RISK MANAGEMENT 2008

Transcription

1 RISK MANAGEMENT 2008

2 CONTENTS in brief 7 2. Organisation Capital management Credit risk Market risk Liquidity risk Operational risk Other risks Business risk Pension risk Insurance risk Consolidation Definitions 106 Appendix A Disclosures required under Pillar III of the Capital Requirements Directive THE OBJECTIVE OF RISK MANAGEMENT 2008 IS TO INFORM SHAREHOLDERS AND OTHER INTERESTED STAKEHOLDERS OF THE GROUP S RISK AND CAPITAL MANAGEMENT POLICIES, INCLUDING RISK MANAGEMENT METHODOLOGIES AND PRACTICES. DANSKE BANK RISK MANAGEMENT 2008 KREDITRISIKO 3

3 in brief Group results In 2008, the capital markets were subject to tremendous turbulence, with sharply falling equity prices, substantially wider credit spreads, frozen money markets and decelerating economic growth. The negative market trends were particularly extreme in the fourth quarter. Developments in January 2009 further illustrated the scope of the economic and financial setback in the fourth quarter of Net profit was DKr1.0bn, against DKr14.9bn in Earnings reflect individual loan impairment charges of DKr8.8bn. In addition, the negative trend, which continued into January 2009, prompted the Group to make collective impairment charges of DKr3.3bn on its loan portfolio and goodwill impairment charges of DKr3.1bn, primarily against National Irish Bank, Ireland. The unsatisfactorily high level of impairment charges was the result of the financial crisis, declining asset values and the economic slowdown in the Group s markets. Risk management The financial crisis led to bankruptcies and meltdowns in the financial sector worldwide. Several financial institutions in both the US and Europe were merged or taken over, in many cases through government intervention. The measures introduced by governments varied, with increased depositor guarantees, state guarantees to protect claims against banks, capital injections and widely expanded central bank funding facilities among the most common features. In Denmark, a state guarantee was set up to protect customer deposits and creditors claims against banks. Nevertheless, the financial sector remains under considerable pressure both in Denmark and abroad. In the autumn of 2008, the most important global players introduced a number of measures to ease the situation in the financial markets and the money markets. In spite of expansionary financial initiatives, including substantial interest rate cuts, the Group expects to see modest economic growth or even economic contraction in its principal markets. Danske Bank chose to participate in the guarantee scheme set up by the Danish state to protect customer deposits and creditors claims against banks. The scheme took effect on October 5, 2008, and expires on September 30, It includes an unconditional state guarantee for the obligations of Danish banks, except for subordinated debt and covered bonds. In February 2009, the Danish parliament passed a bill which allows Danish credit institutions that meet the regulatory solvency requirement to apply to the Danish state for subordinated loan capital in the form of hybrid core capital. Danske Bank s Board of Directors will propose to the general meeting that the Board of Directors be authorised to apply for and let the Group receive subordinated loan capital from the Danish state. The Group expects to receive subordinated loan capital of about DKr26bn. The Group believes that such subordinated loan capital will further strengthen its capital base and enable it to withstand the losses that will inevitably occur during the coming recession while maintaining reasonable lending activities. At December 31, 2008, such a capital injection would raise the Group s core capital ratio further to around 12% and its solvency ratio to around 16% IN BRIEF DANSKE BANK RISK MANAGEMENT 2008

4 At the beginning of 2008, the Group s minimum capital targets for its core capital and solvency ratios were 7.5% and 11.0%, respectively. These capital targets no longer form the basis for optimum solvency level management because the Group believes that higher minimum targets will be needed in response to the international financial turmoil. In the light of this situation, the Group will revise its capital targets when conditions in the financial markets have been clarified. The Group s liquidity strength was seriously tested at the end of September 2008, when access to long-term funding from abroad was suddenly cut off. These market conditions influenced the Group s twelve-month liquidity curve, though the curve at the end of the year shows positive liquidity positions for six months, if the Group is cut off from capital markets. Despite the difficult market conditions, the Group met its targets for short-term liquidity, mainly through stable deposits and large liquid bond holdings, which can be used as collateral for loan facilities with central banks. By the end of 2008, the international debt markets had become more accessible, partly because of the introduction of financial support packages. As a consequence of these support packages and the Group s participation in the Danish state guarantee scheme, the Group gained access to short- and medium-term funding particularly in US dollars. Total credit exposure at the end of 2008 was DKr3,523bn, with DKr2,520bn deriving from lending activities both in and outside Denmark and DKr1,003bn from the Group s trading and investment activities. Credit exposure relating to real property was DKr1,184bn at the end of 2008 corresponding to 47% of the Group s total credit exposure. After several years of increases, property prices in most of the Group s markets saw actual declines in The average loan-to-value ratio of the Group s portfolio of home loans was 54% at the end of The delinquency rate is still very low, and the downturn in the property market did not cause a significant rise in actual losses on home loans, partly because the employment rate remains high. The recessionary developments were especially unfavourable in the Group s markets where many industries and small and medium-sized businesses in particular suffered because of market-related factors. Construction and building activities slowed in most of the Group s markets, especially in Ireland. The transportation and shipping industries endured both falling global demand and a sharp decrease in freight rates over a very short period of time. Credit exposure to the two industries was DKr75bn, or 3.0% of credit exposure relating to lending activities. The amount of impaired loans rose from DKr10bn at the end of 2007 to DKr32bn at the end of Loans to financial counterparties accounted for around 34% of the rise. DANSKE BANK RISK MANAGEMENT IN BRIEF 5

5 The economic crisis and the recession are likely to affect the credit quality of customers in a number of industries. Consequently, the Group made collective impairment charges on facilities to downgraded customers and exposed industries. At the end of the year, industry-related collective impairment charges included charges against facilities to property developers, contractors, transporters, car manufacturers and international financial counterparties. These collective impairment charges totalled DKr4.7bn, or 29% of the total balance in the allowance account. While the overall performance in the market risk area was satisfactory, the Group was severely affected by the financial crisis in specific areas. Since the Danish mortgage bond market is a very important part of the financial markets in Denmark, the Group has relatively large holdings of such bonds. During the second half of the year, mortgage spreads widened considerably, leading to a substantial unrealised loss on the holdings. The Group does not believe that the unrealised loss was caused by the underlying credit quality. Another effect of the extreme volatility in the financial markets was that the Group s internal Value at Risk (VaR) model performed less well than previously. This became evident in the back testing of the model. The test showed a higher-than-expected number of exceptions, and the higher plus factor for the internal model led to a rise in the capital requirement of some 30%. As a consequence of this development, the Group decided to adjust the model to improve its ability to react to a more volatile market situation. The adjustment was made at the beginning of 2009, and in the current market situation, it is expected to raise the VaR figures by 10-20%. For 2008, additional capital was allocated under Pillar II. Insurance risk in the Danske Bank Group concerns primarily life insurance and pension products. The Danica Group s with-profits business contributes by far the most to its total risk. Risks related to unitlinked business are considered minor because most are carried by the policyholders. The collective bonus potential and the bonus potential of paid-up policies, which can be used to cover risks relating to the with-profits policies, were severely reduced because of the global financial crisis in the autumn of Danica therefore, on October 28, 2008, introduced a temporary charge on transfers and surrenders of pension savings in order to protect the remaining policyholders savings. At the end of 2008, Danica still had substantial capital strength IN BRIEF DANSKE BANK RISK MANAGEMENT 2008

6 2. ORGANISATION Risk policies and limits Risk organisation Board of Directors Executive Board Group Finance Group Credits Business units Reporting DANSKE BANK RISK MANAGEMENT 2008 KREDITRISIKO 7

7 An understanding of risk taking and transparency in risk taking are key elements of the Danske Bank Group s business strategy. The Group s ambition is to achieve high standards in risk management. Its risk organisation supports this ambition, and it has developed substantial expertise in risk management. The Board of Directors sets out the overall risk policies for all material risk types. The Executive Board is responsible for the day-to-day management of the Group. The Group uses risk appetite as a strategic concept to determine its risk-based exposure limits in accordance with its overall risk policies. The Group allocates considerable resources to managing and monitoring risk and to ensuring ongoing compliance with the approved risk limits. It has a fixed reporting cycle to ensure that the relevant management bodies, including the Board of Directors and the Executive Board, are kept informed of developments in risk measures. This section describes the Group s organisational framework for risk management. 2.1 Risk policies and limits The Board of Directors sets out the overall risk policies and limits for all material risk types. The Board also decides on general principles for managing and monitoring risk, and it reviews the risk policies and limits annually. The Group uses risk appetite as a strategic concept to determine its risk-based limits. Risk appetite represents the maximum risk that the Group is willing to assume in pursuit of its business targets. The risk appetite framework offers an overview of various risk dimensions and enables the Group to manage risk measurement across these dimensions in accordance with its overall risk policies. The framework is based on analysis of the Group s and the major business units current risk profiles. It includes setting explicit targets, limits and contingency plans in accordance with the risk policies. It also includes monitoring of risk levels. The Group implemented the risk appetite framework in its major business units in Key risk elements are identified on an ongoing basis in a dynamic process warranted by new products, procedures, risk measurement applications and influence from the economic environment. The Group conducts risk management at the customer and industry levels as well as on the basis of geographical location and collateral type. It takes a comprehensive approach to the core risk dimensions: Credit risk Market risk Liquidity risk Operational risk Other risk dimensions are incorporated at the Group and business unit levels where appropriate. They include insurance, pension and concentration risk; financial strength; and earnings robustness. On the basis of the overall risk policies and limits, specific risk instructions for the main business units are prepared. These instructions are used to prepare business procedures and reconciliation and control procedures for the relevant units and for the Group s system development. 2.2 Risk organisation Danske Bank s Rules of procedure for the Board of Directors and the Executive Board specifies the responsibilities of the two boards and the division of responsibilities between them. This two-tier management structure was developed in accordance with Danish legislation, and the Rules of procedure is a key document on the Group s management structure, including the organisation of risk management and authorisations. 8 ORGANISATION DANSKE BANK RISK MANAGEMENT 2008

8 The Board of Directors lays down overall policies, while the Executive Board is in charge of the Group s day-to-day management and reports to the Board of Directors. None of the Group s executive managers serves on the Board of Directors of the parent company. The risk and capital management functions are separate from the credit assessment and credit-granting functions (see figure 2.1). The Group s management structure also reflects the statutory requirements governing listed Danish companies in general and financial services institutions in particular. The Danske Bank Group follows the comply-or-explain principle in respect of the Danish Committee on Corporate Governance s Re commendations. These recommendations apply to companies listed on NASDAQ OMX Copenhagen. FIGURE 2.1 RISK ORGANISATION OF THE DANSKE BANK GROUP BOARD OF DIRECTORS CREDIT COMMITTEE AUDIT COMMITTEE INTERNAL AUDIT SALARY AND BONUS COMMITTEE EXECUTIVE BOARD ALL RISK COMMITTEE EXECUTIVE BOARD S CREDIT COMMITTEE OPERATIONAL RISK COMMITTEE GROUP FINANCE GROUP CREDITS BUSINESS UNITS RISK MANAGEMENT CAPITAL MANAGEMENT CENTRAL CREDIT CREDITS, INSTITUTIONAL CLIENTS LOCAL CREDIT DEPARTMENTS CREDIT RISK MANAGEMENT Board of Directors The Board of Directors must ensure that the Group is organised properly. As part of this duty, it appoints the members of the Executive Board, the group chief auditor, the deputy group chief auditor and the secretary to the Board of Directors. The largest credit facilities are submitted to the Board of Directors for approval, and the Board defines overall limits for market risk and liquidity risk. Regular reporting enables the Board of Directors to monitor whether the overall risk policies and systems are being complied with and whether they meet the Group s needs. In addition, the Board of Directors reviews reports analysing the Group s portfolio, particularly information about industry concentrations. The Board of Directors has set up a number of committees (see figure 2.1) to supervise specific areas and to prepare cases that are later considered by the full Board. Under Danish law, board committees do not have independent decision-making authorities. The committees include the Credit Committee, the Salary and Bonus Committee and the Audit Committee (see table 2.1). DANSKE BANK RISK MANAGEMENT 2008 ORGANISATION 9

9 TABLE 2.1 COMMITTEES ESTABLISHED BY THE BOARD OF DIRECTORS Credit Committee Salary and Bonus Committee Audit Committee The Credit Committee functions as a hearing panel for major credit exposures, monitors trends in the credit quality of the Group s loan portfolio and evaluates special renewal applications and facilities. The Salary and Bonus Committee monitors trends in the Danske Bank Group s salary and bonus schemes and monitors incentive programmes to ensure that they promote ongoing, long-term shareholder value creation. The Audit Committee examines accounting, auditing and security issues. These are issues that the Board of Directors, the Audit Committee itself, the group chief auditor or the external auditors believe deserve attention before they are brought before the full Board. The committee also reviews the internal control and risk management systems. The Group has an independent internal audit department, Internal Audit, whose head, the group chief auditor, reports directly to the Board of Directors. Internal Audit is responsible for ensuring that the administrative and accounting policies of the Danske Bank Group are satisfactory, that there are written business procedures for all material areas of activity, that adequate internal control procedures are in place, and that IT use is controlled and secure in accordance with the control policies adopted. The Group has developed the Danske Banking Concept to optimise the division of duties between business units and support functions. This concept is based on the principle of uniform customer segmentation and service strategy across business units. The overall governance of the Danske Banking Concept is anchored in the Board of Directors, and the Group s business development departments have day-to-day responsibility for activities related to the concept. The Danske Banking Concept includes a uniform organisation and uniform processes in the business units. The processes are based on the Group s shared IT platform. The concept serves to optimise the control measures carried out at group level by Group Credits and Group Finance, among others Executive Board The Executive Board is responsible for the day-to-day management of the Group as stated in the Rules of procedure for the Board of Directors and the Executive Board. The Executive Committee, headed by the chairman of the Executive Board, is a larger body that constitutes the Group s day-to-day executive management and functions as a co-ordinating forum. Its objective is to take an overall view of activities across the Group, focusing on the collaboration between support functions and product suppliers on the one hand, and individual units and country organisations on the other. The Executive Board sets forth specific risk instructions and supervises the Group s risk management practices. It reports to the Board of Directors on the Group s risk exposures and approves material business transactions, including credit applications up to a defined limit. The Executive Board has established three committees that are in charge of ongoing risk management: the All Risk Committee, the Executive Board s Credit Committee and the Operational Risk Committee (see table 2.2). The Group has also set up various subcommittees for specific risk management areas such as asset and liability management and the management of risk parameters and models affecting the Group s economic capital and risk-weighted assets. The subcommittees consist mostly of senior management. 10 ORGANISATION DANSKE BANK RISK MANAGEMENT 2008

10 TABLE 2.2 COMMITTEES ESTABLISHED BY THE EXECUTIVE BOARD All Risk Committee The All Risk Committee is in charge of implementing the Group s In addition, the committee evaluates risk reports to be submitted to the Board of Directors or one of its committees. The All Risk Committee consists of members of the Executive Board and the heads of Danske Markets and Risk Management. Executive Board s Credit Committee Credit applications that exceed the lending authorities of the business units must be submitted to the Executive Board s Credit Committee for approval. The local credit departments of the business units review these applications before the heads of the departments submit them to the Executive Board s Credit Committee for approval. The committee consists of members of the Executive Board and the management team of Group Credits. It is also in charge of preparing operational credit policies and approving or rejecting credit applications involving issues of principle. The Board of Directors determines the lending authorities. In addition, the Executive Board s Credit Committee participates in decisions regarding the valuation of the Group s loan portfolio in connection with the determination of impairment charges. Operational Risk Committee This committee assists the Executive Board in its functions and processes related to operational risk management. The committee s responsibilities include the following: Group s current and potential operational risk security, business continuity and compliance The Operational Risk Committee is headed by a member of the Executive Board and includes managers of all major support functions and resource areas, including IT, and the Group s Business Development department Group Finance Group Finance oversees the Group s financial reporting, budgeting, risk management and strategic business analysis, including the performance and analytical tools used by the business units. The department is also in charge of the Group s investor relations, corporate governance, capital structure, M&A activities and relations with rating agencies. The Group has established a functional separation between units that enter into business transactions with customers or otherwise expose the Group to risk on the one hand, and units in charge of overall risk management on the other. DANSKE BANK RISK MANAGEMENT 2008 ORGANISATION 11

11 The Group s independent risk management unit, Risk Management, is part of Group Finance. Risk Management has overall responsibility for monitoring the Group s risk portfolio and reporting on overall risk measures. It also has overall responsibility for the Group s compliance with the rules of the Capital Requirements Directive (CRD) and for the internal capital adequacy assessment process (ICAAP) (see section 3.3). In addition, Risk Management is responsible for the implementation of risk models and risk analysis, and it conducts back testing of risk parameters and validation of risk models Group Credits Group Credits has overall responsibility for the credit process in all of the Group s business units. This includes responsibility for developing credit classification and valuation models and for seeing that they are used in day-to-day credit processing in the local units. Group Credits is in charge of determining the utilisation of portfolio limits for industries and countries and of the quarterly process of calculating the impairment of exposures. It also keeps track of the credit quality of the Group s loan portfolio by monitoring trends in unauthorised excesses and overdue payments, new approvals to weak customers and other factors. In addition, Group Credits reports to the Group management and to business units on developments in the Group s credit risk. Finally, the department is in charge of providing management information about credits, of monitoring credit approvals in the business units, and of determining the Group s requirements relating to its credit systems and processes Business units Core risk dimensions such as market risk and liquidity risk are managed centrally in the organisation. For credit risk, however, lending authority for specific customer segments and products has been granted to the individual business units. The business units carry out the fundamental tasks required for optimal risk management. This includes updating the necessary registrations about customers that are used in risk management tools and models, as well as maintaining and following up on customer relationships. Each business unit is responsible for preparing carefully drafted documentation before business transactions are undertaken and for properly recording the transactions. Each business unit is also required to update information on customer relations and other issues as may be necessary. The business units must ensure that all risk exposures comply with specific risk instructions as well as the Group s other guidelines. Approvals of loans and credits to retail customers and small business customers are given according to the delegation of lending authority to the individual branches and finance centres. A number of auxiliary tools are available in the approval process, including credit scoring and credit rating. Customer advisers are responsible for the basic credit assessment of customers. Their lending authority depends on customer ratings, and they can approve credits up to certain amounts. Advisers must forward applications for credit facilities beyond their lending authority to the unit s credit department, which may decide to submit applications to the Executive Board s Credit Committee or the Board of Directors. 2.3 Reporting The Group allocates considerable resources to ensuring ongoing compliance with the approved risk limits and to risk monitoring. It has a fixed reporting cycle to ensure that the relevant management bodies, including the Board of Directors and the Executive Board, are kept informed of developments in risk measures, the credit portfolio, non-performing loans and the like. 12 ORGANISATION DANSKE BANK RISK MANAGEMENT 2008

12 The Board of Directors receives the principal risk reports quarterly and others annually (see table 2.3). The ICAAP report is updated quarterly in a condensed format, and once a year the full ICAAP report is submitted to the Board of Directors for approval. TABLE 2.3 REPORTING TO THE BOARD OF DIRECTORS ANNUAL REPORTING Risk appetite A strategic concept used to determine risk-based limits. It represents the maximum risk that the Group is willing to assume in pursuit of its business targets and in accordance with its overall risk policies. Risk policy Review of the Group s overall risk policy to determine whether revisions are required. The Group s risk management models and parameters Update on the use of risk models, including risk parameters. The quality of the Group s credit portfolio Analysis of impairment charges and losses by business unit and portfolio breakdowns by rating category, size, business unit, etc. QUARTERLY REPORTING ICAAP Evaluation of the preferred risk and the level of capital in relation to the internal capital adequacy assessment process (ICAAP). The report contains the conclusions drawn from stress testing and the effect of scenarios on expected losses and capital requirements. Key figures for the credit portfolio An overview of credit-quality indicators focusing on unauthorised excesses and arrears, the number of upgrades and downgrades in the classification system, and trends in lending volumes. The Group s market risk Analysis of the Group s current equity, fixed income and currency positions and reports on the utilisation of Board-approved limits since the preceding report. Large exposures An overview of exposures equal to or exceeding 10% of the Group s capital base and the sum of these exposures, including the percentage of the Group s capital base it represents. Industry analyses Industry research covering some 30 industries used for credit renewals. In addition to reviewing general developments in an industry, these reports evaluate the Group s aggregate exposure to the industry. The heads of Group Finance and Group Credits are members of the Executive Board and receive a large number of risk reports through their positions on the risk committees established by the Executive Board. The All Risk Committee evaluates risk reports to be submitted to the Board of Directors or one of its committees. It also reviews annual reports identifying all the Group s risks and providing information on risk trends. A report on the Group s risk appetite is presented quarterly to the All Risk Committee for approval. In addition, the All Risk Committee regularly receives reports on the Group s solvency and reviews trends in the business units. The Operational Risk Committee regularly reviews trends in the Group s key operational risks and the progress on concrete action plans regarding these risks. The committee receives reports and acts on key risk indicators. DANSKE BANK RISK MANAGEMENT 2008 ORGANISATION 13

13 2. 3. KREDITRISIKO CAPITAL MANAGEMENT The framework of the Danske Bank Group s capital management Pillar I Approaches used to calculate risk-weighted assets Risk-weighted assets and the capital requirement Pillar II The Danske Bank Group s ICAAP methodology Economic capital Stress testing Methodology Stress test scenarios used Results of the stress tests Capital management The Danske Bank Group s leverage ratio Capital base 14 KREDITRISIKO DANSKE BANK RISK MANAGEMENT 2008

14 2. KREDITRISIKO The financial crisis led to bankruptcies and meltdowns in the financial sector worldwide. Several financial institutions in both the US and Europe were merged or taken over, in many cases through government intervention. The measures introduced by governments varied, with increased depositor guarantees, state guarantees to protect claims against banks, capital injections and widely expanded central bank funding facilities among the most common features. In Denmark, a state guarantee was set up to protect customer deposits and creditors claims against banks. Nevertheless, the financial sector remains under considerable pressure both in Denmark and abroad. In the autumn of 2008, the most important global players introduced a number of measures to ease the situation in the financial markets and the money markets. In spite of expansionary financial initiatives, including substantial interest rate cuts, the Group expects to see modest economic growth or even economic contraction in its principal markets. Danske Bank chose to participate in the guarantee scheme set up by the Danish state to protect customer deposits and creditors claims against banks. The scheme took effect on October 5, 2008, and expires on September 30, It includes an unconditional state guarantee for the obligations of Danish banks, except for subordinated debt and covered bonds. In February 2009, the Danish parliament passed a bill which allows Danish credit institutions that meet the regulatory solvency requirement to apply to the Danish state for subordinated loan capital in the form of hybrid core capital. Danske Bank s Board of Directors will propose to the general meeting that the Board of Directors be authorised to apply for and let the Group receive subordinated loan capital from the Danish state. The Group expects to receive subordinated loan capital from the Danish state of about DKr26bn. The Group believes that such subordinated loan capital will further strengthen its capital base and enable it to withstand the losses that will inevitably occur during the coming recession while maintaining reasonable lending activities. At December 31, 2008, such a capital injection would raise the Group s core capital ratio further to around 12% and its solvency ratio to around 16%. At the beginning of 2008, the Group s minimum capital targets for its core capital and solvency ratios were 7.5% and 11.0%, respectively. These capital targets no longer form the basis for optimum solvency level management because the Group believes that higher minimum targets will be needed in response to the international financial turmoil. In the light of this situation, the Group will revise its capital targets when conditions in the financial markets have been clarified. This section describes the Group s capital management practices, in particular its approach to Pillar I and the Pillar II assessment under the Capital Requirements Directive (CRD). DANSKE BANK RISK MANAGEMENT 2008 CAPITAL MANAGEMENT 15

