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August 3, 1990

Bank Failures, Danish Style

The problems with the
deposit insurance
system have spawned numerous proposals for
reform. Some favor abandonment of deposit
insurance altogether, in the hope of enlisting
depositors as a source of discipline on banks
and thrifts. Others propose narrowing sharply
the powers of banks and thrifts to create inherently "safe" banks that would pose no risks of
Another alternative would impose stringent,
market-value capital standards on banks and
thrifts, and close or reorganize any institution
failing to meet those standards. Interestingly, this
approach has been in use for some years in the
Danish banking system, thus providing an opportunity to study its actual performance. This Letter
reviews the Danish experience, and finds that it
functions well, even when banks have broad
powers in a highly competitive, cyclical
economic environment.

The Danish banking system
There are about 74 commercial banks and 131
savings banks in Denmark. (Commercial banks
and savings banks have similar powers and
similar portfolios; they differ in their ownership
form.) Competition appears quite vigorous; on
a per capita basis, for example, Denmark has
about three times the number of banks California
has. Moreover, foreign banks have had difficulty
competing, and have garnered only one percent
of total bank assets in Denmark.
Danish banks have fairly broad investment
powers. In addition to commercial and consumer
loans, Danish banks may invest in corporate debt
and equity, subject to generous limits on aggregate and individual positions. They also may
make direct real estate investments to a maximum of 20 percent of capital.
Danish banks are regulated by the Danish
Inspectorate of Commercial and Savings Banks,
under the authority of the Minister for Industry,
which has the power to issue and revoke bank
charters. Under the Commercial Banks and Savings Banks Consolidated Act of 1974 (CBSBCA),

aii commercial banks, savings banks, and credit
cooperatives face the same regulation.

Reliance on market valuation
Until 1988, there was no deposit insurance in
Denmark. Instead, the government has relied
upon an aggressive bank soundness policy to
limit depositor and public liability. The distinguishing features of that policy are its reliance
on market valuation of bank portfolios and
prompt closure of any institution with impaired
capital, even when that institution still might
have positive, market value capital.
Most components of Danish bank portfolios
must be shown on the balance sheet at actual,
"commercial" value. For example, the CBSBCA
stipulates that traded stocks and bonds must be
marked to the prices quoted by the Copenhagen
Stock Exchange on the last day of the relevant
reporting period. This "marking-to-market"
requirement is not trivial for Danish banks
which, at times, have held as much as 30 percent
of their assets in stocks and bonds. In addition,
for the purpose of meeting capital standards, the
price volatility of the security portfolio must be
calculated, and an adjustment made in the capital requirement for this risk.
Real estate and other fixed assets also must be
accounted for at commercial value. They must be
written down if declines in their market value
occurs, while the recorded value of real estate
held may be written up only if the higher value
is supported by a public land assessment.
Other assets also must be recorded at values
no greater than their "commercial value." The
recorded value of individual loans, therefore,
must reflect all losses, whether actually realized
or only foreseen based on changes in default risk
or the level of interest rates. (In contrast, in the
U.s., losses on individual loans generally are not
recognized on the balance sheet until the loan is
written off.) For non-traded bonds and fixed-rate
loans, banks must adjust the recorded value to
reflect changes in the general pattern of interest
rates. Changes in foreign exchange rates also

must be incorporated into the valuation of all
foreign-currency-denom inated assets.

Capital requirements and closure policy
At present, Danish banks must hold capital or
"own funds" equal to eight percent of total
assets and guarantees. Long-term subOidinated
debt can be used to meet 40 percent of this
requirement. To determine whether banks are
in compliance, Danish banking regulators rely
primarily on reports filed by the banks themselves, and not on inspections, which occur
only at three-year intervals.
Stiff sanctions encourage the provision of
reliable information on banks' condition. Any
time a director, manager, or auditor of a bank
believes that the bank has lost part of its equity,
he or she must report this to the Inspectorate.
Failure to do so carries the risk of fine or imprisonment.

JA,ninstitution that fails to meet Danish capital
standards is subject to rapid sanctions. For losses
which cause an institution's capital-to-asset ratio
to fall below six percent, the bank must immediately seek additional capital in the marketplace.
At most, the bank has until its next shareholders'
meeting to raise at least 75 percent of the capital
If the necessary capital is not provided, closure
is virtually immediate. The CBSBCA states simply
that "[i]f the necessary capital is not provided,
the Minister for Industry shall withdraw the
authorization of the bank:' The Minister for
Industry then convenes a liquidation committee.
Depositors have priority of claim in the liquidation process, and they have representation on
the liquidation committee.

Important benefits
A policy relying on marked-to-market valuation
of bank portfolios and prompt closure of capital
deficient institutions has two important advantages. First, it gives incentives to bank owners
and managers to manage the risk of their institutions, since mismanagement can result in abrupt
loss of the bank charter. And since institutions
may be closed when owner equity still is positive, the liquidation process can lead to additional losses to bank owners and managers.

