High earnings can counteract increased risks for the banks

The ECB and the Fed have communicated that they will keep policy rates at a restrictive level at the upcoming interest rate meetings, but that they will assess adjustments on an ongoing basis. This communication led to a further increase in long-term government bond yields though yields have decreased somewhat in November, see chart 1. The yields on 10-year US and German government bonds are currently respectively 0.6 per cent and 0.1 per cent higher than at the start of 2023. An intentional aspect of monetary policy is that the increase in long-term yields reduces the profitability of long-term business investments and makes it more expensive for homeowners to obtain fixed-rate loans. 

Quantitative tightening could further increase long-term yields

The ECB and the Federal Reserve Bank are expected to continue to reduce their bond holdings through quantitative tightening,¹ and the euro area countries are expected to increase sovereign debt issuance. Both factors could further increase long-term yields. Long-term yields can generally be viewed as an average of the expected future short-term yields, plus a maturity-related risk premium, the term premium. Term premiums may increase as a consequence of quantitative tightening, which, all other things being equal, will further increase long-term yields. Since May, the US term premium has increased, which has helped to push long-term yields further up. Conversely, a relatively low term premium in the euro area is dampening the increase in long-term yields, see chart 2. The low term premium means that long-term yields to a greater extent reflect expectations of short-term yields, and thereby monetary policy. 

Euro area financial market volatility eased in the 2nd half of 2023

Financial market volatility has declined as market expectations of monetary policy have stabilised and the banking turmoil in March 2023 has diminished, see chart 3. This is also supported by corporate bond credit spreads, where yield premiums for riskier businesses have gradually declined since the bank turmoil in March 2023, see chart 4.

Even though financial market volatility has declined since the turmoil in March, both volatility indices and credit spreads are still at a higher level than before monetary policy interest rates were raised in 2022. The banks in the euro area and Denmark also report that credit standards have been tightened for loans to households and firms, and demand for new loans has diminished. In Denmark, the tightening of credit standards has taken place by, among other things, requiring larger disposable incomes as a natural element of the monetary policy transmission to the real economy, and in Denmark there is no indication of any extraordinary contribution from stress in the financial system.²

Falling energy prices have pushed down inflation, but core inflation remains high

Inflation continued to decline in the 2nd half of 2023 in Denmark, the euro area and the USA, see chart 5. In particular, falling energy prices and, to a lesser extent, foods have contributed to a significant decline in inflation over the past year, see chart 6. Yet underlying inflation still remains high. Core inflation has declined to a lesser extent than headline inflation, which has helped raise market expectations about the duration where the monetary policy rates will remain at the current levels. 

High wage growth in the USA and the euro area can be expected to keep inflation at a high level, which may require central banks to either maintain interest rates at the current level for longer, or raise interest rates further to bring inflation down to its 2 per cent target. The drop in energy prices has contributed significantly to falling inflation, but the supply situation in the energy market is still subject to considerable uncertainty and may result in new increases in energy prices and thereby higher inflation.

The monetary policy tightenings will dampen the economy in the coming quarters

In the latest projection, Danmarks Nationalbank expects a continued slowdown in growth for a while longer, bringing the Danish economy close to a neutral cyclical situation in the course of 2024.³ Danmarks Nationalbank’s projection for the Danish economy assumes that inflation in our trading partner countries will be reduced without significantly lower growth than projected in the latest forecasts from international organisations. The International Monetary Fund (IMF) expects slower growth in the major economies in 2023 and 2024, see chart 7. The US and European economies have been more resilient than the market had expected in the wake of historically high interest rate increases. The increased resilience is reflected, among other things, by continued low unemployment and a modest increase in the level of failed businesses in 2023. 

The risk outlook for the Danish and international economies depends on several factors, including how quickly and strongly the monetary policy tightening affects growth and inflation.⁴ There is also considerable geopolitical uncertainty, since the war in Ukraine and further escalation of the conflict in Israel/Palestine may affect energy prices and inflation. Finally, risks related to the Chinese real estate sector may affect Danish growth through, among other things, tighter financial conditions. 

Lending to the real estate industry has previously inflicted heavy losses on the banks. During both the economic crisis in the 1990s and the financial crisis, lending to the real estate industry was the loan category that led to the highest share of impairment charges.⁵

Higher interest rates, an economic slowdown and falling real estate prices increase the risk of bank losses from the real estate sector. The Systemic Risk Council has recommended that a sector-specific systemic risk buffer of 7 per cent be activated for exposures to real estate firms. See also chapter 7, Capital and stress tests.

Institutions have significant and concentrated exposures to real estate firms

The credit institutions have large exposures to the commercial real estate market, which is very heterogeneous, see box 1. Lending to real estate firms amounts to kr. 537 billion, equivalent to approximately 38 per cent of the credit institutions’ corporate exposures. Lending to real estate firms has increased in recent years, with medium-sized banks’ lending increasing by around 15 per cent annually in the 2nd quarter of 2023, while the systemically important credit institutions’ lending increased by almost 8 per cent, see chart 8. Most of the real estate firms’ external financing is mortgage loans from the systemically important credit institutions, although the medium-sized banks also have pronounced exposures to real estate firms, see chart 9. Even though the real estate firms are primarily mortgaged through the mortgage credit institutions, the risk of losses is greatest for the banks. The banks typically provide the financing which in the event of default ranks the lowest in respect of the underlying collateral. 

