Liquidity

Liquidity has improved over the past year for the banking institutions overall, although there is pronounced dispersion between the institutions. Today the banking institutions and mortgage-credit institutes receive temporary liquidity support by way of the general government guarantee, the option to buy an individual government guarantee and Danmarks Nationalbank's expanded credit facilities. The institutions should prepare for the expiry of the temporary facilities. This includes exploiting the opportunity of buying individual government guarantees if required.

Liquidity problems have been a major factor in the financial crisis. This has led to a number of international initiatives to strengthen the liquidity of the institutions. The exact structure of future liquidity regulation has not been determined yet.

Due to extensive financing of long-term adjustable-rate loans by means of short-term bonds, the mortgage-credit institutes are exposed to liquidity risk.

Liquidity risk

The banking institutions transform liquid deposits into loans, which are difficult for the institutions to liquidise without incurring losses. This business model has an inherent liquidity risk, i.e. a risk of being unable to honour commitments as they fall due. Banking institutions may use various instruments to reduce this risk. An inappropriate mismatch between the payment profiles for long-term assets and short-term liabilities can be reduced by increasing the maturity of the financing. Banking institutions may diversify their financing and rely on stable sources of deposit. Finally, a sufficient portfolio of liquid assets may serve as a buffer against liquidity stress. Good liquidity management combines all of these elements.

Liquidity problems have been a major factor in the financial crisis. This has led to a number of international initiatives to strengthen the liquidity of the institutions. The Basel Committee and the Committee of European Banking Supervisors, CEBS, have published new guidelines for sound liquidity risk management by credit institutions. Moreover, in December 2009 the Basel Committee published draft international quantitative liquidity standards for credit institutions, and in February 2010 the European Commission published a draft for incorporation of these liquidity requirements into EU law.¹⁵

The Danish Financial Supervisory Authority and Danmarks Nationalbank have joined forces to intensify liquidity monitoring of Danish banking institutions, cf. Box 5.

The banking institutions' liquidity

Since 2008, the banking institutions have reduced their deposit deficit considerably, cf. Chart 28. The deficit occurred over a few years, in which the institutions increasingly financed pronounced growth in lending by means of market-based financing rather than deposits. Market-based financing includes e.g. issuance of bonds and borrowing from other credit institutions. The increased reliance on this type of financing caused problems for the banking institutions when the financial crisis erupted.

Deposit deficits	Chart 28
Note: Deposit deficits calculated as lending less deposits. Lending calculated before write-downs. Source: Danmarks Nationalbank, Statistics on balance and flows of the MFI sector.

The deposit deficit has declined steadily for institutions in all three groups – 1, 2 and 3 – since early 2009, which has reduced the institutions' need for market-based financing and their exposure to related liquidity risks. In percentage terms, group 3 has the smallest deposit deficit, namely 102 per cent at end-March 2010, cf. Chart 29.

Lending as a percentage of deposits	Chart 29
Note: Lending as a percentage of deposits. Lending calculated before write-downs. Source: Danmarks Nationalbank, Statistics on balance and flows of the MFI sector .

Concurrently, the maturity of the institutions' market-based financing has increased. For institutions in group 1, debt securities issued with a maturity of more than 1 year still constitute the largest share of net debt to other credit institutions and debt securities issued. This share has been rising since March 2009, cf. Chart 30. This increases the maturity of the institutions' financing and reduces the mismatch between the maturities of their assets and liabilities. The institutions in group 2 rely more on other credit institutions than those in group 1, but for this group, too, maturities are increasing.

NET DEBT TO OTHER CREDIT INSTITUTIONS AND DEBT SECURITIES ISSUED	Chart 30
Note: Excluding foreign branches and subsidiaries. Source: Danmarks Nationalbank, Statistics on balance and flows of the MFI sector .

