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"Financial stability 2002"

Financial stability analysis

Trends in the Financial Sector

The banking institutions assume various risks in the course of their business. Credit risk associated with loans and guarantees is the most significant risk. The banking institutions' losses and provisions on loans and guarantees increased in 2001, but from a very low level. This development reflects some deterioration of the current credit quality, also reflecting expectations of higher future credit losses. The economic slowdown had no impact on the banking institutions' overall result, and an economic upturn might dampen further increase in losses and provisions.

The banking institutions' earnings continue to be robust, although the analysis indicates a slight decrease in the robustness compared to 2000.

Financial groups

The largest Danish banks are part of financial groups. Their operation, return on equity and risks are thus closely linked to the other companies in the group, which could be other banks, mortgage-credit institutes or insurance companies. In the following, the trends for seven Nordic financial groups are presented as the background to the development in the Danish financial groups^[1]. It should be noted that comparisons of the financial statements of the Nordic financial groups should be interpreted with great caution^[2].

Trends in the groups' financial statements

With one exception the groups' ordinary operating result before tax tended to be lower in 2001 than in 2000. On average, the groups' return on equity in 2001 corresponded to the average in the period since 1995, cf. Chart 1.

In 2001, the groups' earnings from deposit and lending activities increased owing to greater volumes, among other factors, while fee and commission income decreased due to such factors as lower income from investment banking and asset management, including decreased securities trading. Investment banking activities include IPOs (Initial Public Offerings), mergers and acquisitions and stock market analysis, while asset management activities include portfolio management for private and institutional customers.

Declining stock prices entailed losses on the groups' share portfolios in 2001. However, this was more than offset by positive value adjustments on the far more substantial bond portfolios.

Throughout 2001 the groups' losses and provisions increased overall compared to 2000. Several groups attribute this to weaker international business cycles in 2001 than in the preceding years.

There was no clear trend in costs, which can be explained by e.g. the rationalisation programmes implemented in some groups these years.

The groups' aggregated balance sheet increased by 7 per cent from 2000 to 2001, which can be attributed to growth in existing business areas as well as acquisition of financial companies. A proportion of the groups' earnings is generated by off-balance-sheet activities such as investment banking. As a result, the balance sheet is not necessarily a good indicator of the groups' actual business volume and earnings potential.

The capital adequacy of the Nordic groups

Most of the analysed Nordic groups strengthened their capital base in 2001. According to the Basle Committee's^[3] capital-adequacy rules of 1988 banks must have a solvency ratio^[4] of at least 8. The solvency ratio of the Nordic groups was between 9.1 and 11.4 at end-2001. Overall, the average core capital ratio^[5] of the Nordic groups has decreased since 1995, although it increased marginally during 2001, cf. Chart 2.

In order to create shareholder value some groups bought back their own shares in 2001. Most of the groups state that they intend to adjust their capital structure through share buy-backs again in 2002. The increased focus on the banks' capital structure may on the one hand contribute to enhancing efficiency and profitability. On the other hand a reduction of the capital base will – all other things being equal – also reduce the banks' buffer against unexpected losses. The banks' capital adequacy is described in the chapter on the banks' capital adequacy and earnings.

Structural trends

2001 saw a general trend towards continued consolidation and extension of the strategic cooperation among the players in the Nordic financial sector.

Svenska Handelsbanken acquired Midtbank in 2001. At the time of acquisition Midtbank was a major category-2 bank^[6].

When Nykredit's annual accounts for 2001 were published, the group announced that it would enter into strategic cooperation with Jyske Bank. The principal element of the cooperation will be a joint IT operation company and an agreement for Jyske Bank to promote Nykredit mortgage-credit loans to private customers alongside Totalkredit mortgage-credit loans. In addition, Nykredit must acquire up to 9.9 per cent of Jyske Bank's share capital. As an element of the cooperation, the parties have agreed that Nykredit should exercise the voting rights entailed by the acquired shares as requested by the Board of Directors of Jyske Bank.

Nordea has acquired the Swedish Postgirot Bank at a value of approximately kr. 3.3 billion. According to Nordea, this acquisition will contribute to strengthening the groups' payment settlement competence.