15 2. KREDITRISIKO 3.1 The framework of the Danske Bank Group s capital management In its internal risk capital management, the Group intends to use advanced approaches for all significant risk types. The Group s capital management framework has been developed over time, and it is mapped against international guidelines and best-practice recommendations. The basis of the Group s capital management practices is the regulatory framework in the Capital Requirements Directive (CRD). The CRD consists of three pillars: Pillar I contains a set of rules for a mathematical calculation of the capital requirement based on risk-weighted assets (RWA) for credit risk, market risk and operational risk. Pillar II describes the supervisory review and evaluation process (SREP) and contains the framework for the internal capital adequacy assessment process (ICAAP). Pillar III deals with market discipline and sets forth disclosure requirements for risk and capital management. Sections 3.2 and 3.3 describe the Group s approach under Pillar I and Pillar II. The Group s Pillar III compliance is presented in appendix A to this report. 3.2 Pillar I Under the CRD, the total RWA equal the sum of RWA for credit risk, market risk and operational risk. The capital requirement calculated under the CRD is based on formulas in the Basel II guidelines. Various approaches may be applied for a given risk type. The Group s choice of approach in RWA calculation for each of the three risk types is described briefly in the following sections Approaches used to calculate risk-weighted assets The Danske Bank Group uses the advanced internal ratings-based (IRB) approach to calculate RWA for credit risk. Its use of this approach has been approved by the Danish Financial Supervisory Authority (the Danish FSA), in co-operation with other national FSAs. Under the advanced IRB approach, the Group uses its own risk parameters probability of default (PD), loss given default (LGD) and conversion factor (CF) when calculating RWA for credit risk. In accordance with the CRD, the Group uses the standardised approach for a small part of the credit portfolio. The Group used the IRB approach for around 86% of the lending portfolio at the end of The remaining 14% is treated according to the standardised approach, either because the portfolio segment is subject to a permanent exemption or because it is covered by plans for later transition to the advanced IRB approach. The Group has been granted permanent exemption from the advanced IRB approach for certain exposures, including exposures to governments and equities (see table 3.1). 16 CAPITAL MANAGEMENT DANSKE BANK RISK MANAGEMENT 2008

16 TABLE 3.1 APPROACHES USED TO CALCULATE RISK-WEIGHTED ASSETS FOR CREDIT RISK Asset class Danske Bank Group* Danske Bank A/S (parent company)* Realkredit Danmark A/S Danske Bank International SA, Luxembourg Other subsidiaries Governments Standardised Standardised Standardised Standardised Standardised Institutions Advanced IRB Advanced IRB Advanced IRB Advanced IRB Standardised Corporate Advanced IRB Advanced IRB Advanced IRB Advanced IRB Standardised Retail** IRB IRB IRB IRB Standardised Securitisation Ratings-based method Ratings-based method N/A N/A Standardised Equities Standardised Standardised Standardised Standardised Standardised Other assets Advanced IRB Advanced IRB Advanced IRB Advanced IRB Standardised * Branches in Ireland (National Irish Bank) and the Baltic states are treated in accordance with the standardised approach. The Baltic subsidiaries were converted to branches in the summer of ** For retail exposures, the CRD does not differentiate between foundation IRB and advanced IRB. The Group uses the mark-to-market approach under the CRD for calculating the RWA for counterparty credit risk on derivatives. For market risk, the Group uses an internal Value at Risk (VaR) model to calculate RWA for general market risk at group level. For the calculation of specific risks, the Group currently uses the standardised approach. For operational risk, the Group uses the standardised approach (the intermediate method) to calculate RWA Risk-weighted assets and the capital requirement RWA is an important risk measure for the Group, primarily because it is used to determine the Group s capital requirement (defined as 8% of RWA). It is also used as the basis of the Group s core (tier 1) capital ratio and its solvency ratio since RWA is used as the denominator of these measures. The Group s RWA under Pillar I amounted to DKr960bn at December 31, 2008, against DKr954bn on January 1, 2008 (see table 3.2). TABLE 3.2 RISK-WEIGHTED ASSETS AND CAPITAL REQUIREMENT UNDER PILLAR I (DKr m) December 31, 2008 January 1, 2008 Credit risk, IRB approach 551, ,984 Credit risk, standardised approach 219, ,400 Counterparty credit risk 43,125 26,769 Credit risk, total 814, ,153 Market risk 67,602 72,648 Operational risk 78,298 73,682 Risk-weighted assets 960, ,483 Capital requirement (Pillar I) 76,806 76,359 Note: The capital requirement is calculated as 8% of RWA. For details of the components of RWA, see appendix A. DANSKE BANK RISK MANAGEMENT 2008 CAPITAL MANAGEMENT 17

17 The CRD/Basel II framework for calculating risk-weighted assets is acknowledged to be pro-cyclical. Risk-weighted assets are driven by various factors such as the asset mix of the business model and geographical diversification. The treatment of parameters in RWA calculations particularly for the credit risk parameters PD, LGD and CF has important implications for how this cyclicality will be reflected in RWA figures. The Group s treatment of its credit risk parameters reduces the cyclicality of its RWA. The Group expects this to continue in the year ahead despite the weak macroeconomic outlook. In RWA calculations, the Group uses through-the-cycle (TTC, since 1992) estimates for the probability of default (PD), and downturn estimates (over the same period) for the loss given default (LGD) and the conversion factor (CF). See section 10 for a definition of the parameters. The conversion of point-in-time (PIT) PD to TTC PD is based on steady-state macroeconomic factors. As a consequence, the TTC PDs applied in the RWA calculations tend to be higher than PIT PDs in macroeconomic upturn periods and vice versa in downturn periods. This is illustrated in figure 3.1, which shows the observed PIT PD and the estimated TTC PD for corporate customers. FIGURE 3.1 PROBABILITIES OF DEFAULT, CORPORATE CUSTOMERS (%) Point-in-time PD (observed) Through-the-cycle PD (estimated) Note: The TTC PD for the entire period is a model estimate based on steady-state macroeconomic figures. The post-2008 PIT PD is a forecast from the same model based on expected macroeconomic figures for Pillar II While Pillar I contains uniform rules for capturing a financial institution s risk and determining the capital requirement, Pillar II contains a framework for an internal capital adequacy assessment process based on the situation and characteristics of the individual institution. Pillar II also covers risks not defined under Pillar I and stress testing. Pillar II treats the supervisory review and evaluation process (SREP) as well. The Group s internal capital adequacy assessment process (ICAAP) identifies and measures its total risks and ensures that it has sufficient capital in relation to its risk profile. The process also evaluates the total capital needed on the basis of the Group s internal models for economic capital and ensures that adequate risk management systems are used and further refined. The Board of Directors receives quarterly updates of the ICAAP report in a condensed format, and once a year the full ICAAP report is submitted to the Board for approval. 18 CAPITAL MANAGEMENT DANSKE BANK RISK MANAGEMENT 2008

18 3.3.1 The Danske Bank Group s ICAAP methodology The Group s ICAAP consists of evaluating all relevant risks that the Group is exposed to. The regulatory framework of the CRD (Pillar II) contains 17 risk items that must be assessed in the ICAAP (the rows in table 3.3). The Group s ICAAP framework is based on six risk measures, which are mitigated by capital (the columns in table 3.3). Besides the Pillar I risk types credit, market and operational risks the Group divides the risk measurement of its ICAAP into pension risk, insurance risk and business risk. All these risks are described in the following sections. The Group also makes an assessment of qualitative capital add-ons as needed and takes liquidity risk into account through its stress testing. Table 3.3 shows the relation between the 17 regulatory items and the six risk measures used by the Group, and also shows which of the 17 regulatory items are treated in the Group s stress tests. TABLE 3.3 RISK ITEMS ASSESSED IN THE ICAAP Risk measures treated under the Group s ICAAP framework Risk items treated under the regulatory framework of the CRD (Pillar II) General, including strategic plans Earnings Growth Credit risk Market risk Concentration risk Group risk Liquidity risk Operational risk Control risk Business size Settlement risk Strategic risk Reputational risk Interest rate risk on assets outside the trading book External risks Other Credit risk Pension risk Operational risk Market risk Insurance risk Business risk Stress test Transitional rules for 2008 and 2009 limit the ICAAP result. In 2008, the ICAAP result could not be reduced by more than 10% of the requirement under the previous rules (Basel I), and in 2009 it may not be reduced by more than 20%. The result of the ICAAP, taking the transitional rules into account, was DKr103bn at the end of It declined to around DKr92bn at the beginning of TABLE 3.4 THE RESULT OF THE GROUP S ICAAP (DKr m) December 31, 2008 January 1, 2008 Capital requirement (Pillar I) 76,807 76,359 Result of ICAAP (Pillar II) 102,517 94,529 Note: The result of the ICAAP also takes the transitional rules into account. For Pillar I components, see table 3.2. DANSKE BANK RISK MANAGEMENT 2008 CAPITAL MANAGEMENT 19

19 The result of the ICAAP includes stressed economic capital and stressed Pillar I+ (which is Pillar I plus risks other than those covered by Pillar I). Qualitative capital add-ons are included in economic capital and Pillar I+ if the assessment gives reason for such add-ons. Figure 3.2 shows the Group s capital base, Pillar I+ and the capital needed under the transitional rules. FIGURE 3.2 ICAAP RESULTS AND CAPITAL BASE (DKr bn) Pillar 1+ Transitional rules Capital base Economic capital The ICAAP includes the calculation of economic capital by means of internal models. Economic capital is a statistical measure of risk exposure and is calculated with the Group s own models. Economic capital is the amount of capital required to cover unexpected losses over the next year at a confidence level of 99.97%. The calculation of economic capital takes into account all relevant types of risk, including concentration and migration risks, as well as diversification within the individual risk types. The aggregation across risk types does not take into account the potential benefit from diversification among various risk types. A study at Danske Bank reached a preliminary conservative estimate of the diversification effect, when credit, market and operational risks were aggregated, of 10-20%. In the approach, loss distributions for each risk type are combined into an overall loss distribution. The study also shows that the results are quite sensitive to key assumptions such as the current level of stress in the financial markets, the correlation between risk types, and the type of distribution applied in the calculation. Consequently, the Group does not plan to include the diversification effect in the aggregation of risk, but sees it as an additional layer of protection against unexpected losses. Credit risk accounts for the largest share of risk in both the economic capital method and the Pillar I capital requirement calculation (see figure 3.3). FIGURE 3.3 CAPITAL REQUIREMENT AND ECONOMIC CAPITAL (DKr bn) Pillar I+ Economic capital Credit risk Market risk Operational risk Other risks I. Other risks include business risk, pension risk, insurance risk and an assessment of qualitative capital add-ons where needed. 20 CAPITAL MANAGEMENT DANSKE BANK RISK MANAGEMENT 2008

20 The calculation of economic capital for credit risk is based on PIT parameters. The Pillar I credit risk capital requirement, on the other hand, is based on TTC and downturn parameters over a business cycle. Consequently, the Group s economic capital is more volatile than the capital requirement under Pillar I. In addition to the difference in credit risk parameters, the Pillar I and economic capital calculation methods for credit risk also differ. The Pillar I calculations are based on analytical formulas derived from a one-factor model with a standardised diversification effect, whereas the model for economic capital is based on several underlying factors relevant for the Group Stress testing Stress tests are an important part of the ICAAP and an important tool for analysing the Group s risk profile. The objective of stress testing is to assess the effect of possible unfavourable events on the Group s capital requirement under Pillar I and its internal economic capital. Since 2005, the Group has conducted quarterly stress tests showing the effects of a given economic scenario over a period of three to five years. DANSKE BANK RISK MANAGEMENT 2008 CAPITAL MANAGEMENT 21

21 Methodology There are four phases in the Group s stress testing methodology: (i) choice of scenario; (ii) translation of scenario; (iii) stress test calculation; and (iv) evaluation of results and methodology (see figure 3.4). FIGURE 3.4 SUMMARY OF THE GROUP S STRESS TESTING PROCESS STRESS TEST PHASES CONTENTS OF STRESS TEST PROCESSES/ INTERNAL RELATIONS DECISION-MAKING AUTHORITY Choice of scenario Choice of scenario Example: mild recession Board of Directors/ Executive Board Translation of scenario Macroeconomic assumptions Definition of macroeconomic variables in the individual scenarios, trend in interest rates, etc. Macroeconomic assumptions are defined together with Danske Research Microeconomic assumptions Translation of macroeconomic assumptions into effects on variables such as PD and LGD Risk Management & Group Finance Stress test calculation Risk types Credit risk, market risk, operational risk, liquidity risk, etc.; calculation of economic capital, expected loss and risk-weighted assets Earnings Effect on earnings of change in activity level, interest rate margins, expected loss, etc. Result of the ICAAP in stress situation based on internal risk model Result of the ICAAP in stress situation based on CRD model Capital accumulation during a stress scenario Overall result of stress test Decision on required capital Decision on capital level is based on an overall assessment, including several factors such as probability of the scenario, strategic measures, etc. Board of Directors/ Executive Board The Group assesses its main scenarios and their relevance on an ongoing basis. At least once a year this includes analysing the risks that are most important for the Group in the current economic situation. The analysis is submitted to the All Risk Committee for approval of the scenarios to be used in subsequent stress testing. In addition, new scenarios can be added throughout the year if necessary. The scenarios are a central part of the Group s ICAAP report. The scenarios affect both earnings and risk. The Group has developed translation models to determine the effect on the Group s credit risk parameters in each year of each scenario. 22 CAPITAL MANAGEMENT DANSKE BANK RISK MANAGEMENT 2008

22 The translation models estimate the relation between macroeconomic variables and the Group s historical observation of loss frequencies and other risk drivers. On the basis of these results, the translation models show the relation between macroeconomic developments and customers drawings on credit facilities with the Group. For example, the models calculate the effect on the probability of default (PD). The PD translation model is based partly on the Group s industry-specific loss frequencies since 1992 and their correlation with GDP, unemployment and other measures. For some countries, the Group s internal loss data are not considered sufficient, and supplementary external data are used. On the basis of the current portfolio, the stress tests calculate the consequences of the individual scenarios for net profit, RWA, credit losses and the Group s capital base, taking into account its dividend policy. Earnings are projected on the basis of value drivers. For example, the estimates of interest income take into account the interest margin on deposits and loans, and the volumes of deposits and loans. The calculations take into account that the value of collateral will fall in most unfavourable scenarios. The stress effects are calculated for each year of a three-to-five-year horizon in the individual scenarios. This allows the Group to assess how its total earnings are affected over the period in question, as the largest effect usually does not occur in the first year. For the credit risk component, the stress test calculations cover the expected loss, economic capital and risk-weighted assets. Evaluation of results and methodology In the individual scenarios, the effects are calculated for all relevant types of risk so that the overall effect can be evaluated. This evaluation involves comparing the results of the scenarios with historical data, discussing the results with experts and senior management, and comparing the results with similar analyses from third parties such as peers, rating agencies and central banks. The Group includes this evaluation in an overall qualitative assessment that takes into account growth plans, strategy and other factors Stress test scenarios used The Group currently uses nine main macroeconomic scenarios (see table 3.5). The scenarios are applied uniformly in all markets that is, they assume that all countries are hit by the same changes at the same time, and that there is thus no geographical diversification. Each country is modelled separately, however, to ensure that its dynamics are captured correctly. TABLE 3.5 THE GROUP S MACROECONOMIC STRESS TEST SCENARIOS FOR 2008 Severe recession Could start with factors such as a sharp drop in exports and rising taxes leading to a decline in demand. The scenario is estimated to occur once during a period of 25 years. Deflation Falling real property prices Mild recession Structural problems in Europe lead to recession and deflation. Rising interest rates lead to falling property prices. No economic growth for two consecutive quarters. The scenario is estimated to occur once during a period of seven years. Sharp increase in price of oil Increase in price of oil of 50% and in commodity prices of 25%, reducing purchasing power (for both consumers and businesses). Depreciation of the US dollar US current account deficit triggers a global recession in which the dollar falls 25%. Bird flu Liquidity crisis in banking sector Bird flu becomes an epidemic and causes a significant decline in GDP. A liquidity crisis triggers credit losses and impairs capital procurement. Liquidity crisis, Danske Bank Group Only Danske Bank experiences a liquidity crisis, for example because of default by large customers, and a subsequent downgrade of the Group. DANSKE BANK RISK MANAGEMENT 2008 CAPITAL MANAGEMENT 23

23 The individual scenarios are described as changes in the current portfolio and macroeconomic variables. For example, the mild recession scenario entails all the Group s markets simultaneously experiencing zero GDP growth for two consecutive quarters and then returning to more normal macroeconomic indicator levels. In the severe recession scenario, the downturn is more pronounced, with economic contraction. For the various stress test scenarios, the Group has prepared a number of contingency plans for its options of either raising new capital or reducing risk. These plans, other management interventions, and intra-risk diversification are not included in the ICAAP results. This allows a better interpretation of the effect of the macroeconomic scenarios. Severe recession and mild recession are the Group s primary scenarios. Table 3.6 shows selected macroeconomic variables for the worst year in each of the two scenarios. TABLE 3.6 SELECTED VARIABLES IN STRESS TEST SCENARIOS Macroeconomic variable Severe recession Mild recession Number of years 3 3 GDP growth -2.3% (year 1) and -0.1% (year 2) 1.2% (year 1) Unemployment rate 8.5% (year 3) 4.7% (year 3) House prices (year 1) and -9.6% (year 2) -3.8 (year 1) Note: The table shows figures for the worst year with GDP and house price declines. Figures are calculated as a weighted average based on RWA of the markets in which the Group operates Results of the stress tests In its stress testing, the Group assesses the amount of capital needed in addition to its internal economic capital and the Pillar I capital requirement. The results show that the Group is sufficiently capitalised to withstand all scenarios described in table 3.5. The main negative driver for capital required under the recession scenarios is loan impairment charges (see figure 3.5). FIGURE 3.5 EXPECTED CREDIT LOSSES UNDER SEVERE AND MILD RECESSIONS (Basis points) Severe recession Mild recession Note: Expected credit losses are measured in basis points of loans, advances and guarantees. Expected credit losses may differ from loan impairment charges. Expected credit losses are based on a statistical measure of the predicted losses for a period based on point-in-time parameters. Loan impairment charges are the actual charges for a period recorded in the income statement. 24 CAPITAL MANAGEMENT DANSKE BANK RISK MANAGEMENT 2008

24 In almost all scenarios, however, the Group still expects to make a net profit in all years because of high and stable earnings from its relatively-well diversified portfolio. In two scenarios, the deflation and severe recession scenarios, on the other hand, the Group is projected to make a loss in certain years; it will remain sufficiently capitalised, however. Currently, economic growth is lower than in a mild recession in Denmark and in the other major markets where the Group operates, but the overall growth in these markets is still expected to be higher than in a severe recession. Although these economies are slowing down, the unemployment rate, which is one of the major drivers of the Group s credit risk, is expected to remain below the level in the Group s mild recession scenario. The fundamentals of the economies in the major markets today are also much different from what they were in the 1990s. With low unemployment (particularly in Denmark), low public debt and the public budget surpluses of recent years, the economies are much better able to withstand a severe economic slowdown. The Group s scenarios described above exclude the possibility of management intervention, including increasing lending margins. In the current crisis, with increased funding costs, management intervened by increasing lending margins, especially for long-term loans. If the current crisis continues, this type of intervention can reduce the impact on the scenarios described above. The potential reduction of the capital required in a severe recession by increasing lending margins is illustrated in figure 3.6. The first chart shows the effect of changes in lending margins on Pillar I+. The second chart shows the effect on economic capital. If lending margins increase by 50 basis points, the additional economic capital required declines by DKr10bn. Margin management is thus important for the Group s earnings capacity during recessions. FIGURE 3.6 EFFECT OF LENDING MARGINS ON ADDITIONAL CAPITAL REQUIRED IN A SEVERE RECESSION SCENARIO (DKr bn) Pillar I Decreasing margin Increasing margin (Basis points) Economic capital (Basis points) Decreasing margin Increasing margin DANSKE BANK RISK MANAGEMENT 2008 CAPITAL MANAGEMENT 25

25 3.4 Capital management At the end of 2008, the core (tier 1) capital ratio was 9.2%, while the solvency ratio stood at 13.0%. The Group expects to receive subordinated loan capital from the Danish state of about DKr26bn. At December 31, 2008, such a capital injection would raise the Group s core capital ratio further to around 12% and its solvency ratio to around 16%. At the beginning of 2008, the Group s minimum capital targets for its core capital and solvency ratios were 7.5% and 11.0%, respectively. By the end of 2008, these capital targets no longer formed the basis for optimum solvency level management because the Group believes that higher minimum targets will be needed in response to the international financial turmoil. In the light of this situation, the Group will revise its capital targets when conditions in the financial markets have been clarified. Three international rating agencies Standard & Poor s, Moody s and Fitch Ratings regularly assess the Group s ability to honour its payment obligations (see table 3.7). The rating targets are an essential part of the Group s capital targets because good ratings give the Group easier and cheaper access to capital and liquidity from the capital markets. TABLE 3.7 RATINGS OF DANSKE BANK AND SUBSIDIARIES BY MAJOR RATING AGENCIES Standard & Poor s Moody s Fitch Ratings Danske Bank Short-term P-1 Long-term Aa1 AA- AA- Outlook Negative Negative Stable Covered bonds AAA Aaa AAA Sampo Bank Short-term P-1 - Long-term AA- Aa1 - Outlook Negative Negative - Realkredit Danmark Covered bonds (mortgage bonds) AAA Aaa - Outlook Stable Stable - Danica Long-term/Insurer Financial Strength AA- - - Outlook Negative - - The Group maintained its ratings in 2008, although Standard & Poor s lowered its outlook from stable to negative and Moody s added under review for possible downgrade to its outlook. 3.5 The Danske Bank Group s leverage ratio The leverage ratio is a simplified measure that is often used to compare banking institutions. It is defined as core capital divided by adjusted assets. Unlike the Basel II approach, the measure thus does not take into account the fact that different activities on financial institutions balance sheets have different levels of risk. 26 CAPITAL MANAGEMENT DANSKE BANK RISK MANAGEMENT 2008

26 The leverage ratio was originally introduced as a key figure at certain American banking organisations. The balance sheets of American banks cannot be compared with European banks, however, because of differences between US GAAP and IFRSs. According to IFRSs, derivatives must be accounted for on a gross basis, and the securities continue to be recognised by the seller in a repo transaction. On the other hand, US GAAP allows netting, and for repo transactions in which the counterparty has the right to pledge or resell the securities, the securities are no longer recognised by the seller. Since the gross values of derivatives with netting contracts and repo transactions do not represent a leverage effect, for purposes of comparison the Group has chosen to adjust for them in the calculation of the leverage ratio. The Group s balance sheet includes mortgage lending at Realkredit Danmark and insurance activities at Danica. At first glance, the Group usually seems more highly leveraged than peers without these activities. Since mortgage and insurance activities do not influence the Group s liquidity leverage, the Group adjusts for these activities when calculating the leverage ratio. The Group s adjusted leverage ratio was 4.2 at the end of 2008 and 4.0 at the end of 2007 (see table 3.8). TABLE 3.8 THE GROUP S LEVERAGE RATIO (DKr m) Total assets 3,544,345 3,349,530 Netting of derivatives 453, ,237 Omission of securities sold in repo transactions 229, ,379 Total assets according to US GAAP 2,861,358 2,890,914 Omission of intangibles 25,094 29,296 Total adjusted assets according to US GAAP 2,836,264 2,861,618 Omission of insurance assets 252, ,679 Omission of lending activities at Realkredit Danmark 479, ,693 Adjusted assets 2,103,915 2,079,246 Core (tier 1) capital 88,783 83,360 Leverage ratio, according to US GAAP Leverage ratio, adjusted Capital base The Danske Bank Group s capital base consists of shareholders equity, hybrid capital and subordinated debt. Shareholders equity is part of core (tier 1) capital. Subordinated debt is tier 2 capital. The sum of tier 1 and tier 2 capital constitutes the capital base on which the solvency ratio is calculated. Hybrid capital may make up a maximum of 15% of core (tier 1) capital, and the remaining hybrid capital counts as tier 2. The Group s core (tier 1) capital, excluding hybrid core capital, amounted to DKr77bn at the end of 2008 (see table 3.9). Share capital and retained earnings totalled DKr100bn. The Group s core capital includes special reserve funds totalling DKr3bn in two companies consolidated on a pro rata basis (LR Realkredit A/S and Danmarks Skibskredit A/S). These reserve funds cannot be distributed but can be used to cover any losses at the companies after the other reserves. The Group has raised DKr14bn in hybrid core capital, which is subordinated debt that can be included in core capital up to 15% of core capital before deductions 1. Hybrid core capital may be repaid only upon the Group s initiative and with the Danish FSA s permission 10 years after it has been paid in, at the earliest. The Group s other subordinated debt, which can be included in the capital base 2, amounted to DKr36bn. Of this amount, DKr1bn is hybrid core capital that cannot be included in core (tier 1) capital. In accordance with statutory provisions, the Group s core capital is reduced by the value of intangible assets and deferred tax assets. 1 In accordance with sections 129 and 132 of the Danish Financial Business Act. 2 In accordance with sections 135 and 136 of the Danish Financial Business Act. DANSKE BANK RISK MANAGEMENT 2008 CAPITAL MANAGEMENT 27