At the same time, the institutions’ lending to real estate firms is to a great extent concentrated on their largest customers, see chart 9 – and also to a greater extent than for customers in other sectors, although there is great variation in concentration across the banks. Prior to the financial crisis, several of the failing institutions also had significant real estate exposures and a large proportion of lending concentrated on a few large firms.⁶

Risk of further price drops for commercial real estate

The sharp increase in interest rates is expected to exert downward pressure on commercial real estate prices. Compared to previous years, there have been very few commercial real estate transactions in 2023, see chart 10. This may indicate a wide gap between buyers and sellers and that commercial real estate prices have not yet adjusted to the new interest rate level. Market participants report a 10-per-cent decline in prices in 2022 and expect further price drops in 2023 for all categories of real estate.⁷ Prices are expected to experience a larger decrease outside the major cities.

The valuation of commercial properties is related to the interest rate level via the yield requirement, where lower real estate prices will be reflected in a higher required yield.⁸ The yield requirement has increased by around 1 percentage point since the beginning of 2022 for all real estate categories except retail, see chart 11. The higher yield requirements should be viewed in the light of the rising interest rates, which augment investors’ alternative return options and thereby their required returns from commercial real estate. The 1-percentage-point increase in the yield requirement generally corresponds to the historical correlation between interest rates and yield requirements.⁹ Several of the largest real estate firms state in their annual reports that an increase in the yield requirement of 1 percentage point would reduce the value of their properties by roughly 20 per cent. Therefore, there is a risk of further price drops for commercial properties.¹⁰

Divestment of Swedish firms’ Danish real estate portfolios could lead to falling prices for Danish properties

A number of Swedish real estate firms are facing challenges with refinancing their debt, and there is a risk that this may lead to divestment of their Danish real estate portfolios. Several of the Swedish real estate firms have announced that they will sell off their real estate portfolios. Divestment of substantial real estate portfolios could push down prices for equivalent properties and thereby affect the value of Danish commercial properties. Due to the low level of transactions, a price correction related to divestment by the Swedish firms at this point in time would have a relatively great effect. However, the price impact would be limited by the size of the Swedish firms’ Danish real estate portfolios as a proportion of the overall Danish market. The largest Swedish firms have properties in Denmark worth kr. 99 billion and debt to Danish credit institutions amounting to kr. 43 billion.¹¹

The Danish real estate firms do not face the same refinancing risks as their Swedish counterparts. The Swedish real estate firms are to a great extent financed by corporate bonds with relatively short maturities and thereby have significant debt that will have to be refinanced in the coming years. Unlike the Swedish real estate firms, the Danish firms are predominantly financed by taking out mortgage loans, most of which have long maturities, see chart 12. The Danish real estate firms only issue corporate bonds to a limited extent, and thereby have a limited refinancing risk. 

Falling real estate prices increase institutions’ losses in the event of default

Falling commercial real estate prices may result in the collateral pledged for the loans not being sufficient to cover the full exposure. This may lead to losses for the institutions in the case of default of the loans. For the majority of the real estate firms, the value of the properties pledged as collateral exceeds the value of their total debt by a certain margin. However, there are a number of real estate firms whose loan-to-value ratio is already high and for which falling real estate prices will further increase the loan-to-value ratio, see chart 13.

Loan-to-value ratios are at around the same level as at the start of 2022, before the sharp interest rate increases set in. The moderate change in the loan-to-value ratios should be viewed in the light of the very low number of transactions in 2023. Transactions in the commercial real estate market are indicative of the valuation of similar properties. It can therefore be expected that loan-to-value ratios will increase as trading activity increase and prices adjust to the current interest rate level.

In the event of default on a loan, the institutions’ losses will depend, among other things, on the loan’s ranking and the value of the underlying collateral. As a general rule, the mortgage credit institutions have the highest-ranking mortgages on the properties against which the real estate firms have provided collateral for their loans. For the banks, only around 70 per cent of the lending to real estate firms are therefore covered by mortgaged properties. The remaining lending is covered by other types of collateral, mainly guarantees and surety from other companies that are usually affiliated to the borrower. The value of the sureties and guarantees thereby also depends on the resilience of the guarantors.

Real estate firms are already under pressure from higher interest rates, and more will be challenged if rental income declines

The significantly higher interest rates have increased the real estate firms’ financing costs, as almost 80 per cent of the firms’ mortgage loans are variable-rate loans. Of the firms’ variable-rate mortgage loans, 60 per cent are interest-only, see chart 14.

