Assessment of Financial Stability

The annual publication Financial Stability assesses financial stability in Denmark, with emphasis on financial institutions, markets and payment systems. The most significant risks to the financial system are identified, including situations that are very unlikely to arise, but which might have major consequences for the economy.

Danmarks Nationalbank defines financial stability as a condition whereby the overall financial system is robust enough for any problems experienced within the sector not to spread and prevent the financial markets from functioning as providers of capital and financial services.

The risk of financial instability can be approached on the basis of two dimensions. One dimension is risks stemming from the development in society at large, e.g. the general economic development, unemployment, the finances of the banking institutions' customers, trends in the financial markets, etc. The other dimension is the vulnerability of the financial sector, especially the banking institutions, to inappropriate changes in the risk factors. Are earnings and buffers sufficiently resilient to withstand unexpected events, or are there other trends that may entail a risk, e.g. the development in costs, liquidity or other factors?

Overall, Danmarks Nationalbank finds that there are currently no major threats to financial stability in Denmark.

The international trends are described in the IMF's " Global Financial Stability Report" , April 2007.^[1]

Risk factors
The Danish economy is booming for the fourth consecutive year. Unemployment is the lowest for more than 30 years, inflation is low, interest rates have edged upwards, but are still low, and there is a sound government budget surplus and current-account surplus. So there are no immediate risks to financial stability from the general economic development.

As a result of the sustained upswing, the number of compulsory liquidations of Danish companies is low, while the prospects for the corporate sector are good. The growth in domestic demand is expected to remain high, albeit slightly lower than in the last few years, and forecasts still point to robust growth in the largest Danish export markets.

Calculations based on Danmarks Nationalbank's failure-rate model, KIM, show generally unchanged failure rates for the corporate sector in 2006 compared to previous years. The most vulnerable companies may, however, experience increasing difficulties 1-2 years ahead compared with prospects in Financial stability 2006. One reason is that in an upswing, as in the current situation, many new companies are established, and new companies are more likely to fail than established companies.

The finances of the households are still sound. Disposable real incomes have increased considerably because more people are in employment and real wages have risen. The easing of direct and indirect taxation has also contributed. Wealth has increased quickly in step with the recent surge in housing prices. The households' strong financial position is emphasised by a very low level of enforced sales.

The housing market dampened during 2006 and the beginning of 2007, cf. Chart 1. However, there is no reason to expect a general housing price dive for as long as the economy remains strong. However, some downward price adjustment cannot be ruled out in the areas that previously showed the highest price increases.

The vulnerability of the financial sector
The banking institutions posted record-high earnings again in 2006. The high earnings are the banking institutions' first buffer against increased losses and can be attributed to such factors as the very high growth in lending, which requires more capital. Overall, the excess capital adequacy of the Danish banking institutions as a ratio of loans and guarantees was slightly higher at end-2006 than in 2005 due to the issue of share capital, supplementary capital and hybrid core capital. Stress tests show that the resilience of banking institutions to higher losses remains sound at the end of 2006 compared to 2005.

One consequence of the high lending growth in recent years has been that the banking institutions have built up a large deposit deficit, cf. Chart 2, which is financed by e.g. issuing bonds and borrowing from other credit institutions. Financing via the money and capital markets is generally more exposed than deposits to changes in the banking institutions' own credit standing. Moreover, changes in the general appetite for risk and risk premiums can rapidly increase the cost of market financing, and the individual banking institution's market may potentially " dry out" .

To some extent the deposit deficit reflects the banking institutions' increasing share of the market for housing loans. In future, it will be possible for banking institutions to use these housing loans as collateral for the issuance of covered bonds (SDO). This will provide a new, stable source of funding for the banking institutions.

Similarly, the liquidity reserves of the banking institutions have diminished over a number of years. This may affect the banking institutions' ability to react to unexpected developments, and tight liquidity may reduce their freedom of action.