LECTURE NOTES
LARS ROHDE
THOMAS SANGILL
MACROPRUDENTIAL POLICY IN DENMARK
MACROPRUDENTIAL POLICY AND SYSTEMIC FINANCIAL RISKS,
LECTURE 21, UNIVERSITY OF COPENHAGEN
12 May 2020
INTRODUCTION
(Slide 2)
These lecture notes outline the journey of the Danish Systemic Risk
Council ("the Council"), commencing at the roots of its establishment and end-
ing at the present time where it functions as the macroprudential
authority in Denmark. The lecture notes split this journey into ten sections and
casts light on both struggles and successes along the way. Section 1
summarises how the recommendations of the Committee on the
Structure of Financial Supervision led to the establishment of a systemic risk
council in Denmark. The institutional setup of the Council is elaborated
upon in Section 2, which also draws comparisons to the setup of
macroprudential authorities abroad. With the cornerstones of the institutional
setup laid out, Sections 3 and 4 proceed by outlining the first year of the
Council's work and the Council's two observations on conditions for a
rapid build-up of systemic financial risks, respectively. Subsequently, the
Council's road to introducing borrower-based measures in Denmark is
presented in Sections 5 and 6. In Section 7, the Council's framework for
assessing the countercyclical capital buffer is presented along with the
recommendations for activating and building up the buffer. The Council's
role as a macroprudential authority in the Faroe Islands and Greenland is
summarised in Section 8, while Section 9 outlines the Council's part in
facilitating the debate on systemic cyber risk and resilience in the Danish
financial sector. The last section of the lecture notes reflect on the
Council's work till now and looks into the crystal ball to see what the future
may hold. While the future is uncertain, it is clear that the Council's jour-
ney is far from over and the full potential of macroprudential policy in
Denmark has yet to be seen.
THE DANISH SYSTEMIC RISK COUNCIL IS ESTABLISHED
(Slides 3 - 4)
The global financial crisis of 2007/2008 led many countries to reconsider
their institutional frameworks for the oversight of the financial system.
One obvious place to look is the division of responsibilities between the
central bank and the financial supervisory authority. If these were
separate institutions before the crisis, the crisis may be an argument for
merging them and thereby placing banking supervision with a strong,
independent institution. On the other hand, it may jeopardise the
independence of the central bank to be involved in decisions regarding individual
financial institutions as these are often subject to strong political
interests.
In Denmark the central bank and the financial supervisory authority are
separate institutions. And after the global financial crisis, it was
considered to transfer banking supervision to the central bank. Thus, in
December 2010 the Minister for Business and Growth set up a Committee on the
Structure of Financial Supervision. In the terms of reference of the
committee, it was stated that several countries have taken initiatives to
change the organisation of financial supervision, so that the role of the
central bank is increased.1 However, in Denmark this issue was only
considered for a short period of time. After the general election in
September 2011, the new government concluded that it was not possible to find
a suitable alternative organisation which at the same time ensured that
the Government would have sufficient insight and knowledge about the
financial sector.2 Against this background, the Government and
Danmarks Nationalbank in agreement decided to put this part of the
committee's work on hold. Thus, the central bank and the financial supervisory
authority remained separate institutions. In the autumn of 2011, the
committee was tasked to investigate the need for establishing a national
systemic risk council. This new task gained prominence on the European
agenda in December 2011 when the European Systemic Risk Board
(ESRB) recommended all EU member states to appoint authorities to be
responsible for managing systemic risks.
The committee completed its work in June 2012 and recommended the
establishment of a systemic risk council to that should function as the
macroprudential authority in Denmark. This was written into Danish law
in December 2012.3 The ESRB has subsequently concluded that the
institutional framework of the established systemic risk council is largely
compliant with the guidelines in their recommendation from 2011.4
The Danish Systemic Risk Council ("the Council") has an advisory role and
works to prevent or reduce systemic financial risks that may put pressure
on all or parts of the real economy. The Council comprises two
representatives from Danmarks Nationalbank (the chair of the Board of
Governors of Danmarks Nationalbank being the chair of the Council), two
representatives from the Danish Financial Supervisory Authority, one
representative from each of the economic ministries5 and three independent
experts with knowledge of financial affairs. Danmarks Nationalbank
provides secretariat services to the Council. The Danish Financial Supervisory
Authority and the economic ministries participate in the secretariat. The
secretariat prepares all material for the Council's meetings.
