Framework Conditions for the Financial System

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

New capital-adequacy rules
On 1 January 2007 new capital-adequacy rules, called Basel II, came into force. The new rules entail a more contemporary approach to the capital requirements of credit institutions, whereby the capital requirements of each credit institution to a greater extent reflect the risks undertaken by that institution. At the same time, the new rules give the credit institutions an incentive to implement the best possible risk management. Danish credit institutions already have the opportunity to operate within the framework of the most simple of the new methods to calculate capital requirements, i.e. the standardised approach. The credit institutions that plan to use the more advanced approaches are preparing for this, among other things via the necessary dialogue on implementation with the Danish Financial Supervisory Authority.

The new rules are very extensive and both the authorities and the sector have faced the considerable task of transposing and implementing the new capital-adequacy rules. Some of this work is still ongoing.

Since the rules were adopted in 2005, the EU has worked for the uniform implementation of the new rules in the national legislation of the member states. The aim is for the national supervisory authorities to administer the rules on a uniform basis, to ensure the credit institutions equal terms throughout the EU.

The new rules put the onus on the European Commission, in cooperation with the member states and the ECB, to monitor whether the new capital-adequacy rules have significant effects on the economic cycle.^[1] This work commenced at the end of 2006.

MiFID/Regulation of financial instruments^[2]
MiFID is a comprehensive directive that is described as a new stock-exchange reform. The purpose of the directive is to contribute to developing the single securities market within the EU by harmonising the securities trading rules. Among other things, this relates to protection of investors and expansion of competition.

The directive has been implemented in Denmark via an act to amend both the Securities Trading Act and the Financial Business Act. The Act and the related executive orders will entail a number of adjustments to the current rules for securities trading in Denmark.

A new type of market is introduced, i.e. a multilateral trading facility (MTF). In addition, stock exchanges and authorised marketplaces are given the new designation of regulated markets.

New investor protection rules are introduced, with requirements of customer categories, customer information, advisory services and best execution. At the same time, new organisational requirements are made of securities traders, including registration of customer orders and handling of conflicts of interest.

A number of adjustments are made to the current rules for market transparency. First and foremost, the rules for market oversight (market manipulation and insider trading) and for market transparency are separated. The current rules require reporting to the Copenhagen Stock Exchange (OMX) but do not specify that this reporting also serves to ensure transparency. Today, the rules for transparency are determined solely by the individual market, e.g. the Copenhagen Stock Exchange. In future, there will be two reports: one for the authorities (to the Financial Supervisory Authority) to facilitate market oversight; and a report/publication to ensure market transparency. Pursuant to the directive, only equities are subject to the new transparency rules. However, it is possible to determine national rules for the transparency of other securities besides shares.

The Act requires the Financial Supervisory Authority to issue an executive order on the post-trading transparency of bonds. According to the explanatory notes to the Act, the objective is for these powers to be exercised primarily with regard to bonds with a substantial retail trading volume. On this basis, the draft executive order regulates mortgage-credit bonds, corporate bonds and investment certificates.

In 2006, the European Commission took the initiative to collect information from markets and market participants on whether it is appropriate to expand the new transparency rules for shares to include bonds, or to otherwise establish common transparency rules for bonds.

As before, the individual market may determine rules for the trading that takes place via its systems.

With a few exceptions, the Act enters into force on 1 November 2007. The implementation of the overall MiFID regulation in the financial enterprises will be an extensive and expensive process that will affect the enterprises in the immediate future.

Covered bonds (SDO)
On 28 March 2007 the Minister for Economic and Business Affairs presented a bill on covered bonds (SDO). The purpose of the proposed legislative amendment is to introduce the opportunity for banking institutions to issue covered bonds, and for mortgage-credit institutes and Danish Ship Finance A/S to continue to issue covered bonds. The Act is expected to enter into force on 1 July 2007. Reference is also made to the section on covered bonds in Recent Economic and Monetary Trends in Danmarks Nationalbank's Monetary Review, 1st Quarter 2007.

