Financial Stability

Danmarks Nationalbank is responsible for monetary policy in Denmark, and its objectives include ensuring a stable krone and contributing to efficiency and stability in the payment systems and in the financial markets. This is stated in the Danmarks Nationalbank Act, according to which it is the task of Danmarks Nationalbank to "maintain a safe and secure currency system in this country, and to facilitate and regulate the traffic in money and the extension of credit". Monetary policy and financial stability are closely linked. On the one hand, credible monetary policy and a stable krone are the basis for financial stability. On the other hand, monetary policy is conducted via the financial system, and financial stability is thus crucial to the effective implementation of market-oriented monetary policy. At the same time, the financial system must be sufficiently robust to leave room to conduct the necessary monetary policy.

The annual publication Financial Stability assesses financial stability in Denmark, with emphasis on financial institutions, markets and payment systems. The most significant risks to the financial system are identified, including situations that are very unlikely to arise, but which might have major consequences for the economy. It is assessed whether the overall financial system is robust enough for any problems experienced within the sector not to spread and prevent the financial markets from functioning as providers of capital and financial services. It is the task of the Danish Financial Supervisory Authority to ensure that each financial institution is sufficiently robust.

The purpose of the publication is to create awareness of conditions that are of importance to maintaining financial stability in Denmark.

Summary

In general, the financial institutions are doing well in these years. The background to their success is a slightly unusual combination of a favourable economic climate and low interest rates.The current robustness of the sector should be seen in this light. In the short term, nothing seems to be able to threaten financial stability, but at some point things will change. It could be external conditions, including a sudden rise in interest rates, a change in the consumption or business climate or sudden changes in economic policy that make the economic skies cloud over.

The favourable economic climate in 2004 had a positive impact on the profits of the banking institutions, primarily as a result of low losses and provisions and substantial growth in business volumes.

The high lending growth in the late 1990s has not, to the same extent as previously, resulted in increased losses and provisions in the subsequent period. The reason may be that the cyclical downturn in 2002 and 2003 was relatively modest. In addition, the banking institutions may have improved their risk management in connection with the preparation of the forthcoming capital-adequacy rules, Basel II. The introduction of new accounting standards (IAS/IFRS) has presumably also exerted downward pressure on the level of provisions.

The Danish banking institutions saw considerable growth in lending in 2004. This included growth in mortgage loans ("prioritetslån"), which are offered to households against real estate as collateral and thus compete with mortgage-credit loans offered by mortgage-credit institutes. These loans entail a relatively low risk. Growth in lending to the corporate sector has also been high. Danmarks Nationalbank's calculations show that banking institutions with relatively high lending growth also have the greatest credit risk on their lending portfolios.

The exposure to rising losses has increased slightly, particularly among the small Danish banking institutions. This is attributable to the high lending growth and reduced capital adequacy, among other factors. The Nordic groups, on the other hand, appear more robust in 2004 than in 2003.

On the basis of Danmarks Nationalbank's failure-rate model, the general robustness of the Danish corporate sector is assessed as unchanged in 2004 compared to 2003. The rising tendency for the estimated failure rates of the weakest 10 per cent of the companies seen in recent years has been broken in several sectors, and an increased dispersion of estimated failure rates has also stopped. The development in the estimated failure rates for the various sectors and the distribution of loans by sector point to the overall losses of the banking institutions remaining low in the near future.

During the past year, the finances of the households have improved owing to tax cuts, sustained low inflation, higher employment and very low interest rates. Real-estate prices have increased at the highest rate seen since 1998, which has also underpinned the finances of the households. On the other hand, household debt continued to rise at a faster rate than disposable incomes in 2004. The interest burden fell from 2003 to 2004, however, as a result of the low interest rates and more widespread use of loans with short fixed-interest periods.

