Recommendation on activation of the countercyclical capital buffer

Publiceret 20-12-2017
Recommendations

The Systemic Risk Council, the Council, recommends that the Minister for Industry, Business and Financial Affairs set a countercyclical capital buffer rate in Denmark of 0.5 per cent of credit institutions' total risk exposures in Denmark from 31 March 2019.
If the build-up of risk does not change materially, the Council expects to recommend a further increase of the buffer rate by 0.5 percentage points within the next year.

The Council is ready to recommend a reduction of the buffer rate with immediate effect if substantial stress occurs in the financial system and there is a risk of severe tightening of lending to households and firms.

Every quarter, the Systemic Risk Council assesses what is a suitable level for the countercyclical capital buffer. When the Council finds that the rate should be changed, it will publish a recommendation addressed to the Minister for Industry, Business and Financial Affairs. The Minister is responsible for setting the buffer rate in Denmark.

The Minister is required, within a period of three months, to either comply with the recommendation or present a statement explaining why the recommendation has not been complied with.

Explanatory statement

It is the assessment of the Council that risks are building up in the financial system. The Danish economy is in a balanced upswing. Risk perception is very low in the financial markets and liquidity is ample. There are signs of increased risk-taking among certain market participants in their search for yield. At the same time, prices and activity in both the residential and commercial property markets have risen strongly in recent years. Overall lending growth is subdued, but there are signs of credit growth in certain market segments. Furthermore, total lending is at a high level.

The persistently low level of interest rates combined with a strengthening upswing, rising property prices and easing of credit conditions for corporate lending could lead to a rapid rise in credit risk. Build-up of debt from an already high level amplifies risks associated with future credit growth. This indicates that measures should be taken at an early stage of this development.

Overall, the credit institutions are deemed to be well capitalised, and at the current capital level, the vast majority of the institutions would be able to comply with a requirement for a countercyclical capital buffer rate of 0.5 per cent of total risk exposures.[1] According to the legislation, the buffer requirement will enter into force 12 months after the Minister has announced an increase, giving the institutions one year to meet the requirement. Moreover, it is easier for the institutions to increase their capitalisation in periods of economic expansion and positive earnings, e.g. by reducing share buy-backs or dividend payments.

Purpose of the countercyclical capital buffer

The countercyclical capital buffer should contribute to limiting the negative effects on the real economy of a future financial crisis. The buffer is to be built up during periods when risk is increasing in the financial system. Once the buffer has been built up, it can be reduced when risks materialise, e.g. when the financial system is hit by a negative shock. This will release capital for use by the institutions. In so far as the institutions do not use the released capital for absorbing losses, it may be used for new lending or as a contribution to their excess capital adequacy. This helps the credit institutions to maintain a suitable level of lending in periods of stress in the financial system.

The buffer is primarily an instrument for strengthening the resilience of the institutions. The buffer should not be regarded as an instrument for managing business cycles.

The countercyclical capital buffer was introduced in international regulation after the financial crisis as part of a larger set of reforms aiming to make the financial sector more robust. The countercyclical capital buffer differs from the other capital requirements in that it can be eased in times of financial stress, whereas the other requirements apply in both good and bad times.

Activation of the buffer is to ensure that it is built up in time

The Council has revised its method for assessing the buffer rate.[2] The revised method aims at early phasing-in to ensure that the buffer is built up in time, before the financial system is potentially hit by a negative shock that may have implications for financial stability and the real economy. Early phasing-in also increases the possibility of phasing in the buffer gradually. This gives credit institutions more time to make the necessary adjustments, e.g. by retaining earnings.

Information basis for the Council's assessment of the buffer rate

The Council's assessment of the buffer rate is based on a broad information basis. Selected key indicators are to capture the build-up of systemic risk at various stages of financial development. Supplementary indicators and other relevant information are also taken into account to provide a more detailed picture than that painted by the key indicators.  

The early stage of a financial upswing is often characterised by an increasing risk appetite among investors. This is reflected in higher asset prices, including prices of residential and commercial properties, and easier credit standards for households and firms. At a later stage, households and firms may increase their debt in the expectation that property prices will continue to rise. This means that some indicators, such as property prices, signal the build-up of systemic risk earlier than other indicators, e.g. lending to households and firms.

The overall picture emerging from developments in key and supplementary indicators is that risks are building up in the financial system, see Appendix 1.

