Per Callesen: Current economic and financial issues affecting Denmark
Speech by Mr Per Callesen, Governor of the National Bank of Denmark, at the International
Capital Market Association's (ICMA) Annual General Meeting and Conference 2013,
Copenhagen, 24 May 2013.
* * *
Thank you for the invitation.
As this important event is held in Copenhagen, I expect you would appreciate reflections on
some of our domestic issues and a few international issues seen from our perspective. I will
try to cover:
 Our current economic situation and the experience of negative policy interest rates
 The state of our banking sector, now soon 5 years after the outbreak of the financial
crisis
 Perspectives on the European banking union
 FTT
1. Current economic situation and negative interest rates
The fundamentals of the Danish economy are by and large at par with most other
NorthWestern European economies. We have very large levels of private savings, large current
account surplus, moderate public sector deficit, low inflation, moderate levels of
unemployment and extremely low interest rates.
Growth is low for both structural and cyclical reasons. Structurally, the working age
population is no longer increasing and productivity growth is weak. For a number of years
even weaker than in many peer countries. Cyclically, we are still in the aftermath of a strong
housing and construction bubble which led to overheating in 2006-07. Fiscal policy is over
the years 2011-2013 moderately contractionary, tightening the structural balance by 0.5 per
cent of GDP annually after major stimulus in 2009 and 2010.
High savings and low real investments imply that Denmark is increasingly becoming a
creditor nation. That was not the case just going back 5 years. Now the international
investment position is net assets of 35 per cent of GDP and net annual revenues from the
return on assets are some 3-4 per cent of GDP.
This, together with moderate pressures from net capital inflows, has provided some currency
challenges. We have successfully run a fixed exchange rate policy for 30 years, first against
the Deutsche-mark, later against the euro. We were used to have moderate interest rate
spreads and in some cases had to raise policy rates more significantly to counter negative
currency pressures, which tend to come in recessions, such as in 1993, 2000 and 2008. In
recent years this has reversed. The challenge has been to avoid currency appreciation.
Our policy remedies are a combination of currency intervention and interest rate
adjustments. In most cases we have simply shadowed decisions taken by the ECB. In late
2011 our policy spreads towards the ECB became negative. When the ECB cut its deposit
rate even further in July 2012 we followed suit, this time taking our marginal deposit rate (for
certificates of deposits which have a maturity of one week) to negative territory at -0.2 per
cent. By January 2013 we increased the negative rate to -0.1 per cent following some
reversal of the previous inflows.
Episodes of negative market interest rates are rare, but they happen. There are examples of
negative rates for T-bills in Japan in the 1990s and recently for short term money market
rates in Germany, Switzerland and Denmark. Episodes of negative policy rates are very rare.
So what have we learned?
First, the transmission to market rates has worked well. Money-market rates fell and the
currency weakened - as intended - probably because the remaining uncertainty about our
readiness to introduce negative rates vanished. Subsequently, upwards currency pressure
also faded due to improvements in the debt financing situation of vulnerable euro area
countries. The volume of money market transactions has declined, but the money market still
functions well. We were careful in preparing market participants well in advance that moving
towards negative deposit rates was an option and explained how the system, if invoked,
would work.
Second, spill over, if any, to the retail rates of private banks has been very limited. The
annual costs associated with a negative policy rate of -0.1 per cent compares to 0,013 per
cent of private bank lending volume, or in other words 1.3 basis-points. When private banks
have positive net positions, deposits, at the central bank, lower policy rates will affect their
earnings. The marginal impact is not stronger by moving into negative territory than reducing
a positive rate to a level less positive.
Third, neither private banks themselves nor their customers have increased their cash
holdings. For the former large amounts of cash holdings are probably too costly as compared
to negative policy rates of such a low level. For customers, the incentive to hold more cash
has not been present, since banks have not introduced negative deposit rates for customers.
Can our experience be copied? We do not take positions on the policy stance of other central
banks and we are careful not to make parallels to very different situations. Our case is
specific, a small open economy and a very explicit exchange rate target. Our concern was
not to directly target inflation or spur lending to the real economy.
2. The current state of the banking sector
The Danish banking sector - like banking sectors in peer countries - found itself in 2008 with
far too little capital and too much reliance on short term whole sale funding. We had, and to
some extent still have, a long tail of smaller banks of which too many were weak, although
we also have many well-run smaller banks.
May be surprisingly for some, the collapse of the housing bubble has not caused direct
problems for financial stability. There is much international talk about high household debt in
Denmark and some other Northern European - I would add the term creditor - countries. In
our case, loan impairments in our mortgage institutions due to household exposures - and
these institutions provides by far most of lending for housing - cumulates to less than 1 per
cent of lending over the entire 5-6 years since the collapse of the housing bubble. Also for
the banking sector itself, write down of household exposures have been very limited.
