The Financial Sector
The financial sector has remained relatively unaffected by the weak economic environment in Europe.
For the Nordic groups, including Danske Bank and Nordea, profits have increased, e.g. as a result of cost reductions. The level of losses and provisions has risen, but resilience remains unchanged.
The earnings of the Danish banking institutions have grown significantly, but losses and provisions have increased among the small institutions. A number of institutions had high growth in lending. The high level of activity in terms of arranging and converting mortgage-credit loans has contributed to significantly higher fee and commission income. The improved profits are, however, primarily attributable to capital gains on the sale of shareholdings in Totalkredit. The large Danish banking institutions have generally increased their capital adequacy. The significant capital gains have enhanced the resilience of the banking institutions.
The pressure on the pension companies has subsided as a result of the development in stock prices in 2003.
Nordic groups and danish banking institutions
Unlike previously, the Nordic groups and Danish banking institutions are now divided into three categories, cf. Table 2: Nordic groups (category A), large Danish banking institutions (category B), and small Danish banking institutions (category C). The activities of Nordea and Danske Bank are only included in the Nordic groups category, i.e. category A. This new breakdown is to strengthen the analysis of the development in the financial sector at the Nordic level in view of the growing internationalisation, among other factors. In addition, the new breakdown provides for a higher degree of homogeneity in business areas between the institutions and groups comprised by the analysis.
Earnings and capital adequacy
The Danish banking institutions in categories B and C increased their total profits before tax by 84 per cent in 2003 over 2002, cf. Box 1. This is mainly attributable to capital gains on the sale of shareholdings in Totalkredit, cf. Box 2. Other contributing factors were higher income from fees, e.g. as a result of increased income from trading activities, as well as fees and commission from the arrangement and conversion of mortgage-credit loans as a result of the historically low level of interest rates. Moreover, several Danish institutions had high growth in lending.
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Box 1
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Nordic groups, category A Danish banking institutions in categories B and C |
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| Profits before tax, 2002-03 | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
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Box 2
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In November 2003, Nykredit acquired Totalkredit, which was formerly owned by 106 local and regional banking institutions. Nykredit estimates the total amount payable to the institutions at kr. 7.15 billion, equivalent to a "price"/book value of 2. In practice, payment is effected as a combination of cash payments and a conditional current payment over a number of years. The transaction also includes a strategic cooperation agreement, under which the banking institutions are to arrange mortgage-credit loans from both Totalkredit and Nykredit. In the first years, it is only possible to secede from the cooperation agreement against payment. The stock-exchange-listed banking institutions' estimates of the capital gain on the sale total kr. 3.4 billion, of which kr. 1.8 billion was recognised in 2003. The statement comprises approximately 75 per cent of Totalkredit's share capital. |
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The profits of the Nordic groups, category A, also improved considerably with growth of 22 per cent. Exclusive of value adjustments of capital investments, the improvement was driven by cost reductions via staff cuts. One group in particular has reduced its staff by more than 10 per cent. Net interest income increased slightly.
Operating income over operating expenses has increased for all categories. For category A this is attributable to the cost reductions, while costs have remained unchanged for the institutions in categories B and C.
It is doubtful whether the factors contributing to the significant increase in profits in each of the three categories in 2003 will ensure continued growth in earnings in the coming years.
Chart 3 shows the development in the capital adequacy of the three categories. Category B has increased its core capital, which is consistent with the still sluggish economy.
Operational risks
The Danish banking institutions can be expected to have significant released funds at their disposal in the coming years. Firstly, there will be capital gains on the sale of Totalkredit to Nykredit. Secondly, adjusted valuation rules resulting from the introduction of the international accounting standards (IAS) from 1 January 2005, cf. Box 3, will entail lower provisions for losses on a given loan portfolio. Finally, the introduction of new capital-adequacy rules (Basel II) from 2007 will imply a relatively strong relaxation of the capital requirements for Danish banking institutions due to the structure of their exposures. It is important that the banking institutions carefully consider how large a proportion of the funds released they need to use as buffers.
