The Financial Sector
The financial sector is affected by the slowdown in the international economy, the course of the financial markets and uncertainty concerning the future.
The Nordic groups realised an overall decrease in earnings. For most of them, the level of losses and provisions has increased, but the average is unchanged. In a European perspective, especially compared to the German banking sector, the Nordic groups appear to be robust.
The Danish banking institutions' earnings continue to be sound, and losses and provisions have even decreased. So far, the banking institutions have shown resilience to the effects of the slowdown and the downturn on the financial markets, but there is a tendency for increased dispersion of earnings. A number of Danish banking institutions have enhanced their capital adequacy, which is in harmony with the greater uncertainty regarding the course of the economy.
The sensitivity of the banking institutions' profits one year ahead has remained by and large unchanged over the past year. At the same time, the increased capital adequacy has enhanced the banking institutions' overall resilience to losses on loans and guarantees. The uncertainty is instead associated with the duration of the economic slowdown.
The development of the financial markets in 2002 has negatively affected the pension sector. However, new accounting principles enabled the pension companies to increase their reserves.
Financial groups
The largest financial groups in Denmark are all major market participants within the fields of banking, mortgage credit and insurance. At the same time, a large proportion of the groups' operations are in the whole of the Nordic financial market. The development of the largest financial groups in the Nordic region thus puts that of the largest Danish groups and the Danish banking sector into perspective[1].
Trends in the groups' financial statements
For most of the Nordic financial groups profits before tax were lower in 2002 than in 2001, and returns on equity mainly decreased, cf. Chart 3. However, the groups succeeded in increasing their net interest income, even though both interest income and expenditure fell. Business expanded in terms of the volume of deposits and lending, with mortgage-credit lending accounting for particularly strong growth.
The downturn on the stock markets is reflected in lower net income from fees in connection with investment banking activities, and in a lower return on portfolios of securities and shares in 2002 compared to 2001 for most of the groups. To counter receding revenue several groups have downscaled their investment banking activities and laid off a considerable number of employees in the units concerned.
Nonetheless, investment banking activities do not play a major role for most of the Nordic groups. This may explain why the Nordic groups are doing well in an international perspective.
Most of the groups saw an expansion of losses and provisions on lending as a ratio of total loans and guarantees, but the ratio is on average unchanged at 0.14 per cent. A few groups improved their capital adequacy, which appears to accord with the increased uncertainty concerning the development of the economy. Core capital accounts for 7.3 per cent of risk-weighted assets, which is the same ratio as in 2001.
The Nordic groups are affected by the problems faced by the pension sector via the groups' life-insurance activities, and via their own company pension funds. Life-insurance companies have been subject to pressure from the low level of interest rates and stock-market trends, and some groups had to grant liable loans to insurance and pension companies. Several groups have company pension schemes which could potentially generate losses. One group has stated that it has had to contribute capital to a company pension scheme.
Credit standing in a European perspective
With a view to assessing the credit standing of the Nordic groups Chart 4 presents the individual ratings at the beginning of March 2002 and March 2003 respectively for selected European financial groups, and the ratings of their long-term debt issues. The highest ratings are found to the "south-west" of the chart, and the arrows show the institutions that have been downgraded since March 2002. The banks selected for comparison are the largest European banks measured in terms of total assets. There are four German banks, three French banks, two Dutch banks, two Swiss banks and two British banks.
All Nordic groups have a high rating as a starting point, and no group was subject to downward adjustment during the period.
Especially when compared to the German banking sector, the Nordic groups appear robust. The German banks were downgraded primarily due to their generally low profitability in view of structural factors that have been reinforced by the unfavourable economic climate, resulting in declining revenue and losses on bad loans.
Structural trends
The Nordic groups were subject to a number of structural adjustments in 2002, and the consolidation among regional and local Danish banking institutions continued.
In June 2002, Nordea announced the sale of Tryg Skade to Tryg i Danmark. In September, Nordea acquired 37 per cent of LG Petro Bank in Poland, bringing Nordea's total interest to 92 per cent. Nordea acquired Postgirot Bank in 2001, which was operated as a subsidiary until its merger with Nordea Bank Sweden in December 2002.
