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Europaudvalget 2009-10, Erhvervsudvalget 2009-10
EUU Alm.del Bilag 542, ERU Alm.del Bilag 333
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DANMARKS

NATIONALBANK

FINANSTILSYNET

august

2010

Sagsar

118061

Dokumentar

1048869

Danmarks

Nationalbank

The Basel

Committee

Banking

Supervision

Havnegade

Fax

1093 København

Phone

63 63

33 63

Danmarks

Nationalbank

Basel

Committee's

and

Finanstilsynet strongly

supports the

aim

the

capital

and liquidity

reform

package.

are

howeveT

[email protected]

www.nationalbanken.dk

deeply

concerned

with

the

treatment

of Danish

covered

bonds

the

definition

of liquid

assets

the

Liquidity Coverage

Ratio.

our

assess-

that

the proposal of

the

26th

of July 2010 is

likely

increase the

risk

instability

the Danish

financial

system

and

thus

run

counter

the

ment

FINANSTILSYNET

Arhusgade

110

2100 København

Tlf

Fax

overall

aim

the

reform

package.

33 55

82 00

59 81 84

First,

the

proposal

accords

much lower

weight

covered

bonds than

gov-

bonds

the

Liquidity

Coverage

Ration

(LCR)

formula.

not

ernment

CVR-nr

[email protected]

www.finanstilsynet.dk

SMONOMI-

find

that this is

warranted

by empirical evidence.

fact,

the

liquidity

Danish covered

bonds

has

proven

par

with

that

Danish

Government

bonds

times

severe

financial

ERHVERVSMINtSTERIET

stress.

Second, covered

bonds

are

market, and

important

ity

management.

This

is clearly illustrated

the

shortfall

liquid

assets

for

Danish

banks

under

the

proposal.

This

will

equivalent

approxi-

mately

per

cent

the

total

outstanding

amount

DKK

denominated

government

the

predominant

asset

the Danish

financial

component

of Danish financial institutions liquid-

bonds

end-2009.

suggest that

solution

found

under

which

the

li-

quidity of high quality covered

bonds

Danish

covered bonds is

taken

appropriately into

account.

Please

concerns

see

We,

therefore,

strongly

the

accompanying

and

note

for

detailed

explanation

our

possible

solution.

Yours

sincere

ils

Bernstein

Ulrik Nødgaard

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23 august 2010

Sagsnr.: 118061

Dokumentnr.: 1048979

Danish covered bonds and the Liquidity Coverage Ratio (LCR)

Danmarks Nationalbank

Havnegade 5

DK - 1093 København K

Phone 33 63 63 63

Fax

33 63 71 03

[email protected]

www.nationalbanken.dk

Covered bond liquidity is on par with that of Government bonds

Danmarks Nationalbank is currently carrying out a study comparing the li-

quidity of the Danish government bond and covered bond markets before,

during, and after the financial crisis based on a micro dataset. Due to the

perspective of the study on liquidity risk management the study focuses on

wholesale trades in the large bonds of the two markets. So far the empirical

evidence does not support the idea that government bonds are more appro-

priate instrument in banks' liquidity pools than Danish covered bonds to the

extent reflected in the revised LCR proposed on the 26th of July 2010. In

fact, there was an increase in the number of trades, the median trade size as

well as the turnover rate in the short end of the covered bond market during

the crisis.

Thus during the financial crisis long term covered bonds were just as liquid

as long term government bonds, while short term covered bonds were actu-

ally more liquid than government bonds.

This can be documented by looking at an often used measure of illiquidity,

namely the percentage price change divided by trade size

. Based on this

measure a tendency can be seen that before the crisis government bonds

were slightly more liquid than covered bonds, cf. chart 1 and 2, and this

normal relationship has be re-established. Furthermore the short term cov-

ered bond market has been as liquid as the long term government bond mar-

ket.

FINANSTILSYNET

Århusgade 110

2100 København Ø

Tlf

Fax

33 55 82 82

33 55 82 00

10 59 81 84

CVR-nr

[email protected]

www.finanstilsynet.dk

ØKONOMI

ERHVERVSMINISTERIET

Amihud, Y. (2002). Illiquidity and Stock Returns: Cross-Section and Time-Series Ef-

fects.

Journal of Financial Markets 5(1),

31-56.

