Interview: Peter Engberg Jensen, Nykredit

Peter Engberg Jensen, group chief executive at Nykredit, spoke to Nordic Financial Institutions & Covered about regulatory challenges, Junior Covered Bonds, and the Danish banking system.

You have said regulatory risk is the biggest challenge for Nykredit. What in particular do you have in mind?

The most challenging is capital requirements. We are a financial mutual and it means that we haven’t got the same possibility to simply issue new shares and get equity when capital requirements are increasing. That’s one thing.

Peter Engberg Jensen, group chief executive, Nykredit

The other thing is that the nature of our business is long term. If our balance sheet was a normal bank balance sheet we could reduce it rather fast, perhaps, by just letting loans redeem, or asking people to reduce their loans. But for many of our borrowers our business is of a 30 year nature. So when the regulators increase capital requirements, the two instruments that other institutions can use — reducing their balance sheet or issuing new shares — are not an option for us.

Under Basel II we used to have a capital requirement at a level of Dkr32bn (Eu4.3bn). We actually have capital, real Core Tier 1 equity, of Dkr57bn-Dkr58bn. But the new requirement for 2019, as we see it right now, is at a level of Dkr70bn, maybe Dkr70bn plus. And if we look at the level of income that we have right now, because of the very low interest rates we earn practically no risk free interest on our equity. Our main challenge is the fact that if we simply extrapolate our current earnings up to 2019 we will be able to earn what is needed by then but we will not be able to increase the total amount in our loan book.

We do have certain measures that we can take. Naturally we can reduce lending activity. We can also look at prices — it’s a possibility. We can deal with costs. And we can also look at more efficient use of capital.

On top of that it might be natural to use capital certificates, or so-called Core Tier 1 capital instruments. But we have a little challenge there. Internationally it is a part of CRD IV that it should be possible for financial mutuals that are 100% owned by their customers or an association, as we are, to use these capital certificates. But in Danish legislation there is a rule saying that we are not allowed to issue shares without voting rights. So we are working together with the regulators in Denmark to be sure that we can use this capital instrument if necessary, because we want to have as many capital instruments as possible.

And last, but not least, CoCos [contingent convertibles] could be a part of our capital policy. But in that case we need something that the CoCo can be transferred into. And it would not be normal shares, because we haven’t got normal shares, so here we also need capital certificates so we have something that the subordinated capital can be transferred into if they are to be converted.

It is all very interconnected…

Yes it is. But above all, it is the need for more capital because of our long term business. We are in a situation where we can comply with these rules, but it will reduce our activity. And we have the instruments to change cost, income, whatever. But new capital instruments are also part of solving the challenge of new capital requirements.

So you won’t be able to increase your activity the way things are looking. But during the crisis you did so.

That’s true. We were a kind of “spare wheel” for the supply of credit in Denmark, because if you look at the total amount of loans outstanding from Nykredit, in 2008 it was Dkr965bn and it increased to Dkr1,127bn in 2012, so we increased our activity by some Dkr160bn. And if you look at the rest of the market it decreased Dkr250bn. This is domestic lending, so loans from Danish financial institutions to domestic borrowers.

This was the result of two things. We went into the crisis with very high capital ratios, so we had the possibility to increase lending. And we also had the possibility to fund our activity because of the Danish mortgage system, because it was functioning through the crisis.

The figures you quoted and the way in which the capital requirements will constrain your lending — do you explain these to policy-makers?

That’s what I’m telling them. When we look into the new capital requirements, including some buffers, we need around Dkr70bn, plus some subordinated capital on top of that. We are a conservative company when it comes to capital and we will under no circumstances, if we can avoid it, ever arrive at a situation where we have to be close to the minimum. So when we are looking ahead, if the capital requirements are set so high that if it is necessary for us to stop lending to comply with them, then that is what we will do. That’s life, because we are not magicians.

I know a lot of things can happen from now until 2019. Interest rates can go up because of more activity, then suddenly we will earn much more on our own equity, from the investment portfolio. But as we see it right now, we will only just comply. And that’s what we are saying to the politicians.

Are they listening?

Yes, I would say that they are. The consequences of increasing capital requirements dramatically and quickly are more and more understood by the people that we are talking to. But I also know that the overall rules are made by the international regulators, and we can do nothing about that here in Denmark. But what we are saying to people here in Denmark is this: we have been through the most severe stress test that you can imagine, namely the financial crisis from 2008 up to now, and we have gone through that crisis without being hurt and while being able to offer new loans.