At the beginning of 2002, Den norske Bank in Norway acquired the asset management division of Skandia in Sweden. According to Den norske Bank, one of the purposes of the acquisition was for Den norske Bank to become a leading supplier of asset management services for institutional and private customers in the Nordic region.

In the spring of 2001 the two Swedish groups, SEB and FöreningsSparbanken, announced merger plans which were nevertheless abandoned in September 2001. According to the two groups, the merger was abandoned because the approval requirements of the European Commission would impose costs on SEB and FöreningsSparbanken of such a magnitude that the value of the merger would be lost.

Structural trends influence the composition of the business areas of the various financial groups. Chart 3 shows a breakdown of the groups' balance sheets by business area. The breakdown by business area should be interpreted with caution, since several factors make it difficult to achieve a uniform definition. Table 1 shows the number of employees in the groups.

Table 1 Number of employees in financial groups, end-of-period

The Danish banking institutions

The Danish banking institutions constitute a heterogeneous group, so the average development may conceal considerable variations between the individual players^[7]. A number of indicators reflect a tendency to polarisation whereby the average is pushed in a certain direction by one or more major banking institutions in deviation from the general trend for most banking institutions. This presentation seeks to take these factors into account. The background to and the methodology used in the analysis of the Danish banking institutions are described in the chapter on analysis of banks in relation to financial stability.

Danish banks' financial results in 2001

On an aggregated level the Danish banking institutions' profits in 2001 increased by kr. 1.8 billion over 2000, cf. Box 1. The increase can be attributed mainly to higher interest income and reduced costs, which more than offset increased losses and provisions and a decline in value adjustments and income from commission and fees.

Box 1 The banking institutions' financial statements 2000-2001

Despite the increase in profits the banks' average return on equity has decreased slightly, cf. Chart 4. For 90 per cent of the banks the return on equity is even below the average of 12.8 per cent, while the return on equity for half the banks (represented by the median) is below 8.8 per cent^[8]. The 10th percentile shows the return on equity for the lowest 10 per cent of the banks.

The increase in net interest income can be attributed primarily to growth in deposits and lending, even though growth in lending has been on the decrease, combined with a higher proportion of interest-bearing assets on the banks' balance sheet. For the largest banks the decline in fee and commission income is explained by lower activity in the areas of investment banking and asset management, while growth in raising and re-mortgaging of mortgage-credit loans generally made a positive contribution.

Losses on the banking institutions' share portfolios reduced their financial results. However, this decrease was more than offset by value adjustments of the banking institutions' bond portfolios, whereby the overall value adjustments remained positive.

In 2001, the trends in costs varied considerably between the individual banking institutions. The overall decrease in the banking institutions' costs can be attributed to significant cost reductions in the largest banking institutions against the background of such factors as considerable merger costs in 2000. Most banking institutions' costs increased in 2001. For most banking institutions, earnings from the increasing level of activity were not sufficient to offset the higher costs. Recent years' investments in information technology and the resulting improved efficiency do not appear immediately from the relationship between earnings and costs in the banking institutions' financial statements, cf. Chart 5.

Losses and provisions on debtors^[9] as a ratio of the banks' loans and guarantees increased in 2001 to the highest level since 1996.

The solvency ratio rose by 0.5 percentage points to 10.4 per cent in 2001 after a declining trend in 2000. Overall, the core capital ratio increased a little to 7.5 in 2001. A number of banks, small and medium-sized banks in particular, saw a decrease in the core capital ratio in 2001.

The banking institutions' interest income

In 2001, the banking institutions' net interest income rose by kr. 3.0 billion to kr. 34.2 billion.

The banking institutions' lending has increased strongly since the mid-1990s and more strongly than deposits. This tendency continued in 2001 and led to an increase in total net interest income from deposits and lending. The trend was strongest for a number of medium-sized banking institutions.

The interest margin between the banking institutions' average rate of interest for deposits and lending has shown a slightly increasing trend since the late 1990s. The general increase slowed down in 2001, but the interest margin widened for lending to and deposits from companies, cf. Chart 6. Especially the largest banking institutions, including those with a relatively large proportion of lending to companies, were able to widen the average interest margin.

