Increase of the countercyclical capital buffer rate

Publiceret 25-09-2018
Recommendations

The Systemic Risk Council, the Council, recommends that the Minister for Industry, Business and Financial Affairs increase the countercyclical capital buffer rate in Denmark from 0.5 per cent to 1 per cent from 30 September 2019.

The Council expects to recommend an increase of the buffer rate by 0.5 percentage point in the 1st quarter of 2019 unless the risk build-up in the financial system slows down considerably. The Council's strategy is to increase the buffer rate gradually.

recommendation

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 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.

The buffer should be built up before the tide turns

The Council finds it important to build up the countercyclical capital buffer in Denmark before financial imbalances grow large, making the financial sector vulnerable to negative shocks. Consequently, the buffer should be built up in periods like the current period with an economic upswing and substantial profits for credit institutions overall. This makes it easier for institutions to increase their capitalisation by retaining earnings.

Risks are still building up in the financial system

It is the assessment of the Council that risks are still building up in the financial system. The Danish financial system is highly affected by international market developments. Risk perception continues to be very low in the financial markets and the risk appetite among investors is still notable. The risks for the global economy have increased in 2018 due to, inter alia, the trade conflict and geopolitical tensions. In addition, several large countries' fiscal and monetary policy scope is limited by already high levels of debt and low interest rates. This reduces the possibilities of mitigating the potential adverse effects if risks materialise.

The Danish economy is in a solid upswing, and asset prices are generally high. Prices and activity in both the residential and commercial property markets have risen strongly in recent years. The rate of price increase for owner-occupied flats in the Copenhagen area has been declining in 2018, but price levels remain high.

There are signs of increasing risks in lending by credit institutions, although overall credit growth is modest. In general, the institutions have built up considerable capacity for increasing lending, and credit standards have been eased for corporate customers for a prolonged period. Increased competition for customers may lead to lower credit quality. The modest growth in total lending covers substantial differences across institutions, regions and industries.

The persistently low level of interest rates combined with the upswing, rising asset prices and intensified competition for in particular corporate customers may lead to a rapid rise in credit risk. Risks are amplified by the already high level of total lending. Hence, the pace of lending growth should not be as strong as in the pre-crisis years before the buffer is built up.

Broad information basis for the Council's assessment

The Council's assessment of the buffer rate is based on an overall assessment of developments in the financial system. The Council's information basis includes a number of indicators providing information on, inter alia, risk perception in the financial markets, developments in the property market and credit developments, see the elaboration in Appendix A.[1] There is no mechanical relationship between the indicators and the buffer rate, given the uncertainty of measuring systemic risk developments. Consequently, the Council's recommended buffer rate is based on an overall assessment of the individual indicators and other relevant information.

Most credit institutions have enough capital to meet the requirement

Overall, the credit institutions are found 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 1 per cent.[2] The buffer requirement will not enter into force until 12 months after the Minister's announcement of an increase. This gives the institutions one year to meet the requirement. Gradual phasing-in of the buffer gives credit institutions more time to make the necessary adjustments. The Council thus expects the potential impact on lending by credit institutions to be limited.[3]

A 0.5 per cent increase of the buffer rate will add kr. 7 billion to the total regulatory equity requirement for Danish credit institutions. In comparison, earnings amounted to kr. 43 billion in 2017, and the sector's excess capital adequacy totalled kr. 129 billion in mid-2018. As a result of the higher requirement, a larger share of the institutions' balance sheets needs to be financed by equity. This can be achieved by retaining earnings rather than distributing earnings as dividends or share buy-back. Irrespective of whether earnings are distributed or retained, they belong to the shareholders.

The buffer is to reinforce the institutions' resilience

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 risks are 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. It 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. Several countries have activated the buffer, cf. Chart 1. Each country has its own method for assessing the buffer rate, and the level set depends on the country-specific financial development. On a broad information basis several countries have decided to activate and raise the buffer rate even in times of limited lending growth. Some of these countries are Ireland, Iceland and the UK. Other countries with modest credit growth have not yet activated the buffer. In May 2018, the IMF advised that the buffer rate in Denmark should be increased if risks would continue to build up.[4]

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Other capital requirements

The Council also includes other policy initiatives in its considerations regarding the countercyclical buffer rate, including the phasing-in of future requirements. In mid-2018, the vast majority of the Danish institutions had sufficient capital to meet both the buffer requirements[5] that are being phased in until 2019 and a countercyclical capital buffer of 1 per cent in Denmark. Moreover, the institutions can increase their capitalisation towards 2019 by retaining earnings.

The countercyclical capital buffer differs from the other buffer requirements as it can be reduced in times of financial stress, whereas the other requirements apply in both good and bad times.

Besides the buffer requirements, the institutions will be subject to other forthcoming requirements, including MREL.[6] The purpose of the MREL, inter alia, differs from the purpose of the countercyclical capital buffer, cf. Appendix A.

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 also be limited if the banks fail to comply with the combined capital buffer requirement.[7]

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

"Legislation regarding the Systemic Risk Council stipulates that recommendations addressed to the government must include a statement from the representatives of the ministries on the Council. Neither the representatives of the ministries nor the Danish Financial Supervisory Authority have the right to vote on recommendations addressed to the government.

The Danish economy is strong, employment is record-high and house prices are rising. Credit growth at national level remains moderate, but somewhat higher in Copenhagen and Aarhus where house prices are high. According to experience, credit growth responds with a certain lag to rising house prices. The principal aim of the buffer is that it should be possible to reduce it when the business cycle reverses, in order to support lending and promote a more stable development in e.g. employment and families' disposable incomes. That is why the government relies on building up the countercyclical buffer in times like the current period with strong economic development and before large financial imbalances appear. In addition, it takes 12 months from the announcement of the buffer until it enters into force. The government follows the recommendation to increase the buffer from 0.5 per cent to 1 per cent."

 

For an elaboration on the Council's information basis, see the appendix in the recommendation

 

[1]   See also the Council's buffer assessment method at the Council's website www.risikoraad.dk.

[2]   The institutions must meet the countercyclical capital buffer requirement with Common Equity Tier 1 capital. The vast majority of them would also be able to comply with a 0.5 percentage point increase of the buffer rate, which the Council expects to recommend in the 1st quarter of 2019.

[3]   Danish experience shows that the increased capital requirements, introduced in the international regulation after the financial crisis, have not resulted in declining lending, cf. Brian Liltoft Andreasen and Pia Mølgaard, Capital requirements for banks – myths and facts, Danmarks Nationalbank Analysis, No. 8, June 2018.

[4]   See IMF, Denmark: Concluding Statement for the 2018 Article IV Consultation, May 2018.

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

[6]   MREL stands for minimum requirement for own funds and eligible liabilities. Own funds and eligible liabilities can absorb losses and recapitalise an institution in a resolution situation. As a main rule, the MREL will be phased in towards 2022, cf. the Danish Financial Supervisory Authority's press release of 30 October 2017.

[7]   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.