Earnings of Danish Banks

Introduction

In each of the three last years the banks reported pre-tax profits of around kr. 13 billion. To a significant degree these results were attributable to capital gains on securities and foreign exchange and to reduced loan loss provisions.

Competition for customers has intensified in the 1990s. The new climate of competition and the drop in the level of interest rates have led to a narrowing of the interest margin, while the cost/income ratio is almost unchanged.

Measured in terms of core earnings¹⁾ return on equity was 9-12 per cent in the last four years. However, it is doubtful whether core earnings at this level can be maintained. Indications are that a normalization of the level of loan loss provisions and expectations of increasing domestic and foreign competition will put more pressure on the banks' earnings in the coming years. At the same time, the core earnings of recent years may be overestimated.

This article first considers the interrelations between competition, the interest-rate level and the banks' interest margin. It then turns to value adjustment of securities and foreign exchange, including maturity-related capital gains/losses, which especially in 1997 played a significant role. This is followed by a review of the development in the cost/income ratio and in loan loss provisions. Finally, the article considers the development in core earnings and how the banks' financial statements reflect their reaction to the competitive situation.

Competition, interest-rate level and interest margin

During the 1990s competition between banks has intensified. One reason is a greater degree of transparency in the market for lending and deposits which has made it easier for customers to monitor and compare lending and deposit rates. Another significant factor is the underlying development in the economy where the downturn at the beginning of the 1990s made it difficult for borrowers to change banking relations. For many bank customers this situation has changed in recent years, reflected for example in the extremely low level of enforced property sales and bankruptcies, and thereby also the low level of the banks' loan loss provisions. Concurrently customers have become increasingly aware of the opportunity to change banking relations. The intensified competition has added to the pressure on the banks' interest margin.

The interest margin has also been subject to pressure from a falling interest-rate level as the lower limit for the deposit rate de facto is 0 per cent, whereas the lending rate is still under pressure.

Banks have other interest income and expenditure than that arising from loans and deposits. For example, banks draw considerable interest income from their bond portfolios. Coupon rates on the banks' ongoing bond investments will decrease in line with the declining level of interest rates since bonds are normally issued within the limits for "blue-stamping"²⁾ pursuant to the Danish taxation rules. Interest income from bonds is thus affected adversely by a drop in interest rates, but with the time lag attributable

to the lower coupon rate on the restructuring of the portfolio as bonds mature or are subject to conversion or ongoing restructuring. Since the purpose of this article is to evaluate the core earnings in the sector the focus in the following is on the development in the interest margin for all interestbearing assets and liabilities, cf. Chart 1.

During the period the average annual yield to maturity on 0-3-year government bonds fell from 9.9 per cent to 4.2 per cent. The interest margin decreased from 3.0 per cent to 2.3 per cent. The development in the interest margin shows that it was not affected by the decline in the level of interest rates at the beginning of the period. A possible explanation is that competition for customers was less pronounced at the beginning of the 1990s than in recent years. Concurrently the weak cyclical development enabled the banks to reduce their financing costs and thereby interest expenditure by more than the drop in lending rates and bond yields, entailing a relatively greater reduction in interest expenditure than in interest income. On the other hand, the more intense competition and greater mobility of customers, together with the falling interest rates as from 1995, have led to a considerable narrowing of the interest margin.

This development is reflected in the banks' profit and loss accounts. The falling interest rates and the narrowing of the interest margin thus have an impact as from 1993 when net interest income, cf. Table 1, began to decrease.

Until 1994, where the banks' fee-based income was particularly high due to the banks' involvement in conversions of mortgage-credit loans, the total net income from interest and fees was rising. Since that year net income from interest and fees has been around kr. 36 billion. The increase in fee-based income and the declining interest margin thus both entail that fees are of increasing importance to overall earnings. A significant part of feebased income is derived from securities trading and custody. Fee-based income accounted for 14 per cent of total net income from interest and fees in 1991. The proportion had risen to 24 per cent in 1997. Due to this diversification in earnings the banks have become less dependent on interest income.