Second, prompt closure at positive "market
value" net worth provides a way of ensuring that
losses will be borne primarily by equity holders,
and not by depositors. Unforeseen losses may
occur during liquidation because of errors in valuation and closure, of course, and the Danish
legislature has tended to step in to cover depositor losses. The closure policy, however, ensures
that any such public burdens will be minimized.
The result is that depositors have confidence in
the banking system without the need for a large
deposit insurance fund. (The Danes recently
have instituted one, however, in compliance with
anticipated European Community regulations.)

Portfolio behavior
The behavior of the Danish banking system suggests that Danish regulatory policy has been
effective. Danish bank portfolios reflect a heightened sensitivity to risk on the part of the managements of individual banks. First, virtually all
Danish banks hold more than the required eight
percent capital, and are quick to go to equity
markets when their equity approaches that ratio
(two of the largest banks, Den Danske Bank and
Handelsbank raised new equity last year). In December 1988, the average capital-to-asset ratio at
all banks was 9.5 percent. Savings banks, with
depositor-run management, tend to have capital
ratios two to three percentage points above the
Second, the portfolios of Danish banks tend
to be highly diversified, both across and within
asset categories. Even smaller banks tend to have
portfolios that are diversified across industries
and instruments. Although regulation permits
banks to lend up to 35 percent of total capital
(three percent of assets) to a single credit, loan
concentrations of this magnitude are rare. For the
medium and large banks, such as Privatbanken,
for example, the 25 largest credits tend to make
up less than 15 percent of total loans.
Third, portfolios contain only small proportions
of the kinds of assets that fluctuate significantly
in value and therefore pose a potential threat to
bank capital positions. Long-term, fixed-rate
mortgage loans, for example, are a small fraction
of total assets. Similarly, even though regulations
permit as much as 75 percent of net capital to be
held in corporate stocks, actual holdings tend to

be smaller. Moreover, corporate bond holdings
are unrestricted, but account for only about four
or five percent of total assets.
The market-value orientation of regulation and
the credibility of the closure process also help to
mobilize market discipline in the stock market.
The prices for Danish bank stocks quickly drop
when risk exposure is excessive.

Reactions in times of stress
Equally revealing is the behavior of the Danish
banking system in times of stress. The Danish
economy in the last decade has been exposed to
a number of stresses, including volatile interest
and exchange rates and weakness first in its agriculture and subsequently in other export sectors.
In this environment, bank portfolios have suffered losses, and some banks have failed.
Bank failures have occurred without burden to
depositors and usually without a formal bankruptcy process occurring. As the bank's position
has deteriorated, its shareholders have had an
incentive to seek a merger partner, since a
breach of capital standards would trigger rapid
closure and possible total loss of shareholder
investment. The acquisition of the small Aarhus
Discontobank by Aktivbanken in 1988 and the
acquisition of OK Sparekassen (the fifth largest
savings bank, with assets of about $2 billion) by
Bikuben in 1989 are both examples of privatelyarranged mergers of distressed institutions.
Formal bankruptcy does occur as well, however.
Recent examples include 6'Juli Banken in 1987
and C&C Banken in 1988. Both banks had
"atypical portfolios" which made them unattractive as whole acquisitions to other banks. As a
result, both banks were closed within about six
months of capital inadequacy first becoming
evident. In the case of C&C Banken, however,
prompt closure did not preserve sufficient net
worth to protect all depositors. A decision by the
Danish Parliament to protect depositors against
loss resulted in a government cost (via the central bank) of about $52 million, which may be
reduced as liquidation progresses.

accounting system, it is relatively easy to detect
deterioration in a bank's financial condition.
Danish regulations permit the bank a short time
to raise capital and, thereby, test whether the
marking-to-market of the portfolio fairly reflects
the bank's true market value. But the regulators
try to close promptly institutions that fail this
market test of capital adequacy. This appears to
have minimized the public costs of bank rescues
by ensuring that asset liquidation provides sufficient funds to redeem most obligations to
In the U.s., in contrast, banks and thrifts are
required to report assets only at book value; asset
values thus do not incorporate any impairment
caused by changes in interest rates or the creditworthiness of borrowers. The true financial condition of U.S. banks and thrifts is obscured as
a result, and can lead to delays in regulatory
action. In addition, closure has been neither
prompt, nor based on market value. This policy
creates perverse incentives for weak banks and
thrifts to pursue highly risky, "go-for-broke"
investment strategies and to structure their
portfolios in ways that conceal deteriorated
net worth.
Although the Danes themselves have been
critical of the Inspectorate for not catching
the problems in 1988 and 1989 even sooner, the
Danish approach to bank regulation is widely
regarded as effective, and the Danish banking
system has earned the distinction of being "one
of the strongest in the world," according to
Banker Magazine. Salomon Brothers estimated,
for example, that the big Den Danske Bank in
1989 had capital 50 percent higher than the
standard set by the Bank for International
Settlements (BIS).
In summary, despite a competitive environment
and powers greater than those of U.S. banks, the
Danish system has been able to operate essentially without deposit insurance, without runs,
and with orderly failures of banks large and
small. Such an approach deserves closer scrutiny
to determine its applicability in the U.S. context.

Lessons for the U.S.?
Because the Danish bank regulators require
banks to use something akin to a market-value

Vice President

Opinions expressed in this newsletter do not necessarily refled the views of the management of the Federai Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.

Research Department

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Bank of
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