Financial Institutions and Financial and Economic Developments

The financial markets have recently experienced a more positive development, but they continue to be affected by the financial crisis. It has had a severe impact on the global economy, and international and Danish macroeconomic conditions have deteriorated significantly. The pace and strength of the economic slowdown have come as a surprise.

The financial crisis had a strong effect on the earnings of the Danish banks in the last six months of 2008, their total earnings only just remaining positive. 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.

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

Crisis sentiment in the financial markets

The turmoil in the financial markets culminated in the wake of Lehman Brothers' collapse in September 2008 when it became clear that extraor-

dinary initiatives were needed in order to restore confidence in the financial system. Governments worldwide therefore introduced various measures to support the financial sector and to mitigate the negative impact of the crisis on the real economy.

Equity markets continued to decline in early 2009. When the markets bottomed out at the beginning of March, European and US financial stocks were traded at less than 20 per cent of their worth in early 2007, cf. Chart 2. From the beginning of March to end-May, stock indices in Europe and the USA increased by about 30 per cent.

DEVELOPMENT IN BENCHMARK STOCK INDICES AND BANK INDICES	Chart 2
Source: Bloomberg.

The increases by no means offset the total decline over the preceding eight months, however. On several occasions the global equity markets have reacted strongly to both rumours and actual measures to alleviate the financial crisis and its real-economic consequences. Besides, investors have had to consider the fact that governments have acquired substantial shareholdings in an increasing number of banks as a result of the recapitalisation packages launched by many countries, cf. Box 1.

Uncertainty in the financial markets remains high, but without the same sense of panic as in the autumn of 2008. In 2009, implied volatility indices for equities and interest rates fell back from the extremely high levels at the end of 2008 and are now comparable with previous periods of turmoil, cf. Chart 3.

implied volatility indices for equities and interest rates	Chart 3
Note: Volatility in equity prices is the volatility in US equities, CBOE, VIX. Interest-rate volatility is Merrill Lynch Option Volatility Index, MOVE. Source: Bloomberg.

The Danish money market

Conditions on the Danish money market deteriorated significantly during September and early October 2008. Due to the financial crisis, it was practically impossible for many banks to obtain anything other than very short-term financing. This is reflected in the considerable widening of the spread between collateralised and uncollateralised money-market lending that occurred over the summer and up to the adoption of the Financial Stability Act (Bank Rescue Package I, see Box 2), cf. Chart 4.

Costs and their distribution, Bank Rescue Package I	Box 2
On 5 October 2008, the Danish Contingency Association concluded an agreement on financial stability (Bank Rescue Package I) with the Danish government. Under the agreement, the government provides an unlimited guarantee to all depositors and other unsecured creditors, exclusive of covered bonds (SDOs). Overall, payments from the Danish Contingency Association under Bank Rescue Package I may constitute up to kr. 35 billion. This sum comprises a contingency fund of kr. 10 billion (own risk) to cover the losses of the Financial Stability Company (The Winding-Up company), a market-related guarantee commission to the Financial Stability Company of kr. 7.5 billion annually for two years and, if necessary, an increased guarantee commission of kr. 10 billion to cover further losses. The distribution of the banking institutions' payments under Bank Rescue Package I is determined by the Danish Contingency Association. The contribution from each banking institution is proportional to its share of the total base capital required for the activities comprised by the guarantee. Participation in the government guarantee under Bank Rescue Package I is voluntary, but the great majority of Danish banking institutions have joined the scheme. This is positive, since the default of a Danish banking institution could have widespread consequences for all Danish banking institutions if foreign institutions lose confidence in the sector. The effect of the government guarantee is evident from the banking institutions' financing costs. A selection of bond issues shows that the banking institutions pay a considerably low er price for issuance within than outside the government guarantee, cf. the Chart below.
Spread between bond and reference rates for selected Danish bonds
Note: The Chart shows secondary prices for bonds. The reference interest rate is CIBOR or EURIBOR. Source: Danske Markets.
As a consequence of the adoption of Bank Rescue Package II, cf. Box 3, the Danish Act on Financial Stability has been amended. The amendment enables supplementary purchase of an individual government guarantee for non-subordinated unsecured debt and for loans issued for financing top-up collateral for institutions issuing SDOs and SDROs as well as Danish Ship Finance A/S. The individual government guarantee runs for up to three years and comprises loans issued on 31 December 2010 at the latest. Applications for individual government guarantees must be submitted by 31 December 2010.
1 For further details, see Financial stability 2008, 2nd half.

Spread between collateralised and uncollateralised 3-month money-market interest rates	Chart 4
Source: Bloomberg.

In the autumn of 2008, uncertainty and increasing mistrust among the banks led to a significantly greater spread in very short-term interest rates with the day-to-day rate following Danmarks Nationalbank's official interest rates to a lesser extent than usual, cf. Chart 5.

Short-term money-market interest rates in Denmark, and daily turnover in the Danish day-to-day money market	Chart 5
Note: The day-to-day interest rate is a turnover-weighted Tomorrow/Next interest rate. Daily turnover is a 5-day moving average. Source: Danmarks Nationalbank.

