Lars Rohde: Denmark's economy, housing market, krone, and crisis
management of mortgage banks
Speech by Mr Lars Rohde, Governor of the National Bank of Denmark, at the annual meeting
of the Association of Danish Mortgage Banks 2015, Copenhagen, 1 October 2015.
* * *
Thank you for inviting me to speak for the third time at the annual meeting of the Association
of Danish Mortgage Banks. Let me start by saying how much I appreciate our good working
relationship.
Today I will concentrate on these subjects: the Danish economy, the housing market, the krone
and finally crisis management, with focus on mortgage banks.
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The Danish economy is in an upswing. Employment has risen steadily over the last two years,
and unemployment has fallen. It is now only slightly above the cyclically neutral level. Growth
in GDP has been positive for eight quarters in a row at a level above the potential growth rate
of the economy.
Strong forces are currently driving the economy - oil prices have dived sharply and the level
of interest rates remains very low. The same forces are at work in our key export markets.
Moreover, real household disposable income is rising and so is wealth. The drop in equity
prices over the last month plays only a minor role in this context. Whichever way you look at
it, there is a basis for stronger growth in consumption.
Danmarks Nationalbank expects the growth rate to be 1.8 per cent this year and slightly higher
next year. We also predict that employment will grow by another 80,000 or so from mid-2015
until the end of 2017. There is room for both higher employment and wage increases as the
cyclical position normalises. But unemployment is low relative to the forecast growth in
employment, and therefore most of the increase must come from an expansion of the labour
force. Otherwise there is a risk that the current upswing will be very short and result in
pressures on the economy.
***
The housing market is now picking up in practically all municipalities, and the annual rate of
increase in house prices in Denmark overall has risen since New Year. In some parts of the
country, prices have begun to rise only recently, so there are still large differences in the
housing market across the country.
As such, it is positive that the housing market is picking up. That is a natural element of the
current upswing. But in the large towns and cities there is a risk of price increases being
selfreinforcing. The rate of price increase for e.g. owner-occupied flats in Copenhagen has been
around 10 per cent for several years, and many buyers seem to expect that prices will continue
to rise. It goes without saying that price increases on the scale seen in Copenhagen in recent
years are not sustainable in the longer term.
During previous upswings, the housing market has been a source of macroeconomic instability
and overheating of the economy. This was particularly true during the upswing in the 2000s. A
contributory factor was the absence of sufficient automatic stabilisers in the structure of
housing taxes. The current housing tax rules have also led to a considerable geographical
spread in the rate of taxation - by which I mean the tax payable relative to the value of the
property.
In the Danish mortgage credit system, everyone has access to loans if they can pledge sufficient
collateral. Marginal lending is typically provided by the banks. But there is reason to exert caution
in this respect. In many cases it would be prudent for the banks to require a considerably larger
down payment than the 5 per cent of the purchase price that will be included in the rules on good
practice for financial enterprises from 1 November. More equity among the households will
strengthen their resilience and the robustness of the financial sector.
***
It is important that you do not go right to the statutory limits, but only grant loans if you assess
them to be sound. Easier access to credit should not be a competitive parameter.
For example, a variable rate mortgage loan should not mechanically be granted, even though
the borrower meets the "good practice" requirements and can be approved for a 30-year fixed
rate loan with amortisation. At present this means a fixed rate of around 3 per cent. That is
very low, and the variable rate may soon rise to a higher level. This should be taken into
account when approving a borrower. If it is assessed that the customer may have problems
servicing the loan if interest rates rise to a considerably higher level, a fixed rate loan should
be granted. Even when this is not required in order to observe the "good practice"
requirements.
Total lending by Danish banks and mortgage banks has been virtually unchanged over the last
year. But the level is high, also when viewed relative to GDP. And it should be remembered that
lending has not declined even though it rose strongly in the pre-crisis years. During that period,
the economy overheated, and later it turned out that some banks had eased their credit
conditions far too much. So a rise in lending is not immediately on the cards.
