The greatest risks to Danmarks Nationalbank’s earnings and financial holdings are fluctuations in interest rate levels and the potential capital losses resulting from fluctuations in exchange rates, share prices, gold prices etc. In addition, Danmarks Nationalbank is exposed to credit losses as a result of collateralised lending and investments in bonds.
Danmarks Nationalbank’s financial portfolios
|Government bonds with a credit rating of AA- or higher||26||41|
|Government bonds with credit ratings of BBB- to A+||13||22|
|Other bonds with a credit rating of A- or higher2||57||40|
|Domestic mortgage bonds||32||31|
|Money market products (central bank deposits, reverse repo transactions etc.)||396||342|
|Other holdings and exposures|
|Exposure to equities||8||11|
|Exposure to corporate bonds||3||3|
|Selected risk measures/financial ratios|
|95 per cent expected shortfall4 as a percentage of net capital||5||10|
|Combined average rating of the portfolio5||AA+||AA+|
|Foreign exchange exposure (before FX hedge in brackets)|
Danmarks Nationalbank’s earnings are affected by interest rates
Developments in interest rate levels have a major impact on the returns on Danmarks Nationalbank’s financial portfolio through investment of the foreign exchange reserve and monetary policy deposits and loans. This constitutes a significant financial risk, and a risk that Danmarks Nationalbank has a strong focus on.
Danmarks Nationalbank’s foreign exchange reserves consist primarily of liquid reserves in the form of deposits with central banks, secured deposits with commercial banks (through so-called ‘reverse repo transactions’) and liquid European government bonds with short maturities. Given the generally short maturity of foreign reserve positions, returns typically follow developments in short-term money market interest rates in the euro area. The short-term money market interest rates follow the European Central Bank’s (ECB) monetary policy interest rates.
Similarly, returns on Danmarks Nationalbank’s liabilities also largely follow the monetary policy interest rate in Denmark, as Danmarks Nationalbank pays interest on the deposits that monetary policy counterparties can make into their current account with Danmarks Nationalbank, or in the form of certificates of deposit.
The Danish government also has an account with Danmarks Nationalbank, which carries interest at the transaction-based reference rate, DESTR.
Danmarks Nationalbank’s structural earnings stem from the interest rate differential between Danmarks Nationalbank’s assets and liabilities. This is similar to a commercial bank making money from the difference between deposit and lending rates, but unlike a commercial bank, the interest rate set by Danmarks Nationalbank is reserved exclusively for managing the fixed exchange rate policy.
Banknotes and coins in circulation account for a substantial share of Danmarks Nationalbank’s liabilities. When you withdraw cash from your bank, the bank has bought the cash at face value from Danmarks Nationalbank. In order to do so, the bank can borrow money from Danmarks Nationalbank or transfer some of its assets. Danmarks Nationalbank charges interest on the money it lends or receives a return on the assets it acquires. This return is called seigniorage. When interest rates are positive, Danmarks Nationalbank makes a profit from seigniorage gains. Conversely, it is an expense when interest rates are negative.
Foreign exchange reserve carry risk of fluctuations in exchange rates and gold prices
The foreign exchange reserve consists of assets denominated in foreign currencies and therefore exposes Danmarks Nationalbank to losses due to changes in exchange rates against Danish kroner. As we pursue a fixed exchange rate policy against the euro, the foreign exchange reserve consists mainly of euro-denominated assets. When the krone strengthens, you have to pay more euros for a Danish krone, and the value of foreign exchange reserve measured in kroner is therefore reduced. Thus, Danmarks Nationalbank suffers a foreign exchange loss when the krone strengthens. On the other hand, Danmarks Nationalbank earns an exchange rate gain when the krone strengthens. Danmarks Nationalbank manages the value of the krone against the euro solely for the sake of the fixed exchange rate policy.
Danmarks Nationalbank also holds assets in other currencies, such as the US dollar and the Japanese yen. The associated foreign exchange risk is generally converted into euro by means of so-called forward exchange contracts. This means that the overall foreign exchange risk is low; due to the fixed exchange rate policy, the potential weakening or strengthening of the krone against the euro is limited. For countries with a floating exchange rate, the risk of losses due to large exchange rate fluctuations is often significantly greater.
According to section 10 of the Danmarks Nationalbank Act, Danmarks Nationalbank must own a gold fund. Today, Danmarks Nationalbank owns 66.5 tonnes of gold as part of its foreign exchange reserve. Danmarks Nationalbank is thus exposed to losses resulting from a fall in the price of gold. Although gold constitutes only a small part of Danmarks Nationalbank’s assets, it represents most of Danmarks Nationalbank’s total market risk (see table above).
Potential earnings are weighed against the risk of capital losses in connection with equity and bond investments
In addition to deposits with foreign central banks and foreign government bonds, the foreign exchange reserve also consists of a number of assets aimed at spreading the risk and increasing earnings in the longer term, e.g. equities and bonds with longer maturities and/or lower credit ratings.
By assuming more risk, e.g. by buying even more equities, Danmarks Nationalbank is expected to be able to increase its long-term earnings. However, this means that Danmarks Nationalbank will be more exposed to large capital losses. Danmarks Nationalbank’s investment and asset allocation processes involve weighing up long-term expected earnings against the risk of capital losses. For Danmarks Nationalbank, it is crucial that no uncertainty arises concerning solvency, even in periods of market turmoil. Therefore, the overall level of risk is generally low.
Danmarks Nationalbank bases its day-to-day management of the foreign exchange reserve and domestic securities portfolio on an investment mandate that determines which asset classes Danmarks Nationalbank can invest in and investment frameworks for various risk measures.
The starting point for managing Danmarks Nationalbank’s market risk is the expected shortfall risk measure. Expected shortfall covers, somewhat simplistically, the expected loss in the 5 per cent worst-case scenarios for our portfolio. The risk measure is calculated using Danmarks Nationalbank’s proprietary risk model. Like other financial models, this model is inherently based on a number of assumptions and is therefore supplemented by simpler limits on equity exposure, interest rate sensitivity and currency exposure. Within this framework, Danmarks Nationalbank continuously decides on the most expedient specific asset allocation.
The Committee of Directors is informed at least once a year about developments in financial results, status on investment limits and the concrete allocation of the foreign exchange reserve and the domestic securities portfolio.
Investment assets have contributed positively to earnings in recent years
Danmarks Nationalbank’s earnings have in recent years been subject to structural pressures in the form of low interest rates. This is reflected in the fact that the negative return on money market placements exceeds the negative interest rate paid by Danish banks and the Danish government on their deposits with Danmarks Nationalbank. By investing in equities, bonds with longer maturities etc., Danmarks Nationalbank has generated higher earnings than would have been possible had the portfolio consisted only of gold and short-term deposits with central banks.
Danmarks Nationalbank regularly transfers some of its profit to the central government
Unlike a commercial bank that pays dividends to its shareholders, Danmarks Nationalbank is a self-governing institution. A share of any profit generated by Danmarks Nationalbank is normally transferred to the central government. How much depends on the size of the profit and the need for continuous consolidation of equity. Since 1995, Danmarks Nationalbank’s equity has grown approximately as much as nominal GDP in Denmark. Each year, the Committee of Directors approves how much of any profit is transferred to central government. Due to the structural pressure on earnings, nothing has been transferred in recent years.