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MONTLY MEDIAN OF PERCENTAGE PRICE CHANGE DIVIDED BY TRADE SIZE

0.00045

0.0004

0.00035

0.0003

0.00025

0.0002

0.00015

0.0001

0.00005

Apr-2005

Apr-2006

Apr-2007

Apr-2008

Apr-2009

Chart 1

Long term covered bonds

Note:

Long term government bonds

Long term covered bonds are defined as long term callable mortgage-bonds. Long term government bonds are defined as

government bonds with time to maturity of more than five years.

Source: Danish Financial Supervisory Authority, Nasdaq OMS and own calculations.

The illiquidity measure for both the long term government and covered

bond market increased significantly during the crisis. However, the level of

the illiquidity measure was almost the same for the two markets during the

peak of the crisis. This does not take into account the temporary measures

undertaken during the financial crisis to support the Danish pension sector.

In the short end of the markets the illiquidity measure was higher for gov-

ernment than covered bonds during several months of the crisis. Part of this

result can be explained by the fact that the short term government bonds,

being defined as bonds with time to maturity of less than five years, gener-

ally have a longer time to maturity than the short term covered bonds.

However, the very short end of the government bond market would by no

means be sufficient to cover the banks need for liquid assets under the Basel

proposal. Actually, the Basel proposal would induce the banks to hold long

term government bonds as liquidity, cf. the calculations below based on the

Quantitative Impact Study (QIS).

Apr-2010

Jan-2005

Jan-2006

Jan-2007

Jan-2008

Jan-2009

Oct-2005

Oct-2006

Oct-2007

Oct-2008

Oct-2009

Jan-2010

Jul-2005

Jul-2006

Jul-2007

Jul-2008

Jul-2009

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MONTLY MEDIAN OF PERCENTAGE PRICE CHANGE DIVIDED BY TRADE SIZE

0.00045

0.0004

0.00035

0.0003

0.00025

0.0002

0.00015

0.0001

0.00005

Apr-2005

Apr-2006

Apr-2007

Apr-2008

Apr-2009

Chart 2

Short term covered bonds

Short term government bonds

Note:

Short term covered bonds are defined as fixed-rate bullet mortgage bonds. Short term government bonds are defined as

Source: government bonds with time to maturity of less than five years.

Danish Financial Supervisory Authority, Nasdaq OMS and own calculations.

The high liquidity of Danish covered bonds during the crisis can in large

part be attributed to the history and institutional setup of Danish covered

bonds. In Denmark there is a very long history for issuing covered bonds

under a strict legislative framework. Danish covered bonds are, on top of the

general characteristics of covered bonds, issued under a very strict "balance

principle" that strongly limits the issuers' ability to assume any risks other

than credit risk. In practice the vast majority of loans financed by covered

bonds have loan terms including interest rate and method of prepayment

which are set with direct reference to the terms of the covered bonds issued

to fund the loan. As the bonds are exchange-listed the system is highly

transparent. The close link between loans and bonds makes it possible for

the borrowers to repay their loans by buying the underlying bonds. Thus the

covered bonds cannot trade with a very large discount compared to the

credit quality of the cover assets without attracting buy-side interest from

the borrowers. The strict balance principle also strongly limits the mortgage

banks’ ability to assume any other risks than credit risk. The credit risk is

contained by a number of measures. Besides the maximum loan-to-value

ratio of 80 pct. at all times of the loan, mortgages have a strong legal posi-

tion in Denmark. The mortgage banks possess a senior claim on the pro-

ceeds from a property sale in the event of a borrowers default. The Danish

foreclosure processes are fast at relatively low cost and strategic default by

borrowers is eliminated by borrowers’ personal liability in the Danish legis-

lation.

The high quality of the Danish covered bond system has also been demon-

strated by the fact that the system has worked well in providing a stable

source of credit to households and firms during the financial crisis. In fact

increased lending funded by covered bonds has offset a fall in lending by

Apr-2010

Jan-2005

Jan-2006

Jan-2007

Jan-2008

Jan-2009

Oct-2005

Oct-2006

Oct-2007

Oct-2008

Oct-2009

Jan-2010

Jul-2005

Jul-2006

Jul-2007

Jul-2008

Jul-2009

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the rest of the banking system. Its significance can also be illustrated by the

fact that the market value of all covered bonds is more than EUR 300 bil-

lion. This is equivalent to 1.4 times Denmark's GDP and 7.6 times as large

as the Danish government debt.