Credit institutions operating in such a market should be particularly thorough when assessing
potential borrowers. This includes taking into account the fact that house prices can fluctuate
considerably. When the housing bubble of the 2000s burst, it became clear that a maximum
LTV ratio of 80 per cent for mortgage loans does not necessarily ensure that the value of the
home exceeds the value of the mortgage loan when prices fall.
If we look at the mortgage statistics, we can see that lending is increasing most strongly in the
urban areas, which is hardly surprising as this is where the largest house price rises are seen.
Demand for loans is also highest in these areas. But new loans are also being granted in rural
areas, and the number of municipalities where extraordinary prepayments are exceeding new
lending is very small. This indicates that if there is sufficient collateral to mortgage, loans are
granted. No matter where the property is located. The challenge of declining populations in
some areas is not solved by granting more credit.
***
Turning to monetary policy, the beginning of the year was unusually eventful. Following the
decision by the Swiss National Bank on 15 January to discontinue the minimum exchange rate
for the Swiss franc against the euro, we saw an unprecedented increase in demand for Danish
kroner.
Against that background, Danmarks Nationalbank took a number of unusual steps. We
intervened in the foreign exchange market by selling kroner for a larger amount than ever before
in our history, and the benchmark monetary policy interest rate - the rate of interest on
certificates of deposit - was reduced to -0.75 per cent. On the recommendation of Danmarks
Nationalbank, the Ministry of Finance also suspended issuance of Danish government bonds
temporarily, and finally an extraordinary increase of the limit on the monetary policy
counterparties' current account deposits at Danmarks Nationalbank was introduced.
These measures had the desired effect. The krone remained stable close to its central rate,
and towards the end of February the inflow of foreign exchange ceased. In recent months, the
situation in relation to the krone has gradually normalised, and Danmarks Nationalbank has
sold foreign exchange in the market for a considerable amount. On the recommendation of
Danmarks Nationalbank, the Ministry of Finance has therefore decided to resume issuance of
government bonds effective from October 2015. At the same time, the extraordinary increase
of the current account limit has been rolled back.
January-February this year was by no means the first time Danmarks Nationalbank had to take
resolute action to defend the fixed exchange rate policy. And it will probably not be the last
time. Situations where the krone is under pressure seldom resemble previous situations. The
triggers and series of events differ from time to time, and although Danmarks Nationalbank in
principle applies the same reaction function, our reaction must be adapted to the specific
circumstances. Nevertheless, I think we should reflect on the lessons than can be learned from
the most recent episode.
Firstly, we must realise that pressure on the krone can go either way. There is no law of nature
saying that the krone always tends to weaken in a crisis. On the contrary, Denmark's role as a
creditor nation, which means that we have net foreign assets, means that future krone crises
are likely more frequently to result in upward pressure.
In January-February, capital flows were larger than in previous episodes when the krone has
been under pressure. While the interest rate typically is the most important instrument in a
situation where the krone tends to weaken, intervention in the foreign exchange market
potentially plays a larger role when capital is flowing into the country. In that situation there is
no upper limit to the amount that Danmarks Nationalbank can make available in kroner. The
very low level of interest rates in Denmark means that Danmarks Nationalbank profits from the
increase in the foreign exchange reserve.
The fixed exchange rate policy has served Denmark well for more than 30 years and is the
foundation for stable macroeconomic development. The pressure on the krone gave us an
opportunity to demonstrate, once again, that this policy is not up for discussion. Denmark's overall
economic policy is aimed at supporting the fixed exchange rate policy, and we have the means
and the will to defend the krone. Even if the situation calls for extraordinary measures.
***
Finally, I would like to talk about what the new crisis management regime means for the
mortgage banks.
Basically, the Bank Recovery and Resolution Directive establishes a common framework for
the resolution of credit institutions across the EU. The underlying philosophy is that losses
should be borne by those who took the risks. In other words, owners and creditors. Public
funds should be protected. Those are the rules applying to other firms, and they should also
apply to banks and mortgage banks. That will support market discipline.