An analysis of the households' interest-rate exposure shows that on average the interest expenses of Danish homeowners increase by 1 per cent of gross income if the short-term interest rate goes up by 1 percentage point. The size of the adjustable-rate debt is thus equivalent to gross income on average. The average interest-rate exposure is almost the same across all income brackets, since the low-income brackets have the highest relative interest burden, while the high-income brackets have the highest ratio of adjustable-rate loans. However, there is a considerable dispersion, and many have an interest-rate exposure of more than 2 per cent.

Overall, the banking institutions reduced their interest-rate exposure in 2004, but the smallest institutions still have a relatively high exposure.

Long-term yields in the USA and particularly in Europe have been falling since the summer of 2004. The greater decline in European yields may be ascribed to uncertainty as to the strength of the economic upswing in Europe, as well as to prospects of continued monetary-policy tightening in the USA. The implied volatility of European yields has increased. This indicates growing uncertainty as to the development in interest rates in Europe, but part of the increase is also attributable to substantial demand for hedging of the risk of increasing interest rates.

For the banking institutions, a general rise in interest rates will result in direct losses, depending on their interest-rate exposure. In addition, the banking institutions' credit losses may be expected to increase, depending on the interest-rate exposure and robustness of the corporate sector and the households. On the other hand, rising interest rates will give the banking institutions better opportunities to broaden their interest margins and thus their earnings base.

It is important for the banking institutions to have adequate capital to withstand both direct and indirect impacts of potential interest-rate rises.

The capital adequacy of the small banking institutions is generally higher than that of the larger institutions. The banking institutions' total buffer against losses comprises cumulative provisions for losses on loans and guarantees, and the part of the capital that exceeds the statutory 8 per cent requirement. Overall, the sector's buffer was reduced in 2004 due to a fall in the excess capital adequacy, as well as lower provisions. The new IAS/IFRS accounting standards, effective from 1 January 2005, and the new capital-adequacy rules, Basel II, will both have an impact on the size and composition of the future buffers of the banking institutions.

In general, the banking institutions should exert caution in relation to minimising their buffers.