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Box 3
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As of 1 January 2005, all publicly traded companies, including financial companies must apply the international accounting standards (IAS) to their consolidated accounts. This is a consequence of a regulation adopted by the Ecofin Council and the European Parliament in July 2002 which applies directly in the EU member states. The IAS are global accounting standards prepared by the International Accounting Standards Board (IASB) with a view to making accounts comparable across national borders. The IASB is an independent institution comprising international accounting experts. The IAS regulation is part of the EU's Financial Services Action Plan, creating the framework for the single financial market in the EU. The Danish Financial Supervisory Authority has set up a committee of representatives of the financial sector, the Institute of State Authorized Public Accountants in Denmark, the Danish Financial Supervisory Authority and Danmarks Nationalbank. Among other things, the committee is to assess how valuation of loans under IAS is practically feasible, and how valuation of the banking institutions' lending and thus their level of provisions is affected by the transition to IAS. The result of the committee's work is not yet available. The provision practice applied so far is based on a prudential principle under which losses are recognised when they are imminent, and gains when they are realised. In practice this has meant that assets and commitments are often valued with a high level of conservatism. Under the IAS, losses are recognised when there is a clear indication of a decrease in value, which does not allow the same degree of conservatism. The transition to IAS is therefore expected to entail a significant fall in the level of provisions in Denmark. The IAS regulation gives the individual EU member states an option to permit or require that other companies than publicly traded companies apply the IAS to their consolidated and/or annual accounts. |
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In recent years the small banking institutions in particular have opened new branches, cf. Chart 4. This has intensified competition for customers.
| Percentage change in number of branches, the danish financial supervisory authority's categories 1, 2 and 3, 2000-02 |
Chart 4
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| Source: The Danish Financial Supervisory Authority. | |
Lending
Since mid-2002 the Nordic groups had a decline in loans to the Danish corporate sector, cf. Chart 5. The statement does not include any loans provided by the individual groups from abroad since these are not reported to Danish statistical authorities. The Danish banking institutions in category B have generally seen significantly higher growth in corporate lending than the other categories since the latter part of 2002. The institutions in category C have seen a little growth in lending in the period. The implied corporate lending margin for category B was more or less constant throughout 2003, while the margin for category A declined slightly in the latter part of the year after having increased for a number of years.
There are significant underlying differences in total growth in lending among the individual institutions. In 2003, lending growth exceeded 15 per cent in one institution, and 10 per cent in six institutions in category B. In five category C institutions lending growth exceeded 15 per cent, and in 15 institutions it exceeded 10 per cent in 2003.[1] Six institutions saw lending growth exceeding 10 per cent in both 2002 and 2003. High growth in lending requires greater awareness of the development in credit quality.
Losses and provisions
Overall the losses and provisions of the Danish banking institutions are still very low, cf. Chart 6, but showed a slight increase in 2003. Usually losses and provisions lag behind the economic cycle. In periods of high growth lending increases and the credit quality often falls, leading to increased losses and provisions in subsequent periods. Overall, the high growth in lending in the late 1990s and the subsequent economic slowdown have not, however, led to any appreciable increase in the institutions' losses and provisions. The reason may be that the institutions' credit-risk management has generally become more efficient than in the early 1990s. In preparation for the new capital-adequacy rules (Basel II) several institutions have developed advanced risk-management models. Moreover, losses and provisions reflect compulsory liquidation and enforced sales, cf. the chapter on the corporate sector and the households. The companies may have become better at adapting to the economy in time and adjusting their costs.
