The Risk Outlook

The risk outlook is strongly influenced by the subprime crisis and derived effects on the international financial markets and the global economy. The banks' financing costs have risen as a result of the turmoil. Banks with large deposit deficits, especially those without a good rating, are exposed to these increases. In addition, the banks' market risk has risen as a result of the uncertainty and greater volatility in the financial markets.

The expected slowdown in Danish economic growth also entails risks for the banks. Household finances are sound, but the continually increasing debt makes the households more exposed. The estimated failure rates for companies rose, and the banking sector's expected losses on corporate exposures increased in 2007 compared with 2006, albeit from a low level.

OVERVIEW OF SIGNIFICANT RISKS TO FINANCIAL STABILITY

This chapter describes significant risks to financial stability, i.e. risks associated with the financial markets, macroeconomic risks of both international and Danish origin and any vulnerabilities in the Danish financial sector, cf. Table 2.

In the next chapter, risks to financial stability are translated into a number of hypothetical scenarios, which form the basis for stress tests of the Danish financial sector in comparison to the expected development, or the baseline scenario.

THE SUBPRIME CRISIS SETS THE AGENDA

The risk outlook is strongly influenced by the subprime crisis and derived effects on the financial markets and the macroeconomy.

The strength and duration of the turmoil have generally come as a surprise and been difficult to predict. The turmoil has spread extensively through the international financial system since the summer of 2007, and there is a risk of the subprime crisis escalating, which could include further spill-over effects between financial markets. There are a number of specific risks that can threaten the conditions in the financial sector. The primary risk implies continued adverse development in the US housing market and the US economy. Major international banks' announcement of further significant losses is also viewed as a risk. Finally, it is uncertain how much the subprime crisis will affect the macroeconomy and vice versa, i.e. there is a risk of a negative spiral with escalating turmoil and further weakening of the real economy. 

As a consequence of the turmoil and the resulting uncertainty, the US banks have already tightened their credit policies. This has made it more difficult for households and companies to raise loans. There is a risk that tighter credit policies may cause the US housing market to deteriorate further. In combination with other factors, such as a weak labour market, this may lead to a sustained recession in the US economy.

RISKS TO THE DANISH ECONOMY

The capacity pressure in the Danish economy remains high, and unemployment is below the level that is assumed to be compatible with wage and price stability. There is a risk of high wage increases and thus further deterioration of competitiveness, which would weaken exports. In addition, there is a risk of a stronger-than-expected downturn in the USA with more pronounced effects on Europe and the rest of the world. This scenario would imply considerably weaker growth in Denmark's export markets.

Weaker economic growth and higher unemployment will increase the risk of default on loans, just as lower demand for loans will reduce the banks' basis for earnings. Further depreciation of the dollar also constitutes a risk factor for banks with considerable exposures to companies trading with the USA and other markets where profits are dollar-related.

The low unemployment and Danish households' generally sound finances are expected to buoy up housing prices. The baseline scenario assumes a modest decline in cash prices in nominal terms. However, there is a risk of stronger price drops, especially if interest rates climb to a considerably higher level, or in the event of a marked rise in unemployment. This scenario implies deterioration of household finances. The value of the banks' collateral would thus be reduced, and the banks would be affected in those cases where homeowners' are unable to service their loans.

A further increase in commodity prices is another significant risk. Higher commodity prices would reinforce budget pressures for companies and households. This would imply a higher probability of default on loans from Danish banks.

RISING FINANCING COSTS FOR BANKS

Liquidity and financing problems have been two key characteristics of the subprime crisis. Credit institutions without any significant exposure to subprime and structured credit have also been affected through the widening of the credit spreads and higher costs of financing in the money market. Danish banks have already raised their interest rates due to the higher financing costs.

Rising financing costs pose a risk to banks with large deposit deficits, especially those without a good rating. When interest rates increase, there is a higher risk that the interest rate for financing the deposit deficit will exceed the lending rate. The banks are thus exposed to a risk of lower earnings on lending. This exposure can be amplified by further deterioration of the banks' credit standing. The higher costs for the banks can often be passed on to the customers.^[1] Higher interest costs for the customer can lead to a higher probability of default on loans and thus to losses for the bank. 

