Danish Financial Supervisory Authority's Expectations Regarding Capital Plans and Targets

---

Danish Financial Supervisory Authority's Expectations Regarding Capital Plans and Targets

1. Introduction The financial crisis demonstrated that weak capital buffers in financial firms can become costly – not only for the individual firm, but for society as a whole. During a financial crisis, asset prices typically fall and market risk premiums rise. This can lead to losses and increased provisions for both credit institutions and insurance companies. If these become too large, they will threaten the capital position and potentially the continued existence of the individual firm. Losses for shareholders can be significant, as a breach of capital requirements can lead to the withdrawal of the license to continue operations and thus the value embedded therein. When the capital position of financial firms is under pressure, their ability to act in the public interest as intermediaries of capital between savers and investors is reduced, as the focus of each company shifts to survival. Lending from credit institutions risks drying up, while insurance companies may be forced to sell off their securities holdings at unfavorable prices (fire sales) to reduce losses. Both developments reinforce an economic downturn in society and can create a vicious cycle from the financial sector to the real economy (negative feedback loop). Furthermore, problems in a single firm can spread to other firms due to the close interplay in the sector, thereby threatening financial stability. During the most recent financial crisis, the financial sector came under such pressure that the state was forced to assist the credit institution sector to support lending and financial stability. This was done through both guarantee schemes and state capital injections of DKK 46 billion to credit institutions to ensure the maintenance of sufficient lending. Danish Financial Supervisory Authority 7 November 2018

2/17 In the pension sector, market developments created a risk of an inappropriate large sale of, among other things, Danish mortgage bonds, with resulting negative consequences for pension savers, the bond market, and homeowners. Adjustments were therefore made to the term-dependent discount rate curve for insurance companies to reduce the incentive for fire sales and thereby unnecessary losses for pension savers. The adjustment of the interest rate curve reduced provisions and improved the capital position. Adequate capital buffering is therefore crucial when times turn again. This presupposes robust capital planning that takes into account, among other things, regulatory requirements, business model, economic development, and dividend policy. Up to the financial crisis, banks, as now, paid out large dividends and carried out buybacks of their own shares. Several of these institutions had to raise new capital during the crisis at a time when share prices were at their lowest, see Figure 1. Figure 1: Credit institutions raised capital at a time of low share prices Note: All credit institutions, excluding Nordea Bank Denmark, as Nordea raises capital in its parent company in Sweden. The share price is a simple average of indexed share prices for Danske Bank, Jyske Bank, and Sydbank. Source: Reports to the Danish Financial Supervisory Authority and Bloomberg. If credit institutions had been more restrained in paying dividends, the need for subsequent capital raising during the crisis would have been significantly lower, see Figure 2. Credit institutions and their shareholders would thereby have been in a considerably better position, and several bank rescues with public intervention might have been avoided. One institution, for example, had distributed 26 pct. of the average equity capital (x-axis) but subsequently had to raise capital equivalent to 76 pct. of equity capital (y-axis), see Figure 2. Several institutions would not have needed to raise capital at all after the crisis. This applies to the institutions that lie below the 45-degree line. These institutions paid out larger dividends in the period 2005-2008 than their subsequent need for capital raising. However, the institutions that had the greatest capital challenges (those lying above the 45-degree line) could not have managed alone by refraining from dividend payments. Figure 2: Lower dividends would have meant less need for new capital Note: The figure contains the institutions that distributed dividends in the period 2005-2008 and raised capital in the period 2009-2012. The figure shows each institution's total distributions in the period 2005-2008 in relation to the average equity capital in the period 2005-2012. This is compared with the institution's total capital raising in the period from 2009-2012 in relation to the average equity capital in the period 2005-2012. Some institutions raised capital larger than 150 pct. of the average equity capital. They are not shown in the figure. Source: Reports to the Danish Financial Supervisory Authority. In the years after the financial crisis, the solvency coverage of insurance companies was likewise under pressure due to falling interest rates and larger provisions, see Figure 3. The interest rate curve for discounting insurance liabilities was adjusted for insurance companies in 2008, 2011, and 2012 for various reasons. A consequence of the adjustments was, among other things, eased pressure on solvency. Over the period, the product composition in companies has also changed significantly. Initially, guaranteed products made up by far the largest share of volume, while non-guaranteed market rate products now also account for a significant share. This development has eased the capital requirement for companies, as customers themselves bear the investment risk in market rate products. Finally, the calculation of capital requirements changed to be risk-based in 2014. The level of the lowest 10 pct. percentile was low in the years around the crisis, see Figure 3, and lower than the level where the Danish Financial Supervisory Authority strengthens its focus on individual companies.