Currently, just over 9 per cent of lending to real estate firms is to firms with a solvency ratio below 20 per cent and a debt servicing capacity below 100 per cent¹¹, see chart 15. Before the sharp interest rate increases occurred in early 2022, the corresponding number was just over 4 per cent.¹²

In a risk scenario, where the economic conditions deteriorate, the real estate firms’ earnings will likely decrease, as demand for residential and particularly commercial properties is determined by the level of economic activity. An economic downturn would affect real estate firms’ earnings both through lower rental levels and higher vacancy rates, which would further reduce the firms’ debt servicing capacity. This might cause several additional real estate firms not having sufficient revenue to meet their financial obligations. In a scenario where the firms' earnings decline by 5 per cent as a consequence of higher vacancy rates and lower rental income, approximately 12 per cent of lending to real estate firms is to firms that would not have sufficient earnings to service their debt obligations, while also having a solvency ratio below 20 per cent, see chart 15. If earnings declined by 10 per cent, the share of lending to distressed firms would increase to close to 15 per cent. For comparison, the real estate firms’ primary operating profit excluding value adjustments fell by approximately 23 per cent from 2008 to 2009. Earnings are closely related to the development in vacancy rates, which increased by around 6 percentage points in the years following the financial crisis. Vacancy rates for office, commercial and residential rental properties remain at a low level, see chart 16. An economic downturn could be expected to push up vacancy rates across the various real estate segments. 

There is prospect of interest rates remaining at a higher level, and this is expected to maintain the pressure on homeowners' disposable income. The higher interest rates have not yet had their full impact, and the interest rate pass-through is expected to continue as homeowners with existing variable-rate loans have to pay more to service their debt. This happens when the interest rate is adjusted, and new loans are raised. The higher interest rates increase the risk that some homeowners will not be able to meet their financial obligations. 

Higher interest rates maintain the pressure on homeowners' finances

When homeowners face rising interest payments, this reduces their resilience. It is expected that 43,500 more homeowners will have a budget deficit in 2023, compared to 2021, see chart 17.¹⁴ This corresponds to approximately 4 per cent of all homeowners in Denmark. When homeowners have budget deficits, their income is not sufficient to sustain a modest spending level, pay their fixed expenses and meet their debt obligations. The total debt of homeowners expected to have a budget deficit was kr. 71 billion by the 2nd quarter of 2023. Of the homeowners expected to have budget deficits, 45 per cent have a loan-to-value ratio above 60 per cent. 

Homeowners with budget deficits pose a risk for Danish credit institutions, as they may be under too much pressure to meet their debt obligations. In the event of default, there is a risk that the housing debt will result in losses for the credit institutions. However, the majority of these homeowners’ debt is covered by the underlying mortgage. Danmarks Nationalbank has previously estimated¹⁵ that the difference between housing debt and expected realised sales prices for homeowners with budget deficits amounts to kr. 1.8 billion. This is a relatively modest exposure compared to the systemically important credit institutions’ profits before taxes of kr. 30 billion in the 1st half of 2023, see chapter 5, Earnings.

A homeowner who is expected to have a budget deficit is typically at the lower end of the income distribution and has lower debt and fewer liquid assets compared to other homeowners. This is partly because many of these homeowners live alone, and their household income therefore consists of only one person’s income.

Real wage growth will strengthen homeowners’ personal finances in 2024

In contrast to the sustained higher interest rates, real wage growth will strengthen homeowners’ personal finances in the coming quarters. Therefore, it is expected that the number of homeowners with budget deficit will decline by 19,100 during 2024, se chart 17.¹⁶ The decreasing number of homeowners with an expected budget deficit makes the credit institutions relatively less exposed to losses, if these homeowners are forced to sell their homes. Despite this decline, the number of homeowners projected to have budget deficits in 2024 remains higher than in 2021. This indicates that the higher interest rates will continue to drain the resilience of some homeowners. 

Even if unemployment were to rise significantly, this would only moderately increase the number of homeowners with budget deficits. The moderate increase is due, among other things, to the fact that a significant proportion of the households expected to become unemployed do not have a housing loan. Moreover, the homeowners are, in many cases, supported by unemployment benefits or a partner's unaffected income.¹⁷

Households have become more sensitive to higher interest rates

Since the beginning of 2022, homeowners have increasingly taken out variable-rate housing loans. Of the total mortgage lending to households of kr. 1,633 billion in October 2023, 53 per cent is at variable interest rates. At the same time,  the housing market activity slowed down in the 1st half of 2023, implying that total lending from Danish mortgage credit institutions to households was 2 per cent lower in October 2023 compared to the year before, despite the increase in the variable-rate loan types, see chart 18.¹⁸

The interest rate pass-through is gradual, and a significant proportion of the homeowners already has an interest rate reflecting the higher interest rate level.Of the variable-rate mortgage debt of kr. 875 billion in the 2nd quarter of 2023, kr. 600 billion was taken out before the beginning of 2022. Of these 47 per cent corresponding to kr. 283 billion has an interest rate fixated before 2022, where the short-term interest rates started to rise, see chart 19. This housing debt mainly comprises F3 and F5 loans, which will be subject to interest rate adjustment in the coming years. If interest rates remain at a higher level, these homeowners are expected to have higher mortgage payments after the interest rate adjustments. 