Danske Bank divested Danica Life, a subsidiary of Danica Pension, in October. Furthermore, Danske Securities ceased to be an independent entity on the transfer of its activities to Danske Markets, and Danske Securities' activities are discontinued in full or in part in a number of countries.
Svenska Handelsbanken merged with Midtbank in May 2001. As from January 2002, Midtbank became a branch of Handelsbanken. In May 2002, Handelsbanken announced its intention to establish a new regional bank in the UK.
In February 2002, Den norske Bank acquired a controlling influence in Nordlandsbanken through the acquisition of shares. In June 2002, Den norske Bank acquired Skandia's asset management activities as an element of the establishment of Den norske Bank's asset management.
With effect from 1 January 2002, Vendsyssel Bank and Egnsbank Nord merged to become Nordjyske Bank. Egnsbank Nord is the continuing bank. In May, Sydbank merged with Egnsbank Fyn. Sydbank already owned more than 60 per cent of Egnsbank Fyn's share capital. Ringkjøbing Landbobank merged with Tarm Bank in August 2002, with Ringkjøbing Landbobank as the continuing company. Finally, Nordvestbank and Vestjysk Bank merged in March 2003 with effect from 1 January 2002, with Nordvestbank as the continuing company under the name of Vestjysk Bank.
The Danish banking institutions
There are 181 banking institutions in Denmark, of which the five largest account for 81 per cent of the banking institutions' total balance sheet. The Danish banking institutions thus constitute a heterogeneous group, so the average development may conceal considerable variations between individual banking institutions. The differences are shown by e.g. the dispersion of some of the key ratios analysed[2].
Danish banking institutions' earnings and capital adequacy
On an aggregated level, the Danish banking institutions' profits for 2002 increased slightly over 2001, cf. Box 1.
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Box 1
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The Danish banking institutions' profits totalled kr. 20.2 billion in 2002, which represented a small increase on 2001. The banking institutions' profits have stagnated in recent years, reflecting lower growth in the business volume than in the period 1996-2000 that saw very high growth rates for lending. On the revenue side, the banking institutions' interest income remained unchanged in overall terms. Fee and commission income declined further against 2001 in view of the substantial market fluctuations in the second half of 2001, which particularly undermined the banking institutions' earnings basis via investment banking activities and asset management. The banking institutions' revenue from value adjustment of own portfolios decreased equivalently. However, the importance of value adjustments is relatively modest in relation to interest and fee income. Operating expenses remain unchanged, but especially the largest banking institutions' cost adjustments relative to earnings contribute to maintaining the result for the sector as a whole. Losses and provisions were reduced in 2002, and the continuing subdued economic development has thus not yet impacted on the overall result, although the underlying variations between individual banking institutions and categories have increased. |
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| The banking institutions' financial results, 1999-2002 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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| Note.: Banking institutions in categories 1-3. Source: The Danish Financial Supervisory Authority. |
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Average operating income over operating expenses fell slightly, and the dispersion among banking institutions is still increasing, cf. Chart 5. Few banking institutions were able to reduce costs, while most banking institutions continued to face rising costs. Operating income over operating expenses fell for more than half of the banking institutions.
The Danish banking institutions' overall capital adequacy decreased in the period 1997-2001, but increased a little in 2002, which is in harmony with the greater uncertainty concerning the economic development. The smallest banking institutions still have the highest capital adequacy, cf. Chart 6. The smaller the banking institution, the lower the ratio of supplementary capital to the total capital base. Especially the medium-sized banking institutions increased the supplementary capital ratio. Supplementary capital is ceteris paribus associated with lower financing costs than equity capital, cf. the Capital Structure of Banking Institutions on p. 89. On the other hand, supplementary capital is typically subject to a fixed maturity, and the share of the supplementary capital that can be included in the solvency compilation decreases towards the end of the maturity period[3].