4/17 Figure 3: Pressure on insurance companies' solvency coverage after the crisis Note: All life insurance companies, cross-sector pension funds, and non-life insurance companies. Solvency coverage is calculated as basic capital as a pct. of capital requirements. For 2016 and 2017, solvency coverage is calculated as the lowest overcoverage for either the solvency capital requirement or the minimum capital requirement. The interest rate curve was adjusted in 2008, 2011, and 2012. In 2014, the calculation of capital requirements became risk-based. The 0.1-fractile indicates that 10 pct. of observations have a solvency coverage below the value, and the 0.25-fractile indicates the corresponding 25 pct. of observations. Source: Reports to the Danish Financial Supervisory Authority. This paper describes the regulatory capital requirements, the consequences of breaching these requirements, and the Danish Financial Supervisory Authority's options within the regulation for credit institutions and insurance companies1, which are intended to strengthen companies' capital planning so that the financial sector is better equipped for a future crisis. The paper also contains a description of the Danish Financial Supervisory Authority's expectations regarding how financial firms ensure adequate capitalization while taking into account upcoming requirements and general uncertainty about the future. In the Danish approach, there is an expectation of higher capital overcoverage relative to capital requirements to ensure adequate capitalization, as capital requirements are lower in Denmark than in the other Nordic countries. 2. Credit Institutions 2.1 The regulatory capital requirement for credit institutions Requirements for credit institutions have been tightened significantly. Among other things, stricter requirements have been set for capital (both in quantity and quality), liquidity, and above all for companies' governance.

1 Insurance companies cover life insurance companies, cross-sector pension funds, and non-life insurance companies.

5/17 All credit institutions are subject to a regulatory capital requirement consisting of an individual solvency need, which reflects the institution's risk profile, and a number of capital buffers with different purposes, see Figure 4. Figure 4: Composition of credit institutions' regulatory capital requirements Institutions' individual solvency needs consist of a Pillar 1 requirement of 8 pct. of the institution's risk-weighted exposures and an individual Pillar 2 add-on, which depends on institution-specific factors not subject to capital requirements under Pillar 1. The requirement for the add-on is, for example, imposed if the institution has special credit concentration risks. This can be industry concentrations or significant exposures to large customers in economic difficulties. The Pillar 2 add-on varies considerably between individual institutions but typically lies around 2-3 pct. of risk-weighted exposures. The capital buffers consist of a SIFI buffer for systemically important institutions, the SIFIs, as well as a capital conservation buffer and a countercyclical capital buffer. SIFIs are subject to an individual requirement – a SIFI buffer. This requirement reflects that some institutions are assessed as so significant that uncontrolled crisis management will have major consequences for financial stability. SIFIs must therefore hold capital to withstand larger losses than other institutions. The SIFI requirement is individual and depends, among other things, on the institution's size. The requirement can be up to 3 pct. of the institution's risk-weighted exposures when fully phased in by the end of 2019.

6/17 The capital conservation buffer is intended to ensure that the institution is further resilient in a situation with extraordinary losses not linked to economic development. The capital conservation buffer is 2.5 pct. of risk-weighted exposures when fully phased in by the end of 2019, and is the same for all institutions. The countercyclical capital buffer is imposed on institutions during periods when risks are built up, e.g., when risk perception on financial markets is very low and liquidity is abundant. The countercyclical capital buffer is intended to give institutions extra resilience to withstand losses that arise when economic cycles turn and losses on the loan portfolio increase. Fully phased in by 2019, the countercyclical capital buffer can be up to 2.5 pct. of risk-weighted exposures. In special cases, it can be set higher than 2.5 pct. Currently, the countercyclical capital buffer is 0 pct., but will be raised to 0.5 pct. effective 31 March 2019 and an additional 0.5 pct. to 1 pct. from 30 September 2019. Unlike the capital conservation buffer, the countercyclical capital buffer can be lowered. For example, a lower capital requirement in a situation with low or negative growth may enable an institution to support demand for lending. The buffer therefore not only protects against losses when economic cycles turn, but also helps reduce pro-cyclicality in the financial sector. Economic cycles are generally amplified by credit institutions because loan growth is high in good times but low in bad times. An economic downturn is thus amplified. When the buffer is reduced, it releases capital that improves the ability of institutions to maintain appropriate lending during periods of stress in the financial system. Requirements are set for credit institutions' boards to prepare capital plans that must ensure sufficient capital to meet regulatory capital requirements in the future and taking into account, among other things, the institution's business plans and societal conditions.2 A number of requirements are set for the capital base to meet capital requirements to ensure the quality of capital, see Box 1.