27 TABLE 3.9 CAPITAL BASE, DANSKE BANK GROUP (DKr m) December 31, 2008 January 1, 2008 December 31, 2007 Share capital 6,988 6,988 6,988 Retained earnings 92,970 99,388 99,388 Minority interests 3,001 3,149 3,149 Proposed dividends - -5,940-5,940 Intangible assets of banking operations -25,204-29,411-29,411 Deferred tax assets Deferred tax on intangible assets 1,433 1,464 1,464 Revaluation of real property ,602-1,602 Core (tier 1) capital (excluding hybrid core capital) 77,293 73,537 73,537 Hybrid core capital 13,640 12,977 12,977 Difference between expected losses and impairment charges Statutory deduction for insurance subsidiaries -2,555-2,230-2,230 Statutory deduction for holdings > 10% Core (tier 1) capital 88,347 83,360 84,266 Subordinated debt, excluding hybrid core capital 35,023 34,714 34,714 Hybrid core capital 1,120 3,477 3,477 Revaluation of real property 924 1,602 1,602 Difference between expected losses and impairment charges 2, Statutory deduction for insurance subsidiaries -2,555-2,230-2,230 Statutory deduction for holdings > 10% Capital base 124, , ,811 Danica s capital requirement, less the difference between Danica s capital base and the carrying amount of the holding, is deducted from the Group s capital base. Danica s capital base contains supplementary capital of DKr3bn. In 2008, half of the deduction was made from core capital and half was made from supplementary capital. The carrying amount of the Group s holding in Danica, reduced by the deduction from the Group s capital base, was included in the calculation of RWA at a 100% weighting. 28 CAPITAL MANAGEMENT DANSKE BANK RISK MANAGEMENT 2008

28 4. CREDIT RISK Definition Policy Credit process Risk classification Rating of corporate customers Rating of institutions Rating of sovereign risk Credit scoring of retail customers Credit exposure Credit exposure, lending activities Credit exposure, lending activities with financial institutions Credit exposure, trading and investment activities Risk mitigation Mortgages on real property Monitoring and portfolio management Credit portfolio risk management Risk concentrations Impairment Default Calculation of the capital requirement CAPITAL MANAGEMENT DANSKE BANK RISK MANAGEMENT DANSKE BANK 2008RISK RISIKOSTYRING MANAGEMENT MARKEDSRISIKO KREDITRISIKO 29

29 The Group s total credit exposure at the end of 2008 was DKr3,523bn, with DKr2,520bn deriving from lending activities both in and outside Denmark and DKr1,003bn from the Group s trading and investment activities. Credit exposure relating to real property was DKr1,184bn at the end of 2008 corresponding to 47% of the Group s total credit exposure. After several years of increases, property prices in most of the Group s markets saw actual declines in The average loan-to-value ratio of the Group s portfolio of home loans was 54% at the end of The delinquency rate is still very low, and the downturn in the property market did not cause a significant rise in actual losses on home loans, partly because the employment rate remains high. The recessionary developments were especially unfavourable in the Group s markets where many industries and small and medium-sized businesses in particular suffered because of market-related factors. Construction and building activities slowed in most of the Group s markets, especially in Ireland. The transportation and shipping industries both endured falling global demand and a sharp decrease in freight rates over a very short period of time. Credit exposure to the two industries was DKr75bn, or 3.0% of credit exposure relating to lending activities. The amount of impaired loans rose from DKr10bn at the end of 2007 to DKr32bn at the end of Loans to financial counterparties accounted for around 34% of the rise. The economic crisis and the recession are likely to affect the credit quality of customers in a number of industries. Consequently, the Group made collective impairment charges on facilities to downgraded customers and exposed industries. At the end of the year, industry-related collective impairment charges included charges against facilities to property developers, contractors, transporters, car manufacturers and international financial counterparties. These collective impairment charges totalled DKr4.7bn, or 29% of the total balance in the allowance account. This section describes the Group s credit risk policies, credit process and risk classification, along with its credit risk exposure and approach to risk mitigation. It also explains the Group s impairment calculation process. 4.1 Definition The Group defines credit risk as the risk of losses arising because counterparties fail to meet all or part of their payment obligations to the Group. Credit risk also includes country, settlement and counterparty credit risks, among others. Country risk is the risk of losses arising from economic difficulties or political unrest in a country, including the risk of losses resulting from nationalisation, expropriation and debt restructuring. Settlement risk is the risk of losses arising when payments are settled, for example payments for trades in financial instruments, including derivatives, and currency transactions. The risk arises when the Group remits payments before it can ascertain that the counterparties consideration has been received. The credit risk on derivatives contracts, which is also called counterparty credit risk, is the risk of losses resulting from a customer s default on derivatives contracts with the Group. 30 CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

30 4.2 Policy The Board of Directors sets the overall policies for the Group s credit risk exposure. The Group s risk appetite framework is determined in accordance with these policies (see section 2.1). The key components of the credit risk policies are described below. The Group aims to build long-term relationships with its customers. For the vast majority of products, credits are granted on the basis of the customer s financial circumstances and of specific assessments that provide a background for the credits. Ongoing follow-up on developments in the customer s financial situation enables the Group to assess whether the basis for the credit has changed. The facilities should match the customer s creditworthiness, capital position and assets, and customers should be able to substantiate their repayment ability. The Group aims to assume risks only within the limits of applicable legislation and other rules, including rules on good practices for financial undertakings. The Group normally considers requiring collateral in order to mitigate credit risk. Guarantees from private individuals are avoided unless they are customary in the product segment. The Group exercises caution before granting credit facilities to businesses or individuals if it is obvious that there will be practical difficulties maintaining contact with the customer. The Group is particularly cautious in granting credits to businesses in troubled or cyclical industries. In managing country risk, the Group exercises particular caution when assuming risk in countries with an unstable economic or political climate. When processing customers and the Group s own orders in the liquidity, currency and securities markets, the Group collaborates extensively with other financial enterprises that also need to trade in these markets. The Group participates in local clearing in countries where it has retail banking operations and when business considerations require it. In doing so, it assumes credit risks relating to payment settlement. 4.3 Credit process The Group s credit management relies on a proven credit process that is adjusted to market conditions on an ongoing basis (see figure 4.1). The process ensures the proper correlation between customer creditworthiness, credit portfolio category and employee authorisation and lending authority. When the Group processes a credit application from a customer, it uses a comprehensive global electronic credit file system. For each application, the Group gathers various data that are used as the basis of the decision. The data include the following: Overview of the facility and collateral Financial analysis data or financial data from the annual tax assessments of personal customers Supplementary comments on the application Credit portfolio category Company profile Overview of the Group s total exposure to the customer The system gives an overview of all credit files and enables Group units to transfer credit applications to other units. DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 31

31 FIGURE 4.1 DANSKE BANK GROUP S CREDIT PROCESS LOAN APPLICATION ebanking Branch Contact centre LOAN PROCESSING Credit system Exposure data Score/rating Other customer data APPROVAL Adviser/ Credit officer Automatic ESTABLISHMENT Automatic loan establishment and disbursement FOLLOW-UP Ongoing reassessment of score/rating Adviser contact Unauthorised excess processing Non-performing Performing CLOSING Central collection Loan redeemed The Group assigns system authorisations for lending on the basis of the customer segment and the individual customer s classification. The system authorisations are monitored on an ongoing basis and adjusted to market conditions. The Group uses an automatic authorisation control system. In combination with the credit application and approval system, this system ensures that the approvals made by individual managers and employees are within their authorisations. Group Credits monitors authorisation breaches on an ongoing basis. Authorisations are differentiated by business unit and employee category and are also divided into authorisations for home financing and other financing. As part of the follow-up process, the Group monitors its customers financial circumstances. This includes a regular reassessment of the customers scores or ratings, adviser contact on an ongoing basis and follow-up on unauthorised excesses. If a customer fails to meet obligations to the Group, and the Group has not reached an acceptable agreement with the customer, the customer s facilities will be terminated and the case will be referred to the Group s central collection unit. If all attempts to recover the debt are unsuccessful, the customer normally applies to the bankruptcy court for a declaration of insolvency. The case is then filed for possible reopening later. 32 CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

32 When a large customer shows signs of weakness, one of the Group s workout functions takes over the credit process. There are workout functions in the central Credits department in Group Credits and many of the credit departments at the country units. The workout function prepares an action plan intended to reduce the Group s exposure to the customer. 4.4 Risk classification As part of the credit process, the Group classifies customers according to risk and updates the classification upon receipt of new information about them. The main objectives of risk classification are to rank the Group s customer base according to risk and to estimate the probability of default (PD) of each customer. The risk classifications used in the dayto-day credit process are based on point-in-time estimates (see section 10). This means that the Group uses the customer s current general and financial situation as a starting point. A change in the customer s situation or financial position therefore results in an upgrade or downgrade of the customer. The risk classifications can be divided into the following categories: Ratings of corporate customers Ratings of institutions Ratings of sovereign risk Credit scores assigned to retail customers (personal customers and small and medium-sized enterprises) In 2008, the Group implemented a classification scale, the Master Scale, which consists of 11 grades. Most of the grades are divided into two or three sub-grades, making a total of 26 categories. The former rating scale had 10 categories. The Group implemented a more finely graduated scale in order to gain more accuracy in customer classification. Grades 1 to 4 on the scale correspond to the investment-grade level of the external rating agencies, while grades 5 to 7 are sub-investment-grade levels, albeit with an acceptable credit risk. Grades 8 and 9 apply to customers who represent higher risk and therefore receive special monitoring. Grade 10 applies to doubtful and non-performing exposures for which objective evidence of impairment exists. Grade 11 applies to defaulted customers. In the following pages, rating categories refers to the 11 classification grades of the Master Scale, covering both ratings and scores assigned. Rating process Two persons are always involved in a rating decision: a rating officer who recommends the rating and a senior rating officer with authority to approve the rating. The Group has internal procedures for the use of the rating system and the various rating models. The procedures identify the specific customers, industries and so on that are covered by each rating model. This helps to ensure that each customer is rated with the correct model. A rating may deviate from the model-based rating only if the rating officer has further information that affects the rating. In every such case, the rating officer must explain the deviation. The Group validates the rating process and the rating models in accordance with external guidelines. While Group Credits is responsible for the rating process, Group Finance is responsible for validation. Validation is thus performed independently of the rating process. Internal Audit regularly audits the various elements of the rating process, including the rating models, ratings procedures and the use of the rating system. DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 33

33 4.4.1 Rating of corporate customers Corporate customers are rated in a process managed by the Group s credit organisation. Customer advisers can provide factual information for the process but have no influence on the outcome. This ensures that the rating is independent of the adviser. The rating is determined with a rating model. The model s key components build on financial statements concerning the customer, including an assessment of the customer s prospects. A recent development of the model allows the inclusion of qualitative data such as the earnings outlook for the industry and an evaluation of the company s management. On the basis of these data, the model proposes a rating. Ratings are approved according to a hierarchy of delegation. Ratings of customers whose facilities do not exceed a given level are approved by the credit department of the business unit in question. If the facilities exceed this level, the rating is referred to Group Credits for approval. Ratings of customers who apply for facilities that require the approval of the Board of Directors are submitted to a member of the Executive Board s Credit Committee for approval Rating of institutions For commercial banks, the Group uses a rating model that calculates a rating proposal on the basis of financial and qualitative data. The process is identical to the one described above for corporate customers. For other institutions, the rating process is based on expert assessments according to certain guidelines Rating of sovereign risk The Group does not have an internal rating model for sovereign risk. The ratings of sovereign counterparties and individual central banks are based on external ratings from Moody s, Standard & Poor s or Fitch Ratings. Ratings of local governments and other local authorities are based on expert assessments. The Group follows rules based on local conditions that it has defined for each country Credit scoring of retail customers The Group assigns credit scores to customers who are not rated, including personal customers and small and medium-sized enterprises. The Group uses various models to determine the probability of customers defaulting on their obligations. Customer advisers use the credit scores in granting loans and in pricing. Since the accessibility of data about personal customers varies from one country to another, the Group has developed a retail customer model for each market in which it operates. The models ensure that the Group always has an updated credit score for each customer. The score is based on either application data (for new customers) or behavioural data (for existing customers). Scores are updated monthly. Customers are downgraded in accordance with certain rules, for example after a long period of arrears. They may also be downgraded if negative events of material importance occur, for example if the Group receives new negative information about the customer s financial standing. As part of the integration of Sampo Bank into the Danske Bank Group, Sampo Bank s credit scoring methods were aligned with the Group s other models. 34 CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

34 4.5 Credit exposure At the end of 2008, the Group s total credit exposure was DKr3,522bn, with DKr2,520bn deriving from lending activities and DKr1,003bn from credit exposure relating to trading and investment activities, such as bonds and other financial instruments (see table 4.1). TABLE 4.1 TOTAL CREDIT EXPOSURE (DKr m) Credit exposure relating to lending activities* Balance sheet items: Demand deposits with central banks 9,968 6,813 Due from credit institutions and central banks 215, ,959 Bank loans and advances 1,352,113 1,360,413 Loans and advances at fair value 667, ,809 Off-balance-sheet items: Guarantees 107, ,242 Loan commitments < 1 year 51,874 97,598 Loan commitments > 1 year 115, ,940 Total credit exposure relating to lending activities 2,519,870 2,679,774 Credit exposure relating to trading and investment activities Balance sheet items: Trading portfolio assets 860, ,137 Investment securities 140,793 37,651 Off-balance-sheet items: Other unutilised commitments 1,042 3,542 Total credit exposure relating to trading and investment activities 1,002, ,330 Total credit exposure 3,522,493 3,373,104 * Covers items with credit risk that form part of the core banking operations Credit exposure, lending activities At the end of 2008, the exposure to corporate customers, the largest asset class, amounted to DKr1,197bn, or 48% of the total credit exposure relating to lending activities (see table 4.2). Personal customers constituted the second-largest asset class, with an exposure of DKr834bn, or 33% of the total credit exposure relating to lending activities. TABLE 4.2 CREDIT EXPOSURE, LENDING ACTIVITIES At December 31, 2008 (DKr m) Retail, personal customers Retail, business customers Corporate customers Institutions Governments Securitisation Due from credit institutions and central banks ,124 38, ,791 Bank loans and advances 409,379 37, ,743 67,983 33,814 21,437 1,352,113 Mortgage loans 419,249 16, ,651 2, ,181 Guarantees 4,880 2,668 69,689 30, ,648 Loan commitments ,621 28,914 2,352 18, ,137 Total 833,747 56,935 1,196, ,486 75,852 40,146 2,519,870 Total DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 35

35 At December 31, 2007 (DKr m) Retail, personal customers Retail, business customers Corporate customers Institutions Governments Securitisation Due from credit institutions and central banks ,861 87, ,772 Bank loans and advances 410,522 35, , ,945 47,550 18,006 1,360,413 Mortgage loans 421,122 15, ,390 1, ,809 Guarantees 10,592 2,427 65,870 29, ,242 Loan commitments 8,257 1, ,696 53,923 2,984 22, ,538 Total 850,493 54,297 1,086, , ,696 40,518 2,679,774 Total In 2008, the average credit quality of the Group s portfolio declined. The exposure-weighted average PD was 0.64% against 0.41% in 2007, and 80% of the portfolio had a PD of 0.13% or lower at the end of 2008 against 0.09% in Table 4.3 shows credit exposure broken down by rating category for each asset class. TABLE 4.3 CREDIT EXPOSURE BROKEN DOWN BY RATING CATEGORY At December 31, 2008 (DKr m) Rating category Lower PD Upper PD Retail, personal customers Retail, business customers Corporate customers Total , ,511 7,752 57,202 11, , ,063 1,543 80,378 87,139 14,387 16, , ,873 7, , ,928 1,248 3, , ,216 6, ,179 43, , , ,615 6, ,655 26,034 1, , ,685 15, ,739 14, , ,120 11,409 84,967 1, , ,892 5,956 74,806 2, , , ,282 1,067 16, , , , , , , ,703 Total 833,747 56,935 1,196, ,486 75,852 40,146 2,519,870 Institutions Governments Securitisation At December 31, 2007 (DKr m) Rating category Mid-point PD Retail, personal customers Retail, business customers Corporate customers Institutions Governments Securitisation Total ,933 18, ,907 12, , , , ,554 13,055 15, , , , ,850 2,529 2, , ,941 15, ,572 35, , , ,952 8, ,888 12, , ,714 15, ,399 12, , ,160 9,338 42,271 2, , ,994 3,094 8, , , , , , ,350 Total 850,493 54,297 1,086, , ,696 40,518 2,679,774 The Group s credit portfolio is also diversified across countries. At the end of 2008, credit exposure to Denmark amounted to DKr1,293bn, or 51% of the total credit exposure to lending activities (see figure 4.2). 36 CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

36 FIGURE 4.2 GEOGRAPHICAL BREAKDOWN OF CREDIT EXPOSURE, 2007 AND 2008 Denmark Sweden UK Finland Ireland Germany Baltics Other EU member states Norway North America Asia Other 0% 10% 20% 30% 40% 50% 60% The Group has limited exposure to the Baltic states. After a long period of strong economic activity and high lending growth, the Baltic economies are slowing down. At the end of 2008, the Group s total credit exposure to the Baltic states amounted to DKr31bn, or 1.2% of the total credit exposure. Credit exposure to countries other than Denmark, Finland, Sweden, Norway, Ireland, the UK, the rest of the EU and North America was modest, amounting to 1.4% of the total exposure at the end of Figure 4.3 shows credit exposure broken down by industry. FIGURE 4.3 CREDIT EXPOSURE BROKEN DOWN BY INDUSTRY (GICS), 2007 AND 2008 Personal customers Diversified financials Consumer discretionary and consumer staples Banks Commercial property Other financials Subsidised housing companies Other industrials Central and local governments Transportation and shipping Materials Energy and utilities Construction, engineering and building products Health care IT Telecommunication services 0% 5% 10% 15% 20% 25% 30% 35% DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 37

37 Construction and building activities slowed in most of the Group s markets, especially in Ireland. The transportation and shipping sectors both endured falling global demand and a sharp decrease in freight rates over a very short period of time. Credit exposure to transportation and shipping was DKr75bn, or 3.0% of the Group s total credit exposure. Part of the Group s credit exposure consists of facilities with variable utilisation. Such facilities, which enable customers to optimise the management of liquidity fluctuations in their daily payments, are a basic component of the Group s lending business. Some facilities have a fixed expiry date, which means that during the term of the facility the Group can revoke the credit only if the customer defaults. Such facilities are considered irrevocable, and the Group charges a fee for the customers drawing rights. These irrevocable loan commitments are included in the total credit exposure. At the end of 2008, the utilised portion of facilities with variable utilisation was DKr327bn, or 66% of the aggregate limit, against 42% at the end of 2007, indicating an increased need for liquidity among customers in 2008 (see table 4.4). TABLE 4.4 FACILITIES WITH VARIABLE UTILISATION Irrevocable loan commitments by term: < 1 year ,169 9, ,322 51,874 > 1 year ,453 18,962 2, ,263 At December 31, 2008 (DKr m) Retail, personal customers Retail, business customers Corporate customers Institutions Governments Securitisation Total Limits 22, ,194 79,491 4,137 30, ,173 Utilised portion 22, ,572 50,577 1,786 11, ,036 Irrevocable loan commitments ,622 28,914 2,351 18, ,137 At December 31, 2007 (DKr m) Retail, personal customers Retail, business customers Corporate customers Institutions Governments Securitisation Total Limits 21,168 1, ,807 63,918 4,462 29, ,391 Utilised portion 12, ,112 9,994 1,478 6, ,852 Irrevocable loan commitments 8,258 1, ,695 53,924 2,984 22, ,539 Irrevocable loan commitments by term: < 1 year ,294 29,383-21,920 97,599 > 1 year 8,258 1,164 94,401 24,541 2, , Credit exposure, lending activities with financial institutions Financial institutions are defined as banks, investment banks, brokers/dealers, mortgage banks, life insurance and pension companies, casualty insurance companies, investment companies and other financial businesses not under local supervision. At the end of 2008, the Group s credit exposure relating to lending activities with financial customers amounted to DKr634bn, against DKr807bn at the end of These figures represented 25% and 30%, respectively, of the total credit exposure relating to lending activities. In addition, the Group had bond exposures and derivatives contracts with financial customers (see section 4.5.3). 38 CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

38 Table 4.5 shows a breakdown of the Group s exposure by type of financial institution. TABLE 4.5 BREAKDOWN OF EXPOSURE BY TYPE OF FINANCIAL INSTITUTION At December 31 (DKr m) Banks 183, ,975 Life insurance and pension companies 132,360 20,341 Finance companies etc. 89, ,081 Investment undertakings etc. 115, ,851 Mortgage credit institutions 35,877 43,934 Brokers/dealers 7,638 49,078 Investment banks 7,479 31,000 Casualty insurance companies 3,486 6,111 Other 58,956 98,247 Total 633, ,618 Table 4.5 does not include exposures to central banks amounting to DKr41m in 2008 (2007: DKr88bn). The definition above of financial institutions is broader than the definition of the asset class used in other tables in this section (see table 4.6). TABLE 4.6 FINANCIAL CUSTOMERS BROKEN DOWN BY ASSET CLASS At December 31 (DKr m) Corporate customers 277, ,134 Institutions 316, ,966 Securitisation 40,146 40,518 Total 633, ,618 The Group s rating process for financial institutions is described in section During 2008, many financial institutions were adversely affected by the financial crisis, and a number of national governments introduced rescue plans. Some of the Group s counterparties in the financial segment defaulted as a result of developments in 2008; in most cases, the Group was protected from losses by the rescue plans. Although the credit quality in the segment deteriorated in 2008, the credit quality of 75% of the customers is still considered to correspond to the investment-grade level, against 79% in In 2008, the exposure-weighted average PD was 0.31% (2007: 0.16%), and 80% of the portfolio had a PD of 0.03% or lower at the end of 2008 (2007: 0.04%). DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 39

39 Table 4.7 shows a breakdown of financial institutions by rating category. TABLE 4.7 FINANCIAL INSTITUTIONS BROKEN DOWN BY RATING CATEGORY At December 31 (DKr m) Rating category , , , , , , , , , , ,192 Total 633,994 At December 31 (DKr m) Rating category , , , , , , , , , Total 806, CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

40 Table 4.8 shows a breakdown by the financial institutions country of domicile. TABLE 4.8 GEOGRAPHICAL BREAKDOWN OF FINANCIAL INSTITUTIONS At December 31 (DKr m) Denmark 214, ,781 Finland 5, Sweden 47,891 73,721 Ireland 40,024 39,201 UK 148, ,624 Germany 14,345 27,057 Baltics 7,661 3,397 Other EU member states 80,272 70,017 Norway 11,543 10,603 Eastern Europe 1,428 1,430 Other European countries 8,545 6,363 North America 43, ,374 Central and South America 640 1,759 Africa Asia 8,894 8,486 Oceania Total 633, ,618 In the past years, an increasing portion of unsecured interbank transactions have been converted to collateralised transactions. This trend continued in A number of national governments provided public guarantees for parts of banks obligations. The Group recognises credit exposures to banking sector counterparties covered by a public guarantee as secured claims. This mainly concerns exposures to financial institutions in Denmark. A large percentage of the exposure to financial institutions 68% is fully secured by guarantees, securities and the like. Collateral received in repo transactions, typically government bonds or Scandinavian mortgage bonds, is subject to regular adjustments upon changes in fair value. At the end of 2008, DKr25bn of the Group s exposure to financial institutions both in and outside Denmark was covered by state guarantees. Table 4.9 shows other types of collateral received by the Group. TABLE 4.9 MITIGATION OF CREDIT RISK ON FINANCIAL INSTITUTIONS At December 31 (DKr m) Real property 7,978 23,126 Bank accounts Custody accounts and securities 359, ,948 Vehicles 66 7 Equipment Vessels and aircraft - - Guarantees 16,813 6,315 Amounts due 102 3,566 Other assets 48,553 33,593 Total 433, ,252 In the current financial crisis, the Group actively manages its credit portfolio with financial institutions to reduce overall exposure. DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 41