The banking institutions' operational risks
Losses and provisions normally lag behind the business cycle. When the economy is booming, lending increases, while losses and provisions are typically low. Credit quality deteriorates gradually in periods with high growth in lending, leading to increased losses and provisions in subsequent periods.
The development in the banking institutions' losses and provisions on loans and guarantees generally corresponds to the course of actual losses realised, particularly losses on loans and guarantees to corporate entities.
Since 1997, the banking institutions' losses and provisions have been at a very low level, even though they increased slightly in 2001. This reflects the favourable economic development in this period. Prior to 2002, some banking institutions stated that unless the economic climate improved, their losses and provisions would increase. At an aggregated level, however, the banking institutions reduced their losses and provisions in 2002, cf. Chart 7, to an average of 0.34 per cent of loans and guarantees.
| Growth in lending and losses and provisions as a ratio of loans and guarantees, all banking institutions in categories 1-3, 1980-2002 |
Chart 7
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| Source: The Danish Financial Supervisory Authority. | |
The low level of total losses and provisions conceals a wider dispersion among the banking institutions. In 2002, there was an increase in the losses and provisions of the banking institutions already accounting for the largest losses and provisions, represented by the 90th percentile in Chart 8. The 10th percentile decreased.
The banking institutions with the highest growth in lending from 1996 to 2000 stand to lose most. A few banking institutions suffered considerable losses on single exposures at the end of 2001 and the beginning of 2002. These banking institutions' losses and provisions are considerably above the level of the 90th percentile. Among the banking institutions analysed the highest ratio of losses and provisions to loans and guarantees was 3.3 per cent in 2002, and 12 of the 48 banking institutions analysed had losses and provisions accounting for more than 1 per cent of loans and guarantees.
According to the latest MFI statistics, there are still no indications of an increase in the banking institutions' loan losses at the beginning of 2003 compared to 2002.
Interest income
The widening of the average interest-rate margin for lending to the corporate sector shown in Chart 9 reflects that especially the largest banking institutions, including those with a relatively high corporate lending ratio, have increased their average interest-rate margin over the past year.
This is in harmony with the banking institutions' own indications that they will match price and risk on the individual exposures. At the same time, the corporate lending of especially the largest banking institutions declined, cf. Chart 10.
Many private customers redeemed bank loans by raising mortgage-credit loans, in view of the banking institutions' generally higher lending rates than mortgage-credit loan rates, even with the same maturity.
In a situation with sustained lower interest rates, ceteris paribus the banking institutions find it more difficult to maintain the current level of interest income.
The most recent MFI balance-sheet statistics indicate that the banking institutions' lending largely remained unchanged at the beginning of 2003.
Fee and commission income
Fee and commission income have become increasingly important to the banking institutions. Fee and commission income rose from around 16 per cent of total interest and fee income in 1992 to around 27 per cent in 2002, cf. Chart 11.
Fee and commission income comprises e.g. brokerage commission and commission on custody accounts, remortgaging and borrowing fees, fees for use of payment systems, and guarantee commission.
A few large banking institutions publish data on the composition of their fee and commission income. This data shows that brokerage commission and commission on custody accounts account for the largest share.
Especially the largest banking institutions are indirectly exposed to market fluctuations via brokerage commission and commission on custody accounts, whereas the smallest banking institutions appear to be more exposed to fluctuations in remortgaging and borrowing fees. As regards banking institutions in categories 1 and 2, higher fee and commission income from conversion of mortgage-credit loans has thus by no means offset the decrease in fee and commission income as a result of the downturn in stock trading. However, an additional source of income for the banking institutions may be guarantees to mortgage-credit institutes in association with individual mortgage-credit loans.
The banking institutions' financial risks
The banking institutions' deposit surplus fell from 1996 to 2001, and 2001 was the second consecutive year with a deposit deficit, cf. Chart 12. This trend was reversed in 2002.
The proportion of the analysed banking institutions with a deposit deficit has fallen from 31 per cent to 23 per cent. Mainly the small banking institutions have turned a deposit deficit back into a deposit surplus.
Debt to other credit institutions may constitute a less stable source of financing than deposits. Deposits from other credit institutions are thus associated with a greater refinancing risk than ordinary customer deposits at longer maturities in real terms.
