How Danish banks managed the recent economic downturn (2007-2008) taking into account

that Basel II, the new capital regulation, poses some constrains to the banks risk capital.

Three distinct research questions were formulated. The first question was related to the
reasons for why Basel II is magnifying the banking sectors pro-cyclicality as well as how the
solvency of the Danish banks has been affected in the economic downturn. The second
question was about the reasons for different impact on banks solvency. The third question
addressed how the capital regulation of banks could be improved.

Analysis identified few reasons, why banks are inherently pro-cyclical. First, banks business
model is inherently pro-cyclical - they provide credit to the customers whose credit quality is
depending on the general economic cycle. Second, since very large losses are extremely
infrequent events, banks economic capital models have been unable to take them into
consideration when calculating the risk capital required for unexpected losses. It was also
found that Basel II magnifies the industrys pro-cyclicality, because it introduces closer
alignment between the actual risk and capital adequacy. The more accurately the value, and
relative risk, of each bank is measured at any point of time, the greater will be the pro-
cyclicality of the prudential regime. Medium sized Danish banks were more negatively
affected by the downturn pro-cyclicality effect than (Internal rating based approach) IRB
banks. 7 out of 9 standard banks had significantly deteriorated solvency in 2008. One reason
for this inconsistency could be that large banks have more sophisticated methods and models
to calculate both expected and unexpected losses. The medium sized Danish banks, which
seem to have suffered most during the crises, may have not been so successful with
predicting the behaviour in the tails of the credit loss distribution.

In the heart of the Basel II pro-cyclicality critique is the notion that new regulation makes the
solvency of banks highly dependent on the credit rating of banks customers. Thus, in the
current macroeconomic recession Danish banks solvency was worsened not because of
write-offs of bad loans or additional lending activities, but simply because of worsened credit
rating on customers of the banks.

In addition, it probably has been difficult for banks to estimate the creditworthiness of their
customers because of the lack of loss data, very little experience with new Basel II rules and
because the statistical models they use have not yet been tried out in the crisis situation. All
this makes it extremely difficult for banks to estimate the level of capital they need to hold
against unexpected losses. Therefore the implementation of Basel II in the end of the
macroeconomic expansion period in Denmark has had quite significant impact on the
solvency of Danish banks.

The deterioration of profitability from 2006 to 2008 and the asset quality (indicated in 2008
impairment losses) seem to be part of the reasons for difference in the downturn pro-
cyclicality impact. Four out of seven banks, whose solvency suffered most, had both severe
decreases in their profitability and high impairment losses in 2008. High exposure to the real
estate sector (property management business) and the relatively higher exposure to the
corporate sector have in case of some banks also contributed to the severe negative solvency
impact. The higher exposure to the financial institutions has in some cases too exaggerated
the negative downturn effect. Two main solutions to how to improve the capital regulation
were analysed: extra capital buffers and time varying levels of risk curves. It was concluded
that both could help to mitigate the pro-cyclicality in the sector, but regulators must carefully
weigh the advantages and disadvantages of each measure, and be aware of that the more
complex capital regulation is also more costly to supervise.

In the years up to the crisis, and hence during a period when considerable credit expansion
was already taking place, financial regulation was eased on certain central points,
particularly by the new International Financial Reporting Standards (IFRS) and capital
adequacy requirements (Basel II). In this context the financial sector attributed great
importance to the fact that regulation in Denmark was not stricter than abroad ("level playing
field"). In practice the introduction of the new financial reporting standards ended up
reducing the financial institutions' cushioning against losses, as the banks did not increase
their individual solvency needs sufficiently, as otherwise dictated by the transitional rules in
the Danish implementation of the Basel II rules. The result was an increased leverage ratio
instead. The shift in focus from capital cushion to risk management with the changeover to
the Basel II rules proved de facto to provide the banks with an opportunity for greater equity
leverage and increased lending. The financial institutions' capital cushion was thus reduced at
an inappropriate point in time. Regulation has since been tightened.

Prior to the crisis, regulation and supervision of financial institutions in Denmark was based
on a fundamental principle that only the executive boards of the financial institutions were
responsible for the banks' business models.

Hence the Danish Financial Supervisory Authority's (FSA) focus was more on ensuring that
credit institutions were complying with the formal rules than on putting in place and
monitoring signposts to measure the sustainability of the business model chosen by those
banks. This approach to supervisory operations during the years before the crisis may have
been influenced by the FSA's experience during the previous financial crisis at the start of the
1990s, when the Authority was criticized for its sometimes pragmatic efforts to deal with
distressed financial institutions.

Note:

Strictly speaking, procyclicality refers to the tendency of financial variables to fluctuate
around a trend during the economic cycle. Increased procyclicality thus simply means
fluctuations with broader amplitude.