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interest rates in recent years, the banks have incurred considerable maturity-related capital losses on their bond portfolios, which have offset the banks' relatively high interest income on bonds.

Since the banks are no longer obliged to compile their maturity-related capital gains or losses in their financial statements it is not possible to determine the extent of these capital losses in 1997. However, an estimate can be made on the basis of data from Statistics Denmark concerning the bond holdings of the financial sector distributed by maturity segment. On this basis the maturity-related capital losses are estimated at around kr. 2 billion in 1997.

Total capital gains on securities and foreign exchange, etc. in 1997 also conceals a large difference between the development in the first and second half-years. During the first half-year the banks achieved capital gains on securities and foreign exchange, etc. of kr. 3.2 billion, but a capital loss of kr. 1.2 billion in the second half-year.

During the second half of 1997 a number of banks chose to reduce the interest-rate sensitivity of their bond portfolios in view of expectations that interest rates would rise. One way of reducing sensitivity to changes in interest rates is to purchase short-term government securities. Another is to purchase mortgage-credit bonds at high yields which are therefore likely to be converted. After adjustment for the conversion probability the expected maturity of these securities is relatively short.

Box 2 High-yield mortgage-credit bonds High-yield mortgage-credit bonds are sensitive to shifts in the term structure of interest rates, like that which occurred during the second half of 1997. The reason was firstly that the drop in long-term interest rates increased the conversion gain to home-owners, giving them a greater incentive to convert their mortgage-credit loans. On conversion the outstanding bonds are redeemed at par, with a capital loss to the owner of the bond which is traded at a premium due to the high coupon rate. The second reason is that the bond owner suffers a loss since the disbursed amount must be reinvested at a lower yield. Thirdly,  the increase at the short-term end of the term structure reduced the value of a redeemed bond. As from the date of publication the bonds to be redeemed on the forthcoming interest-settlement date must be regarded as short-term zero-coupon bonds whose value drops when the short-term interest rate rises. All three factors contributed to the decrease in the price for the high-yield mortgage-credit bonds in the second half-year, in contrast to the low-yield mortgage-credit bonds, cf. the Chart.

However, during the second half of 1997 the term structure of interest rates flattened out. Short-term interest rates rose, whereas long-term interest rates dropped, cf. Chart 2.

The development in interest rates in the second half-year meant that yields were higher on long-term than on short-term bonds and that an investment strategy favouring purchase of short-term bonds and sale of medium- and long-term bonds gave substantial capital losses. Banks with high-yield mortgage-credit bonds were affected particularly, cf. Box 2.

In general the banks do not divulge their capital gains on trading activities in securities and foreign exchange, etc. so that the overall amount for the financial sector is not known. In the light of the high level of activity on the financial markets in 1997 these capital gains can be assumed to have been considerable.

In overall terms the value adjustments under unchanged market conditions and value adjustments as a consequence of a change in the market conditions for the banks' bond portfolios made a negative contribution to earnings in 1997. This was only partly offset by earnings derived from customer transactions.

The accounting principles imply overestimation of interest income in relation to core earnings since the maturity-related capital gains/losses, which are interpreted as being equivalent to interest income, are omitted. On the other hand, core earnings are underestimated since e.g. earnings on trading margins in connection with securities and foreign-exchange trading, etc. are included under value adjustments. The overall impact of the aforementioned factors on core earnings must be assumed to be negative.

Cost/income ratio

In absolute terms the level of costs has been receding compared to the beginning of the 1990s. However, on comparison with income the picture is less clearcut.

The cost/income ratio expresses the ability to match costs to the level of earnings. The Danish Financial Supervisory Authority defines the cost/income ratio as ordinary expenses¹⁾ to ordinary earnings²⁾. The calculation is based on data reported to the Financial Supervisory Authority. Chart 3 shows the development in the cost/income ratio, together with personnel expenses to ordinary earnings.

The cost/income ratio fell significantly up to the end of 1994 and has since remained stable as a consequence of moderate increases in expenses and income. The effect of the reductions in the number of staff is a decrease in personnel expenses to ordinary earnings over the entire period. However, the overall cost/income ratio shows that falling personnel expenses have been replaced by other operating expenses in recent years. The new expenses are related to e.g. information technology and to expansion or restructuring of distribution channels. Expenses of this type must be expected to be a significant element of banking activities in the years to come.

