Framework Conditions for the Financial System

The Lamfalussy procedure
The Lamfalussy procedure was originally introduced within the securities area to speed up the legislative process in the EU. To briefly outline the procedure, the European Parliament and the Council, level 1, jointly adopt the overall framework regulation, while more technical provisions are laid down in legal acts issued by the European Commission following consultation with a special committee of member state representatives, i.e. level 2. Level 3 comprises close cooperation between the member states' supervisory authorities, while level 4 is enforcement of the provisions by the European Commission.

It has now been decided to extend the Lamfalussy procedure to the EU's work on banking and insurance. Consequently, level 2 and 3 committees have been established in these areas.

The level 3 committees, which act as cooperation bodies for the European supervisory authorities^[3], play important roles in relation to advising on implementation provisions (level 2 regulation) and as forums for coordination/alignment of supervisory practices between the member states. In an integrated single market with national supervisory powers, it is important to establish a well-functioning framework for cooperation and exchange of information between supervisory authorities.

With the implementation of the single financial market in the EU, more regulation and supervisory practices will be laid down by the EU. Consequently, Danish market participants and supervisory authorities must, individually and jointly, exert influence at EU level in order to put their stamp on the framework conditions. It takes considerable resources to monitor and influence the processes on an ongoing basis.

Like the recommendations of the Basel Committee, the proposed EU directive is based on three pillars. The existing, uniform capital-adequacy rules will be replaced by more institution-specific rules, whereby the risks incurred by each individual credit institution are reflected more accurately. Pillar 1 is the minimum capital requirement to cover credit and market risk and, as a new element, operational risk. Under Pillar 2, the credit institutions must assess their own capital need, and the supervisory review process is strengthened. The supervisory authorities must supervise that the credit institutions' capital base is sufficient to cover their risks. In addition, credit institutions are encouraged to optimise internal risk management and control. Pillar 3 lays down a number of requirements for credit institutions as regards disclosure of more detailed information on risks, capital structure and capital adequacy, risk management, etc. The pillars are interdependent and supplement each other with a view to ensuring that the capital requirement is calculated to reflect the risks incurred by the credit institutions.

For Danish credit institutions, the new rules under Pillar 1 are generally expected to entail a reduction in the capital requirement, partly because Danish credit institutions have a relatively high volume of lending to households and small and medium-sized enterprises, for which the capital requirement is lowered. On the other hand, the new, more institution-specific capital-adequacy rules entail that the capital requirement more accurately reflects the risks incurred by each individual credit institution, and the institutions are encouraged to optimise their risk management. In addition, the introduction of Pillar 2 will, in itself, increase risk awareness of boards and managements of credit institutions, since each individual credit institution must assess its own capital need, i.e. assess whether its strategy, risk management, control and capital are adequate in relation to its risks. Pillar 2 also comprises a good supervisory tool for dialogue with the credit institutions concerning their capital need, and the supervisory authorities are given more powers to impose demands to prevent problems within the individual credit institution.

 The international accounting standards must be approved by the EU before they enter into force. It has not been possible to reach agreement on one of the standards, IAS 39 on recognition and measurement of financial instruments, i.e. a large part of a credit institution's balance sheet. Particularly the option to include assets and liabilities at market value has been the subject of discussion. It is essential for Danish mortgage-credit institutes to have this option under IAS since considerable fluctuations that are not supported by economic realities might otherwise occur in the financial results and equity capital of the mortgage-credit institutions when they trade in their own bonds. The Danish Financial Supervisory Authority and Danmarks Nationalbank have pointed this out to the European Commission. It is expected that a recent proposal tabled by the IASB for a revision of the standard will take account of the problems experienced by the mortgage-credit sector.

The new accounting rules entail a transition from the prudent accounting principle to a neutrality principle on valuation of assets and liabilities by credit institutions. This will reduce the credit institutions' provisions and thus their buffer against future losses.

In a transitional phase between the implementation of the new accounting rules and the introduction of Basel II, Denmark has introduced a supplement to the existing solvency rules in that the individual credit institutions must determine their own capital need. The new solvency rules are inspired by Pillar 2 of the Basel Committee's revised recommendations for capital requirements.

For credit institutions, the capital need must, as a minimum, take into account the credit institution's business profile, risk concentration, large exposures, growth in lending, growth expectations, funding opportunities, dividend policy, control environment and sensitivity to cyclical fluctuations. In addition, the impact of the transition to new accounting rules must be considered. The credit institutions must report their capital need to the Danish Financial Supervisory Authority. If the latter deems the capital need calculated by the board and management to be insufficient, it may require the credit institution to raise the requirement. Under the Act, the institutions are not required to publish their capital need.

As a branch, Nordea will have the same impact on financial stability in Denmark as it currently has as an independent subsidiary bank under Danish supervision. Nordea will remain part of the Danish financial infrastructure, including payment systems and securities settlement systems, and any problems experienced may spread to the rest of the financial sector via these systems, in the same way as if the company were domiciled in Denmark.

The EU regulation does not generally grant the authorities of the host country insight into the risks associated with the activities of a branch. All supervisory reporting by the credit institution takes place to the supervisory authorities of its home country. In addition, branches do not present separate annual reports. Consequently, the Danish authorities will not have insight into Nordea's risks. This entails a need for more binding cooperation between the authorities in the Nordic countries than envisaged by the EU regulation.

Within the EU, this has been regarded as a specifically Nordic problem. With the development of the single market and focus on areas that might impede financial integration, the EU has, however, become more attentive to this "Nordea issue". A number of issues, including amendment of the Directive on Deposit-Guarantee Schemes, have thus been discussed under the auspices of the EU.