Despite substantial fluctuations, the Danish money market has seen a significant reduction of the spread between uncollateralised and collateralised money-market interest rates in 2009 – from around 175 basis points in mid-January to around 100 basis points in late May, cf. Chart 5. Short-term money-market interest rates are again following Danmarks Nationalbank's official interest rates, and several banks are reporting easier access to liquidity. Nervousness in the market has decreased as a result of Bank Rescue Packages I and II, among other reasons, cf. Boxes 2 and 3, but market conditions remain far from normal. This is illustrated by the spread between collateralised and uncollateralised 3-month money-market interest rates in Denmark, which is still considerable despite the fact that uncollateralised loans are covered by the government guarantee until 30 September 2010.

As regards the development in the Danish money market compared with the development in the euro area, the narrowing of the spread between collateralised and uncollateralised money-market interest rates in Denmark has been slower and less smooth than in the euro area, cf. Chart 4. The Danish spread is almost twice as wide as in the euro area.

Apart from a few periods, the banks' daily turnover of uncollateralised day-to-day lending was stable in both 2008 and during 2009 to date and at more or less the same level as in 2007, cf. Chart 5. The banks generally reduced the volume of their money-market transactions, but due to the crisis the money market has seen a shift towards shorter-term loans.

The decline in money-market transactions has been offset by a significant increase in Danmarks Nationalbank's monetary-policy operations (sale of certificates of deposit and granting of monetary-policy loans), cf. Table 7 in the Appendix of Tables.

Nationalbankens kreditgivning

In order to ease the problems in the money market, Danmarks Nationalbank has introduced new temporary credit facilities several times since May 2008. This has led to a significant relaxation of Danmarks Nationalbank's extension of credit to banks and mortgage-credit institutes compared to the framework for credit operations that applied prior to the onset of the crisis, cf. Box 4.

The primary purpose of the new credit facilities is to prevent solvent banks from experiencing difficulties due to insufficient liquidity. This has been done by expanding the collateral base with securities that are not normally eligible as collateral for loans from Danmarks Nationalbank, and by offering uncollateralised credit where the credit line depends on the institutions' excess capital adequacy.

The expansion has also made it easier for banks to meet the statutory liquidity requirements.

Temporary credit facilities
Danmarks Nationalbank's framework for credit operations was adjusted for the first time in May 2008 when confidence among the institutions was still relatively high. The institutions had become reluctant to lend to each other, however, as they did not want to tie up liquidity in a money-market loan.

In view of this, Danmarks Nationalbank chose to approve a new type of securities, loan bills, as eligible collateral for loans. Every Friday, these securities, which must meet a number of standard terms, can be pledged as collateral for a 7-day loan from Danmarks Nationalbank. The rate of interest is Danmarks Nationalbank's lending rate plus a premium. The objective was to facilitate lending among the institutions. A banking institution can borrow by issuing a loan bill, and the institution buying the bill can raise liquidity by using it as collateral for a loan from Danmarks Nationalbank. As a result, the latter institution can also include the bill in its liquidity, cf. section 152 of the Danish Financial Business Act.

The loan bill scheme assumes that the banking institutions want to lend to each other. However, confidence among the banking institutions weak ened during the summer of 2008 as the scope of the problems in the financial sector became more apparent, and further measures were needed.

In September 2008, Danmarks Nationalbank introduced a new temporary credit facility. Banking institutions and mortgage-credit institutes were given access to borrow an amount depending on their excess capital adequacy, i.e. the difference between their base capital and capital need. The institutions must apply for this, and the governors of Danmarks Nationalbank decide whether to grant the loan. If an application is approved, the institution is granted a credit line equal to its excess capital adequacy less a margin of 1 per cent, but normally not more than kr. 800 million. Every Friday the institution can then borrow an amount within the credit line for seven days at the lending rate plus a premium. As is the case with the loan bills, the credit line can be included in the institution's liquidity.

Unlike the loan bill scheme, the solvency scheme is meant for loans raised directly from Danmarks Nationalbank. The purpose of the latter scheme is to prevent banking institutions with adequate capital from incurring liquidity problems as a result of insufficient assets that can be pledged as collateral to Danmarks Nationalbank. We have no knowledge of any similar schemes in other central banks.

In addition to the solvency scheme, Danmarks Nationalbank expanded the temporary collateral base with quoted shares, investment fund shares and loans issued for financing top-up collateral for covered bonds (known as SDOs in Denmark) and – on request and based on Danmarks Nationalbank's concrete assessment – unquoted shares.

The expansion to include unquoted shares enabled the banking institutions to pledge shares issued by their jointly owned companies, e.g. PBS Holding A/S and VP Securities A/S as collateral. Furthermore, when calculating their liquidity, the institutions can now include these shares in line with liquid securities.

In June 2009, Danmarks Nationalbank expanded the collateral base with bank bonds and loans issued for financing top-up collateral issued in connection with SDOs that are guaranteed by the Danish government. The expansion included both bonds covered by the general government guarantee introduced with Bank Rescue Package I in October 2008, and bonds with individual government guarantees, cf. the Act to Amend the Act on Financial Stability.

The expansion with government-guaranteed bank bonds was a natural ad just ment of the collateral base. Quoted shares in banking institutions were already eligible for lending. The expansion also aimed to promote interest in these bonds, thereby supporting long-term market-based loan financing.

The temporary credit facilities will run until 30 September 2010. The expansion of the collateral base with government-guaranteed bank bonds and loans issued for financing top-up collateral in connection with SDOs will apply until 31 December 2013, however.