The widening of the interest margin for the corporate sector could be a result of recent years' efforts in the sector to achieve a better match between price and risk. The widening may thus reflect a higher risk premium. This is supported by an overall decline in the level of interest rates in 2001, which is generally reflected in the banking institutions' deposit rates, while the lending rate for the corporate sector only declined slightly.

Compared to 2000 bonds account for a larger proportion of the banking institutions' overall balance sheet, and most banks increased their interest-rate risk^[10] in 2001.

The banking institutions' losses and provisions

Losses and provisions give an indication of the development in the quality of the banking institutions' credit portfolio. Actual losses and the need for provisions for future losses on loans and guarantees depend on the business cycle, cf. Chart 7. Losses and provisions are typically low in periods of strong economic activity due to such factors as reversal of previous provisions for expected losses when it is established that the risk of losses on the exposures in question no longer exists. Experience shows that the credit quality tends to deteriorate gradually in periods of high growth in lending, leading to increased losses and provisions in the following periods.

In 2001, losses and provisions for the year as a ratio of loans and guarantees (ratio of losses and provisions) rose to the highest level since 1996, cf. Chart 8. However, the level is still low^[11] in a historical perspective. The banking institutions with an already relatively high ratio of losses and provisions compared to the average for the sector saw the strongest increase in provisions.

A major part of the – mainly small and medium-sized – banking institutions with the strongest growth in lending in the period 1996-2000 accounted for the largest increase in losses and provisions in 2001.

Losses and provisions for the year are a net item which in most banking institutions' financial statements does not reflect the individual components, including unexpected losses and new provisions as well as reversal of previous provisions. This makes it difficult to separate the development in actual losses from the development in the banking institutions' expected future losses.

However, provisions do indicate how the banking institutions perceive the risk of credit losses^[12]. New provisions increased in 2001. Reversal of previous provisions in 2001 remained at the level of 2000 after an increase for a number of years in step with new provisions.

Transfers of provision exposures between banking institutions may provide an indication of the development in credit quality among the categories. Chart 9 shows that category-1 banking institutions continue to dispose of more provision exposures than they receive, while the opposite is the case for banking institutions in categories 2 and 3, although with a narrower margin between disposed and received exposures for banking institutions in category 2. Transferred provision exposures amount to only kr. 1.5 billion in total.

Naturally, banking institutions receiving a provision exposure do not expect the received exposure to lead to credit losses. The exposure may have been transferred in connection with improvement of the debtor's financial situation. The receiving banking institution may e.g. have greater confidence in the debtor than the disposing banking institution, or the receiving banking institution can obtain a higher risk premium on the exposure. Furthermore, the calculation of transferred provision exposures does not consider the volume of total transfers among banking institutions in individual years, i.e. the share of received exposures subject to provisions.

The banking institutions' accounts with other credit institutions

After a decrease in the banking institutions' deposit surplus a deposit deficit has prevailed since 2000, cf. Chart 10. This implies that debt to other credit institutions has gained significance as a source of financing of the banking institutions' growth in lending. Furthermore, the volume of bond issues by the major banking institutions has grown in recent years.

The banking institutions' net debt to other credit institutions has risen steadily since the beginning of the 1990s. The increases were significant in 2000 and 2001 and could be attributed to such factors as significant growth in deposits from non-resident credit institutions in a number of the banking institutions. Other important factors which contributed to the increase in 2001 were deposits from mortgage-credit institutes and a decrease in the banking institutions' net claims on Danmarks Nationalbank.

In a tighter credit environment, debt to other credit institutions can be a less stable source of financing than deposits. Deposits from other credit institutions are therefore subject to a greater refinancing risk than ordinary deposits from customers, which have a longer maturity in real terms. Box 2 details the banking institutions' liquidity.

Box 2 The banking institutions' liquidity

Danish banks' capital adequacy

Danish banks' total capital adequacy increased in 2001, cf. Chart 11, but the aggregate conceals very different trends for the individual banks.