41 The Group conducts regular reviews of credit facilities, both those on which drawings are made and those on which no drawings are made. The Group also runs stress tests on certain assets to determine the sensitivity of the credit quality and the level of excess collateral in the individual portfolios. As a result of the financial crisis, a number of investment companies have been unable to fund activities by their usual sources and have drawn on their backup liquidity facilities instead. The Group has been disclosing its total exposure in the form of liquidity facilities to such investment companies since the crisis started. Through active management of this portfolio of liquidity commitments, the Group reduced its exposure substantially during 2008, from DKr31.1bn at the end of 2007 to DKr13.4bn at the end of Cancellation of facilities accounted for most of the reduction DKr15.9bn and the remaining DKr1.8bn arose because the Group changed its refinancing to more closely follow the expected terms of the underlying assets. At the end of 2008, DKr10.7bn, or 80% of the total exposure to backup liquidity facilities, had been drawn. The underlying collateral at the end of 2008 consisted of bonds based on US subprime, UK prime and corporate exposures, of which 81% were investment-grade (see table 4.10). TABLE 4.10 RATINGS OF UNDERLYING COLLATERAL FOR BACKUP LIQUIDITY FACILITIES (%) December 31, 2008 December 31, 2007 Aaa/AAA AA-BBB Subinvestment grade 19 2 Unrated - 2 Total Note: The comparative figures exclude backup liquidity facilities through Polonius. In 2008, the Group closed its own investment vehicle, Polonius, without effect on the financial statements or liquidity since Polonius was already included in the consolidated financial statements. The portfolio taken over continues to be of a high quality; all assets are externally rated, with 70% rated AAA, 25% rated AA and 2% rated A Credit exposure, trading and investment activities At the end of 2008, the Group s credit exposure relating to trading and investment activities amounted to DKr1,003bn. It consisted mostly of exposure to bonds and derivatives. Derivatives with positive fair value were the largest single class with an exposure of DKr574bn, or 57% of the total credit exposure relating to trading and investment activities (see table 4.11). TABLE 4.11 CREDIT EXPOSURES, TRADING AND INVESTMENT ACTIVITIES At December 31 (DKr m) Bonds 422, ,688 Shares 4,540 7,484 Derivatives with positive fair value 574, ,616 Other unutilised commitments 1,042 3,542 Total 1,002, ,330 Note: Other unutilised commitments include commitments relating to private equity investments and other obligations. 42 CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

42 Bonds The Group s bond holdings amounted to DKr423bn; 89% of the bonds is recognised at market prices and 9% on the basis of observable market data. At the end of 2007, 97% was recognised at market prices. This reflects the liquidity squeeze in the market. Most of the bonds in the portfolio are Danish mortgage bonds; covered bonds under public supervision, mainly in Sweden, Spain and the UK; and bonds issued by sovereign states or guaranteed by central or local governments. The bond holdings form part of the Group s liquidity reserve, most of which can be refinanced at the Danish central bank. About 7% of the portfolio consists of short-dated instruments (commercial paper and the like) issued primarily by banks in Finland, Spain, France and Scandinavia. Some 6% of the holdings are credit bonds consisting of corporate bonds, including bonds issued by banks, and covered bonds not under public supervision. The holdings include no structured issues based on US subprime loans. The majority of issuers are based in Italy, Scandinavia, Ireland, Germany and the US. TABLE 4.12 BOND PORTFOLIO BROKEN DOWN BY TYPE AND GEOGRAPHY At December 31, 2008 (DKr m) Central and local government bonds Quasigovernment bonds Danish mortgage bonds Swedish covered bonds Other covered bonds Shortdated bonds (CP etc.) Credit bonds Total Total 2007 Denmark 11, , , , ,751 Finland 3, , ,933 13,302 Sweden 7, ,441-4, , ,921 Norway 1, ,124 3,707 2,206 8,512 8,575 Ireland ,705 4,335 4,069 UK 9, , ,811 25,116 16,237 Germany 22,924 1, , ,616 29,439 21,772 Spain 1, ,700 4, ,769 17,633 France 3, ,858 3, ,559 6,113 Italy ,556 7,253 8,943 North America 146 6, ,752 8,332 17,532 Other 4, ,534 2,429 3,569 12, Total 66,737 8, ,695 84,441 38,645 29,831 23, , ,688 Only a small part of the bond portfolio (1%) was assigned to rating categories This reflects the good credit quality of the Group s bond holdings (see table 4.13). DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 43

43 TABLE 4.13 BOND PORTFOLIO BROKEN DOWN BY TYPE AND RATING CATEGORY At December 31, 2008 (DKr m) Central and local government bonds Quasigovernment bonds Danish mortgage bonds Swedish covered bonds Other covered bonds Short-dated bonds (CP etc.) Credit bonds Total 1 63,848 6, ,105 5,251-7,888 86, ,836 1, ,677 78,141 19,846 21,356 6, , ,014 3,195 11,033 6,427 3,344 41, ,095 1,091 1,597 4, ,863 4, ,128 1, Total 66,737 8, ,695 84,441 38,646 29,830 23, ,585 At December 31, 2007 (DKr m) Total 1 93, , , , , Total 457,688 Derivatives When entering into derivatives transactions with businesses and institutions, the Group endeavours to ascertain whether the customer has adequate knowledge of the risks involved in the transactions. The Group enters into derivatives contracts with retail customers only if it has ascertained that the customer has a sound understanding of the products risk profile and has the ability to cover possible losses. The Group normally requires collateral for derivatives contracts with personal customers, and the Group s collateral management agreements are monitored separately from the derivatives contracts. For professional counterparties in the market, mutual collateral agreements are becoming customary. The Group s policy is to promote such collateral management agreements in order to reduce counterparty credit risk. For each customer, the Group sets specific limits for the risk it is prepared to take on. Since exposures are often subject to netting and collateral management agreements, risk arises only if market fluctuations occur at a time when the counterparty is unable to meet an obligation under a margin call. Counterparty credit risk exposures are included in the Group s calculation of a customer s credit facilities. 44 CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

44 Table 4.14 shows derivatives contracts with positive and negative fair value broken down by utilisation. TABLE 4.14 DERIVATIVES BROKEN DOWN BY UTILISATION Positive fair value Negative fair value At December 31, 2008 (DKr m) Notional amount Carrying amount Notional amount Carrying amount Currency contracts: Forwards and swaps 2,111, ,734 2,250, ,675 Options 73,301 2,790 56,109 2,873 Interest rate contracts: Forwards/swaps/FRAs 12,829, ,222 13,616, ,755 Options 6, , Equity contracts: Forwards 4, , Options 55,164 3,469 57,938 3,510 Other contracts: Commodity contracts 16,375 2,376 17,345 2,291 Credit derivatives bought 11,560 2,982 8, Credit derivatives sold 2, , Total derivatives held for trading purposes 561, ,475 Hedging derivatives: Currency contracts 316,536 2, , Interest rate contracts 622,510 10, ,124 4,210 Total derivatives 574, ,521 Positive fair value Negative fair value At December 31, 2007 (DKr m) Notional amount Carrying amount Notional amount Carrying amount Currency contracts: Forwards and swaps 1,980,600 59,039 1,900,443 59,607 Options 69, ,853 1,108 Interest rate contracts: Forwards/swaps/FRAs 12,151, ,673 11,333, ,461 Options 12,713 8,140 14,575 8,411 Equity contracts: Forwards 7,575 1,059 7,734 1,041 Options 71,051 2,132 71, Other contracts: Commodity contracts 8,088 1,041 10,134 1,301 Credit derivatives bought 10,031 1,206 1,070 7 Credit derivatives sold 1, , Total derivatives held for trading purposes 222, ,217 Hedging derivatives: Currency contracts 126, ,557 1,031 Interest rate contracts 172,440 1, ,430 1,539 Total derivatives 224, ,787 DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 45

45 The rise in the positive fair value of derivatives was owing primarily to an increase in the positive fair value of conventional interest rate and currency contracts caused by substantial interest and exchange rate fluctuations. The increase in value was offset by a similar increase in the negative fair value of derivatives recognised as trading portfolio liabilities. The Group has made agreements with many of its counterparties to net positive and negative market values. Most of these net facilities are secured by collateral management agreements. TABLE 4.15 COUNTERPARTY CREDIT RISK ON DERIVATIVES (DKr m) Derivatives with positive fair value 574, ,616 Netting benefits 453, ,237 Net current exposure 120,568 43,379 As table 4.16 shows, most of the Group s counterparties in derivatives contracts have high ratings. TABLE 4.16 DERIVATIVES BROKEN DOWN BY RATING CATEGORY Issued by At December 31, 2008 (DKr m) Financial customers Others Total 1 12,392 17,147 29, ,422 4, , ,238 5, , ,090 7,673 31, ,137 5,261 13, ,232 2,984 6, ,493 1,574 27, Net derivative exposure 529,138 45, ,456 The counterparty credit risk on derivatives is calculated daily at netted market values. 4.6 Risk mitigation Reducing risk in the credit portfolio is a key component of the Group s business strategy. For many loan products, collateral is required by legislation or by market practice, as in the mortgage finance market, or is agreed upon with the customer. The Group strives to maintain sufficient information about the pledges and guarantees it has received so that it can estimate their values on an ongoing basis. The market values are estimated in various ways depending on asset type and the asset s liquidity. The Group estimates the market values of real property by using indices and external or internal valuations. Market values of financial assets are calculated on the basis of current stock exchange prices. For unlisted securities, the Group uses an internal valuation method. The Group deducts a haircut from the market value of the assets. For real property, the haircut represents the expected cost of a compulsory sale. For listed securities, it is calculated with an internal model based on price volatility. For unlisted securities, the haircut is 100%. 46 CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

46 In some cases, the Group receives guarantees for credit facilities. Many of them are provided by companies or persons related to the debtor. Because of the default correlation, no independent value is attached to such guarantees. Important means of risk mitigation are pledges, guarantees and netting arrangements in master agreements for derivatives. The most frequently used pledges are mortgages on real property (64% of total collateral received) and pledges of financial assets such as custody accounts and securities (24% of total collateral received) (see table 4.17). TABLE 4.17 TYPES OF COLLATERAL At December 31, 2008 (DKr m) Retail, personal customers Retail, business customers Corporate customers Total Real property 663,239 26, ,314 1,864 1,007 23,701 1,068,488 Bank accounts , ,179 Custody accounts and securities 4, , ,799 7,091 2, ,614 Vehicles 5,415 3,312 7, ,594 Equipment 92 1,526 13, ,707 Vessels and aircraft , ,171 Guarantees 8,809 4,271 20,720 14,302 1,002-49,104 Amounts due , ,147 5,321 Other assets 1, ,999 4, ,286 Total 684,626 36, , ,867 10,371 27,554 1,621,464 At December 31, 2007 (DKr m) Retail, personal customers Retail, business customers Corporate customers Institutions Governments Securitisation Institutions Governments Securitisation Total Real property 677,563 26, ,261 1,763 1,137 6,277 1,029,189 Bank accounts , ,209 Custody accounts and securities 7, , ,332 49,939 22, ,922 Vehicles 4,671 2,085 5, ,910 Equipment 1,298 1,421 12, ,523 Vessels and aircraft , ,010 Guarantees 13,799 4,584 20,442 1, ,948 Amounts due , ,331 6,530 Other assets 6,776 1,086 39,705 13,645 1, ,943 Total 713,068 36, , ,121 53,983 32,660 1,722,184 The unsecured portion of the total credit exposure increased in 2008 because of the general economic slowdown and the decline in asset prices. At the end of 2008, an average 35.7% of the Group s credit exposure was unsecured, unchanged from 2007 (see table 4.18). DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 47

47 TABLE 4.18 UNSECURED CREDIT EXPOSURE At December 31, 2008 (DKr m) Retail, personal customers Retail, business customers Corporate customers Institutions Governments Securitisation Total Credit exposure 833,747 56,935 1,196, ,486 75,852 40,146 2,519,870 Collateral value 684,626 36, , ,867 10,371 27,554 1,621,464 Total unsecured credit exposure 149,121 20, , ,619 65,481 12, ,406 Unsecured portion of credit exposure (%) At December 31, 2007 (DKr m) Retail, personal customers Retail, business customers Corporate customers Institutions Governments Securitisation Total Credit exposure 850,493 54,297 1,086, , ,696 40,518 2,679,774 Collateral value 713,068 36, , ,121 53,983 32,660 1,722,184 Total unsecured credit exposure 137,425 17, , ,845 85,713 7, ,590 Unsecured portion of credit exposure (%) In table 4.19, the unsecured portion of the credit portfolio is broken down by rating category. TABLE 4.19 UNSECURED CREDIT EXPOSURE BROKEN DOWN BY RATING CATEGORY At December 31, 2008 (DKr m) Unsecured portion of credit exposure (%) Rating category Credit exposure Collateral Avg. unsecured portion (%) 1 206, , ,860 1,329 1, , , , ,923 12,038 6,169 3,921 85, , , ,822 21,277 14,473 7, , , , ,360 23,093 23,454 8, , , , ,043 29,126 30,011 15, , , , ,222 23,943 25,666 11,981 91, , ,292 85,771 18,224 25,723 7,708 63, ,823 99,103 65,596 11,654 18,207 6,928 53, ,038 17,394 11,638 1,689 2,589 1,090 9, ,916 5,687 2,166 1,107 1, , ,703 16,122 12,105 2,108 5,181 1,220 3, Total 2,519,870 1,621,464 1,331, , ,480 65, , CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

48 At December 31, 2007 (DKr m) Unsecured portion of credit exposure (%) Rating category Credit exposure Collateral Avg. unsecured portion (%) 1 161,444 75,214 77,167 1, , , , ,496 41,552 10,485 1, , , , ,722 56,402 31,243 5, , , , ,547 20,638 24,071 10, , , , ,291 21,598 31,228 13, , , , ,063 21,508 20,166 9, , , ,803 92,487 5,601 4,966 2,799 38, ,149 10,330 8,383 1,070 1, , ,120 2,047 1,033 1, ,350 3,696 3, , Total 2,679,774 1,722,184 1,488, , ,884 43, , Mortgages on real property Most of the collateral the Group receives for providing loans takes the form of mortgages on real property. In 2008, the value of the mortgages amounted to DKr986bn, or 82% of total collateral (see table 4.20). Some 64% of the value of mortgages on real property relates to loans to personal customers. After several years of rising property prices, some property segments, particularly in Denmark, Ireland and the Baltic countries, saw declines in House prices in Sweden and Norway also declined. The turnaround in the property markets resulted in a slight increase in the average unsecured percentage of the Group s mortgage loans in TABLE 4.20 COLLATERAL RECEIVED FOR MORTGAGE LOANS At December 31, 2008 (DKr m) Retail, personal customers Retail, business customers Corporate customers Institutions Governments Securitisation Total Credit exposure 750,865 22, ,548 2,074 2,668-1,183,935 Collateral value 640,751 20, ,983 1,864 1, ,825 Total unsecured credit exposure 110,114 2,560 83, , ,110 Unsecured portion of credit exposure (%) At December 31, 2007 (DKr m) Retail, personal customers Retail, business customers Corporate customers Institutions Governments Securitisation Total Credit exposure 670,198 25, ,025 2,429 2,517-1,041,477 Collateral value 595,394 21, ,906 1,289 1, ,167 Total unsecured credit exposure 74,804 3,867 72,119 1,140 1, ,310 Unsecured portion of credit exposure (%) In the personal customer portfolio, the average loan-to-value (LTV) ratio was 54.1% in 2008, against 50.3% in 2007 (see table 4.21). DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 49

49 TABLE 4.21 LTV, HOME MORTGAGE LOANS TO PERSONAL CUSTOMERS At December 31, 2008 (DKr m) 0-20% 20-40% 40-60% 60-80% % Total Avg. LTV (%) Banking Activities Denmark 183, ,324 93,036 42,299 7,138 1, , Segment from Realkredit Danmark 154, ,034 79,223 35,207 4, , Banking Activities Finland 25,989 19,305 12,388 6,218 2, , Banking Activities Sweden 15,381 11,706 7,546 3,991 1, , Banking Activities Norway 17,281 14,858 10,219 4,312 1, , Banking Activities Northern Ireland 5,768 3,571 1, , Banking Activities Ireland 11,680 8,553 4,883 2, , Banking Activities Baltics 7,218 5,887 3,805 1, , Total 267, , ,665 61,574 12,713 4, , Note: In the breakdown, every krone lent is categorised according to its seniority in the total debt on the individual property. For each property, the average LTV is calculated on the basis of the last krone lent. The Unspecified column contains loans for properties whose current value is unknown. At December 31, 2007 (DKr m) 0-20% 20-40% 40-60% 60-80% % Unspecified Unspecified Total Avg. LTV (%) Banking Activities Denmark 190, ,512 81,609 26,851 2, , Segment from Realkredit Danmark 164, ,271 70,920 22, , Banking Activities Finland 29,738 24,372 16,763 6,431 1,586 4,351-83, Banking Activities Sweden 15,270 11,413 7,426 3, , Banking Activities Norway 17,441 14,693 9,325 3, , Banking Activities Northern Ireland 4,263 2,807 1, , Banking Activities Ireland 7,364 5,498 3,285 1, , Banking Activities Baltics 4,419 3,918 2,713 1, , Total 269, , ,686 43,790 5,821 7, , Note: The end-2007 loan-to-value figures for Banking Activities Finland are calculated on the basis of mortgage loans. The figures for the period after Sampo Bank Finland s migration to the Group platform are calculated on the basis of home mortgage loans in line with the calculation method used for the other units. After several years of increases, property prices in most of the Group s markets saw actual declines in The delinquency rate is still very low, and the downturn in the property market did not cause a significant rise in actual losses on home loans, partly because the employment rate remains high. 50 CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

50 FIGURE 4.4 DELINQUENCY RATE FOR REALKREDIT DANMARK S LOAN PORTFOLIO (%) FIGURE 4.5 HOUSE PRICE DEVELOPMENT Index 2003 = Denmark Sweden Norway Ireland Northern Ireland Finland Construction and building activities slowed in most of the Group s markets, especially in Ireland. Falling house prices caused Realkredit Danmark s average loan-to-value ratio (LTV), calculated on the basis of the last krone lent for every property, to rise from 53% at the end of 2007 to 57% at the end of 2008 (see figure 4.6). FIGURE 4.6 AVERAGE LTV FOR REALKREDIT DANMARK S LOAN PORTFOLIO (%) Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q Private market Urban trade Agriculture Residential Total DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 51

51 For personal mortgage loans granted by Realkredit Danmark, the average loan-to-value ratio was 58% in 2008, against 53% in 2007 (see table 4.20). Realkredit Danmark s personal customer portfolio is divided into priority customers and other customers. A priority customer is defined as a customer who meets certain requirements, for example having made timely mortgage repayments for the past two years. On average, priority customers have a lower loan-to-value ratio than other customers. Less than 1.3% of the total outstanding value of personal mortgage loans granted by Realkredit Danmark concerns loans with a loan-to-value ratio above 80%. For priority customers, the percentage is 1.4%, and for other customers, it is 2.1%. See table 4.21 for details. At the end of 2008, personal mortgage loans without amortisation (interest-only loans) accounted for 47% of total personal mortgage loans granted by Realkredit Danmark, against 44% at the end of TABLE 4.22 REALKREDIT DANMARK S PERSONAL CUSTOMER PORTFOLIO Loans to priority customers Other mortgage loans At December 31, 2008 (DKr m) Fixed rate Variable rate Total Fixed rate Variable rate Total Total Realkredit Danmark 0-20% 74,703 52, ,120 14,914 11,978 26, , % 57,888 43, ,249 12,890 10,895 23, , % 33,734 26,870 60,604 10,188 8,430 18,618 79, % 12,644 11,197 23,841 6,357 5,009 11,366 35,207 1,487 1,496 2, ,737 4,720 Total 180, , ,797 45,315 37,083 82, ,195 Segment from interest-only loans 59,454 78, ,423 22,847 27,423 50, ,693 Note: Priority customers are defined as customers with loans not past due for the past two years. Loans to priority customers Other mortgage loans At December 31, 2007 (DKr m) Fixed rate Variable rate Total Fixed rate Variable rate Total Total Realkredit Danmark 0-20% 65,607 68, ,381 16,571 13,319 29, , % 46,678 55, ,261 14,020 11,990 26, , % 22,605 29,303 51,908 10,436 8,576 19,012 70, % 5,952 7,087 13,039 5,260 3,991 9,251 22, Total 141, , ,028 46,470 38,128 84, ,626 Segment from interest-only loans 36,893 83, ,573 23,028 26,613 49, , Monitoring and portfolio management The Group monitors credit facilities centrally through its credit systems. It registers the customers classifications, data on the limits and utilisation of all types of facility, and information on the estimated realisation value of collateral after the deduction of the estimated costs of realisation. The Group sets limits individually according to the customer classification and the collateral provided. At least once a year, it reviews all exposures above a certain level, with new financial and other data taken into account. Customers who show a weak financial performance are transferred to a watch list so that the Group can monitor them more closely and reduce the risk of losses. 52 CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

52 Unauthorised excesses above the approved limits are automatically referred to the customer s adviser, who decides whether or not to accept the excess. For good customers, the Group often accepts excesses on one or more accounts for a certain period. If the excess is not accepted, a reminder procedure is initiated. If the excess is not repaid, the procedure may lead to debt recovery proceedings. Claims submitted for debt recovery are transferred to a centralised debt collection department in each country. The Group monitors credit quality trends at industry level. Industry research reports are submitted both to the Board of Directors and, in a shorter form, to the business units. In addition to credit management at the individual customer level in the credit systems, the Group has set up measures for credit portfolio risk management at the business unit, sector, industry, product and country levels on the basis of data registered in the Group s data warehouse Credit portfolio risk management Credit portfolio risk management involves two sets of portfolios. One set is used to monitor the total credit risk broken down by industry, country and business unit dimensions. The risk appetite for each portfolio is based on a combination of industry input and the current credit quality of the portfolio. The other set of portfolios concerns specific areas where the Group has identified a need for close attention, for example exposure to commercial property. For both sets of portfolios, the Group determines credit limits based on exposure, credit quality and portfolio outlook. The limits are typically set at the industry level, with possible variations among the business units. Additionally, the business units monitor and review credit quality on a quarterly basis and report to Group Credits on various credit portfolio characteristics. The Group may take steps to counter negative developments in the portfolio. Detailed monitoring reports are sent to the business units credit departments, and general reports are submitted to the Executive Board s Credit Committee Risk concentrations As part of its risk appetite framework, the Group uses risk concentrations identified in the credit portfolio as a credit risk management parameter. The Group has defined internal concentration limits, including a limit on single-name exposures. It monitors the concentrations and evaluates them against the internal limit framework regularly. The limits are approved by the All Risk Committee. Monitoring three risk concentrations loans to customers in Denmark, loans to financial customers, and real property financing is an integral part of the Group s business strategy (see table 4.23). Real property financing consists mainly of Realkredit Danmark s mortgage loans. These loans are match funded through the issuance of Danish mortgage bonds. The Group thus has no refinancing or interest rate risk on these loans. As an international credit institution, the Danske Bank Group of course lends to other international financial institutions. The Group takes special care in monitoring this exposure. The concentration of customers residing in Denmark is owing largely to the Group s long history in the country and thorough knowledge of the market. In recent years, however, the Group has increased its international diversification. DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 53