2 Regulation on the calculation of risk exposures, capital base, and solvency need.

7/17 In the years leading up to the financial crisis, the share of own equity capital (CET1) in credit institutions fell relative to the total capital base. In 2004, CET1 accounted for 79 pct. of the capital base, while it fell to 73 pct. at the end of 2007, see Figure 5. The share of CET1 fell even though institutions had record-high earnings during the period. At the same time, institutions issued significantly more supplementary capital – from DKK 42.5 billion in 2004 to DKK 78.6 billion in 2007 –, which subsequently became difficult to refinance. Supplementary capital is typically characterized by a maturity of 8-10 years3, meaning there will be a need for refinancing at maturity, whereas hybrid core capital essentially has an infinite maturity. When the crisis hit, institutions had to seek help to raise new capital. This was primarily done through state capital injections of hybrid core capital of approx. DKK 46 billion as a result of the credit package (Bank Package II) in 2009. In recent years, the share of CET1 has been roughly constant. Credit institutions have, in other words, not on the whole used the high earnings of recent years to significantly buffer their capital base.

3 The issuances were typically linked to an interest rate trigger that made repayment more expensive after a certain horizon if the issuance was not redeemed at the time the interest rate increase was activated. Box 1: Requirements for credit institutions' capital instruments The capital base can consist of own core capital (CET1), hybrid core capital (AT1), and supplementary capital (T2). CET1 has the highest quality and consists of share, guarantee, and partnership capital, transferred earnings, and other reserves. Pillar 1 requires capital of 8 pct. of risk-weighted exposures (RWA) and further specifies the composition of capital. Own core capital must account for at least 4.5 pct. of RWA, and total core capital, i.e., the sum of CET1 and AT1, must account for at least 6 pct. of RWA. Supplementary capital to meet Pillar 1 may therefore maximally account for 2 pct. of RWA. The Pillar 2 requirement must be met with the same distribution key as the Pillar 1 requirement. The other buffer requirements must be met with CET1.

8/17 Figure 5: Credit institutions' distribution of capital instruments Note: All credit institutions at the highest consolidation level. State hybrid capital is calculated at nominal values as stated in institutions' accounts. The development is calculated at year-end. Source: Reports to the Danish Financial Supervisory Authority and financial reports. The Danish Financial Supervisory Authority will also in the future focus on whether credit institutions rely more heavily on supplementary capital, which risks having to be refinanced in difficult times. 2.2 Write-down eligible liabilities for credit institutions In addition to tightened capital requirements, credit institutions are subject to new rules for write-down eligible liabilities – NEP liabilities – effective 1 July 2019. The rules prescribe how a resolution or reconstruction can be carried out by writing down parts of the institution's liabilities in a clearly predefined order. The purpose is to protect simple depositors from losses and avoid the need for public funds to reconstruct troubled credit institutions. The NEP requirement consists, in addition to the solvency need and capital buffers, of any loss absorption add-on and a recapitalization amount. NEP liabilities consist of share capital and other capital instruments that are written down first. In addition, NEP liabilities can be special NEP issuances that sit immediately after capital instruments in the bankruptcy order. The requirement for write-down eligible liabilities is largest for systemically important institutions. The requirement for write-down eligible liabilities is not directly a requirement for additional capital. In practice, however, meeting the NEP requirement for many, especially smaller, banks will require additional capital, as they will have very limited access to bond financing. Even though the current market is very favorable, it may later prove difficult to refinance NEP issuances.

9/17 2.3 Consequences of breaching the regulatory capital requirement for credit institutions Breaching the regulatory capital requirement entails restrictions on the institution's ability to act, see Figure 6. On the one hand, automatic legal restrictions enter into force, and on the other hand, there may be market reactions that constrain the institution's actions. Figure 6: Consequences of breaching the capital requirement for credit institutions The Danish Financial Supervisory Authority must also approve capital repayments and here also refers to capital plans and their sustainability. Breach of capital buffers Breaching capital buffers limits institutions' ability to pay dividends, interest on subordinated debt instruments, and performance-based remuneration. At the same time, institutions must prepare and submit a capital conservation plan to the Danish Financial Supervisory Authority and initiate measures to re-establish capital buffers. Breaching capital buffers will also result in a loss of confidence among the institution's shareholders, both current and potential, and creditors, which can complicate or at least make more expensive the re-establishment of capital buffers. Larger institutions that use market funding risk, furthermore, that this funding becomes more expensive, and in the worst case, that they cannot refinance it at maturity. In capital planning, credit institutions must meet all capital buffers even under stress. The buffers will help cover any losses that turn out larger than expected/fears. There is thus inherently great uncertainty in such calculations and estimates. There are institutions that have suffered severe losses even during mild economic downturns, and conversely, institutions that have managed considerable economic downturns without deficits. Breach of the individual solvency need The Danish Financial Supervisory Authority intensifies its involvement and requirements for recovery initiatives upon breach of the individual solvency need. The Danish Financial Supervisory Authority typically, for example, requires that the institution must not increase lending. However, it may also be necessary to transfer the institution to Financial Stability already upon breach of the individual solvency need if the institution cannot present a realistic solution. Breach of Pillar 1 requirement When the institution breaches the Pillar 1 requirement (the 8 pct. requirement), it is immediately transferred to Financial Stability, which explores possibilities for selling the whole or part of the institution. Breach of NEP requirement It does not automatically entail restrictions on institutions' freedom of action if they do not meet the NEP requirement, as is the case if they breach the capital requirement. In the event of a breach of the NEP requirement, the Danish Financial Supervisory Authority will conduct an individual and concrete assessment of what consequences it should have. The goal is to achieve a private solution, e.g., through capital injection, divestment of units and assets, or through a merger. The Danish Financial Supervisory Authority can, if necessary, hand over control to Financial Stability. This will, however, only occur when other solutions are exhausted or not assessed as sustainable. 3. Insurance Companies 3.1 The regulatory capital requirements for insurance companies Solvency II was implemented in 2016. This has, among other things, meant that capital requirements have become risk-based, and that insurance companies can include a number of new elements in the capital base. Insurance companies must meet two capital requirements: the Solvency Capital Requirement and the Minimum Capital Requirement, see Figure 7.