Think about it. Every time that the capital requirement percentage is increased by 1% it means Dkr4bn extra for Nykredit and it means Dkr50bn less lending capacity. And I feel that I have gotten their ear when I tell them that.

Another key question has been whether covered bonds might qualify for the equivalent of Basel III’s Level 1 under CRD IV, something the Danish have been lobbying for. What do you expect?

I am quite confident. I would say that when we got the first proposals for CRD IV and especially Basel III we were quite afraid of what could happen. Because at that time it was only government bonds that were Level 1. And we are in Denmark in a situation where if you look at the amount of covered bonds to GDP, it is something like 140%-150%, and if you look at government bonds to GDP, it’s around 40% of GDP. According to our calculations it would be difficult for Danish financial institutions to comply with the liquidity rules if they can’t use covered bonds as the best quality liquidity assets. And it would also mean that a lot of covered bonds owned by Danish financial institutions would have to be sold to foreigners, and you can imagine what would happen to the interest rate if that were to happen.

When we look at what has happened during the last two or three years, in the discussions and process with the Commission and the EBA, I would say that they have listened to the arguments, not only from Denmark but from many others, and now use a more generic definition of what is good liquidity, where you look at the actual liquidity and actual safety of the different bonds. And when we look at the last recommendation that I am aware of from the EBA to the Commission, it is also along these lines. So right now we are quite confident that we will end up with a situation where Danish covered bonds will be within the first and best quality of liquidity. That’s how we see it right now.

Some people have suggested that while Denmark — given the arguments you have outlined — might have its covered bonds accepted as Level 1 assets, other covered bonds might not be accepted, with the rules possibly being written in such a way that only Danish covered bonds are accepted. Is that your understanding? Or will there be a real chance of other covered bonds being accepted as Level 1 assets?

My expectation is the latter. I haven’t heard anybody talking about a specific Danish exception. Our expectation, from what we have heard and seen, is that it will be a general set of rules that will be formed in a way defining what is good liquidity, where we would expect Danish covered bonds to comply with rules, but also that other countries will be eligible. Where the borderline will be, I don’t know.

We have always said if you are talking about liquidity, then good liquidity means two things. It means that you have something that is rather safe and with high credit quality, that’s one thing. And the other thing is that you can trade them in a market at market prices for certain amounts within a certain period of time. In my view it doesn’t matter if it is a government bond or a covered bond or who is the issuer. It is more the question of credit quality and liquidity. And it is our opinion that this is what the law-makers are looking at for the time being.

Junior Covered Bonds are another Danish exception…

Or innovation. Because actually it was here in Nykredit we started to design them, because the nature of our business made it a necessity for us to develop Junior Covered Bonds.

Having followed their development over the past few years, they do seem to have caught on despite some scepticism, and some other Danish issuers are using them.

We are satisfied. You can say in the beginning it was a little bit of an uphill struggle to come with something like this and people were asking: what are these Junior Covered Bonds? But what we see now is that we have got a lot of both Danish and international investors to understand what it is. Looking at the security, it is between a normal covered bond and senior debt.

We are very satisfied with the development as it has been possible for us to issue something like Dkr45bn — I think we are at a little more even, now — in the Junior Covered Bond market.

But in the long term — and I have really got the long term glasses on — I must say that I do not like it that we have got what we could call a liquidity risk into the Danish mortgage system, which we have never had before. We have always been in a situation where when we made the loan and then issued the bonds that were parallel to the loans we could forget about liquidity risk for the mortgage institution. If we issue one year bullets we have to refinance them every year, but the price risk is on the customer. But here we are in a situation that if house prices are falling and our LTVs increase and go up above the 80% LTV limit, then we have to find extra collateral, and I don’t like to have that liquidity risk.

So we have divided our loan activity into two, so to speak, so we have split the loans into up to 60% using the covered bond rules and from 60%-80% LTV we use the old, traditional Danish mortgage bonds, where it is not a necessity to put in extra collateral if the LTV goes above. This means that we are satisfied with the Junior Covered Bond market and we will still be in the market. But it is naturally a goal for us that this market should be reduced because it expresses a liquidity risk that we have got in Nykredit.

