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"Financial stability 2002"

Financial-Market Trends

The banks seem to be robust to the major shocks which affected the financial markets in 2001, whereas the pension companies were more severely affected. The development in the Danish financial markets is to a great extent driven by trends abroad, including in the USA. As a result, the financial institutions can only to a limited degree reduce their market risks by spreading their investments to other countries. Fluctuations in the stock markets are usually accompanied by fluctuations in the bond markets, although no constant correlations can be established. The uncertain correlations and the periods with strongly fluctuating markets emphasise the need to apply stress tests when assessing the stability of financial institutions.

The number and total amount of share issues on the Copenhagen Stock Exchange was considerably lower in 2001 than in 2000.

The market risks of financial institutions

The banks, pension companies and mortgage-credit institutes undertake a number of market risks in the course of their business. The principal market risks are interest-rate risk, the risk of stock-price fluctuations and exchange-rate risk. As shown by the sensitivity analysis in the chapter on trends in the financial sector, Danish banks as a whole are robust to market risks, but some individual banks may be more exposed. Trends in the financial markets affect pension companies in particular, but as described in the chapter on pension companies and financial stability, pension companies are only of indirect significance to financial stability. The mortgage-credit institutes are almost immune to market trends, since the composition of their balance sheets is subject to statutory rules.

In the autumn of 2001, the interest-rate and stock markets saw strong fluctuations, and a number of pension companies found it difficult to meet the solvency requirement. The recovery of the stock markets eased the pressure on the pension companies, but the development in the autumn of 2001 drew attention to the financial institutions' robustness to market risks.

The market situation

The terrorist attacks on the USA on 11 September 2001 caused stock prices to plummet in the industrialised countries in the following weeks, cf. Chart 32. At the same time, market uncertainty concerning the future course of stock prices increased, as appeared from e.g. the high level of implied volatility in the US stock index, S&P500^[1]. Stock prices recovered relatively soon after the terrorist attacks and the uncertainty concerning future developments again diminished. However, stock prices have tended to decrease overall in the industrialised countries since the reversal of the course of the US economy in 2000. At the end of April 2002, the benchmark stock indices in the USA, the euro area and Denmark were approximately one third below their peaks in 2000.

Chart 32 Stock indices in the usa and denmark and implied volatility

Note:	Implied volatility one month ahead. No implied volatility is calculated for the KFX, since options on the index are not traded on the stock exchange.
Source:	Bloomberg and Ecowin.

In the spring of 2002, the indications of an economic upturn in the USA and the euro area generated only a limited reaction in the stock markets. The moderate reaction is particularly attributable to the very high level of US stock prices compared to the latest corporate earnings. Another possible factor is investors' focus on the fact that corporate accounts may not give a complete view of the companies' commitments, as the liquidation of the US energy company Enron showed.

In the autumn of 2001, long-term interest rates in the USA and Europe briefly fell to a very low level. At the same time, the 10-year yield differential between Denmark and Germany narrowed, and the yield for the 30-year Danish government bond fell below the yield for the corresponding German bond. This trend reflects strong interest in long-term bonds among Danish pension companies, which generally require assets with long duration in view of their pension commitments. When interest rates were low in the autumn, some pension companies also purchased euro-denominated interest-rate options, including swaptions. The pressure to buy contributed to high option premia as reflected in the high implied volatility on swaptions, cf. Chart 33. The use of swaptions is described in Box 6^[2].

Chart 33 10-year yields in denmark and germany and implied volatility

Note:	Implied volatility of a 20-year euro swaption receiving a 10-year yield.
Source:	Bloomberg.

Box 6 Options, swaptions and implied volatility

An option implies a right, but no obligation, to buy or sell an asset at a pre-determined price, called the strike price. The option can thus be used as a hedge against market trends which would generate losses. For example, a pension company can hedge against a low level of interest rates by purchasing a "swaption" at a strike price around the level of the issued interest-rate-guarantees. If the pension company decides to utilise the swaption, it will receive a fixed interest rate corresponding to the strike price against payment of a variable interest rate.

