The Corporate Sector and the Households
In 2004, the earnings capacity of the Danish corporate sector was generally unchanged compared to 2003. The decline in earnings experienced by the weakest companies in recent years seems to have stopped, and the strongest companies are still performing well.
This pattern is supported by the failure-rate model, in which the estimated failure rates for the weakest companies generally stagnated in 2004 after having risen for several years. On the basis of the development in estimated failure rates and the distribution of lending to the corporate sector, the banking institutions' losses are expected to remain low in the immediate future.
The finances of the Danish households have improved during the past year, e.g. because disposable real incomes have risen. The households' debt continues to increase at a higher rate than their income, but falling interest rates and more loans with shorter fixed-interest periods have more than neutralised the budget impact of the households' growing indebtedness. The debt composition of homeowners is still shifting in the direction of more adjustable-rate loans, which increases their interest-rate exposure.
THE SIGNIFICANCE OF THE CORPORATE SECTOR AND THE HOUSEHOLDS TO FINANCIAL STABILITY
Extending credit to the corporate sector and the households is one of the primary functions of the banking institutions. In doing so, the banking institutions incur a credit risk. The finances of the corporate sector and the households and their robustness to adverse developments have an impact on the banking institutions' earnings and balance sheets and thus on financial stability.
CORPORATE SECTOR
Since mid-2003 the Danish economy has seen a cyclical upturn, primarily driven by domestic demand. The development in exports has been more dampened in recent years, reflecting low growth in a number of important export markets. Furthermore, the strengthening of the effective krone rate and a higher rate of wage increase than abroad have also had an adverse impact on competitiveness. The upturn has been most pronounced in the building and service sectors, which mainly cater to the domestic market, while more subdued development has been seen in manufacturing, which is more export-oriented. Corporate investments in new technology have been at a high level for a number of years. The low level of interest rates and the prospects of sustained growth in the Danish and international economies, including higher growth in the euro area, provide the basis for continued growth in investments and underline the generally positive outlook for the Danish corporate sector.
This view is supported by the banking institutions' lower loan losses in 2004, cf. the chapter on the financial sector. In the short term, rising interest rates are deemed to constitute a risk to the corporate sector. The chapter on financial markets elaborates on market expectations of interest rates.
The incidence of compulsory liquidation in the Danish corporate sector has been stable in recent years. This development covers minor geographical variations, cf. Chart 19.
| NUMBER OF COMPULSORY LIQUIDATIONS IN THE CORPORATE SECTOR,1995-2005 |
Chart 19
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| Note: The Chart shows monthly observations for the number of compulsory liquidations calculated as a 12-month moving average. | |
| Source: Statistics Denmark. | |
Development in the companies' key figures
Overall, the return on assets in Danish public and private limited liability companies remained almost unchanged in 2004 compared to 2003, but the spread between the companies has increased, cf. Chart 20. Among the 10 per cent of companies with the highest return on assets, the return as a ratio of total assets has been increasing slightly since 2001. Expressed as the 90th percentile, these companies yielded a return on assets higher than or equal to 26 per cent in 2004. For the lowest 10 per cent, the return on assets has remained unchanged at less than or equal to ‑15 per cent since 2002.
| RETURN ON ASSETS EXPRESSED AS THE 10TH, 50TH AND 90TH PERCENTILES, 1995-2004 |
Chart 20
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| Note: The return on assets is defined as the primary operating result as a ratio of total assets. In the IT and telecom sector, the return on assets for the 10th percentile was around -50 per cent in 2000-02. Business service comprises real estate letting and administration, rental of cars, machinery and other equipment, legal services, consultant engineering services and auditing and other similar consulting and service. | |
| Source: KOB and own calculations. | |
The companies' ability to withstand losses, measured as the solvency ratio, remained virtually unchanged in 2004. The IT and telecom sector stands out as the only sector where the solvency ratio of the 10 per cent weakest companies improved between 2002 and 2004, albeit from the lowest starting point, cf. Chart 21.