Use of the credit facilities
The temporary credit facilities at Danmarks Nationalbank have been used only to a limited extent. This is mainly attributable to the government guarantee under Bank Rescue Package I which came into force in October 2008. As a result of that package, the banking institutions started lending to each other in the money market again, and the need to borrow from Danmarks Nationalbank has been modest.

At the end of April 2009, Danish banking institutions had issued loan bills to other institutions amounting to approximately kr. 6 billion. Similarly, credit lines based on excess capital adequacy totalling kr. 14 billion, distributed on 35 banking institutions, had been granted. No institutions have borrowed against loan bills or raised loans under the solvency scheme.

Use of the expanded collateral base has also been limited. At the end of April 2009, 18 Danish banking institutions and mortgage-credit institutes had pledged shares, etc. for approximately kr. 3 billion. While the majority were quoted shares, the institutions had pledged unquoted shares for approximately kr. 1 billion as collateral.

These figures concerning the use of the temporary collateral base should be seen in relation to a total value of assets pledged as collateral to Danmarks Nationalbank at the end of April 2009 of kr. 332 billion. The usual eligible assets thus continue to account for the vast majority of the assets pledged as collateral for loans from Danmarks Nationalbank.

Nevertheless, the temporary credit facilities have been of major importance for the liquidity of several banking institutions. Not least the solvency scheme, which has helped individual banking institutions to meet the liquidity requirements under section 152 of the Danish Financial Business Act.

In addition, the schemes may have contributed to capping the borrowing costs of some banking institutions. A banking institution that wants to borrow from another institution can refer to what it would cost to borrow the amount from Danmarks Nationalbank, e.g. via the solvency scheme. As a result, the institution will not normally borrow from another institution at a higher interest rate.

Use of the normal collateral base
The normal collateral base for loans from Danmarks Nationalbank consists predominately of Danish bonds of high credit quality. When calculating the collateral value, the bonds are divided into four liquidity categories depending on their negotiability. Chart 6 shows the distribution of the securities pledged on those categories.

Breakdown of collateralised bonds by liquidity categories	Chart 6
Note:The principles for breakdown of bonds pledged as collateral by liquidity categories can be found at www.nationalbanken.dk under Rules/Pledging of collateral. Source: Danmarks Nationalbank.

Banking institutions and mortgage-credit institutes pledge government securities (liquidity category I) as collateral only to a limited extent. At the end of April 2009, the institutions had pledged government securities for only approximately kr. 10 billion as collateral. Instead, the institutions mainly provided mortgage-credit bonds and SDOs as collateral (liquidity categories II and III). This distribution primarily reflects that liquid government securities are more acceptable in the private lending market than mortgage-credit bonds and SDOs. The banking institutions and mortgage-credit institutes therefore prefer to reserve their government securities for the private lending market and to pledge their less liquid mortgage-credit securities as collateral to Danmarks Nationalbank.

The international economy

The global economic recession has intensified over the last year, and the world economy is experiencing its worst post-war setback.

The crisis has had a severe effect. Considerable loss of wealth as a result of falling stock indices and housing prices has reduced consumer and business confidence, leading to a general slowdown in demand. Households and the corporate sector are finding it more difficult to obtain credit, which exacerbates the setback. In addition, unemployment is rising rapidly around the globe.

The global economic slowdown is reflected e.g. in a large decrease in industrial production and international trade in 2008, but in the spring of 2009 there have been certain indications of a stabilisation. The economic development remains a matter of considerable uncertainty, however

The Danish economy

The Danish economy had been slowing down for some time, but even more so in the latter part of 2008. GDP fell by 1.1 per cent in 2008, so that growth was negative for the first time in 15 years. In Denmark, too, there are indications that the economy is stabilising, but the development is not unequivocal and uncertainty remains high.

Both domestic and – as a result of the global economic slowdown – foreign demand for Danish products have declined. Private consumption shows a downward trend although real disposable incomes have risen considerably. The decline in private consumption should be viewed in the light of negative consumer expectations and decreasing wealth, including home equity, due to falling housing prices and stock indices.

An increasing number of enterprises are having difficulties coping with the downturn, resulting in a rise in the number of failures. The last months have seen the highest number of compulsory liquidations since the statistics were published for the first time in 1979, cf. Chart 7. The economic slowdown has also had a severe impact on the labour market with unemployment rising by more than 30,000 person in the first four month of 2009 alone.

Compulsory liquidations in the non-financial sector and enforced sales	chart 7
Note: The Chart shows seasonally adjusted monthly data for the number of compulsory liquidations. Enforced sales have not been seasonally adjusted. Source: Statistics Denmark.

The housing market and enforced sales
House prices fell during 2008 and into 2009. At the national level, cash prices of single-family and terraced houses have declined by 12 per cent since the peak in the 2nd quarter of 2007, cf. Chart 8. Prices in the Copenhagen area have tumbled by approximately 25 per cent during the same period, while the trend has been more moderate for the rest of Denmark overall. The prices of owner-occupied flats have fallen by even more than those of single-family and terraced houses. In general, the areas most severely affected are those where the rate of price increase was most rapid prior to the reversal, and where the price per square metre is highest.

Housing prices and homes for sale	chart 8
Sourcee: Association of Danish Mortgage Banks and Danish Association of Chartered Estate Agents, www.boligsiden.dk.