Payment for the option is in the form of a premium or option price. The price depends on such factors as the asset's current price in relation to the strike price and the expected future volatility of the asset price. For a fixed strike price the price of a swaption will increase, all other things being equal, when interest rates decrease and when the expected volatility rises. In practice, options are often priced on the basis of the Black-Scholes model.

The expected volatility cannot be observed, but can be derived from the Black-Scholes model if the option price is known, so it is also called implied volatility. This is the volatility theoretically applied by the market when pricing the option.

Identification of market risks

The financial institutions have large holdings of bonds and stocks denominated in Danish kroner and foreign currency, cf. Table 5.

Table 5 Assets of financial institutions, kr. billion

	Banks	Pension companies	Mortgage- credit institutes
Shares, total	37.9	258.7	4.6
Shares in foreign companies	-	160.0	-
Bonds, total	461.7	455.2	232.2
Mortgage-credit bonds	231.3¹	342.9	202.2¹
Foreign bonds	97.4²	44.4	-1.9²
Balance sheet	1,913.0	919.0	1,616.7

Note:	The portfolios of the banks and the mortgage-credit institutes are calculated as of end-2001. The portfolios of the pension companies are calculated as of end-2000.
Source:	The Danish Financial Supervisory Authority, unless otherwise stated.
1	The portfolio of debt instruments (excl. money-market papers) issued by monetary financial institutions in Denmark according to Danmarks Nationalbank's MFI statistics.
2	Portfolios of foreign debt instruments (including bonds) according to Danmarks Nationalbank's MFI statistics. The negative portfolio of the mortgage-credit institutes can be attributed to resale of foreign bonds in connection with repurchase agreements.

The effects of changes in market conditions on the equity of financial institutions also depend on the financial institutions' liabilities. If assets and liabilities have the same market-risk characteristics, the financial institutions' equity is less exposed to market trends than what is entailed by separate market risks on assets and liabilities. On the other hand, a pronounced mismatch between assets and liabilities may imply that the equity is relatively strongly exposed to market trends. Furthermore, the financial institutions' use of derivatives could expand or diminish the exposure of their equity in relation to the exposure shown by their balance sheets.

As regards the interest-rate risk,callable mortgage-credit bonds account for a significant proportion of the bond portfolios of financial institutions. The expected time to maturity of these bonds is very short when the price is close to par due to the increased probability of the borrower exercising the early-redemption right. The interest-rate risk of financial institutions is therefore very sensitive to falling interest rates.

The exchange-rate risk of financial institutions is negligible, since most positions in foreign currency are hedged in forward transactions.

The sensitivity of various types of financial institutions to market trends is described in further detail in Box 7.It appears from the Box that pension companies are particularly exposed. Since the composition of the mortgage-credit institutes' balance sheets is subject to statutory rules, their market-risk exposure is very limited.

Box 7 The market risks af financial institutions

For the banks taken as one the Danish Financial Supervisory Authority has calculated an interest-rate risk of 3.5 at end-2001, compared to 2.6 in 2000. The Financial Supervisory Authority's measure of the interest-rate risk is an approximation of the percentage loss of equity if bond yields increase by 1 percentage point. The banks' equity is thus immediately reduced when bond yields increase, although the effect is modest. As for life-insurance companies and pension companies the interest-rate guarantee system increases their interest-rate risk exposure when interest rates are low, cf. the chapter on pension companies and financial stability. The composition of mortgage-credit institutes' balance sheets is subject to the statutory rules. Against this background the exposure of the mortgage-credit institutes' equity to changes in interest rates is limited. When interest rates are low, however, the volume of re-mortgaging will typically be high, which contributes to growth in the mortgage-credit institutes' earnings. Shares account for approximately 2 per cent of the banks' assets. This implies a limited overall sensitivity to declining stock prices. Nevertheless, decreasing stock prices could reduce the banks' earnings from share trading. Shares account for around 25 per cent of the assets of life-insurance companies and pension companies, and foreign shares account for just over half of this share. Life-insurance companies and pension companies are thus exposed to stock-market trends in both Denmark and abroad. The share portfolios of the mortgage-credit institutes are negligible. In general the financial institutions are exposed to a limited exchange-rate risk, since positions denominated in foreign exchange are normally hedged in the forward market. For the banks taken as one, the Danish Financial Supervisory Authority has calculated a Value-at-Risk indicator. The indicator is a measure of the maximum percentage loss – at a probability of 99 per cent – of net capital over a period of 10 banking days. At the end of 2001 the indicator was 0.14, compared to 0.15 in 2000. Since the composition of mortgage-credit institutes' balance is subject to statutory rules, they are not exposed to exchange-rate risks. The Table below summarises the assessment of the market-risk exposure of each type of financial institution. Estimated market risk exposure of financial institutions
Risk factor	Banks	Pension companies	Mortgage-credit institutes
Interest-rate risk	***	*****	**
Stock-price risk	***	****	*
Exchange-rate risk	**	**	*