| SOLVENCY RATIO EXPRESSED AS THE 10TH, 50TH AND 90TH PERCENTILES, 1995-2004 |
Chart 21
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| Note: The solvency ratio is defined as equity capital as a ratio of total liabilities. In the IT and telecom sector, the solvency ratio was -26 per cent in 2002. Business service comprises real estate letting and administration, rental of cars, machinery and other equipment, legal services, consultant engineering services and auditing and other similar consulting and service. | |
| Source: KOB and own calculations. | |
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Box 5
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While the development in most other sectors is reflected in data from KOB, this does not apply to the Danish agricultural sector since few farms are operated as public or private limited liability companies. Accounts from the Food and Resource Economics Institute for 2004 will not be available until the autumn of 2005. In 2003, agriculture's average operating result fell to kr. 94,000 per full-time farm business. For pig farmers, 2003 was a poor year. The average return on assets fell further, to 3.6 per cent, which is very low compared to other sectors. The Danish Agricultural Advisory Service expects the 2004 figures to be even worse as a consequence of poor earnings across the board. In 2005 agricultural earnings are expected to rise considerably, primarily among dairy and pig farmers, although this prognosis is very uncertain since the financial consequences of the EU's agricultural reform are to a large extent unknown. Structural adjustments within agriculture with a shift to fewer and larger farms – primarily cattle and pig farms – entail a sustained high level of investments in the agricultural sector. The high level of investments and the poor operating results in the last two years have increased the demand for external financing, and consequently the average solvency ratio in agriculture declined from 43 per cent in 2002 to 39 per cent in 2003. However, the solvency ratio of the agricultural sector remains relatively high compared to other sectors due to high land prices. Besides the level of interest rates and the earnings and production potential in the agricultural sector, the development in land prices is influenced to a great extent by framework conditions such as environmental requirements and various EU programmes. Earnings in 2003 and expected earnings in 2004 show that agriculture is experiencing difficulties in achieving sufficient income in relation to the work effort and an adequate return on the capital invested. The low earnings and growing indebtedness, as well as the uncertainty relating to the consequences of the EU's agricultural reform, make the agricultural sector vulnerable to any possible rising interest rates and falling land prices. Agriculture is mainly financed via mortgage-credit institutes. Agriculture accounts for 29 per cent of total lending by mortgage-credit institutes to the corporate sector. In the banking sector, the ratio of lending to agriculture is highest among the smaller banks. Lending to agriculture thus constitutes more than 20 per cent of lending to the corporate sector for 64 per cent of the category C banks, but only 17 per cent of the category B banks. |
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The financial sector's exposure to the corporate sector
Annual growth in lending by banking institutions to the corporate sector was significantly higher throughout 2004 and into 2005 than in 2003. Growth in lending by mortgage-credit institutes to the corporate sector was stable in the same period. Corporate investments as a ratio of the gross domestic product at factor cost have been rising since mid-2003, which could explain the increase in lending by banking institutions to the corporate sector in 2004. This time lag between corporate investments and lending growth has also been seen in previous cyclical upturns. At end-February 2005, total lending by banking institutions to the corporate sector was kr. 320 billion, while the equivalent figure for mortgage-credit institutes was kr. 315 billion.
Estimated failure rates by sector
On the basis of Danmarks Nationalbank's failure-rate model, the general robustness of the Danish corporate sector is assessed to have been unchanged in 2004 compared to 2003. The rising tendency in the estimated failure rates of the weakest 10 per cent of the companies seen in recent years has been broken in several sectors, and the widening of the spread in estimated failure rates has also stopped. This is attributed to improved macroeconomic conditions, but the median estimated failure rate in 2004 remained at the same level as in recent years, cf. Chart 22. The failure-rate model is described in Box 6.
| ESTIMATED FAILURE RATES EXPRESSED AS THE 10TH, 50TH AND 90TH PERCENTILES, 1995-2004 |
Chart 22
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| Source: KOB and own calculations. | |
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Box 6
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Based on a company's accounts, Danmarks Nationalbank's failure-rate model can be used to estimate the probability of the company failing within the next few years. The estimated failure rate can be seen as a weighted index of key figures, etc. The failure-rate model does not include agriculture. Compared to the sector-specific failure-rate model presented in Financial stability 2004, a number of improvements have been introduced, mainly of a technical nature. The model's estimation period has been extended to comprise the years 1995-2001, but it still does not cover an entire economic cycle, which may affect the level of the estimated failure rates. The technical estimation method has been fine-tuned. The model now takes into account that companies may close down for various reasons: financial difficulties, voluntary closure, acquisition, etc. In the literature, this type of model is known as a competing-risks model2. In addition, the model's explanatory variables have been adjusted and extended slightly. Variables
Data Estimated failure rates |
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| DISTRIBUTION OF COMPANIES' ESTIMATED FALURE RATES FOR THE COMING YEARS | |
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| Note: The value "1" on the x axis indicates that the companies within this range have an estimated failure rate of above 0 and below or equal to 1 per cent. ">20" indicates all estimated failure rates above 20 per cent. The estimated failure rate for companies subject to failure is based on the latest accounts before failure. Source: Own calculations. |
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| 1 For a more detailed review of the failure-rate model, see Lykke, Morten, Kenneth Juhl Pedersen and Heidi Mølgaard Vinter, A Failure Rate Model for the Danish Corporate Sector, Danmarks Nationalbank, working paper no. 16, 2004.2 For a more detailed review of the technical estimation method, see Dyrberg, Anne, Firms in Financial Distress: An Exploratory Analysis, Danmarks Nationalbank, working paper no. 17, 2004. | |
The interval between the 90th and 10th percentiles indicates the spread between respectively the weakest and strongest 10 per cent of the companies in each sector. This spread can be seen as an expression of the uncertainty associated with extending credit to each sector.
