Financial Institutions and Financial and Economic Developments

Since the summer of 2007, developments in the global financial markets have been characterised by turmoil. Uncertainty has increased, the prices of many types of securities have fallen, and the banks' costs for market financing have risen. The Danish banks have not been affected to the same extent as banks in many other countries. The financial statements of the Danish banks showed lower earnings in 2007 than in 2006. This decline is solely attributable to the 2nd half of the year, which was a turning point for many banks after a long period of growth in earnings.

The banks' lending growth subsided in 2007, and preliminary data for the 1st quarter of 2008 shows that lending growth has declined further. The turmoil in the financial markets and the higher financing costs have dampened the banks' expansion, and many banks have raised their lending rates.

New capital-adequacy rules, combined with international accounting standards, have contributed to a reduction in the banks' reserves, and all other things being equal the banks have become more exposed to rising losses.

TURMOIL IN THE FINANCIAL MARKETS

The problems in relation to US subprime mortgages^[1] really surfaced in the summer of 2007, and since then the financial markets have been characterised by turmoil.

The turmoil was triggered by falling housing prices and an increasing rate of default on subprime mortgages in the USA, cf. Chart 3. The turmoil has spread through the international financial system due to opaque financial structures.^[2] Over the last 10-20 years, international banks have been offering customers still more complex financial products, without the banks taking on the full credit risk. Banks have thus divested the credit risk on parts of their lending by issuing securities against pools of loans as collateral.

Regular payments to investors in such securities have depended on, inter alia, the borrowers' ability to fulfil their obligations. This was seen as a safe way for banks to divest credit risk, including credit risk on subprime mortgages to US homeowners.

The surge in the number of defaulted subprime mortgages shook confidence in this structure. The price of bonds based on subprime mortgages has dropped sharply since the summer of 2007, and the bonds have been downgraded. This has created major problems for e.g. the investment units that have specialised in purchasing securities based on housing loans with long maturities. Financing has been based on loans with short maturities, typically three months. In addition, some of the investment units had obtained commitments from banks for supply of liquidity in the event of financing problems, and several banks were co-owners of the units. This exposure has not been stated clearly in the banks' financial statements.

Lack of transparency in relation to exposure to subprime-related products led to general distrust among the banks and reluctance to provide liquidity in the money market. Particularly in the autumn of 2007 the US and European money markets were under severe pressure. In the first months of the subprime crisis the turmoil affected virtually only the uncollateralised money markets, and at the turn of the year 2007-08 the spread between collateralised and uncollateralised money-market interest rates in the euro area was wider than ever before since the introduction of the euro in 1999, cf. Chart 4.

The tight money-market conditions landed the UK bank Northern Rock in dire financial straits in September 2007. Customers queued outside the bank's branches to withdraw their deposits, the Bank of England had to provide liquidity support, and coverage under the Financial Services Compensation Scheme was increased, cf. Box 1. In February 2008 Northern Rock was nationalised following vain attempts to find a private-sector solution.

In March 2008, the turmoil spilled over into the collateralised money market owing to lack of confidence in counterparties and collateral.

Central banks have responded to money-market developments by providing extra liquidity on several occasions, and some central banks have lowered their interest rates. In the period from the summer of 2007 to April 2008, the Federal Reserve lowered its policy rate by 3.25 percentage points to 2.00 per cent in an attempt to counteract the impact of housing-market developments on the economy, among other things. The ECB has kept its interest rate unchanged.

In the USA, the default wave has gradually spread from subprime mortgages to other parts of the US housing market, and to credit-card loans and car loans. In early 2008 this put the financial markets under renewed pressure. At the same time, confidence in credit strengthening for structured financial products was undermined by problems within the monoline insurance companies that have insured many subprime-related bonds against losses.^[3] In addition, the spread between corporate and government bonds widened considerably further in the first months of the year, partly on account of concerns that more companies would fail.

Chart 5 illustrates the course of the subprime crisis as the development in the spread between 3-month money-market interest rates in the USA and the yield on US government bonds with the same maturity.

The financial turmoil has also caused equity prices to fall, while the yield on government bonds declined because investors' risk appetite waned, resulting in a "flight to safety". Widespread uncertainty regarding future developments is reflected in higher volatility in the financial markets, cf. Chart 6. However, this increase follows period of unusually low volatility and low risk premiums, supported by factors such as ample liquidity.

Economic prospects for the euro area are more favourable than for the USA, and the expected impact of the subprime crisisis less severe than in the USA. The dollar has been depreciating strongly as the slowdown in the US economy has become evident.

