Summary
Robust Financial Sector in Denmark

The international financial markets have been characterised by turmoil since the summer of 2007. This is reflected in Danish banks' financial statements for 2007. Earnings rose in the 1st half of the year, but the 2nd half marked a turning point for many banks after a prolonged period of earnings growth. Looking ahead, the banking sector will continue to be affected by the financial turmoil and the less favourable outlook for the Danish economy. Risks to financial stability have become more pronounced recently. The banks have become more exposed in the light of their growing lending portfolios and the reduction of their capital buffers in recent years. The Danish financial sector is, however, deemed to be sufficiently resilient to withstand major economic shocks.

The financial turmoil affects Danish banks
The current turmoil in the international financial markets stems from falling housing prices in the USA and the rising number of defaults on mortgages by less creditworthy homeowners, i.e. subprime borrowers.

At first, the strong price drops were mainly observed in structured financial products composed of subprime mortgages. However, the turmoil quickly spread to other parts of the financial system, and the period since August 2007 has been turbulent for both money and equity markets.

Banks in the USA and Europe have suffered considerable losses as a result of the subprime crisis. Consequently, several banks have tightened their credit policies. Growth prospects have deteriorated, and especially for the US economy the outlook is more gloomy.

The turmoil in the international financial markets is also visible in Danish banks' financial statements for 2007. The 1st half of 2007 saw continued earnings growth, while the 2nd half marked a turning point for many banks after a prolonged period of earnings growth. For the year as a whole, the banks' earnings fell by 14 per cent on 2006.^[1] The decrease is attributable to capital losses on securities and higher write-downs on lending, among other things.

The banks' lending continues to increase, albeit at a diminishing pace. Higher financing costs and the financial turmoil have dampened the banks' expansion, and many banks have raised their lending rates in 2008.

The new capital-adequacy rules, Basel II, together with the International Financial Reporting Standards, IFRS, have contributed to the banks reducing their capital reserves. Consequently, the banks have become more exposed to adverse economic scenarios.

The risk outlook
The turmoil in the international financial markets impacts the risks faced by the banks.

Increased volatility in the financial markets entails higher market risk and hedging costs for the banks. In addition, the turmoil has brought the banks' liquidity risk into focus. Some banks operate with small liquidity reserves, which affects their scope of manoeuvre under unexpected circumstances. These banks may be forced to raise loans in periods when market conditions are unfavourable or to raise loans with shorter-than-required maturities in a situation where some markets tend to disappear completely.

In the event of sustained turmoil in the international financial markets, with continuously high credit spreads, the price of the banks' financing via the money and capital markets may increase further. Banks with large deposit deficits and without a good rating are particularly exposed to interest-rate fluctuations in the money and capital markets.

In addition to risks related to the financial markets, there are also risks associated with the macroeconomic development. Expectations of economic growth in the USA have been steadily reduced as a result of the weak US housing market and the financial turmoil, and the probability of a recession in the USA has increased. A slowdown in the US economy and the global economy overall will also affect the Danish economy and Danish banks.

Unemployment has decreased further in Denmark in 2007 and the beginning of 2008. The capacity pressure is high in the Danish economy, and economic growth is expected to slow down. Rising wages and higher commodity prices may lead to intensified pressure on the companies' budgets, which will increase the probability of default on loans, resulting in losses for the Danish banks.

The depreciation of the dollar is an additional risk factor for banks with considerable lending to companies exporting to the USA and other dollar-priced markets.

Calculations based on Danmarks Nationalbank's failure-rate model, KIM, show higher estimated failure rates for Danish companies in general. This can be attributed to increased indebtedness, more companies with negative earnings, and the establishment of many new companies in 2007. Viewed in isolation, the estimated failure rate is higher for new companies than for well-established companies. The higher indebtedness and estimated failure rates for the companies imply that the banking sector's expected losses on corporate exposures have risen from 2006 to 2007, although they continue to be low.

In 2006, the surging housing prices made way for stagnating or falling prices, cf. Chart 1. Danish household finances are still sound overall, despite high and increasing debt, and unemployment is very low. There are no significant indications of the households having difficulties in servicing their loans. A more pronounced downturn in the housing market, with plummeting prices, is a risk factor, but it is only found to be probable in the event of significant increases in interest rates and unemployment.

The Danish banking sector is still assessed to be robust overall
The risk scenario described above is illustrated by the following three constructed stress test scenarios:

• The subprime crisis continues and leads to a recession in the USA: The price of interbank financing rises sharply. The increase is partially passed on to the customers. Growth in the US economy is negative for eight quarters.
• Increases in commodity prices: Commodity prices, especially oil prices, rise sharply, and official interest rates are raised to keep inflation at bay.
• Property price drop: Interest rates and unemployment increase, while property prices and the value of assets pledged as collateral for bank loans decrease.

The stress test scenarios are compared with a baseline scenario that is considered to be the most likely development in the Danish economy and the financial sector. Calculations based on Danmarks Nationalbank's stress test model show that all banks classified by the Danish Financial Supervisory Authority in groups 1 and 2 will achieve a profit at almost the same level as in 2007 if Danmarks Nationalbank's baseline scenario is realised. In the stress test scenarios the financial result will be negative for most banks in at least one of the three scenario years, but without leading to solvency problems, cf. Chart 2. Only one bank will have solvency problems if exposed to the tough economic scenarios. All in all, the results show that the Danish financial system is resilient to the scenarios in question, but that it cannot be ruled out that a few banks will have problems.

A static sensitivity analysis also shows that the Danish financial sector is robust. However, the analysis shows greater exposure to rising financing costs and increasing losses on lending portfolios compared with corresponding calculations based on the banks' financial statements for 2006.

The Nordic groups have also become more exposed to both increasing losses and rising financing costs. At the same time, the market assessment of the resilience of the Nordic groups is on the decrease, although the resilience in most cases exceeds the level for other European and US banks.