Table 1 shows that total personnel and administration expenses were very stable at kr. 20-21 billion throughout the period, but with a slightly rising trend from the low in 1995. The sector's adjustment of resources and costs has thus resulted in stable expenses in nominal terms, disregarding non-recurring expenses, for example severance pay. The reduction of the number of branches and employees has also contributed to the development in personnel and administration expenses.

Loan loss provisions

The amount of loan loss provisions is a normal indicator of the quality of the loan portfolio and the state of the economy. Loan loss provisions also fluctuated strongly in the period 1991-1997. The related expenses were historically high in both relative and nominal terms in 1992 when the banks recorded expenditure of kr. 15.8 billion, cf. Table 1. Thereafter loan loss provisions have decreased gradually to kr. 2.6 billion in 1997. These two extremes correspond to loan loss provisions/loans and guarantees of respectively 2.5 and 0.3 per cent (the provisions ratio).

Since loan loss provisions are accounted for in net terms it is not possible to see the amount of new loan loss provisions because they are netted with surplus provisions, which are carried back. Provisions are carried back if the previously evaluated risk of loss is reduced, for example as a consequence of the cyclical development.

In a historical perspective the level of losses and provisions in recent years is hardly sustainable. The average provisions ratio was 1.2 per cent in the period 1975-1997. The natural level of provisions in the future will not necessarily correspond to the historical level, but will be related to the risk profile as well as the balance-sheet structure. The following is a more detailed analysis of the development in the financial result in 1991-1997 on application of an average provisions ratio of 1.2 per cent.

Core earnings

The development in the financial result can be measured as the return on equity through core earnings. Chart 4 compares core earnings to equity with actual losses and provisions for the year, and with theoretical core earnings based on average provisions of 1.2 per cent of loans and guarantees.

The difference between the two curves in the Chart illustrates that the low level of provisions in the last three years contributed to improving core earnings to equity. With provisioning requirements closer to the historical average the banks' financial statements would have shown more clearly that in reality core earnings have been under pressure in recent years. In addition, core earnings may be overestimated as a consequence of maturity-related capital losses, cf. the section on value adjustments.

The greater pressure on earnings has led several banks to engage in new business areas, for example mortgage-credit products, or to strengthen their activities in e.g. trading and various types of project or corporate financing. Any earnings from these strengthened activities are typically included in core earnings, with the exception of earnings derived from customers, cf. the section on value adjustments, whereas earnings from new activities concerning new products are stated separately in the item

"value adjustment of capital interests". This item is a result of value adjustment of the business enterprises on whose operational and financial management the bank directly or via intra-Group companies exerts a significant influence.

Particularly at the beginning of the period the value adjustment of capital interests fluctuated from positive to negative amounts. Since 1995 there has been a clear change to a contribution to earnings of kr. 2-3 billion, cf. Table 1. It would seem that earnings related to this erosion of sectoral barriers may make a fixed contribution to the banks' earnings. However, the size of the earnings will depend on the competitive situation in the "new sector". In addition, the barriers between various types of financial enterprise are generally being eroded, entailing intensified competition in all sectors.

In connection with the new activities and products the banks, in some cases, charge fees or commission for services rendered to companies within the same financial group. These intra-Group payments are included directly in core earnings under net fee income in the banks' financial statements. In correctly consolidated accounts intra-Group transactions will be eliminated. In line with the growing significance of the activities of financial subsidiaries to a group's total earnings the consolidated accounts should be used as the basis for analysis, rather than the banks' accounts.

Summary

To a certain degree low loan loss provisions and negative maturity-related capital gains conceal that the banks' core earnings are subject to pressure as a consequence of greater competition and a lower level of interest rates.

There seems to be little prospect of less competition from either domestic or foreign operators in the financial sector. This may increase pressure on the interest margin and thus on core earnings in the coming years. Tight cost control will therefore still be required.

Competition and the low level of interest rates are positive trends for the development in the economy and for customers. In recent years the banks have reacted mainly by expanding their activities within either traditional banking operations or new activities.

Footnotes