According to the Financial Business Act, the Council's mandate is rather
broad within the financial area. Thus, the Council can address systemic
risks in areas which are only subject to limited regulation or no
regulation at all. However, the Act also put limits on how far the Council can go.
Hence, the judicial framework prohibits the Council from expressing
opinions about overall economic policy (e.g. fiscal, tax, or monetary policy) or
about sector policy beyond the financial area. Therefore, for example, the
Council in its work has had to take property taxation as given, even
though inappropriately designed property taxation may foster the
buildup of house price bubbles that together with loose credit standards may
lead to systemic risks. Also, according to the Act, the Council cannot take
a position on crisis management efforts in the form of bank packages or
specific banks in distress.
The Council has no direct power over any macroprudential instrument.
Instead, the Council may issue observations and warnings if specific
systemic risks are found to be building up, and it can issue
recommendations with specific initiatives to mitigate the identified risks.
Recommendations are issued on a comply-or-explain basis and may be addressed
towards the Danish Financial Supervisory Authority or, if it concerns
legislation, to the Government. However, in practice, the Council has
addressed all recommendations to the Government. This reflects that, while
the Council is the macroprudential authority in Denmark, the Minister for
Industry, Business and Financial Affairs has the exercising power when it
comes to, for instance, setting the countercyclical capital buffer. At the
time of the Council's establishment, Danmarks Nationalbank argued that
this responsibility should be delegated to the Danish Financial
Supervisory Authority or the Council.6 This opinion was rooted in the fact that
institutions facing public pressure may act too little and too late, as
macroprudential measures will often need to be implemented at a time when it
is difficult for the public to see the need hereof. On the other hand, one
can argue that as macroprudential instruments - especially so-called
borrower-based measures - directly affect households, they should not be
placed with non-elected officials.
According to the Act, decisions within the Council are taken on the basis
of majority voting. If the Council decides on a recommendation to the
government, however, only the members from Danmarks Nationalbank
and the independent experts are allowed to vote. A recommendation to
the government must include a statement by the representatives of the
ministries. The judicial framework also states that the Council should
strive for consensus. Therefore, all decisions made by the Council are
based on thorough discussions among all its members.
HOW DOES THE INSTITUTIONAL SETUP IN DENMARK COMPARE TO
OTHER COUNTRIES?
(Slide 5)
Compared to other European countries, the institutional setup in
Denmark is unusual. Only in two European countries (Denmark and Norway)
is the government responsible for the use of macroprudential
instruments specified in the capital requirements directive and regulation
(CRD/CRR), e.g. the countercyclical capital buffer, the systemic risk buffer
and SIFI buffers.
In general, the different institutional setups in Europe can be split into
two groups.7 In the first group, the macroprudential authority controls
the macroprudential instruments in the CRD/CRR. In this group, the
macroprudential authority is the central bank (12 countries), a systemic
risk council (4 countries), the financial supervisory authority (2 countries),
or the government (1 country (Norway)).
In the second group of countries, the macroprudential authority does not
control the macroprudential instruments. In this group, the
macroprudential authority is either a systemic risk council (9 countries) or the
central bank (1 country), whereas the authority controlling the instruments is
the central bank (6 countries), the financial supervisory authority (3
countries), or the government (1 country (Denmark)).
Looking only at countries where the central bank chairs a systemic risk
council without direct control over macroprudential instruments, it is the
central bank that controls the instruments in all countries except for
Denmark. Thus, the Danish institutional setup, where the Chair of the
Board of Governors at the central bank also chairs a risk council that can
issue recommendations to the Government on a comply-or-explain basis,
is indeed rather unique.
Internally in the Danish central bank, this setup has led to some
considerations as regards the dual role of the Governor. It is impossible for the
Governor to communicate the views on macroprudential policy of both
the central bank and the Council to the public. The press and people in
general would have difficulties distinguishing between different views
coming from the same person. Consequently, in order to preserve the
central bank's independence - including on its financial stability mandate
- the Governor can only speak on behalf of the central bank. This leaves
the Council without a voice in public. In fact, the only way the Council
communicates is through press releases and other documents released
on its webpage. The Council's secretariat can answer factual questions
from journalists, but all requests for interviews or further elaborations on
the Council's decisions have to be declined.