The overall solvency ratio rose in 2001, and the growth was primarily driven by the banks in category 1 and some banks in category 2. The banks in category 2 showed no clear trend, whereas the solvency ratio decreased for most of the banks in category 3.

The core capital ratio declined constantly in the period 1996-2000, but stabilised in 2001 at a level around 7.5. The trend was not clear, but there was an evident indication of the banks in category 3 reducing their core capital ratio in 2001, which is also the reason for the declining solvency ratio in this category. The banks in category 3 still enjoy by far the highest capital adequacy on average.

Sensitivity analysis and stress test

The sensitivity analysis examines how various changes in accounting items affect the banking institutions' financial results one year ahead. For the banking institutions with negative scores in the individual tests the solvency ratio is calculated on the assumption that the negative result is deducted from liable capital and that any losses on a balance-sheet item are fully deducted from the risk-weighted assets. This is to give an indication of whether the excess capital reserves^[13] are sufficient to withstand the losses which cannot be covered by the earnings for the year. Only the direct effects are considered. For example, the fact that an increase in interest rates can have an adverse impact on credit quality is thus not considered. Otherwise the observations are "all-other-things-being-equal" observations.

The stress test shows the losses the banking institutions can suffer – without the financial result moving into negative territory – and still in compliance with the solvency requirement. The stress test gives an indication of the current earnings and capital buffers of the banking institutions.

The sensitivity analysis and the stress test are based on accounts data for 50 banking institutions in categories 1-3, cf. the footnote on p. 18.

 
Sensitivity analysis

The basis is the ordinary operating result for 2001 of kr. 18.2 billion. All items not included in the individual tests are kept unchanged from 2001. The analysis indicates the result if the scenarios had been realised. The scenarios of the sensitivity analysis are based on variations in the individual accounts items of a magnitude seen in the period 1980-2001 for the average of Danish banking institutions, or variations which could reasonably be expected to occur. Box 3 explains the background to the individual tests. The test results appear from Table 2.

Box 3 Scenarios in the sensitivity analysis

Table 2 Sensitivity test of the banking institutions' operating result

Tests 1 and 2: The banking institutions' interest income has increased in the last two years after being stable for a period. In the first test the interest margin^[14] is set to decline by 0.5 percentage point. This would lead to a decrease in the banking institutions' overall ordinary operating result from kr. 18.2 billion to kr. 10.3 billion. In the second test net fee and commission income is set to decline by 25 per cent. The lowest calculated solvency ratio for banking institutions with deficits in the first two tests would be just over 9, i.e. still somewhat higher than the statutory requirement of 8 per cent.

Tests 3 and 4: Since the banking institutions increased their interest-rate risk in 2001 compared to 2000, two tests are included to indicate what the banking institutions' financial results would have been if interest rates were to increase by 1 and 3 percentage points respectively. At an interest-rate increase by 1 percentage point the results of 5 banking institutions would become negative. At an interest-rate increase by 3 percentage points the overall financial result would fall to kr. 7.7 billion and the results of 19 banking institutions would become negative. In the latter situation the solvency ratio of 3 banking institutions in category 2 would be just over 9, while it would be more than 10 for the other banking institutions.

Test 5: Value adjustments of shares traditionally show a high degree of volatility. At a 30-per-cent decline in stock prices the overall ordinary operating result would fall to kr. 16.6 billion. The calculated solvency ratio for the 2 banking institutions with a deficit would be just under 11.

Tests 6-8: In the sixth test losses and provisions are assumed to be 1 per cent of loans and guarantees. In the seventh test losses and provisions are assumed to account for 2.5 per cent of loans and guarantees. The result would be kr. -6.1 billion, and the results of 38 of the 50 banking institutions would become negative. In the various categories the lowest solvency ratio would be just under 10 in category 1, just over 8 in category 2 and just over 10 in category 3. In the eighth test losses and provisions are assumed to account for 2.5 per cent of loans and guarantees to corporate customers and 1 per cent of loans and guarantees to households. The overall result would be kr. -1.8 billion and 14 institutions would move into deficit. The lowest calculated solvency ratio among the 14 banking institutions would be 8.4.