Variable-rate mortgages combined with deferred amortisation increase homeowners’ interest rate sensitivity and may pose a risk to households and banks if interest rates rise further. It is important that homeowners who take out variable-rate loans with deferred amortisation have a sufficient economic buffer to stand against any further interest rate increases.

Higher interest rates increase home buyers' debt service-to-income ratio

Higher interest rates increase home buyers’ mortgage payments relative to their disposable income, i.e. the debt service-to-income ratio. The median debt service-to-income ratio for home buyers has increased by more than 6 percentage points since the beginning of 2022, see chart 20.

Especially the home buyers, who have taken out housing loans with deferred amortisation, have experienced a large increase in the debt service-to-income ratio, as the median has risen 9.5 percentage points during the considered period. The notable increase in the debt service-to-income ratio for loans with deferred amortisation means that the difference in the actual debt service-to-income ratio between loans with and without deferred amortisation has narrowed significantly. The reduced difference is primarily due to the fact that the interest rate pass-through is larger for loans with deferred amortisation. The debt servicing costs consist of interest and administration payments as well as principal payments. The annuity principle implies that part of the interest rate increase will be offset by lower principal payments, whereas the increasing interest rates will pass-through fully for loans with deferred amortisation.¹⁹ On average, home buyers obtaining loans with deferred amortisation have higher debt relative to their income, which contributes to a higher pass-through onto their debt service-to-income ratio. 

The higher interest rates have caused a decrease in house prices in 2022 and are still eroding  home buyers’ disposable amounts. However, the decrease in house prices has been somewhat smaller than expected, given the significant interest rate increases and high inflation. The housing market has recovered slightly within the most recent months, and the wage growth is expected to push up nominal house prices. Yet there is still a risk of declining house prices going forward. This risk may materialise if, for example, the supply situation worsens and the home buyers’ disposable amounts are reduced further by rising energy prices.²⁰

The systemically important credit institutions’ profit before tax was kr. 30 billion in the 1st half of 2023 and has increased by kr. 8.4 billion compared to the 2nd half of 2022, see chart 21. The result for the 1st half of the year corresponds to a return on equity of 12 per cent p.a. The increase was driven by sustained positive development in the institutions’ core earnings, continued low loan impairment charges, and positive value adjustment of securities portfolios. Earnings are the first safeguard against losses, and the improved performance therefore helps to strengthen the institutions’ resilience.

The banks’ impairment charges remain low

Loan impairment charges remained low in the 1st half of 2023, see chart 21. On determining their impairment requirement, institutions must take expectations of future performance into account. Most institutions have maintained or increased their management estimates as a consequence of the macroeconomic uncertainty. The total amount reserved by the institutions for future loan losses amounted to approximately kr. 40 billion at the end of the 1st half of 2023.²¹ For comparison, impairment charges in 2009 amounted to approximately kr. 45 billion; and in the 2008-12 period to a total of kr. 131 billion, which contributed to weak results despite strong core earnings. 

The positive earnings effect from higher interest rates will be reduced by increased impairment charges in the event of a significant cyclical downturn.²²

Higher interest rates increase core earnings

The increase in core earnings in the 1st half of 2023 is primarily driven by higher net interest income, see chart 22. The higher net interest income should be seen in light of the fact that institutions have raised their deposit margins in line with the increases in monetary policy interest rates since 2022 as described in the following section. Conversely, the contribution of net fee income to core earnings declined, mainly as a result of lower loan fees due to lower activity in the housing market and lower fee income from securities transactions and accounts. The gradually increasing staff and administrative costs over a number of years should be seen in light of increased administrative costs, including regulatory and compliance measures as well as IT investments.

The increase in net interest income is primarily driven by the deposit margin

The increase in net interest income is mainly driven by institutions having significantly increased their deposit margins²³ in line with the interest rate increases since 2022, see chart 23. This means that the difference between banks' deposit rates and the money market interest rate has increased, see box 3. The institutions’ deposit margins for households and non-financial businesses are 2.5 and 2.1 percentage points, respectively, the highest level in two decades. From the 1st half of 2022 until the 1st half of 2023, net interest income has increased for the systemic banks by approximately kr. 10 billion. The various contributions are estimated to amount to kr. 10 billion from the deposit margin, kr. -3 billion from the lending margin²⁴ and kr. 3 billion from other effects²⁵, respectively. The negative contribution from the lending margin is mainly due to the fact that the institutions’ lending margin for households has declined since the 1st half of 2022. The decline is driven by interest rate hikes not having fully passed through to lending rates for households since 2022.

In the 1st half of 2023, institutions’ deposit margins were significantly above their 2006-08 levels,²⁶ averaging 1.1 percentage point for households and 0.6 percentage points for non-financial corporations. In the longer term, institutions may not be able to maintain the current deposit margin levels. With the current balance sheet composition, the impact on earnings would have halved if the deposit margin had been at the average level seen in 2006-08.

Institutions in all EU countries have increased their deposit margins

Institutions in all EU countries have increased their deposit margins since 2022, and in several countries deposit margins have been raised to around 2006-08 levels, see chart 24. The increase in deposit margins should be seen in light of the fact that institutions in most EU countries have maintained their deposit rates as interest rates have risen. In Denmark, however, the deposit margin was higher in 2023 than it was in 2006-08. Despite a higher deposit margin in 2023, the deposit margin in Denmark is still among the lowest in the EU.