53 TABLE 4.23 RISK CONCENTRATION MEASURES Loans to customers resident in Denmark Customers resident in Denmark account for 51% (2007: 43%) of the Group s credit exposure. Loans to financial customers Customers in the financial sector represent 25% (2007: 30%) of the Group s credit exposure. Most of the exposure is to large counterparties with good ratings. Real-property-related financing Financing of real property or for businesses engaged in related industries represents 47% (2007: 48%) of the Group s credit exposure. A large percentage of this exposure derives from the retail segment s financing of real property. Under section 145 of the Danish Financial Business Act, exposure to a single customer or a group of related customers after deduction of particularly secure claims may not exceed 25% of the capital base. Moreover, after deduction of particularly secure claims, the sum of all exposures that exceed 10% of the capital base may not exceed 800% of the capital base. In 2008 and 2007, none of the Group s exposures exceeded these limits (see table 4.24). The Group submits quarterly reports to the Danish FSA on its compliance with these rules. TABLE 4.24 LARGE EXPOSURES At December 31 (DKr m) 2008 Exposures calculated in accordance with section Exposures calculated in accordance with section 145 Number 9 11 Exposure >20% of capital base - 24,829 Exposure between 10% and 20% of capital base 131, ,782 Total 131, ,611 Utilisation of 800% limit (%) Note: Outstanding intra-group amounts are not included in the table. 4.8 Impairment According to the definitions in IAS 39, objective evidence of impairment of a financial asset may appear before default, for example when a debtor is found to be in major financial difficulties or is likely to go bankrupt or enter into financial restructuring. If objective evidence of impairment of a loan, advance or amount due exists, the Group determines the individual impairment charge. The charge equals the difference between the carrying amount and the present value of the estimated future cash flow from the asset, including the realisation value of collateral. The Group estimates the future cash flow on the basis of the most likely scenario. Customers subject to objective evidence of impairment but not in default are downgraded to the Group s risk category 10, while customers in default are downgraded to category 11. The Group has identified a set of individual impairment events on the basis of the definition of impairment in IAS 39, paragraph 59. For personal customers, objective evidence of impairment normally means that a facility has been in arrears for 90 days. Items sent to the Group s debt collection unit are also considered impaired. For corporate customers, objective evidence of individual impairment usually appears upon bankruptcy, a suspension of payments or financial restructuring. In table 4.25, the allowance account for individual impairment charges is broken down by the main reason for impairment. 54 CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

54 TABLE 4.25 ALLOWANCE ACCOUNT BROKEN DOWN BY REASON FOR INDIVIDUAL IMPAIRMENT (DKr m) Exposure before impairment charges Impairment charges Exposure before impairment charges Impairment charges Bankruptcy 14,581 3,580 2, Collection/suspension of payments 4,927 1,778 2, Composition/restructuring of debt 7,651 1,624 1, days past due 3, Other financial difficulties 13,266 3,342 6,791 1,679 Total 43,808 11,190 13,046 3,575 Loans and advances without objective evidence of impairment are included in an assessment of collective impairment. The assessment is based on a migration analysis in which portfolios are defined according to the customers classification on the balance sheet date. Portfolio assessments cover loans and advances to customers in categories 1 to 9. Collective impairment charges are determined by changes in ratings between the original rating assignment and the balance sheet date (if the changes are considered important to the portfolio s future cash flow). The rating changes are calculated as net changes within each portfolio. When market information indicates that an impairment event has occurred, even though it has not yet materialised in ratings, the Group sets up an early event impairment charge. Early event charges apply only until the migration analysis captures the credit deterioration. If a rating downgrade does not occur, for example because the market information no longer indicates impairment, the early event impairment charge is reversed. Collective impairment is calculated as the difference between the carrying amounts of the loans and advances in the portfolio and the present value of estimated future cash flows. According to the amortised cost method, the value of a portfolio cannot exceed the value at the initial recognition less the amounts repaid during the period from initial recognition to the balance sheet date. Table 4.26 shows reconciliations of the allowance account in 2008 and Of Other items of DKr782m, some DKr764m derives from Sampo Bank upon its initial consolidation. TABLE 4.26 RECONCILIATION OF ALLOWANCE ACCOUNT Total impairment charges, end of year Total impairment charges, end of year (DKr m) Individual impairment Collective impairment Individual impairment Collective impairment At January 1 3,575 1,325 4,900 3, ,204 New impairment charges 9,750 3,790 13,540 2,956 1,009 3,965 Reversals of impairment charges from previous periods 1, ,534 2, ,166 Write-offs debited to allowance account Foreign currency translation Other items At December 31 11,190 4,668 15,858 3,575 1,325 4,900 The Group conducts impairment tests quarterly in a process managed by the central credit organisation. For practical reasons, the process ends at a cut-off date before the balance sheet date. For small-balance loans, the Group adjusts for this statistically. Large-balance loans are always processed individually. DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 55

55 Because of the deterioration in the economy in 2008, impairment charges increased throughout the year, both individual and collective impairment charges. The unsatisfactorily high level of impairment charges was the result of the financial crisis, declining asset values and the economic slowdown in the Group s markets. Developments in Ireland were particularly negative. Table 4.27 shows the components of the loan impairment charges recognised in the income statement. TABLE 4.27 LOAN IMPAIRMENT CHARGES At December 31 (DKr m) New impairment charges 13,540 3,965 Reversals of impairment charges from previous periods 1,533 3,166 Write-offs recorded directly in income statement Recoveries recorded directly in income statement Foreign currency translation - - Other items - - Total 12, Total loan impairment charges as basis point value of lending 57 3 Loans and advances are written off after the Group s debt collection procedures have been completed and losses on individual loans or advances have been determined. Write-offs are netted against the impairment charge accumulated on the allowance account. When the economic climate is favourable, recoveries of write-offs can be substantial. Even though, in accordance with IFRSs, impairment charges are recognised only when objective evidence of impairment exists, the recognition of impairment charges still does not coincide with the actual recognition of the loss. Table 4.28 shows loan impairment charges included in the income statement and recognised losses (corresponding to write-offs in the period). TABLE 4.28 LOAN IMPAIRMENT CHARGES AND RECOGNISED LOSSES At December 31 (DKr m) Retail, personal customers Retail, business customers Corporate customers Institutions Governments Securitisation Total 2008 Loan impairment charges 753 3,740 7, ,088 Recognised losses , Loan impairment charges Recognised losses , CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

56 Table 4.29 shows claims that are past due or impaired (rating categories 10 and 11) broken down geographically. TABLE 4.29 LOAN IMPAIRMENT CHARGES, GEOGRAPHICAL BREAKDOWN Credit exposure Allowance account 2008 (DKr m) Total Past due Rating categories Allowance account, individual Allowance account, collective Total Loan impairment charges Denmark 1,295,324 12,838 9,822 5,045 1,437 6,482 6,739 Finland 204,642 3,047 2, , Sweden 271, , Ireland 120,029 2,019 6,536 1, ,849 1,645 UK 205, , ,212 2, Germany 31, Baltics 31,348 2, Other EU member states 97, Norway 169,050 1,782 1, Eastern Europe 2, Other European countries 12, North America 58, ,348 1,182-1,182 1,244 Central and South America 1, Africa 1, Asia 15, Oceania Total 2,519,870 23,759 32,619 11,190 4,668 15,858 12,088 Credit exposure Allowance account 2007 (DKr m) Total Past due Rating categories 9-10 Allowance account, individual Allowance account, collective Total Loan impairment charges Denmark 1,161,704 11,655 3,291 1, , Finland 204,134 1, Sweden 290,268 3, Ireland 109,311 1, UK 400, , Germany 45, Baltics 32, Other EU member states 85, , Norway 179,684 2, Eastern Europe 2, Other European countries 9, North America 138, Central and South America 2, Africa Asia 14, Oceania Total 2,679,774 21,088 9,470 3,575 1,325 4, DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 57

57 Table 4.30 shows claims that are past due or impaired (rating categories 10 and 11) broken down by industry. TABLE 4.30 LOAN IMPAIRMENT CHARGES, INDUSTRY BREAKDOWN Credit exposure Allowance account 2008 (DKr m) Total Past due Rating categories Allowance account, individual Allowance account, collective Total Loan impairment charges Central and local governments 75,852 1, Subsidised housing companies 159, , Banks 245, Diversified financials 234, ,208 1,799 2,267 4,066 3,986 Other financials 155, Energy and utilities 44, Consumer discretionary and consumer staples 240,387 3,759 3,319 1, ,473 1,469 Commercial property 205,428 3,323 7,408 2, ,913 2,533 Construction, engineering and building products 42, , , Transportation and shipping 75, Other industrials 94,007 2,066 2, , IT 15, Materials 56, Health care 33, Telecommunication services 8, Personal customers 833,747 8,282 6,661 1, , Total 2,519,870 23,759 32,619 11,190 4,668 15,858 12,088 Credit exposure Allowance account 2007 (DKr m) Total Past due Rating categories 9-10 Allowance account, individual Allowance account, collective Total Loan impairment charges Central and local governments 139,696 2, Subsidised housing companies 150, Banks 332, Diversified financials 396, , Other financials 82, Energy and utilities 30, Consumer discretionary and consumer staples 208,311 2, , , Commercial property 172,893 1, Construction, engineering and building products 56, Transportation and shipping 60, Other industrials 100,802 1,849 1, IT 14, Materials 49, Health care 26, Telecommunication services 7, Personal customers 850,493 7,921 2, , Total 2,679,774 21,088 9,470 3,575 1,325 4, CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

58 4.9 Default The Group uses a definition of default consistent with the requirements of the CRD (that is, 90 days past due). It registers amounts due as being in default when it appears unlikely that the customer will fully repay all obligations to the Group. A default situation in a group of related customers requires an individual assessment of whether default should be registered for each customer in the group. In this context, if a customer or a customer s creditors have filed for bankruptcy, or if a customer has notified the court of a suspension of payments, instigated negotiations for financial restructuring or taken similar steps, the Group considers it unlikely that the customer will fully repay all obligations. Danish legislation on the disclosure of information between the companies of a financial group does not permit the dissemination of sensitive information about personal customers. This also applies to information that may lead to the registration of default status. A personal customer default in one Group unit, therefore, will not necessarily lead to a default marking in other Group companies. This stipulation does not apply to corporate customers, so for these customers default status may in certain circumstances lead to default on all amounts due to the Group. When a personal customer s account is overdrawn or in arrears, a file is set up and the customer s adviser decides whether or not to accept the unauthorised excess or arrears. For many good customers, the Group accepts excesses or arrears for an extended period for practical reasons. If the excesses or arrears are not accepted, a reminder procedure is initiated. The procedure may lead to debt recovery proceedings in the courts within 90 days of the claim. Customers in default are downgraded to the lowest level of the Group s classification system Calculation of the capital requirement The Group s regulatory capital requirement is based on the Capital Requirements Directive (CRD), which includes a set of rules for a mathematical calculation of risk-weighted assets for credit risk and other risk types. The Group uses mainly the advanced internal ratings-based (IRB) approach for calculating risk-weighted assets for credit risk. This means that the Group can use its own risk parameters for PD, LGD and CF. For further information on the Group s capital requirement, see section 3.2. DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 59

59 TABLE 4.31 CAPITAL REQUIREMENT FOR THE CREDIT RISK PORTFOLIO (DKr m) December 31, 2008 January 1, 2008 IRB approach: Institutions 3,186 4,143 Corporate customers 28,003 30,978 Exposures secured by real property 5,386 3,172 Qualifying revolving retail exposures Other retail exposures 3,220 4,454 Securitisation 2, Other non-credit-obligation assets 1,234 1,520 IRB approach, total 44,153 45,039 Standardised approach: Central governments and central banks Regional governments and local authorities Administrative bodies and non-commercial undertakings 8 10 Institutions Corporate customers 10,987 10,507 Retail customers 2,507 2,358 Exposures secured by real property 3,105 3,263 Past due items Securitisation positions Other items Standardised approach, total 17,531 17,471 Counterparty credit risk 3,450 2,142 Credit risk, total 65,134 64,652 Risk-weighted assets 814, ,153 In 2006, 2007 and 2008, the Group entered into transactions structured as synthetic securitisations hedging part of the risk on Realkredit Danmark loans of a current net notional amount of DKr255bn. The transactions complied with the rules on reduced weighting (as guarantees) under the capital adequacy rules applicable until 2007 (Basel I), and thus resulted in capital relief. According to the CRD rules (Basel II), the transactions do not qualify for reduced weighting, and hedge accounting is not applied. The transactions will be phased out in 2009 and In 2006, Sampo Bank entered into an agreement to hedge credit risk on loans to SMEs of 1bn. This transaction qualifies for reduced weighting under the CRD rules. The transactions are structured to be phased out during the transition from Basel I to Basel II. During the financial crisis, guarantee schemes have been adopted in various countries. The Group has therefore adjusted the risk weighting of financial institutions covered by the guarantees in accordance with the guidelines issued by the relevant authorities. In determining its capital requirement, the Group also takes into account its share of the total commitment made by Danish banks to the state guarantee scheme adopted by the Danish Parliament on October 10, CREDIT RISK DANSKE BANK RISK MANAGEMENT 2008

60 Economic capital The Group calculates economic capital for credit risk with an internal credit risk model. This is a portfolio model that calculates all credit risks in the Group s portfolio across business segments and countries. The calculations cover all loans, advances, bonds and derivatives. Economic capital is used in the internal capital adequacy assessment process (ICAAP) under Pillar II (see section 3.3). The model also allocates the Group s economic capital at the facility level according to an internally developed allocation model. Economic capital at the facility level is used for risk-based pricing and for performance measurements by return on allocated capital (ROAC). Parameters The credit risk management models that the Group uses incorporate several risk parameters that are essential in calculating the regulatory capital requirement and economic capital. The parameters are also used in day-to-day credit management. The Group evaluates and validates these parameters regularly. To the greatest extent possible, the Group uses historical in-house data or market data to validate the risk parameters. The data available are always subject to some degree of statistical uncertainty. To capture the uncertainty of the parameters, the Group incorporates a margin of conservatism in the determination of parameters. In addition, all parameters are compared with external benchmarks when relevant benchmarks exist. See section 10 for a definition of the credit risk parameters (PD, LGD and CF) and the difference between point-in-time and through-the-cycle estimates. DANSKE BANK RISK MANAGEMENT 2008 CREDIT RISK 61

61 2. 5. KREDITRISIKO MARKET RISK Definition Policy and responsibility Monitoring Use of models Market risk exposures Interest rate risk Exchange rate risk Equity market risk Other market risks Value at Risk Back testing Stress testing Model validation Market risk at Danica Pension Capital requirement 62 KREDITRISIKO DANSKE BANK RISK MANAGEMENT 2008

62 In 2008, the Danske Bank Group s market risk was strongly influenced by the turmoil in the financial markets. During most of the year, and especially in the autumn, the world witnessed the most extreme daily changes in interest rates, spreads and equity prices for many years. In September, defaults by several major financial institutions caused the financial crisis to escalate, leading to a breakdown of the interbank money market worldwide. While the overall performance in the market risk area was satisfactory, the Group was severely affected by the financial crisis in specific areas. Since the Danish mortgage bond market is a very important part of the financial markets in Denmark, the Group has relatively large holdings of such bonds. During the second half of the year, mortgage spreads widened considerably, leading to a substantial unrealised loss on the holdings. The Group does not believe that the unrealised loss was caused by the underlying credit quality. Another effect of the extreme volatility in the financial markets was that the Group s internal Value at Risk (VaR) model performed less well than previously. This became evident in the back testing of the model. The test showed a higher-than-expected number of exceptions, and the higher plus factor for the internal model led to a rise in the capital requirement of some 30%. As a consequence of this development, the Group decided to adjust the model to improve its ability to react to a more volatile market situation. The adjustment was made at the beginning of 2009, and in the current market situation, it is expected to raise the VaR figures by 10-20%. 5.1 Definition The Group defines market risk as the risk of losses arising because the fair value of assets and liabilities varies with changes in market conditions. Market risk consists of the following components: Interest rate risk: the risk of losses caused by changes in interest rates Floor risk: the risk of a loss of earnings on deposits when the Group cannot implement a parallel reduction of deposit and lending rates because market interest rates approach zero Exchange rate risk: the risk of losses on foreign currency positions caused by changes in exchange rates Equity market risk: the risk of losses caused by changes in equity prices Credit spread risk: the risk of losses caused by changes in credit spreads Inflation rate risk: the risk of losses caused by changes in traded future inflation rates Commodity risk: the risk of losses caused by changes in commodity prices DANSKE BANK RISK MANAGEMENT 2008 MARKET RISK 63

63 5.2 Policy and responsibility The Group s market risk management covers all of its assets, liabilities and off-balance-sheet items except for the market risk in Danica Pension and the Group s defined benefit pension plans. The Board of Directors sets the overall policies for the Group s market risk exposures, including overall risk limits. After the Board of Directors has set the overall limits, the All Risk Committee sets limits and guidelines for the main business units that reflect the strategic priorities for risk exposure. The Group s overall market risk limits do not apply to the risk on the assets in which Danica Pension s equity is invested. This risk is described in section Section 7.3 describes the market risk on assets allocated to policyholders, and section 7.2 treats the market risk relating to defined benefit pension plans. On the basis of the Group s overall risk instructions, the All Risk Committee defines market risk limits for the major business areas in Danske Markets. Subsequently, the overall limits are allocated to individual business units, including foreign branches and subsidiaries. Authority to take on market risk is granted only to certain business units with expert knowledge of such risk, mainly Danske Markets in Copenhagen. For all major business units taking on market risk, a risk policy including market risk is prepared and approved. The Group takes positions for its own account, primarily in its treasury investment portfolio and its trading activities in Danske Markets. Market risk in individual Banking Activities units is transferred directly to Danske Markets or measured and managed under Danske Markets limits as part of the treasury position. The Group measures the floor risk on banking activities, and the All Risk Committee takes this risk into account when it considers the Group s strategic interest rate risk. A committee, the Asset/Liability Committee, has been set up at Danske Markets to monitor and discuss issues relating to market and liquidity risk, among other things. Danske Markets and Group Finance are represented on the committee. 5.3 Monitoring Operational risk policies form the basis for written business procedures as well as reconciliation and control procedures for relevant units and for the Group s system development work. Measurement, monitoring and management reporting on market risk are carried out on a daily basis. The Group calculates current market risk by means of a database that is integrated with its trading systems. In addition, the Group conducts intra-day spot checks of the risks in the individual business units. Day-to-day risk management includes setting limits for business units and sub-units. These limits are monitored systematically, and follow-up procedures have been established in the organisation. 5.4 Use of models The Group uses both conventional risk measures and internal mathematical and statistical measures, such as Value at Risk (VaR), to calculate its market risk exposures, including floor risk. These calculations are used in the following: Reporting to Group management Reporting to the Danish FSA Day-to-day management of the business units 64 MARKET RISK DANSKE BANK RISK MANAGEMENT 2008

64 The Group also develops in-house pricing models. The models are used for pricing and risk management of financial products that cannot be valued directly on the basis of quoted market prices or standardised financial models. 5.5 Market risk exposures The table below shows the Group s market risk at the end of 2008 and 2007 calculated according to conventional risk measures (except for exchange rate risk, for which VaR is used) for trading as well as banking book items. TABLE 5.1 MARKET RISK, CONVENTIONAL MEASURES At December 31 (DKr m) Interest rate risk (parallel shift of the yield curve of 1 percentage point) 2,776 2,417 Exchange rate risk (VaR, confidence level of 95%, 10-day horizon) 76 7 Equity market risk, listed equities (net position) 558 1,105 Equity market risk, unlisted equities (net position) 3,153 3,340 Credit spread risk on corporate bonds (basis point value) 4 3 Inflation rate risk (change in traded inflation of 1 percentage point) Commodity risk (10% change in commodity prices) 7 3 The table shows that risk exposures at the end of 2008 were broadly in line with the figures at the end of 2007, except for the net position in listed equities (down 50%) and interest rate risk (up almost 15%). 5.6 Interest rate risk Most of the Group s interest rate risk derives from activities that involve marketing, trading and position-taking in a variety of interest-rate-related products in all the Group s local markets. Many of the trading activities involve relatively simple products, but new and more complex products are gaining in importance. As a result, the Group is constantly working to develop its trading and risk management infrastructure. Interest rate risk is measured and managed across the Group on a daily basis for all products involving such risk. The measurement of interest rate risk includes interest rate options. The Group s Banking Activities units offer fixed rate loans, deposits and other interest-rate-related products. Much of the resulting interest rate risk is hedged and treated under the rules of fair value hedge accounting. The interest rate risk on the following fixed rate items is not hedged but is managed on a daily basis: A portfolio of fixed rate mortgage loans in Denmark Fixed rate loans and advances provided by Banking Activities units in Finland, Ireland, Northern Ireland and the Baltics Operating leases Prepayments of Realkredit Danmark loans The Group also has a structural interest rate risk exposure in its Banking Activities units in Northern Ireland, Ireland and Finland. This risk derives from demand deposits whose interest rate has been stable at a very low level over a considerable period and where the portfolio has been stable and is expected to remain so. Two technical criteria are used to identify the accounts to be included in the interest rate risk calculation: repricing stability (the accounts should not be materially repriced) and portfolio stability. On the basis of these criteria, the Group models the risk by designating 1/60th of the balance in each month for 5 years as a liability cash flow; this results in an implicit average duration of the deposits of 2.5 years. The risk is included in the Group s interest rate risk calculations and thus in the day-to-day risk management. DANSKE BANK RISK MANAGEMENT 2008 MARKET RISK 65

65 Table 5.2 shows the Group s total interest rate risk, measured as the expected loss on interest rate positions that would result from a general interest rate rise of 1 percentage point. At December 31 (DKr m) DKK 798 4,094 EUR 1,426-2,369 SEK USD NOK GBP JPY Other 8 14 The Group also measures yield curve risk, which is the risk of losses arising because interest rates for various terms change independently of one another. The yield curve risk is measured individually for an interest rate rise of 1 percentage point at 0, 3, 6 and 9 months and at 1, 2, 5, 10, 15 and 25 years. TABLE 5.3 INTEREST RATE RISK At December 31 (DKr m) < 1 year 1-3 years 3-7 years 7-11 years > 11 years Total , , , ,417 For units trading in interest rate options, the Group also measures the maximum loss in the event of interest rate changes of plus or minus 2 percentage points and measures vega, which is the sensitivity to changes in the expected future volatility of interest rates priced into the options markets. Figure 5.1 shows the trend in interest rate risk at group level, measured as the financial effect of a general 1 percentage point increase in interest rates. FIGURE 5.1 GROUP INTEREST RATE RISK (DKr m) 3,000 2,500 2,000 1,500 1, Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec MARKET RISK DANSKE BANK RISK MANAGEMENT 2008

66 Floor risk Floor risk derives from the existence of an interest rate floor on managed liability products whose rates are influenced by, but not linked directly to, the benchmark interest rates of central banks. Floor risk is defined as the risk of a loss of earnings on deposits because market interest rates approach zero. It is measured as the effect of a 1 percentage point drop in rates on net interest income over a 12-month period. Earnings on deposits fall when the Group cannot reduce deposit and lending rates in tandem and lending rates must be reduced more than deposit rates. This causes the interest margin to narrow and reduces the Group s earnings. Any possible mitigating effects are not taken into account. Floor risk is reported to the All Risk Committee, but it is not included in the Group s interest rate risk. 5.7 Exchange rate risk The Group measures and manages exchange rate risk at group level on the basis of a Value at Risk calculation incorporating all currency positions, including options. The Value at Risk figure represents the maximum loss within 10 days at a confidence level of 95%. At lower organisational levels, the risk is managed on the basis of the net exposure for each currency. For units trading in currency options, the Group also measures exchange rate risk as the maximum standardised loss based on a number of predefined standard scenarios with large exchange rate fluctuations. Sensitivity to volatility, vega, is measured as well. Earnings at units outside Denmark are denominated in local currency and are therefore subject to exchange rate risk. The Group hedges this risk by exchanging the monthly earnings for Danish kroner. At the end of 2008, the exchange rate risk was DKr76m. 5.8 Equity market risk Equity market risk is calculated as the net value of long and short positions in equities and equitybased instruments. Equity market risk management distinguishes between risk on listed and unlisted shares. Positions in individual companies are measured and monitored separately. For units trading in equity options, the Group also calculates the maximum standardised loss due to equity price changes of up to +/-20% as well as vega risk figures. For unlisted shares, the Group distinguishes between ordinary open positions, unutilised commitments to private equity funds and banking-related investments. Banking-related investments comprise equity holdings in financial infrastructure and payment service activities. At the end of 2008, the value of the Group s net position in listed shares was reduced by half compared with the level at the end of The average net position in unlisted shares was in line with the position in DANSKE BANK RISK MANAGEMENT 2008 MARKET RISK 67