Some banks have a safety valve in the form of mortgage loans since, under certain circumstances, the banks can pledge these loans as collateral for issuance of covered bonds. The latter constitute a stable source of financing equivalent to mortgage-credit bonds and enable the banks to match the maturities of bonds and loans. In addition, covered bonds are classified as eligible collateral by Danmarks Nationalbank, which means that they are included in the banks' liquidity reserves.

In 2007, the banks' excess liquidity cover beyond the statutory minimum requirement generally remained at the level of the preceding period, cf. Chart 25. However, several banks had very little excess cover; the lowest was 18 per cent at end-2007. Low excess liquidity cover makes the banks' more vulnerable, particularly in periods of turbulent financial markets. 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 are not functioning.

HIGHER INTEREST-RATE RISK FOR THE LARGE BANKS

The recent turmoil has led to increased volatility in the financial markets, and to higher costs of hedging against fluctuations in the market value of assets.

In 2007, the exposure to interest-rate fluctuations increased for a few banks. The banks in the Danish Financial Supervisory Authority's group 1 would have lost on average 2.0 per cent of their capital at the end of 2007 if interest rates had increased by 1 percentage point, compared with 0.6 per cent at the end of 2006. The interest-rate risk for the medium-sized banks in group 2 has generally decreased over the last year and is now close to the level for the banks in group 1, cf. Chart 26. This is in line with the tendency of previous years, i.e. bond holdings accounting for a diminishing share of assets in group 2.

HIGHER CREDIT RISK FOR DANISH BANKS

Extending credit to the corporate sector and the households is one of the primary functions of the banks. In doing so, the banks incur a credit risk. The finances of the corporate sector and the households and their resilience to adverse developments affect the banks' earnings, losses and capital structure, and thereby financial stability.

Increase in the estimated failure rates^[2] for Danish companies and the banking sector's expected losses on corporate exposures
The risk of especially the weakest Danish companies failing in the next few years rose considerably in 2007 compared with the preceding years, cf. Chart 27. The reasons are 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 established ones. The estimated failure rate for the median company also rose in 2007. The increase in estimated failure rates is broadly based across sectors, reflecting a general trend in the economy.

The banks' expected losses on corporate exposures^[3] rose considerably in 2007, albeit from a low level. The increase particularly reflects the higher estimated failure rates for companies. The banks' expected losses on corporate exposures amounted to around 0.8 per cent of total lending, compared with approximately 0.6 per cent in 2007. The losses may be greater if risks to the Danish economy are realised.

The banks' credit risk on households is still moderate
Capital gains on homes and equities have contributed strongly to the households' accumulation of wealth in recent years. The households are thus well-consolidated.

The households' debt as a ratio of income has, however, risen so that their ability to meet payments has become more sensitive to a decrease in income. The development in incomes is strongly related to the development in employment and unemployment, where some mild deterioration is expected during 2008 and 2009.

Danmarks Nationalbank has developed a method to simulate the effect of higher unemployment and interest-rate increases on the finances of Danish households, cf. Financial stability 2007. An analysis is performed of the share of Danish households that are financially vulnerable, assessed on the basis of their financial margin^[4]. The financial margin is compiled as the household's disposable income less a standard consumption budget and income-dependent housing costs.

On the basis of actual data for 2006 and simulated data for 2007, the households are still deemed to be robust, even in tough scenarios for the development in interest-rate costs and falling income.^[5] The calculations show that the situation of the households improved marginally in 2007, both in terms of the number of vulnerable households and the percentage of total household debt attributable to these households. Debt and interest costs rose substantially in 2007, but the impact was more than offset by rising incomes and falling unemployment.

Against that background, the banks' credit-risk exposure to households is assessed to remain moderate. However, uncertainty about the housing market in some parts of Denmark still constitutes a risk factor that these calculations are unable to capture.

Upward trend in credit-risk measures for banks
On the basis of Danmarks Nationalbank's failure-rate model, KIM, and assumptions of expected losses on exposures to households and agriculture, a credit-risk measure can be calculated for each bank.^[6] The credit-risk measure expresses the individual bank's expected loss ratio on its entire lending portfolio. The credit risk increased for all banks in groups 1 and 2 in 2007, cf. Chart 28. The increase is primarily attributable to the generally higher credit risk on corporate exposures. In addition, the banks have expanded their corporate exposures relative to other types of lending, and corporate exposures are normally associated with a higher credit risk than lending to e.g. households. The credit-risk measure is generally higher for banks in group 2 than for those in group 1, and these banks also accounted for the strongest growth in the credit-risk measure in 2007.

