The Domestic Financial System^[1]

The substantial increase in the banks' profits continued in 2005, driven by considerable growth in lending and historically low losses. The very low losses are attributable to the favourable economic situation, but also to the introduction of new accounting rules in 2005.

The earnings of the mortgage-credit institutes continued to rise in 2005, as a result of such factors as significant remortgaging activity and sustained high growth in lending.

Favourable market conditions have led to positive, and increasing, returns, which has strengthened the assets of investments associations and the earnings of pension companies.

In 2005, the EU reached political agreement on the proposed directive for new capital-adequacy rules, known as Basel II.

The banking supervisory authorities, central banks and finance ministries of the European Union in 2005 concluded a memorandum of understanding (MoU) on cooperation in financial crisis situations. The Danish authorities have also entered into an MoU on financial supervision, supplemented by a bilateral MoU between the Danish Financial Supervisory Authority and Danmarks Nationalbank.

BANKS

The banks improved their total profit after tax in 2005 against 2004. The increase in the banks' revenue in 2005 was a result of substantial lending growth, a sustained low level of losses and higher income from fees. The largest banks achieved a return on equity after tax of around 18 per cent, compared to 15 per cent in 2004.

Total lending by the banks amounted to kr. 1,095 billion at the end of 2005, compared to kr. 860 billion at end-2004. Lending growth is driven by the favourable economic situation, combined with low interest rates, which stimulates borrowing demand. The strong growth in the banks' lending to households seen in recent years is to a large extent attributeable to increased lending for home financing on terms equivalent to mortgage credit, i.e. variable-rate loans, long maturities and in some cases deferred amortisation. The loans are granted against real property as collateral and thus entail relatively low risk. These loans include "bank mortgage loans", whereby both a lending and a deposit account are set up in the borrower's name on the same interest-rate terms, typically at a higher interest rate than for a mortgage-credit loan. The counterpart to the increasing lending to households is higher liquidity, which is reflected in a rising volume of deposits with the banks, cf. Chart 23.

Income from fees has risen significantly, primarily as a result of remortgaging activity and considerable trade in securities, including shares. The banks' operating costs have increased due to investments in the expansion and adjustment of the branch network, as well as staff increases in response to a higher level of activity.

As of 1 January 2005, the new international financial reporting standards, IFRS, were implemented in Denmark. Under the new accounting standards, provisions for lending are no longer to be made on the basis of a demonstrated risk of losses under the prudent accounting principle. Instead, lending is written down according to a neutrality principle in the event of value impairment. This means that one or several events must have occurred that give an objective indication of a value impairment before claims are written down. Write-downs thus take place at a later stage than provisions under the prudent accounting principle, and often by a smaller amount.

In 2005, write-down on lending was reduced from an already very low level as a consequence of the favourable economic development and the new accounting rules.

MORTGAGE-CREDIT INSTITUTES

The mortgage-credit institutes improved their total profit after tax in 2005 compared to 2004. The improved earnings are attributable to significant remortgaging activity and high growth in lending, cf. Chart 23.

Total lending by mortgage-credit institutes amounted to kr. 1,663 billion at end-2005, against kr. 1,488 billion at end-2004. Net new lending rose by kr. 75 billion to kr. 163 billion in 2005. Adjustable-rate loans accounted for a large share of the growth in lending.

Adjustable-rate loans comprised 49 per cent of mortgage-credit lending at end-2005, cf. Table 4. Loans with short fixed-interest periods of up to and including 1 year, make up 71 per cent of the adjustable-rate loans.

Deferred-amortisation loans continued to win ground in 2005, and there was also considerable remortgaging of existing loans to deferred- amortisation loans. Deferred-amortisation mortgage-credit loans as a ratio of total lending thus rose from 16 per cent at end-2004 to 26 per cent at end-2005. The increase was more or less equally distributed on fixed-rate and adjustable-rate loans.

