably, thereby enabling it to conduct an increasing number of on-site inspections. In support of its on-site inspection program, the DFSA’s AML Division has developed, but not yet finalized, a new institutional risk assessment model. The authorities comprising the MLF have adopted a new MOU to guide the coordination of domestic AML/CFT activities.

49. The process of reform must proceed apace to ensure the full implementation of the risk-based approach and make effective use of the DFSA’s expanded powers. Ensuring the full implementation of the risk-based approach will require completing the testing and refining of the DFSA’s new AML/CFT risk model, issuing the associated final questionnaires, and using the results to set the annual on-site inspection schedule. In addition, and as a matter of priority, the DFSA should intensify its on-site inspections of higher-risk financial institutions and demonstrate effective use of its new monitoring and enforcement powers, as and when appropriate, in response to violations of AML/CFT requirements.

50. Denmark should continue to strengthen AML/CFT international and domestic cooperation arrangements. Further strengthening international cooperation arrangements will require the Government to consider next-stage options for the integration/consolidation of AML/CFT supervision at the sub-regional or EU levels and pursue the selected option(s). Further strengthening domestic cooperation arrangements, including as between the public and private sectors, will require the MLF to review the recommendations released by Finance Denmark’s AML Task Force that would imply action by the authorities, and advance agreed initiatives.

Systemic Liquidity

51. Covered bond markets—which are key to bank funding—continued to facilitate mortgage financing despite the tightening of financial conditions, though there are important tail risks. Covered bond markets have demonstrated resilience during past episodes of financial turbulence. More recently, after a brief period of more subdued primary market activity in March 2020, Danish covered bond issuers were able to resume new issuances and facilitate the financing of mortgages. In the secondary market, covered bond spreads spiked during March and early April, but recovered quickly thereafter. The high degree of interconnectedness of the financial system—through covered bond holdings—means that ensuring the health of this market under stressed conditions is crucial for financial stability.

52. DN’s standard operational framework is credible and effective. DN has been able to keep the exchange rate stable through adjustments to its policy rate and FX interventions. Money market rates have moved in tandem with the policy rates and the introduction of daily market operations in 2017 has improved further the functioning of the interbank market by reducing the volatility of short-term interest rates.

53. DN promptly provided liquidity support in response to the intensification of the crisis. In particular, DN has launched extraordinary liquidity facilities and reactivated bilateral swap lines with the ECB and the Federal Reserve thereby ensuring counterparties’ access to liquidity in the needed currencies. Although it is too early for a comprehensive assessment, the measures taken by the DN have been accompanied by a stabilization in money markets and an easing of liquidity and financial conditions. DN has continued to further strengthen its capacity to manage liquidity conditions in times of stress. Nonetheless, the current crisis underscores the importance of further refining its operational preparedness in the following areas:

  • Complete the planned refinements to the framework for accepting non-standard collateral (which include credit claims). Increasing automatization for mobilization, eligibility assessment, and pricing of credit claims would significantly improve operational efficiency. In addition, such automatization would ultimately broaden the collateral base for market-wide liquidity support and ELA, given that a larger number of credit claims can be processed expeditiously.

  • Seek greater domestic interagency information sharing and collaboration to enhance the operational preparedness for liquidity support (for example, via joint simulation exercises and horizon scanning).

  • Communicate clearly to key financial institutions the specific information requirements in the context of ELA.

Crisis Management and Financial Safety Nets

54. Since 2014, Denmark’s financial safety net and crisis management frameworks, including bank resolution, have improved significantly. In response to the 2014 FSAP and through transposition of pertinent European Union rules, Denmark has enacted major reforms such as new legislation for resolution and deposit insurance, introduction of a resolution framework for banks and MCIs, designation of two national resolution authorities (DFSA and the Financial Stability Company, FSC), changes to the governance of the deposit insurance system (DIS), and the revival of cross-border cooperation through the Nordic-Baltic Stability Group (NBSG), including a joint crisis simulation 2019. Denmark’s financial safety net rests on sound legal foundations and its resolution strategy for small- and medium-sized banks has been successfully tested in practice.

55. The governance of the resolution authorities, and especially the FSC, should be strengthened by enhancing its operational autonomy. The FSC Board should be able to autonomously execute the FSC’s mandate without interference from the government or the industry. The government should be involved in resolution decisions only when fiscal support is needed. The company’s Board members should serve a term that is disconnected from the political cycle and sufficiently long to ensure the ability to develop pertinent expertise. A formal dismissal procedure should foresee that directors and manager can only be dismissed for certain causes and that a statement of reasons is given for their dismissal. In order to prevent perceived conflicts of interest, rules should prohibit active bankers to serve as FSC Board members.

