IMF Review of the Financial Sector in Denmark

Gitte Wallin Pedersen, International Relations

The IMF has in recent years stepped up the financial surveillance of its member countries in view of the financial systems' key role in ensuring economic stability. In 2005-06 the IMF reviewed the financial sector in Denmark, providing a good opportunity for an in-depth analysis of the financial systems. Overall, the IMF found the systems to be resilient and well supervised. Notwithstanding the IMF's surveillance, each individual country is responsible for its financial sector.

BACKGROUND TO THE IMF'S FINANCIAL SURVEILLANCE

Since the financial crisis in Asia in 1997-98, the IMF has reviewed the financial sector in more than 100 of its 184 member countries. In 2005-06 it was Denmark's turn to be reviewed under the Financial Sector Assessment Program, FSAP, whereby the IMF conducts detailed review and assessment of virtually every aspect of the financial system, cf. Box 1.

CONTENT OF FSAP	Box 1
FSAP is a review of the financial sector in order to assess the stability of the financial systems. The IMF's point of departure is the macroeconomic conditions, and the performance of stress tests. Stress tests are simulations used to examine how various types of hypothetical macroeconomic shocks affect the key financial institutions and thereby the entire financial system. In addition, it is assessed whether international standards for the financial sector are observed for areas such as banking supervision, insurance supervision or the efficiency of payment systems. There are 12 standards in total, but the IMF and the country in question typically select 4-5 standards for the FSAP review after identifying the aspects of the financial systems that are of special interest to financial stability. Issues that are nearly always selected for review are e.g. the country's banking supervision and its measures to combat money laundering and the financing of terrorism. At the same time, the most important players and the structure of the financial sector are reviewed. This assessment comprises the division of responsibility between the country's national authorities, as well as the market conditions, i.e. whether the financial markets are characterised by a few large or many small financial institutions, or by particular financial instruments. Finally, the IMF undertakes an overall assessment of the stability of the financial systems, recommending concrete reforms and development of the financial sector. The IMF typically conducts FSAP up to an Article IV consultation, which is the core element of the IMF's surveillance of the macroeconomic conditions in the member countries. Article IV consultations take place once a year or every other year. The close link between FSAP and Article IV consultations strengthens the relations between the IMF's assessments of the macroeconomic and financial developments in the member countries.
FSAP is described in more detail in Review of the Financial System in Denmark, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2005, p. 43ff.

The rationale behind FSAP is that the free movement of capital has made the financial sector decisive to economic stability in individual countries, as well as globally, since a financial crisis in one country can have a contagion effect on other countries. Problems in the financial systems can e.g. lead to economic crises and may require substantial expenditure to support financial institutions, which may affect economic stability. If vulnerabilities in the financial sectors of individual countries are identified and managed in time, there is less risk of new crises in the financial markets, also globally.

The IMF's objective for FSAP in the individual countries is thus:

• to identify strengths and vulnerabilities in the financial system,
• to determine how key sources of risk are being managed,
• to ascertain the financial sector's developmental needs, and
• to help prioritise policy responses to meet these challenges.

In the IMF review, everything is questioned in terms of both the structure and functioning of the financial systems. In some countries, the review has disclosed a need for fundamental changes. In countries with well-functioning financial sectors, a review is more likely to lead to fine-tuning and even better systems.

THE FSAP PROCESS IN DENMARK

Around 20 IMF experts participated in the review of the Danish financial sector in order to assess the scope for improvements. A large body of information is available on Danish websites, but the IMF also asked the parties involved to complete a number of questionnaires. In addition, the IMF visited Denmark to meet relevant authorities, organisations and business enterprises.

The IMF visited Denmark seven times over a 12-month period. Four visits were for the sole purpose of FSAP, while the other three had a broader focus on the Danish economy and the relations betweenmacroeconomic and financial issues. In August 2005, the IMF gave an initial presentation for the relevant authorities and organisations in the financial sector. This was followed up in May 2006 with a presentation of the IMF's main conclusions on the financial sector. In the interim period, the authorities, organisations and specific financial institutions had readily attended meetings with and answered questions from the IMF. The FSAP process was resource-consuming for both the IMF and the parties involved in Denmark. For example, almost 90 meetings with the IMF were held during a two-week period in November 2005.