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				Introduction and Summary
					Danmarks Nationalbank is responsible for monetary policy in Denmark, and its objectives include ensuring a stable krone and contributing to efficiency and stability in the payment systems and in the financial markets. This is stated in the Danmarks Nationalbank Act, according to which it is the task of Danmarks Nationalbank to "maintain a safe and secure currency system in this country, and to facilitate and regulate the traffic in money and the extension of credit". Monetary policy and financial stability are closely linked. On the one hand, credible monetary policy and a stable krone are the basis for financial stability. On the other hand, monetary policy is conducted via the financial system, and financial stability is thus crucial to the effective implementation of market-oriented monetary policy. At the same time, the financial system must be sufficiently robust to leave room to conduct the necessary monetary policy. The annual publication Financial Stability assesses financial stability in Denmark, with emphasis on financial institutions, markets and payment systems. The most significant risks to the financial system are identified, including situations that are very unlikely to arise, but which might have major consequences for the economy. It is assessed whether the overall financial system is robust enough for any problems experienced within the sector not to spread and prevent the financial markets from functioning as providers of capital and financial services. It is the task of the Danish Financial Supervisory Authority to ensure that each financial institution is sufficiently robust. The purpose of the publication is to create awareness of conditions that are of importance to maintaining financial stability in Denmark. Summary In general, the financial institutions are doing well in these years. The background to their success is a slightly unusual combination of a favourable economic climate and low interest rates.The current robustness of the sector should be seen in this light. In the short term, nothing seems to be able to threaten financial stability, but at some point things will change. It could be external conditions, including a sudden rise in interest rates, a change in the consumption or business climate or sudden changes in economic policy that make the economic skies cloud over. The favourable economic climate in 2004 had a positive impact on the profits of the banking institutions, primarily as a result of low losses and provisions and substantial growth in business volumes. The high lending growth in the late 1990s has not, to the same extent as previously, resulted in increased losses and provisions in the subsequent period. The reason may be that the cyclical downturn in 2002 and 2003 was relatively modest. In addition, the banking institutions may have improved their risk management in connection with the preparation of the forthcoming capital-adequacy rules, Basel II. The introduction of new accounting standards (IAS/IFRS) has presumably also exerted downward pressure on the level of provisions. The Danish banking institutions saw considerable growth in lending in 2004. This included growth in mortgage loans ("prioritetslån"), which are offered to households against real estate as collateral and thus compete with mortgage-credit loans offered by mortgage-credit institutes. These loans entail a relatively low risk. Growth in lending to the corporate sector has also been high. Danmarks Nationalbank's calculations show that banking institutions with relatively high lending growth also have the greatest credit risk on their lending portfolios. The exposure to rising losses has increased slightly, particularly among the small Danish banking institutions. This is attributable to the high lending growth and reduced capital adequacy, among other factors. The Nordic groups, on the other hand, appear more robust in 2004 than in 2003. On the basis of Danmarks Nationalbank's failure-rate model, the general robustness of the Danish corporate sector is assessed as unchanged in 2004 compared to 2003. The rising tendency for the estimated failure rates of the weakest 10 per cent of the companies seen in recent years has been broken in several sectors, and an increased dispersion of estimated failure rates has also stopped. The development in the estimated failure rates for the various sectors and the distribution of loans by sector point to the overall losses of the banking institutions remaining low in the near future. During the past year, the finances of the households have improved owing to tax cuts, sustained low inflation, higher employment and very low interest rates. Real-estate prices have increased at the highest rate seen since 1998, which has also underpinned the finances of the households. On the other hand, household debt continued to rise at a faster rate than disposable incomes in 2004. The interest burden fell from 2003 to 2004, however, as a result of the low interest rates and more widespread use of loans with short fixed-interest periods. An analysis of the households' interest-rate exposure shows that on average the interest expenses of Danish homeowners increase by 1 per cent of gross income if the short-term interest rate goes up by 1 percentage point. The size of the adjustable-rate debt is thus equivalent to gross income on average. The average interest-rate exposure is almost the same across all income brackets, since the low-income brackets have the highest relative interest burden, while the high-income brackets have the highest ratio of adjustable-rate loans. However, there is a considerable dispersion, and many have an interest-rate exposure of more than 2 per cent. Overall, the banking institutions reduced their interest-rate exposure in 2004, but the smallest institutions still have a relatively high exposure. Long-term yields in the USA and particularly in Europe have been falling since the summer of 2004. The greater decline in European yields may be ascribed to uncertainty as to the strength of the economic upswing in Europe, as well as to prospects of continued monetary-policy tightening in the USA. The implied volatility of European yields has increased. This indicates growing uncertainty as to the development in interest rates in Europe, but part of the increase is also attributable to substantial demand for hedging of the risk of increasing interest rates. For the banking institutions, a general rise in interest rates will result in direct losses, depending on their interest-rate exposure. In addition, the banking institutions' credit losses may be expected to increase, depending on the interest-rate exposure and robustness of the corporate sector and the households. On the other hand, rising interest rates will give the banking institutions better opportunities to broaden their interest margins and thus their earnings base. It is important for the banking institutions to have adequate capital to withstand both direct and indirect impacts of potential interest-rate rises. The capital adequacy of the small banking institutions is generally higher than that of the larger institutions. The banking institutions' total buffer against losses comprises cumulative provisions for losses on loans and guarantees, and the part of the capital that exceeds the statutory 8 per cent requirement. Overall, the sector's buffer was reduced in 2004 due to a fall in the excess capital adequacy, as well as lower provisions. The new IAS/IFRS accounting standards, effective from 1 January 2005, and the new capital-adequacy rules, Basel II, will both have an impact on the size and composition of the future buffers of the banking institutions. In general, the banking institutions should exert caution in relation to minimising their buffers.


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Introduction and Summary

Summary