56. Regarding SIFIs, further progress is needed to ensure the operational readiness to rapidly execute recovery and resolution measures. Notwithstanding ongoing efforts, the resolution planning process for SIFIs should be expedited, in particular the work on the priority areas already identified by the authorities such as operational continuity. More conceptual work is also needed, for example, regarding the potential use of a bridge MCI to ensure continuity of critical mortgage-related functions and for the practical execution of the bail-in tool.

57. The COVID-19 pandemic has underscored the importance of contingency planning. In particular, the authorities should define strategies for liquidity assistance for institutions in resolution. Without such a facility, the resolution framework is missing an important element. An institution in resolution may need liquidity to ensure the continuation of critical functions. The DN should be able to provide liquidity to enable resolution plans to be put into effect, subject to safeguards, to an institution which is considered systemic and viable and whose solvency concerns will be resolved with certainty and within a short time frame. The authorities will have to assess if the Resolution Fund (with back-up funding from the government) is well suited to secure the needed amounts within a short period of time and on a continuous basis.

58. Other aspects of domestic contingency planning and crisis management should be further enhanced. The Coordination Committee for Financial Stability needs to include the FSC as an important pillar of the financial safety net.13 Under the auspices of the Coordination Committee, nationally coordinated crisis management and communication plans should be developed. The authorities should also test their operational readiness with a system-wide financial crisis simulation exercise.

Denmark: Key Policy Measures Taken in Response to the COVID-19 Pandemic

As of June 2020, the Danish authorities have implemented a range of measures to contain the spread of COVID-19 and to support the economy. Containment measures included closure of all borders, prohibition of events with more than 10 people, sending home non-essential public employees, and asking all private businesses to keep employees home when possible. More recently, the authorities announced a careful and gradual lift of some containment measures, while others would remain in place for a few more months.1 Key policy responses to support economic activity and financial stability are summarized below:

Fiscal policies

  • The authorities initially responded to the ongoing crisis by providing discretionary fiscal support of DKK 60 billion (2.6 percent of 2019 GDP). The increased spending will mainly finance additional health care needs and extraordinary budgetary measures to support workers and businesses. Another 6.2 percent of GDP in countercyclical support is expected to come through Denmark’s strong automatic stabilizers— including from weaker tax receipts and higher social benefits. Temporary liquidity measures, including postponement of tax payments and government guarantees, will further support activity. More recently, the fiscal measures were adjusted, providing an additional DKK 30.7 billion in fiscal support (1.3 percent of 2019 GDP) and about DKK 70 billion (3.0 percent of 2019 GDP) in guarantees and liquidity measures. Likewise, a green renovation of public housing (DKK 30.2 billion or 1.3 percent of 2019 GDP) is planned for 2021–16.

Monetary and financial policies

  • Danmarks Nationalbank (DN) announced on March 12 the launch of an “extraordinary lending facility” which was later expanded to a three-month collateralized lending operation. The new lending facility will ensure the banking sector access to liquidity at favorable terms, should the effects of the spread of Coronavirus have an impact on the liquidity situation in the Danish banking sector.

  • The standing swap line with ECB was activated and its size was doubled to EUR 24 billion. It will remain in place as long as needed. DN also reached an agreement with the Federal Reserve to establish a USD 30 billion swap line that will stand for at least 6 months.

  • Although DN increased the policy rate by 15 basis points to –0.6 percent, monetary policy rates remain lower in Denmark than in the euro area. The DN continues to maintain the krone’s tight peg to the euro.

  • The authorities preemptively released the countercyclical capital buffer and canceled planned increases meant to take effect later (March 12).

  • The Danish Financial Supervisory Authority (DFSA) also announced a case by case relaxation of regulation on the liquidity coverage ratio (LCR) requirement. Banks and insurance companies are urged by the DFSA not to pay out dividends or buy back shares (March 30).

1 For details: https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19

Denmark: The Danske Bank Case: A Summary

This box briefly discusses the possible laundering of up to $230 billion in payments through the Estonian branch of Danske Bank from 2007–2015.

• Danske Bank acquired Finnish Sampo Bank in 2007, converting it into a branch of Danske Bank A/S in 2008.

• From 2007–2015, the Danske Bank branch in Estonia serviced a total of approximately 15,000 nonresident customers, both within and outside its International Banking Department.

• Over that time frame, external parties transferred approximately DKK 1,500 billion ($230 billion) to the Estonian branch’s non-resident customers, who then forwarded a similar sum to external recipients.