The banking institutions' use of market-based financing to a large extent reflects the accessibility of and financial attractiveness of the various sources of financing. The price of short-term liquidity, illustrated by the spread between collateralised and uncollateralised money-market interest rates, has narrowed substantially since the peak of the financial crisis. Over the last six months it has stabilised at just over 0.5 percentage points, cf. Chart 31. Conditions in the short-term money market have improved, with increased confidence and willingness to provide liquidity in the interbank market. Prices are, however, significantly higher than before the financial crisis, and the liquidity premium in the market thus remains elevated. Moreover, the spread is greater in Denmark than in the euro area even though Danish banking institutions are comprised by the general government guarantee until 30 September 2010.

SPREAD BETWEEN COLLATERALISED AND UNCOLLATERALISED MONEY-MARKET INTEREST RATES, 3-MONTH MATURITY	Chart 31
Note: The euro spread is 3-month Euribor less the 3-month Eonia swap spread. The krone spread is 3-month Cibor less the 3-month swap spread. Source: Bloomberg.

The institutions can minimise liquidity risks by building up portfolios of liquid assets that are eligible as collateral for loans from Danmarks Nationalbank or can be sold in the market at short notice without large capital losses. The Danish Financial Supervisory Authority's key ratio for liquidity provides an indication of the excess liquidity cover at a given time. This is an expression of the institutions' holdings of liquid assets relative to the statutory minimum requirement. The institutions' excess liquidity cover generally increased during 2009, cf. Chart 32. However, there is still considerable dispersion between the institutions.

excess liquidity cover in Danish banks	Chart 32
Note: The Chart is based on the Danish Financial Supervisory Authority's key ratio "cover relative to statutory liquidity requirement", which shows excess liquidity after compliance with the 10-per-cent requirement, cf. section 152 of the Danish Financial Business Act. Liquidity must amount to at least 10 per cent of the total debt and guarantee commitments less subordinated capital investments, which can be included in the calculation of the base capital. Source: Financial statements and liquidity reporting to the Danish Financial Supervisory Authority and Danmarks Nationalbank.

Government guarantees

Under the Bank Rescue Package from October 2008, the Danish government provides an unlimited guarantee to all depositors and other unsecured creditors, exclusive of covered bonds (SDOs), against losses in Danish banking institutions up to and including 30 September 2010.¹⁶ Furthermore, the Credit Package from February 2009 made it possible for Danish credit institutions to enter into agreements to purchase individual government guarantees for non-subordinated unsecured debt, etc. Individual government guarantees run for up to three years. Under the Financial Stability Act, the individual government guarantee covers loans issued before 31 December 2010, subject to current approval by the European Commission. The Financial Stability Company has announced that on the basis of statements from the Commission it is uncertain whether the Commission will approve an extension after 30 June 2010 – and if so on which conditions.¹⁷Banking institutions wishing to purchase an individual government guarantee should thus apply without delay.

The general government guarantee entails that deposits are fully covered until 30 September 2010. Concurrently with the expiry of the general government guarantee, the deposit guarantee will be increased to cover net deposits of up to 100,000 euro, approximately kr. 750,000, for ordinary deposits, while special deposits, including pension savings, will be fully covered.¹⁸

A good 45 per cent of the banking institutions' current deposits will be covered by the deposit guarantee scheme after 30 September 2010, cf. Chart 33. Large deposits are often concentrated in large banking institutions. Typically the deposits not covered by the deposit guarantee scheme will be deposits from local authorities and large companies, but some private individuals also have deposits exceeding the limit. When the government guarantee expires, depositors of large amounts will have to consider the credit standing of the individual institution. This means that institutions with low credit standings that are highly dependent on large deposits may find it difficult to procure liquidity.

Deposits covered by the deposit guarantee scheme after 30 September 2010	Chart 33
Note: Based on figures at end-March 2010. Source: Liquidity reporting to the Danish Financial Supervisory Authority and Danmarks Nationalbank.

If depositors trust the institution where they place their funds, the transition from a general government guarantee to the deposit guarantee scheme may be smooth. The deposit guarantee is not the only factor to influence the stability of deposits. Depositors who not only have deposits, but also transact large volumes of business with the institution in question, will typically be less inclined to move deposits than depositors with lower business volumes. During the financial crisis, the banking institutions' access to market-based financing was to a large extent influenced by the general government guarantee.

