Danish FSA introduces the Supervisory Diamond for banks

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1 Board of directors and board of management of [omitted] Director General 25 June 2010 Dear Sirs, Danish FSA introduces the Supervisory Diamond for banks The mission of the Danish FSA is to work for financial stability and confidence in financial undertakings and markets. An important element of this mission is for the Danish FSA to prevent financial undertakings from getting into financial distress. Experience shows that banks with problems as a result of the financial crisis share a number of common characteristics. These characteristics include high lending growth at the cost of credit quality, over-optimistic assessments of credit risks (among other things regarding commercial property exposures) and inadequate management of large exposures. This pattern has also been seen during previous crises. DANISH FINANCIAL SUPERVISORY AUTHORITY Aarhusgade Copenhagen Denmark Tel Fax finanstilsynet@ftnet.dk MINISTRY OF ECONOMIC AND BUSINESS AFFAIRS Therefore, the Danish FSA has set up a number of benchmarks to indicate banking activities which initially should be regarded as having a higher risk profile; what is called the Supervisory Diamond. The Supervisory Diamond stipulates a number of special risk areas, stating limit values which, as a point of departure, the bank should keep to from the end of 2012, see the figure below. The limit values will be included in the Danish FSA s supervision activities, and they mean that in future, for special risk areas, the Danish FSA will start its dialogue with financial undertakings at a much earlier stage.

2 2 The Supervisory Diamond for banks Sum of large exposures < 100 percent Lending growth < 20 percent Funding-ratio < 1.25 Concentration on commercial property exposure < 25 percent Excess liquidity coverage > 50 percent The limit values have been set so that, on the one hand they counteract excessive risk-taking, and on the other hand they make it possible for resilient banks to carry out profitable banking activities and offer the credit required to undertakings and households. Some of the risk areas in the Supervisory Diamond may be difficult for banks to change in the short term. Therefore, the Danish FSA has made of point of phasing in the Supervisory Diamond up to the end of 2012, after which the Danish FSA will implement systematic monitoring of the benchmarks in the Supervisory Diamond. In the period up to the end of 2012, the Danish FSA expects banks to incorporate the Supervisory Diamond benchmarks. Therefore, all banks can expect a dialogue at future inspections etc. on how the bank is positioned in the Supervisory Diamond. For your information, on the basis of reporting as at the end of 2009, [name of bank omitted] has a commercial property exposure of [omitted] percent of total loans and the bank has therefore breached the benchmark in the Supervisory Diamond relating to commercial property exposure. After phasing in the Supervisory Diamond at the end of 2012, this breach may mean that the Danish FSA reacts by giving the bank a letter of risk information which will have to be made public.

3 3 Therefore, the Danish FSA expects that the board of directors will look into the matter as well as set up and implement a strategy to counteract the breach of the benchmark, if the bank wants to avoid such a reaction by the Danish FSA after the end of Yours faithfully Ulrik Nødgaard

4 4 1. More information about the Supervisory Diamond Sum of large exposures less than 100 percent of total capital, excluding exposures of less than DKK 3 mill. Large exposures are currently defined as exposures inside and outside the trading portfolio which, after deduction of particularly secure claims, amount to 10 percent or more of the bank s total capital. Insufficient management of large exposures has been one of the main reasons for banks getting into financial distress. For smaller banks, the lower amount of total capital means that an exposure does not have to be particularly high to comprise a large exposure. Therefore, the limit of 100 percent is combined with a monetary sum of DKK 3 mill. Exposures (after deductions) of less than DKK 3 mill. can therefore be excluded from the calculation. Lending growth of less than 20 percent The year-to-year lending growth is another important factor for financially distressed banks. It will be possible to adjust the limit value for lending growth in relation to macro-economic developments. The limit value is calculated excluding repos. Commercial property exposure less than 25 percent At present, the property exposure is defined as the percentage of total loans and guarantee debtors relating to the property administration and trading, and business services sector. A concentration of exposures related to the commercial property sector has caused difficulties for many banks in a market with falling property prices. The limit value is calculated after impairments. Stable funding The financial crisis has shown that a deficit of deposits and dependence on short-term market funding makes banks vulnerable to shifts in confidence in the financial markets. Therefore, a funding ratio is being utilised as a preliminary benchmark, corresponding to loans/deposits. The amount of loans and deposits is calculated excluding repos. The object of the limit value of 1.25 as the funding ratio is not necessarily to eliminate the deposit deficit. The object is rather to achieve a more longterm funding structure, composed of sources of finance with a longer maturity. In this respect, the Danish FSA is aware that bond issuances of