It is well-known that macroprudential policy decisions may suffer from
inaction bias. Their benefits will materialise only at some future point in
time while their costs occur immediately, which results in an incentive for
policy-makers to delay activating policy. However, in an institutional
setting as the one in Denmark, there is an extra dimension to this problem.
It may certainly be costly for the Government in the long run if it turns
down recommendations from the Council and a systemic crisis occurs.
But the Council also faces costs if its recommendations are not followed.
Furthermore, these costs are felt immediately. If a recommendation by
the Council is not followed, the Council's credibility is challenged. If this is
repeated, the Council risks becoming irrelevant. This can lead to a
"selfimposed inaction bias" by the Council.8 Therefore, long-term success of
the unique Danish model depends on policy-makers' continued
implementation of the Council's recommendations.
Finally, to compare the Danish institutional setup with countries in a
broader international perspective, Edge and Liang (2020) look at the
ways in which financial stability committees in various countries manage
the Countercyclical Capital Buffer (CCyB).9 The dataset that the authors
put together covers 58 countries. Of these, 47 countries have a financial
stability committee, most of which were set up after the financial crisis.
In the dataset, the average number of agencies on financial stability
committees is four, meaning that the number of agencies on the Danish
systemic risk council is a little above the average, though not significantly
so. The authors find that, in general, financial stability committees with
fewer agencies are more likely to overcome inaction bias. In terms of
setting the CCyB, the Danish setup is quite unusual, also in a broader
international comparison. In most countries, the central bank has the
authority for setting the policy, with a significant minority giving the authority to
the prudential regulator.
Edge and Liang (2020) also group countries based on aspects of each
country's financial stability committee that are considered to be
conducive to stronger policy-setting. The Danish Systemic Risk Council is
considered to be one of the strongest as it is formally created in national
legislation, it takes votes on its policies, it has a single, specified chair and it
has a formal role in advising the agency that sets the CCyB policy.
Therefore, while the Danish Systemic Risk Council is unusual by international
standards, it contains some features that can help overcome inaction bias
in macroprudential policy-making.
THE FIRST YEAR
(Slides 6 - 7)
The members of the Council were appointed by the Ministry of Business
and Growth on 21 February 2013. The three independent experts are
appointed by the Ministry of Business and Growth after consultation with
Danmarks Nationalbank. The overall philosophy behind appointing the
three independent experts is that they have different perspectives on
systemic risks in Denmark. One should be able to see systemic risks in
Denmark from the outside, using the experience of another country. In this
regard, Sigríður Benediktsdóttir, Head of the Financial Stability
Department of the Central Bank of Iceland, was appointed. She was later
followed by Ida Wolden Bache, Executive Director of the Monetary Policy
Department of Norges Bank. One independent expert should have
experience from the Danish financial sector. Here, Peter Schütze, former CEO
of Nordea Denmark, was - and still is - appointed. Lastly, one expert
should be from academia with knowledge of the insurance sector. In this
regard, Torben M. Andersen, professor at Aarhus University, was
appointed, and later followed by Svend Erik Hougaard Jensen, professor at
Copenhagen Business School.
The Council held its first meeting on 8 April 2013. At the first meeting, the
Council made a suggestion for rules of procedure for the Council to the
Minster for Business and Growth.10 While the Financial Business Act
provides the framework for the Council's tasks and responsibilities and
contains rules for appointment of members, the rules of procedure lay out
the services of the secretariat, what the Council publishes and rules for
appointing alternates. The Minister approved the rules of procedure.
At its first meeting, the Council decided to issue a press release.11 It has
definitely added to the transparency of the Council that all its meetings
have been followed by a press release. The press releases highlight the
main discussions and conclusions from the meetings and provide
information if the Council has issued observations, warnings or
recommendations, which are also published on the Council's webpage.