• Danske Bank relied on global correspondent banks to handle the dollar clearing for these transfers; JP Morgan terminated its correspondent banking relationship with the Estonian branch in 2013, with Bank of America and Deutsche Bank’s U.S. subsidiary following suit in 2015.

• In December 2017, Danske Bank announced that it had been fined DKK 12.5 million ($2 million) by the Danish authorities for violating AML/CFT rules in relation to the monitoring of transactions to and from correspondent banks.

• In September 2018, Danske Bank released a report on the results of an internal investigation which concluded that a large proportion of the transfers described above consisted of suspicious and potentially illegal activities likely related to money laundering and stated that the AML/CFT procedures at its Estonian branch had been “manifestly insufficient and inadequate”.

• In January 2019, the DFSA released a report on its supervision of Danske Bank as regards this case.

• In February 2019, the European Banking Authority’s (EBA’s) Board of Supervisors (BoS) set up a panel to investigate any possible breach of European Union law in connection with the Danish and Estonian financial supervisory authorities’ (DFSA’s and EFSA’s) supervision of Danske Bank and its Estonian branch.

• In April 2019, the EBA BoS, while acknowledging past failings of the DFSA and EFSA’s supervision, rejected the panel’s recommendation with respect to the breach of union law proceeding.

• In October 2019, Danske Bank announced that its Estonian business had entered into liquidation in response to an EFSA order.

Sources: Report on the Danish FSA’s Supervision of Danske Bank as Regards the Estonia Case (DFSA, 2019), Report on the Non-Resident Portfolio at Danske Bank’s Estonian Branch (Bruun & Hjejle, 2018).

Denmark: Key Elements of the Danish Mortgage Finance System

MCIs business activities are limited to the provision of mortgage loans (legally they are not allowed to accept deposits). The loans must be funded by the issuance of covered bonds backed by assets segregated in bankruptcy remote capital centers (which are still on the balance sheet of the MCI), and a residual claim (ranking senior to non-covered bond creditors) on the general balance sheet if the assets of the capital center cannot fully cover the investor’s exposure. A margin over the covered bond cost is charged to cover administrative costs, risk, and profit.

In contrast to other covered bond legal frameworks, all issuers are required to apply a balance principle which serves as a strict asset-liability management mechanism. As a result, a close connection exists between timing and amount of payments from the underlying mortgage loans to the covered bond investors. That is, mortgage loan-related cash flows are passed through to the covered bond investor. The balance principle, in addition to other rules (such as overcollateralization, and stress tests) implies that issuers substantively reduce their exposure to market risks (interest rate, foreign exchange, and prepayment risks), as they are passed on to the covered bond investor. Moreover, refinancing risk has been attenuated by legislation which allows for the extension of a bond’s maturity by one year if a refinancing auction fails or if interest rates have risen by more than five percentage points in the preceding year.

Denmark: Climate Change and Financial Stability in Denmark

Flood-related disasters are one of the main physical risks associated with climate change confronting Denmark. Many Danish cities and large towns are located along the coastline with many buildings situated in low-lying areas. In terms of financial stability, this renders a sizeable share of banking assets prone to flood-induced risks. Estimates by the Danmarks Nationalbank (2019) suggest that although 1½ percent of mortgage assets serving as collateral are currently at risk of flooding, this share could increase to 13 percent. Bearing in mind the uncertainty of such estimates, currently 1–3 percent of SIFIs’ mortgaged assets are at risk of flooding, but for two SIFIs, this estimate could exceed 15 percent reflecting their greater exposure to rising sea levels.

The financial sector has relatively limited exposure to the highest carbon-emitting industries. Credit institutions have generally provided lending to corporate customers in industries with less carbon-intensive production processes (accounting for 23 percent of corporate sector lending). However, transition risks are larger for institutions with large exposures to the agricultural sector (especially relevant for smaller banks) and the energy sector.

Flood Risk and Mortgaged Assets

(Share of systemic group assets, percent)

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Carbon Intensity, Lending, and Investments by Selected Sectors

(Billions of DKK; index)

Citation: IMF Staff Country Reports 2020, 250; 10.5089/9781513552965.002.A001

Source: Danmarks Nationalbank (2019), “Climate Change Can Have a Spillover Effect on Financial Stability, Analysis No. 26 (December).

Appendix I. Banking Sector Stress Testing Matrix (STeM)

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Appendix II. Insurance Sector Stress Testing Matrix (STeM)

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1

Note that more than 50 percent of variable-rate mortgages have fixed-interest-rate periods that are greater than one year.