The number of owner-occupied homes for sale remains high, and sales for the 1st quarter of 2009 were at the lowest level since the statistics began in 1995. The total number of homes for sale masks different development trends for different parts of the market. Since mid-2007, the number of owner-occupied flats for sale has fallen by 30 per cent, while the supply of single-family and terraced houses has increased by 36 per cent. This may indicate that the price adjustment process for owner-occupied flats may be complete, while the prices of single-family and terraced houses are likely to decrease further. A major factor behind the housing market situation is expectations of further price drops.

The negative trend in the housing market is also reflected in the increasing number of enforced sales, cf. Chart 7. The level remains low in a long-term perspective, however, which should be viewed in the light of a sustained low rate of unemployment.

The financial institutions

Strong decline in bank earnings in 2008
The financial crisis really impacted on the banks' earnings in 2008, especially in the 4th quarter. The total profits of banks in groups 1 and 2 fell from kr. 31.3 billion in 2007 to kr. 0.4 billion in 2008 (see Box 5 for a description of the groups). The lower earnings in 2008 are mainly attributable to write-downs on loans amounting to kr. 19 billion, corresponding to a weighted write-down ratio of 0.8. Capital losses of kr. 5 billion, the majority on equities, also contributed to the decrease in earnings. On the other hand, net interest income increased by kr. 10 billion due to higher lending margins and increased lending.

Write-downs on loans accelerated throughout 2008. In the 4th quarter alone, write-downs on loans amounted to kr. 14 billion, equivalent to a weighted write-down ratio of 0.6 in that quarter for the banks in groups 1 and 2 overall. In group 2 alone, the average weighted write-down ratio was 1.2 in the 4th quarter of 2008. Several banks reported that the write-downs primarily concerned loans to financial institutions and corporate customers, while the write-downs on private customers remained limited. The write-down ratio was reduced for both groups in the 1st quarter of 2009, cf. Chart 9.

Quarterly Write-downs	Chart 9
Note: Group-level data is exclusive of Nordea Bank Danmark and Arbejdernes Landsbank. Source: Danish Financial Supervisory Authority and annual and quarterly financial statements.

In 2008, the return on equity before tax for the banks in groups 1 and 2 fell to 2.2 per cent and -11.9 per cent, respectively, against 18.3 per cent and 18.0 per cent in 2007, cf. Chart 10. Increased write-downs on loans were the major reason for this. The average return on equity after tax at the end of 2008 was 1.9 per cent for group 1 and 8.8 per cent for group 2.

Return on equity before tax	chart 10
Note: Return is calculated on the basis of an average of equity and the beginning and end of the year. Source: Financial statements.

The financial statements published for the 1st quarter of 2009 show improved earnings capacity compared with the 4th quarter of 2008. The improvement is mainly attributable to fewer write-downs and positive value adjustments.

The recent decline in earnings, tight liquidity conditions, etc. have contributed to a growing number of banks being subject to winding-up, mergers or acquisitions, cf. Box 6. Strong lending growth and considerable exposure to the property sector are among the characteristics of the banks that experience difficulties.

Reclassification of financial assets
With the European Commission's adoption of amendments to the International Financial Reporting Standards on 15 October 2008, banking institutions are now able to reclassify financial assets in rare cases. Reclassification entails that unrealised value adjustments on the assets in question will no longer affect the income statement. Depending on the category to which the asset is reclassified, the unrealised value adjustments will be entered as equity capital or just appear from the notes to the financial statement. For a further description of the various categories, see Box 4 "Reclassification of assets" in Financial Stability 2008, 2nd half.

A few Danish banking institutions chose to make use of this opportunity, thus considerably improving their earnings in 2008.

The argument for reclassification has been to remove part of the financial asset volatility from the income statement. It is worth noting, however, that the quality of the banking institutions' financial assets and thus the risk on individual assets did not change as a result of the reclassification. The reclassification option made it more difficult to compare the banking institutions' profits and return on equity as not all institutions have chosen to make use of it. Moreover, the institutions that did, chose to reclassify the financial assets to different categories with varying effects on their equity capital.

Reduced growth in lending
The decline in the banks' growth in lending in 2007 continued in 2008. Compared to the peak in 2005, the growth in lending for banks in both group 1 and group 2 decreased by more than 20 percentage points up to 2008, cf. Chart 11.

Growth in lending	chart 11
Note: Adjusted for the effect of the recognition of Danske Bank's banking activities in the Baltic states as branches, Sydbank's acquisition of Bank Trelleborg, Nordea Bank Danmark's, Spar Nord Bank's and Arbejdernes Landsbank's acquisition of branches of Roskilde Bank, Nykredit Bank's acquisition of SEB's Hellerup branch and the merger of Vestjysk Bank and Ringkjøbing Bank. Growth in lending is calculated at year-end, i.e. growth in lending in 2008 is calculated as lending as at 31. December 2008 divided by lending as at 31 December 2007. Source: Financial statements.

Adjusted for large acquisitions and take-overs, almost half of the banks saw negative lending growth in 2008. Only three banks experienced lending growth of more than 10 per cent, in one case primarily caused by growth in repo transactions.

The banks' financial statements showed negative lending growth for banks in groups 1 and 2 in the 1st quarter of 2009 compared with end-2008. The development in lending also reflects the banks' deposit deficits, which decreased in the 1st quarter, cf. Chart 12.

Deposit surplus (deposits less lending)	chart 12
Source: Danmarks Nationalbank.