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Box 4
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Based on Danmarks Nationalbank's failure-rate model, which is described in the chapter on the corporate sector and the households, calculations can be performed to indicate the credit risk in relation to the individual banking institutions' loans to the corporate sector. This is done by estimating the estimated failure rates for individual companies. The estimated failure rates for the individual banks' corporate exposures are then summed on the basis of the companies' information about their bankers. A comparison of the estimated failure rates for the individual banks' corporate lending with selected key accounting ratios gives a picture of e.g. the extent to which the banking institutions are compensated for credit risk via their lending margins. The analysis does not provide a comprehensive picture of the credit risk associated with the banking institutions' loans to the corporate sector. For instance, there is no information on the losses which the bank may sustain if a company fails, including e.g. the value of collateral. In addition, the failure-rate model estimates failure rates for only a section of the institutions' corporate exposures. These include public and private Danish limited liability companies, of which only approximately 60 per cent state their banker. Agriculture is not included. Finally, the companies may have other bankers that could incur losses in connection with financial difficulties in a company. The Table below ranks the banking institutions by the weighted estimated failure rates for the companies stating the institutions in question as their bankers. The banking institutions have subsequently been grouped in 10 categories comprising an equal number of institutions. The average weighted estimated failure rate is compared with selected average key ratios for each group. |
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| The analysis shows that the weighted estimated failure rate for loans to the corporate sector in the 10 categories to some extent seems to be reflected in the ratios of losses and provisions, and that higher lending rates partially compensate for increased risk. | |||||||||||||||||||||||||||||||||||||||||||||||||||||
Chart 7 shows the development in losses and provisions in relation to loans and guarantees for the Nordic groups (category A) and the Danish banking institutions in categories B and C, respectively.
The ratio of losses and provisions has increased marginally in three of the Nordic groups. Two groups stand out with higher losses and provisions as a result of significant losses on marine fish farming in Norway.
The Danish banking institutions' ratio of losses and provisions rose in 2003. Category C's total ratio of losses and provisions was the highest since the first half of the 1990s. In category B, a few banking institutions have reduced their losses and provisions after few but large losses in 2002.
Among the Danish banking institutions, the highest ratio of losses and provisions was 1.9 per cent of loans and guarantees in 2003, and almost one third of the institutions analysed had losses and provisions exceeding 1 per cent of their loans and guarantees[2]. For comparison, the highest ratio of losses and provisions in 2002 was 3.4 per cent. Eight of the institutions analysed had ratios of losses and provisions of 1 per cent or more in both 2002 and 2003.
The Danish Financial Supervisory Authority calculates the scope of the net provision exposures surrendered, i.e. exposures with booked provisions of a certain size that are fully or partially reversed by the surrendering banking institution in connection with the transfer of the exposure to another banking institution. As in previous years, the largest institutions have a net outflow of provision exposures, while the small and medium-sized institutions have a net inflow. The largest institutions' proportion of the provision exposures surrendered has, however, fallen marginally compared with 2002.
Fee and commission income
Fees and commission income accounts for an growing percentage of the Danish banking institutions' income, cf. Chart 8. The reason is partly that a low level of interest rates per se increases the percentage.
The opposite development is seen in the Nordic groups, where fee income peaked in 2000. Part of the explanation could be that the Nordic groups have been affected by the development in the stock markets since brokerage and custody commission has fallen, cf. Box 5.
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Box 5
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The Chart below illustrates the fee and commission income of the Nordic groups by source. Brokerage and custody commission comprises the largest item of the Nordic groups' fee income. The item's size depends on the volume of trading in shares and bonds, among other things. For comparison, the small Danish banking institutions seem to be more dependent on the demand for mortgage-credit loans, i.e. remortgaging and loan fees. The decline in stock-market-related fee income in the Nordic groups is to some extent offset by higher income from the other fee items, notably use of payment systems and other commission. |
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Resilience of Nordic groups and Danish banking institutions
Stress and sensitivity tests may give an impression of the resilience of the Nordic groups and Danish banking institutions. Their resilience to higher losses and lower net income from fees is analysed in the following. The analysis of the Danish banking institutions also includes a scenario without the significant increases in value adjustments in 2003 in order to outline how e.g. the extraordinary capital gains from the sale of Totalkredit and the changed accounting rules for unquoted securities affect the profits for the year.
