The International Financial Crisis

For more than a year, the international financial crisis has raged in waves. For a long time, the assessment was that the crisis was limited to certain parts of the financial system, and that financial stability as such was not threatened, even though several banks and investment banks could suffer considerable losses. The adjustments in the financial markets could actu ally benefit financial stability since they could induce the banks to im prove their risk management and lead to more accurate pricing of risk.

This picture changed in the autumn of 2008, when the financial crisis escalated and became a real threat to financial stability in the USA and Europe. Governments and central banks worldwide have responded with decisive action, by implementing measures in relation to individual institutions, and by adopting several general rescue packages. The over riding objective is to short-circuit the process of the financial markets panicking and confidence eroding. This process generates a negative spiral with serious implications for the real economy. Like most other European countries, Denmark has provided a government guarantee for the banks' unsecured creditors.

The government guarantees of the various countries have put the in ternational financial crisis on standby, but it is probably not over yet. The financial institutions will continue to adjust their balance sheets, possibly resulting in considerable shifts in the financial markets. In addi tion, the crisis will impact the real economy and contribute to low growth for a while, thereby increasing the losses of the financial institu tions, all other things being equal.

The crisis will affect the future structure and regulation of the financial sector, both nationally and internationally, but it is yet too early to draw conclusions. The causes must be analysed first. However, there is no doubt that the capital-to-risk requirements imposed on the financial institutions will be tightened.

Looking forward, a key issue will be how to phase out the wide range of government guarantees. This will probably require an internationally concerted effort to prevent distortion of competition between countries.

THE CRISIS ERUPTED FROM THE US HOUSING MARKET

The years up to the international financial crisis were characterised by high lending growth and equity gearing for the banks. Interest rates were low and there was ample liquidity. Many banks increased their lending far beyond the level of their deposits, thereby accumulating considerable deposit deficits. Consequently, they had to rely on the fi nancial markets as a source of financing. In addition, the macroeconomic environment was generally favourable, and housing prices were soaring in many countries. At the same time, financial innovation had made it possible to resell credit risk.¹ The banks' focus was on expected con tinued growth in the prices for the underlying collateral, including hous ing prices, rather than on the creditworthiness of the borrowers. As a result, liquidity and credit risks were generally underestimated.

The international financial crisis began in the summer of 2007 and was triggered by losses in the market for US subprime mortgages. This is a large, but well-defined financial market. The development of new finan cial instruments had, however, spread the risk of losses over many dif ferent types of investors. Uncertainty as to who would ultimately bear the losses and which financial institutions were exposed to potential losses created a nervous mood in the financial markets. Loss of confidence be tween the banks led to restraint on uncollateralised lending in the money markets. The market players sought to safeguard their own liquidity and hesitated to grant loans to counterparties, particularly at long maturities. The spread between collateralised and uncollateralised 3-month money-market interest rates multiplied during August 2007, cf. Chart 1.

On several occasions central banks all over the world have expanded their lending facilities to loosen up the tight money markets. In order to stem the crisis, the central banks have thus expanded the range of assets eligible as collateral, offered new credit facilities and established curren cy swap lines to improve liquidity in other currencies.

To a considerable extent, this has resulted in the banks' increasing their borrowing from central banks, without increasing the exchange of liquidity through the interbank market. This means that the money mar kets have now become part of the balance sheets of the central banks.

Over the past year, the international financial markets have seen ten sions come in waves, as illustrated by the banks' CDS spreads², cf. Chart 2. CDS spreads reflect, among other things, market expectations of the probability of a bank going into liquidation or defaulting on its obligations.

New crisis waves have often been triggered by single events. Box 1 outlines the chronology of selected events in the international financial crisis, including those in Denmark.

MOST RECENT EVENTS

The financial crisis escalated in September 2008, more than a year after it had begun. The events really took off when the US government took control of the mortgage giants, Freddie Mac and Fannie Mae, which account for just under half of all mortgage lending and guarantees on the US market. The bailout reduced the expectations of losses on un secured debt and bonds issued by the two institutions, but it also re sulted in losses for the shareholders. The problems of Freddie Mac and Fannie Mae brought other banks into focus, particularly large invest ment banks exposed to distressed assets and with a high degree of de pendence on financing via the financial markets.

