The Danish Government and Danish Bankers Association have agreed on measures to safeguard financial stability

The banking sector, however, is facing two problems. First, the general liquidity problem shared by all countries due to the international financial crisis including – in particular - the very unusual situation of a “frozen” interbank market. Secondly, the Danish banking sector is relatively fragmented. Denmark has approximately 140 banks.

To safeguard financial stability, the Government and Danish Bankers Association have agreed on a set of measures to ensure the credibility needed to normalise the interbank market and the confidence of depositors.

Claims of depositors and other creditors of Danish banks are safeguarded by the agreed measures.

It builds on a large contribution from the private sector (essentially an insurance premium to which the banks have committed themselves) in addition to which a state guarantee is included, designed to deal with the resolution of insolvent banks.

On a mutual basis, the banking sector will finance the losses of the state-owned company charged with taking over insolvent banks up to a limit of 2 per cent of GDP. Any additional loss will be covered by a state guarantee.

Accordingly, insolvent banks will be taken over by the government, which will subsequently liquidate these banks, i.e. sell off assets and insure depositors and other creditors against losses.

The system is designed as an insurance mechanism to which banks will pay significant premiums and supply additional capital, in order to cover losses associated with the liquidation of insolvent banks. It is based on the following principles:

· The private sector is given strong incentives to find private sector solutions to troubled banks.

· There will be no bail out of shareholders and supplementary capital. Bank management will be held accountable.

· In order to minimize both the cost to taxpayers and the risks of moral hazard, the private banking sector will contribute significantly to cover losses associated with the winding-up of insolvent banks.

· There will be no discrimination between domestic and foreign-owned banks.

All banks in Denmark are covered, provided they contribute to the Private Contingency Association, which finances the private sector coverage of losses in the government company. Currently, essentially all banks in Denmark, including foreign owned, contribute to the association.

Entry into the insurance scheme will only be open for a few days. Measures will be taken to ensure that financial institutions and foreign affiliates are not established to speculate in the scheme.

Subsidiaries of foreign banks in Denmark are covered. Depositors in branches of foreign banks in Denmark are covered. Subsidiaries of Danish banks in other countries are not covered. Depositors in branches of Danish banks in other countries may be covered if other banks in the country concerned have a comparable arrangement. The design avoids distorting competition and minimises the risk that any other country is negatively affected.

That combination minimises the risk to taxpayers and ensures a strong incentive for the private sector to find solutions including mergers and acquisitions of troubled banks (i.e. on a commercial basis without government involvement), thus avoiding triggering payments from the Private Contingency Association.

The government participates in the upside risk to the extent that contributions to the Private Contingency Association exceed the losses they will have to cover.

The Danish government continues to support all international efforts to find solutions to the common problems in financial markets, including in the EU. The agreement in Denmark supplements these efforts and is tailored to the specific structure of the Danish banking system (i.e., a large number of small and mid-sized banks).

The government would welcome similar steps in other countries to the extent they follow similar principles of private sector engagement, non-discrimination and continuous full responsibility of shareholders and management in individual banks.

Strong initial conditions have placed the Danish economy in at good position to meet the challenges ahead.

Overall, the Danish economy is in a healthy position, just around a cyclical peak. Hence, the difficulties experienced in parts of the Danish banking sector are not rooted in domestic macroeconomic imbalances.

Economic activity and employment are at very high levels, following the recent upturn. Unemployment has been reduced to an extraordinarily low level of 1½ per cent of the labour force. And both the current account and public finances show sizeable surpluses.

Despite strong increases in domestic demand until late last year, the current account has remained in surplus and stood at 1 per cent of GDP in 2007.

The public sector budget has been in surplus for several years reflecting a strategy of consolidation during good times. In 2007, the government surplus was 4.8 per cent of GDP and outstanding central government debt constituted 26 per cent of GDP by the end of 2007. The public sector surplus is expected to be above 3 per cent of GDP in 2008. Correcting for temporary factors and the strong business cycle, the structural budget balance is estimated at 1½ per cent of GDP in 2008.

This leaves the Danish economy in a better position than many other countries. The strong state of the Danish economy – and the strength of the banking sector – was also emphasised by the IMF, when concluding its Article IV consultation of Denmark on Thursday last week.

Denmark is thus in a good position to weather the recent international financial turmoil. Some dampening of demand pressures would serve to bring economic activity in line with the estimated production potential. In the present juncture, the timing of the international slowdown thus helps to achieve a soft landing, and allow the fiscal policy stance to be slightly expansive in 2009.

Inflation – which has risen as in most other countries following global increases in food and energy prices – is likely to taper off throughout the rest of 2008. And with a strong surplus on public finances, automatic stabilisers are free to work.

While developments in the Danish housing market have attracted some attention, it is neither caused by, nor causing, the financial turmoil in Denmark. Also, households are in a solid net wealth position, and only a very small share of homeowners is technically insolvent. Furthermore, household real incomes are expected to increase by approx 2 per cent annually despite higher inflation, and while rising, forced sales are still at a very low level.

So far, the direct effects of the financial crisis have been relatively modest in Denmark, because Danish banks have limited exposures to sup-prime assets and generally appear well consolidated. The main channels of contagion have, as in several other countries, been an increase in risk aversion and a drying-up of liquidity, which have increased short-term interest rates and shut down parts of the interbank market.

Some small and medium sized banks have been exposed to refinancing risk and thereby forced into a process of restructuring, which has so far evolved in an orderly fashion through private take-overs, although in a few cases in cooperation with the Danish Central Bank and the Danish Government.

However, in recent weeks an increasing number of banks have experienced problems, when rolling over their funding. The Danish Central Bank has established several additional temporary liquidity facilities, which have eased liquidity constraints. Despite these measures, short term funding markets remain extremely tight. Accordingly, the Danish financial system is presently exposed to significant liquidity risks with potential systemic implications. If such a scenario were to unfold, severe macroeconomic effects could be hard to contain.

On that background the package, which have been put forward, intends to effectively address the evolving liquidity shortage, while adhering to market principles and minimizing international spill-overs. The package is also designed to limit problems related to moral-hazard in the banking sector, and minimize the risks to, and impact on, public finances.

A separate paper on the macroeconomic background is available here.

For an unofficial translation of the agreement click here.