Weaker-than-expected economic growth or a downturn in the housing market may further reduce the ability of households and companies to service their bank debt.

Group 1 banks are more exposed to large exposures
The concentration of exposures in a bank affects its credit risk. A lending portfolio can be concentrated on a few customers, sectors or geographical areas. A high concentration on a few customers entails a greater risk of large losses, which is amplified by a high correlation between the estimated failure rates of the customers.

To gain an impression of the size of large exposures relative to the banks' buffers, large exposures are stated as a percentage of the excess capital adequacy, i.e. the part of the capital that exceeds the minimum requirement of 8 per cent, cf. Chart 29. The key ratio does not say anything about the correlation between the individual exposures.

At the end of 2007, the weighted average of large exposures amounted to 426 per cent of the excess capital adequacy for the banks in group 1. This is an increase by just over 100 percentage points on end-2006. The dispersion in group 1 was considerably lower at end-2007, cf. Chart 29.

For banks in group 2, the weighted average of large exposures as a ratio of excess capital adequacy fell in 2007 compared with 2006. Some banks are still operating with a substantial concentration of large exposures, and the correlation between exposures is likely to constitute a risk for these banks in particular.

RISKS IN IMPLEMENTATION OF INTERNATIONAL LEGISLATION

Transition risks in new capital-adequacy rules
The new capital-adequacy rules, Basel II, entered into force on 1 January 2007 with transitional provisions applying until the end of 2009. The transition to the new rules entails a number of risks to the banks.

The risks in the transition to Basel II are especially system-related and data-related risks associated with the new ways of calculating the minimum capital requirement. This is a very extensive and complex set of rules. In relation to Danish institutions, implementation of the new rules will result in a considerable overall reduction of the minimum capital requirement. This emphasises the significance of ensuring, from the outset, a good basis for determination of the institutions' individual solvency requirements and any additional capital requirements.

The implementation of the International Financial Reporting Standards, IFRS, in 2005 is an example of how difficult it can be to implement new models that are different from the previous procedures. In Denmark, the challenges related in particular to write-downs (impairments) on loans. In several cases the Danish Securities Council decided to request supplementary or new financial statements from the institutions in question as they had initially set their impairments too high. The Danish Financial Supervisory Authority extended the deadline for implementation several times. As a result, final implementation of the new rules did not take place until the presentation of the financial statements for 2007.

OPERATIONAL RISK

Payments, credit transfers and securities and foreign-exchange transactions are executed via the financial infrastructure. At the core of the infrastructure are a few systems handling very large amounts on a daily basis. Less reliable and efficient functioning of these systems would impose risks and costs on the financial institutions. 

There are several other types of operational risk, e.g. fraud that results in an unexpected loss for the bank in question. In 2007, the French bank Société Générale suffered a loss equivalent to 0.5 per cent of its assets and 15.7 per cent of its equity as a result of a single employees unauthorised dealings.

Focus on operational risk and liquidity risk in the financial infrastructure
In recent years, Danmarks Nationalbank's oversight of the financial infrastructure in Denmark has focused on the core systems operational stability, etc., and on liquidity conditions for system participants.

In 2007, the core systems were characterised by a high degree of operational stability. This is particularly important in a situation with financial turmoil, as a system failure is reflected in unintentional accumulation of liquidity and credit exposure among participants. A lack of confidence in the operational stability of the systems may have negative implications for the settlement of payments, etc., for example if the participants withhold payments to avoid liquidity shortages. If the participants start to withhold payments, this will be observed by Danmarks Nationalbank as a shift in the time profile for interbank payments in the Kronos payment system, among other indications. The time profile has been very stable over the last three years.

The participants' holdings of liquidity for transaction of payments are found to be generally sufficient despite the slight decrease in the excess liquidity cover for settlement of payments via Danmarks Nationalbank in recent years.