The investment bank Lehman Brothers had considerable exposures in commercial real estate loans, which was one of the reasons why several investors doubted that the bank was sufficiently capitalised. During Sep tember, the bank found it more and more difficult to refinance its ac tivities. The US government refrained from rescuing Lehman Brothers, which had to file for bankruptcy (Chapter 11) on 15 September. This sent shockwaves through the financial markets as they had expected a bail out along the same lines as the Bear Stearns case in the spring of 2008. As a result of the complexity of Lehman Brothers, with innumerable fi nancial contracts with other financial institutions, and as a consequence of the bank's cross-border structure, its failure had a severe adverse im pact on the financial markets. This reinforced the banks' reluctance to provide uncollateralised interbank lending. The global money markets froze, and the spread between collateralised and uncollateralised money-market interest rates widened to almost 200 basis points, cf. Chart 1.

Later that week, US Secretary of the Treasury Paulson announced a plan that included acquisition of troubled assets from financial insti tutions for 700 billion dollars. The act was signed by President Bush on 3 October.

Europe was also affected by the mounting pressures. By the end of September, several European banks had received emergency capital in jections, mainly from the respective governments. Iceland was hit the worst, in that the entire financial system collapsed and the three major Icelandic banks³ were nationalised, cf. p. 5.

Each of these events increased the vulnerability of other institutions due to the interdependent nature of the financial system, and to the di minishing confidence in other institutions' ability to survive. The banks tried to reduce their exposures to other financial institutions, and the maturities of interbank loans shortened.

Panic ruled the international financial markets. Investors, banks and other financial institutions held fire sales of assets to obtain liquidity, which caused asset prices to fall even more. In the extremely volatile markets, there was speculation in further price drops, which reinforced the crisis sentiment. During September, several countries, including the USA and the UK, temporarily banned short selling⁴ of financial stocks in an attempt to halt the plummeting prices and dampen market vola tility.⁵On 13 October, Denmark followed suit with a general ban on short selling stocks in Danish banks.

It was clear that the international financial crisis was a real threat to financial stability. At the same time, it had moved beyond a liquidity cri sis that central banks could alleviate by providing liquidity to the mar kets. The crisis had deeper roots, the banks' capital adequacy was called into question, and quite extraordinary measures were needed in order to restore stability and confidence in the financial markets.

In Europe, Ireland was the first country to provide a government guar antee for the banking sector. It was announced on 30 September and comprised six named Irish banks. The aims of the Irish government's de cision were to maintain financial stability in Ireland and safeguard the interests of the Irish economy. In the first instance, the guarantee did not comprise branches of foreign banks, which therefore came under pressure in the Irish market.

The Irish government guarantee created a snowball effect throughout Europe, and in the intervening period, most EU member states, includ ing Denmark, have had to issue guarantees for their banking sectors – wholly or partially. The government guarantees vary considerably in terms of duration as well as institutions and claims covered. The Appen dix on p. 40 provides an overview of rescue packages in the USA and Europe.

In the globalised financial environment, even countries whose banks have pursued relatively conservative lending policies have had to issue government guarantees. The reason is that financing conditions have been tightened for everyone and it is difficult to be an outsider when other countries issue government guarantees for their banks. In general, but especially in these uncertain times, investors, depositors and other banks tend to prefer countries with government guarantees. This illus trates the importance of concerted action in view of the global nature of the problems.

On 12 October, the euro area member states agreed on a set of common bank rescue principles, which were endorsed by the other EU member states on 15 October. The EU member states will be allowed to recapitalise banks. They can also issue temporary government guaran tees for future borrowing by the banks with maturities of up to 5 years. Rescue packages must ensure fair competition and it is considered im portant that the banks must pay for the guarantees.

On 15 November, the G20 countries⁶ agreed on five basic principles for addressing the financial crisis. These principles extensively overlap the principles adopted by the EU Heads of State and Government. The five principles are:

• Strengthening transparency and accountability
• Enhancing good regulation
• Promoting integrity in financial markets
• Reinforcing international cooperation
• Reforming international financial institutions.

THE DEVELOPMENT OF THE FINANCIAL CRISIS IN DENMARK

The liquidity support given to Roskilde Bank in July 2008 and the takeover of the bank on 24 August drew negative attention to Denmark in the international financial markets. Roskilde Bank had suffered from an unsuitable combination of very large exposures in the property mar ket and a lenient credit policy, and this landed the bank in solvency problems. The problems were thus self-inflicted and had little to do with the financial crisis. However, during the international turmoil foreign in vestors found it difficult to assess whether Roskilde Bank was an exception.