2

The pandemic has likely aggravated these financial vulnerabilities to varying degrees. For example, highly indebted and/or lower-income households are relatively more susceptible to shocks—a concern that could become more acute amid a protracted unemployment spell. Likewise, several nonfinancial corporate sectors, some of which were highly leveraged before the onset of the crisis, are being severely affected by the pandemic. At the same time, the credit quality of medium-sized banks’ corporate customers is considerably lower relative to SIFIs. Notwithstanding the government support, a possible sharp rise in insolvencies would further add to banking strains.

3

Note that these illustrative COVID scenarios differ from the April 2020 WEO baseline projections (Table 2).

4

Although the three scenarios differ, including with respect to their assumptions on financial conditions and house prices, the same methodology is used across the scenarios to quantify their implications on bank solvency. Note that the “market shocks” scenario, designed before the onset of the COVID-19 pandemic, incorporates a combination of credit, market, and cost of funding shocks. The solvency stress tests use 2020 Q1 capital ratios, which are the latest available data.

5

The analysis also presumes that pre-crisis relationships between macroeconomic and financial variables remain unchanged. The possible amplification of the COVID shocks for banking liquidity or potential system-wide contagion risks have not been assessed, underscoring the uncertainty surrounding the solvency stress test results, including their implications for individual SIFIs.

6

The liquidity stress tests were conducted before the onset of the COVID-19 pandemic.

7

According to the May 2020 DN Financial Stability Report (FSR), systemic banks, in aggregate, could cover their liquidity needs under a severe liquidity stress scenario. The FSR notes that the overall liquidity situation for systemic banks has not been materially affected by the COVID-19 pandemic as of mid-March. Moreover, the median LCR across systemic banks increased to 198 percent in April 2020 from 174 percent at end-2019.

8

These sensitivity tests were also conducted prior to the COVID-19 pandemic.

9

The stress test of ATP was implemented before the COVID-19 outbreak.

10

Economic committee is the formal body where all economic ministries participate.

11

Representatives from the DFSA and economic ministries participate in the secretariat.

12

Since not all members of the SRC have an explicit mandate financial stability, their other, sometimes conflicting, priorities could delay the process and further entrench the inherent inaction bias associated with macroprudential policy whereby the cost of policy actions is sooner and more easily observable than their potential benefits.

13

The Coordination Committee consists of high-level representatives from the MIBFA, MOF, DFSA, and DN and its tasks include coordinating the failure of a SIFI or coordination of financial crisis policy responses.

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Cover IMF Staff Country Reports
Denmark: Financial System Stability Assessment-Press Release; and Statement by the Executive Director for Denmark
Author:
International Monetary Fund. Monetary and Capital Markets Department
Volume/Issue:
Volume 2020: Issue 250
Publisher:
International Monetary Fund
ISBN:
9781513552965
ISSN:
1934-7685
Pages:
79
DOI:
https://doi.org/10.5089/9781513552965.002
Figure 1.

Denmark: Macroeconomic Developments
Figure 2.

Denmark: Monetary Policy, Operations, and FX Markets
Figure 3.

Denmark: Monetary and Financial Conditions
Figure 4.

Denmark: Cross-Sectoral Interconnectedness
Figure 5.

Denmark: Covered Bond Market
Figure 6.

Denmark: Assets and Liabilities of MFIs
Figure 7.

Denmark: Cross-border Holdings of Bank Claims
Figure 8.

Denmark: Comparison of Selected Financial Indicators
Figure 9.

Denmark: Performance Indicators for Financial Institutions
Figure 10.

Denmark: Insurance and Pension Fund Sector
Figure 11.

Denmark: Household-Sector Vulnerabilities
Figure 12.

Denmark: Growth-at-Risk
Figure 13.

Denmark: House Prices at Risk
Figure 14.

Denmark: Housing Finance-Related Vulnerabilities
Figure 15.

Denmark: Debt of Non-financial Corporations (NFCs)
Figure 16.

Denmark: Commercial Real Estate
Figure 17.

Denmark: Pre-COVID Default Risk Analysis: Nonfinancial Corporate Sector
Figure 18.

Denmark: Macroeconomic Scenarios for Stress Testing
Figure 19.

Denmark: Solvency Stress Tests for Banking Groups
Figure 20.

Denmark: Pre-COVID Insurance Stress Test Results
Figure 21.

Denmark: Topology of the Financial System
Figure 22.

Denmark: Contagion Analysis Results

Flood Risk and Mortgaged Assets

(Share of systemic group assets, percent)

Carbon Intensity, Lending, and Investments by Selected Sectors

(Billions of DKK; index)