Tests 9-12: In the ninth test both interest margin and net fee and commission income decrease, whereby 6 institutions would move into deficit. In the tenth test, tests 1 and 2 are applied simultaneously and losses and provisions are set to be 1 percentage point of loans and guarantees. The ordinary operating result of 15 institutions would become negative, and the lowest solvency ratio among these would be 8.4. In the eleventh test interest rates increase by 1 percentage point, while stock prices decrease by 30 per cent. This implies a decrease in the overall result to kr. 13.1 billion and the lowest solvency ratio among the 12 banking institutions with a deficit would be 10. In the last test interest rates rise by 1 percentage point and losses and provisions are set to be 1 per cent of loans and guarantees. In this case the overall result before tax would fall to kr. 7.7 billion and the results of 8 banking institutions would become negative. The lowest solvency ratio among the 8 banking institutions would be 9.1.

The sensitivity analysis shows that the banking institutions' earnings are still robust, although slightly less so than in 2000. The analysis also shows that the solvency ratio of the banking institutions remains above the statutory limit in all the tests. In the sensitivity analysis the excess capital reserves are thus sufficient to absorb any losses which cannot immediately be covered by earnings.

Stress test

The following simple stress test gives an impression of the ability of the banking institutions' earnings and capital adequacy to withstand losses on loans and guarantees. The stress test will thus show how much losses can increase before the result becomes negative and before the solvency ratio falls below the statutory limit.

The result of the stress test in Chart 12 shows how many banking institutions would get a deficit in case of rising losses on loans and guarantees. The most exposed banking institution would get a deficit when losses account for 0.7 per cent of loans and guarantees. The dotted line in the Chart shows that the percentage of losses on loans and guarantees must reach 2.1 before half of the banking institutions move into deficit.

The calculation of the effect on capital adequacy assumes that the negative result is deducted from liable capital and that the loss is fully deducted from risk-weighted assets. Capital adequacy is not affected until the banking institution's income becomes negative.

Chart 13 shows how many banking institutions would fall below the statutory limit for capital adequacy when losses on loans and guarantees increase. The first banking institution would encounter problems at a loss of 2.7 per cent of loans and guarantees. The least robust banking institutions are in category 2, but there is no clear correlation between the size of the banking institutions and their ability to withstand losses.

The highest average ratio of losses and provisions for the year in the period 1980-2001 was 2.6 per cent in 1992, but the variation among the institutions was considerably greater than now. In 1992, 10 per cent of all banking institutions had a ratio of losses and provisions of almost 5 per cent, or more. All of the analysed banking institutions could still comply with the solvency requirements if losses as a ratio of loans and guarantees were to rise to 2.6 per cent. Even in case of very significant losses of 5 per cent of loans and guarantees few of the analysed banking institutions would have problems complying with the solvency requirement.

Development in the pension companies

The pension sector was severely affected by the strong drops in stock prices and low interest rates after the terrorist attacks in the USA in the autumn of 2001, cf. the chapter on trends in the financial markets. Against this background the Danish government initiated amendment of tax rules, the solvency order and the accounting regulations. The initiatives included moving forward measures already adopted, but scheduled to enter into force at the beginning of 2002. Issues related to the pension companies^[15] are described in further detail in the chapter on pension companies and financial stability.

Market and regulatory trends complicate an assessment of the tendencies for the pension companies' results and balance sheets. However, the development in the two key consolidation indicators, bonus reserve^[16], and equity capital reserve^[17] may provide an indication of the development in the pension companies' total buffer capital to withstand any future earnings problems or fluctuations in returns. In terms of the two key indicators, the life-insurance companies' buffer capital weakened in 2001, cf. Chart 14. This development should be interpreted with caution, since the figures for 2001 are estimates based on data from half the life-insurance companies' reporting for the period 1996-2000. Furthermore, the key consolidation indicators do not consider the degree to which life-insurance companies have hedged market and insurance risks.

Footnotes

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Version 1.0 Maj 2002 Nationalbanken.
Published by Danmarks Nationalbank Maj 2002, http://www.nationalbanken.dk/