11/17 Figure 7: Insurance companies' capital requirements The Solvency Capital Requirement reflects the risk that the insurance company has undertaken and the risk the company expects to undertake over the coming 12 months. The Solvency Capital Requirement is set as the necessary capital to ensure that a bankruptcy situation occurs at most once every 200 years. This corresponds to the company having a probability of at least 99.5 pct. of being able to meet its obligations to policyholders and beneficiaries over the following 12 months.4 All shocks to the Solvency Capital Requirement are calculated based on this safety level. The Solvency Capital Requirement is calculated based on insurance companies' risk profiles, taking into account the effects of any risk-mitigating techniques, such as reinsurance and diversification effects. For example, the calculation may contain assumptions that stock price declines and changes in interest rates do not necessarily occur simultaneously. The Minimum Capital Requirement is the second minimum requirement for the size of capital. If this requirement is not met, it will create a risk that the company cannot safeguard policyholders' interests. The Minimum Capital Requirement is thus calculated so that the company has the opportunity with a probability of at least 85 pct. to meet its obligations to policyholders and beneficiaries over the following 12 months. The Minimum Capital Requirement is calculated based on the company's risk profile and accounts for 25-45 pct. of the company's Solvency Capital Requirement. At the same time,

4 The same applies to credit institutions that can use IRB models, that the calculation of risk-weighted exposure amounts – and thus also capital requirements – is set based on a confidence level of 99.9 pct. This corresponds to an institution expected to have losses exceeding the capital base once every thousand years. An Explanatory Note on the Basel II IRB Risk Weight Function, Bank for International Settlements, July 2005 and CRR Article 153 and Article 154.

12/17 a monetary lower limit for the Minimum Capital Requirement has been set, where the amount varies depending on the type of insurance business the company conducts. The Minimum Capital Requirement therefore constitutes the largest of either the calculated Minimum Capital Requirement or the set amount for the lower limit of the Minimum Capital Requirement. The regulation gives the Danish Financial Supervisory Authority the opportunity to set a capital add-on. A company may be required to pay a capital add-on if its risk profile deviates significantly from the assumptions for the standard formula or an approved internal model used to calculate the Solvency Capital Requirement. The company may also be required to pay the add-on if its corporate governance deviates significantly from the requirements for the management system. The calculated Solvency Capital Requirement plus the capital add-on constitutes the new Solvency Capital Requirement. No Danish companies have so far been required to pay a capital add-on. Insurance companies' capital base consists of a basic capital base and a supplementary capital base. The basic capital base consists of the amount by which the value of assets exceeds the value of liabilities, minus the value of own shares plus the value of subordinated debt. Expected future earnings on the existing portfolio of policies are included as part of the basic capital base. The supplementary capital base consists of capital that is not included in the basic capital base and that can be used to cover losses. The capital base can cover the Solvency Capital Requirement, while the basic capital base must cover the Minimum Capital Requirement. The capital base is divided into classes to ensure sufficiently high quality, see Box 2. As part of the requirements for the management system, Solvency II requires that insurance companies assess their own risk and solvency. The assessment is an integrated part of the company's business strategy, and the company must regularly – and at least annually – assess its total solvency need with its specific risk profile in mind. The purpose of this assessment is not to set a new Solvency Capital Requirement, but for the company to continuously improve risk understanding and risk management. An important element of the assessment is that the company compares actual risks with the risk assumptions that enter into the standard formula. The assessment of own risk and solvency must cover the company's entire strategic planning period. Requirements are set for insurance companies' boards to prepare a capital plan that must ensure sufficient capital to cover the risks the company can be expected to face during continued operations according to