At sector level, the most robust sector is business service, comprising e.g. real estate administration, engineering services and auditing. The negative development in the IT and telecom sector seems to have been halted.
Expected losses by sector
The largest share of lending by banking institutions to the corporate sector comprises lending to the business service sector, cf. Chart 23, and this share rose from 2003 to 2004. This sector also has the lowest estimated failure rate. The banking institutions' losses by sector depend on the distribution of lending to corporate customers, as well as the robustness of the individual companies. Estimated failure rates for the individual companies within a sector are therefore used to calculate a sector-specific expected loss ratio for bank debt, cf. Box 7. The loss ratio is defined as the expected losses as a percentage of the sector's total bank debt and thus indicates the risk of losses within the next few years on lending to the sector in question.
| BANKING INSTITUTIONS' CORPORATE LENDING BY SECTOR,END-2003 AND END-2004 |
Chart 23
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| Note: Lending is calculated as lending by sector as a ratio of total corporate lending by banking institutions. The calculation is based on the institutions' reporting in full to the MFI balance-sheet statistics. IT and telecom, which is mainly comprised by the business service sector, cannot be shown as a separate sector. Business service also comprises real estate letting and administration, rental of cars, machinery and other equipment, legal services, consultant engineering services and auditing and other similar consulting and service. | |
| Source: Danmarks Nationalbank. | |
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Box 7
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The expected losses for each individual company are calculated as the probability that the company fails multiplied by the loss given failure. The bank debt is weighted to reflect the circumstance that, in most cases, the creditor recovers some of the debt. The calculation assumes that all short-term bank debt is lost, while only half of the long-term bank debt is lost. The expected loss ratio at sector level is then estimated by calculating the sum of the expected losses on the individual companies in the sector in question as a ratio of total bank debt in the sector, cf. the formula below. |
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| Note: Only companies specifying bank debt are included in the calculation. | |
Overall, the expected loss ratio on lending to the corporate sector was virtually constant in the period 2002-04, cf. Chart 24. The reason may be that the banking institutions have mainly increased credit extension to companies with low estimated failure rates. The expected loss ratio in the building and construction sector is relatively high and increased in 2004, but lending to this sector constitutes only a small percentage of the banking institutions' total lending. The lower expected loss ratio in the IT and telecom sector reflects, inter alia, the development in this sector's estimated failure rates in recent years. The increase in lending to the business service sector, in particular, has not resulted in a higher expected loss ratio.
| EXPECTED LOSS RATIO FOR BANK DEBT IN THE CORPORATE SECTOR, 2002-04 |
Chart 24
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| Note: Total comprises all public and private limited liability companies in the sectors listed, as well as companies with the sector code "unknown". Companies in this category are often young. | |
| Source: KOB and own calculations. | |
HOUSEHOLDS
The finances of the Danish households have improved during the past year. Tax cuts and low inflation have contributed to a significant rise in the households' disposable real incomes. These factors, combined with increased employment and the very low level of interest rates, have contributed to strong growth in private consumption, and in early 2005 consumer confidence reached its highest level since 1998.
The substantial increase in the households' disposable real incomes is also reflected in the number of registrations of late payments with RKI. The number has been falling since mid-2004 after having risen almost constantly since 1999. For financing companies, this tendency has been registered for an even longer period of time, cf. Chart 25.
| REGISTRATIONS OF LATE PAYMENTS BY PRIVATE INDIVIDUALS FROM CREDIT PROVIDERS AND ALL CREDITORS, 2000-05 |
Chart 25
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| Source: RKI Kredit Information A/S. | |
The number of enforced sales of owner-occupied homes fell throughout 2004 and early 2005. At national level, the prices of single-family houses and terraced houses rose by 9 per cent in 2004, which is the highest rate of increase since 1998, and the average price per square metre is approximately kr. 9,500, cf. Chart 26. However, there are considerable regional differences, with Copenhagen and Northern Zealand as the absolute "high jumpers". The sustained increase in housing prices should be viewed against the background of the low interest rates, the new loan types, the tax freeze and a low supply in the housing market. In the same period, the prices of summer cottages rose by 18 per cent, and on average a summer cottage now costs kr. 2,800 more per square metre than a single-family house. The prices of owner-occupied apartments rose by 13 per cent in 2004.
| PRICE PER SQUARE METRE FOR HOUSING IN DENMARK, 1995-2004 |
Chart 26
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| Source: Association of Danish Mortgage Banks. | |
The development in housing prices has underpinned the improved finances of the households. As explained in the chapter on the interest-rate exposure of Danish homeowners, the free mortgageable value of Danish homes is considerable, and the average interest costs of Danish homeowners will increase by 1 per cent of their income before tax if the short-term interest rate increases by 1 percentage point.