Market expectations of bank earnings have subsided as a result of the subprime crisis, bank credit spreads have widened, and bank shares have shown a more pronounced decline than the market in general, cf. Chart 7.

The IMF estimates that the total potential loss in connection with the subprime crisis is approximately 600 billion euro^[4], of which half is expected to be incurred by the banks. The degree to which the individual banks have been affected varies considerably, cf. Box 2.

Short-term Danish money-market interest rates only mildly affected
In the Danish money market, the turmoil has largely been limited to long-term, uncollateralised money-market interest rates, a segment with relatively low turnover. The international financial turmoil does not seem to have limited the Danish banks' willingness to lend kroner to each other at the short end of the market. Until April 2008, turnover in uncollateralised day-to-day loans was at more or less the same level as previously, but in April turnover declined somewhat. The day-to-day interest rate has followed the rates of Danmarks Nationalbank. Fluctuations in interest rates have by no means been extraordinary. The same applies to 1-week CIBOR, except in the period around New Year, which reflected the increase in euro area interest rates often seen at the turn of the year^[5], cf. Chart 8.

A number of monetary-policy structures in Denmark have presumably helped to mitigate the impact. For example, the substantial market for mortgage-credit bonds means that the system as a whole has an ample supply of securities to pledge as collateral for loans from Danmarks Nationalbank. The structure of Danmarks Nationalbank's open market operations also enables banks to build up liquidity reserves in the form of certificates of deposit issued by Danmarks Nationalbank.^[6]

The extensive shortage of dollar liquidity was felt in the Danish market for currency swaps (and the forward foreign-exchange market), in which the price of borrowing dollars – and to a lesser extent euro – against kroner rose considerably during the period, and much more than immediately warranted by the spread between the uncollateralised reference interest rates.

In March 2008, the turmoil in the international financial markets spread to highly rated European mortgage-credit and government bonds. The yield spread between Danish mortgage-credit and government bonds also widened. However, this is not in itself likely to have had an impact on the demand for housing loans in Denmark.

Few indications of liquidity pressure in the Danish payment systems
A well-functioning financial system requires safe and efficient settlement of payments and securities transactions between financial institutions. This is only possible if the financial institutions trust their counterparties to have the necessary liquidity to meet their own payment obligations and those of their customers.

In 2007 and 2008 so far, financial institutions participating in the Danish payment and settlement systems did not overall experience problems in procuring liquidity to meet their payment obligations and effect payments. This circumstance is attributable to their large portfolios of bonds, notably mortgage-credit bonds, that can be pledged as collateral to Danmarks Nationalbank. In recent years the financial institutions' excess liquidity cover in connection with settlement of payments has, however, declined slightly.

MORE SUBDUED GROWTH IN THE DANISH ECONOMY

Growth in the Danish economy was high in 2007, but lower than during the strong upswing in the preceding years. The Danish economy is characterised by a tight labour market and rising wage growth. Supply-side limitations such as shortage of labour and pressure on the capital stock are the main reasons for the moderation in growth, which is expected to continue in the coming years, cf. Table 1.

The number of compulsory liquidations among Danish companies rose in 2007 to around the same level as in the period 2002-05, cf. Chart 9. The greatest increase is seen in building and construction, one of the most cyclically sensitive sectors of the economy, and one in which a dampening of growth is rapidly reflected.

In 2006, strong housing price increases made way for stagnating or falling prices. At the national level, prices of owner-occupied flats dropped, while prices of single-family and terraced houses remained more or less unchanged throughout 2007, cf. Chart 10. In the 1st quarter of 2008, the prices of single-family and terraced houses and owner-occupied flats all decreased. There are considerable regional differences in price developments. The slowdown in the housing market is also reflected in turnover in owner-occupied flats, which in 2007 was lower than in recent years. At the same time, the number of homes for sale is high, cf. Chart 10.

The development in the housing market should be seen against the background of the higher level of interest rates, as well as extensive building activity in recent years, whereby the stock of housing has increased. At the same time, there seems to be a change of sentiment in the housing market. Expectations of a sustained increase in prices have been replaced by expectations of stagnating or falling prices.

Unemployment is low, and Danish households generally have sound finances. The number of enforced sales rose slightly in 2007, but from a very low level.

The households' total debt to banks and mortgage-credit institutes grew at a faster pace than their disposable gross income in 2007, but the growth gap is narrowing. At end-2007 the households' total debt was 2.5 times higher than their disposable gross income. There are no general indications that the Danes have major problems in servicing their loans.