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Box 6
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The banking institutions in the Danish Financial Supervisory Authority's category 4 have a working capital of less than kr. 250 million. Almost three quarters of these institutions have a working capital of less than kr. 125 million, and over a third have a working capital of less than kr. 50 million. This category comprises almost half the 180 banking institutions in Denmark, but their lending represents only 0.5 per cent of the total volume of loans. In addition to many small, local banking institutions and cooperative banks the category comprises a number of specialist banks, often with a narrow clientele, typically owned by larger financial groups. These differences should be kept in mind when interpreting the data. |
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Income and capital adequacy The banks in the Danish Financial Supervisory Authority's category 4 are extremely well capitalised. In 2002 the average solvency ratio was 28.2 per cent, against 17.4 per cent for the institutions in the Danish Financial Supervisory Authority's category 3. Deposits and lending |
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The tests are static and based on the banks' accounting items. This means that the banks' possible reactions to the analysed scenarios, e.g. if they raise their interest rates, are not comprised by the analysis. Such analyses are therefore not suited for assessing long-term resilience. The data and method used in the tests are described in detail in Box 7.
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Box 7
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The analyses comprise six Nordic groups and 46 Danish banking institutions, i.e. 17 large Danish banking institutions in category B and 29 small Danish banking institutions in category C. The analysis is based on the accounting items as at 31 December 2002 and 2003. For each bank, the scenarios apply a shock to one or more accounting items, and the effects on the profits and solvency ratio are calculated. A shock may be an increase in losses by 1 percentage point in relation to the "losses and provisions" item for the individual bank. The analysis only deals with the direct effects of the shocks. The sensitivity tests comprise only the banks' profits, while the stress tests are applied to both the profits viewed in isolation and the profits plus the part of the capital adequacy that exceeds the statutory solvency requirement. |
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Sensitivity analysis of Nordic groups and Danish banking institutions
In view of the significantly higher profits of the Danish banking institutions in categories B and C in 2003 it is not surprising that these categories are considerably more robust in the sensitivity analysis, cf. Table 3. This is primarily attributable to the large increase in value adjustments, cf. scenario 4. In all the sensitivity tests, all institutions meet the statutory solvency requirement in 2003, while one did not meet it in 2002.
In terms of profits, the Nordic groups have become less sensitive to higher losses. However, in the most stringent scenario two groups are below the statutory solvency requirement in 2003, against one in 2002.
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Box 8
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The structural changes seen in the Nordic markets in recent years continued in 2003. In February 2003 the Norwegian Ministry of Finance gave Den norske Bank permission to acquire Nordlandsbanken against the background of Nordlandsbanken's problems meeting the solvency requirements after considerable losses on the Finance-Credit Group. Den norske Bank and Gjensidige NOR merged their two holding companies with accounting effect as from November 2003 and with Den norske Bank as the continuing company. The merger of the two operational subsidiary banks is pending the solution of a number of outstanding issues. The structural development to some extent affects the composition of the individual groups' business areas (banking activities, mortgage-credit activities, etc. and insurance), as illustrated in the Chart below. The Chart should be interpreted with caution since several circumstances make uniform delimitations difficult. |
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| Note: The percentages are based on the annual accounts of the groups and subsidiaries with banking, mortgage-credit and/or insurance activities that are deemed to be part of the group's overall strategy. Different accounting principles in the various Nordic countries mean that comparison of the groups' percentages should be undertaken with caution. Mortgage credit etc., comprises mortgage-credit lending and housing loans. Insurance comprises both life and non-life insurance, calculated on the basis of the direct contribution to the group balance-sheet total or via the size of the life or non-life insurance company's balance-sheet total. Source: Annual accounts. |
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Stress tests of the Nordic groups, category A
The stress tests for higher losses for the Nordic groups show that from an overall perspective the increased earnings in 2003 boosted resilience so that most groups can sustain higher losses without incurring a negative result, cf. Chart 9. As regards the size of the losses that can be sustained before the groups experience difficulties meeting the capital requirement, their resilience remains unchanged, cf. Chart 10.