Note:

The asterisks in the Table refer to the estimated size of the risk.
***** = relatively high risk,
*** = minor risk,
** = low risk,
* = no or a very low risk.

Characteristics of the history of the risk factors

In periods with calm financial markets the fluctuations in stock prices, interest rates and exchange rates are limited, but at other times they may be considerable. This is reflected in the fact that the historical distribution of the changes in these risk factors comprises more extreme observations than what is warranted by a normal distribution.

The Danish KFX index increased from just over 100 to around 260 from the beginning of 1990 to end-April 2002. This period saw strong fluctuations in both directions. On a month-to-month basis the KFX predominantly fluctuated by less than 10 per cent, cf. Chart 34.

Chart 34 Historical fluctuations in the kfx index

Note:	The Chart is based on 147 monthly observations in the period January 1990-March 2002. During this period the average monthly increase in the KFX was 0.8 per cent with a standard deviation of 5.1 per cent. The dotted lines define approximately 95 per cent of the observations in the middle, i.e. the "tails" are outside this area.
Source:	Ecowin.

In the same period the tendency was for long-term interest rates to decrease. At the end of April 2002 the yield for the 10-year Danish government bond was thus approximately 5.4 per cent, against 10.4 per cent at the beginning of 1990. The monthly fluctuations in the Danish 10-year yield were predominantly below 60 basis points, cf. Chart 35.

Chart 35 Historical fluctuations in the danish 10-year yield

Chart 35 Historical fluctuations in the danish 10-year yield

Note:

The Chart is based on 147 monthly observations in the period January 1990-March 2002. In this period the average monthly change in the 10-year Danish yield was -3.3 basis points with a standard deviation of 31 basis points. The vertical dotted lines define approximately 95 per cent of the observations in the middle, i.e. the "tails" are outside this area.

At the moment there is a close correlation between fluctuations in the financial markets in Denmark and abroad, cf. the left-hand curves in Chart 36 which show the correlations between Danish and US stock indices and bond yields. In the 12 months until March 2002 the Danish markets have closely followed market trends in the USA (and the rest of Europe).

Stock-market fluctuations will often coincide with bond-market fluctuations. Higher bond yields may lead to lower stock prices, since the latter reflect expected future corporate cash flows, the present value of which tends to decrease when interest rates go up. Furthermore, an increase in the level of interest rates will entail higher interest-rate costs for the corporate sector and generally dampen economic activity, which may also cause stock prices to decrease. Indeed, the historical correlation between the percentage change in the Danish KFX index and the change in the level of the 10-year yield has been predominantly negative in the period since 1990, cf. the right-hand curves in Chart 36. However, recent years have seen a positive co-variation between changes in stock prices and changes in 10-year yield levels. This also applies in the USA. The positive co-variation between interest-rate and stock-market trends can be attributed to a portfolio effect whereby investors substitute stocks for bonds and vice versa.

Chart 36 Correlations between risk factors

Note:	Based on monthly changes in the preceding year. The stock indices are the KFX for Denmark and the S&P500 for the USA.
Source:	Ecowin and own calculations.