Covered bonds are central to Danish banks liquidity management

The results of the Quantitative Impact Study (QIS) underline the importance

of the covered bond market to the Danish financial sector. Table 1 shows

weighted average estimates of the Liquidity Coverage Ratio for the Danish

institutions taking part in the QIS.

LCR ESTIMATES FOR DANISH QIS BANKS (WEIGHTED AVERAGE)

Limit on Level 2 assets

Baseline scenario of

Broad buffer scenario of

December 2009 proposal December 2009 proposal

Table 1

Scenario of GHoS press

release of 26 July

0 per cent

40 per cent

50 per cent

100 per cent

34 per cent

56 per cent

68 per cent

81 per cent

59 per cent

71 per cent

89 per cent

Note: Calculations under the GHoS scenario are made under simplifying assumptions given the level of detail in the original QIS

While the GHoS scenario stipulates a limit on level 2 assets in the portfolio of liquid assets at 40 pct., calculations have also

been made based on alternative limits but using the same stress scenario. Own issued covered bonds currently held in the

portfolio of liquid assets are excluded from the calculation

Under the baseline scenario of the Basel December 2009 proposal the Dan-

ish banks obtain a weighted average Liquidity Coverage Ratio (LCR) of 34

per cent. Allowing covered bonds to be included in the portfolio of liquid

assets significantly improves the LCR, up to a level of 89 per cent given full

inclusion. The substantial impact on the LCR is due to the relatively small

government debt market in Denmark and a large and well developed cov-

ered bond market. Covered bonds are the predominant asset in the Danish

financial market, and an important component of Danish financial institu-

tions liquidity management. In 2009 one third of the Danish mortgage bonds

were held by monetary financial institutions.

Under the July 26th scenario of the Group of Governors and Heads of Su-

pervision (GHoS) the total shortfall in liquid assets is EUR 28 billion for the

Danish banks taking part in the QIS. This is equivalent to 49 per cent of the

total outstanding amount of DKK denominated government bonds exclud-

ing holdings in government funds at end-2009, c.f. table 2.

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NOMINAL AMOUNT OF DKK GOVERNMENT BONDS AND DKK COVERED BONDS IN

CIRCULATION AT END 2009, DISTRIBUTED BY REMAINING TIME TO MATURITY

time to maturity

<= 5 years

5 years < time to

maturity <= 10 Time to maturity

years

> 10 years

Table 2

Billion EUR

Total

Outstanding amount of DKK govern-

ment bonds

- Amount held by government funds

- Amount held by Danish monetary

financial institutions

Remaining amount of DKK government

bonds in free circulation

Outstanding amount of DKK covered

bonds

Source: Danmarks Nationalbank

29,9

7,2

3,1

19,6

197,9

22,9

1,9

4,2

16,7

29,8

15,2

1,3

13,8

135,2

67,9

10,4

7,3

50,2

362,9

Extrapolating the shortfall figure to the entire Danish banking sector on the

basis of total assets, and subtracting any current holdings of Danish gov-

ernment bonds by Danish monetary financial institutions, the shortfall is

equivalent to 81 per cent of Danish government bonds in circulation. Re-

quiring Danish financial institutions to hold such a very large proportion of

the government bonds in circulation in a liquidity buffer would in itself

negatively impact the liquidity of these bonds.

Finally, as evident from table 2, a large proportion of Danish government

bonds outstanding are very long-term bonds, not well suited as liquidity risk

management instruments. In contrast, a large amount of short term covered

bonds exist.

Conclusion

In conclusion, Danish covered bonds have proven to be very liquid even

during times of stress and are subject to a very strict legal structure. Hence,

there is no evidence to support the treatment of Danish covered bonds vis-a-

vis government bonds in the current proposal. In addition, the large and im-

portant Danish covered bond market in combination with a significant short-

fall of government bonds under the current proposal may create severe ten-

sions in the Danish financial system. We therefore strongly suggest that a

solution is found under which the liquidity of high quality covered bonds

like Danish covered bonds is taken more appropriately into account.

High quality covered bonds should be included in the definition of "level 1"

liquid assets. If not, the cap on high quality covered bonds should be lifted

considerably. Given the insufficient availability of currently defined "level

1" assets in Denmark, a solution must be found so that Danish high quality

covered bonds can be included as liquid assets in the LCR of Danish banks

to a higher extent than the current proposal allows.