| Number of banking institutions in categories b and c with a deficit on an increase in losses on loans and guarantees, 2002 and 2003 |
Chart 11
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| Source: Annual accounts and own calculations. | |
Stress tests of Danish banking institutions, categories B and C
The banking institutions in categories B and C have enhanced their resilience considerably so that they can sustain higher losses without having deficits, cf. Chart 11. This is indicated by the bars having moved significantly rightwards compared with last year. Likewise, higher losses may be sustained before the institutions have problems meeting the capital requirement, cf. Chart 12. As previously stated, the banking institutions saw large increases in value adjustments in 2003. Exclusive of these adjustments, resilience in 2003, illustrated by the yellow curves, is closer to the 2002 level.
Mortgage credit
The mortgage-credit institutes' total profit after tax was kr. 7 billion in 2003, equivalent to an increase by 43 per cent over 2002. The increase was driven by a very high level of gross new lending owing to the low interest rates and supported by the introduction of deferred-amortisation mortgage-credit loans as from 1 October 2003. As a result of the higher turnover, net income from fees more than doubled.
The resilience of the mortgage-credit sector is high. The sector as such was able to sustain losses of up to 2.7 per cent of the loan portfolio and still meet the regulatory capital requirement. Actual losses and write-downs amounted to 0.0 per cent of the loan portfolio in 2003.
Mutual guarantees between banking institutions and mortgage-credit institutes
The degree of integration between Danish banking institutions and mortgage-credit institutes has accelerated since the early 1990s, and mortgage-credit products are now a regular product offered by most banking institutions. The annual growth in lending by mortgage-credit institutes and banking institutions over a number of years shows that growth in lending by mortgage-credit institutes is more stable over the economic cycle than growth in lending by banks, cf. Chart 13.
The banking institutions' sales of mortgage-credit products are in some cases linked to a guarantee vis-à-vis the mortgage-credit institute. The banking institution provides a guarantee for the "last-ranking" part of the mortgage-credit loan for a limited number of years against guarantee commission[3].
In practice, under the guarantee system the intermediary banking institution assumes most of the credit risk associated with the mortgage-credit loan. The banking institutions' capital burden is thereby proportionate to the size of the guarantee under the current capital-adequacy rules and thus does not reflect that the guarantee covers the last-ranking element of the loan. Under the future capital-adequacy rules (Basel II) the distribution of the risk may, however, be taken into account.
Pension companies
The pressure on the pension companies eased in 2003. The market development in 2003 with rising stock prices enhanced the solvency of the companies. In spite of market developments, the structure of the pension companies' investment assets was more or less unchanged at end-2003 compared with end-2002, cf. Chart 14.[4]
From the financial year 2003 onwards, life-insurance companies and pension funds, jointly referred to as pension companies, must publish their sensitivity to various risk scenarios in connection with their annual accounts. The sensitivity shows the overall impact of the risk scenarios in the Danish Financial Supervisory Authority's "red light" on the companies' financial buffers, cf. Box 9.
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Box 9
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Table 4 shows that the pension companies' total sensitivity to market risk was kr. 37.6 billion at end-2003.[5] Of this total, the pension companies' owners were to cover a minimum of kr. 3.4 billion, while the policyholders' maximum would be kr. 34.2 billion. The distribution of the total market risk between owners and policyholders in the various scenarios is based on the "contribution principle", cf. Box 9. Sensitivity has been calculated taking into account the companies' possible hedging of risks via financial derivatives, cf. Box 10.