The final FSAP meetings with the IMF were held in June 2006 in connection with the Article IV consultation regarding the Danish economy. FSAP is linked to Article IV consultations in order to strengthen the interrelations between the IMF's assessments of respectively macroeconomic and financial developments. FSAP is an extraordinary review, whereas Article IV consultations are conducted regularly and in Denmark every other year. In the following three months, the IMF completed a number of general reports with specific assessments and recommendations for Denmark. These reports were discussed by the IMF's Executive Board on 29 September 2006 and then published^[1].

Chart 1 illustrates the FSAP process in Denmark.

THE IMF'S ASSESSMENT OF DENMARK

In Denmark, the IMF's starting points were the country's favourable cyclical position, which generally has a positive impact on the performance of the Danish financial sector, and the substantial increase in lending by credit institutions. Keeping in mind the overall objective of financial stability – in Denmark's case maintaining financial stability – the IMF was to assess whether e.g. the authorities are taking adequate measures for the favourable development to continue.

The IMF's main conclusions after FSAP in Denmark illustrate how the IMF links information on the financial sector with the supervisory authorities' opportunities to influence the financial sector and the impact of macroeconomic policy.

The IMF's overall assessment is that Denmark's financial systems are resilient and well supervised. However, it is pointed out that sustaining the strong financial performance and stability requires support from the macroeconomic policy and continued supervisory vigilance, including continuous monitoring and assessment of the economic developments and related risks. It is also stated that any easing of the banks' capital requirements allowing for further expansion of credit should be done gradually, and that the supervisors should make greater use of their regulatory authority to require additional capital as appropriate in individual cases.

As regards the housing market, the IMF finds that the current situation warrants close monitoring and strict application of supervisory regulations. The IMF finds this to be reflected in the letter from the Danish Financial Supervisory Authority (DFSA) to the credit institutions in February 2006, in which the DFSA requests the institutions to include in the calculation of the solvency requirement any risk for the institution concerning loans based on real estate as collateral in the light of e.g. the rising housing prices.^[2] In addition, the IMF finds it important to ensure continued public information to consumers on the risks involved in over-borrowing. The IMF's main recommendations are presented in Box 2.

Two analyses were at the core of the IMF's assessment of Denmark.

1. Performance of a number of stress tests to calculate the impact of hypothetical macroeconomic shocks on the financial sector.^[3]
2. Review of Denmark's compliance with international standards in the financial area. The IMF and Denmark selected four areas of special relevance to the stability of financial systems in Denmark, i.e. banking supervision, insurance, payment systems and securities settlement systems, and anti-money laundering and combating the financing of terrorism.

Stress testing
From the outset, the financial institutions were found to have record-high profits and to appear robust. The banks' average solvency ratio, i.e. regulatory capital as a ratio of risk-weighted assets, was thus 13 per cent at the end of 2005, which is considerably above the statutory capital adequacy requirement of 8 per cent.

The IMF therefore examined the consequences of possible macroeconomic shocks to the balance sheets of the financial institutions. From the outset, the IMF and Danmarks Nationalbank agreed on three extreme macroeconomic scenarios calculated using Danmarks Nationalbank's economic model:

1. Boom-bust in real estate prices and credit. Asset prices fall and credit growth decreases by 14 per cent. The result is an increase in unemployment to 8.8 per cent after three years with zero growth in GDP over three years.
2. External shock to the effective exchange rate stemming from correction of global imbalances, with the Danish krone (and the euro) appreciating by 29 per cent against other currencies. The result is an increase in unemployment to 8.2 per cent after three years and growth in GDP by 2.6 per cent over three years.
3. Boom-bust in real estate prices and credit combined with an interest-rate increase by 250 basis points. The result is an increase in unemployment to 10.1 per cent after three years and a decrease in GDP by 2.9 per cent over three years.