Bank deposit surpluses and legal requirements for bank liabilities have reduced the value of deposits  as funding

Deposits constitute an important source of funding for the institutions, as deposits are used as a stable source of loan financing, among other things. In contrast to the years leading up to the financial crisis, banks have since 2017 had a growing deposit surplus, i.e. the difference between their bank deposits and bank lending, see chart 25. The growing bank deposit surplus is due, among other things, to a structural shift in credit from bank lending to mortgage lending, where funding is provided by external bond investors. From 2017 to 2022, deposits as a share of total lending, including mortgage lending, have grown from 35 to 42 per cent. The growing bank deposit surplus has meant that the banks have a reduced need for additional deposits, which, taken in isolation, has reduced the incentive for banks to raise deposit rates.

Furthermore, the value of deposits as a source of financing has decreased due to the regulatory requirements for the composition of the institutions’ liabilities introduced after the financial crisis, including requirements for stable funding, the net stable funding ratio²⁷ (NSFR) and the minimum requirement for eligible liabilities (MREL). The requirements address various risks. MREL implies that a certain amount of the institution’s liabilities must be eligible liabilities, which deposits are not.²⁸ Thereby, eligible liabilities accounts for a larger share of the banks’ financing than previously, which, taken in isolation, decrease the need for deposits. NSFR has generally increased the cost of funding, including in relation to deposits, which, however, are relatively less affected than other sources of funding. NSFR requires that the institutions may have a need for a larger amount of deposits than previously, as deposits as a general rule must be placed in short term assets, which typically contributes to a lower return. All else being equal, the two requirements have thus lowered the value of deposits as a source of funding. 

Households only look for alternatives to deposits to a limited extent

Since 2022, the interest rate differential between demand deposits, time deposits and bonds has increased significantly, see chart 26. Some Danish households have begun to respond to the interest rate gain by holding time deposits or bonds instead of demand deposits, but overall, the response from Danish households has been limited. 

As the interest rate differential increases, it becomes relatively less attractive to have demand deposits with banks. Taken in isolation, bond purchases or debt repayments may prompt customers to reduce their bank deposits. Since the beginning of 2022, Danish households have increased their holdings of time deposits and bonds by kr. 25 billion and kr. 11 billion, respectively, see chart 27. At the end of the 1st half of 2023, Danish households’ demand and time deposits amounted to kr. 748 billion and kr. 268 billion, respectively. At the same time, household bond holdings were kr. 34 billion.

There may be several reasons why households have only to a limited extent responded to the interest rate gain. The size of deposits held by households varies considerably. For example, 64 per cent of Danish households have bank deposits below kr. 100,000, see chart 28. Among other things, households hold bank deposits in order to carry out transactions, and the deposits also act as savings. If households choose to place their demand deposits in, for example, time deposits or bonds, they will be able to achieve an interest rate gain. However, this placement implies a different risk profile, and whether the gain is sufficient depends on the time horizon and preference of the individual household. Overall, households’ limited response to the interest rate gain shows that direct access to bank deposits without, for example, having to pay a fee is important to households. However, a higher interest rate differential has historically contributed to households buying bonds or paying off debt, which may lead to a decrease in bank deposits.²⁹

Danish banks continue to have a robust liquidity position, enabling them to withstand severe liquidity stress. It is important that institutions have sound liquidity management, which includes adjusting their liquidity position based on adequate liquidity stress tests, which is also required of banks in the EU.

In Danmarks Nationalbank’s most severe liquidity stress test scenario, all systemic banks in Denmark have a survival horizon of at least five months with positive excess liquidity, see chart 29. In the scenario, there is assumed to be no access to funding markets, while customers’ drawing on the banks’ loan facilities increases, and deposits fall significantly.³⁰

Credit spreads on European banks’ capital and debt instruments have declined since March

Credit spreads across European banks’ capital and debt instruments have been declining since the end of March, although they remain higher than before central banks’ started tightening monetary policy in early 2022, see chart 30. At the same time, the European Central Bank (ECB) expects to increase the quantitative tightening introduced in March, suggesting that higher credit spreads may be persistent. Both Danish and European banks issued a large amount of debt on the capital markets in 2023, which should be seen in the context of the maturity of a large part of the ECB’s lending to banks from their TLTRO loan programme.

Banks meet regulatory liquidity and funding requirements with good excess capital adequacy

Both systemic and non-systemic banks meet the regulatory liquidity coverage ratio (LCR) with good excess capacity, see chart 31 and chart 32. The LCR helps to ensure that credit institutions have a sufficient amount of liquid assets to withstand a 30-day severe liquidity stress scenario.  

Banks continue to have sufficient liquidity buffers to deal with increased liquidity demand from their customers. Over the past few years, institutions have experienced several periods of considerable uncertainty about the demand for liquidity. However, liquidity demand has materialised only to some extent, and banks have been able to cope with it. Among other things, there has been uncertainty about the liquidity demand from the energy, insurance and pension sectors in connection with the ongoing provision of collateral on derivatives due to large increases in energy prices and interest rates.

