Framework Conditions for the Financial System

Changes in the framework conditions for the financial system in Denmark have primarily been driven by the development towards further harmonisation of regulation within the EU. Internationalisation and realisation of the EU's single financial market have paved the way for more efficient financial markets. This process makes great demands of all parties involved in terms of handling considerable structural adjustments. It is important to the stability of the financial system that both the financial sector and the authorities responsible deploy the necessary resources. Particularly the introduction of new capital-adequacy rules and new rules in the securities area will continue to require substantial resources. This chapter describes the changes in the framework conditions for the financial system that are assessed to have a significant impact on financial stability in Denmark.

FINANCIAL STABILITY AND THE FRAMEWORK FOR THE FINANCIAL SYSTEM

The framework for the financial system is of importance to financial stability. Regulatory amendments may affect the financial sector and the incentive to maintain stable development in the short and long term. The framework for the financial sector is typically adjusted on the basis of initiatives from the authorities or the financial sector.

Interaction between the sector and the authorities
The regulatory development in the financial sector can be seen as an iterative process, the driving forces being new requirements within the sector, as well as other considerations taken by the authorities, e.g. in order to avoid crises, realise visions or safeguard consumer interests.

In an ideal world, regulatory adjustments would take place steadily over time, in step with changing preconditions. In the actual world, the process tends to be far less gradual, since in many cases regulatory initiatives are not being implemented until a need has already materialised, and because it may take some time to reach agreement, particularly on far-reaching international rule sets. Consequently, regulation can be outdated in some periods, and a great many changes may be seen in the sector within a short interval, when new regulation is introduced. In both cases, there may be consequences for financial stability.

The introduction of the Lamfalussy procedure in 2001 exemplifies the issue. The procedure was aimed at speeding up decision-making in the EU since the authorities had realised that the EU was no longer able to implement the necessary common regulation sufficiently rapidly to keep up with developments in the financial sector.

The EU's regulation of the securities markets reflects a wish to influence development via regulation in order to create a well-functioning single securities market to the benefit of both borrowers and investors.

Amendment of the capital-adequacy rules has been driven by market developments over a prolonged period of time. When the current rules, Basel I, were introduced in 1988, they could be seen as the authorities' reaction to the banking crisis in the 1980s, when a large number of banks were struggling, as well as the burgeoning internationalisation. The new capital-adequacy rules, Basel II, reflect the sector's subsequent development in terms of methods to manage credit risk. At the same time, consolidation within the financial sector has led to the formation of considerably larger financial entities, many of which operate across national borders. Consequently, there has been a call for regulation that is to a greater extent based on the differences between the credit institutions, and for the supervisory focus to be adjusted to system supervision, dialogue with credit institutions and international supervisory cooperation, rather than more traditional reviews of the credit institutions' exposures.

With the realisation of the single financial market within the EU, Danish market participants and supervisory authorities must, individually and jointly, operate at the EU level in order to influence the framework conditions for the financial sector. This involves e.g. the European supervisory committees: the Committee of European Banking Supervisors, CEBS (banking institutions); the Committee of European Securities Regulators, CESR (securities markets); and the Committee of European Insurance and Occupational Pensions Supervisors, CEIOPS (insurance). ^[1]

THE SINGLE FINANCIAL MARKET

In May 2005, the European Commission (hereinafter the Commission) published a report on the follow-up of the EU's Financial Services Action Plan, FSAP. A main conclusion of the report is that there is only a limited need for new EU regulation in the financial area, and that attention should rather be turned to effective implementation and application of the initiatives introduced under FSAP. Looking ahead, the report calls for better regulation in preference to more regulation. Another main conclusion is that while FSAP was primarily aimed at the wholesale markets, future initiatives should predominantly be aimed at the retail market, where there are substantial challenges in terms of realising the single financial market in the EU. Initially the Commission has given priority to initiatives relating to investment associations and mortgage credit. In each of these areas, a report was prepared in 2005.

CREDIT INSTITUTIONS

The EU directives to implement Basel II
Towards the end of 2005, the Council and the European Parliament reached agreement on the final wording of the directives on new capital-adequacy rules, the implementation of Basel II. This was an important step towards a more up-to-date rule set whereby the capital requirements better reflect the risks incurred by each individual credit institution, and the credit institutions are encouraged to optimise risk management.^[2] On 29 March 2006, the Danish government presented a bill to transpose the new directives into Danish legislation. The new act will enter into force on 1 January 2007. Much of the implementation in Denmark will be effected via executive orders.

For credit institutions that prefer internal approaches to calculating credit risk or operational risk, the directive operates with a 3-year transitional period during which limits for easing the capital requirements are defined. However, the large majority of Danish credit institutions will opt for the standardised approach, in which case the directive does not envisage a similar transitional arrangement. ^[3]

The following comment on the issue is included in the consultation memorandum from the Minister for Economic and Business Affairs to the Trade and Industry Committee of the Folketing (Parliament):

"The Danish Financial Supervisory Authority has estimated the impact of the new rules for companies applying the standardised approach for credit risk and the basic indicator approach for operational risk. The expectation is that the new solvency rules will, by and large, be neutral in relation to the existing rules for most of the companies that apply the simplest approaches. It is expected that the reduced requirements in relation to credit risk will be set off by the new requirements in respect of operational risk. However, it cannot be ruled out that a few companies will achieve substantial reductions.