INVESTMENT ASSOCIATIONS

At end-2005, investment associations managed total assets of kr. 724 billion, which is an increase of 40 per cent compared to 2004. Two thirds of the increase is attributable to net payments received, while the remainder stems from investment returns. In relative terms equity funds grew the most due to rising stock prices. At year-end, 36 per cent of the assets of investment associations were placed in shares, 50 per cent in bonds and the rest in mixed funds, cf. Chart 24.

At the end of 2005, private investors held 35 per cent of the investment certificates issued. The share held by pension companies remained more or less unchanged at 30 per cent.

The new legislation on hedge associations, which came into force on 1 July 2005, makes it possible to set up hedge associations in Denmark. Hedge associations are the Danish equivalent of hedge funds^[2]. At the end of 2005, a small number of associations had applied to the Danish Financial Supervisory Authority for approval as hedge associations.

PENSION COMPANIES

Based on the market development and the financial statements presented, life insurance companies and professional pension funds, hereinafter pension companies, are generally assessed to have achieved positive investment returns in 2005. Significantly rising share prices in Europe, modest increases in US stock market prices and relatively stable market conditions are expected to have contributed positively to earnings in this sector in 2005. The pension companies' increasing use of financial instruments to hedge their investments against adverse fluctuations in interest rates is also expected to have made a positive contribution.

Several pension companies increased their range of pension products without interest-rate guarantees in 2005.

THE BOND MARKET

The total outstanding volume of listed krone-denominated bonds was kr. 2,748 billion at end-2005, representing an increase by 8 per cent on 2004, cf. Table 5. The volume of outstanding government bonds fell by kr. 95 billion, while the volume of mortgage-credit bonds rose by kr. 283 billion.

In 2005, premature redemptions of Danish mortgage-credit bonds reached a record-high level of kr. 543 billion, an increase by kr. 233 billion from the preceding year. The increase should be viewed against the background of the falling interest rates, cf. Chart 25. Bond yields continued to fall in 2005, from an already low level, cf. p. 42, and the minimum coupon rate was lowered from 3 per cent in the 1st half to 2 per cent in the 2nd half of 2005. The minimum coupon rate for the 1st half of 2006 remains unchanged at 2 per cent.

Trading in Danish government securities
Danish government securities are traded via electronic trading platforms with various types of price quotation, and in the OTC market. A large part of the electronic trading in Danish government securities takes place on the electronic trading platform MTSDenmark. Government bonds have been issued and traded on MTSDenmark since November 2003, and in 2005 trading in Danish Treasury bills was also introduced.

In 2005, average daily turnover on MTSDenmark reached almost kr. 2 billion. Besides MTSDenmark, Danish government securities are traded on other electronic trading platforms such as TradeWeb, BloombergBondtrader and BondVision. In addition, a price-quoting scheme has been established at the Copenhagen Stock Exchange. This gives small investors access to a transparent and efficient market for trading in Danish government securities.

AGREEMENT ON NEW CAPITAL-ADEQUACY RULES IN THE EU

In Denmark, a bill to implement the directive on new capital-adequacy rules, known as Basel II, was submitted for consultation in February 2006. The bill is expected to be introduced in the Folketing (Parliament) in the spring.

In the autumn of 2005, the EU reached political agreement on the proposed directive on new capital-adequacy rules. The new directive entails amendments to the existing Banking and Capital-Adequacy Directives and complies with the Basel Committee's revised recommendations for an international capital adequacy framework. Basel II is a further development of the existing capital-adequacy rules, which are observed in more than 100 countries worldwide. The aim is for capital requirements to better reflect the risks incurred by the individual credit institutions in the course of their business.

The directive in its final version is expected to be published during 2006, and will then be formally adopted by the EU Council of Ministers^[3]. The directive is to be transposed into national legislation of the member states effective from the beginning of 2007. However, up to the end of 2007 it will still be possible for credit institutions to apply the existing rules. The most advanced methods for calculation of the minimum capital requirement cannot be applied before 1 January 2008.

The new capital-adequacy framework is thus in place. The more technical aspects will be determined by the European Commission after consultation with the European Banking Committee (EBC).