The weaker lending growth is in line with the credit managers' reports in connection with Danmarks Nationalbank's new lending survey, cf. Box 7. According to the survey, the banks will tighten their credit policies even further in the current quarter.

Box 8 compares the development in a number of key parameters for the banking sector as a whole in 2008 with the period up to the onset of the crisis and with the period from 1991 to 2008. The comparison shows that the banks' lending growth was significantly higher up to the onset of the crisis than in the period from 1991 to 2008. In 2008, lending growth fell to below the average for 1991-2008.

DEvelopment in selected key parameters for the Danish banking sector	Box 8
The Chart below shows selected key parameters for the Danish banking sector in the period 1991-2008 and 2005-07 and in 2008. Prior to the financial crisis, the Danish banking sector was characterised by a rising ratio of lending to deposits and increasing lending gearing, measured as the ratio of lending to equity capital, cf. the Chart below. Compared with the average for the growth years 2005-07, the banks reduced their lending growth considerably in 2008. However, the sector average masks considerable differences between the banks in the population. Lending growth has also been reduced when compared with the average for the period 1991-2008. The exposure to the property market, measured as lending to the property market as a percentage to total loans and guarantees was reduced in 2008 and is now in line with the average for the period 1991-2008. Total large exposures as a percentage of base capital was reduced in 2008 compared with the average for the other two periods; this indicates a declining concentration risk. Excess capital adequacy, measured as the difference between the base capital and the minimum capital requirement as a percentage of loans and guarantees, rose slightly in 2008 compared with the average for the other two periods. This calculation does not take into account the individual capital need, which exceeds 8 per cent for a number of banks, cf. the section on the banks' solvency. In summary, the Chart shows that in 2008 several key parameters for the banks were brought more in line with the average for the period 1991-2008.
Development in selected key ratios for the Danish banking sector
Note: The population is 47 banks from the Danish Financial Supervisory Authority's groups 1-3. Lending gearing is lending as a ratio of equity capital. Large exposures correspond to the Danish Financial Supervisory Authority's key ratio by the same name. The sector average for large exposures is for the period 2003-08 rather than 1991-2008. Lending growth is the average annual growth rate. Property loans are defined as loans and guarantees to the building and construction sector and property administration, etc. The excess capital adequacy is the excess cover as a percentage of loans and guarantees, and the sector average is for 1993-2008 rather than 1991-2008. Source: Financial statements and own calculations.

In addition to deposits, the banks in group 1 primarily rely on issuance of debt securities with maturities of more than one year for financing, cf. Chart 13. The share of debt securities issued with maturities of less than one year has increased since September 2008, while debt to other credit institutions has fallen.

Net debt to other credit institutions, and debt securities issued	chart 13
Note: Exclusive of foreign branches and subsidiaries. Source: Danmarks Nationalbank, MFI statistics.

The source of financing for group 2 banks has changed over the last year to the effect that they are now relying more on issuance of debt securities and less on debt to credit institutions. Nevertheless, short-term debt to other credit institutions still remains the primary source of financing in group 2.

Amended rules drive the increase in the banks' solvency ratio
For most Danish banks, the transition to the new capital-adequacy rules (Basel II) in early 2008 meant reduced capital requirements in Danish kroner due. This is because Danish banks are primarily exposed to retail customers and small and medium-sized enterprises, which are given lower risk weights in the new risk calculation. Institutions using the IRB (Internal Ratings-Based) approach to calculating credit risks, of which most are found in group 1, experienced the largest reduction in risk-weighted items.¹ This explains the strong increase in the solvency and Tier 1 ratios of the group 1 banks in 2008, cf. Chart 14. The fact that the solvency and Tier 1 ratios are higher in 2008 than in previous years thus reflects primarily the decrease in the risk-weighted assets due to a changed calculation method and not that the banks have obtained more capital. The lower solvency and Tier 1 ratios in 2008 for medium-sized banks in group 2 are mainly attributable to a single institution with a very strong increase in repo lending and thus risk-weighted assets.

solvency and tier 1 ratios	chart 14
Note: The estimated capital injections are based on preliminary announcements in the banks' financial statements and in the press, i.e. only banks that have explicitly stated that they will apply for capital have been included. Capital injections cover banks only, not affiliated mortgage-credit institutes. Capital will be injected in 2009, but is shown in the Chart for 2008. Source: Financial statements.

A further reduction of risk-weighted items for the IRB institutions occurred at the turn of the year 2008/09 when the transitional arrangement, under which these institutions are subject to a higher capital requirement for a transition period, was reduced.² The new capital-adequacy rules will not be fully implemented until 2010. The purpose of the transitional arrangement has been to prevent a large one-off decrease in the banks' capital requirements.

The injections of hybrid core capital via Bank Rescue Package II will strengthen the banks' capital position. In the financial statements from the 1st quarter of 2009 and subsequent press releases, most banks in the population have indicated the capital injection they will apply for. If the capital had been injected at the end of 2008, the solvency and Tier 1 ratios would be 2.2 percentage points higher for group 1 banks and 3.6 percentage points higher for group 2 banks, corresponding to a total capital injection of just over kr. 40 billion.³ The deadline for applications is 30 June 2009.

