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

Denmark is currently enjoying favourable economic conditions. The Danish economy is in an upswing that began almost three years ago. This benefits the financial sector, and again in 2005 the banking institutions posted record-high earnings.

Overall, the financial institutions are still found to be robust, and there seem to be no potential threats to financial stability in Denmark.

The banking institutions achieved high growth in lending in 2005, the highest since the mid-1980s, cf. Chart 1. A few banking institutions even saw very high lending growth. The growth in lending was driven by such factors as the continued low level of interest rates and rising property prices. A comparison of the banking institutions' credit risk with the growth in lending shows that high lending growth has a certain tendency to coincide with a higher credit risk, even though considerable dispersion is seen. In a situation with very high growth in lending it is important that the banking institutions are more alert to any decrease in credit quality, and that they adjust their capital base and buffers against increasing losses accordingly.

Overall, the banking institutions and the Nordic groups appear to be robust. The strong lending growth and a minor decrease in capital adequacy do mean, however, that the resilience to increasing losses has decreased a little. At the same time, there is no clear positive link between the resilience of the individual banking institution and the probability of the banking institution experiencing a loss. Consequently, it is not necessarily the banking institutions with the highest credit risk on their lending portfolios, i.e. with the highest probability of losses, that are resilient to the greatest losses.

The new Basel II capital adequacy rules provide for calculation of credit institutions' capital requirements by means of internal credit-risk models. This gives the credit institutions various options with regard to data and methodology that may affect the resulting capital requirement. The special chapter on advanced approaches to calculation of capital requirements under Basel II illustrates the effects of some of these choices.

The rules for banks' liquidity is one of the elements of the EU framework that so far has not been harmonised. The special chapter on the banks' liquidity describes the banks' liquidity management, and various liquidity indicators are presented. The liquidity of Danish banks by far exceeds the statutory requirement, even though the excess liquidity cover has declined somewhat in recent years in step with the stronger increase in lending by, than deposits to, the banking institutions.

Secure and efficient payment systems are an important prerequisite to financial stability, and the special chapter on protection of settlement in Danish payment systems describes how settlement of retail payments and securities transactions is ensured in relation to financial risks.

Based on Danmarks Nationalbank's failure-rate model, the estimated failure rates of Danish companies are generally found to have decreased in 2005. The situation of the weakest companies has become more difficult, however, since many new companies are established when economic conditions are as favourable as they are now. All other things being equal, the estimated failure rate is relatively higher for newly-established companies than for older companies. The development in estimated failure rates for the various sectors and the distribution of lending by sector give grounds to expect that the banking institutions will continue to record low losses in the immediate future.

The economic conditions of the households have improved. Real incomes have risen, and more households have a sound income concurrently with the fact that unemployment has fallen. The prices of owner-occupied housing have risen significantly in recent years. The increases are higher than previously seen and among the highest in the world. Combined with a low level of interest rates, this has contributed to high growth in private consumption. The favourable economic conditions for the households are reflected in an ever higher rate of indebtedness, and the households' interest burden has grown.

On average, homeowners' mortgage-credit interest expenses will increase by 1.2 per cent of gross income on an increase in the short-term interest rate by 1 percentage point, compared to 1 per cent of gross income last year. Considerable dispersion is seen, however, and some homeowners' interest expenses will rise by more than 3 per cent of their gross income. Homeowners' increasing use of capped adjustable-rate loans dampens the effect on the average increase in the interest burden in the event of substantial interest-rate increases, cf. Chart 2.

The increased use of adjustable-rate loans in recent years makes the homeowners more exposed to fluctuations in the short-term interest rate. This exposure is particularly pronounced for households that have also opted for deferred amortisation since they have already made use of the buffer which the deferred-amortisation option provides, unless the deferred amortisation has been used to repay other, more expensive debt.

The households' favourable economic conditions have contributed significantly to the strong economic growth. There are exposed groups of households, but in overall terms the development in the households' interest-rate exposure poses no threat to the functioning of the financial system or to financial stability.

The favourable cyclical conditions can lead to an overoptimistic outlook in which it can be hard to spot the risks. Combined with the continued low level of interest rates this may increase the appetite for higher yields and quick gains, leading to speculation in continuously rising property prices or loan-financed investment in exotic investment products such as bonds linked to the price of commodities or the development in the yield curve. The marketing of loan-financed securities purchases has gained ground in recent years. As such, these loans pose no threat to financial stability. Usually, the financial intermediaries hold collateral for most of the lending, and charge high commission, which contributes to the favourable earnings. However, the individual investor must be aware that a higher expected return can only be achieved by concurrently taking a higher risk, so that losses can be substantial. At the same time, the various risks may be connected; for example, rising interest rates and falling bond prices concurrently with a drop in property prices. This can exacerbate the losses on the individual investor's total portfolio.