67 FIGURE 5.2 FAIR VALUE OF THE GROUP S NET POSITIONS IN LISTED AND UNLISTED EQUITIES (DKr m) 4,000 3,500 3,000 2,500 2,000 1,500 1, Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q Net position in listed equities Unutilised commitments, private equity Banking-related investments Other unlisted equities 5.9 Other market risks Mortgage spread risk Since the Danish mortgage bond market is one of the pillars of the financial markets in Denmark, the Group has a relatively large holding of Danish mortgage bonds. The management of risk on this exposure has always been based on the credit approval of issuer lines for nominal amounts of bond holdings. In 2008, the Danish mortgage bond market was extremely illiquid, and the spread between mortgage bonds and the swap curve widened and fluctuated considerably, leading to substantial market value losses on these holdings. As a consequence, the Group decided to supplement the issuer lines with market risk limits for Danish mortgage bonds as well as for other European covered bonds. The Group limit is based on basis point value (BPV), which measures the loss resulting from a 1 basis point change in the mortgage bond spread. Similar limits have been used during earlier periods of turmoil such as the Asian crisis in At the end of 2008, the Group s mortgage spread risk was DKr97m. For capital requirement purposes, mortgage spread risk is part of specific risk, for which the Group uses the standardised approach under the Danish executive order on capital adequacy. The Group is developing an internal model to supplement the management of the risk related to issuers, but it is important to point out that no model could have predicted the effect of the current crisis on Danish mortgage bond pricing. Credit spread risk The value of the Group s holdings of corporate bonds and credit default swaps depends on changes in credit spreads. The Group monitors credit spread risk as part of interest rate risk by measuring the price sensitivity to a change in credit spreads of 1 basis point. As with mortgage bond holdings, the Group manages the spread risk on corporate bonds and credit default swaps by means of issuer lines supplemented with limits on BPV. The capital requirement for credit spread risk is also part of the Group s capital requirement for specific risk. Inflation risk The value of a few of the Group s products is dependent on changes in inflation. Accordingly, the Group has also set limits on losses in case of changes in traded future inflation rates. Risk is measured as the loss caused by a change in traded future inflation rates of 100 basis points. 68 MARKET RISK DANSKE BANK RISK MANAGEMENT 2008

68 Commodity risk Commodity risk is measured as the expected loss on commodity positions caused by changes of +/-10 percentage points in individual commodity indices. The Group has a limited commodity risk in its Finnish trading activities. The positions are related primarily to energy products. The Group has set a limit on losses caused by changes in commodity prices. Interest rate risk on shareholders equity The shareholders equity on the balance sheet theoretically carries an interest rate risk because it is included in the consolidated financial statements as a non-interest-bearing liability. The derived theoretical interest rate sensitivity is symmetrical for rising and declining interest rates. This risk is not hedged and is not included in the calculation of the Group s interest rate risk. The implication is that the liquidity from the shareholders equity is always held at the Group s standard variable Danish kroner rate (comparable to the overnight rate) Value at Risk The Group uses Value at Risk (VaR) in the management of interest rate, exchange rate and equity market risks. While inflation risk is modelled as part of interest rate risk, the VaR model does not cover commodity risk at present. Since the purpose of the VaR model is to determine the general market risk, neither credit spread nor mortgage spread risk is included. VaR is a statistical measure of the maximum loss that the Group may incur over a certain period of time at a certain confidence level under recent market conditions. The Group supplements VaR with stress tests to take account of situations with abnormal market conditions. In mid-2007, the Group replaced its parametric VaR model with a historical simulation model. The main advantages of the historical simulation model are that it uses full revaluation and makes no assumptions regarding loss distribution. This gives more accurate results for non-linear products than other methods can produce. The Group s VaR model is based on two years historical market data. Each calculation is based on one thousand scenarios representing possible future outcomes of the risk factors. On this basis, an empirical loss distribution is calculated, and it is used to determine the VaR. A confidence level of 95% corresponds to the fiftieth-largest loss in the distribution. The scenarios are generated by means of a bootstrap method. To construct a ten-day scenario, ten independent drawings are made from a dataset of two years historical daily returns. The outcomes are generated at random, and 70% of the scenarios are based on the latest year of historical market data; this improves the model s ability to react to a more volatile market situation. Each outcome contains all the risk factors so that the correlation is maintained. The risk factors used are interest rates, equity indices and exchange rates. The Group runs a number of reconciliations to ensure that the model input for the daily calculations is correct. The reconciliations cover the market data used for the calculations, the scenarios generated and the portfolios included. The internal VaR model is used for various purposes: Risk monitoring, at a confidence level of 95% Calculation of the capital requirement, at a confidence level of 99% (see section 5.13) Calculation of economic capital, at a confidence level of 99.97% Table 5.4 shows the VaR used for internal risk monitoring. VaR is broken down by risk type, and the table also shows the diversification benefit from using VaR as a total risk measure rather than treating each risk type separately. The figures cover all the Group s risk portfolios. DANSKE BANK RISK MANAGEMENT 2008 MARKET RISK 69

69 TABLE 5.4 VALUE AT RISK (CONFIDENCE LEVEL OF 95%, 10-DAY HORIZON) (DKr m) Risk category Avg. VaR Minimum VaR Maximum VaR Dec. 31 Avg. VaR Minimum VaR Maximum VaR Dec. 31 Interest rate risk Exchange rate risk Equity market risk Diversification benefit Total VaR Since the minimum and maximum readings for the risk types do not occur on the same days, these values are not shown under the diversification benefit Back testing The Group conducts daily back testing based on the trading book portfolios to document that the internal VaR model used to measure market risk is sufficiently reliable. Assuming unchanged exposure and changes in market prices, back tests compare the losses predicted by the model with hypothetical losses. The calculation of hypothetical losses does not include intra-day trading gains and losses. The VaR figure used for back testing is based on a confidence level of 99% (as in the calculation of the capital requirement), and the expected number of exceptions per year is 2 to 3. The back test results for 2008 are shown in figure 5.3. FIGURE 5.3 BACK TEST RESULTS, P/L EFFECT, 2008 (DKr m) Upper and lower VaR As the figure shows, the number of exceptions in exceeds the expected number by far. The main reasons are that volatility increased during most of 2008 from a low level, and that the two years of historical market data that constitute the basis for the thousand scenarios are weighted equally. This means that the huge daily changes in the market risk factors seen in 2008 only gradually influenced the VaR. As a consequence of the number of exceptions, the Group decided to adjust the model to improve its ability to react to a more volatile market situation. As described in section 5.10, the adjustment gives more weight to the most recent year of historical market data than to the year before. The adjustment was made at the beginning of 2009; in the current market situation, it is expected to increase the VaR figures by some 15%. For 2008, additional capital was allocated under Pillar II. 70 MARKET RISK DANSKE BANK RISK MANAGEMENT 2008

70 Stress testing The Group conducts stress tests for market risk on a regular basis. The results are submitted to the Asset/Liability Committee. On a daily basis, the Group tests the effect on the total market value of its positions if they are subjected to interest rate shocks of +/-50bp, +/-100bp and +/-200bp combined with changes in equity prices of +/-20% and exchange rate fluctuations of +/-10%. Some of these scenarios are also used in setting limits on the losses that may be incurred by business units that hold option positions. As a supplement to stress tests based on standard shocks, the Group also quantifies the consequences of steepening and flattening yield curves as well as changes in the yield spreads between major currencies. The macro scenarios used in the ICAAP are also part of the daily calculations. In addition, historical events and future events expected to have an effect on the financial markets can be used as input for the calculations. The scenarios are reviewed regularly and modified to reflect changes in the Group s risk profile and developments in the financial markets. Table 5.5 shows the maximum losses for 2007 and 2008 determined by stress tests based on an interest rate shock of +/-200bp combined with standard equity and exchange rate shocks. TABLE 5.5 STRESS TESTS FOR VARIOUS RISK TYPES (DKr m) Change Maximum loss 2008 Maximum loss 2007 Equity market risk Exchange rate risk - - Interest rate risk 4,193 4,885 Besides the daily stress tests, the Group also conducts weekly stress tests of the VaR model s results using the standard shocks shown above. The results give an overview of how the total VaR exposure responds to such shocks. Table 5.6 shows the maximum stressed VaR by risk type and in total at a confidence level of 99% and a 10-day time horizon at the end of 2008 and For purposes of comparison, the table includes the corresponding actual VaR figures. TABLE 5.6 STRESS TESTS, VALUE AT RISK (CONFIDENCE LEVEL OF 99%, 10-DAY HORIZON) (DKr m) Actual VaR Stress test VaR Actual VaR Stress test VaR Equity market risk Exchange rate risk Interest rate risk 612 1, Diversification benefit Total VaR 593 1, The stress test VaR figures shown are the result of a general interest rate change of +200bp, equity price changes of +20% and exchange rate changes of -10% Model validation Certain of the Group s financial instruments cannot be valued by means of market prices. Instead, they are valued on the basis of pricing models developed by Danske Markets. As shown in table 5.7, most of the pricing models are based on observable inputs. DANSKE BANK RISK MANAGEMENT 2008 MARKET RISK 71

71 TABLE 5.7 FINANCIAL INSTRUMENTS CARRIED AT FAIR VALUE 2008 (DKr m) Quoted prices Observable input Non-observable input Total Financial assets Trading portfolio assets 280, ,466 1, ,787 Investment securities 98,644 33,901 1, ,317 Mortgage loans - 667, ,181 Assets under pooled schemes and unit-linked investment contracts 34, ,635 Assets under insurance contracts 145,929 7,669 1, ,345 Total 559,465 1,288,217 4,583 1,852,265 Financial liabilities Trading portfolio liabilities 16, , ,290 Issued mortgage bonds 479, ,534 Deposits under pooled schemes and unit-linked investment contracts - 41,827-41,827 Total 496, ,572-1,144, (DKr m) Quoted prices Observable input Non-observable input Total Financial assets Trading portfolio assets 434, , ,137 Investment securities 32,737 2,591-35,328 Mortgage loans - 627, ,809 Assets under pooled schemes and unit-linked investment contracts 40, ,758 Assets under insurance contracts 160,998-3, ,299 Total 669, ,311 3,844 1,520,331 Financial liabilities Trading portfolio liabilities 10, , ,547 Issued mortgage bonds 518, ,693 Deposits under pooled schemes and unit-linked investment contracts - 50,260-50,260 Total 529, , ,500 Group Finance is responsible for validating the models developed by Danske Markets. A model must be validated before Danske Markets can trade in new types of product that must be priced and riskmanaged with the model. The purpose of the validation process is to test, independently of the business unit, whether the model is properly implemented and whether its stability and quality are sufficient to enable the Group to price and risk-manage financial products in a satisfactory manner. The first step in the validation process is to determine whether the Group has chosen a proper model. Group Finance identifies whether the new model improves the Group s ability to price and risk-manage financial products. It also verifies the model documentation containing a theoretical description of the model. 72 MARKET RISK DANSKE BANK RISK MANAGEMENT 2008

72 The next step in the validation is an independent check of the model implementation to reduce the number and severity of any programming errors. The aim is not a complete reimplementation of the model but rather a test through spot checks to ensure that the implementation corresponds to the model documentation. The spot checks are chosen in such a way that the risk of severe errors is minimised. It is essential that a pricing model is stable and produces consistent prices and risk figures. The check of stability ensures that model outputs are stable over time and under various market conditions. Despite thorough testing, errors and model flaws may still occur. Therefore, whenever possible, the Group quantifies the risks of using the model. In addition to this validation process, the Group has established procedures to monitor and validate the market data used to calculate market values and risk on an ongoing basis Market risk at Danica Pension As mentioned above, the market risk on the assets in which Danica s equity is invested is not included under the Group s overall market risk limits and risk management. Table 5.8 shows the assets with market risk in which Danica s equity is invested. TABLE 5.8 ASSETS WITH MARKET RISK, DANICA (DKr m) Government bonds 172 4,259 Mortgage bonds 13,605 8,386 Other bonds Listed bonds, total 13,897 12,714 Listed shares 1,132 3,385 Unlisted shares Total 15,190 16,265 VaR (confidence level of 95%, 10-day horizon) for the bond portfolio in which Danica s equity is invested was DKr76m at the end of Market risk related to policyholders funds and shareholders equity in Danica is treated in section 8.3. This part of the Group s market risk is covered by the capital requirement that Danica is subject to as an insurance company. The capital requirement is deducted from the Group s capital base (see section 3.6). The exposure is treated in the Group s ICAAP (see section 3.3.1) Capital requirement In the capital requirement calculations concerning market risk, the Group distinguishes between general and specific risks and between items in the trading book and items outside the trading book. DANSKE BANK RISK MANAGEMENT 2008 MARKET RISK 73

73 Definition of general and specific risks General risk is the Group s risk of losses on its positions because of general changes in market prices, including interest rates, exchange rates, equity prices and commodity prices. It applies to all positions in the trading book. Exchange rate risk and commodity risk apply to positions outside the trading book as well. Specific risk is the risk of losses in the trading book portfolio that can be attributed to the specific issuer of a financial instrument. Mortgage spread risk, described in section 5.9, is an important part of the Group s specific risk. Another element of specific risk is credit spread risk, although the Group s exposure to this risk is limited. Counterparty credit risk on derivatives is treated in section Items in the trading book and outside the trading book Since January 1, 2007, the Group has used an intention-based definition of its trading book. As stated above, this definition is used in the treatment of both general risk and specific risk. All the Group s positions with market risk are considered to be part of the trading book, with the following exceptions: Unlisted shares Holdings in associated companies Strategic fixed income and equity positions taken at the request of the All Risk Committee and Asset/Liability Committee Interest rate risk in Banking Activities Calculation of the capital requirement The Group uses the internal VaR model to calculate the capital requirement for general risk on items in the trading book and also exchange rate risk on items outside the trading book. Since commodity risk is not covered by the internal VaR model, the Group uses the standardised approach under the Danish executive order on capital adequacy. The capital requirement for market risk equals the average estimated VaR for the preceding 60 days multiplied by a scaling factor. The VaR is based on a time horizon of 10 days and a confidence level of 99%. The precise scaling factor, which must be at least 3.00, is determined by the supervisory authorities on the basis of an assessment of the model s quality. The Group currently applies a scaling factor of Depending on the number of exceptions revealed by back tests conducted during the preceding 12 months, another factor is added. This factor was zero at the end of 2007; at the end of 2008, it was The calculation of the capital requirement for specific risk is based on the standardised approach under the Danish executive order on capital adequacy. In accordance with the Group s strategy of using more advanced models for all the main risk areas, the Group intends to implement an internal model for specific risk within the next few years. The financial crisis has created a need for new, more comprehensive rules within this area, however, and they have not yet been determined. 74 MARKET RISK DANSKE BANK RISK MANAGEMENT 2008

74 Table 5.9 shows the capital requirements for general risk and specific risk at the end of 2007 and TABLE 5.9 CAPITAL REQUIREMENTS FOR GENERAL RISK AND SPECIFIC RISK (DKr m) General risk, internal model General risk, standardised approach Specific risk, standardised approach Total General risk, internal model General risk, standardised approach Specific risk, standardised approach Total Interest rate 2,239-3,013 5,252 1,571-3,839 5,410 Equity risk Exchange rate risk Commodity risk Diversification benefit Total VaR 2, ,048 5,408 1, ,951 5,811 Outside the trading book, there is no commodity risk and only limited exchange rate risk. The capital requirement for the Group s risk on shares outside the trading book is calculated in accordance with the standardised approach (see section 3). Economic capital Economic capital for market risk, which is used for internal performance measurement (ROAC) as well as for the ICAAP under Pillar II, is calculated by means of several models. For general market risk, except commodity risk, the Group uses its internal VaR model, and it also uses an internal model for floor risk. It uses the standardised approach under the Danish executive order on capital adequacy for both commodity risk and specific risk. DANSKE BANK RISK MANAGEMENT 2008 MARKET RISK 75

75 2. 6. KREDITRISIKO LIQUIDITY RISK Definition Control and management Operational liquidity risk Liquidity stress testing Twelve-month liquidity Structural liquidity risk Funding sources Collateral provided by the Group Capital requirement 76 KREDITRISIKO DANSKE BANK RISK MANAGEMENT 2008

76 In 2008, the international financial crisis led to increased volatility in the financial markets and to poorly functioning international debt markets. In certain periods, it was very difficult to issue both short- and long-term bonds. The Group s liquidity strength was seriously tested at the end of September 2008, when access to long-term funding from abroad was suddenly cut off. These market conditions influenced the Group s twelve-month liquidity curve, though the curve at the end of the year shows positive liquidity positions for six months if the Group is cut off from capital markets. Despite the difficult market conditions, the Group met its targets for short-term liquidity, mainly through stable deposits and large liquid bond holdings, which can be used as collateral for loan facilities with central banks. By the end of 2008, the international debt markets had become more accessible, partly because of the introduction of financial support packages. As a consequence of these support packages and the Group s participation in the Danish state guarantee scheme, the Group gained access to short- and medium-term funding particularly in US dollars. The Group s liquidity management framework has been developed over time, and it is mapped against international best-practice recommendations from BIS and CEBS on an ongoing basis. 6.1 Definition Liquidity risk is defined as the risk of losses arising because the Group s funding costs increase disproportionately lack of funding prevents the Group from establishing new business lack of funding ultimately prevents the Group from meeting its obligations 6.2 Control and management Taking on liquidity risks is an integral part of the Group s business strategy. The Board of Directors determines the overall policies for the Group s liquidity risk exposure. The Group s risk appetite framework reflects these limits (see section 2.1). Liquidity reports are submitted to the Asset/Liability Committee and the All Risk Committee on a regular basis. Danske Markets is responsible for ensuring that the Group observes the operational liquidity risk limits. The Group has implemented contingency plans to ensure that it is ready to respond to unfavourable liquidity conditions. DANSKE BANK RISK MANAGEMENT 2008 LIQUIDITY RISK 77

77 In calculating liquidity risks, the Group excludes Realkredit Danmark and Danica. At Realkredit Danmark, the financing of mortgage loans by issuance of listed mortgage bonds with matching conditions has, in all material respects, eliminated liquidity risk. Danica s balance sheet contains long-term life insurance liabilities and assets of which a large part is invested in easily marketable bonds and shares. Since both companies are subject to statutory limits on their exposures to Danske Bank A/S, their liquidity is not included in group-level liquidity management. At group level, liquidity management is based on the monitoring and management of the Group s short-term and long-term liquidity risks, and is organised around the four themes set out in table 6.1. TABLE 6.1 THE DANSKE BANK GROUP S LIQUIDITY MANAGEMENT Theme Operational liquidity risk Liquidity stress testing 12-month liquidity Structural liquidity risk Objective Ensuring that the short-term liquidity position is positive Calculating potential liquidity gaps under various scenarios and identifying the means to close them Monitoring the liquidity position over 12 months if the Group is cut off from capital markets Input for long-term liquidity planning: ensuring diversification of funding Horizon 0-6 months 0-12 months Control Limit set by Board of Directors Contingency plan Soft limit Soft limit Operational liquidity risk The Group s operational liquidity risk management is intended primarily to ensure that the Group always has a liquidity buffer sufficient, in the short term, to absorb the net effects of current transactions and expected changes in liquidity. For liquidity management purposes, the Group distinguishes between liquidity in Danish kroner and liquidity in other currencies. Separate limits are set for liquidity in Danish kroner and liquidity in foreign currencies. Liquidity is calculated on the basis of known future receipts and payments under current transactions. The calculation includes the estimated effects on the Danish kroner liquidity of the Danish government s receipts and payments. The Group s bond holdings that can be used in repo transactions with central banks are considered liquid assets. Undrawn committed credit facilities are also included in order to take account of the potential risk of drawings under such commitments. Danske Bank s strong position in the Danish market gives the Group a substantial deposit base that is a valuable and stable source of funding. To track the trend in the Group s liquidity position on the Danish market, the Asset/Liability Committee has defined a number of targets to be monitored as part of the management of the operational liquidity risk Liquidity stress testing The Group conducts stress tests to measure its immediate liquidity risk and to ensure that it has a certain amount of time to respond to crises. Stress testing is conducted regularly and covers a time horizon of up to six months. The tests estimate liquidity risk under various scenarios, including four standard scenarios covering mild and severe Danske Bank-specific crises and mild and severe systemic crises. Crises rarely occur as described in stress test scenarios. The current crisis has shown, however, that the stress testing framework helped the Group establish a strong liquidity position that was able to withstand adverse events similar to those in the scenarios. 78 LIQUIDITY RISK DANSKE BANK RISK MANAGEMENT 2008

78 The analyses are based on the assumption that the Group s current lending activities are not reduced and continue to require funding. The Group s bond holdings that can be used in repo transactions with central banks are considered liquid assets, and potential liquidity outflows from undrawn committed credit facilities are also factored in. The degree of possible refinancing varies depending on the scenario in question. For example, the Group s opportunities to issue commercial paper will be more limited in a scenario where Danske Bank s short-term rating is downgraded than in a scenario with a mild recession. Liquidity stress testing should be seen in the context of the Group s overall liquidity preparedness. Its considerable holdings of easily marketable bonds are a key element. Most of the Group s bond holdings 92% at December 31, 2008 (2007: 91%) may be used as collateral for loan facilities with central banks. The Group applies haircuts to the value of the bond portfolio. The Group monitors the diversification of funding sources by product, currency, maturity and counterparty to ensure that it has the funding base that provides the best possible protection if markets come under pressure Twelve-month liquidity In its Bank Financial Strength Ratings: Global Methodology, Moody s has set various classification requirements for banks liquidity management. One requirement is that a stress test of the twelvemonth liquidity curve must generally be positive. Liquidity calculations must assume, among other factors, that the Group is cut off from capital markets and that refinancing in those markets is not possible. This means that issued bonds, issued certificates and subordinated debt will not be refinanced at maturity. The analysis also assumes only a moderate reduction in business activities. Figure 6.1 shows the Group s twelve-month liquidity curve. The Group s liquidity strength was seriously tested at the end of September 2008, when access to long-term funding from abroad was suddenly cut off. These market conditions influenced the Group s twelve-month liquidity curve, though the curve at the end of the year shows positive liquidity positions for six months if the Group is cut off from capital markets. FIGURE 6.1 TWELVE-MONTH LIQUIDITY (DKr bn) week 2 weeks 3 weeks 1 month 2 months 3 months 4 months 5 months 6 months 9 months 12 months At December 31, 2008 At December 31, 2007 DANSKE BANK RISK MANAGEMENT 2008 LIQUIDITY RISK 79

79 6.2.4 Structural liquidity risk Structural liquidity risk is managed on the basis of the Group s long-term liquidity mismatch. The aim is to ensure that the Group does not create an unnecessarily large need for funding in the future. Quantifying structural liquidity risk is important when the Group plans its funding activities. Structural liquidity risk management is based on a breakdown by maturity of the Group s assets, liabilities and off-balance-sheet items. The Group bases its calculations on the contractual due dates of individual products but takes into account that some balance sheet items have maturities that make their actual due dates deviate materially from their contractual due dates. The maturities of such items are therefore modified to provide a more accurate view of the actual behaviour. This includes demand deposits from the private sector which are considered a relatively stable funding source although contractually such deposits are very short-dated funding. Another example is the Group s large bond holdings, which have varying terms to maturity. Most of the portfolio can be used as collateral in repo transactions with central banks and is therefore included in the calculation as immediate liquidity. On the other hand, the bond holdings that are used as collateral for the settlement of the Group s current transactions, for instance clearing, are classified as illiquid bonds. As part of the management of the structural liquidity risk, the liquidity position is broken down by a number of variables such as currency, product, business area and organisational unit. The calculations show, among other things, that the Group has a structural liquidity surplus in Danish kroner from surplus deposits and a large liquid bond portfolio and has structural funding needs in foreign currencies Funding sources The Group monitors its funding mix to make sure that it is well diversified in its funding sources, maturities, currencies and other criteria (see tables 6.2 and 6.3). A well-balanced portfolio of liabilities generates a stable flow of funding and provides protection against market disruptions. The Group s balance sheet composition combined with centralised funding management at head office enables it to fund its activities at the lowest possible cost, both at present and in future. Like the Group s substantial deposits from the retail market, its comprehensive and well-established funding programmes in Europe and the US play an essential role. In November 2007, the Group was licensed under Danish legislation to issue covered bonds. The Group has since set up an international programme under which it can issue covered bonds for the equivalent of up to 15bn. Access to covered bond funding has further diversified the Group s funding base. At December 31, 2008, the Group had issued covered bonds for an amount of around 10bn, equivalent to DKr78bn, and there is still a considerable unexploited potential for covered bond issues. The bonds are currently based on Danish, Norwegian and Finnish loans. The tables below also include the match-funding of loans provided by Realkredit Danmark through the AAA-rated Danish mortgage finance system. 80 LIQUIDITY RISK DANSKE BANK RISK MANAGEMENT 2008

