Academic journal article National Institute Economic Review

Mirror, Mirror, Who Is the Fairest of Them All? Reflections on the Design of and Risk Distribution in the Mortgage Systems of Denmark and the UK

Academic journal article National Institute Economic Review

Mirror, Mirror, Who Is the Fairest of Them All? Reflections on the Design of and Risk Distribution in the Mortgage Systems of Denmark and the UK

Article excerpt

This paper describes the Danish mortgage system by comparing it with the UK mortgage system. The Danish mortgage system has attracted attention in the literature on the design of mortgage systems. It is a type of narrow banking model where mortgage loans are financed by specialised institutions that issue bonds with cash flows that match that of the mortgage loans. Thereby, the Danish mortgage system outsources many of the risks that are usually kept on the balance sheet of banks to bond investors. Measured in terms of four criteria, the Danish mortgage system performed better during the financial crisis than the UK mortgage system. However, both in Denmark and the UK, alignment of the mortgage and the pension systems could offer significant advantages.

Keywords: financial intermediaries; mortgage; mortgage market; refinancing; regulation

JEL Classifications: G21; G28; R31


The purpose of this paper is to explain the design of the Danish mortgage system, comparing it with that of the UK and specifically focussing on the allocation of risk among the different stakeholders. The stakeholders are the borrowers, the intermediaries, those who finance the intermediaries and society at large.

Commenting on the US mortgage system in a recent editorial, the Financial Times (2013) argued for winding down the government-sponsored mortgage lenders, among other things noting that "no other countries allow borrowers to lock in fixed-rate 30-year mortgages and then to refinance their loans when rates fall". Denmark and the UK are only separated by a small ocean and not divided by the use of a common language, but the Danish mortgage system actually allows borrowers to lock in fixed-rate 30-year mortgage loans and then to refinance their loans, when rates fall.

A crucial element in the design of mortgage systems is the allocation of risk among the different stakeholders. A 30-year fixed-rate mortgage loan is a big risk for a depositary institution whose funding is mostly variable-rate and can disappear at short notice. For a depositary institution with such liabilities, the ideal mortgage contract would be variable-rate and allow for redemption at short notice. However, for the borrower this would not be an ideal loan.

The UK was among the countries that were particularly hard hit by the financial crisis. Major high-street banks failed. As a result, extraordinary steps towards reforming financial regulation have been taken. One of the most prominent of these is the Vickers Committee's recommendation of structural separation of financial institutions (ICB, 2011). Very little attention has been paid to the role of mortgage financing in the UK, and the UK Treasury's review of covered bonds (UK Treasury, 2011) essentially suggested continuing as before. (1)

The financial crisis also had a significant impact on Denmark, but the mortgage system emerged from the crisis relatively unscathed. Nevertheless the financial crisis has given rise to a lot of soul searching, especially on how to make the mortgage system even safer. Mortgage systems are remarkably idiosyncratic, making it very difficult to understand the choices made with respect to their design. By making comparisons with the UK system, the implicit choices made in relation to both will hopefully be clearer.

Probably the most significant difference between the UK and the Danish mortgage system is that in Denmark, mortgage loans are not granted by deposit-taking banks, but by specialised institutions akin to narrow banks. More generally, there are two sides to a mortgage system: The financing that it provides and how it is funded. In the Danish system these two sides are intimately connected, as it is essentially a pass-through system where the loans provided are matched by the covered bonds that fund them. In the UK, financing is more diversified, and there is no direct link between the assets side and the liabilities side of the intermediary. …

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