Supervision of Danish mortgage banks
 
Tale holdt af Finanstilsynets direktør Henrik Bjerre-Nielsen den 19. oktober 2004 ved 8th European Covered Bond Conference i København 
 
 
First, I would like to thank the organisers of this conference for giving me the opportunity to share with you our experiences in the Danish Financial Supervisory Authority with the special tasks related to supervising Danish mortgage banks.
 
As we so far do not have a common European mortgage credit regime, my contribution is naturally going to focus on the special characteristics of the Danish mortgage credit system. Nevertheless, I hope that it will be possible for me to provide you with some useful thoughts about public authorities' possible role in maintaining a well-functioning mortgage credit system.
 
You are probably familiar with the special importance that mortgage bonds have for the Danish economy and the financial stability. Loans granted by mortgage banks account for the majority of the total loans granted by the banking sector as a whole.
 
Homeowners and other owners of real estate rely on the mortgage credit system for cheap funding of their assets, and the confidence of and security for the mainly domestic investors such as credit institutions, insurance companies and pension funds in the mortgage bonds is of the highest importance.
 

Risk evaluation

The Danish Financial Supervisory Authority uses a risk based approach in our supervision of financial institutions. In the case of mortgage banks our supervision must in addition take account of maintaining confidence in the Danish mortgage bond as a kind of special label. It is necessary to ensure that all the characteristics of the bond as prescribed by law correspond to reality when bonds are issued by mortgage banks.
 
Our risk evaluation of a financial institution is composed of a general risk estimated for the type of institution in question and a specific risk estimated for each financial institution.
 
The legal framework for Danish mortgage banks limits the businesses in which mortgage banks may be engaged. In addition, the regulation of placement of funds of mortgage banks, the balance principle and the lending limits contribute to a limitation of the risks that mortgage banks are allowed to assume.
 
Because of these risk limitations, mortgage banks are in general supposed to have an average general risk, whereas commercial banks are assumed to have a high general risk.
 
The specific risk for each financial institution is determined by our internal rating systems containing a number of key ratios. These rating systems are used on a continuous basis on all institutions under supervision.
 
For mortgage banks the rating is among other things based on ratios related to solvency, growth in outstanding loans, market risks and share of loans granted to high risk types of property.
 
On the basis of the rating it is determined which intensity of supervision the individual mortgage banks must be subject to.

 
Off-site inspection

As for other types of financial institutions, our supervision of mortgage banks is broadly speaking divided in off-site and on-site inspections.
 
For the purpose of our off-site inspections we receive data required from all banks like financial reports, solvency and large exposures.
 
Important input also comes from auditors' reports where we require a number of specific statements, e.g. related to the issuance of mortgage bonds, the balance principle and the use of funding received from mortgage bonds.
 
In addition, the legislation requires mortgage banks to report on different figures of specific relevance for their type of business and the limitations set up by law. This means that the mortgage banks e.g. must report on differences in payments on mortgage bonds and on mortgages, differences in redemption terms and on interest rate risks, all of which are related to upholding the balance principle that Danish mortgage banks are subject to.
 
Furthermore, they are required to report on late payments and losses. Late payments are a very important early warning of potential problems in a mortgage bank. Comparison across the various mortgage banks on late payments is also a good indicator of the quality in the loan portfolios. Consequently we use this indicator in drawing a picture of the risk profile of the individual mortgage bank. We also use an average of this indicator to assess the overall resilience of the mortgage banks.
 
A special remedy in our supervision that I would like to touch upon is the data we receive regularly from the mortgage banks concerning all loan offers made in the previous quarter. Every single offer is specified in various characteristics e.g. concerning location, type, size and estimated value of the mortgaged real estate.
 
This reporting system was set up as a result of difficulties in the mortgage banking sector in the early 1990'es and has so far served as a useful tool on the level of the individual loan offers when selecting offers to be examined further on an on-site inspection.
 
