Danish Capital Injections Scheme 2009 (DK GFC)

Prior to the establishment of this capital injections scheme, Denmark passed Bank Rescue Package I in October 2008 (OECD 2009). This included a government scheme for participating banks that guaranteed domestic and foreign claims by depositors, debt holders, and creditors until September 30, 2010, though the guarantee was later extended to last until 2013. The guarantee covered all Danish banks that were members of the deposit insurance scheme and Danish branches of foreign banks that did not have such a scheme in their own countries. Participating banks could not pay dividends, engage in stock buybacks, or create new stock option arrangements. Ordinary deposits were also covered by an increased guarantee of DKK 750,000. Bank Package I also included a winding-up company, the Financial Stability Company, that could facilitate the takeover and resolution of insolvent banks where they could not find a private solution. The Financial Stability Company provided capital to help a new company wind up and take over a failed bank to protect debt holders and creditors; the private sector provided DKK 35 billion to cover losses in this winding-up company. Bank Package I also implemented a ban on short-selling shares of Danish banks.

Bank Package II was passed in February 2009 and established a capital injections scheme for which all solvent Danish credit institutions were eligible. To participate, banks issued subordinated debt to the government. Regulators considered subordinated debt a form of hybrid Tier 1 capital. Danmarks Nationalbank projected in 2009 that converting the subordinated debt into share capital would greatly improve the Danish banks’ core capital ratios (OECD 2009). Bank Package II also authorized the authorities to provide a capital subscription guarantee to help non-participating banks attract private investors (Denmark 2009a).

The Bank Rescue Package II also amended the Danish Act on Financial Stability by enabling individual government guarantees for non-subordinated unsecured debt and for loans issued for financing top-up collateral for institutions issuing særligt dækkede obligationer and særligt dækkede Realkreditobligationer (SDOs and SDROs) which are covered bonds and covered mortgage bonds respectively,  as well as Danish Ship Finance A/S (Denmark 2009). This individual government guarantee ran up to three years and included loans issued through December 31, 2010.

The European Commission (EC) approved the capital injections scheme pursuant to their State Aid policies that aim to avoid distortions of competition that may result from government policies (EC 2009c). Policies that constitute state aid may be approved if they help to “remedy a serious disturbance in the economy of a Member State” (EC 2009a,). As with many similar capital injections schemes in Europe during the GFC, the EC considered that the program gave beneficiaries an advantage relative to their competitors. However, as the capital injections program was crucial to remedying liquidity access problems in the economy, and supported the banking system in Denmark, the EC approved it.

The Ministry of Economic and Business Affairs could also pass more detailed rules governing the amount of interest to be paid on the capital injections (Denmark 2009a). The Ministry of Economic and Business Affairs also supervised credit institutions receiving capital injections, producing a report every six months on the activity of these institutions.

Through Bank Package II, Denmark made DKK 100 billion available for capital injections of hybrid core capital to solvent banks and mortgage lenders, allowing them to reach a Tier 1 capital ratio of up to 12% (Denmark 2009a). The use of the capital injections scheme by all eligible institutions to achieve a 12% Tier I capital ratio would have involved approximately DKK 100 billion (EC 2009a). A total of 50 institutions applied for DKK 63 billion in total (OECD 2009). In 2009, 43 institutions received DKK 46 billion in capital injections at an average yield to maturity of 10.08% (Danmarks Nationalbank 2011).

The amount of capital provided was decided based on the individual institution’s capitalization and risk profile along criteria such as basis capital, deposit deficit, liquidity risk, and quality and earning of credit (EC 2009a).

Applications for the capital injections were initially accepted until June 30, 2009. On July 10, 2009, the Danish authorities extended the time frame to perform capital injections until December 20, 2009, as they needed more time to review the 50 applications they had received (EC 2009b).

The Minister of Economic and Business Affairs, upon making an agreement with an institution to perform a capital injection, could use the government account at Danmarks Nationalbank to fund the capital injection (Denmark 2009a).

Eligible institutions were primarily bank and mortgage credit institutions that fulfilled the solvency requirements established by the Danish Financial Supervisory Authority (EC 2009a). Subsidiaries of foreign banks in Denmark were also eligible if they used the capital injection to ensure consolidation and increase lending in Denmark (Denmark 2009a).

Applications for capital injections required explanations of the financial institution’s economic situation, capital adequacy, and future projections, with an independent audit (EC 2009a).

For institutions that met the prior Tier 1 capital ratio of 9% or more, the capital injections scheme offered a maximum increase in Tier 1 capital of 3% up to a ratio of 12% Tier 1 capital (Denmark 2009a; EC 2009a). Credit institutions with a Tier 1 capital ratio between 6% and 9% were offered a capital injection to achieve a 12% Tier 1 capital ratio. Institutions below a 6% Tier 1 capital ratio were required to individually negotiate with Danish Authorities prior to applying for the capital injections scheme.

The 12% Tier 1 capital ratio target was supported by a stress test prepared by the Danish National Bank based on three scenarios for the 15 largest Danish banks. This was decided on the basis of the Danish National Bank concluding that a Tier 1 capital ratio of 13.5% would allow those 15 banks to individually meet their capital needs (EC 2009a). The central bank said that the target 12% level would increase banks’ ability to get capital market funding and support the real economy.