It shall be ensured that resolution of an institution does not have serious implications for the
economy and for financial stability. The functions that are critical to general economy must
therefore be preserved in the event of resolution, irrespective of the organisational set-up. In
this way, society in general is not taken as a hostage and forced to bail out an institution in
difficulties. That can only be achieved via robust planning of recovery and resolution. Such
planning will also ensure that bail-in becomes a real option in the future.
Since mortgage credit is a core element of the Danish financial system, the new framework
will obviously affect the individual mortgage banks. Overall, there are three reasons why
difficulties experienced by a mortgage bank may have serious implications for the economy
and for financial stability. These should be taken into account in our planning.
Firstly, the mortgage credit sector is large and highly concentrated. Mortgage loans make up
around three quarters of all lending by credit institutions to households and the corporate
sector. And these loans are provided by just a small number of mortgage banks.
Secondly, the mortgage credit sector is closely interconnected with the rest of the financial
system, in that mortgage bonds, especially covered bonds - SDOs, are used as liquidity and
wealth instruments. So if their value deteriorates, this will affect the rest of the system.
Thirdly, all mortgage banks are based on more or less the same business model. This means
that they are also faced with more or less the same risks. If the market loses confidence in a
bond issued by one mortgage bank, confidence in and thus funding for the rest of the sector
may rapidly evaporate.
Therefore recovery and resolution planning should ensure that a mortgage bank in difficulties
will still be able to lend on market terms so that the lending capacity of the system does not
decrease. And it is necessary to ensure that the problem is contained within the mortgage bank
in question. Finally, it is essential that the government is not compelled to take on any
significant risk.
To prevent a situation where resolution becomes necessary, each mortgage bank must
prepare a recovery plan. The plan should examine the steps that may be taken if the mortgage
bank is in difficulties. This will allow you to spot any weaknesses and inappropriate structures
yourselves.
The recovery plan should take into account challenges in relation to both solvency and liquidity.
Obviously, it is critical for an institution if losses reach a magnitude that jeopardises its
solvency. But that will happen at a very late stage. Doubt about the viability of the business
model will arise at a much earlier stage, namely when the mortgage bank can no longer
maintain SDO status for bonds issued and fund itself on market terms. So it is crucial for the
mortgage bank to have a reliable plan to minimise the risk that this situation arises.
The plan should cover situations where only the mortgage bank itself is under stress as well
as situations where stress affects the entire financial system. This has a bearing on the
potential courses of action. In a situation where the entire financial system is under stress, the
option to divest and access to new capital may be limited.
In the event that a mortgage bank is deemed likely to fail, resolution procedures must be
initiated. If this is to be effected in an expedient way, it is necessary to have a robust plan
ready. That is the responsibility and task of the authorities. This task is fundamental to financial
stability. Together with the two resolution authorities - the Danish Financial Supervisory
Authority and Financial Stability - Danmarks Nationalbank is therefore working actively with
such plans for the systemically important financial institutions in Denmark.
The work on the resolution plans and the assessment of whether they will work involves a large
element of learning by doing. It is not work that will be completed this year. And the plans will
need to be updated on a continuous basis.
The mortgage banks are fully comprised by the crisis management regime. However, there is
one significant exemption, in that the minimum requirement for own funds and eligible liabilities
does not apply to them. This means that bail-in is not an option in connection with resolution.
Instead, the mortgage banks must hold a "debt buffer" of 2 per cent of their lending.
Right now, it is an open question whether a plan for resolution of a mortgage bank can observe
the resolution targets I have already mentioned without the bail-in tool. This also applies in
relation to the special winding-up model which the Mortgage Credit Act provides for. As we
have previously said, it would have been better if a minimum requirement for own funds and
eligible liabilities had to be set. In a resolution situation it would then have been possible for
perform bail-in on uncollateralised liabilities to a sufficient extent to ensure the operation of the
mortgage bank and the value of the SDOs - thereby supporting confidence in the mortgage
credit system. And the Danish mortgage credit model would not have acquired yet another
element that is not in conformity with the market.
***
Thank you.