Besides demand deposits net debt to other credit institutions consists primarily of deposits with an agreed maturity of up to and including 3 months, cf. Chart 13. The banking institutions reduced their net debt to other credit institutions in 2002, predominantly the proportion of the debt at the longest maturity.
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Box 2
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The banking institutions in category 4 have a working capital of less than kr. 250 million. In 2001, this category accounted for almost under half of the 181 banking institutions in Denmark, while the category's lending represented a mere 0.6 per cent of total lending. Earnings The banking institutions in category 4 are very well-consolidated. In 2001, their average solvency ratio was 26.8, against 17.3 for banking institutions in category 3. Growth in deposits and lending |
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| Operating income over operating expenses, 1995-2002 | |
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| Note: Data for 2002 is estimates based on data for Q1-Q3 2002. Source: The Danish Financial Supervisory Authority. |
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Losses and provisions |
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| Losses and provisions as a ratio of loans and guarantees, 1995-2002 | |
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| Note: Data for 2002 is estimates based on data for Q1-Q3 2002. Source: The Danish Financial Supervisory Authority. |
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Issue of bonds is a source of financing used especially by the largest banking institutions with an international rating. Depending on maturity, bonds constitute a stable source of financing. However, they may be associated with a greater refinancing risk than ordinary customer deposits. One reason is that bank bonds are primarily aimed at a professional segment, and that deposits up to a certain limit are subject to deposit guarantees.
Sensitivity analysis and stress testing of Danish banking institutions
A number of sensitivity analyses and stress tests are performed to examine the banking institutions' resilience to various types of risk one year ahead. The extent to which the banking institutions' earnings and capital adequacy are sufficient to withstand the direct effects of a number of predetermined risk scenarios within a financial year is examined. On the other hand, the extent to which the banking institutions can withstand increased losses for prolonged periods is not examined.
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Box 3
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The sensitivity analysis is based on 48 banking institutions, i.e. 4 in category 1, 13 in category 2, and 31 banking institutions in category 3. In Financial stability 2002 the analysis population consisted of 50 banking institutions, of which 9 have fallen out of the population due to mergers or restructuring as branches of foreign banking institutions, etc. 7 more banking institutions in category 3 are now included in the analysis. The scenarios in the sensitivity analysis are based on the levels for individual banking institutions, and the consequences of changes are calculated in percentage points in relation to these levels, e.g. an increase by 2.25 percentage points in the individual banking institutions' losses as a ratio of loans and guarantees. The basis for each scenario is the selected banking institutions' total ordinary operating result of kr. 18.8 billion in 2002. The items included in the individual tests are calculated on the basis of their original value and the changes resulting from the risk scenarios. In each test the alternative result for the relevant risk scenario is calculated for each banking institution. The sensitivity analyses take no account of indirect effects including possible diminished credit quality due to increasing interest rates, indirect effects of falling stock prices on the banking institutions' losses and provisions due to reduced values of stocks provided as collateral for loans, or the significance of stock-price trends to the banking institutions' fee and commission income, etc. For banking institutions housing a negative result in the individual tests a new solvency ratio is calculated by deducting the result from the capital, and fully deducting any losses on balance-sheet items (assets) from the risk-weighted assets. |
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Sensitivity analysis
Increased losses on loans and guarantees are found to be the most significant risk for the banking institutions in view of the uncertain economic outlook and developments in the financial markets. This may be combined with diminishing interest income as a consequence of declining growth in lending and a continued low level of interest rates. There is also the risk that fee and commission income will continue to decline, as well as the direct effects of further stock price drops.
The basis for the analysis is the banking institutions' profits and capital adequacy in 2002, which in overall terms was a little better than in 2001. The underlying spread between the individual banking institutions' profits has increased. In addition, two banking institutions realised deficits in 2002, of which one is in category 2 and one in category 3. In 2001, all banking institutions in the analysis reported surpluses.
