CRD IV: Implications for the Danish financial sector

Abstract

This thesis deals with the effects derived from the implementation of the Basel III framework in Denmark through EU’s Capital Requirement Directive IV. The directive imposes strict, new requirements on the Danish financial sector, in the hope of providing financial stability. In this process significant costs might however be imposed on the financial sector, with ripple effects going through the rest of the Danish economy. The goal of this thesis is to identify these costs and gauge the effect they will have on the rest of society. Analysis of solvency ratios reveals that the Danish financial sector is generally quite well equipped to meet the solvency requirements, although a few of the smaller FIs have significant solvency issues. We estimate that FIs will mainly respond by reducing their loan portfolio as this is the most efficient strategy. Moreover, it is our belief that the financial sector is heavily challenged by the uncertainty regarding LCR as the widely used covered mortgage bonds may not be considered of sufficient liquidity. If this happens, we estimate that SIFIs will experience a significant liquidity shortfall as a result, which will lead to huge total costs to be able to comply with the requirements. Our analysis shows that FIs will respond by trading covered bonds with each other or by selling covered bonds and place funds in local or foreign government bonds. However, this will put pressure on the value of the Danish Krone and increase exchange rate risk. Finally, it is revealed that NSFR and leverage ratio requirements will not have an immediate impact on FIs, but will prevent them from seeking more unstable funding or increasing leverage. The societal effects face the same uncertainty as the impact on the financial sector. Our analysis and literature study suggest that the effects of a 5 percentage point increase in capital buffers would be an increase in cost of capital by 32 bps, which would increase lending spreads by up to 52 bps and result in a GDP growth decrease around 85 bps. Due to present compliance with solvency requirements, the final impact might be smaller, depending on FIs’ decisions regarding excess capital buffers. Moreover, LCR will have a significant impact on the Danish funding of real estate through increased interest and contribution rates. Altogether, these implications will create ripple effects through the financial sector with a decline in investments, consumption and employment as a result. Legislators will hope that the societal benefit of increased financial stability outweighs the societal costs imposed.