The banks' buffers
The difference between a bank's actual capital and its capital requirement constitutes the excess capital adequacy or buffer available to cover negative earnings, including losses on loans. A bank's actual capital is reflected in the solvency ratio, while the capital requirement is expressed by the individual capital need (minimum 8 per cent of the risk-weighted items). The capital need reflects the bank's assessment of the capital required to cover its total risks. Among other factors, this individually calculated capital need should take into account any deterioration in the credit quality of exposures that are not included in the write-downs. Consequently, as it is based on a number of estimates and assessments made by the management of the institution, the calculation cannot be made unequivocally.

In the 2008 financial statements very few banks published their individual capital needs. The adoption of Bank Rescue Package II empowered the Danish Financial Supervisory Authority to lay down more detailed rules on disclosure of the banking institutions' and mortgage-credit institutes' individual capital needs and any higher solvency requirement stipulated by the Danish Financial Supervisory Authority. The institutions will therefore be required to disclose information about their individual capital need.

The development in the banks' excess capital adequacy/buffer depends on the size of the individual capital need and the effect of the transitional arrangement, cf. Chart 15. According to the Danish Financial Supervisory Authority, the excess capital adequacy of the banking institutions is 3 per cent of loans and guarantees.⁴ This means, cf. Chart 15, that the average individual capital need is close to 10 per cent, and that the banking sector has become more vulnerable to losses over the past year. These aggregate figures mask considerable dispersion across the sector.

Development in bank buffers	chart 15
Note: Up to and including 2004, provisions were split into 'A' and 'B' provisions, the former being assumed to have a certain buffer effect. This buffer effect does not exist in write-downs under IFRS. The Chart is based on all banks in the Danish Financial Supervisory Authority's groups 1-3. Source: Danish Financial Supervisory Authority and financial statements.

If the banks' excess capital adequacy at a 10-per-cent capital need were to be increased to 4.3 per cent of loans and guarantees, which is the level at a capital need of 8 per cent, the banks, other things being equal, would have to reduce their total loans and guarantees by just under one third.

It should be noted that the above calculations do not take into account the fact that the supplementary capital must not be included at more than 100 per cent of the Tier 1 capital, and the buffer at a low level of Tier 1 compared to the capital base may consequently be eroded more quickly than in the calculation, cf. Box 16 in the chapter on the banks' resilience.

In 2008, accumulated write-downs rose to 1.6 per cent of loans and guarantees, which is the highest level since the introduction of the new accounting rules.

The existing capital-adequacy rules have been criticised for being procyclical. During an upswing, when the risk is considered to be limited, the capital requirement will tend to fall. This allows the banks to increase their lending. On the other hand, lending will decrease and the capital requirement increase during economic downturns, when the risk is considered to be high. This means that the new capital-adequacy rules (Basel II) reinforce cyclical developments and have a negative impact on financial stability.

Limiting procyclicality is one of the central aims of a number of initiatives launched in response to the crisis (for a review of international initiatives as a result of the crisis, see Box 9).

Sensitivity analysis – reduced resilience in 2008
A static sensitivity analysis, based on the banks' earnings and capital structure, shows that their resilience was reduced from 2007 to 2008, cf. Chart 16. At the baseline – the banks' actual financial result before sensitivity analysis – 7 out of 14 banks had deficits in 2008, whereas all banks posted profits in 2007.

Sensitivity analysis	chart 16
Note: The banks have been listed in random order. Losses on lending in the sector have been distributed on the individual banks in proportion to their credit-risk measures. Source:Financial statements and own calculations.

It appears that, other things being equal, only one bank's earnings in 2008 would have been sufficient to cover rising financing costs on loans of 1.5 percentage points. In 2007, 10 banks would have been able to cope with a similar scenario.

A loss corresponding to 10 per cent of the sum of large exposures would have resulted in deficits in 10 banks in 2008 (against six in 2007), and in two cases the base capital would have fallen below the capital requirement. A similar trend is seen in relation to losses on loans in general. None of the banks' earnings in 2008 were sufficient to cover a general increase in losses on loans of 1 percentage point in the sector, and three banks would have had solvency problems, compared with one in 2007.

Mortgage-credit institutes – increased write-downs and increasing arrears ratios

The mortgage-credit institutes' total earnings in 2008 amounted to kr. 2.2 billion before tax, corresponding to a return on equity of 2 per cent p.a. Compared with 2007, profits decreased by 76 per cent. The development was driven by one institution with a significantly poorer result in 2008 than in 2007. The results of the remaining mortgage-credit institutes improved by approximately 10 per cent in 2008. Net income from interest increased by almost 10 per cent in 2008. This includes both increasing contributions and rising interest income from mortgage-credit loans.

In total, the four mortgage-credit institutes had to write down kr. 841 million on loans in 2008. In comparison, they reversed losses and write-downs of kr. 65 million in 2007. Individual mortgage-credit institutes' write-down ratios were between 0.01 per cent and 0.06 per cent of their total mortgage-credit lending in 2008. The four institutions analysed all reported increasing arrears ratios in 2008, but this was from a very low level compared to previous years.

Portfolio earnings affected the mortgage-credit institutes' results in different ways. Two of them had positive portfolio earnings, while the other two recorded losses on that item in 2008.

On the balance-sheet side, the total amount of outstanding mortgage-credit loans in the four institutions increased by 8 per cent compared with 2007, to kr. 1,832 billion.