The households' exposure to large interest-rate increases fell in 2007 due to a higher share of fixed-rate loans and activated capped loans. On the other hand, more homeowners are choosing deferred-amortisation loans, so that they no longer have the buffer which the possibility of shifting to deferred amortisation provides.

FINANCIAL INSTITUTIONS – DECLINING BANK EARNINGS

Bank earnings in 2007 were influenced by the international financial turmoil. While earnings in the 1st half of 2007 rose, the 2nd half of the year was a turning point for many banks after several years with rising earnings. The total pre-tax profit for the largest 16 banks was kr. 31.8 billion in 2007, down by 8 per cent from 2006. Adjusted for Danske Bank's acquisition of Sampo Bank, the banks' total result declined by 14 per cent. Preliminary bank data indicates that this trend has continued into 2008.

The banks saw considerable valuation losses in 2007; particularly bond portfolios were adjusted downwards.

In 2007, the banks made larger new write-downs on loans than in previous years. On account of reversal of previous write-downs, this item made a positive net contribution to income in 2007.

The financing costs of the Danish banks have increased since the financial turmoil began in mid-2007. For the full year, the banks' net interest income grew by 17 per cent against the background of 12.8 per cent lending growth and 20.3 per cent growth in deposits. In 2008 so far, several banks have raised their interest rates in response to the higher financing costs.

The return on the banks' equity fell in 2007, cf. Chart 11. A lower profit ratio, combined with lower earnings in relation to the business volume measured as risk-weighted items, has contributed to a lower return on equity for banks in both group 1 and group 2.

Declining lending growth, but the deposit deficit is still large
The turmoil in the financial markets and the high financing costs have dampened the banks' expansion. Lending growth therefore declined in 2007, cf. Chart 12. The lower lending growth was most pronounced for the banks in group 1. Preliminary data for bank lending indicates that lending growth declined further in the 1st quarter of 2008.

The banks' deposit deficit has been increasing since early 2005. In 2007 the rate of increase was, however, far more subdued than in the preceding two years.^[7] Data for the 1st quarter of 2008 points to a moderate fall in the deposit deficit, cf. Chart 13.

OVERVIEW OF FINANCIAL INSTITUTIONS IN THE REPORT	Box 3
BANKS IN THE DANISH FINANCIAL SUPERVISORY AUTHORITY'S GROUPS 1 AND 2, MORTGAGE-CREDIT INSTITUTES, LIFE-INSURANCE COMPANIES, AND NORDIC GROUPS Note: Nordea Liv & Pension is part of the Nordea Bank AB group. Source: Financial statements.
The Danish financial sector is dominated by a few large groups whose activities and earnings cover various financial business areas. Banking is by far the largest and most important business area in relation to financial stability. Danish banks are sometimes parent companies, sometimes subsidiaries in groups comprising other financial enterprises too. Ownership and the chosen group structure affect the earnings and risk profiles of the individual banks. Typically, most of a group's excess capital adequacy is held by the parent company, from which it is easiest to channel the funds to any parts of the group that need further capital. Consequently, subsidiaries often have lower capital adequacy in relation to risks. On the other hand, an assessment of a parent company must take into account that its capital adequacy must to some extent also hedge unexpected losses to subsidiaries. Mortgage-credit institutions arrange loans for financing of real estate and in this capacity they are the largest bond issuers in Denmark. The development in the mortgage-credit institutes may have a direct impact on the banks via group structures and cooperation agreements or an indirect impact in that the mortgage-credit institutes compete with the banks in the home-financing market. Life-insurance companies manage considerable assets and can thus impact price formation in the financial markets. They, too, can have a direct impact on the banks via group structures. Mortgage-credit and life-insurance activities are undertaken by special institutions and subject to special rules aimed at mitigating risk. Asset management, including running investment associations, is assessed to be an area with limited risk for the banks and little impact on financial stability. The risk of investment losses as a result of changing market conditions is typically borne by the customer. The analyses in this report focus on banks in the Danish Financial Supervisory Authority's groups 1 and 2, comprising the largest 16 banks as well as the mortgage-credit institutes and life-insurance companies affiliated with the selected Danish banks, cf. the Table below. Selected items from the financial statements of a wider selection of banks are described in the chapter "The Banking Institutions' Financial Results". Danske Bank and Nordea Bank Danmark belong to large groups with activities in most of the Nordic region, the Baltics and a few other countries. In a group context, they are therefore compared with similar large Nordic banking groups. Banks comprised by the analysis account for 93 per cent of the balance-sheet total of the Danish banks and have a market share of 77 per cent of total bank lending in Denmark.