80 TABLE 6.2 BREAKDOWN OF FUNDING SOURCES BY TYPE OF LIABILITY (%) Due to central banks Due to credit institutions 7 9 Repo transactions 6 10 Short-dated bonds 9 5 Long-term bonds Issued mortgage bonds Deposits (corporate) Deposits (personal) Subordinated debt 2 2 Shareholders equity 4 4 Total TABLE 6.3 BREAKDOWN OF FUNDING SOURCES BY CURRENCY (%) DKK EUR USD SEK 5 7 GBP 4 8 CHF 3 1 NOK 2 4 Other 2 2 Total Danica s balance sheet items (long-term life insurance liabilities and assets of which a large part is invested in easily marketable bonds and shares) are not included in the Group s funding sources mentioned above. 6.3 Collateral provided by the Group Through a number of mutually binding agreements, the Group has undertaken to provide collateral if the fair value of current transactions changes unfavourably for the Group. The Group has entered into other agreements in which the counterparty has made it a condition that the Group maintains its present rating. A downgrade could mean that all obligations under the contracts in question must be fulfilled or that securities must be provided as collateral. Under these agreements, at December 31, 2008, the Group would have been obliged to fulfil its obligations under the contracts or to provide the amounts shown in table 6.4 as collateral or supplementary collateral. DANSKE BANK RISK MANAGEMENT 2008 LIQUIDITY RISK 81

81 TABLE 6.4 SUPPLEMENTARY COLLATERAL AT DOWNGRADE At December 31, 2008 (DKr bn) Supplementary collateral 17 Downgrade to a rating below A-1 18 Downgrade to a rating below A-2 18 Downgrade to a rating below A-3 18 The ratings listed above are based on Standard & Poor s rating scale. The bond issues of the Group s subsidiary Realkredit Danmark have Aaa and AAA ratings from Moody s and Standard & Poor s, respectively. A downgrade of these ratings could potentially affect Realkredit Danmark s position in the market but would not directly require the immediate provision of collateral. 6.4 Capital requirement There is no capital requirement for liquidity risk under Pillar I of the CRD. Under Pillar II, the Group takes liquidity scenarios into account in stress tests. The external requirements concerning the Group s liquidity are defined in section 152 of the Danish Financial Business Act. Throughout 2008 the Group s liquidity was well above the required level. 82 LIQUIDITY RISK DANSKE BANK RISK MANAGEMENT 2008

82 7. OPERATIONAL RISK Definition Policy Measurement and control Calculation of the capital requirement DANSKE BANK RISK RISIKOSTYRING MANAGEMENT MARKEDSRISIKO KREDITRISIKO 83

83 The Danske Bank Group has a defined process for operational risk management that ensures a structured and uniform approach across the Group. The process includes risk identification and assessments, monitoring through key risk indicators, controls and mitigation plans. The process ensures strong operational risk management that creates value for the business while also providing a foundation for a later application to use the advanced measurement approach. 7.1 Definition Operational risk is the risk of losses owing to deficient or erroneous internal procedures and processes human or system errors external events, including legal events Operational risks are often associated with one-off events, such as failure to observe business or working procedures, defects or breakdowns of the technical infrastructure, criminal acts, fire and storm damage and litigation. Operational risks are thus non-financial risks. The Danske Bank Group has also chosen to include indirect effects in its qualitative approach to operational risk management. These include effects such as negative media coverage, loss of customers and rating agency scrutiny. 7.2 Policy The Executive Board set up the Operational Risk Committee to assist the Board with its operational risk management functions and processes. The committee is chaired by a member of the Executive Board. The committee s tasks reflect the Group s operational risk policy. They include the following: Identifying, monitoring and managing the Group s current and potential operational risk exposures. Handling critical exposures, that is, exposures that, in the view of business unit managements or the committee itself, require follow-up and further reporting. Following up on reviews by and reports from financial supervisory authorities, and informing the Executive Board of issues affecting the Group s operational risks. Following up on reports prepared by Internal Audit, and informing the Executive Board of unusual circumstances. Preparing management information on issues such as IT security, physical security, business continuity and compliance. The Group has other policies, such as policies on security, control and compliance, that also support operational risk management. In addition, the Group has policies regulating other operational risk areas, such as an insurance policy for risk-mitigation purposes, an outsourcing policy and an auditing policy. Each business unit is responsible for the day-to-day monitoring of operational risks and for mitigating operational risk losses. 7.3 Measurement and control The Group conducts thorough risk identification in its business units and subsidiaries on an ongoing basis and has compiled a list of various operational risks. The list covers risks ranging from IT failure and internal fraud to model errors. In co-operation with the Group s Risk Management department, the business units assess the severity of each risk, in terms of both direct impacts through monetary losses and indirect impacts such as negative media coverage and customer defection. The Group includes indirect impacts in the assessments because they can have significant long-term effects. 84 OPERATIONAL RISK DANSKE BANK RISK MANAGEMENT 2008

84 The Group manages its operational risks in a process that includes controls, mitigation and monitoring through risk indicators. The Group s control organisation is built on the separation of duties, independent controls and extensive management reporting that gives an overview of income, risks and potentially deviant behaviour. The Group s operational risk losses are registered in the Operational Risk Information System (ORIS). Losses are categorised according to the Basel II event types. Only direct losses are registered. The Group is a member of the Operational Risk Exchange Association, and historically the Group s total loss level has been relatively low in comparison with peers. The Group experienced a number of external fraud risk events in 2008, but the resulting losses were relatively small. External fraud consists of events such as bank robberies and card skimming. External fraud accounted for 57.5% of the total number of loss events but only 18% of the total loss amount (see figure 7.1). On the other hand, business disruption and system failures (technology risks) represented only 2.6% of loss events but 34.3% of the total loss amount. Events related to technology tend to cause large and potentially severe losses. FIGURE 7.1 BREAKDOWN OF LOSS EVENTS AND LOSS AMOUNTS, 2008 (%) Execution, Business delivery and disruption process and system management failures External fraud Clients, Damage products to physical and business assets practices Internal fraud Employment practices and workplace safety Percentage of total losses Note: Based on Basel II event categories. Percentage of all events One of the Danske Bank Group s largest operational risk events in the past year was the migration of Sampo Bank to the Danske Bank platform. Unfortunately, a series of system-generated issues adversely affected customer service in Finland after the migration. The Group suffered a loss because it had to waive customer fees of DKr75m. The losses from the Sampo migration are reflected in figure 7.1 in the category Business disruption and system failures. Furthermore, the Group lost some 41,000 Sampo Bank customers as a result of the migration. The normalisation of operations and customer service helped reduce the customer outflow significantly in the second half of DANSKE BANK RISK MANAGEMENT 2008 OPERATIONAL RISK 85

85 7.4 Calculation of the capital requirement The Group uses the standardised approach of the Capital Requirements Directive (CRD) to calculate risk-weighted assets. For operational risk, the calculation of capital requirements in accordance with the standardised approach is based on a single indicator: income. Risk-weighted assets associated with operational risk are calculated as a percentage of income at a rate ranging from 12% to 18%, depending on business activity as specified by the CRD. The Group continually improves its operational risk management. For example, it is currently developing a scenario-based model for operational risk that incorporates both internal and external data. The model is expected to be AMA compliant. The new model will be used in regulatory capital calculation when the Group has been approved for the AMA. It will also be used for calculating economic capital for operational risk. Today, economic capital is calculated on the basis of the standardised approach of the CRD. Operational events resulting in credit losses are part of the credit risk calculations. 86 OPERATIONAL RISK DANSKE BANK RISK MANAGEMENT 2008

86 8. OTHER RISKS Business risk Definition Control and management Use of models Pension risk Definition Control and management Use of models Capital requirement Insurance risk Definition Control and management Risk exposure and sensitivity analysis Capital requirement DANSKE DANSKE BANK BANK RISK MANAGEMENT RISIKOSTYRING OPERATIONAL MARKEDSRISIKO RISK 87

87 8.1 Business risk Definition Business risk is the risk of losses caused by changes in external circumstances or events that harm the Group s reputation or earnings. It includes the risk of a decline in earnings due to strategic decisions (strategic risk). Business risk manifests itself in the form of an unexpected fall in earnings. The fall may be due to narrowing lending margins as a result of increasing competition, falling lending volumes because competitors introduce new products, strikes, new legislation or negative media coverage. A company needs to adjust its expenses to such factors in order to avoid their full effect on earnings. This risk is measured on the basis of fluctuations in earnings that cannot be ascribed directly to other risk categories Control and management Because of the variety of possible risk factors, the Group uses a broad range of tools to identify and report on business risk exposure. Several management processes ensure that new external risks are channelled to the relevant department or the right organisational level. Reputational risk is managed through policies and business procedures, including compliance activities. Strategic risk management is largely a top-down process in which decisions are made by executive management Use of models The Group has developed a model for calculating economic capital for business risk at the individual business units based on historical earnings volatility over the past 12 quarters. Other things being equal, high earnings volatility increases the risk of losses and thus raises the Group s business risk. The model was first used in the first quarter of The calculated results are validated against actual results on an ongoing basis. The Group continues to develop methods to estimate business risk in order to improve the model. There is no capital requirement for business risk under Pillar I. This risk type is covered by the ICAAP under Pillar II (see section 3.3). 8.2 Pension risk Definition The Group s pension risk is the risk of a shortfall in its defined benefit pension plans that requires the Group to make additional contributions to cover pension obligations to current and former employees. Additional contributions may be required, for example, as a result of changes in the underlying calculation of parameters for the pension obligation. 88 OTHER RISKS DANSKE BANK RISK MANAGEMENT 2008

88 Basically, there are two types of pension plan: Defined contribution pension plans A defined contribution plan is a post-employment benefit plan under which the employer pays fixed contributions into a separate entity and has no further obligations. The pension entitlement accumulated by the employee depends on the size of the contributions agreed upon, the performance of invested pension funds and associated expenses. Accordingly, the employee bears the risk relating to the future pension benefits. The benefits may be influenced, for example, by unfavourable developments in the financial markets that affect the pension assets under management. The Group thus has no pension risk on defined contribution plans because contributions to such plans are expensed when the obligation to make the payments is incurred. Defined benefit pension plans In defined benefit plans, the pension agreement contains a provision stipulating the pension benefit that the employee will be entitled to receive on retirement. The employer s obligation is thus recognised as a liability. The benefit is typically stated as a percentage of the employee s salary immediately before retirement, but it can also be a percentage of the average salary during the entire period of employment. The pension benefit will typically be payable for the rest of the employee s life, and this increases the employer s uncertainty about the amount of the future obligations since the liability and pension expenses are measured actuarially Control and management The Group s defined benefit plans are funded mainly by contributions made by the Group and the employees to separate defined benefit pension funds. The pension funds manage the assets by investing the contributed amounts in such a way that the contributions and the related returns cover future pension obligations. In addition, the Group has unfunded defined benefit pension plans that are recognised directly on the consolidated balance sheet. The Group s defined benefit pension obligations consist of pension plans in Northern Ireland, Ireland and Sweden as well as a number of small pension funds in Denmark. All these plans are closed to new members with the exception of the Swedish plan, which is actually a hybrid plan: pension benefits are based on only a portion of the employee s salary. The use of financial derivatives to eliminate part of the inflation and interest rate risks is a cornerstone of the Group s risk management. By matching the proceeds from the derivatives and the associated assets with expected future pension obligations, the Group minimises its pension risk. Because of the complexity of the pension obligations, the Group does not use its normal limit structure when monitoring pension risk. Instead, the Group manages market risk on pension plans according to special follow-up and monitoring principles called business objectives. The Group has established procedures to be followed in the case of deviations from these objectives. The All Risk Committee has defined risk targets for the Group s pension funds. To follow up on the objectives, the Group uses quarterly risk reports that analyse the financial status of the individual plans by means of sensitivity analyses and the Value at Risk (VaR) measure. The Group has fixed limits for risk exposure levels. On the basis of the average actuarial assumptions set out in table 8.1, the Group s total net exposure relating to defined benefit plans was DKr0.9bn at the end of 2008 against DKr1.3bn a year before. DANSKE BANK RISK MANAGEMENT 2008 OTHER RISKS 89

89 This exposure improved primarily because of an increase in the discount rates used for calculating the present value of the pension obligations, but also because of a fall in inflation forecasts and in expected salary increases that reduced the gross pension obligation by a total of DKr2.4bn, from DKr12.1bn to DKr9.7bn. The fair value of the assets under the defined benefit plans was DKr9.3bn at the end of 2008, down DKr1.9bn from DKr11.2bn at the end of The fall mainly reflected the performance of equity investments (a negative DKr2.7bn), although this was partly offset by the DKr0.9bn rise in the value of a portfolio of interest rate derivatives used to hedge recessionary scenario effects. The difference between the net pension obligation and the net pension obligation according to IFRSs was due to accumulated positive market value adjustments of DKr483m. These adjustments included changes in actuarial assumptions, such as revised discount rates, and other valuation assumptions, for example inflation and salary growth, which are not to be accounted for because the Group applies the corridor principle set out in IAS 19. TABLE 8.1 DEFINED BENEFIT PENSION PLANS (DKr m) Present value of unfunded pension obligations Present value of fully or partly funded pension obligations 9,421 11,953 Fair value of assets under the plans 9,301 11,169 Net pension obligation at December Actuarial gains/losses not recognised in the net pension obligation Net pension obligation according to IFRSs at December ,305 Net pension obligation recognised on the balance sheet Pension assets recognised under Other assets Pension provisions recognised under Other liabilities 1,178 1,675 Total 899 1,305 Average actuarial assumptions at December 31 (%) Discount rate Return on assets under the plans Inflation rate Salary adjustment rate Pension adjustment rate Use of models The Group s defined benefit pension obligation is calculated as the discounted value of the pension benefits earned to date. The calculation methodology is based on several factors (see table 8.2). TABLE 8.2 FACTORS USED TO CALCULATE DEFINED BENEFITS Demographic factors Mortality rate Staff turnover rate Disability rate Early retirements Financial factors Interest rates Future salary and benefit levels Inflation rate Expected return on plan assets Defined benefit plans are particularly exposed to interest rate and investment risks and increases in life expectancy, because the benefits will typically be payable many years into the future. 90 OTHER RISKS DANSKE BANK RISK MANAGEMENT 2008

90 The Group applies a number of very different calculation methods to determine its pension obligations (see table 8.3). The methods reflect distinct pension obligation issues and serve separate purposes. TABLE 8.3 METHODS OF CALCULATING THE GROUP S PENSION OBLIGATIONS The pension fund s internal calculation Consolidated financial statements based on IFRSs Capital management principles Risk management principles Discount factor Expected return on pension assets Corporate bond with AA rating and the same duration as the obligation Corporate bond with AA rating and the same duration as the obligation Zero coupon yield curve/swap curve Methods Calculation of the level of the Group s contributions The net obligation is adjusted for the corridor Capital base calculation: the corridor method is not allowed VaR is used as an indicator The discount factor varies from method to method. The Group calculates market risk on defined benefit plans on a quarterly basis. For each pension plan, the calculations include net funding and the sensitivity of net funding to changes in interest rates, equity prices and life expectancy (see table 8.4). Net funding expresses the difference between the market value of the assets and the present value of the pension obligations. TABLE 8.4 SENSITIVITY ANALYSIS OF NET FUNDING Sensitivity analysis (DKr m) Change Effect 2008 Effect 2007 Equity prices -20% ,259 Interest rates Life expectancy To supplement the sensitivity calculations, the Group calculates the risk in the individual pension funds, expressed as VaR. The calculations are based on a long-term horizon. In this scenario, share price volatility (20%) and the correlation between interest rates and share prices (25%) have been set at values reflecting normal market data. The duration of the pension obligations is reduced by half since empirical data show that inflation risk reduces the interest rate risk on the obligations by about 50% over the long term. At the end of 2008, VaR was DKr1,966m, against DKr3,051m at the end of VaR is calculated at a confidence level of 99.97% and a time horizon of one year. The calculation includes an adjustment for inflation risk. The VaR figure for the pension funds fell throughout 2008 because the discount rates used in the calculations increased. Follow-up and reporting are based on a model that Danske Markets also uses when advising customers in the life insurance and pension fields. The model includes assumptions about trends in the yield curve and share prices and about the correlation between interest rates and share prices. Input for the analysis of liabilities is based on demographic and economic assumptions for the gross obligation, while input for assets consists of the duration and the convexity of the pension portfolio s composition Capital requirement The net pension obligation under defined benefit plans is deducted from the capital base. The obligation is measured with a discount factor based on a corporate bond with an AA rating and the same duration as the obligation, and the corridor method is not applied. Pension risk is covered by the ICAAP (see section 3). DANSKE BANK RISK MANAGEMENT 2008 OTHER RISKS 91

91 8.3 Insurance risk Insurance risk in the Danske Bank Group concerns primarily life insurance and pension products. The Danica Group s with-profits business contributes by far the most to its total risk. Risks related to unitlinked business are considered minor because most are carried by the policyholders. The collective bonus potential and the bonus potential of paid-up policies, which can be used to cover risks relating to the with-profits policies, were severely reduced because of the global financial crisis in the autumn of Danica therefore, on October 28, 2008, introduced a temporary charge on transfers and surrenders of pension savings in order to protect the remaining policyholders savings. At the end of 2008, Danica still had substantial capital strength. As a result of the financial crisis, the Danish government made an agreement with the Danish Insurance Association to ensure financial stability. These are the main components of the agreement: A Danish mortgage bond spread was added to the discount curve for liabilities Bonus payments to policyholders were limited The yellow traffic light stress test was abandoned All life insurance and pension companies were required to submit quarterly financial statements to the Danish FSA The addition of the mortgage spread to the discount curve and the limit on bonus payments are temporary measures that will cease to apply at the end of Definition Insurance risk in the Danske Bank Group is defined as all types of risk in the Danica Group, including market risk, life insurance risk, business risk and operational risk. The Danica Group provides life insurance, health and accident insurance and pension products. Insurance risk concerns primarily life insurance and pension products. Risks on these products relate to Danica s conventional with-profits policies in Denmark and unit-linked policies in Denmark, Sweden, Norway and Ireland. By far the most of the risk derives from the with-profits business. The unitlinked business carries only minor risks because most of the risk is borne by the policyholders Control and management Danica s Board of Directors defines the framework of the Danica Group s risk management, while the management monitors Danica s risks on an ongoing basis to ensure compliance with the framework. In addition, Danica s Board of Directors determines the Danica Group s investment strategy and follows up on results, and the management prepares the specific investment plans. Market risk Market risk for the insurance business is the risk of losses arising because the fair value of Danica s assets and liabilities varies with changes in market conditions. Such changes in value can be caused by changes in interest rates, exchange rates, equity prices, property values, credit risk spreads and liquidity risk as well as by issuer or counterparty credit defaults. For with-profits policies, the most important factor is the relation between investments and life insurance obligations. If the year s investment return on customers funds does not cover the customers guaranteed benefits, any necessary increase in life insurance provisions, and other obligations, then the shortfall is covered first by the collective bonus potential and subsequently by the bonus potential of paid-up policies. The amount of bonus potential on paid-up policies available depends on whether there is a charge on transfers and surrenders as well as on the size of such a charge. If the bonus potentials are insufficient to cover the shortfall, funds are allocated from shareholders equity. 92 OTHER RISKS DANSKE BANK RISK MANAGEMENT 2008

92 To ensure a reasonable balance between the return on customers funds and the guaranteed benefits, the Danica Group monitors financial risks on an ongoing basis. Stress tests are conducted regularly to ensure that Danica is able to withstand a fall in equity prices of 30% in combination with a significant change in interest rates. For most unit-linked policies, policyholders bear all the investment risk; 48% of policyholders have an investment guarantee, however. The guarantees apply only at the time of retirement and are paid for by an annual fee. The Group manages the risk on guarantees in Danica Link by hedging it with equity derivatives and by adjusting the investment allocation during the last five years before disbursement. It manages the risk on guarantees in Danica Balance primarily by making adjustments to the individual customers investment portfolios. The proportion of funds invested in shares is adjusted on the basis of the guarantee amount, the remaining term and other factors. Because of these hedging and risk management strategies, the Group considers the investment risk on guarantees in unit-linked products to be very minor. In addition to market risk related to policyholders savings, Danica s equity is also exposed to market risks on its own investments and on investments related to health and accident insurance. Danica s Board of Directors has set a separate investment strategy for shareholders equity. The investments related to health and accident insurance follow essentially the same investment strategy as customers funds allocated to with-profits policies. The credit risk on Danica s bond portfolio is modest since 73% of the bond portfolio consists of government and mortgage bonds with high ratings (AA to AAA) from international rating agencies. Around 6% of the portfolio is invested in non-investment-grade bonds. Concentration risk is limited by internal investment restrictions, and collateral is provided for financial derivatives. The Danica Group reduces liquidity risk by investing a large part of its funds in liquid bonds and shares. Life insurance risks Life insurance risks are linked to mortality, disability, critical illness and similar factors. For example, an increase in life expectancy affects the time during which benefits are payable under certain pension plans, while the trends in mortality, sickness and recoveries affect life insurance and disability benefits. Life expectancy is the most significant life insurance risk factor. Danica s life insurance risks are subject to ongoing actuarial assessment for the purpose of calculating insurance obligations and making relevant business adjustments. For life insurance policies, Danica calculates the insurance obligations according to expected mortality rates based on empirical data from its own insurance portfolio. These rates reflect a likely increase in life expectancy in the future. For health and personal accident policies, insurance obligations are calculated according to expectations for future recoveries and re-openings of old claims. The expectations are based on empirical data from Danica s own insurance portfolio and are updated regularly. To mitigate the life insurance risk, Danica uses reinsurance to cover a small proportion of the risks related to mortality and disability. Danica also hedges the risk of disbursements occasioned by disasters. Other risks Business risk is defined as strategic risk, reputational risk and other risks related to external factors. Danica systematically reviews its business areas to minimise the risk of financial losses due to sanctions, claims and reputational damage resulting from non-compliance with legislation, rules and standards. Danica closely monitors the competition in all relevant markets to ensure that prices and customer satisfaction are competitive. Operational risk is the risk of losses due to errors in IT systems, legal disputes, insufficient or erroneous procedures and fraud. Danica manages operational risk through standard operating procedures that are regularly updated to reflect the current business environment and through internal controls. DANSKE BANK RISK MANAGEMENT 2008 OTHER RISKS 93

93 Temporary charge on transfers and surrenders of with-profits policies As a result of the global financial crisis in the autumn of 2008, negative investment returns reduced the collective bonus potential to zero for most of the with-profits policyholders. Danica therefore introduced a temporary charge on transfers and surrenders in order to protect the remaining policyholders savings. At December 31, 2008, the charge was 5%, and it applied to all policies except some policies originally written by Baltica Livsforsikring before January 1, 1983, and some private policies written after April 1, Risk exposure and sensitivity analysis As mentioned above, the Group s insurance risk is related primarily to life insurance and pension products. Health and accident insurance accounts for a small part of the risk. At the end of 2008, provisions related to conventional life insurance (with-profits policies) and unitlinked products amounted to DKr210bn, or 93% of the Danica Group s total liabilities (see table 8.5). This also includes collective bonus potential reserves. TABLE 8.5 DANICA GROUP S BALANCE SHEET BROKEN DOWN BY BUSINESS SEGMENT Health and At December 31, 2008 (DKr m) Conventional Unit-linked accident insurance Other areas and elimination Total Investment assets 191,816 30,951 9, ,258 Other assets 9,423 2, ,009 9,593 Total assets 201,239 33,130 9,909-1, ,851 Provisions for insurance and investment contracts 179,571 30,584 8, ,139 Other liabilities 12,372 2,191 1,383-8,120 7,826 Equity 9, ,693 16,886 Total liabilities and equity 201,239 33,130 9,909-1, ,851 It has been a regulatory requirement in Denmark that insurance companies report the results of two sets of stress tests, commonly known as the red and yellow traffic light scenarios. According to the agreement between the Danish government and the Danish Insurance Association, the yellow traffic light was abandoned on October 31, The red traffic light scenario tests the effect of changes in interest rates, equity prices, property prices, exchange rates and counterparty risk on insurance companies. A company is said to be in red or yellow light status if it does not have sufficient capital to cover its solvency requirement less 3% of the life insurance provisions when stressed by the scenarios. If a company is in red light status, the Danish FSA will become involved in its financial management. Table 8.6 shows the effect on Danica s equity, the collective bonus potential and the bonus potential of paid-up policies caused by the red traffic light scenario. The table also shows the effect of changes in the actuarial assumptions and credit spreads. If the bonus potential is insufficient to cover policyholders losses, the shortfall will be covered by shareholders equity. Risks related to unit-linked business affect shareholders equity directly, but they are considered very minor, as mentioned above. 94 OTHER RISKS DANSKE BANK RISK MANAGEMENT 2008

