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Increase of the countercyclical capital buffer rate

Publiceret 26-03-2019
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 1.0 per cent to 1.5 per cent from 30 June 2020.
The Council expects to recommend a further increase of the buffer rate by 0.5 percentage point in the 3rd quarter of 2019 unless the risk build-up in the financial system slows down considerably. The incremental increases follow the Council's strategy to increase the buffer rate gradually.
The Council is ready to recommend a reduction of the buffer rate with immediate effect if 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 countercyclical capital buffer must be of a certain size to make a difference. That is why the build-up of the countercyclical capital buffer must continue before financial imbalances grow too large, making the financial sector vulnerable to negative shocks.

It is the assessment of the Council that risks are still building up in the financial system. Moreover, the conditions for further build-up of risks also exist. The Danish economy is still in an upswing, and the financial conditions are expansionary, although some indicators have slowed down. The Council thus follows its announced strategy to recommend an increase of the buffer rate in the current quarter. Unless the risk build-up in the financial system slows down considerably, the Council is of the opinion that the buffer rate should be built up to 2.5 per cent.

Risk build-up in the financial system

The Danish financial system is highly affected by international market developments. The risk appetite among investors is still notable, and risk perception in the financial markets remains low in a longer perspective, despite more pronounced uncertainty and volatility over the last half year. The risks for the global economy have increased during 2018 and in early 2019 due to heightened uncertainty about Brexit, the trade conflict and geopolitical tensions, among other factors. Market participants thus expect interest rates to remain low for quite some time to come.

Several large countries' fiscal and monetary policy scope has been limited by already high levels of debt and low interest rates. This reduces the scope for mitigating the negative effects which may arise if risks materialise. This emphasises the importance of credit institutions (banks and mortgage credit institutions) being resilient.

The Danish economy is still in an upswing, and asset prices are generally high. Prices have risen for several years in both the residential and the commercial real estate markets, but have flattened since mid-2018. Owner-occupied flats in the Copenhagen area have accounted for the strongest slowdown, but price levels in this segment remain high.

The institutions show signs of higher risk appetite, although overall credit growth is moderate. Driven by intensified competition for customers, several institutions have eased corporate credit standards for a relatively long period. Indeed, corporate credit growth has risen the most over the most recent period, with broadly based growth across institutions and industries.

The long period of low interest rates and expansionary financial conditions, combined with the upswing, provides a basis for further build-up of 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.

The Council's assessment of the buffer rate is based on an overall assessment of financial system developments. 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, including that historical indicators are not necessarily adequate for indicating future developments. Consequently, the Council's recommended buffer rate is based on an overall assessment of the indicators and other relevant information.

The institutions have capital to meet the requirement

There are no Danish institutions that breach their capital requirements as a result of an increase in the countercyclical capital buffer to 1.5 per cent.[2]The higher buffer requirement enters into force 12 months after the Minister has announced an increase.

A 0.5 percentage pointincrease of the buffer rate will add kr. 7 billion to the total regulatory equity requirement for Danish institutions. By comparison, earnings totalled kr. 32 billion in 2018, and the sector's excess capital adequacy totalled kr. 112 billion at end-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-backs. In 2018, the institutions' dividends totalled kr. 17 billion and their share buy-backs totalled kr. 10 billion. Earnings always belong to the shareholders, irrespective of whether they are distributed or retained.

The requirement that the institutions must maintain a countercyclical capital buffer is not a "hard" requirement, meaning that institutions 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 they fail to comply with the combined capital buffer requirement.[3]

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 should therefore be built up before financial imbalances become too large. The aim is for the institutions to be more resilient whenever risks materialise, e.g. in the event of a negative shock to the financial system. In that situation, the buffer can be reduced. 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 Council's strategy is a gradual phasing-in of the buffer . This makes it easier for the institutions to adapt to the new, higher capital requirements e.g. by retaining earnings. The Council thus expects the potential impact on lending by credit institutions to be limited.[4]

The buffer is primarily an instrument for strengthening the resilience of the credit institutions. It cannot be used as an instrument to manage the business cycle, either in an upswing or in a downturn. The buffer must be released if there is a risk of severe tightening of lending to households and firms, not just in an economic slowdown situation.

The countercyclical capital buffer was introduced in international regulation after the financial crisis as part of an extensive set of reforms to make the financial sector more resilient.

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. At end-2018, the Danish institutionshad, in general, sufficient capital to meet the total fully phased-in buffer requirements[5] and a countercyclical capital buffer of 1.5 per cent in Denmark. The countercyclical capital buffer differs from other buffer requirements in that it can be eased 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 the requirement that a bank must have a certain volume of capital and debt instruments that can absorb losses in a crisis situation, known as the MREL.[6] The purpose of the MREL differs from the purpose of the countercyclical capital buffer, cf. also Appendix A.  

The Danish Financial Supervisory Authority's overall assessment is that the phasing-in of the individual MRELs by 2023 will have little impact on the banks' ability to meet a countercyclical capital buffer of 1.5 per cent. The Danish Financial Supervisory Authority expects the small banks to be able to meet their MRELs via their existing capital base as well as retained earnings, while the large institutions will extensively be able to meet the requirement by issuing MREL instruments.

Another future requirement is a minimum leverage ratio requirement for the institutions, expected to be met as from 2021 when new EU regulation enters into force. The countercyclical capital buffer will not increase the leverage ratio requirement. While the buffer is calculated as a ratio of risk-weighted exposures, the leverage ratio is calculated relative to unweighted exposures. It is, in particular, large institutions with large shares of assets with low risk weights which may be affected by the leverage requirement.

 

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

 

Lars Rohde, Chairman of the Systemic Risk Council

 

Statement 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 government will use the three months period stipulated in legislation to consider the recommendation from the Systemic Risk Council."

 

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 http://www.risikoraad.dk/english/.

[2] The institutions must meet the countercyclical capital buffer requirement with Common Equity Tier 1 capital.

[3] 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.

[4] Danish experience shows that the increased capital requirements introduced under the international post-crisis regulation 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.

[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 requirements of eligible liabilities. They are own funds and eligible liabilities which can absorb losses and recapitalise an institution in a resolution situation. The MREL will be phased in by 2023 as a main rule.