To ensure a well-functioning market, also in the financial area, it is important to ensure uniform implementation of the directive, and to work towards convergence in its practical enforcement by the supervisory authorities. Much of this work is vested in the Committee of European Banking Supervisors, (CEBS), where for more than two years the national supervisory authorities and central banks have been preparing common guidelines, standards and recommendations, etc.

HIMMERLANDSBANKEN

Together with a number of banks (the Guarantee Consortium) Danmarks Nationalbank provided a guarantee of maximum kr. 150 million in connection with the compulsory winding-up of Himmerlandsbanken in August 1993. Danmarks Nationalbank's share was kr. 90 million. The purpose of the guarantee was to cover certain concrete exposures that were not taken over by Spar Nord in connection with its assumption of most of the assets and liabilities from Himmerlandsbanken, and also to cover unbooked guarantees or compensation claims on the Himmerlandsbanken winding-up estate. The purpose of the guarantee was not to cover the share capital or subordinate capital. In addition to the maximum guarantee of kr. 150 million, Danmarks Nationalbank provided an unlimited guarantee for unbooked liabilities. Claims accepted as simple claims on the winding-up estate will be subject to the guarantees of the Guarantee Consortium or Danmarks Nationalbank.

In April 2005, the estate being wound up lost the "bond case" at the Danish Supreme Court, which thus upheld the previous rulings by the court of Hobro and the Danish Western High Court. The ruling ordered the estate to acknowledge that the subordinate capital originally subscribed to as supplementary capital in the form of bonds in 1991 was to be recognised as a simple claim on the estate being wound up. This meant that the bonds were comprised by the Guarantee Consortium's guarantee. After the ruling, Danmarks Nationalbank attached importance to initiating the procedures required to ensure that eligible claims under the guarantee were met as soon as possible. Against this background a unanimous Guarantee Consortium decided to disburse payments to bondholders via VP Securities Services. In this way, the claims of all bondholders were honoured according to the same principles. Disbursement took place on 5 July 2005.

It is expected that the estate will be finally wound up in the 1st half of 2006, after which the guarantees can be released. Danmarks Nationalbank's contribution to the winding-up of Himmerlandsbanken will hereafter amount to approximately kr. 90 million, including the winding-up costs. This is by and large equivalent to Danmarks Nationalbank's share of the guarantee furnished by the Guarantee Consortium. A provision for the guarantee commitment of kr. 90 million was made when it was entered into in 1993. Consequently, the settlement of the estate is not expected to have any significant impact on Danmarks Nationalbank's accounts for 2006.

MEMORANDA OF UNDERSTANDING

In 2005, Danmarks Nationalbank concluded several Memoranda of Understanding (MoU). A MoU is a declaration of intent and is not legally binding.

On 1 July 2005, the banking supervisory authorities, central banks and finance ministries of the European Union agreed on a Memorandum of Understanding on cooperation in financial crisis situations.^[4] The MoU relates to principles and procedures for exchange of information between authorities within the EU in the event of a financial crisis where there is a risk that the crisis will spread to several member states and also be of a systemic nature. To further strengthen cross-border cooperation between the authorities, the MoU also includes such issues as contingency planning, stress tests and crisis exercises.

In the spring of 2005, a Memorandum of Understanding concerning financial supervision was concluded between Danmarks Nationalbank, the Danish Ministry of Finance, the Danish Ministry of Economic and Business Affairs and the Danish Financial Supervisory Authority. The MoU confirms the existing informal and pragmatic cooperation on maintaining financial stability and, if required, coordinating the handling of financial crises by the parties to the MoU. Responsibility for the cooperation is anchored in a Coordination Committee on Financial Stability made up of representatives of all four authorities.

Under the MoU concerning financial supervision, Danmarks Nationalbank and the Danish Financial Supervisory Authority have concluded a separate Memorandum of Understanding.^[5] This MoU is to contribute to transparency in relation to the cooperation, and contribute to a clearer division of tasks, easier administration and exchange of knowledge and information between the two parties. The MoU comprises three sub-agreements on, respectively, the stability of the financial system, financial statistics, and payment systems and clearing centres.