During the first meetings of the Council, the topics of discussion revolved
around creating a framework for risk-monitoring in Denmark and
assessing the current systemic risks in the financial system through this
framework. It became a practice to start each meeting with an
assessment of current risks in the financial sector in Denmark, followed by
discussions of potential macroprudential measures to address identified
risks and ad-hoc analysis if warranted. For instance, at its second meeting
in June 2013, the Council decided to analyse: 1) whether the high indebt-
edness of Danish households could involve systemic financial risks, and 2)
systemic risks related to a prolonged period with low interest rates.12
Already at the Council meeting in June 2013, the Council published its first
recommendation. It was a recommendation on the phasing-in of the
capital requirements in Danish legislation. Specifically, the Council
recommended that the government put forward legislative proposals that
implement the recommendations of the Committee on Systemically
Important Financial Institutions and the capital and liquidity requirements of
the CRD IV and CRR. However, the Council recommended three
exceptions to the time-frame for implementation. One of the exceptions was
that the countercyclical capital buffer framework should be introduced
from 1 January 2015.
The Government's response to the recommendation was support, but the
Government also pointed out that action could not be taken until political
negotiations regarding financial regulation, including regulation of SIFIs,
had been completed. During the fall of 2013, a proposal to implement
CRD IV into Danish law was put forward, and on 18 March 2014 the law
passed in parliament. On that background, the Government issued a
second response to the Council. On 27 March 2014, the Council responded
to the answer from the government, acknowledging that the
recommendation had generally been followed. However, the Council noted some
deviations, e.g. that the framework for the countercyclical capital buffer
would be phased in gradually from 2015 to 2019. The Council had
recommended that the framework should be implemented in full from 2015.
The Council found that if, for example, credit developments in the period
up to 2019 would warrant a level of the countercyclical buffer that was
higher than the one allowed under the gradually implemented
framework, new legislation would be required.
MACROPRUDENTIAL POLICY IN A LOW INTEREST RATE ENVIRONMENT
(Slide 8)
While macroprudential policy has gained prominence as a response to
the global financial crisis of 2007/2008, the focus of policy actions has to
a large extent been on limiting the potential negative side effects of a
prolonged period of very low interest rates.
In the fall of 2014 and again in the spring of 2015, the Council issued
socalled observations entitled "Low interest rates and build-up of systemic
risks".13 An observation is one of the three forms of statements the
Council can issue apart from the press release. An observation implies that
according to the Council's assessment there is a risk that systemic financial
risks may be building up; however, no-one is required to comply with an
observation.
In the first observation, the Council outlines the potential transmission
channels through which the very low interest rates could give rise to a
number of systemic financial risks. The first channel is the search for yield,
with investors seeking higher risk in expectation of higher yields,
resulting in low risk premia and rising asset prices. The second channel is the
expectation that central banks will always come to the rescue if
developments in the financial markets are contrary to expectations. That pattern
of monetary policy was actually so widely practised by the Fed under
chairman Greenspan that it was called the "Greenspan put" - referring to
the protection of a put option on asset prices.14 The pattern of providing
ample liquidity to markets every time there are signs of unrest is now
even more widely used - by more central banks and with more monetary
policy tools such as direct asset purchase programmes. However, the
short term stabilisation of markets comes at a price - misaligned
incentives leading to further risk-taking behaviour.
All in all, a prolonged period of low risk premia, low volatility and rising
asset prices may result in inherent expectations of these developments
continuing for a long time. This may lead to underestimation of risk - or
risk illusion - on the part of both financial institutions and their
customers. Unfortunately, governments and authorities are not immune to risk
illusion either - over time they may also be led to believe in an
everlasting boom of the economy.
In its statement, the Council finds that at that point in time "no
considerable systemic risks have built up in the Danish financial system as a result of
the level of interest rates".15 However, the Council also points out a
number of areas where systemic risks might potentially develop and require
extra caution, such as credit growth and credit standards, house price
developments and search for yield resulting in excessive risk-taking by
both borrowers and lenders.
In the second observation from March 2015, the Council draws special
attention to the housing market, noting that: "There is currently an
unusual combination, not previously seen, of extraordinarily low interest rates,
rising house prices and an expanding economy. This combination could
lead to inappropriate behaviour in the form of excessive risk-taking and risk
16
illusion among borrowers and credit institutions..." The Council therefore
urges banks to exercise suitable caution when granting mortgage loans,
particularly when granting interest-only loans or loans with variable
interest rates.
With these two observations, the Council also maps out the areas that it
would address in its policy discussions and policy decisions at the
following meetings: credit growth and credit standards, the search for yield
resulting in excessive risk-taking by both borrowers and lenders and finally
the housing market.