Around 20 per cent of the banking institutions' debt issued with an original maturity of more than 1 year will fall due before the expiry of the general government guarantee, cf. Chart 34. Of the debt issued with a maturity of less than 1 year the largest share by far will fall due before the expiry of the government guarantee. Issuances with a remaining term to maturity of 1-2 years or 3-4 years make up relatively small shares.

Maturity profile for Danish banks' issues with an original maturity of more than 1 year	Chart 34
Note: Based on figures at end-March 2010 for Danish banks in groups 1 and 2. Source: Liquidity reporting to the Danish Financial Supervisory Authority and Danmarks Nationalbank.

The institutions hold considerable medium-term and long-term financing that extends beyond the expiry of the general government guarantee. This is partly attributable to the option to purchase individual government guarantees with a maturity of up to 3 years. As at 3 May 2010, 27 institutions had been approved for individual government guarantees totalling kr. 254 billion. So far, 20 institutions have issued for a total of kr. 93 billion with individual government guarantees.¹⁹In addition, several institutions have issued debt on normal market conditions.

For many institutions, it is financially advantageous to raise government-guaranteed financing with an individual government guarantee. For institutions without ratings, the annual price of a government guarantee is 0.95 per cent of the principal. If the interest-rate spread between unguaranteed and guaranteed issuance exceeds this percentage, it is most advantageous to issue under an individual government guarantee. Since the summer of 2009 there has been a tendency for large, well-capitalised institutions to opt for longer-term financing without purchasing individual government guarantees.

Most of the banking institutions' gross issues of securities expire on 30 September 2010 or earlier, and thus they are covered by the general government guarantee, cf. Chart 35. Since mid-2009, the institutions have, however, begun to issue with longer maturities, both with and without individual government guarantees. For example, Danske Bank and BNP Paribas have established an SPV, Valhalla, which has issued bonds in euro on the basis of government-guaranteed issues from seven smaller Danish banking institutions for 750 million euro. Other institutions are considering similar initiatives.

Gross securities issuance by Danish banks	Chart 35
Source: Danmarks Nationalbank.

Danmarks Nationalbank's measures to support liquidity

Some banking institutions – especially in group 3 – have been supported by temporary liquidity measures launched by Danmarks Nationalbank, cf. Box 6. These initiatives include expanding the collateral base, as well as an option to obtain credit on the basis of excess capital adequacy. Parts of these measures were scheduled to expire on 30 September 2010, but have been extended until 26 February 2011.

The excess liquidity cover – with and without Danmarks Nationalbank's temporary facilities – of banking institutions in groups 1, 2 and 3 is illustrated in Chart 36. Data is based on liquidity reporting by the institutions to Danmarks Nationalbank and the Danish Financial Supervisory Authority. Under the credit facility against excess capital adequacy, credit lines totalling kr. 12.4 billion had been granted at end-April 2010, but had been drawn on only a few times. Both this facility and Danmarks Nationalbank's expanded collateral base may be included in the institutions' statutory liquidity. Not all institutions have stated in their liquidity reporting whether they include Danmarks Nationalbank's expanded collateral base in their statutory liquidity. Consequently, the effect of this facility may be underestimated in Chart 36.

STATUTORY EXCESS LIQUIDITY COVER FOR Danish banks IN GROUPS 1, 2 AND 3, WITH AND WITHOUT DANMARKS NATIONALBANK'S TEMPORARY LIQUIDITY FACILITIES	Chart 36
Note: Data based on figures as at end-February 2010 for Danish banks in groups 1, 2 and 3. The data set covers 95 of the institutions. 34 of these have credit facility against excess capital adequacy. For 54 of the 95 institutions, we have information on Danmarks Nationalbank's expanded collateral base. 35 of the 54 institutions have reported portfolios of securities included in Danmarks Nationalbank's expanded collateral base (excluding loan bills and SPV bonds). Source: Liquidity reporting to the Danish Financial Supervisory Authority and Danmarks Nationalbank.