The banking institutions' earnings generally show by and large unchanged resilience to the risk scenarios set up at the end of 2002 compared to 2001, cf. Table 2. In test 2, which is the most strict scenario, most of the institutions analysed would show a deficit. In 2002, one of the small banking institutions would fall below the statutory capital requirement in the scenarios where the losses are increased by at least 1 percentage point. Other banking institutions are within the statutory solvency requirement in all tests.
Stress tests
The stress tests show the level of losses on loans and guarantees that the banking institutions can withstand at the current level of earnings and capital adequacy.
As regards the banking institutions' earnings, the resilience is almost unchanged from 2001, cf. Chart 14. As in 2001, the level of losses on loans and guarantees must increase by 1.5 percentage points before half of the banking institutions realise a deficit.
| Number of banking institutions with a deficit on an increase in losses on loans and guarantees, 2001 and 2002 |
Chart 14
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| Source: Annual accounts and own calculations. | |
Taking both annual earnings and the current capital in excess of the statutory requirement into account the banking institutions' overall resilience to losses has strengthened a little, cf. Chart 15. Compared to 2001 most of the banking institutions were able to withstand a large increase in losses on loans and guarantees in 2002, while observing the statutory solvency requirement.
| Number of banking institutions with a solvency ratio below 8 on an increase in losses on loans and guarantees, 2001 and 2002 |
Chart 15
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| Source: Annual accounts and own calculations. | |
As in 2001, primarily banking institutions in category 2 are among the least robust. However, there is no straightforward correlation between the size of the banking institutions and their resilience to losses.
The mortgage-credit institutes
In Denmark, the mortgage-credit institutes play an important role in the financial sector as the largest credit provider in connection with financing of real property, and as bond issuers with issue volumes totalling kr. 1,584 billion at end-2002, corresponding to more than 60 per cent of the Danish bond market.
The balance sheets of the mortgage-credit institutes in particular comprise liabilities in the form of issued bonds, and assets in the form of mortgage loans. The statutory framework for the mortgage-credit sector contributes to limiting liquidity, market and credit risks. A rough outline of the balance principle in the Mortgage Credit Act is thus that future disbursements to holders of mortgage-credit bonds must correspond to future receipts on mortgage loans.
Operating profits
The mortgage-credit institutes' total profit after tax was kr. 5 billion in 2002, which was unchanged from 2001.
Net interest income, which is the most significant source of income for mortgage-credit institutes, rose by 4.6 per cent in 2002.
Claims losses and write-downs
Chart 16 shows the mortgage-credit institutes' buffer against future losses. In 2002, the sector as a whole was able to withstand losses of more than 2.4 per cent of the loan portfolio, while remaining within the statutory solvency requirement of 8 per cent. Actual losses and write-downs accounted for 0.01 per cent of the loan portfolio. For comparison, the actual ratio of losses and write-downs was 1.36 in 1990.
Since 1997, the capital in excess of the statutory requirement has been reduced. The background is a general adjustment of capital in relation to actual losses, so that the development does not reflect a negative trend for the financial result.
Mortgage-credit institutes and financial stability
Since the beginning of the 1990s the structure of the mortgage-credit sector has changed from independent mortgage societies to limited liability companies, in many cases owned by banking institutions or by several banking institutions jointly.
The banking institutions' ownership of mortgage-credit institutes is the result of e.g. economies of scale, since it enables the banking institutions to use their existing network of branches for the distribution of mortgage-credit products.
Mutual guarantee systems are often used for this purpose. The bank that intermediates the mortgage-credit loan guarantees the last-ranking element of the mortgage-credit loan for a limited number of years[4]. In return, the mortgage-credit institute pays the intermediary bank a guarantee commission. The bank is thus more exposed to falling real property prices.
In practice, under the guarantee system the intermediary bank assumes most of the credit risk associated with mortgage-credit loans, against payment of a fee. On the other hand, the banking institution's capital burden is thereby proportionate to the size of the guarantee, and thus does not reflect that the guarantee covers the last-ranking element of the loan.
The guarantee system e.g. supports the high rating of mortgage-credit bonds.