5 5 different types can be part of a bank s funding base, just as the bank s equity capital will be part of the Danish FSA s individual and specific assessment. The funding ratio stated is regarded as a high-risk indicator. The Danish FSA will set up a dialogue with the Danish Bankers' Association on establishing better reporting so that a more fine-meshed liquidity goal can be set up which includes long-term funding, for example by bond issuances. Moreover, the new Basel/CRD regulations are on the way. When these new regulations have been implemented, the Danish FSA will assess whether it is necessary to change the funding ratio and limit in the Supervisory Diamond. Excess liquidity coverage must be greater than 50 percent A limit of 50 percent is applied for excess liquidity coverage compared to the statutory requirement. The excess liquidity coverage is the amount of the excess after meeting the statutory minimum requirement (the 10 percent requirement in section 152 of the Danish Financial Business Act), as a percentage of the statutory minimum requirement. When the new Basel/CRD regulations for the area have been implemented, the Danish FSA will assess whether it is necessary to change the liquidity benchmark and limit value in the Supervisory Diamond. 2. The Supervisory Ladder of Action From the end of 2012 the Danish FSA will implement systematic monitoring of the benchmarks mentioned in the Supervisory Diamond. When the limit values in the Supervisory Diamond are exceeded, the Danish FSA will enter into a dialogue with the bank and take any supervision reactions necessary, see the Supervisory Ladder. The Ladder is illustrated below. Reaction possibilities are listed according to how intrusive they are. On the basis of a proportionality assessment, the Danish FSA will apply the least intrusive reaction. Therefore, the Danish FSA will only apply reactions on a higher step of the ladder in more serious situations, e.g. for repeated transgressions and when the bank fails to react.

6 6 Publication on the Danish FSA website Possible increase in the solvency need on the basis of an individual assessment The following is a review of the possible reactions the Danish FSA can apply for a breach of the limit values in the Supervisory Diamond. All reactions are based on an individual and specific assessment. Stricter monitoring With effect from the end of 2012, the Danish FSA will introduce stricter monitoring of banks which breach a limit value in the Supervisory Diamond. Amongst other things, stricter monitoring will mean that the Danish FSA may call for more frequent reporting on the limit values in the Supervisory Diamond which have been breached. A bank subject to stricter monitoring can also expect regular dialogue with the Danish FSA on how the bank intends to deal with the breach of the limit values in the Supervisory Diamond. It is important to distinguish between stricter monitoring and stricter supervision. Stricter supervision often means that the bank is subject to additional supervisory activity, typically an inspection of the bank. Stricter monitoring is based on reporting from the bank and dialogue on this reporting.