Especially the credit facility against excess capital adequacy has contributed to increasing the institutions' excess liquidity cover, cf. Chart 36, but even without this facility the excess relative to the statutory requirement would have been considerable. It is seen that the institutions that have made use of Danmarks Nationalbank's temporary measures to support liquidity have generally had lower excess liquidity cover than the sector overall. This applies both when the excess liquidity cover is calculated with and without these facilities.

Overall, the banking institutions have improved their liquidity over the past year. It is paramount that the institutions continue to focus on their liquidity needs, applying financing strategies that provide the necessary security.

The mortgage-credit institutes' liquidity risk

The mortgage-credit institutes are exposed to liquidity risk. In contrast to the risks incurred by the banking institutions, this is, however, a relatively new risk, which was introduced when the mortgage-credit institutes began to finance long-term adjustable-rate mortgage loans with short-term bonds.

Irrespective of future regulation, the extensive use of short-term bonds to finance long-term loans makes it relevant for mortgage-credit institutes to consider solutions to reduce the liquidity risk in this connection.

Adjustable-rate loans and liquidity risk
The structure of the mortgage-credit institutes' lending has changed rapidly over the last decade. While in the past loans were predominantly fixed-rate loans with amortisation, approximately 65 per cent of the outstanding volume is now made up of adjustable-rate loans, and only around half of the outstanding volume is with amortisation, cf. Chart 37.

ADJUSTABLE-RATE LOANS AND DEFERRED-AMORTISATION LOANS AS RATIOS OF TOTAL LENDING BY MORTGAGE-CREDIT INSTITUTES	Chart 37
Note: Monthly figures. Loans for all sectors excluding the MFI sector. The series for deferred-amortisation loans is the result of linear interpolation from quarterly data up to and including 2004. The series for capped adjustment is composed of lending data from the MFI statistics as from March 2008 and the volume of outstanding bonds issued to finance capped-rate loans before March 2008. Source: Danmarks Nationalbank.

The rising share of adjustable-rate loans is mainly financed via short-term bonds with regular refinancing. Moreover, refinancing is to a large extent concentrated on the last few months of the year.

Following discussions between Danmarks Nationalbank, the Association of Danish Mortgage Banks and the Danish Mortgage Banks' Federation it was agreed that members of the latter two should implement measures to ensure a more suitable and even distribution of these refinancing activities over the year than has been the case until now.²⁰This will reduce the concentration risk and thus also eliminate some of the operational risk arising when very large payments need to be settled within a short space of time.

Even if the refinancing auctions are spread out, it nevertheless remains a fact that investors buying short-term bonds, which must regularly be refinanced at a variable rate of interest, make liquidity available for relatively short periods only, often just one year. This is in stark contrast to the traditional fixed-rate loans, where bond investors make liquidity available throughout the maturity of the loan.

The adjustable-rate structure, with regular refinancing of short-term bonds, entails automatically passing on the refinancing interest to the borrower. Consequently, the borrower must initially pay up if investors at some point during the maturity of the loan require a higher rate of interest in return for providing liquidity. However, there is a limit to the interest that borrowers are able to pay. All other things being equal, large interest-rate rises will increase the credit risk of the mortgage-credit institutes. As a result, investors may demand even higher interest for still providing liquidity. This could lead to a situation where no rate of interest can be found at which the institutes can obtain the necessary liquidity. Moreover, the financial crisis has shown that situations may arise where it is not possible to issue in certain markets.

This risk does not exist in relation to fixed-rate loans, which are financed by means of long-term bonds. Nor does it exist for variable-rate loans financed by variable-rate long-term bonds. In these cases investors from the outset make liquidity available throughout the maturity of the loan. Experience from the financial crisis, as well as the proposals for future liquidity regulation make it relevant for the institutions to consider structures entailing more limited liquidity risk.