No transitional arrangements are thus proposed for companies applying the standardised approach; a general transitional arrangement in Denmark would constitute an administrative burden for the majority of companies, since for a period they would have to report solvency calculations on the basis of two sets of rules. The general supervision of financial enterprises takes account of situations where a company achieves substantial reduction of its solvency requirement. In such situations it will be possible to impose higher individual solvency requirements on the company in question pursuant to section 124(5) of the Act, if the risk profile of the company no longer matches its capital base."

The EU is currently detailing the procedures for approval of applications from cross-border groups to apply the more advanced approaches to calculation of capital requirements. Approval will be granted on the basis of close cooperation between the supervisory authority in the parent company's home country and the supervisory authorities in member states where it has subsidiaries. Ultimately, the decision will lie with the supervisory authority in the parent company's home country.

Covered bonds
The new capital-adequacy rules include provisions for covered bonds, i.e. specially collateralised bonds issued by credit institutions. For investors subject to the EU's capital-adequacy rules, investment in covered bonds will carry a smaller capital requirement than investment in ordinary bond issues from credit institutions. On the other hand, the capital-adequacy rules impose special collateral requirements that the banking institutions as issuers of covered bonds will find it relatively easier to meet, while this will be considerably more difficult for mortgage-credit institutes, unless they reduce their loan limits. This may shift the competitive balance between the banking institutions and the mortgage-credit institutes.

The best basis for competition is achieved by giving both banking institutions and mortgage-credit institutes a legislative framework for issuing covered bonds, so that there are many providers of home financing – including large providers. In this context it is important that the future statutory basis creates a framework for secure and transparent home financing on capital-market terms for the individual homeowner.

IFRS
On 1 January 2005, the EU's Regulation on International Accounting Standards entered into force, under which all listed undertakings, including listed credit institutions, must present their consolidated financial statements in accordance with the International Financial Reporting Standards, IFRS, issued by the International Accounting Standards Board (IASB). Other credit institutions may present their financial statements either in accordance with IFRS or in accordance with the national accounting standards, which are compatible with IFRS, but which do not provide the same options.

In connection with the EU's procedure to approve the International Financial Reporting Standards, it was not possible to reach agreement on the accounting standard IAS 39, concerning recognition and measurement of financial instruments. Consequently, a reduced version of IAS 39 was initially adopted, which did not permit the application of the fair-value option to financial commitments. Subsequently, IAS 39 was revised by IASB, and in 2005 it was approved by the Commission. The revised IAS 39 resolves the special issues faced by the Danish mortgage-credit sector and provides the required opportunity to assess both mortgage-credit lending and issued mortgage-credit bonds at fair value.

IASB revises its international accounting standards and issues new standards on an ongoing basis. International efforts are directed at harmonising IFRS and US GAAP (US Generally Accepted Accounting Principles) with the aim of making the two standards fully compatible as soon as this is feasible. New or revised IFRS standards must be approved by the Commission before they apply in the EU.

New rules for current profits and core capital
As a new element, banking institutions and mortgage-credit institutes, among others, will in future be able to include the current profit for the year less expected dividend and reserves in their core capital when calculating their solvency ratio.

In this respect, the Danish rules are transposed into the EU's minimum rules. In future the profit for the year can be included in the core capital before the company in general meeting has approved the annual report and the distribution of profits.

The background to this amendment is that the new International Financial Reporting Standards, IFRS, allow for several value adjustments via own funds, and the amendment entails that the calculation of core capital in an annual report includes the profit for the year excluding dividend and reserves for all reporting years. Under the Danish Financial Business Act, the current loss for the year must be deducted from the core capital. The amendment thus achieves more symmetrical treatment of current losses and profits.

SECURITIES MARKETS

MiFID
The MiFID directive^[4] is the key directive for further development of the single European securities market. The very extensive work relating to the technical implementation measures that is still ongoing in the EU has led to postponement of the deadline for the directive's coming into force. The directive is expected to have been finally transposed into Danish legislation by the end of 2006, and the work in this respect is conducted in parallel with the design of the technical implementation measures. This impedes the task of national implementation.

A core issue in relation to price formation and the efficiency of securities trading is market transparency. Different types of securities require different market structures, including various types of market transparency, in order to be traded efficiently. The point of departure of the MiFID directive is that the new transparency rules should only be applied to trading in equities. However, the member states may apply the rules to other securities. When assessing whether there is a need to apply the new rules on pre-trade and post-trade information (transparency rules) to other securities, it is relevant to consider whether the market itself is able to bring about sufficient transparency. If that is the case, there is in principle no need for special national legislation. Not later than two years after the directive has entered into force, the Commission must prepare a report on the need for rules on pre-trade and post-trade information for other securities than equities.