No major regional differences were seen in the development in unemployment and the number of enforced sales in Denmark in 2004. Greater Copenhagen had the lowest number of enforced sales and the lowest unemployment rate.
The financial sector's exposure to the households
In 2004, the total debt of the households continued to rise at a higher rate than their disposable income, which means that the debt burden of the households has increased, cf. Chart 27. Falling interest rates and more loans with shorter fixed-interest periods have, however, more than neutralised the budget impact of the growing indebtedness since interest costs as a ratio of income (the interest burden) fell in 2004 compared to 2003.
| THE HOUSEHOLDS' DEBT AND INTEREST BURDENS, 1995-2004 |
Chart 27
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| Note: The debt burden is defined as the households' debt as a ratio of disposable income. The interest burden is defined as net interest expenditure after tax as a ratio of disposable income. Figures for disposable income and net interest expenditure for 2004 are preliminary estimates based on projections by the Ministry of Finance. | |
| Source: Ministry of Finance and Danmarks Nationalbank. | |
Growing indebtedness among Danish households is not a new phenomenon. This trend has been relatively constant for the last 10 years. Since 2001, total annual growth in lending by banking institutions and mortgage-credit institutes to the households has been stable at around 8-9 per cent, cf. Chart 28. During the past year, the households' behaviour has, however, changed, both in terms of loan types and choice of credit providers. Every single month throughout 2004, mortgage-credit institutes thus issued more adjustable-rate loans than traditional fixed-rate loans. This had not been seen previously. In addition, the banking institutions have acquired a larger share of this market from the mortgage-credit institutes. Lending by banking institutions to households in-creased significantly during 2004, and in January 2005 the annual growth rate exceeded 20 per cent. This growth is mainly attributable to the introduction, in the 2nd half of 2003, of adjustable-rate bank mortgage loans to homeowners as an alternative to traditional capital-market financing via mortgage-credit institutes. However, mortgage-credit institutes still account for the largest share by far of total lending to the households, viz. 78 per cent. At end-February 2005 lending by mortgage-credit institutes to the households totalled kr. 1,158 billion, while lending by banking institutions amounted to kr. 329 billion.
| ANNUAL GROWTH IN LENDING TO HOUSEHOLDS BY BANKING INSTITUTIONS AND MORTGAGE-CREDIT INSTITUTES, 2001-05 |
Chart 28
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| Source: Danmarks Nationalbank. | |
In addition to a higher ratio of adjustable-rate loans, the introduction on 1 October 2003 of mortgage-credit loans with an option to defer amortisation has had a significant impact on the composition of lending by the mortgage-credit institutes, cf. Chart 29. Traditional fixed-rate mortgage-credit loans now account for less than half the total mortgage-credit volume, while fixed-rate and adjustable-rate mortgage-credit loans with the option to defer amortisation are gaining ground and constituted 17 per cent at end-February 2005.
| THE MORTGAGE-CREDIT INSTITUTES' OUTSTANDING LENDING BY LOAN TYPE, 2003-05 |
Chart 29
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| Source: Danmarks Nationalbank. | |
Consequently, more households have become exposed to fluctuations in the short-term interest rate. This exposure is particularly evident for households that have also opted for deferred amortisation since these households have also made use of the buffer that the possibility of deferring amortisation offers[1]. In the autumn of 2004 the mortgage-credit institutes launched a new mortgage-credit product comprising adjustable-rate bond loans with a cap on the interest rate. This cap typically applies throughout the term of the loan, i.e. for up to 30 years, and protects the borrower against any increases in interest rates that exceed the cap. However, many households will experience a considerable rise in their costs before the cap is reached. Demand for these loans has been high from day one, and at end-March 2005 the total nominal volume amounted to more than kr. 60 billion.
[1] This is a buffer since a household that experiences higher housing costs as a result of rising interest rates or lower income owing to e.g. unemployment is able to temporarily neutralise part of this impact by switching to a deferred-amortisation loan.