7 7 The Danish FSA will be able to put a bank under stricter supervision for breaches of the limit values in the Supervisory Diamond, but this authority will not necessarily be imposed. Risk information and immediate publication of this From the end of 2012 the Danish FSA will conduct an individual and specific assessment of the extent to which risk information must be given in the situations in which the bank exceeds the limit values in the Supervisory Diamond. The Danish FSA will carry out its assessment taking into account mergers, acquisitions, conditions of the group as well as other conditions (e.g. temporary conversion from mortgage to bank loans). The Danish FSA Executive Order on publication entered into force on 1 April Under the Executive Order, banks and mortgage-credit institutions are obliged to publish the reactions from the Danish FSA in the form of risk information, reprimands and orders. With regard to the Supervisory Diamond, the Executive Order means that in general the bank must publish risk information, even though this information is not given in connection with an inspection of the bank, see section 2(2). Publication must take place, if it is significant for the bank s customers, depositors, other creditors, or the financial markets on which shares in the bank are traded. In relation to the Supervisory Diamond, a breach of one or more limit values will probably be significant for the persons in these groups. Therefore, as a rule, risk information must be published. Account and/or inspection of the bank For the next step on the Supervisory Ladder, the Danish FSA can request the bank to prepare an account of future activities to prevent continued breaches of the limit values in the Supervisory Diamond. According to section 349 of the Danish Financial Business Act, the Danish FSA can also order the management of an undertaking to prepare an account of the financial circumstances and future prospects of the undertaking. The object of the account is to explain and analyse the financial situation of the undertaking and its future prospects for use by the management of the undertaking and for use in the supervisory activities carried out by the Danish FSA.

8 8 The Danish FSA may order the bank to prepare such an account when there is reason to believe that the bank could run into problems in the future, but when the bank has not breached any legislation. According to the Supervisory Diamond, the order can be given when the bank repeatedly has not reacted adequately to the risk information from the Danish FSA in relation to the Supervisory Diamond, and after a specific assessment of the financial situation of the bank. The Danish FSA may also initiate an inspection of the specific risk area, if it is assessed that there are areas related to the Supervisory Diamond which have not been adequately accounted for. The assessment will be based on the account from the bank and on the basis of the reports received by the Danish FSA from the bank. Following the inspection, the Danish FSA will prepare a brief report which the bank must publish, see section 2(1) of the Executive Order on publication. The report will contain the Danish FSA s overall assessment of the bank, including important orders, reprimands and risk information. Section 350 of the Danish Financial Business Act - orders According to the Supervisory Diamond, on the basis of a specific and individual assessment based on information from e.g. inspections and reports, the Danish FSA can ultimately issue an order to, for instance, reduce lending growth. If the bank can document, or at least show that it is likely, that the breaches will not lead to a high risk, an order pursuant to section 350 will not necessarily be issued. The order can be issued in situations where (1) the financial position of the undertaking has deteriorated to such a degree that the interests of the depositors or investors are at risk, or (2) there is a significant risk that the financial position of the undertaking will develop so that the undertaking loses its license. The amendment to the Financial Business Act just adopted changes section 350(2) so that the Danish FSA can now react to the bank at an earlier stage, when there is a not insignificant risk that, in the short term or long term, the bank will lose its license to carry out financial activities. An order pursuant to section 350 must be specific enough to enable the management of the bank to comply with it realistically. Examples of orders pursuant to section 350 could be: Reduce business areas and sell assets. Limit expansion of the branch network or close branches. Prohibit or limit certain business areas, products or customer segments.

9 9 As a general rule, the bank must publish orders pursuant to section 350 of the Financial Business Act, if it is deemed that the order is significant for the bank s customers, depositors, other creditors or the financial markets on which the shares in the bank are traded, see section 2(2) of the Executive Order on publication. Orders pursuant to section 350 are presumed to be significant for persons in the groups mentioned, and therefore as a general rule the bank must publish an order issued pursuant to section Publication on the Danish FSA website With regard to the Supervisory Diamond, supervisory reactions which involve publication will not be carried out until the end of A breach of the limits in the Supervisory Diamond will not automatically lead to a supervisory reaction, and a supervisory reaction will always be underpinned by a specific and individual assessment. In general, publication of supervisory reactions on the basis of the limit values in the Supervisory Diamond may not take place if it will mean disproportionate damage for the bank, or if issues relating to investigations make publication inadvisable, see section 3 of the Executive Order on publication.