At end-2007, the deposit deficit accounted for 24 per cent of lending and 11 per cent of assets. Only one of the 16 banks had a deposit surplus, cf. Chart 14. The differences in deposit deficit among the banks not only reflect lending growth in recent years, they may also be attributable to different business models.

The banks in groups 1 and 2 finance their deposit deficits in different ways. In group 2, debt to other credit institutions is the preferred source of financing, while the group 1 banks rely more on bond issuance, cf. Chart 15. Group 2 has increased the maturity since 2006.

The banks' reserves were reduced in 2007
The banks' solvency and core capital ratios were reduced in 2007, cf. Chart 16. Part of the explanation for the pronounced reduction in group 1 is that Danske Bank's capital adequacy was extraordinarily high at end-2006 since the bank had issued new capital in the 2nd half of 2006 for the acquisition of Sampo Bank in Finland. Adjusted for this outlier, the solvency and core capital ratios in 2007 were reduced by around 1 percentage point compared with 2006. The relatively modest reduction in both ratios in group 2 reflects that most of these banks issued supplementary capital in 2007, and a few also issued share capital.

In 2007, new capital-adequacy rules, Basel II, entered into force with a transition period until 2010, after which the rules will be fully implemented. At end-2007 only two of the 16 banks in groups 1 and 2 had stated their solvency on the basis of Basel II, and the reported effect was a reduction of the capital requirement by kr. 2 billion. This should be seen in relation to an estimated aggregate capital requirement for groups 1 and 2 of kr. 192 billion at year-end.^[8]

In 2008, all banks must state their solvency in accordance with Basel II, and five – primarily large – banks expect their capital requirements to be reduced by a total of kr. 14 billion in 2008 and a further kr. 19 billion in the following years. Only one bank expects its capital requirement to increase under Basel II. Viewed in isolation, a total reduction of the capital requirement by kr. 34 billion is equivalent to an increase by 3 percentage points in the solvency ratio of the group 1 and 2 banks taken as one.

In recent years, Danish banks have made lower provisions, measured as a percentage of loans and guarantees, against losses that exceed earnings, cf. Chart 17. The reduced reserves have made the banks more exposed to rising losses. The reason for reducing the reserves could be that the banks see their exposures as less risky than previously. However, another reason is presumably the introduction of the International Financial Reporting Standards, IFRS, from 1 January 2005, and new capital-adequacy rules, Basel II, from 1 January 2007, whereby the reserve requirements have changed.

Under the previous accounting rules, the prudential principle applied, and provisions were broken down into A and B provisions. A provisions were for probable losses, while B provisions were for unavoidable losses.

A provisions could thus be included in the banks' reserves. Under IFRS, a neutrality principle applies, and provisions have been replaced by write-downs, which require an objective indication that the bank will lose money. Consequently, write-down takes place very close to the time of the actual loss, like the previous B provisions.

Under Basel I, all banks had to observe a statutory capital requirement of 8 per cent. Any capital adequacy beyond 8 per cent, i.e. excess capital adequacy, could thus be seen as a buffer against losses that exceeded earnings. Under Basel II, a new concept has been introduced, capital need. Banks must review their total risks and assess how much capital they need. This individual capital need should take into account factors such as deterioration of the credit quality of exposures, to the extent that this has not been done by means of write-downs. It is not a requirement that the capital need is published, but it must be reported to the Danish Financial Supervisory Authority, which may order the individual bank to raise its capital need if it finds that the bank has uncovered risks. The individual bank's capital requirement may thus exceed the statutory 8 per cent, and consequently not all capital in excess of 8 per cent can be included in the bank's capital buffers.

Interaction between IFRS and Basel II has made it more difficult for readers of the financial statements to assess the resilience of the banks. Previously, a steady increase in credit risk would be reflected in higher provisions, which in turn would reduce the bank's profit. If the bank's earnings were not sufficient, its capital adequacy would decrease. This development could be read from the financial statements. However, the requirement that there must be objective indications of losses before loans are written down means that expectations of rising future losses will now increase the capital need – not published in the financial statements. Thus, readers of the accounts may perceive an ailing bank as a sound business with relatively low write-downs, a positive bottom-line result and capital adequacy well in excess of the statutory 8 per cent. Nevertheless, the bank may have a hidden capital need that may in effect have consumed a large share of the excess capital adequacy and thus of the bank's reserves.

Danmarks Nationalbank finds it unfortunate that the EU has not been able to agree on a requirement to publish the capital need. In the opinion of Danmarks Nationalbank it would be an advantage for the banks to publish their own capital needs.

