Overview

EXECUTIVE SUMMARY The Danish authorities have taken important steps in recent years to improve financial system resilience. Financial regulation and supervision have been strengthened. A new bank resolution framework that includes bail-in of creditors has been adopted and deployed to resolve small and medium-sized banks. An institutional framework for macroprudential policy has also been adopted. Recent legislation requires maturity extension of covered bonds in stress situations, with the aim of reducing refinancing risk in the mortgage finance system. Although stress tests suggest that financial stability risks are contained, the financial system s large size and interconnectedness call for additional measures to further strengthen resilience. In a severe stress scenario, solvency levels at large banks and mortgage credit institutions (MCIs) remain well above regulatory requirements, owing to high current capital ratios. Stress tests also suggest that concentration risk and extreme increases in covered bond spreads would be manageable. However, this analysis cannot fully capture second-round and non-linear effects, and so may underestimate contagion risks that are material in light of the large size and interconnectedness of balance sheets in Denmark. For this reason, staff recommends the measures described below to further enhance systemic resilience. Given that covered bonds backed by mortgage loans are at the heart of the financial system, risks in mortgage finance should be reduced. The mortgage finance system has a long history of good performance based on important strengths, including a balance principle that limits most non-credit risks. However, the rapid growth of adjustable-rate and interest-only (IO) mortgage loans have increased the share of long-term loans funded by short-term covered bonds (refinancing risk), increased the risk of payment difficulties when interest rates rise (credit risk), and reduced resilience to house price declines. It would be advisable to use regulatory policies to encourage longer bond maturities, ensure that eventual interest-rate increases are better reflected in loan pricing and approvals, and increase buffers in loans with interest-only periods, e.g. by reducing the loan-to-value (LTV) ceiling. The proposed prudential limits on MCIs higher-risk activities are welcome. Prudential supervision is generally sound, but there is scope for further improvement. The intensity of the risk-based approach and the early and firm enforcement policy are areas of strength. However, additional resources are needed to increase the frequency of onsite inspections, including for AML/CFT supervision, and the operational independence of the Danish Financial Supervisory Authority (DFSA) should be ensured. In banking supervision, the information on operational and market risk that is reported routinely should be broadened, and systemic review of Pillar III disclosures should be implemented. In insurance supervision, a minimum solvency level should be established, and assessments of companies governance and management as well as the supervision of market conduct, fraud, and AML/CFT should be enhanced.

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