Risk Management

Operational risk

Cash supply
In both 2007 and 2008 there were large-scale robberies against the cash supply system in Denmark. This prompted Danmarks Nationalbank to contact the National Police in 2008 to discuss the security of the cash supply system, and the police decided to inspect all cash centres. The recommendations of the police resulted in measures to tighten security at the cash centres and also in a set of general security recommendations for cash centres. These have been provided to the relevant industry associations and all players in the cash supply system.

The recommendations of the police will be considered by the working group established in 2008 by Danmarks Nationalbank jointly with the Danish Bankers Association. The working group is to examine various models for the future set-up of the Danish cash handling system.

Danmarks Nationalbank's own security conditions are reviewed on an ongoing basis. Besides the review following the recommendations of the National Police, a special focus area in 2008 was security at The Royal Mint.

Business continuity
In all of Danmarks Nationalbank's business areas, 2008 saw a review of the plans for business continuity in the event of various major incidents such as extensive fire in a building. This revealed a need for a few improvements to the IT infrastructure, to be implemented in connection with the upcoming IT investments in the relevant areas.

Insurance strategy
Danmarks Nationalbank's insurance policies are reviewed on an annual basis in collaboration with an external insurance agent. No major changes were made to the insurance strategy in 2008.

Financial risk

Danmarks Nationalbank is exposed to a number of financial risks. Some of them arise from its role as monetary authority and are thus unavoidable, while others reflect how Danmarks Nationalbank, in its capacity as a financial enterprise, weighs risk and reward. Danmarks Nationalbank is primarily exposed to market risks such as interest-rate, gold and foreign-exchange risks. In addition, it is exposed to liquidity and credit risk.

The risk environment changed significantly in 2008 compared with previous years. As described above, the financial markets were characterised by considerable uncertainty and nervousness, especially in the 2nd half of the year. This entailed a strong increase in market volatility, and Danmarks Nationalbank's market risk almost doubled during the year.

average cds spreads for selected counterparties in 2008	Chart 2
Note: A Credit Default Swap (CDS) can be regarded as insurance against losses due to counterparty default on obligations. The CDS spread can be regarded as the insurance premium, expressing the market assessment of the estimated failure rate for a given counterparty. Consequently, the CDS spread is used as an indicator of the credit risk on a given counterparty. The calculated averages are simple averages for the selected counterparties' 5-year CDS spreads. Source: Fitch Ratings.

2008 saw a significant widening of credit and liquidity spreads, cf. Chart 2, which had an adverse impact on the prices of credit-sensitive products. The value of Danmarks Nationalbank's portfolios of mortgage bonds and covered bonds was also affected. The net outcome for Danmarks Nationalbank was, however, a capital gain since the rising demand for low-risk and liquid securities had a positive effect on the value of the government bond portfolio. In addition, Danmarks Nationalbank achieved a gain on its gold stock.

Market risk
Market risk is the risk of suffering a loss as a consequence of price fluctuations in the financial markets.

In the following, a distinction is made between exposure and risk.

Exposure (sensitivity) is the extent to which a loss is incurred on a given change in a specific risk factor. Exposure does not account for the probability of change.

Risk combines exposure with the probability of changes in the risk factors. Risk is thus a measure of expected gains or losses.

Interest-rate exposure
Part of Danmarks Nationalbank's portfolio is invested in bonds, which entails exposure to changes in interest rates as fluctuations in market value mirror variations in interest-rate levels.

Danmarks Nationalbank's interest-rate exposure was kr. 1.5 billion at end-2008. Consequently, an increase by 1 percentage point in interest rates would entail a loss of kr. 1.5 billion due to price fluctuations. This is almost unchanged compared with 2007, cf. Table 4.

Danmarks Nationalbank's current revenue is affected by interest-rate fluctuations. Since interest-bearing investments total just below kr. 120 billion, a general drop in interest rates would entail lower income from interest. Another important factor in relation to current net income from interest is the spread between interest rates in Denmark and market interest rates in the euro area, where most of the foreign-exchange reserve is placed.

Gold exposure
Pursuant to the Danmarks Nationalbank Act, Danmarks Nationalbank is obliged to hold a stock of gold. Throughout 2008 the gold stock was at 66.5 tonnes.

In view of the strong volatility in the gold price compared with previous years, the market value of Danmarks Nationalbank's gold stock changed considerably during the year. For example, within one month the value of the gold stock rose by more than kr. 2 billion. Over the year, the market value of the gold stock rose from kr. 9.1 billion to kr. 9.8 billion. This has increased Danmarks Nationalbank's gold exposure in 2008 as higher prices entail larger potential losses.

Foreign-exchange exposure
The foreign-exchange reserve reflects Denmark's fixed-exchange-rate policy. The foreign-exchange reserve is invested in euro, US dollars, pounds sterling and Swedish kronor. Danmarks Nationalbank has converted most of its foreign-exchange exposure in non-euro currencies to euro by means of forward foreign-exchange contracts.

At the end of 2008, Danmarks Nationalbank's foreign-exchange ex posure was kr. 220.0 billion, cf. Table 5. Danmarks Nationalbank will thus incur a loss of kr. 2.2 billion if the krone strengthens by 1 per cent. Since the foreign-exchange exposure is predominantly in euro, the
exchange-rate risk is very small on account of the fixed-exchange-rate policy.

Value-at-Risk
One measure of Danmarks Nationalbank's aggregate market risk is Value-at-Risk (VaR). VaR combines the exposure to various market conditions with an estimate of the volatility in these conditions, and is an expression of the capital loss that Danmarks Nationalbank may incur within one year under normal market conditions.

