Denmark’s central bank is inviting financial instability by urging the nation’s lenders to ignore a European rule easing how risks for small- and medium-sized business loans are calculated, an industry group said.
Encouraging the banks to be tougher than the directive on SME loans would open the door to them underestimating risks elsewhere, Michael Friis, head of prudential regulation at the Danish Bankers Association, said in an interview.
The central bank in June told lenders to disregard a section of the capital requirements directive -- approved by European lawmakers last month -- that reduces risk weights by 24 percent because implementing it would weaken Denmark’s financial system. Access to credit remains high in a historical perspective, Deputy Governor Hugo Frey Jensen said last month.
“If the banks ignore the SME rebate, then by the same logic banks should also ignore capital charges that they don’t think properly reflect the risk associated with their business,” Friis said in an interview this month.
Denmark’s financial industry has yet to recover from a lending glut in the last decade that has sunk more than a dozen banks and forced at least another 12 to merge. Last year, loan loss impairments climbed 11 percent, and small and medium-sized Danish banks continue to hold a disproportionate share of weak loans, the Financial Supervisory Authority said in May.
Europe’s economic slump has led lawmakers to embrace measures once considered taboo in the wake of the financial crisis. Denmark in March proposed bundling and selling small business loans as the stigma of securitization fades.
The European Parliament included the SME provision in the fourth capital requirements directive in April, with council following in June over objections from the European Banking Authority. The banking group said in September that the directive already makes allowances for SMEs and recommended other measures to support small businesses.
Lack of credit poses a risk to SMEs which supply 85 percent of new jobs, according to the European Commission. The euro area is facing a second year of contraction this year and is estimated to shrink 0.6 percent, the International Monetary Fund said July 9.
“This extra rebate has been included,” Friis said, “for political reasons. The purpose is to neutralize the effects of the capital buffers so as not to harm SME lending.”
Avoiding politics and attaining the uniformity in regulation envisioned by the Basel Committee on Banking Supervision, whose recommendations triggered the directive, has been an uphill battle.
U.S. regulators proposed July 9 the country’s biggest banks hold equity equal to at least 5 percent of assets, compared with an international target of 3 percent. Sweden sought tougher requirements in Europe’s capital directive because its banking industry is four times the size of its economy.
The SME capital provision instructs banks to reduce charges for exposures by multiplying the amount by a factor of 0.7619. That effectively lowers risk weights by 24 percent, according to the Danish central bank.
“This is surprising since, from a risk perspective, a general reduction in risk weights on loans to small and medium-sized enterprises doesn’t appear to be justified,” the central bank said last month in its annual review of the country’s banks and mortgage lenders.
While domestic lenders have improved their capital levels, “much” of that stems from a decline in risk-weighted assets as a result of falling lending volumes, the bank said in its June financial stability report. While most banks hold enough equity to meet coming requirements, it warned lenders will probably need excess capital.
“The reduction of risk weights does not provide for a more resilient financial system, on the contrary,” the Copenhagen-based central bank said. The provision also may cast doubt on whether risk-weighted assets actually reflect real risk, the bank said.
Banks’ risk weighting of assets is coming under increased scrutiny to avert what Danish FSA Director General Ulrik Noedgaard, who also sits on the EBA’s supervisory board, called in November “backdoor” dilution of capital requirements.
The FSA last month ordered Danske Bank A/S to increase its risk-weighted assets by 13 percent after concluding the bank, the country’s largest, hadn’t correctly accounted for possible losses. The Copenhagen-based bank said Friday that it will appeal the ruling to Denmark’s company appeals board. The demand would lower the bank’s ratio of total capital to risk-weighted assets to about 19.1 percent from 21.6 percent at the end of March, the bank said in June.
The Basel Committee on Banking Supervision, which draws up global banking guidelines, said this month it will address complaints about banks “gaming the system” with risk-weighting models. Regulatory measures may be necessary to even out “material” differences among global lenders, it said July 5.
The SME reduction “may also erode confidence in risk-weighted assets as a measure of bank asset risk,” according to the Danish central bank.
Ignoring the directive carries its own risks, Friis said. Regulators concerned banks hold too little capital after taking the rebate can always raise lenders’ individual solvency requirements, he said. Those are imposed by national agencies to reflect banks’ particular business models and risks.
“Picking out separate issues in the regulation that you don’t think applies for your bank -- and therefore not including in the calculation of your capital requirement -- isn’t how it should be done,” Friis said.