Junior Covered Bonds are not for everyone, such as traditional covered bond investors, but even if people don’t want to buy them they do seem to at least appreciate it’s something sensible. However, some people don’t like the name, saying it should not include the “covered bond”. What do you make of that?

I have never heard that before, but I’m sure my colleagues have. It is actually not something we thought about. We discussed the name here in Nykredit when we introduced the bonds back in 2009 or 2010. I actually think that it is a good term, Junior Covered Bonds, because what it illustrates is that it is issued based on a capital centre. I could maybe understand if somebody questioned Junior Covered Bonds when it comes to other systems, but you should be aware that this is an issuance from a specialised institution and it is issued in our example from a capital centre. That’s why we have said it’s junior to a normal covered bond, but it is from a capital centre. So that’s the internal rationale, so to speak. I would still say it is a good term.

Do you expect a stabilisation of Danish house prices?

Yes. If we look into the market, there are certain things that support stable prices and even better prices in the housing market.

The affordability index is very cheap compared to anything we have seen for many years. We also produce a house price confidence indicator here in Nykredit, and it has gone up. And all in all we have good balances in the Danish economy, and when I look at delinquencies and so on, they are going down for the time being. And so, taking into account all these things, it speaks for a small increase in house prices.

The other thing is that normally, nearly always, it has been Copenhagen that has been the first mover. We saw in 2005-2006 that it was Copenhagen where prices exploded, and it was also Copenhagen that went down from the peak first and had the highest volatility. And what we see right now is that people are moving to Copenhagen, and there is almost what you could call an undersupply of apartments in Copenhagen. So we see prices going up in Copenhagen, and this could extend into the countryside.

The main problem, as we see it, is a geographic or demographic problem, where people are moving away from some areas of Denmark. It is what you see in many European countries, that people are moving away from the countryside into the big city areas, and when we get losses, that is where we have the losses. But the general housing market looks more stable and better than I have seen for many years, since the crisis began.

We had a somewhat similar situation at the beginning of 2011, but then we got the European government debt crisis, and confidence went down dramatically during the summertime and it affected our housing market. But right now it looks like confidence has returned and the financial situation for customers looks good, so we are quite confident. It’s not an explosion, but it’s a confident view on the housing market.

You mentioned that Nykredit has come through the worst possible stress test well and that the bond system has worked very well. But not every bank in Denmark has done so well. There have been various Bank Packages put in place, but we’ve still seen problems emerging at banks. Where do you see the Danish banking system in general being in terms of coming out of the crisis?

There are two answers. There is one for the general banking system, and there the answer is that it has come through the crisis. At Nykredit we are through it and quite confident as we see it right now.

But there are three things that still can affect some banks. Firstly, it depends on where they are geographically situated. Secondly, the Danish economy is split in two different parts, with a difference between big companies and small companies — and then there is also agriculture. And thirdly, for some banks the problem is with large exposures.

At Nykredit we are not in any specific geographic area or any specific area of business, so we cover the whole country and it means that we are a mirror of what is happening in the Danish economy. But if you are a small bank in a region where activity is lower than general activity in Denmark, and you maybe have got large exposures, then you can still face some challenges, and so I would not say that we are through the crisis for all banks.

Another thing to be aware of is that it would be difficult for some banks to refinance their subordinated debt when it redeems. If you are a small bank also relying on subordinated debt and you want to refinance that in 2014, 2015 or whatever, it could be difficult. And so this combination of geography, what type of borrowers you have got, large exposures, and then subordinated debt that has to be refinanced, this is a combination that can give you challenges that maybe means that you have got to be restructured in some way.

But on the other hand, I would say that the dramatic developments that we have seen before, with Amagerbanken or whatever, I think that we have come through that process.

Apart from the points you made about CoCos earlier, what is your expectation about what might or might not be possible, taking into account the regulator’s position?

I don’t know. But I would say — and we have also expressed our opinion on this to the regulator — that if you make that trigger too high then it would be really difficult to sell the bonds, the subordinated capital. So if you say that on the one hand it is a capital instrument that could be used in Denmark, then on the other hand you have to use triggers that are at an internationally accepted level. And that’s what we are telling the regulators here in the Denmark, and the politicians. Where it will end, I don’t know, but I think that they are listening.