Both systemic and non-systemic banks also meet the regulatory requirement for stable funding, the net stable funding ratio (NSFR), with good excess capital adequacy, see chart 33 and chart 34. The NSFR requirement ensures that institutions have a sufficient amount of stable funding to finance their assets, thereby reducing the institutions’ refinancing risk. 

Banks’ NSFR has remained stable since the introduction of the requirement in the 2nd quarter of 2021. In particular, this reflects the fact that bank deposits have been stable, which is by far the most important part of the Danish sector’s long-term funding. Deposits have remained stable, despite the fact that customers can now achieve better returns on short-term low-risk investments, for example by buying Danish government and mortgage bonds with short maturities or by moving their deposits to banks that offer higher deposit rates, see also chapter 5, Earnings, above.

The regulatory LCR and NSFR requirements help strengthen the individual bank’s liquidity position but are not enough in themselves to ensure a robust liquidity position; the institutions must also have sound liquidity risk management. The events surrounding specific foreign banks in March showed that withdrawals of deposits can occur very quickly if there is no confidence in the bank in question. It is important that institutions’ liquidity risk management reflects the actual circumstances and risks to which they are exposed.

Some mortgage credit institutions’ dependence on their affiliated bank increased in autumn 2022

Like the foreign bond markets, the Danish mortgage bond market was also affected by the sharp interest rate hikes and uncertainty about future interest rates in 2022. As a result, purchasing interest decreased and market liquidity deteriorated. 

In autumn 2022, some of the banks affiliated with a mortgage credit institution increased the share of newly issued bonds bought from their affiliated mortgage credit institution, see chart 35. In particular one bank bought a large share of bonds from its affiliated mortgage credit institution, while it bought roughly the same or a smaller amount of the other mortgage credit institutions’ bonds. 

It is good for the robustness of the Danish mortgage bond market and thereby financial stability that there are several potential buyers for the mortgage credit institutions’ bonds. If mortgage credit institutions become dependent on selling to only one bank, it can make the Danish mortgage bond market less robust. Therefore, mortgage credit institutions must ensure that they can always sell their bonds and continue to issue new loans if one or more banks are challenged, also during periods of stress.

Several pension and life insurance companies have strengthened their access to liquidity

In November 2022, Danmarks Nationalbank recommended that pension and life insurance companies focus on maintaining or increasing the number of counterparties through which they obtain liquidity, the so-called repo counterparties. The companies use the liquidity for the ongoing provision of collateral in the event of fluctuations in the value of their interest rate hedging contracts. Since Danmarks Nationalbank issued its recommendation, several companies have increased the number of repo counterparties, thereby strengthening their access to liquidity. Since the end of June this year, pension and life insurance companies have had to settle new interest rate hedging contracts via a so-called central clearing house. In a central clearing house, ongoing collateral must be provided by means of cash deposits, and therefore the requirement increases the companies’ need for cash deposits in the event of large interest rate fluctuations. This underlines the need for companies to continuously focus on their number of repo counterparties. So far, no liquidity challenges associated with the switch to central clearing have been observed.

During the year, all the large credit institutions³¹ significantly raised their full-year earnings outlook. The raised outlook is primarily due to higher net interest income and lower than expected impairment charges, see also chapter 5, Earnings. The upward revisions of the full-year earnings outlook illustrate that earnings forecasts, even over a short time horizon, are subject to considerable uncertainty. There is considerable uncertainty as to whether the institutions can maintain their current level of earnings, among other things due to the level of the deposit margin and impairment charges, and institutions should therefore exercise prudence when projecting earnings in their capital planning.³² Current earnings are the institutions’ first line of defence against losses. If earnings are overestimated, the need for capital to cover losses in a crisis becomes underestimated, increasing the risk of breaching capital requirements.

Sector-specific systemic risk buffer ensures increased capitalisation for institutions’ lending to real estate firms 

One area that demands particular attention is institutions’ exposures to real estate firms. The institutions have significant and concentrated exposures to the real estate firms, which means that higher interest rates, economic slowdown and price falls increase the risk of substantial losses for banks in this segment, see chapter 3, Risk of losses on loans to real estate firms. 

A long period characterised by favourable conditions and low impairment charge ratios may lead to an underestimation of the actual risks for the segment and consequently too low capital reservations. Experience from previous crises shows that negative shocks to the real estate sector may lead to a sudden increase in impairment charges and losses. It is therefore important that institutions reserve capital to cover possible losses in the event of problems in the real estate sector.

The Systemic Risk Council has recommended that a sector-specific systemic risk buffer of 7 per cent be activated for exposures to real estate companies. A sector-specific buffer is a targeted capital requirement intended to address systemic risks related to a particular portfolio, see box 4. The requirement will ensure increased capitalisation of institutions so that they are better able to counter impairment charges and losses on their lending to real estate firms without having to tighten credit lending to firms and households. 