We have for some time worked together with the industry to improve the quality and consistency of the data received. Hopefully, this should eventually enable us to assess the risks assumed by individual mortgage banks on an aggregated level. This would also allow us to better compare the risk profiles of mortgage banks with those of the industry in general.    
 

On-site inspection

Now turning to our on-site inspections of mortgage banks, they can be divided in those forming part of the ordinary inspection programme and those forming part of a special inspection programme.
 
The ordinary inspection programme prescribes that all mortgage banks must be subject to an on-site inspection at least every 4th year on every important aspect of their business.
 
In addition our special inspection programme determines that on-site inspections of the largest and most important groups, including mortgage banks, should not address all important aspects of the businesses on one inspection. Instead, at least one risk area must be inspected every year.
 
For our overall on-site inspection programme of mortgage banks this means that one risk area should be examined every year, and that all important risk areas are examined in a four year period.
 
One important aspect of the on-site inspections is the valuation of property used as collateral for mortgage loans. It is a key requirement in the legislation that loans funded by mortgage bonds must not exceed certain lending limits according to the type of collateralised property.
 
In order to determine the value of property used as collateral for mortgages we have valuators employed in the Danish Financial Supervisory Authority. Prior to an on-site inspection in a mortgage bank, the valuators select a number of recent loan offers made by the mortgage bank according to lists of loan offers reported.
 
When on inspection, the valuators read through the documentation on the mortgaged property kept in the files of the mortgage bank. On this background the valuators choose the property they wish to do a valuation on. Normally, this valuation is done together with representatives from the mortgage bank. As on-site inspections often address specific types of property mortgaged, the outcome of the many valuations made by our authority will normally give an indication of where the mortgage bank might need to adjust its valuation practices.
 
In addition to ensuring the security of the mortgage bonds, the valuation of property also has the function of ensuring a level playing field among mortgage banks. Therefore we have often done valuations of one type of property simultaneously in different mortgage banks. 
 
Another important aspect of our on-site inspections is related to the observation of the balance principle. For this purpose we have teams of inspectors specialised in examining financial divisions of mortgage banks.
 
I should add that the Danish Financial Supervisory Authority in addition uses a special inspection programme in cases where the supervised institution faces serious problems. So far no Danish mortgage bank has been subject to this intensified supervision.
 

Cross border lending

A special issue is related to the cross border lending of Danish mortgage banks. So far the cross boarder activity of European mortgage banks has for various reasons been of minor importance. However, as the potential for further development of the Danish market is limited it is possible that we will experience an increase in the cross boarder lending.
 
The legislation allows Danish mortgage banks to use real estate outside Denmark as collateral when granting loans funded by mortgage bonds. There is no limitation to where loans can be granted, but the Danish Financial Supervisory Authority has the option of lowering the lending limits according to our estimation of higher risk for the mortgage bank. I assume that it is a challenge to the mortgage banks as well as to us to understand foreign real estate markets, their risks and possibilities for taking possession of mortgaged property.
 
 

Future prospects

Now what are the prospects for Danish mortgage bonds? As you are aware new capital adequacy rules for credit institutions are being prepared both within the framework of Basel and within the EU. In this connection great interest is being paid to the minimum requirements for the favourable 10 % weighting of covered bonds. Several questions still remain unanswered as for these minimum requirements. E.g. what does "independent valuation" of a property mean?
 
Supplementary to this the Danish mortgage banking sector is pushing continuously for liberalization in the Danish Mortgage Credit Act. Among other things the sector asks for amendments that will make it possible to finance objects like roads and bridges with Danish mortgage bonds. This and other requests for amendments will of course have to be held up against the final requirements regarding covered bonds and the favourable 10 % weighting.
 
Until all these questions and issues have been addressed and answered we do not know exactly what the consequences will be for the Danish mortgage banking sector. But the system has survived ongoing changes for hundreds of years and I believe that we will also in the time to come find ways to uphold the very strong security of Danish mortgage bonds. This is of vital importance for the whole Danish economy.