Chart 17 shows the development in the mortgage-credit institutes' buffers against losses. Like the banks, cf. page 33, a limit has also been imposed on the mortgage-credit institutes as regards the decrease in their capital requirement in connection with the transition to Basel II, the so-called transitional arrangement. Chart 17 illustrates the effect of the transitional arrangement, using the Danish Financial Supervisory Authority's calculations.⁵The transitional arrangement accounts for more than half of the credit institutions' buffer in 2008, which indicates that they became more vulnerable to losses from 2007 to 2008.

mortgage-credit institutes' buffers against losses	chart 17
Note: Maximum losses are calculated including actual losses and write-downs. The population changes from 2004 onwards. From 2004, the population comprises Nordea Kredit, Nykredit Realkredit, Realkredit Danmark and Totalkredit. Previously it also included BRFkredit, DLR Kredit, LR Realkredit and FIH Realkredit. The shaded area has been estimated on the basis of data from the Danish Financial Supervisory Authority, covering all eight mortgage-credit institutes. Source:Financial statements and Danish Financial Supervisory Authority.

Life insurance companies' reserves heavily reduced

The financial groups' life insurance companies (hereafter called the life insurance companies) have had low or negative returns in 2008, cf. Chart 18. This was the third consecutive year that the return on investments was lower than the interest-rate guarantees associated with a large part of the companies' commitments and the rate of interest on policyholders' savings announced by the companies at the beginning of 2008.⁶ Consequently, the life insurance companies have not been able to recognise risk compensation as revenue, and the amount has therefore been transferred to shadow accounts, see Box 10. According to the Danish Executive Order on the Contribution Principle, subsequent disbursements from such shadow accounts are conditional on the re-establishment of the companies' "bonus potential in respect of paid-up policies".

Return after pension-yield tax in the financial groups' life insurance companies	chart 18
Source: Financial statements.

The negative development in the financial markets and the resulting low returns on investment led to a considerable reduction of the life insurance companies' reserves. The life insurance companies have had to make inroads into their collective bonus reserves and bonus potential in respect of paid-up policies in order to honour the announced rates of interest on policyholders' savings. The life insurance companies' collective bonus reserves are more or less gone, cf. Table 1, and one company has received a capital injection from the parent company to ensure its continued capital strength and flexibility.

On 31 October 2008, the Danish Insurance Association entered into a stability agreement with the Ministry of Economic and Business Affairs, entailing, among other things, a new method of calculating the yield curve used to discount provisions. This led to a reduction of the current value of about 0.5 per cent of the life insurance companies' provisions. In principle, this is not a major change. It should be noted, however, that no matter how the current value of future liabilities is calculated technically, this does not change the fact that the pension companies' current income over a number of years must be sufficient to enable the companies to fulfil the promises they have made to their customers.

The life insurance companies have generally reduced their equity portfolios in 2008, and highly-rated bonds constitute the largest share of the investment assets, cf. Chart 19. Nonetheless, exposure of the base capital to share price risk⁷increased from end-2007 to end-2008 in all three companies. Generally, the companies' reserves have been reduced, thereby increasing base capital-related risks. This means that owning a life insurance company has become more of a risk for the financial institutions. The probability of the financial groups having to inject new capital into the life insurance companies is assessed to have increased.

Breakdown of investment assets	chart 19
Source: Financial statements.

All three companies have reduced their rate of interest on policyholders' savings for 2009. This is the first step towards restoring the companies' reserves. This is a precondition if the financial groups are once again to obtain a return on the capital invested in the life insurance companies and reduce the owners' risks.

For all three companies green light applied at end-2008, as defined by the Danish Financial Supervisory Authority's risk scenarios. The yellow risk scenario was abolished by the Danish Financial Supervisory Authority in connection with the agreement of 31 October 2008⁸. However, according to the three life insurance companies' financial statements they all observed the yellow scenario throughout 2008. The yellow scenario is tougher than the red as it implies providing earlier warnings about problems than the red scenario.

Nordic groups

Danske Bank and Nordea are the largest banking groups in the Nordic region in terms of balance-sheet assets, cf. Chart 20. The total assets of Nordea and DnB NOR increased by more than 20 per cent in 2008, while Danske Bank and SEB experienced the lowest growth at 6 and 7 per cent, respectively. In terms of the market value of outstanding shares at end-2008, Nordea is the largest group, with a value of kr. 97 billion, compared to 36 billion for Danske Bank.

Balance-sheet totals, Nordic banking groups	chart 20
Note: On translation into Danish kroner, the exchange rate at end-2008 has been applied for all years. Source: Financial statements.

Earnings in the Nordic groups in 2008 were in line with the global development. Profit for the year and return on equity fell significantly compared to 2007, cf. Chart 21. Net interest income generally increased due to higher lending margins and sustained growth in lending, whereas net fee income was reduced due to lower investment activity and a weak stock market. Reduced valuation adjustments further contributed to the decline in earnings. Write-downs on loans increased significantly, and several groups had to make extraordinarily large write-downs on goodwill relating to activities in countries that are particularly severely affected by the economic slowdown. Cases in point are Danske Bank's activities in Ireland and Swedbank's activities in Ukraine.

Return on equity before tax, Nordic groups	chart 21
Note: Return on equity is calculated in the local currency on the basis of an average of equity, beginning of period, and equity, end of period. The return on equity for the 1st quarter of 2009 has been annualised. Source: Annual and quarterly financial statements.