The sector-specific buffer means that the institutions must fund a slightly larger share of lending by means of equity. For example, for a loan of kr. 1 million with a risk weight of 20 per cent, this will require the institution to fund a larger share of the loan, kr. 14,000, by means of equity. 

Room for both the systemic risk buffer, consolidation and dividends

Several of the large credit institutions have a policy of paying out a percentage of their annual profits as dividends. As an alternative or supplement to dividend payments, some institutions choose to buy back shares. The expected earnings in 2023, together with moderate loan growth, leave room for most institutions to increase the excess capital adequacy relative to their capital requirement, including the sector-specific systemic risk buffer, and possibly pay dividends.³³

Stable development in institutions’ capital ratios

The Common Equity Tier 1 capital ratios of large credit institutions have remained relatively stable over the past five years, see chart 36. Despite this, credit institutions improved their capitalisation over the period. This is due to regulatory tightening³⁴ of the risk-weighted exposure requirements based on which capital ratios are calculated.

In parallel to the risk-based capital requirement, institutions must comply with a minimum requirement for their non-risk-weighted exposures, the so-called leverage requirement. The requirement means that the institutions’ Tier 1 capital must make up at least 3 per cent of their non-risk-weighted exposures. In the 3rd quarter of 2023, all large credit institutions had excess capital adequacy relative to the leverage requirement of at least 1 percentage point, see chart 37. The leverage requirement is intended to hedge risks in cases where the institutions’ risk weighting is too low.³⁵ A breach of the leverage requirement will generate the same regulatory response as a breach of the minimum capital requirement.³⁶ The interaction between the risk-based capital requirement and the leverage requirement means that, all else being equal, institutions with a low risk weighting have lower excess capital adequacy relative to the leverage requirement. This applies, for example, to institutions with a high share of loans secured on owner-occupied homes, where the risk weighting is relatively low.

Some systemic credit institutions come close to the combined buffer requirement in a severe recession scenario

Danmarks Nationalbank stress test the financial sector every six months.³⁷ The purpose of the stress test is to assess whether credit institutions hold sufficient capital to comply with capital requirements in three scenarios, see box 5 for a description of the scenarios and Appendix A2 for key figures from the scenarios.

The stress test shows that all credit institutions would be resilient to a severe recession scenario. The scenario represents a drastically worsening business cycle, where the Danish economy is hit by a severe economic downturn and the countercyclical capital buffer is released.³⁸ However, some systemic credit institutions come close to the capital conservation buffer, while the remaining systemic credit institutions have a reasonable level of excess capital, see chart 38, the right-most panel.

In addition to the capital effect of a severe recession scenario, the individual institutions must also hold sufficient capital to meet future capital requirements. This entails that individual credit institutions should ensure that they can cope with severe stress while meeting future regulatory requirements before making dividend payments.

The stress test takes into account the expected effects of The European Commission’s banking package.³⁹ The total capital requirement for the systemic institutions, in a severe recession, is estimated to increase by kr. 6 billion in 2025 and to remain at this level in 2026. The final impact of the banking package remains uncertain. Consequently, it is important to be prudent in capital planning. The sector-specific systemic risk buffer for real estate firms proposed by the Systemic Risk Council⁴⁰ has also been taken into account and will be included from the 2nd half of 2024.

In the interest rate increase scenario that represents a worsening business cycle and is characterised by further interest rate hikes, all credit institutions are resilient with a reasonable level of excess capital relative, see chart 38, centre panel. The interest rate hikes contribute positively to the institutions’ earnings, despite the negative economic growth and a significant fall in house prices compared to the baseline scenario. 

The choice of scenarios and the variables included in them reflect the macroeconomic situation and the uncertainty surrounding the macroeconomic outlook. The stress scenarios in this stress test are broadly in line with those in the financial stability analysis for the 1st half of 2023,⁴¹ see box 5 for a description of the scenarios and Appendix A2 for key figures from the scenarios.

Some institutions may find it difficult to meet their MREL requirement under stress

Concurrently with the capital requirements, the credit institutions must meet an aggregate minimum requirement for their eligible liabilities, the total risk-based MREL. The MREL requirement is intended to ensure that the institutions can be restructured or liquidated without causing significant negative effects on financial stability.⁴²

During times of turmoil in the financial markets where the refinancing of expiring issuances may be difficult, the institutions must still be able to meet their MREL requirement. Danmarks Nationalbank’s stress test shows that some systemic credit institutions will not be able to continue to meet their total MREL requirement (incl. the combined buffer requirement) during a one-year period with limited options for issuing new debt instruments.⁴³ Overall, in a severe recession the systemic credit institutions need an additional kr. 27 billion in the 2nd quarter of 2025. 

Results of the 2023 EBA stress test reflect restrictive assumptions and severe macroeconomic scenarios

On 28 July 2023, the European Banking Authority (EBA) published the results of the EU-wide stress test. The results for the Danish credit institutions reflect more restrictive assumptions, including relatively conservative earnings restrictions, in addition the macroeconomic scenario for Denmark is significantly harder than the most severe scenario in Danmarks Nationalbank’s stress test.⁴⁴ The purpose of the EBA stress test is to assess the capitalisation and capacity of the European banking sector to absorb losses. Danish institutions included Danske Bank, Nykredit, Jyske Bank and Sydbank. Danske Bank and Jyske Bank break with the capital conservation buffer at the end of the stress test.