The Directive on Deposit-Guarantee Schemes lays down minimum standards for such schemes in the EU. Since the directive operates with minimum harmonisation, the coverage, financing and organisational structure of the schemes differ materially. However, all deposit-guarantee schemes are based on the home-country principle, i.e. branches in other EU member states are comprised by the parent enterprise's deposit-guarantee scheme in its home country. This home country principle is important in that the supervision is aimed at protecting depositors. The home country principle thus ensures coherence between the supervision performed and the compensation to the depositors via the deposit-guarantee scheme in the event of compulsory winding up.

The Danish deposit-guarantee scheme is set up as a private independent institution providing coverage in the event of compulsory winding up or suspension of payments by a credit institution up to an amount of kr. 300,000, and full coverage for special deposits^[6]. The fundamental principles of the Danish deposit-guarantee scheme differ from Nordic practice in many ways. The other Nordic schemes are based on an insurance principle with ongoing cash payment of premiums without co-ownership of the fund's assets, i.e. previously paid premiums are not repayable. The Danish scheme, on the other hand, is based on a fund principle, whereby members have the right to a share in the assets of the fund. These differences matter when the home country, and thus the deposit-guarantee scheme, of a credit institution changes. In a broader perspective, it is inexpedient that differences in financing models between countries may be a decisive factor behind the choice of an institution's domicile and group structure.

In the European Commission, work is underway to revise the Directive on Deposit-Guarantee Schemes.

On 23 February 2005, the Danish government presented a bill to provide a basis for establishing hedge associations. Such associations will be the Danish equivalent of hedge funds, and like hedge funds they will not be subject to limitations to their gearing and short-selling options. According to the bill, consumer protection will mainly consist of requirements to publish investment strategies and risk profiles.

Today, individual investors are already able to gear investments and short-sell in the market. Hedge associations will make it possible to do so via an association. This allows the construction of more sophisticated hedging strategies and portfolio compositions.

International focus on the significance of hedge funds to the financial markets and financial stability has increased. No unambiguous conclusions can be drawn at present.

Danish hedge associations are not deemed to pose a risk to financial stability. The capital to be managed by Danish hedge associations is expected to comprise only a small share of the overall Danish financial market. Likewise, the impact of the banks' accounts with hedge associations (prime brokerage) is expected to be limited.^[7]

The directive is applicable to regulated markets and enterprises conducting investment services and/or investment activities on a professional basis. The objectives of the directive are to create a uniform, high level of consumer protection and to facilitate and streamline trade in securities across national borders, e.g. by laying down rules for granting the so-called European passport^[9].

MiFID is a much-needed replacement for the existing Investment Service Directive from 1993 and is a key element of the efforts to promote well-functioning and integrated trade in financial instruments in the European capital markets.

A large part of the actual content of MiFID will not be known until the implementing provisions have been finalised. This applies not least to the rules on market transparency, which is one of the areas where it has proved most difficult to reach agreement. Different types of securities require different market structures, including varying types and degrees of market transparency, if they are to be traded effectively^[10]. It is essential to the development of the European capital markets that the implementation provisions offer solutions that take account of the flexibility requirements in the market structures of the various markets, as well as the uniformity required when granting a European passport.

Acquisition of the Copenhagen Stock Exchange A/S by OMX AB
In a joint press release issued on 1 December 2004, Swedish OMX AB (OMX) and the Copenhagen Stock Exchange A/S (CSE) announced that an agreement had been signed regarding the consolidation of the two stock exchanges.

OMX already owned the stock exchanges in Stockholm, Helsinki, Tallinn, Riga and Vilnius. The consolidation of the two companies is aimed at creating an integrated securities market comprising Denmark, Sweden, Finland and the Baltic states in the course of 2005 and 2006. After the consolidation, CSE will still be domiciled in Denmark and subject to Danish regulation and supervision.

The consolidation of the Nordic and Baltic marketplaces should be viewed against the background of the development in European stock exchange business. As Chart 37 shows, the combined OMX-CSE will still not be among the largest stock exchanges in Europe.

Consolidation among stock exchanges may have an impact on the efficiency of capital markets. Stock-exchange business is by nature characterised by economies of scale and scope. The marginal costs of conducting transactions are small, and liquidity in terms of depth and turnover is self-reinforcing and makes a marketplace more attractive.

However, the impact on financial stability depends on whether the consolidated stock exchanges are able to develop different markets and submarkets where trading systems and rules match the various types of financial instruments.

Implementation of the Market Abuse Directive and the Prospectus Directive
On 16 December 2004, the Folketing (Parliament) passed a number of amendments to the Securities Trading Act with a view to transposing the Market Abuse Directive and the Prospectus Directive into Danish legislation. Some of the amendments entered into force on 1 January 2005, while the remaining amendments will take effect on 1 July 2005.

The objective of the Market Abuse Directive is to introduce common EU rules to prevent insider trading and market manipulation. The objective of the Prospectus Directive is to ensure uniform rules for prospectuses so that investors are protected via a high level of information and so that the prospectuses can be granted the so-called European passport.

Under the Prospectus Directive, each member state must have one central, competent administrative authority responsible for obligations under the directive, including the power to approve prospectuses. In Denmark, approval of prospectuses for securities to be listed is currently delegated to the respective markets. Under the Prospectus Directive such delegation of authority must cease, but may, however, continue for a transitional period until the end of 2011. The amendment to the Danish legislation does not include a date for delegation to cease.

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