The financial statements for the 1st quarter of 2009 indicate that the development continues, with increasing net interest income, but also substantial write-downs on loans and further write-downs of goodwill in Swedbank and SEB on activities in Ukraine.

The development in return on equity in all six groups was adversely affected by the decline in earnings in 2008. The return on equity in 2008 and in the 1st half of 2009 is positively affected by the groups' reclassification of financial assets in accordance with the new accounting rules that were implemented in the autumn of 2008.

Write-downs on loans in Danske Bank increased significantly in the 4th quarter of 2008 while the other Nordic groups were still at a relatively modest level, cf. Chart 22. Write-downs in the Nordic groups in the 4th quarter of 2008 were primarily related to financial institutions and corporate customers. In the 1st quarter of 2009, write-downs on loans increased further, and the spread in the groups' write-down ratios became more apparent. Swedbank's write-down ratio amounted to more than 2 per cent p.a., mainly related to the Baltic States.

Write-downs for the year	chart 22
Note: Write-down ratios calculated as write-downs for the year as a percentage of loans and guarantees before write-downs. The write-down ratios for the 1st quarter of 2009 have been annualised. Source: Annual and quarterly financial statements.

The accumulated write-down ratio (the corrective account) also varies greatly among the Nordic groups, cf. Chart 23. In the period from 2005 to 2007, Danske Bank was among the groups with the lowest sum of accumulated write-downs. Following substantial write-downs in 2008 and in the 1st quarter of 2009, Danske Bank had the highest write-down ratio on its loans. Handelsbanken's write-downs remain at a very low level. Factors such as the loan distribution on sectors and the value of assets pledged as collateral determine the credit quality of the lending portfolio, and certain geographical areas are more severely affected by the economic downturn than others.

Accumulated write-downs	chart 23
Note: Calculated as the sum of accumulated write-downs on loans and provisions for losses on guarantees as a percentage of loans and guarantees without write-downs and provisions. Source: Annual and quarterly financial statements.

More than 10 per cent of Danske Bank's lending activities are in Ireland and the UK, cf. Chart 24. In both these countries, the economic setback was particularly severe in the early stages of the international downturn. Denmark was also affected by the economic decline earlier than the other Nordic countries. Several of the other Nordic groups have a higher exposure to countries that were affected later by the setback. SEB and particularly Swedbank have relatively large exposures to the Baltic States, however.

Geographical distribution of credit exposures, end-2008	chart 24
Note: SEB's share of lending to Ukraine is not specified in the financial statements. Source: Financial statements.

The global financial crisis has made it extremely difficult for many banks to gain access to new capital, and in anticipation of increased losses in the banks, the focus of the market, including rating agencies, is now on the banks' capital adequacy and the quality thereof. The Nordic groups, with the exception of DnB NOR, have all raised or had injections of new Tier 1 capital since the 4th quarter of 2008, and the Tier 1 capital of the groups concerned has increased significantly, cf. Chart 25.

Development in solvency ratio broken down by Tier 1, hybrid core and supplementary capital	chart 25
Note: Capital adequacy at the end of the 1st quarter of 2009 includes the financial result for the period. For DnB Nor only half of the financial result is included. The "new capital" bar comprises capital adequacy at end-March 2009 plus new capital injections announced but not included in the quarterly financial statements. Calculated on the basis of risk-weighted items in accordance with Basel II, i.e. excluding the transitional arrangement. Source: Annual and quarterly financial statements.

In May 2009, the Danske Bank group received capital injections of kr. 26 billion from the Danish government under Bank Rescue Package II (kr. 24 billion to Danske Bank and kr. 2 billion to Realkredit Danmark). The capital injections were in the form of hybrid core capital and improved the group's Tier 1 ratio from 9.0 to 11.7 per cent. Danske Bank can convert part of the hybrid capital to share capital if its hybrid core capital exceeds 35 per cent of its total Tier 1 capital. If the hybrid core capital exceeds 50 per cent of its total Tier 1 capital, Danske Bank is obliged to convert part of the capital injections to share capital.⁹

In April 2009, Nordea launched a share issue providing net proceeds of 2.5 billion euro and bringing the group's Tier 1 ratio to 12.4 per cent.

SEB also issued new shares in the 1st quarter of 2009, the proceeds of which amounted to 14.9 billion Swedish kronor within the accounting period and another 212 million after closing of the quarterly accounts. SEB's Tier 1 ratio then amounted to 12 per cent.

Handelsbanken issued new hybrid core capital in both the 4th quarter of 2008 and the 1st quarter of 2009 of 2.6 and 2.7 billion Swedish kronor, respectively, bringing the group's Tier 1 ratio to 11.6 per cent at the end of the 1st quarter of 2009.

Swedbank launched preference share issues in December 2008 and January 2009, the proceeds of which amounted to 12 billion Swedish kronor. The group's Tier 1 ratio at the end of the 1st quarter of 2009 amounted to 10.8 per cent.

DnB NOR differs from the other Nordic groups in that its Tier 1 ratio was 7.0 per cent at the end of the 1st quarter of 2009. Despite having the lowest capital requirement as a ratio of the risk-weighted items, the group's excess capital adequacy is still the lowest. The Nordic groups have not published their individual capital needs, and the capital requirement is therefore calculated as minimum 8 per cent of the risk-weighted items with the addition of any capital requirement in relation to the transitional arrangement for IRB implementation under Basel II.