Danish Bank Watchdog Burned Once Hunts Hidden Credit Risk

Denmark’s financial regulator is warning the country’s banks that an understatement of lending risks won’t be tolerated as it embarks on a hunt to catch what it’s dubbed “backdoor” capital dilution.

The Financial Supervisory Authority will review internal rating models that determine how much capital a lender sets aside to ensure banks don’t find a way around stricter standards. While banks may fulfill capital requirements on paper, recent failures suggest risk weights don’t always reflect reality, leaving buffers too small to absorb losses.

“Politicians and regulators have said that we have to increase capital ratios, and they will go up by quite an amount,” Ulrik Noedgaard, director general of the FSA, said in an interview. “But if that is being diluted by the backdoor by firms aggressively recalculating their models or rolling out new models for new areas, then clearly the whole purpose hasn’t been served.”

When Denmark’s housing bubble burst more than four years ago, it revealed widespread capital shortfalls that have since led to the demise of more than a dozen regional lenders. Toender Bank A/S, the most recent insolvency, followed a reported three-fold increase in profit in the first half and a solvency ratio - - a measure of financial strength -- of 17.3 percent at the end of June. Yet an inspection last month by the FSA revealed bad loans almost 10 times as big as those reported by the bank, wiping out its equity.

Moody’s Responds

Toender’s collapse “underlines the continued asset and risk management challenges that Danish banks face, even when reportedly profitable,” Oscar Heemskerk, senior credit officer at Moody’s Investors Service, said in a Nov. 8 note. The lender, based near the German border in southwestern Denmark, had reported profits since at least 2008.

The government has urged the industry to consolidate rather than risk more failures, extending state guarantees and granting access to depositor guarantee funds to help finance takeovers.

The FSA today approved Spar Nord Bank A/S’s takeover of Sparbank A/S in a share swap deal that gave Sparbank holders two Spar Nord shares for every Sparbank share.

The European Union is moving closer to agreeing on legislation for implementing capital rules recommended by the Basel Committee on Banking Supervision after negotiations this week in Brussels. The measures will require lenders in some cases to more than triple their capital.

‘Our Worry’

“What’s really our worry is the potential dilution” of regulatory standards, Noedgaard said. “Our ambition here is to make sure to avoid this dilution, and therefore we need to spend more time understanding and making sure that these risk weights do reflect the actual risks of the portfolios.”

Banks operating in Denmark have lashed out at the FSA, arguing its insistence on more rigorous standards in the middle of a crisis is exacerbating the nation’s economic decline as lenders compensate by raising fees and withholding credit.

Tougher writedown rules imposed by the Danish FSA in April are “extreme” and “unique” in their severity, Nordea Bank AB Chief Executive Officer Christian Clausen said during a conference call last month. A doubling in impairments last quarter was partly caused by the stricter rules, Clausen said.

Credit Risks

An International Monetary Fund working paper, published in March, called for closer scrutiny of how banks calculate their credit risks, and noted investor “confidence in reported risk-weighted assets is ebbing.”

Denmark’s housing market, which has slumped about 25 percent since peaking in 2007, still has further to fall, the government-backed Economic Council said Nov. 1. A similar assessment comes from the IMF’s Thomas Dorsey, mission chief for Denmark, who said Nov. 5 that the nation’s housing market may not yet have bottomed out, adding to the risk of a recession.

Banks have pleaded with the FSA not to publish solvency levels, arguing that the practice of advertising which lenders are weakest makes it more difficult to raise capital. The FSA has no intention of accommodating the industry on that score, Noedgaard said.

“It’s not up for discussion,” he said. “This transparency has served us quite well as a disciplinary force, and we aim to keep it that way.”

Recession Risks

Denmark’s twin banking and housing crises have depressed consumer demand, pushing the economy to the brink of its second recession in less than year. The decline risks spurring a vicious circle as banks retrench and households spend less. Gross domestic product contracted 0.4 percent in the second quarter and probably shrank again in the three months through September, the Confederation of Danish Industry estimates.

Three regional banks failed the central bank’s latest stress test, published Oct. 25. A fourth bank would be close to breaching capital rules, while the nation’s four biggest lenders, including Danske Bank, all passed.

With its dual focus on asset quality and solvency ratios, the FSA has put in place the main pillars it needs to do its job, Noedgaard said. The regulator, which typically gives a bank that fails an inspection about 48 hours to find extra capital, is now seeking parliamentary approval to give lenders more time to meet the tougher solvency requirements.

“We’ll do a more patient approach so that you’re given, say, three months to come up with your capital,” Noedgaard said. “We are so far into the crisis that all the obvious risks have, to a certain extent, been addressed, so we would say the potential danger of shutting down something that could actually work its way through is increasing.”

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