Danmarks Nationalbank, the DFSA and selected Danish banks hereafter contributed to the macroeconomic stress tests since the consequences for the banks' solvency were to be calculated by both the IMF and the banks. The DFSA agreed on participation by the individual banks since the participating banks were to represent a very large proportion of the banking sector and have the capacity to handle the macroeconomic scenarios in their internal systems. The calculations of the IMF and the banks showed approximately the same results, although the banks'
calculations revealed a stronger decrease in the solvency ratio, cf. Tables 1 and 2.

On the basis of the calculations, the IMF concluded that the banks can withstand sizeable shocks, but would experience considerable capital shortfalls if subjected to severe shocks. The mortgage-credit institutes were not included in the analysis, while the insurance companies were assessed using the DFSA's " traffic-light" test. As of the end of 2005, the test flagged only one insurance company as being under the " red light" , which entails close monitoring by the DFSA.

International standards
After a detailed review of Danish legislation, procedures and the structure of the financial systems, the IMF's overall conclusion was that the financial sector in Denmark shows a high degree of compliance with the international standards.

Nonetheless, the IMF identified scope for improvement of the systems and supervision in the individual areas – banking supervision, insurance, payment systems and securities settlement systems, and anti-money laundering and combating the financing of terrorism.^[4] The DFSA is responsible for banking supervision and insurance, while Danmarks Nationalbank holds the primary responsibility for payment systems and securities settlement systems. Furthermore, the DFSA holds the overall responsibility for anti-money laundering and combating the financing of terrorism together with the Public Prosecutor for Serious Economic Crime.

As regards banking supervision and insurance, the IMF found that all principles were fully or broadly observed. Nonetheless, the IMF found that considering the challenges ahead, some further strengthening would be desirable, inter alia with respect to the autonomy and resources of the DFSA and its cross-border supervision. Furthermore, the IMF found that the DFSA should broaden the coverage of " fit-and-proper" requirements from board members to all key staff in order to enable the DFSA to take action against unfit key staff members. The IMF also emphasised the need to strengthen the authorities' capacity for stress testing of the financial institutions.

As regards payment systems and securities settlement systems, the IMF considered the systems to be secure and efficient, but with room for minor improvements. The IMF's review showed high compliance with the standards. The review covered Danmarks Nationalbank's large-value payment system (Kronos), the Danish Bankers Association's system for settlement of retail payments (Sumclearing) and VP Securities Services' securities settlement system. The IMF's recommendations for Kronos comprised further reduction of certain operational risks and further documentation of Kronos' efficiency. As regards securities settlement, the IMF among other things called for consideration of the benefits and drawbacks of introducing a central counterparty in the settlement of transactions. The IMF's recommendations for the Sumclearing included restructuring of certain elements of the settlement and further strengthening of oversight. Danmarks Nationalbank is following up on the IMF's recommendations.

In the area of anti-money laundering and combating the financing of terrorism, the IMF found that Denmark has a solid framework for anti-money laundering and combating the financing of terrorism. However, in certain areas the assessment is that Denmark does not fully comply with the international standards. This should be viewed against the background of the entry into force of a new, very extensive Act on 1 March 2006, i.e. during the IMF visit. The IMF was thus not able to assess whether this Act would be implemented effectively. Furthermore, the Act does not cover the Faroe Islands and Greenland, which influenced some of the IMF's assessments.

With respect to all the standards reviewed, it is up to the relevant Danish authorities to decide on the response to the IMF's specific recommendations. The Danish authorities have generally been very responsive to the IMF's recommendations, and in many areas the recommendations are being implemented in order to improve the already well-functioning financial systems. The authorities' responses to the IMF's recommendations are summarised in Box 3.^[5]

Just as FSAP was concluded with an Article IV consultation, the IMF is expected to follow up on Denmark's response to the recommendations in future Article IV consultations. More detailed updates of FSAP and the international standards typically take place after five years or more.

However, the IMF and the individual member country can agree on a review of specific standards outside FSAP. In many countries the IMF has reviewed the standards concerning e.g. statistics^[6] or fiscal transparency^[7] outside the framework of FSAP.