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Box 10
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The pension sector has been severely affected by the fall in interest rates in recent years, which has increased the focus on the interaction between the interest-rate sensitivity of the pension companies' assets and commitments. Many pension companies have fully or partly hedged their interest-rate risk via financial derivatives. The financial derivatives most commonly used by pension companies are CMS floors (Constant Maturity Swap floors) and swaptions, but a number of pension companies also use interest-rate swaps. These instruments enable the pension companies to minimise the disparity between the interest-rate sensitivity of the assets and commitments. An interest-rate swap is an agreement between two parties to receive (pay) a fixed rate of interest in a given period against paying (receiving) a variable rate of interest in the same period. The pension companies can use interest-rate swaps to hedge the risk that interest rates fall below the yield level that the pension companies have guaranteed the policyholders. A swaption is an option for a swap, e.g. an interest-rate swap. The buyer of a swaption has the right, but not the obligation, to enter into an interest-rate swap on predetermined conditions. If the pension company thus wishes to hedge the risk that the market interest rate falls below the level for the guaranteed yield, the pension company may enter into a swaption under which the pension company receives a fixed rate of interest and pays a variable rate from an agreed point in the future if the interest rate falls below this level. A CMS floor provides a floor for the interest rate and comprises a series of interest-rate options expiring at fixed intervals. The price depends on the level of interest rates, maturity, liquidity and credit risk and the uncertainty at the time of the transaction. For instance, it would be relatively expensive for the pension company to hedge if market interest rates are close to the level against which the pension company wishes to hedge. 49 pension companies of a total 71 used hedging instruments at end-2002. The Table below illustrates the effect of various changes in interest rates in per cent of the pension sector's aggregate balance-sheet total, which was kr. 945.5 billion at end-2002. It can be seen that the financial derivatives contribute to reducing the net impact of various changes in interest rates on the pension sectors' balance-sheet total significantly. |
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The total market risk can be compared with the companies' financial buffers, which are shown in the lower part of Table 4. This gives an impression of the sector's total robustness.
The accounts for the individual pension companies show that no companies were in the "red light" at end-2003 and only one was in the "yellow light". At end-2002 two companies were in the "red light" while 11 companies were in the "yellow light".
For the individual pension companies, Chart 15 shows the effect on the financial buffers of a fall in interest rates by 0.7 percentage point, a fall in share prices by 12 per cent, a fall in property prices by 8 per cent, and losses in connection with credit, counterparty and exchange-rate risks, hereinafter referred to as the "red" scenario. The Chart does not include bonus potential related to benefits on premium-free policies since the application of these as buffers is subject to certain limitations, cf. Box 9. It is therefore not possible for external readers of the accounts to assess the "buffer value" of the bonus potential related to benefits on premium-free policies.
Chart 15 illustrates that for the vast majority of the companies the collective bonus potential would not be sufficient to cover the policyholders' maximum losses in the "red" scenario at end-2003 since the blue bars are mainly negative. In these companies the bonus potential related to benefits on premium-free policies and the capital base, respectively, had to act as buffers for the remainder of the loss in the "red" scenario in accordance with the contribution principle. The yellow bars in the figures illustrate the individual pension company's excess capital base after a minimum impact on the capital base in the "red" scenario. In only one company, as indicated in the Chart, the excess capital base would not be sufficient to cover this loss[6]. In other words, practically all pension companies would be able to handle the market effect in the "red" scenario at end-2003, even without including the bonus potential related to benefits on premium-free policies as a buffer.
[1]The calculation is based on the 46 institutions included in the sensitivity and stress tests, cf. Box 7.
[2]The calculation is based on the 46 institutions included in the sensitivity and stress tests, cf. Box 7.
[3]For owner-occupied housing mortgaged at 80 per cent of the property value the banking institutions may e.g. guarantee the last-ranking 20 percentage points.
[4]The following review of the pension companies is based on annual accounts published before 23 April 2004.
[5]The scenario with falling interest rates involved the greatest losses to the sector as a whole.
[6]A detailed review of the company's annual accounts shows that according to the company itself it is comfortably in the "green light". The bonus potential related to benefits on premium-free policies is therefore a sufficient buffer for the company to be able to handle the market effect of a "red" scenario.