Lower earnings in mortgage-credit institutes, but still no losses
Following several years of rising earnings for the mortgage-credit institutes, the tide turned in 2007, and the profit was 12 per cent lower than in 2006. Lower capital gains than in 2006 contributed to reducing earnings in spite of growth in lending. The mortgage-credit institutes' earnings before tax in 2007, kr. 9,4 billion, are equivalent to a return on equity of 8.6 per cent p.a.

In line with the development in earnings, the resilience of the mortgage-credit institutes to higher losses fell in 2007, but remains considerable in relation to actual losses, cf. Chart 18.

Low market returns in the financial groups' life-insurance companies
Financial groups incur an investment risk by owning life-insurance companies. The size of this risk depends on the commitments of the life-insurance company in terms of future pension payments and the expected return on investment assets. From 1982 until mid-1994, life-insurance companies were entitled to guarantee pension savers an annual minimum return after tax of up to 4.5 per cent. In 1994, the limit was reduced to 2.5 per cent and in 1999 to 1.5 per cent.

It is seen from Chart 19 that in 2007 none of the companies under review achieved an investment return after taxation of pension yields that exceeded the 4.5 per cent guarantee.

This was the second consecutive year that the market return of the pension companies did not make it past the 4.5 per cent mark. In a short-term perspective this is not alarming, particularly since returns were generally high in both 2004 and 2005. However, over a somewhat longer horizon it is evident that if the return on investments does not improve, the investment activities of the life-insurance companies will not generate sufficient income to meet their commitments, and, being the owners, the financial groups will have to inject extra capital.

In spite of low returns on investments, two of the three life-insurance companies reviewed have decided to raise the rate of interest on policyholders' savings in 2008, i.e. the interest accruing to customer accounts and payments in 2008. If a life-insurance company achieves a lower return than the announced rate of interest on policyholders' savings, the company must transfer funds from the collective bonus potential, cf. Box 5.

The investment mix chosen by the individual pension company varies considerably, but all three companies primarily invest in bonds. None of them have large portfolios of credit bonds, which have generally been severely affected by the subprime crisis.

All three companies state that at end-2007 green light applied, as defined by the Danish Financial Supervisory Authority's risk scenarios.

Nordic groups
Danske Bank and Nordea are the largest banking groups in the Nordic region in terms of balance-sheet assets, cf. Chart 20. With the acquisition of Sampo Bank in the 1st half of 2007, Danske Bank further consolidated its position. In terms of the market value of outstanding shares at end-2007, Nordea is the larger of the two groups, with a value of kr. 221 billion, compared with Danske Bank's market value of kr. 137 billion.

The aggregate profit before tax for the Nordic groups was kr. 106 billion in 2007, equivalent to an increase by 8 per cent on 2006. Adjusted for Danske Bank's acquisition of Sampo Bank in 2007, the increase is 5 per cent. The groups' average return on equity was 24 per cent p.a., down from 25 per cent p.a. in 2006. Danske Bank had the lowest return in 2007, just over 19 per cent, cf. Chart 21. Among other things, this is attributable to integration costs in connection with the acquisition of Sampo Bank.

On a net basis, write-downs on loans was an income item for Nordea, while it was an expense item for the five other groups. 

Lending by the Nordic groups grew by an average of 14 per cent in 2007, which is in line with the preceding two years. The differences between the groups, cf. Chart 22, reflects factors such as varying volumes of repo transactions.

A breakdown of activities by geographical areas shows some differences between the Nordic groups. The Baltic customer segment constitutes a larger proportion in Swedbank and SEB than in the other Nordic banks. After several years' strong increase in growth, the Baltic economies are now overheated with high inflation in all three countries.

The development in the Nordic groups' capital adequacy is relatively stable, cf. Chart 23. Only Danske Bank registered a pronounced fall from end-2006 to 2007 on account of its acquisition of Sampo Bank in February 2007.

With the exception of Danske Bank, all the Nordic groups implemented parts of Basel II in 2007. Danske Bank has exercised the option provided by the transition rules to state its capital adequacy in 2007 in accordance with Basel I.

All groups have reported lower capital requirements in connection with the implementation of Basel II, cf. Chart 24. The greatest impact is seen for Handelsbanken, which will be able to reduce its capital requirement in kroner to 58 per cent of the requirement under Basel I. The reduction will be implemented gradually until 2010, and in accordance with the transition rules only 5 per cent was implemented in 2007.

The reductions vary on account of the groups' different choices of model and different business profiles. It should be emphasised that the assessment of a bank's risks by its management or by supervisory authorities may entail higher capital requirements by way of individual capital needs.