Other information

The Council also includes other policy initiatives in its considerations regarding the countercyclical buffer rate, including the phasing-in of future requirements. In mid-2017, the vast majority of the institutions had sufficient capital to meet both the buffer requirements[3] that are being phased in until 2019 and a countercyclical capital buffer of 0.5 per cent of total risk exposures. Moreover, the institutions can increase their capitalisation towards 2019 by retaining earnings.

Another future requirement for credit institutions is the MREL, i.e. the minimum requirement for own funds and eligible liabilities.[4] The MREL differs significantly from the countercyclical buffer. The purpose of the MREL is to ensure that institutions can be restructured or resolved without the use of government funds, without such resolution having any substantial negative impact on financial stability. This differs from the purpose of the countercyclical capital buffer, which is to make it easier for the credit institutions to maintain suitable credit extension in periods of stress in the financial system. The countercyclical capital buffer should preferably be built up before such a period begins. The MREL may be met using several types of capital and debt instruments, whereas the buffer requirements can be met using Common Equity Tier 1 capital only.

Future requirements for the institutions also include the Basel Committee's recently published recommendations for adjustment of the capital requirements. According to the Basel Committee, the purpose is to ensure a more uniform calculation of risk-weighted exposures across countries. However, the requirements to be adjusted are of a permanent nature, whereas the countercyclical buffer can be reduced when risks materialise. The Basel Committee envisages full phasing-in of the adjusted requirements by 2027. A lengthy negotiation process between the EU member states will now start in preparation for the implementation in EU legislation.

The Danish Financial Supervisory Authority expects that the banks and mortgage banks have capital targets that are sufficiently high to ensure that they can comply with the capital requirements in the Authority's severe stress scenario. According to the Danish Financial Supervisory Authority, the countercyclical capital buffer should not be taken into account in the institutions' capital targets, as it must be assumed to have been released in a severe stress scenario. Furthermore, the requirement that the banks must maintain a countercyclical capital buffer is not a "hard" requirement. So banks in breach of the requirement will not lose their banking licences. Instead, they will be required to submit a capital conservation plan to the Danish Financial Supervisory Authority, and bonus and dividend payments etc. may be limited if the banks fail to comply with the combined capital buffer requirement.[5]

Foreign credit institutions with risk exposures in Denmark must also comply with the Danish countercyclical buffer requirement. According to EU legislation, the institution-specific countercyclical buffer rate will be calculated as the weighted average of the countercyclical buffer rates applying to the countries in which the institution has exposures.[6] 

The Council's recommendation is in compliance with current legislation.

 

 Lars Rohde, Chairman of the Systemic Risk Council

Statements from the representatives of the ministries on the Council

 

"It follows from the legislation on the Systemic Risk Council that recommendations addressed to the government must include a statement by the representatives of the ministries on the Council. The representatives of the ministries and the Danish Financial Supervisory Authority have no voting rights in relation to recommendations addressed to the government.

The CCyB is one of the capital instruments that was introduced in Danish legislation following the recent financial crisis. The government will now look into the recommendation. In the coming period, the government will assess whether the economic conditions are present for the activation of the buffer, including in light of the work with resolution plans and the latest capital requirements of the Basel Committee. In this context, the government will decide in the next three months whether to activate the buffer."

 

For appendix, see PDF document.

 

[1]    The institutions must meet the countercyclical capital buffer requirement with Common Equity Tier 1 capital. The vast majority of the institutions would also be able to comply with a further increase of the buffer rate by 0.5 percentage points, which is what the Council expects to recommend within the next year.

[2]    The revised method paper can be found at the Council's website www.risikoraad.dk.

[3]    The buffer requirements comprise the capital conservation buffer for all institutions and a SIFI buffer for systemically important financial institutions, SIFIs.

[4]    Eligible liabilities can absorb losses and recapitalise an institution in a resolution situation. As a main rule, the MREL will be phased in towards 2020, cf. the Danish Financial Supervisory Authority's press release of 20 November 2017.

[5]    In addition to the countercyclical capital buffer, the combined capital buffer requirement comprises the capital conservation buffer and the systemic buffer, cf. Executive Order no. 1349 of 12 December 2014 on calculation of the combined buffer requirement, the maximum distributable amount and the content of a capital conservation plan for certain financial enterprises and the Danish Financial Supervisory Authority's memo, "Bestemmelser om kapitalbevaringsplan og opgørelse af det maksimale udlodningsbeløb" (Provisions on a capital conservation plan and calculation of the maximum distributable amount) at the Danish Financial Supervisory Authority's website.

[6]    EU legislation includes mandatory reciprocity of countercyclical buffer rates of up to 2.5 per cent. The same applies to countries with which the EU has concluded agreements in the financial area.