The new directive provisions e.g. specify which LTV (loan-to-value) ratios are to be complied with for a bond issue to qualify for covered bond status. For housing loans, an LTV of 80 per cent applies. The LTV must be complied with on a continuous basis, in contrast to the current rules for Danish mortgage-credit bonds, whereby the limit only applies when the loan is established. If falling house prices, for example, entail that the LTV of 80 per cent cannot be complied with, the bond issuer must immediately supplement the assets pledged as collateral for the issue, e.g. with government bonds.  

The bill proposes to allow credit institutions to issue covered bonds using two different models. Under the first model, the existing limitations apply, i.e. a maximum maturity of 30 years and a maximum of 10 years' deferred amortisation. In this case, LTV at the time of granting the loan and for the loan's duration must not exceed 80 per cent for loans for residential properties, which account for the largest share of loans against real estate as collateral. The second model imposes no limitations on terms and redemption profiles, and for residential properties the upper limit for LTV is reduced to 70 per cent at the time that the loan is granted. From 1 July 2009, this limit will be raised to 75 per cent. For these loans too, the maximum current LTV will be 80 per cent.

The ongoing observance of an LTV of maximum 80 per cent will help to ensure that covered bonds are extremely secure bonds with a very low credit risk and thus a low interest rate compared with other bonds. However, if house prices fall abruptly on a downturn in the economy, considerable additional collateral may be required, which the credit institution will have to transfer from its other assets, or buy for borrowed funds in order to maintain the status of covered bonds. This may reduce the general strength of the credit institution in a situation where the economy is already declining and earnings are squeezed, which in turn may weaken financial stability. Lowering the LTV limit to below 80 per cent when the loan is granted will thus make it easier for credit institutions to observe the Directive's requirement of a current maximum LTV of 80 per cent.

In connection with the new regulation of covered bonds, a new balance principle will be established. The purpose of a balance principle is to limit the issuer's risk to the credit risk. For both the existing and the proposed new balance principles the fundamental rule is that no interest-rate risk, option risk or exchange-rate risk may be taken. Today, risks are primarily hedged by selling bonds that exactly correspond to the housing loans. This will also be possible under the new balance principle. However, the new balance principle also makes it possible to make greater use of modern financial instruments to cover risk.

Depositor guarantee – private scheme
A bill has been tabled whereby the opportunity for the Depositor Guarantee Fund to participate in the winding up of a failing banking institution by transferring assets and liabilities to another banking institution will be removed from the Act on a depositor guarantee fund. The reason is that the European Commission finds this opportunity to be in conflict with the rules on state aid. At the same time, the opportunity is given for a private scheme to be established, which among other things requires amendment of the rules on confidentiality. For some time the Danish Bankers Association has worked to establish a scheme under its own auspices that in the event of a crisis must have access to participate in the winding up of failing banking institutions by transferring assets and liabilities to another banking institution, if this solution entails lower costs than compulsory liquidation.

Target2-Securities
On 8 March 2007 the ECB announced^[3], that the Governing Council has decided to proceed with the Target2-Securities (T2S) project^[4]. The purpose is to integrate European securities settlement with the future trans-European payment system, Target2^[5].

The final decision on development of T2S is expected to be taken at the beginning of 2008. Up to then, the ECB and the Eurosystem, in cooperation with the European central securities depositories and their participants, must determine user requirements of T2S. Danmarks Nationalbank coordinates the Danish participants' user requirements. In this connection, a briefing was held by Danmarks Nationalbank in March 2007.

Payment Services Directive
At the meeting of the ECOFIN Council on 27 March 2007 political agreement on the Payment Services Directive was reached. The Directive was adopted by the European Parliament on 24 April 2007 and must be implemented in national legislation by 1 November 2009.

A key objective of the Directive is to support the development of a Single Euro Payments Area (SEPA) by harmonising the EU member states' legislation in the area of retail payments.^[6] The Directive is aimed not only at euro-denominated payments, but will also cover payment services in other EU currencies, including payments in Danish kroner.

Among other things, the Directive introduces a new type of institution in EU law, namely payment institutions. These can conduct cross-border payment services within the EU on the basis of a national authorisation. Payment institutions will be subject to various supervisory regulations, including capital requirements.