At the close of 2008, Danmarks Nationalbank's VaR was calculated at kr. 5.7 billion, which is kr. 2.5 billion higher than at the beginning of the year, cf. Chart 3. The result indicates that in 2009, with a probability of 95 per cent, Danmarks Nationalbank will not incur a capital loss exceeding kr. 5.7 billion.

danmarks nationalbank's VALUE-AT-RISK	Chart 3
Note: Value-at-Risk (VaR) indicates the maximum loss, with a probability of 95 per cent, that Danmarks Nationalbank will incur during the next year. VaR is calculated at the end of the year. The sum of the contributions from the three risk factors – interest rates, the gold price and exchange rates – exceeds the total VaR. The reason is that the various risk factors often have a low or negative correlation so that losses on all risk factors seldom occur at the same time. This is expressed as the diversification gain, illustrated by the negative green column in the Chart.

The notable increase in VaR was attributable to the considerably stronger uncertainty (volatility) in the market due to the financial crisis. The increase in Danmarks Nationalbank's exposure is modest relative to end-2007, but the market risk has almost doubled as a consequence of the market turbulence.

As shown in Chart 3, the higher VaR is primarily attributable to the gold risk. Exchange-rate risk and interest-rate risk are minor factors in this context. On the other hand, the diversification gain increased in 2008, although its share of Danmarks Nationalbank's gross risk is smaller than in 2007.

Stress test
VaR is a widely used risk measure, but it has its limitations. Since VaR is based on the most recent period, the estimates are strongly influenced by market developments in that period. It follows that VaR does not express the risk under all market conditions. Consequently, Danmarks Nationalbank supplements VaR with stress tests that reflect how extreme, but possible, scenarios for market developments affect Danmarks Nationalbank's current portfolio.

In the most pessimistic stress scenario, the loss to Danmarks Nationalbank will be almost kr. 20 billion. Such a loss, which is equivalent to around one third of Danmarks Nationalbank's net capital, will be related to a significant drop in the gold price, considerable appreciation of the Danish krone vis-à-vis the euro and the dollar, and substantial interest-rate increases in the US and European markets.

Liquidity risk
The purpose of the foreign-exchange reserve is to support the fixed-exchange-rate policy. In the management of the foreign-exchange reserve it is important to ensure that most of the reserve can readily be used for intervention in support of the krone. Consequently, a large proportion of the foreign-exchange reserve is placed in the money market or in gilt-edged bonds that can easily be realised or pledged as collateral. In addition, Danmarks Nationalbank can normally quickly raise considerable amounts of foreign exchange by drawing on various standby credit facilities. These include government borrowing in Commercial Paper, as well as Danmarks Nationalbank's lending facility with the ECB under the ERM II agreement.

2008 saw very substantial drawings on Danmarks Nationalbank's foreign-exchange reserve. At the same time, liquidity has dried out in many financial markets, which has made it difficult to sell certain securities at fair prices. Danmarks Nationalbank has been able to raise the necessary funds on account of its investment strategy. 2008 has demonstrated the importance of a highly liquid foreign-exchange reserve.

Credit risk
Credit risk is the risk of loss due to a counterparty's default on its obligations. Credit risk also comprises the risk that the credit rating of a counterparty is reduced, resulting in a capital loss.

Danmarks Nationalbank's exposure to credit risk has many aspects. The credit risk relates to e.g. monetary-policy lending, payment systems and Danmarks Nationalbank's investment portfolios.

Other credit risk factors include Danmarks Nationalbank's temporary financial stability measures launched in 2008, such as extension of the credit facilities available to monetary-policy counterparties by expanding the collateral base and establishment of new credit facilities. Furthermore, Danmarks Nationalbank has taken over the distressed Roskilde Bank and its commitments. In addition, Danmarks Nationalbank has agreed swap facilities with the central banks of Iceland and Latvia.

Most of these exposures entail a very modest credit risk. Monetary-policy lending and credit in connection with payment systems are collateralised, and the Danish Act on Financial Stability ensures that nearly all Danish banks are comprised by a government guarantee. ¹ Credit extended to Iceland and Latvia is also collateralised by Icelandic kronur and Latvian lats, respectively. This entails a credit risk, however, in the event that Iceland or Latvia fails to honour its commitments and the currency is not convertible. Iceland and Latvia have been rated Baa by the credit rating agency Moody's.

Credit risk from Danmarks Nationalbank's portfolios
Danmarks Nationalbank's credit risk exposure rose in 2008, cf. Table 6. This can be attributed to the higher foreign-exchange reserve, which has increased the need for placement in the money and securities markets, and to the higher risk of counterparty failure as a result of the financial crisis. Moreover, the crisis has shown how quickly counterparties can be downgraded, which entails a greater risk of capital losses as a result of wider credit spreads. The crisis has also demonstrated that in most cases, systemically important banks were rescued, which has reduced the credit risk on these. Overall, however, the credit risk has increased.

Danmarks Nationalbank seeks to reduce its credit risk by spreading its assets over many counterparties with high credit ratings. In addition, the investments are predominantly subject to provision of collateral. Collateralised placement means acceptance of larger deposits with the individual counterparties, as well as counterparties with a slightly lower credit rating. The collateral, typically government bonds, ensures coverage of Danmarks Nationalbank's claims in the event of counterparty failure. This was the case e.g. when the US investment bank Lehman Brothers collapsed on 15 September 2008. Danmarks Nationalbank had placed kr. 4.5 billion at Lehman Brothers, but since the deposit was based on German government bonds as collateral, Danmarks Nationalbank could sell the collateral to cover its claim. The collapse of Lehman Brothers thus entailed no loss for Danmarks Nationalbank.

¹ Losses related to Roskilde Bank are, however, covered by a separate government guarantee.