The strong correlations between financial-market trends in Denmark and abroad reflect that market trends in Denmark are very much driven by market trends abroad, including in the USA. Against this background the financial institutions can only to a limited extent diversify by extending their investments to foreign assets. However, the major stock markets abroad are considerably more liquid than the Danish stock market and can therefore absorb larger trading volumes without any considerable price effects. The positive correlation in recent years between changes in the level of interest rates and changes in stock prices has contributed to a reduced market risk on portfolios comprising both shares and bonds. Nevertheless, experience shows that the correlation between shares and bonds is far from constant and that it may move from positive to negative or vice versa, cf. Chart 36. Against this background it is important to assess the market risks assuming various scenarios for the co-variation between the various types of assets and liabilities.

The occurrence of periods with strong market fluctuations, cf. the "fat tails" in the distribution of risk factors in Charts 34 and 35, emphasise the importance of focusing on the solvency of financial institutions under extreme market conditions. The need for this focus is reinforced by the fact that extremely adverse market conditions often lead to increased credit and liquidity risks. The financial institutions may be exposed to counterparties that are relatively hard hit by such effects.

Other effects of financial-market trends

Several sources of revenue for the banks are affected by financial-market trends. In the autumn of 2001, decreasing stock prices entailed a decline in share issues and securities trading activities.

Share issues

The capital contribution from and the number of initial public offerings decreased strongly in 2001 after having shown an increasing trend in recent years, cf. Chart 37. The issuing activity of already listed companies also declined, partly since falling stock prices increased, in relative terms, the costs of this source of financing, partly due to the generally more unfavourable investment climate.

Chart 37 Number of new companies and proceeds from initial public offerings and public offerings from listed companies on the copenhagen stock exchange, 1997-2001

Note:	The number of new companies is shown in the bars. A share of kr. 30.1 billion of the proceeds in 2000 can be attributed to Danske Bank's acquisition of RealDanmark.
Source:	The Copenhagen Stock Exchange.

Trading volume of shares and derivatives

The trading volume of shares on the Copenhagen Stock Exchange declined in 2001 compared to 2000, reflecting the tendency for trading volumes to fall in a declining market. The apparently strong decrease in share trading volumes in the 2nd half of 2001, which appears from Chart 38, can be attributed to amended rules for reporting to the Copenhagen Stock Exchange. The new reporting rules have reduced the number of transactions reported twice, which led to a technical decrease in share trading volumes by around 40 per cent. The trading volume of derivatives decreased by a total of 47 per cent in 2001 compared to 2000, while trading volumes of stock options increased considerably.

Chart 38 Share trading volume and price development on the copenhagen stock exchange

Note:	The total index includes all listed shares. As from June 2001 a projection of the trend in the KAX (a new all-share index) is used, since the Copenhagen Stock Exchange has restructured the sectors in its index.
Source:	The Copenhagen Stock Exchange.

Market shares

On 1 January 2002 the Copenhagen Stock Exchange began to calculate market shares in terms of its members' trading volume. Chart 39 shows that the Danske Bank Group (Danske Securities AB and Danske Bank A/S) accounted for the largest share, viz. 23 per cent, of the total trading volume in March 2002. The Nordea Group accounted for the second largest share, viz. 14 per cent. Foreign participants account for a significant share of the trading volume, dominated by the Swedish banks.

Chart 39 Total trading volume and number of transactions on the copenhagen stock exchange, march 2002, percentage

Source:	The Copenhagen Stock Exchange.

However, these data should be interpreted with caution, since they relate to the trading volume in one month only.

A comparison between the total trading volume and the number of transactions shows that the average transaction size is typically somewhat larger for the foreign banks than for the Danish banks. The reason is that private investors primarily trade securities via Danish banks.

Internet banks accounted for 4 per cent of the total trading volume, but 9 per cent of the number of transactions. This confirms the view that it is mostly private customers who trade shares via the Internet.

Footnotes

[1]	Cf. Box 6.
[2]	See also Louise Mogensen, Market Dynamics at Low Interest Rates, Danmarks Nationalbank, Monetary Review, 1st Quarter 2002.

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