Summary

2008 and the 1st half of 2009 have been dominated by the international financial crisis. After a number of years with high profits, Danish banks have had to make large write-downs on loans, and several banks had negative earnings in 2008. The banks are faced with considerable challenges in terms of restoring confidence and making necessary adjust ments. The global economy is set to slow down further and credit risk is rising, so substantial write-downs can also be expected in the coming quarters. Stress tests of the largest 14 banks show that if the opportunities for capital injections under Bank Rescue Package II are exploited, these banks will be relatively robust.

Danmarks Nationalbank finds it positive that most large and medium-sized Danish banks have indicated that they will apply for government capital injections. Due to the economic uncertainty, the banks should carefully consider the option of being able to convert such capital injections into share capital. In an uncertain world it is an advantage for the banks to have extra buffers against any future losses.

The financial markets are slowly beginning to pick up
The turmoil in the financial markets culminated in the wake of Lehman Brothers' collapse in September 2008, when it became clear that extraordinary initiatives were needed in order to restore confidence in the financial system. Governments worldwide therefore introduced various measures to support the financial sector and mitigate the negative impact of the crisis on the real economy.

Recently the financial markets have begun to show positive signs. Stock markets have risen since early March 2009, and uncertainty in stock and interest-rate markets has been receding since the autumn of 2008, although it remains higher than previously.

The global economy has been severely hit, and what began as a financial crisis has developed into a global economic crisis. Forecasts for the global economy have been adjusted substantially downwards over the last year. The strength and pace of both the global and Danish economic slowdown have come as a surprise. Recent indicators do, however, point to stabilisation of the economy, although they are not unambiguous.

Danish banks severely affected by the crisis
In 2008, the Danish banks really felt the impact of the financial crisis, which severely affected earnings in the 2nd half of the year. The aggregate result for the sector was only just within the positive range. Increasing write-downs on loans and negative value adjustments more than offset a strong improvement in the banks' core earnings that was attributable to rising lending margins. In the 1st quarter of 2009, write-downs on loans fell, but remained appreciably higher than in recent years, cf. Chart 1.

QUARTERLY WRITE-DOWNS	Figur 1
Anm.: Group-level data is exclusive of Nordea Bank Danmark and Arbejdernes Landsbank. Kilde:Danish Financial Supervisory Authority and annual and quarterly financial statements.

The banks' lending growth fell strongly in 2008 and was negative in the 1st quarter of 2009.

Risk outlook
Economic developments are of paramount importance to the risks faced by the banks.

Several factors could lead to a further worsening of the very uncertain growth outlook for both the international and the Danish economy. A protracted decline in global trade, continued sharp drops in housing prices and renewed turmoil in the financial markets could all make the current macroeconomic downturn deeper and longer than expected.

Developments in the financial sector may also cause the macroeconomic outlook to deteriorate. Expectations of higher unemployment and a rise in the number of failing companies, as well as lower housing prices, reduce Danish banks' risk appetite. In other words, there is still a risk of a credit crunch, although the credit package (Bank Rescue Package II) has made this scenario less probable.

Calculations based on Danmarks Nationalbank's failure-rate model show higher estimated failure rates for Danish companies in all sectors. A number of companies posted negative earnings in 2008. Combined with higher indebtedness, this poses a substantial credit risk for Danish banks.

After having risen strongly for a long period, land prices began to fall in the 3rd quarter of 2008. The increases in recent years are not immediately attributable to changes in fundamental economic conditions within the agricultural sector, so there is a risk that land prices will plunge further. This could affect banks with particularly strong exposure to agriculture.

The financial crisis has put the liquidity and capital contingency planning of Danish banks under strong pressure. The Folketing (Danish parliament) has adopted Bank Rescue Package II, offering solvent credit institutions injections of new capital as an extra buffer against rising losses. The government guarantee on bank debt has been of paramount importance to the banks' access to liquidity and has thus helped to reduce their liquidity risks. These measures are temporary, and the banks should therefore prepare strategies for the time after discontinuation of the schemes.

The Danish mortgage-credit system is, and always has been, exposed to credit risk. Homes with a high mortgaging ratio are frequently financed by the most interest-rate-sensitive loans, often with deferred amortisation. Part of the explanation is that previously homeowners only had access to traditional loan types. Developments within mortgage credit mean that many homeowners are more vulnerable to rising interest rates or loss of income than they used to be. Moreover, on average homeowners with deferred-amortisation loans have a higher debt burden than those who have loans with amortisation, and there are considerable regional differences. In general, households in areas with the most pronounced increases – and subsequent falls – in property prices are most vulnerable.

Covered bonds (known as SDOs in Denmark) have introduced a new risk element, as credit institutions must restore the collateral behind the SDOs issued when house prices fall. The need for extra collateral will rise more than proportionally as house prices fall, since an increasing number of loans will require top-up collateral. Danmarks Nationalbank finds it important that these risks are addressed in the current evaluation of SDO legislation.

Stress test
The Danish economy is in recession, and a considerable slowdown in activity is expected in 2009. The negative economic development means that write-downs by banks will be higher than in recent years. The 14 banks analysed are, however, expected to be able to meet the statutory solvency requirements if they exploit the opportunity to receive capital injections under Bank Rescue Package II. This scenario is regarded as representative of the most probable development in the Danish economy and the financial sector (baseline scenario). In this scenario, unemployment reaches 6.3 per cent by the end of 2011, and the average loss ratio is 1.3 per cent in each of the three years of the scenario.

The resilience of the banking sector is tested in two stress scenarios:

1. Negative shock to the Danish economy: The banks tighten their credit policies compared with the baseline scenario, and pessimism becomes more widespread among households and in the corporate sector. In this scenario, unemployment reaches 9.6 per cent by the end of 2011, and the average loss ratio is 2.2 per cent in each of the three years of the scenario.
2. Long, deep recession: While Denmark is hit by a domestic shock, the financial crisis also leads to an international recession that is longer and deeper than expected. In this scenario, unemployment reaches 11.8 per cent by the end of 2011, and the average loss ratio is 2.9 per cent in each of the three years of the scenario.