The stress test considered three scenarios. In the first scenario, the financial crisis would lead to a deep international recession, entailing lower demand for Danish products; central banks worldwide would adopt a more expansionary monetary-policy stance, and interest rates would fall. In the second scenario, the financial crisis would prompt the Danish banks to significantly reduce their lending; the Danish economy would experience a credit crunch. The third scenario was a combination of the first two scenarios, in which a deep international recession would coincide with a credit crunch in Denmark, causing a historical decline in economic activity (EC 2009a). The stress test accounted for the fact that banks could not pay dividends for two years due to the State guarantee issued in October 2008, and that the banks had to contribute to the guarantee scheme. The stress test modelled the pressure on bank earnings and capital adequacy that would result from the scenarios modeled.

The capital injections took the form of perpetual subordinated debt with no voting rights (Denmark 2009a). Interest payments were noncumulative. Reimbursement of the injected capital could start after the third year at 100% of the face value plus interest but was subject to step-up provisions after five and seven years. After the fifth year, the instrument was callable at 105% of the face value plus interest, and as of the seventh year at 110%. The government had no conversion rights, but the subordinated loans were transferable (EC 2009a).

On July 10, 2009, the Danish authorities extended the time frame to perform capital injections until December 20, 2009, as they needed more time to review the 50 applications they had received. In addition, they made it possible for participating banks to convert their subordinated debt into share capital within five years of the initial injection. This was to enhance the quality of capital issued by participating banks under the program. The initially issued subordinated debt, as notified on January 23, 2009, did not fully meet markets’ and rating agencies’ expectations in terms of quality of capital issued and did not satisfy rating agencies' standards for core Tier 1 capital. With the conversion option, the debt would qualify as core Tier 1 capital. Therefore, by introducing this conversion option, Danish authorities were hoping to ensure that participating banks could maximize the use of capital injection for external rating purposes while minimizing changes to the authorized original plan (EC 2009b).

The conversion option was available for five years after issuance and could be exercised to avoid the step-up provisions related to interest rates and reimbursement prices; the conversion option was thus an incentive for banks to convert the subordinated debt into ordinary shares to avoid higher payments (EC 2009b).

Several criteria had to be met in order for a bank to exercise its conversion option and benefit from the higher capital quality (EC 2009b). First, the banks’ shares had to be trading in a regulated market. Second, the issuing bank’s total hybrid Tier 1 capital had to be more than 35% of its total Tier 1 capital. Third, the conversion amount at any given time could not exceed 20% of the original capital injection received by the bank.

The conversion price included a 5% discount from the average share price derived over three working days from the conversion date, limiting the ability of issuers to use the conversion option to entirely avoid the step-up clauses. For the conversion option, banks had to pay an additional annual fee of 20 to 60 bps, as per European Central Bank (ECB) recommendations, to align it with the range of remuneration set up for ordinary shares. The European Commission (EC) verified appropriate fee levels of convertible hybrid capital on a case-by-case basis. The EC considered these conditions appropriate to safeguard the use of the capital injections scheme and avoid undue distortions of competition as required by the State Aid policy.

According to their capitalization and risk profiles, potential recipient credit institutions were divided into three categories which determined their interest rate (EC 2009a). Credit institutions in Group I (ratings of AA- or above) qualified for an interest rate of approximately 9%; Group II (ratings between A- and A+) qualified for an interest rate of approximately 9.55%; and Group III (ratings at or below BBB+) qualified for interest rates of approximately 11.25%. Institutions without a rating were manually sorted into one of these three groups based on the criteria above.

Four years after the capital injection, interest rates would be fixed at the greater of the fixed interest rate or 125% of the dividend payments to ordinary shareholders.

The expected yearly return of these capital injections was approximately 10%, but the interest was noncumulative.

In the case of bankruptcy, losses would first be covered by equity, then the injected subordinated debt, followed by other debt holders and creditors (EC 2009a). No further materials relating to the motivation behind this design were found.

Executives could not receive additional share compensation even through the extension of previous programs (Denmark 2009a). Variable salary compensation for executive board in financial companies could not exceed 50% of the total basic salary including pension.

Credit institutions benefitting from capital injections also had to produce reports on their lending every six months that would later be consolidated and published (EC 2009a). These reports included information on the loans made, including the industry of the recipient, the share of credit to households and companies, the size of loans, and credit conditions. Subsidiaries of foreign credit institutions based in Denmark had to commit not to transfer their capital injections to their parent companies.

Institutions receiving capital injections were banned from making dividend payments in 2009 and 2010. They could only pay out dividends covered by their annual profits thereafter (EC 2009a). Until the recipient exited the capital injection program, they were also banned from creating stock option programs for management and from repurchasing stock.

The injected capital was callable at 100% starting the fourth year. After five years, it was callable at 105% face value plus interest, and after seven years, it was callable at 110% face value plus interest (EC 2009a). The Danish authorities did not have any conversion rights, and the recipient institutions could not reimburse their capital before the beginning of the fourth year. However, the Danish state could transfer the capital. The minimum waiting period of three years before exiting the capital injections was intended to create stability for recipient institutions and provide a clear incentive to lend, addressing the credit squeeze of the financial crisis.