Several institutions should consider increasing their capital target

The credit institutions’ capital target contributes to ensuring that the institution is adequately capitalised. Generally, the institutions must have a capital target that is sufficiently high to enable them to cope with both institution-specific and macroeconomic stress without breaching the combined buffer requirement.⁴⁵

Danmarks Nationalbank has carried out an additional stress test calculation in the severe recession scenario, assuming that the institutions at the beginning of the stress test have a capital ratio corresponding to their capital target.⁴⁶ Danmarks Nationalbank’s stress test of the institutions’ capital targets shows that several systemic banks would not be sufficiently capitalised to withstand a severe recession if their initial capital ratio was on a par with their capital target, see chart 39, right panel. Overall, the institutions would have a capital shortfall relative to the buffer requirements of approximately kr. 14 billion by the end of 2026. This indicates that several institutions should consider increasing their capital target.

The green transition is a central and necessary measure to protect against the future consequences of climate change. But it is inevitable that climate change and the green transition will have negative financial consequences for some of the credit institutions’ customers. This can have a spill over effect on the financial sector and therefore requires the financial sector to identify and manage the risks posed by climate change and the green transition. One consequence of the green transition may, for example, be an increasing level of costs in the businesses whose activities continue to emit large amounts of greenhouse gases. This may lead to lower lending quality in institutions where these businesses are customers.    

EU financial authorities are considering the framework for regulating climate-related financial risks, see box 6. It is suitable that both micro- and macroprudential regulation include the possibility to address climate-related risks. Danmarks Nationalbank thus supports the investigative initiatives to adjust the common European rules so that both the institution-specific and systemic climate-related risks identified by institutions and authorities can be included in capital requirements and other requirements imposed on the institutions. 

Across countries, authorities and institutions are building skills and data to assess the magnitude of climate-related financial risks. Danmarks Nationalbank is also working to identify the climate-related financial risks that are deemed to potentially be significant for the financial system in Denmark.⁴⁷

In the worst case, serious cyber attacks may threaten the stability of the financial sector. Financial stability may for instance be threatened, if a cyber attack limits societally critical functions performed by one or more institutions or if the confidence in the financial sector is affected.

The cyber threat remains significant

The Centre for Cyber Security, CFCS, still assesses the threat from cyber espionage and cyber crime as very high, whereas the threat from destructive cyber attacks⁴⁸ against Danish targets is assessed as low. However, the CFCS assesses it as likely that state-sponsored hacker groups are developing the capability to launch destructive cyber attacks against critical infrastructure in Denmark, including via cyber espionage. As a result of the war in Ukraine, the CFCS also assesses that the threat posed by cyber activism has increased to high. The nature of the cyber threat can quickly change if the political situation were to escalate.⁴⁹

Continued focus on increasing cyber resilience

For a number of years, the Danish financial sector has targeted work at strengthening its resilience to cyber attacks, both through individual and joint measures.⁵⁰ The individual financial institution is itself responsible for ensuring stable operations and operational resilience.

The cyber threat cannot be eliminated, and there is still a need to increase cyber resilience. This is due to the development in the capabilities and methods of cyber criminals. In addition, several states have the capabilities needed to carry out destructive cyber attacks, but currently limited intentions of launching such attacks against Denmark. The threat could change with little or no warning. It is therefore important that the financial sector continues to target work at strengthening cyber resilience and limiting the impacts of cyber attacks.

Management commitment makes a difference

It is important that the board of directors and the executive management are committed to and assume responsibility for the work on cyber security, as it is a prerequisite for an organisation to have the right focus on the importance of cyber resilience in line with other types of risks.

Danmarks Nationalbank’s surveys on cyber resilience in the financial sector indicate that organisations in which responsibility for cyber security is well anchored in the board of directors and executive management also have a higher maturity level in terms of protecting themselves against cyber attacks and their potential consequences.⁵¹

Analysis data basis

The analysis uses the term ‘credit institutions’ when referring to the activities of both banks and mortgage credit institutions. The term ‘bank’ refers specifically to entities carrying out banking activities. These institutions are listed in table A1.

The analysis of Danish credit institutions’ earnings, liquidity and own funds comprises nine systemic credit institutions selected by the Danish Financial Supervisory Authority in 2023. The analysis also includes the non-systemic banks. This group consists of the institutions in group 2 defined by the Danish Financial Supervisory Authority for 2023, with the exception of Danish Ship Finance, which has been omitted due to its business model. The grouping applies retrospectively.

In the analysis and assessment of lending activity, focus is on the grouping of large and medium-sized banks in Danmarks Nationalbank’s lending survey. Large banks are the Danish Financial Supervisory Authority’s group 1 plus Nordea Danmark, while medium-sized banks are the Danish Financial Supervisory Authority’s group 2 plus Santander Consumer Bank.