It helps of course that debt servicing costs are very low and falling. It helps that our mortgage
system has a very strong prudential framework. It helps that households also have very large
financial assets. Whereas previous generations of owner occupied houses paid down debt
almost entirely before retirement, current generations have large private pensions and can
continue to serve debt. Note also that household debt is strongly correlated with income. The
20 per cent of households with the highest income owe more than 50 per cent of household
debt. They are also those most likely to hold large financial assets in addition to the value of
houses.
Neither was trouble for the banking sector caused by their investment or proprietary trading
positions - structural separation of banks is not the issue in this country.
What caused the banking problem was, on the back of small capital and liquidity buffers,
traditional lending - one could add reckless lending - to commercial real estate, some
expansionary business developers and certain branches such as agriculture. Also, our
largest bank had a branch in Ireland which suffered from very high losses. Domestically the
housing bubble and its collapse indirectly reinforced these problems due to the large
contributions to the bust of the real economy. Of course also the negative spill over from the
weak international economy took its toll on the real economy and bank exposures.
In our assessment, Denmark has come a long way to clean up problems in the banking
sector. Profitability is still low due to high levels of loan impairments related to the lending
previous referred to. And some smaller banks still struggle. But overall the sector has
become much better capitalized and prepared for the future. However, we are not done yet.
Recently, a government-appointed commission on systemically important financial
institutions recommended, inter alia, a special capital surcharge for Danish SIFI's. The
surcharge varies between 1 and 3.5 per cent of risk-weighted assets. We would expect the
total capital charges for our SIFI's to be by and large at the level set in peer countries with
similarly sized banking sectors. Our recommendation is therefore to implement the
recommendations of this committee (in which we took part) and strengthen capital
requirements without delay. To quickly clarify the regulatory requirement for SIFI's has strong
merits.
Arguments, if any, for a mediocre capitalization of banks are weak and not persuasive.
As a point of departure, the risk of and return to assets of a bank are not related to the
composition of liabilities. Higher capital should therefore not have much of an impact for its
overall funding costs. To the extent this would not be the case, the main reason is likely to be
that investors attribute a high probability of government intervention and bail-out in case a
failure of a bank due to its low capital. Implicit government guarantees are not a good
substitute for well capitalized banks. They would be distortive, expensive for tax payers and
leads to too much risk-taking.
It is an investment worth taking even if funding costs and therefore lending costs would
increase marginally due to higher capital requirements. Financial crisis are very costly and it
has a strong payoff to reduce their frequency.
In the Danish case the larger banks has already come a long way by increasing their capital
positions, in some cases beyond the stipulated future regulatory requirements. Benefits have
also already materialized: As an example, the funding costs of Danish banks relative to
competitors have come down substantially over the last 1-2 years in parallel with better
capital positions
3. Banking Union
The European Banking Union is a major issue under discussion and development. We
believe this makes a lot of sense. Just a few remarks to make clear where we stand:
Denmark is a strong supporter of a harmonized approach to resolution where comprehensive
and rules-based bail-in of bank creditors comes first and in center of any resolution of a
troubled financial institution. Of course a fiscal lending or capitalization backstop is needed
and dealing with any SIFI in distress will have to manage the systemic concerns.
While there are euro area specificities related to banking, most issues of the banking union
has a broad scope of caring for the internal market, ensuring efficient cross-border
cooperation and breaking the link between sovereign and banks, creating better mutual
insurance. Thus, it is a matter for all EU countries.
The Central Bank has urged the government to engage actively in discussions of
developments of the full the banking union, including potential participation in the Single
Supervisory Mechanism. It is our impression that this is taken up well.
4. FTT
Finally, a few words on the Financial Transaction Tax, which I understand has been a focus
area for ICMA. In short, we share the concerns raised about this. Banks are wrong if they
complain about higher capital requirements. They are right if they complain about FTTs.
Some issues debated have been the difficulties of ensuring the global coverage of such a tax
and the incidence of costs. The real and most important issue should, however, be how such
a tax will affect the functioning of the detailed machinery of financial markets. A few
observations:
We observed in the financial crisis that illiquidity is problematic and can trigger large
difficulties. Bank regulation therefore calls for larger liquidity buffers. The FTT is effectually a
tax on market liquidity and thus works counter to the intention of liquidity regulation.
As liquidity in secondary markets is intentionally reduced by introducing an FTT, one should
expect higher investor premiums in primary markets. This will raise funding costs in many
markets, including for government debt.
Very many transactions are undertaken by financial institutions on behalf of non-financial
companies in order to mitigate risks of fluctuation of currencies, raw materials etc. Higher
costs of such insurance would likely lead to less risk mitigation, or in other words more
"speculative" exposures.
As regards volatility in financial markets it is doubtful that less liquid markets would reduce
such volatility. Here the effects tend to move in different directions and the literature tends to
be inconclusive. Markets for real products would probably be more volatile. If financial
instruments can no longer serve the functioning of smoothing and shift the risk of exposures
to those who can professionally bear it at smaller costs.
Overall an FTT does not fit well with current efforts to repair the financial system.
Thank you for the attention!