IMPACT OF FSAP ON FINANCIAL STABILITY

The Independent Evaluation Office (IEO), established by the IMF, has examined whether the IMF's extended financial surveillance has had any impact. In addition to a thorough review of the IMF's reports and procedures, the IEO has, among other things, conducted a questionnaire survey in countries that have been subject to FSAP. 45 countries replied, and the IEO furthermore conducted in-depth reviews of 25 countries.^{[8] [9]}

The IEO's surveys show that FSAP promotes internal dialogue in the individual countries' administrations, and that many countries regard FSAP as instrumental in raising some " taboo" issues. Virtually all the countries consider it vital to the value of FSAP that the assessment of the financial sector is independent and external. The IEO finds that the impact of FSAP has been greatest in countries whose governments were already committed to reform of the financial sector, either for internal reasons or reflecting strong external considerations, such as EU membership. Approximately 50 per cent of the countries find that FSAP has strengthened their strategic view on development of the financial sector.

Both the IEO and the respondent countries find that the quality of FSAP is very high. This is also Denmark's experience. Just under half of the 45 countries even find that FSAP has provided new analytical insight into the financial systems, and areas such as stress testing and review of international standards are considered particularly important.

Changes in key policies and institutions cannot necessarily be attributed directly to FSAP, but many countries emphasised two particular contributions from FSAP. Firstly, FSAP was found to entail a new approach to risk assessment, and many governments began to publish financial stability reports or develop stress tests after FSAP. Secondly, quite a few countries stated that the credibility of planned reforms was enhanced as a result of the independent expert advice. Approximately 70 per cent of the countries found that FSAP had influenced the prioritisation of reforms, and just as many believed that FSAP contributed to changes in the financial sector, cf. Chart 2.

FSAP is widely supported since approximately 90 per cent of the countries reply that they implemented some or all of the IMF's recommendations. This high degree of implementation is by and large confirmed by the IMF's FSAP team leaders. Furthermore, FSAP appears to answer the purpose since almost 40 per cent of the countries believe that vulnerabilities in the financial sector have actually been reduced since the completion of FSAP.

The countries' positive responses are probably part of the reason why approximately three quarters of the IMF's 184 member countries have volunteered for an FSAP review. Nearly all the European countries have participated in FSAP, cf. Chart 3.

The IMF also seeks to apply some pressure to the member countries to encourage them to sign up for an FSAP, even though FSAP is resource-consuming and the IMF can conduct 15-20 FSAP reviews per year at the most. In this connection, the IMF gives priority to countries of great systemic importance to the international financial markets because a crisis in such countries can easily spread to other countries. The IEO has estimated that 20-25 per cent of these countries have not yet participated in FSAP. The countries include the USA, China and most emerging
market economies in Asia. In the IMF, they are regularly encouraged to participate in FSAP.

LITERATURE

The IMF's overall reports on the Danish economy and FSAP are available at Danmarks Nationalbank's website:

The International Monetary Fund (October 2006), Denmark: 2006 Article IV Consultation – Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for Denmark www.nationalbanken.dk.

The International Monetary Fund (October 2006), Denmark: Financial System Stability Assessment, including Reports on Observance of Standards and Codes on the following topics, Banking Supervision, Insurance Supervision, Systematically Important Payment Systems, and Anti-Money Laundering and Combating the Financing of Terrorism www.nationalbanken.dk.

The IMF's general documents concerning FSAP and published country reports are available at the IMF's website. Special reference is made to the following documents:

The International Monetary Fund (29 June 2006), Standards and Codes – Implementing the Fund’s Medium-Term Strategy and the Recommendations of the 2005 Review of the Initiative www.imf.org.

Independent Evaluation Office (IEO) (5 January 2006), Report on the Evaluation of the Financial Sector Assessment Program www.imf.org/ieo.

The International Monetary Fund and the World Bank (29 September 2005), Financial Sector Assessment – A Handbook www.imf.org.

The International Monetary Fund and the World Bank (22 February 2005), Financial Sector Assessment Program – Review, Lessons, and Issues Going Forward www.imf.org.

The International Monetary Fund and the World Bank (22 February 2005), Financial Sector Assessment Program – Background Paper www.imf.org.

The International Monetary Fund and the World Bank (24 February 2003), Analytical Tools of the FSAP ww.imf.org.