The pension companies
As from 1 January 2002, life-insurance companies and pension funds, hereafter called pension companies[5], could present accounts based on market values, and this became mandatory as from 1 January 2003. A number of pension companies presented their 2002 annual accounts according to the new rules, while others presented their annual accounts on the basis of the previous accounting rules. This circumstance diminishes opportunities for comparison between companies. Accounts presented on the basis of market values are described in Pension Companies on p. 67. Furthermore, the pension companies are subject to relaxed requirements regarding the publication of annual accounts, and not all companies had published annual accounts at the time of going to press. The review of the development in the pension companies thus only includes approximately 75 per cent of all pension companies measured in terms of life-insurance provisions. The Folketing (Parliament) is currently hearing a bill[6] to e.g. harmonise the deadlines for publication of the annual accounts of financial corporations, including tighter publication deadlines for pension companies.
Premiums were increased in 2002 over 2001, but insurance claims and operating expenses rose even more.
The continuing downturn on the stock markets in 2002, combined with the falling level of interest rates towards the end of the year, had a negative impact on the pension companies. The loss on stocks was in the area of 25 to 35 per cent. This contributed directly to reducing the value of the shares as a proportion of total investment assets, cf. Chart 17. To a certain extent, the pension companies have hedged the risk of further stock price drops by purchasing financial derivatives and selling shares, thereby matching the investment risks to commitments and capital strength.
Bond portfolios were increased as shares were divested. The falling level of interest rates has helped to secure capital gains on the pension companies' bond portfolios, and positive returns on property investments. However, the capital gains on the bond portfolios were not sufficient to cover the need for further provisions, since the liabilities to be covered are generally more sensitive than bonds to interest-rate fluctuations. Many companies hedged the risk of falling interest rates by purchasing financial derivatives. This has covered the pension companies' losses due to market developments. As Chart 17 shows, the pension companies have significantly increased their holdings of bonds denominated in foreign exchange in recent years.
The pension companies' overall resilience to e.g. losses relating to insurance or market risks may be covered by three different capital buffers: 1) Capital base exceeding the statutory requirement; 2) Collective bonus potential, which is the undistributed reserves of the policyholders; and 3) Bonus potential related to benefits on premium-free policies, which can now be included as a reserve under the new accounting rules. The three capital buffers measured as a ratio of life-insurance provisions give an overall indication of the pension companies' economic resilience, cf. Chart 18. Developments in 2002 weakened the collective bonus potential especially, but also the excess capital base. The bonus potential related to benefits on premium-free policies brings the total capital buffer to a higher level than in 2001. This reserve would no doubt have been even larger if all pension companies had applied the new accounting rules based on market values at end-2002. The overall development in 2002 conceals diverging trends for the individual pension companies.
[1]The groups analysed are Danske Bank, Den norske Bank (DnB), Föreningssparbanken (Swedbank), Nordea, Skandinaviska Enskilda Banken (SEB) and Svenska Handelsbanken.
[2]The analyses primarily apply data for banking activities, including banking institutions that are part of financial groups. The development in earnings and capital adequacy is analysed for the groups as a whole for the banking institutions that are part of groups, while the other banking institutions are included in the analyses with data for actual banking activities. Analyses of the dispersion of various key indicators are based on the same population as the subsequent sensitivity analyses and stress tests comprising 48 selected banking institutions and groups.
[3]See Birgitte Bundgaard and Suzanne Hyldahl, Structure of the Banks' Capital – New Statutory Requirements and Opportunities, Danmarks Nationalbank, Monetary Review, 3rd Quarter 2002.
[4]For an owner-occupied home financed by mortgage credit for 80 per cent of the property value, the banking institution may e.g. guarantee the last-ranking 20 percentage points of the loan. The guarantee may be exercised if the borrower defaults on its obligations, and if the realised value of the mortgage deed is less than 80 per cent of the nominal loan. In such case, the banking institution will guarantee the part of the mortgage-credit loan exceeding 60 per cent of the nominal loan.
[5]Accounting items for pension companies are described using the terms applying to life-insurance companies.
[6]Bill to amend the Financial Business Act.