Consequently, small and medium-sized Danish banks generally found it very difficult – not to say impossible – to obtain financing abroad, while Danish banks responded by further reducing the exchange of interbank liquidity. In addition, large term deposits from local author ities, business enterprises and private individuals moved away from the small and medium-sized banks. Danmarks Nationalbank's measures to enhance the credit facilities for banks, cf. Box 2, failed to cover the large deposit deficits of the individual banks. As a result, many banks strug gled to make ends meet by rolling large financing amounts in front of them, i.e. every day they had to refinance large amounts on an over night basis. This made then extremely exposed.

On 5 October, the Danish government concluded an agreement with the Danish People's Party, the Social Democrats and the Social-Liberal Party and with the financial sector in order to safeguard continued financial stability in Denmark. The agreement became law on 10 October and de facto constitutes a safety net – provided by the central government and the financial sector – so that all claims of depositors and other unsecured creditors in banks in the Kingdom of Denmark are fully covered under the government guarantee.

The financial sector (the Danish Contingency Association) is to contrib ute up to kr. 35 billion, equivalent to 2 per cent of GDP. The Danish Con tingency Association will provide a contingency fund of kr. 10 billion (own risk) and in addition pay market-related guarantee commission of kr. 7.5 billion annually. A company has been established with the pur pose of facilitating the winding-up of insolvent banks. For banks that do not meet the statutory solvency requirement, if no private-sector solu tion can be found, this company will inject capital into a newly-estab lished subsidiary, which will take over and wind up the bank in question. If the estimated losses, including the return on contributed capital in the winding-up company, exceed the guarantee provided and the paid-up guarantee commission, the Danish Contingency Association will cover losses to the amount of a further kr. 10 billion via increased guarantee commission.

Furthermore, the agreement on financial stability emphasises that, in return for the safety net, the financial sector must show restraint and consolidate over the next two years. The agreement thus includes a ban on dividend payments from banks and puts a stop to new buy-back pro grammes of own stocks. No new stock option programmes may be established, and existing programmes may not be extended. The scheme expires on 30 September 2010.

AGREEMENT ON FINANCIAL STABILITY IN THE PENSION AREA IN DENMARK

During October Danish mortgage-credit bonds were hit by a wave of un rest, and the spread to government bonds widened considerably, cf. Chart 3.

As a result of the abnormal market conditions, several pension com panies had to divest Danish mortgage-credit bonds from their portfolios. Major divestment of Danish mortgage-credit bonds could have serious implications for pension savers and homeowners in the form of falling prices and rising interest rates. Against this background, on 31 October the Ministry of Economic and Business Affairs and the Danish Insurance Association decided to launch a number of initiatives to ensure market stability and prevent systematic divestment of Danish mortgage-credit bonds.

• The mortgage-credit yield will temporarily be included in the yield curve used in the calculation of the pension companies' liabilities. This will address the considerable increase in provisions that can be attri buted to the extraordinary interest-rate pattern.
• In order to promote consolidation of the sector, an upper limit is set on the pension companies' bonus policy and fixing of interest rates on policyholders' savings.
• In the calculation of their individual capital needs, the pension companies may, to a reasonable extent, take into account the im provement in result they can achieve when the situation is normalised.
• The use of the yellow "traffic light" scenario of the Danish Financial Supervisory Authority is discontinued to avoid inappropriate market behaviour. Instead, like other Danish financial enterprises, the pension companies are to submit quarterly financial statements, including the consumption of reserves, to the Danish Financial Supervisory Authority.

The agreement has significantly enhanced the pricing of mortgage-credit bonds, and the widening of the spread had to a large extent re versed, cf. Chart 3.

CONCLUISON

The rescue packages in a number of countries have had a positive impact on the money markets. Most indicators thus show that the accelerated deterioration of the crisis has stopped and that the situation has been stabilised. The nervous sentiment regarding risk of bank failures has sub sided.

In the Danish money market, there are signs of beneficial effects of the rescue package. Among other factors, the banks have reduced their portfolios of certificates of deposit and their current-account balances with Danmarks Nationalbank. In addition, several banks are reporting easier access to liquidity after the adoption of the rescue package.

On the other hand, the spread between collateralised and uncol lateralised money-market interest rates is virtually unchanged compared with the level before the package was adopted, which is also the case in the euro area, cf. Chart 4. The restoration of confidence among the banks is expected to take some time, and the rescue packages will only slowly improve the market conditions.

So far, the government guarantee for the banks' unsecured claims has created a good foundation for the banks once again to obtain financing in the national and international financial markets. However, the assessment is that, like other countries, Denmark may have to supple ment the capital that can be raised in the private market, so that well-run Danish banks gain access to temporary financing on conditions that resemble those in the market as closely as possible.

APPENDIX: OVERVIEW OF SELECTED BANK RESCUE PACKAGES