THE COUNCIL'S FIRST ATTEMPT TO LIMIT INTEREST-ONLY MORTGAGES
(Slide 9)
After the September meeting in 2014, the Council issued a
recommendation addressed to the government. The objective of the recommendation
was to lower the maximum LTV limit on interest-only mortgages, i.e.
mortgages where amortisation is deferred.
To understand the context of the recommendation, it is important to
understand that Danish mortgage credit institutions play a very important
role in the Danish economy and the financial system. Mortgage credit
institutions are specialised banks that grant loans collateralised by real
estate. These mortgages constitute some two-thirds of total credit granted
to Danish citizens and enterprises. The bonds that mortgage credit
institutions issue to fund the mortgage loans are important liquidity
instruments for Danish banks as well as a major asset class for Danish pension
companies.
The current legislation stipulates that Danish mortgage credit institutions
may issue mortgage loans against residential real estate corresponding
to a maximum of 80 per cent of the value of the property. The
introduction of interest-only mortgages did not change that. However,
interestonly mortgages may imply higher credit risk if households do not use
these mortgages for other consolidation purposes. Further, studies by
Danmarks Nationalbank documented that the introduction of
interestonly mortgages could account for a significant share of the excessive
house price development prior to the crisis.17 The recommendation of
the Council was for the government to change the statutory LTV limit in
order to strengthen confidence in, and the robustness of, the Danish
mortgage-credit model.
The recommendation was issued at a time when the so-called
Supervisory Diamond for Mortgage Credit Institutions was being drafted. The
Supervisory Diamond is a microprudential tool that addresses a number of
risk dimensions that materialised during the financial crisis. In the
drafting phase, it was discussed whether risks related to interest-only
mortgages should be a part of it. The Council's recommendation should also
be seen in this context. Both by acknowledging that risks related to
interest-only mortgages with high LTVs should be included in the Diamond,
but also by explicitly stating that the government should go further: The
Supervisory Diamond should be supplemented with hard legislation on
lower LTV limits for interest-only mortgages as the Diamond leaves too
much room for discretion.
The government disagreed. A somewhat stricter version of the
Supervisory Diamond for Mortgage Credit Institutions was implemented with the
aim of reducing risks related to interest-only mortgages with LTVs above
60 per cent. But the statutory LTV limits remained at 80 per cent. In the
written statement by the representatives of the government, the
Supervisory Diamond - in conjunction with other national and international
measures taken - was deemed sufficient to reduce the current risks linked
to households' home financing in an appropriate way.
The government's reluctance to impose stricter measures probably
reflects the political economy trade-off where it is much more difficult for
politicians to restrict a measure rather than loosening it. The party starter
that turns on the music and brings cocktails to the table wins more
popularity contests in the short run than the guy that turns off the music while
encouraging the crowd to get a good night's sleep to avoid hangovers.
Restrictions on lending represent a cost which is immediately visible to
the public, whereas the benefits of borrower-based measures, e.g. a
reduced probability of financial crises, are abstract and will be reaped only
in the longer term when the current elected representatives may not be
in charge.
In the Council's assessment, the verdict was that the government had
only partially complied with the recommendation. Overall, the Council found
that systemic risks linked to interest-only mortgages were reduced by the
Supervisory Diamond but that there were still systemic risks linked to the
mortgage credit institutions' ability to grant interest-only mortgages at
high LTV ratios. That is, the Council did not agree with the government's
explanation for not complying in full with the recommendation.
The partial compliance by the government initiated some internal
discussions in the central bank regarding the comply-or-explain mechanism. On
the one hand, the government had evidently put forward an initiative
that addressed the identified risks in the recommendation. Accordingly,
the explanation by the government carried some weight - at least in the
eyes of the greater public - and the Council also acknowledged that the
Supervisory Diamond was a step in the right direction. On the other
hand, if partial compliance by introducing softer versions of
recommended measures was a sign of what to expect in the future, then perhaps the
comply-or-explain mechanism needed to be revised. The government is
represented in the Council and takes part in the discussions, so in theory
they could always be able to front-run a recommendation before it is
published by implementing a soft version of a proposed measure - thus
signalling to the public that it has done enough. Formal discussions in the
Council on this issue were, however, not put forward.