Value adjustment of securities and foreign exchange

The Executive Order on Presentation of Accounts issued by the Danish Financial Supervisory Authority contains the concept of financial current

assets, which account for the largest share of the banks' securities portfolios. The latter are marked to market in the banks' accounts. This Danish accounting policy entails that "value adjustment of securities and foreign exchange, etc." in the profit and loss account in principle comprises the value adjustment of the securities portfolio for the year.

However, value adjustment of securities and foreign exchange, etc. in total comprises three subcomponents: earnings derived from customer transactions³⁾, value adjustments under unchanged market conditions⁴⁾ and value adjustments due to changes in market conditions⁵⁾.

It can be argued that an analysis of the development in the banks' core earnings should include earnings derived from customer transactions as income from fees and commission, since customer-derived earnings depend on the bank's trading and capital-market activities. Likewise value adjustments under unchanged market conditions, which depend on the choice of coupon rate for the bond portfolio, should be accounted for as an adjustment of interest income. The remaining actual value adjustments, which should be kept separate from core earnings, are thus solely value adjustments due to changes in market conditions⁶⁾.

The banks' large portfolios of fixed-yield bonds entail that the overall result is very sensitive to changes in the level or term structure of interest rates. Changes in the market value of shares do not affect the result as strongly since the banks' own portfolios are modest compared to their bond holdings.

As shown in Table 1, Value adjustment of securities and foreign exchange, etc. yielded considerable gains as well as considerable losses during the period. In 1993 net gains totalled kr. 9.2 billion, while in the following year the net capital loss was kr. 5.0 billion. Since 1995 capital gains have been positive but declining. In 1997 the banks' total capital gains on securities and foreign exchange, etc. amounted to kr. 2.0 billion, compared with kr. 4.6 billion in 1996. The decrease is related primarily to capital losses on bonds and derivatives, whereas capital gains on both shares and foreign exchange were considerable. It is important to isolate the banks' pooled pension funds' share of the value adjustment of bonds, shares, mortgage deeds, foreign exchange and other financial instruments from the respective bank's value adjustment of its own securities portfolio. Otherwise value adjustments are obscured.

The substantial negative value adjustments of the banks' bond portfolios are primarily due to maturity-related value adjustments, i.e. value adjustments related to a reduction of remaining maturity and to early redemption. The reduction of remaining maturity is the value adjustment arising when a bank e.g. holds bonds with coupon rates higher than the market yield. These bonds are traded above par, leading to negative value adjustment solely because the price approaches par as the maturity date of the bonds draws nearer. The early redemption of bonds at high coupon rates which are traded above par likewise entails a capital loss because the bonds are redeemed at par. Since, in 1997, the coupon rates for especially short- and medium-term bonds exceeded market yields due to the significant drop in

Box 1 Example of reduction of remaining maturity The Chart shows the price fluctuation in 1997 in a 9-per-cent bullet issue 1998 in relation to the beginning of the year. The value adjustment is broken down into a contribution from the reduction of remaining maturity and a contribution from the change in the level of interest rates. The two contributions are compiled from the daily calculations of the price of the bond on the following trading day at an unchanged yield to maturity. The difference between the calculated price and the price on the previous trading day reflects the effect of the reduction of remaining maturity. The difference between the calculated price and the actual price on the following trading day expresses the proportion of the value adjustment which is due to the change in the interest-rate level. On January 2, 1997 the price was kr. 108.65 per 100. Since the loan expires on November 15, 1998 the bond had just under two years to drop by 8.65 price points to par. The total price drop in 1997 was 4.75 price points, of which 4.54 price points could be attributed to the reduction of remaining maturity and the remaining 0.21 price points to the rise during the year at the short-term end of the term structure of interest rates, cf. Chart 2.

"to be continued"

Footnotes