Supervisory initiatives in the Nordic securities market
The acquisition of the Copenhagen Stock Exchange A/S by OMX AB in 2005 resulted in the new Swedish company OMX Group, which e.g. owns the stock exchanges in Copenhagen, Stockholm, Helsinki, Tallinn, Riga and Vilnius. The Copenhagen Stock Exchange is still domiciled in Denmark and subject to Danish regulation and supervision. Likewise, the Stockholm Stock Exchange is Swedish and subject to Swedish supervision, and the Helsinki Stock Exchange is Finnish and subject to Finnish supervision. In 2005, the supervisory authorities in Denmark, Sweden and Finland concluded a Memorandum of Understanding (MoU) on supervision of the OMX Group. The objective of the MoU is to lay down the framework for supervisory cooperation. Well-functioning international supervisory cooperation is a prerequisite for maintaining stability in the securities markets in connection with cross-border consolidation of trading places, including avoidance of regulatory and supervisory arbitrage.

PAYMENT AND SETTLEMENT SYSTEMS

Danmarks Nationalbank's oversight of payment systems
Danmarks Nationalbank oversees systemically important payment system and securities settlement infrastructures in Denmark. Until now, oversight has been based solely on the Danmarks Nationalbank Act, under which Danmarks Nationalbank has an obligation to maintain a safe and secure currency system, and to facilitate and regulate the traffic in money. For Danmarks Nationalbank this entails oversight with a view to contributing to secure and efficient payment and securities settlement systems, thereby minimising the risk that systemic problems jeopardise financial stability.

In order to distinguish more clearly between the tasks of Danmarks Nationalbank and the Danish Financial Supervisory Authority in relation to systemically important payment systems, as of 1 March 2006 Danmarks Nationalbank's responsibility for oversight was incorporated in the Danish Securities Trading Act.

In connection with this amendment, Danmarks Nationalbank has also taken over responsibility for registering systemically important payment systems under section 57a of the Act. Such registration entails that the system is comprised by the pan-European protection of settlement via such systems, as stipulated in the Settlement Finality Directive.^[5]

ESCB-CESR standards
International standards for payment and securities settlement systems are subject to ongoing development in various international fora.^[6] Danmarks Nationalbank applies these standards in its oversight of Kronos, the Sumclearing and VP settlement.

In September 2004, ESCB-CESR^[7] published new European standards for securities settlement systems, Standards for Securities Clearing and Settlement in the European Union. The new standards will tighten the existing requirements concerning e.g. contingency planning. In order to ensure uniform implementation, ESCB-CESR has subsequently been preparing assessment guidelines for the standards. In October 2005 this work was suspended, however, pending the Commission's expected initiative in this area. Consequently, the ESCB has decided to update the existing user standards from 1998 for central securities depositories handling collateralisation in connection with the extension of credit by the Eurosystem. The Danish central securities depository, VP Securities Services, must comply with these user standards since collateral for euro-denominated credit from Danmarks Nationalbank is registered with VP.

EU directive on payment services
On 1 December 2005, the Commission tabled a proposal for an EU directive on payment services (New Legal Framework). The objective is to create a legal framework for a single market for customer-to-customer payments (retail payments) by harmonising the existing, very diverse national rules. In addition, the directive is to support the European banking sector's current work to establish the infrastructure for a single retail payment area in euro (Single Euro Payments Area).

The Commission proposes introducing a new type of financial institution in EU legislation, viz. payment institutions, which would obtain European passports. Payment institutions would have access to providing all types of payment services that are not related to receiving deposits and issuing e-money. Under the Commission's proposal, these new institutions would have to obtain the approval of a national supervisory authority, but would not be subject to capital requirements, as is the case for credit and e-money institutions. The Council and the European Parliament are expected to finalise the Commission's proposed directive during 2006.

[1] For further information on the three committees and their work, see their respective websites: www.c-ebs.org, www.cesr-eu.org and www.ceiops.org.

[2] The chapter on the use of advanced methods for calculation of capital requirements under Basel II illustrates some of the options available under the provisions of the new directives for credit institutions to calculate their own capital requirements.

[3] See Lisbeth Borup and Dorte Kurek, Proposal for a Directive on New Capital-Adequacy Rules ( Basel II), Danmarks Nationalbank, Monetary Review, 1st Quarter 2005.

[4] Directive on Markets in Financial Instruments, adopted in 2004 by the Council and the European Parliament.

[5] See Danmarks Nationalbank, Payment Systems in Denmark, 2005.

[6] For a description of international standards for payment and securities settlement systems, reference is made to Danmarks Nationalbank, Payment Systems in Denmark, 2005.

[7] ESCB is the European System of Central Banks. CESR (Committee of European Securities Regulators) is the EU member states' committee for supervision of securities markets.