THE LONG WAY TOWARDS A BORROWER-BASED MEASURE
(Slide 10)
After its 17th meeting in March 2017, the Council issued a new
recommendation on a borrower-based measure. The government was
recommended to restrict lending to households with a DTI ratio above 4. The
recommendation had a narrow geographical focus as it only applied to
mortgage lending in Copenhagen and Aarhus.
It had been a long way towards this borrower-based measure. The
government had rejected the Council's recommendation on lowering LTV
limits on interest-only mortgages in 2014, so it was important for the
Council that the government would follow a subsequent recommenda-
tion on a borrower-based measure. If not, the Council might lose its
relevance.
A number of initiatives and public statements were initiated to help pave
the way. In March 2015, the Council issued its second observation on
risks related to a prolonged period of low interest rates. The observation
stressed, among other things, that the current combination of low
interest rates and rising house prices could lead to excessive risk-taking and
risk illusion.
In November 2016, the Council hosted a conference with the title
"Macroprudential instruments targeted at the real estate market". The
programme included speeches and panel discussions among Danish and
international macroprudential authorities, academics and banking
industry representatives.18 A discussion paper outlining possible ways to
address housing market-related risks was published by the Council as a way
of setting the stage for the conference, and a public consultation was
launched.19 The banking industry acknowledged that macroprudential
measures may be warranted but called for flexibility.
The recommendation was then issued in March 2017. As mentioned
earlier, the recommendation asked the government to restrict new lending to
households with a debt-to-income ratio above 4. The recommendation
allowed 15 per cent of new loans to be exempted. 30-year fixed rate
mortgages with regular principal repayments were also exempted. Thus,
credit institutions were granted flexibility to deviate from the rule as
initially requested.
The main concerns stated in the recommendation were related to high
house price increases in the larger Danish cities and, as a consequence,
increased lending growth to households with high debt levels and high
interest rate sensitivity. It is often debated whether macroprudential
policies should target house prices explicitly. Is a high price level a systemic
risk concern, an efficiency issue or a distributional problem? And, further,
are macroprudential policies the best way to address house price
developments if they are deemed a concern? During internal discussions in the
Council, the observed high house price growth was not considered to be
the main cause of concern per se. Rather, it was risk build-up related to
lending to vulnerable households coupled with the widespread use of
interest-only mortgages that the Council wanted to address. The
emphasis of concerns related to house price growth in the recommendation
reflects the fact that the Council only has soft powers and, hence, relies on
the will of the government to act. And to the public, it was very visible
that house prices in Copenhagen and Aarhus were increasing rapidly,
whereas the risks associated with lending growth and loosening of credit
standards might have been more abstract. The final recommendation
thus contained references to both house prices and lending growth.
The geographical focus on Copenhagen and Aarhus was also related to
political economy considerations. As in many other Western economies,
urbanisation trends are strong in Denmark and the recovery since the
financial crisis has been highly asymmetric. The larger cities have
experienced strong growth, whereas rural areas have remained below pre-crisis
levels in terms of economic activity and house price levels. Many
government policies - regardless of who has been in charge - have had an
explicit focus on not making areas outside the larger cities worse off.
Making the recommendation applicable only to Copenhagen and Aarhus
was considered to increase the chances that the government would
accept it. And, in terms of archiving its goal of reducing systemic risks, the
geographical differentiation was fully justified as high lending growth and
loosening of credit standards were concentrated around the big cities.
The government initially decided to follow the recommendation in its full
wording and credit institutions had to comply with rules from 1 October
2017. However, in the fall of 2017 it was also time for local elections and
it turned out that housing market regulation became a theme. Politicians
in municipalities located just inside the greater Copenhagen area were
complaining that these municipalities would be treated unfairly relative to
municipalities just outside the area. After a few days of critique in the
media, the government decided to postpone the implementation of the
measure. Geographically differentiated housing market regulation turned
out not to be easy to implement after all, at least not during local
elections. The government subsequently chose to implement a somewhat
softer version of the measure applicable to all of Denmark from January
2018. The adopted measure was softer primarily in the sense that
interest-only mortgages could also be exempted if the interest rate was fixed
for 30 years. Nevertheless, the Council officially acknowledged that it
served its purpose.
The measure was implemented as an executive order in the so-called
good practice for mortga