94 TABLE 8.6 SENSITIVITY ANALYSIS At December 31, 2008 (DKr bn) Effect on shareholders equity Maximum effect on collective bonus potential Maximum effect on bonus potential of paid-up policies Total effect Increase in interest rates of 0.7 of a percentage point Decline in interest rates of 0.7 of a percentage point Decline in equity prices of 12% Decline in real property prices of 8% Exchange rate risk (VaR 99.5%) Loss on counterparties of 8% Fall in mortality of 10% Increase in mortality of 10% Increase in disability claims of 10% Credit spread widening of 1 percentage point At December 31, 2007 (DKr bn) Effect on shareholders equity Maximum effect on collective bonus potential Maximum effect on bonus potential of paid-up policies Total effect Increase in interest rates of 0.7 of a percentage point Decline in interest rates of 0.7 of a percentage point Decline in equity prices of 12% Decline in real property prices of 8% Exchange rate risk (VaR 99.5%) Loss on counterparties of 8% Fall in mortality of 10% Increase in mortality of 10% Increase in disability calims of 10% Of the two interest rate scenarios, the rate increase is the most severe for the Danica Group. Combined with the other traffic light scenarios, this would reduce shareholders equity by DKr2.5bn and the collective bonus potential by DKr0.7bn. It would also increase the bonus potential of paid-up policies by DKr1.1bn. Throughout 2008, the Danica Group was in compliance with the red traffic light standards, as shown in figure 8.1. DANSKE BANK RISK MANAGEMENT 2008 OTHER RISKS 95

95 FIGURE 8.1 RED TRAFFIC LIGHT SCENARIO FOR THE DANICA GROUP (DKr bn) Q4-07 Q1-08 Actual capital Q2-08 Q3-08 Q4-08 Q4-07 Q1-08 Red light scenario Q2-08 Q3-08 Q4-08 Solvency requirement Bonus potential on paid-up policies Excess base capital Collective bonus potential The calculation of life insurance provisions assumes a rise in life expectancy for a sixty-five-year-old of almost one year above today s level. At the current level of interest rates, this results in additional provisions of DKr7.5bn above the level of with-profits policyholders savings. An additional 10% decline in the mortality rate, corresponding to a rise in life expectancy of about one year, would increase liabilities and thus reduce the bonus potential by DKr0.8bn and reduce shareholders equity by DKr0.9bn Capital requirement Danica is subject to a capital requirement pursuant to the solvency rules for insurance companies. The Danske Bank Group s capital requirement concerning insurance business was DKr5,110m at December 31, 2008, against DKr4,460m at the end of The amount was deducted from the Danske Bank Group s capital base (see section 3.6). In addition to the regulatory capital requirement, individual capital adequacy ratios for insurance companies were introduced by the Danish FSA at the end of These are risk-based capital requirements that supplement the regulatory capital requirement. All Danish insurance companies are required to maintain a capital base equal to or greater than the larger of the regulatory and the individual capital adequacy ratio. Danica has developed a model for stress testing all relevant risk factors, including equity prices, property prices, interest rates and mortality rates. The individual capital adequacy ratio is calculated as the total capital requirement after stress testing, adjusted for the use of the collective bonus potential and the bonus potential of paid-up policies. Danica is also preparing for Solvency II, which is the European transition to a risk-based solvency regime. The Directive on the new regime is currently being debated in the European Parliament, and it is expected to take effect in The Danish FSA s individual capital adequacy ratio can be seen as a forerunner to Solvency II. 96 OTHER RISKS DANSKE BANK RISK MANAGEMENT 2008

96 9. CONSOLIDATION DANSKE DANSKE BANK BANK RISK MANAGEMENT RISK RISIKOSTYRING OPERATIONAL MARKEDSRISIKO OTHER RISKS 97

97 Risk Management 2008 is based on the definition of the Group used in Annual Report This definition complies with IFRSs. According to IFRSs, Danske Bank A/S s subsidiaries are the companies in which it has direct or indirect control over financial and operating policy decisions. The Group does not consolidate its insurance companies in its solvency calculations. Danica s capital requirement, less the difference between Danica s capital base and the carrying amount of the holding, is deducted from the Group s capital base. Danica is consolidated in the accounts of the Danske Bank Group, and its risk management practices are described in separate sections of the risk statements. In accordance with the Danish executive order on the contribution principle, Danica Pension has notified the Danish FSA of its profit policy. According to the contribution principle and the profit policy, policyholders both receive the return on allocated assets and take on the associated risk. Assets are allocated to policyholders to ensure customers guaranteed benefits. The various types of risk that Danica has taken on as an integral part of its activities and that affect assets and liabilities allocated to policyholders are presented in section 8.3 Insurance risk. In its solvency calculations, the Group consolidates Danmarks Skibskredit A/S and LR Realkredit A/S on a pro rata basis, while, for accounting purposes and in risk reporting, it treats the two companies as associated undertakings, that is, in accordance with the equity method. The Group has holdings of 24% and 31%, respectively, in the two companies. Danmarks Skibskredit A/S offers shipowners and other shipping companies loans secured by mortgages on the vessels. As of mid-2008, the company had total assets of DKr79.2bn and risk-weighted assets worth DKr62.5bn. LR Realkredit A/S provides mortgage loans primarily for subsidised housing and other subsidised properties. At the end of 2007, the company had total assets of DKr12.2bn and risk-weighted assets worth DKr10bn. Restrictions on dividend payments from subsidiaries All credit institutions and insurance operations under the supervision of national FSAs are subject to local statutory provisions on the required capital base. These provisions restrict dividend payouts. Forsikringsselskabet Danica Skadeforsikringsaktieselskab af 1999 is the parent company of Danica Pension. Danica Pension is a life insurance company and the parent company of a life insurance group. Danica Pension has an obligation to allocate part of the excess equity to certain policyholders of Statsanstalten for Livsforsikring (now part of Danica Pension) if the percentage by which the equity exceeds the statutory solvency requirement is higher than the percentage that had been maintained by Statsanstalten for Livsforsikring prior to the privatisation of this company in In addition, it is the intention not to distribute dividends for a period of at least 25 years from Paid-up capital and interest accrued thereon may, however, be distributed. Table 9.1 shows the differences between the general consolidation principles and those used in solvency calculations. It shows only major subsidiaries that are currently active. 98 CONSOLIDATION DANSKE BANK RISK MANAGEMENT 2008

98 TABLE 9.1 DIFFERENCES BETWEEN CONSOLIDATION PRINCIPLES AND SOLVENCY CALCULATIONS Danske Bank A/S, Copenhagen Solvency calculations Consolidation Full Pro rata Deduction Full Consolidation of accounts Ass. undertakings Credit institutions Realkredit Danmark A/S, Kgs. Lyngby x x Sampo Bank plc, Helsinki x x Sampo Housing Loan Bank plc, Helsinki x x Northern Bank Limited, Belfast x x Danske Bank International S.A., Luxembourg x x Danmarks Skibskredit A/S, Copenhagen x x LR Realkredit A/S, Copenhagen x x ZAO Danske Bank, Saint Petersburg x x Insurance operations Forsikringsselskabet Danica, Skadeforsikringsaktieselskab af 1999, Copenhagen x x Danica Pension, Livsforsikringsaktieselskab, Copenhagen x x Danica Pension I, Livsforsikringsaktieselskab, Copenhagen x x Danica Liv III, Livsforsikringsaktieselskab, Copenhagen x x Danica Pension Försäkringsaktiebolag, Stockholm x x Danica Pensjonsforsikring AS, Trondheim x x Danica Life Ltd., Dublin x x Investment and real property operations, etc. 3 C Asset Management Ltd., Helsinki x x Danica ButiksCenter A/S, Copenhagen x x Danica Ejendomsselskab ApS, Copenhagen x x Danske Capital AS, Tallinn x x Danske Capital Norge AS, Trondheim x x DDB Invest AB, Linköping x x Danske Corporation, Delaware x x Danske Invest Management A/S, Copenhagen x x Danske Leasing A/S, Birkerød x x Danske Markets Inc., Delaware x x Danske Private Equity A/S, Copenhagen x x Fokus Krogsveen AS, Trondheim x x home a/s, Åbyhøj x x National Irish Asset Finance Ltd., Dublin x x UAB Danske Lizingas, Vilnius x x DANSKE BANK RISK MANAGEMENT 2008 CONSOLIDATION 99

99 10. DEFINITIONS 100 KREDITRISIKO DANSKE BANK RISK MANAGEMENT 2008

100 All Risk Committee The All Risk Committee is in charge of implementing the Group s risk appetite process overall structure of and development policy for the balance sheet targets for capital structure and solvency rating strategy overall funding structure general principles for measuring, managing and reporting on the Group s risks risk policies for relevant business units overall risk exposure guidelines, for example for identifying and managing risk concentrations, and follow-up measures overall investment strategy capital deployment The All Risk Committee consists of members of the Executive Board and the heads of Danske Markets and Risk Management. AMA The Advanced Measurement Approach used to calculate risk-weighted assets for operational risk. Business risk Business risk is the risk of losses caused by changes in external circumstances or events that harm the Group s reputation or earnings. Business risk includes the risk of a decline in earnings due to strategic decisions (strategic risk). Capital requirement The capital requirement is calculated as 8% of risk-weighted assets. Commodity risk Commodity risk is the risk of losses caused by changes in commodity prices. Conversion factor The conversion factor (CF) is the expected utilisation of a given facility at the time of default and is used in the calculation of the exposure at default (EaD). The CF estimates are based on in-house default data. As in the LGD estimation, the Group makes estimates of both point-in-time (PIT) and downturn parameters. Counterparty credit risk Counterparty credit risk is the risk of loss resulting from a customer s default on derivatives contracts with the Group. Country risk Country risk is the risk of losses arising from economic difficulties or political unrest in a country, including the risk of losses resulting from nationalisation, expropriation and debt restructuring. DANSKE BANK RISK MANAGEMENT 2008 DEFINITIONS 101

101 CRD rules The European Union s Capital Requirements Directives (2006/48/EC and 2006/49/EC), incorporated in the Danish executive order on capital adequacy of December 22, 2006, which took effect on January 1, The rules stipulate that the advanced approach for calculating credit risk and operational risk could be applied no earlier than January 1, 2008, and requires approval of the supervisory authority. Credit risk Credit risk is the risk of losses arising because counterparties fail to meet all or part of their payment obligations to the Danske Bank Group. Credit risk also includes country, dilution and settlement risks. The credit risk on derivatives contracts, which is also called counterparty credit risk, is the risk of losses resulting from a customer s default on derivatives contracts with the Group. Credit spread risk Credit spread risk is the risk of losses caused by changes in credit spreads. Danica Group The Danica Group encompasses the Danske Bank Group s activities in the life insurance and pensions market. Danske Banking Concept The Danske Banking Concept is the Group s business model. It is based on the principle of a uniform customer segmentation and service strategy in the individual business units. Danske Markets Danske Markets is responsible for the Danske Bank Group s activities in the financial markets. Danske Research Danske Research is the Danske Bank Group s research department. It prepares analyses of economic and financial factors of importance to the Group and its clients. Defined benefit pension plans In defined benefit plans, the pension agreement contains a provision stipulating the pension benefit that the employee will be entitled to receive on retirement. The benefit is typically stated as a percentage of the employee s salary immediately before retirement, but it can also be a percentage of the average salary during the entire period of employment. The pension benefit will typically be payable for the rest of the employee s life, and this increases the employer s uncertainty about the amount of the future obligations. Defined contribution pension plans A defined contribution plan is a post-employment benefit plan under which the employer pays fixed contributions into a separate entity and has no further obligations. The pension entitlement accumulated by the employee depends on the size of the contributions agreed upon, the performance of invested pension funds and associated expenses. Economic capital Economic capital is the amount of capital, calculated with the Group s own models, required to cover unexpected losses over the next year at a confidence level of 99.97%, which corresponds to an AA rating. The calculation of economic capital takes into account all relevant types of risk, including concentration and migration risks, as well as diversification within the individual risk types. The aggregation across risk types does not take into account the potential benefit from diversification among various risk types. The calculation of economic capital is based on point-in-time parameters for PD, LGD and CF, and it will therefore fluctuate with the business cycle. Stress tests are intended to identify the effects of these fluctuations. Equity market risk Equity market risk is the risk of losses caused by changes in equity prices. 102 DEFINITIONS DANSKE BANK RISK MANAGEMENT 2008

102 Exchange rate risk Exchange rate risk is the risk of losses on the Group s foreign currency positions caused by changes in exchange rates. Executive Board s Credit Committee The Executive Board s Credit Committee consists of members of the Executive Board and the management team of Group Credits. Credit applications that exceed the lending authorities of the business units must be submitted to the Executive Board s Credit Committee for approval. The local credit departments of the business units review these applications before the heads of the departments submit them to the Executive Board s Credit Committee for approval. The committee is also in charge of preparing operational credit policies and approving or rejecting credit applications involving issues of principle. The Board of Directors determines the lending authorities. In addition, the Executive Board s Credit Committee participates in decisions regarding the valuation of the Group s loan portfolio in connection with the determination of impairment charges. Executive Committee The Executive Committee constitutes the day-to-day executive management. It is headed by the Chairman of the Executive Board. The Executive Committee functions as a co-ordinating forum whose principal objective is to take an overall view of activities across the Group with particular attention to the interaction between support functions and product suppliers on the one hand, and individual units and country organisations on the other. The Executive Committee does not take part in the credit approval process. Floor risk Floor risk is the risk of a loss of earnings on deposits because market interest rates approach zero. General risk General risk is the Group s risk of losses on its positions because of general changes in market prices, including interest rates, exchange rates, equity prices and commodity prices. It applies to all positions in the trading book. Exchange rate risk and commodity risk apply to positions outside the trading book as well. Group Credits The Group s credit organisation is led by the head of the central credit department, Group Credits. Group Credits has overall responsibility for the credit process in all of the Group s business units. This includes the responsibility for developing credit classification and valuation models and for seeing that they are used in day-today credit processing in the local units. Group Finance Group Finance oversees the Group s financial reporting, budgeting, risk management and strategic business analysis, including the performance and analytical tools used by the business units. The department is also in charge of the Group s investor relations, corporate governance, capital structure, M&A activities and relations with rating agencies. Risk Management is part of Group Finance. As the Group s risk monitoring unit, Risk Management is responsible for the Group s implementation of the CRD rules, risk models and risk analysis. ICAAP In 2006, in preparation for the transition to the CRD, the Group established an Internal Capital Adequacy Assessment Process (ICAAP). This is a collection, expansion and validation of many assessments and considerations that had also been conducted earlier. The Group s ICAAP includes an internal evaluation of the capital needed under Pillar II. DANSKE BANK RISK MANAGEMENT 2008 DEFINITIONS 103

103 The ICAAP identifies and measures the Group s risks and ensures that it has sufficient capital in relation to its risk profile. The process also ensures that adequate risk management systems are used and further developed. The ICAAP report is updated quarterly in a condensed format, and once a year the full ICAAP report is submitted to the Board of Directors for approval. IFRSs International Financial Reporting Standards. Insurance risk Insurance risk in the Danske Bank Group is defined as all types of risk in the Danica Group, including market risk, life insurance risk, business risk and operational risk. Interest rate risk Interest rate risk is the risk of losses caused by changes in interest rates. Investment-grade ratings Investment-grade ratings correspond to categories 1 to 4 on the Group s internal rating scale. Leverage ratio The leverage ratio is a simplified measure that is often used to compare banking institutions. It is defined as core capital divided by adjusted assets. Unlike the Basel II approach, the measure thus does not take into account the fact that different activities on financial institutions balance sheets have different levels of risk. Liquidity risk Liquidity risk is defined as the risk of losses arising because the Group s funding costs increase disproportionately lack of funding prevents the Group from establishing new business lack of funding will ultimately prevent the Group from meeting its obligations. Loss given default Loss given default (LGD) is the expected loss on an exposure calculated as the percentage of the expected facility utilisation that will be lost if a customer defaults. LGD is also estimated as a PIT parameter. The Group makes a downturn adjustment to reflect the losses identified in a downturn period. The downturn adjustment reflects the most severe economic conditions in the estimation period, and these estimates are used in the calculation of the Group s risk-weighted assets. Market risk Market risk is the risk of losses arising because the fair value of the Group s assets and liabilities varies with changes in market conditions. Mortgage spread risk Mortgage spread risk is the risk of losses arising because of changes in mortgage spreads. Operational risk Operational risk is the risk of losses owing to deficient or erroneous internal procedures and processes human or system errors external events, including legal events. Operational Risk Committee This Committee assists the Executive Board in its functions and processes related to operational risk management. The committee s responsibilities include the following: 104 DEFINITIONS DANSKE BANK RISK MANAGEMENT 2008

104 Implementing a group-wide programme that addresses and manages the Group s current and potential operational risk Processing reports from operational risk management functions Monitoring the development and mitigation of the Group s key operational risks Handling critical risks Processing management information on issues such as IT security, physical security, business continuity and compliance. ORIS Operational Risk Information System. Probability of default Probability of default (PD) is a credit risk parameter. Point-in-time (PIT) PD represents the probability that a customer will default on a loan within the next 12 months. The prediction of default is based on inputs that are sensitive to the underlying business cycle. This produces PD estimates that reflect changes in general economic factors. In other words, in a given portfolio, the overall PIT PD level changes over time. In the grades of the Group s rating scale, the underlying PD bands defining each grade are fixed, and over time the percentage of customers within each grade will vary according to the effect of the business cycle on the model input. The calculated PIT PD is converted to a through-the-cycle (TTC) PD used in the calculation of the Group s risk-weighted assets. The TTC PD level is based on steady-state macroeconomic data. Risk policies To ensure that the Group s business units comply with the approved risk limits, the Board of Directors has adopted overall risk policies regulating all risk-taking by the Group. On the basis of the overall risk policies, operational risk policies are prepared for the main business units and submitted to the Group s All Risk Committee for approval. RWA Risk-weighted assets for credit risk, market risk and operational risk. Settlement risk Settlement risk is the risk arising when payments are settled, for example payments for trades in financial instruments, including derivatives. The risk arises when the Group remits payments before it can ascertain that the counterparties consideration has been received. Solvency ratio Total capital base divided by risk-weighted assets. Solvency II The European transition to a risk-based solvency regime for insurance companies. Specific risk Specific risk is the risk of losses in the trading book portfolio that can be attributed to the specific issuer of a financial instrument. SREP Supervisory Review and Evaluation Process. Sub-investment-grade ratings Sub-investment-grade ratings correspond to categories 5 to 7 of the Group s internal rating scale, provided that the credit risk is acceptable. US GAAP US Generally Accepted Accounting Principles VaR Value at Risk. Used for calculating market risk exposures. DANSKE BANK RISK MANAGEMENT 2008 DEFINITIONS 105

105 APPENDIX A DISCLOSURES REQUIRED UNDER PILLAR III OF THE CAPITAL REQUIREMENTS DIRECTIVE General requirements Sections 1-2 (CRD, annex XII, part 2, points 1-2) Regulatory capital requirements Sections 3-4 (CRD, annex XII, part 2, points 3-4) Counterparty credit risk Section 5 (CRD, annex XII, part 2, point 5) Credit and dilution risk Sections 6-14 (CRD, annex XII, part 2, points 6-14) Qualifying requirements for the use of particular instruments or methodologies Sections (CRD, annex XII, part 3, points 1-3) 106 KREDITRISIKO DANSKE BANK RISK MANAGEMENT 2008

106 This appendix addresses the disclosure requirements stipulated by the Capital Requirements Directive (CRD, 2006/48/EC) and the Danish executive order on capital adequacy of December 22, The organisation of the contents follows that of the Danish executive order on capital adequacy. For each item, a cross-reference to the corresponding requirement of the CRD is shown in parentheses. Each item contains either a reference to the section of Risk Management 2008 with the disclosure in question or explanatory material. Exposure at Default (EaD) figures for 2007 are included for purposes of comparison. The Group did not use the advanced IRB approach in 2007 because the statutory rules stipulate that this approach could be used no earlier than January 1, DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 107

107 General requirements Section 1: The risk management objectives and policies of the credit institution (CRD, annex XII, part 2, point 1) Section 1 (CRD, annex XII, part 2, point 1) The Group s risk management objectives and policies are described in Risk Management The general risk management objectives and policies are described in sections 2 and 3 of the report, and the objectives and policies for each risk type are described in sections 4-8. Relevant additional information on risk management policies and objectives are disclosed in the subsequent sections of this appendix. Section 2: Scope of application of the requirements of the Capital Requirements Directive (CRD, annex XII, part 2, point 2) Section 2.a (CRD, annex XII, part 2, point 2(a)) The name of the credit institution to which the requirements of the Directive apply is Danske Bank A/S. The disclosures in this appendix and in Risk Management 2008 are based on Group figures. Section 2.b (CRD, annex XII, part 2, point 2(b)) See Risk Management 2008, section 9. Section 2.c (CRD, annex XII, part 2, point 2(c)) See Risk Management 2008, section 9. Regulatory capital requirements Section 3: Own funds (capital base) (CRD, annex XII, part 2, point 3) Section 3.a-e (CRD, annex XII, part 2, point 3(a)-(e)) See Risk Management 2008, table 3.9. Section 4: Capital requirement and internal capital adequacy assessment (CRD, annex XII, part 2, point 4) Section 4.a (CRD, annex XII, part 2, point 4(a)) See Risk Management 2008, section 3.3. Section 4.b-e (CRD, annex XII, part 2, point 4(b)-(e)) and section 9.a-g (CRD, annex XII, part 2, point 9) 108 APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

108 CAPITAL REQUIREMENTS AND RISK-WEIGHTED ASSETS Capital requirement Risk-weighted assets (DKr m) Credit risk: IRB approach: Institutions 3,366 4,143 42,070 51,788 Corporate customers 28,172 30, , ,223 Exposures secured by real property 5,386 3,172 67,327 39,655 Qualifying revolving retail exposures ,676 5,046 Other retail exposures 3,220 4,454 40,245 55,682 Securitisation 2, ,381 4,596 Other non-credit-obligation assets 1,234 1,520 15,420 18,994 IRB approach, total 44,502 45, , ,984 Standardised approach: Central governments and central banks ,336 Regional governments and local authorities Administrative bodies and non-commercial undertakings Institutions ,008 6,113 Corporate customers 10,986 10, , ,341 Retail customers 2,507 2,358 31,343 29,473 Exposures secured by real property 3,105 3,263 38,818 40,792 Past due items ,662 3,196 Securitisation positions ,447 1,329 Other items ,453 4,241 Standardised approach, total 17,572 17, , ,400 Counterparty credit risk 3,060 2,142 38,254 26,769 Credit risk, total 65,134 64, , ,153 Market risk: Exposures with position risk: instruments of debt 3,013 3,838 37,664 47,982 Exposures with position risk: equities and the like ,399 Exposures with position risk: commodities ,035 4,058 Exposures with delivery and similar risks Value-at-Risk (VAR) exposure 2,277 1,535 28,464 19,190 Total foreign exchange position Market risk, total 5,408 5,812 67,602 72,648 Operational risk 6,264 5,895 78,298 73,682 Total risk-weighted assets 960, ,483 Total capital requirement 76,806 76,359 Note: In appendix A the credit risk on repo transactions are not included as counterparty credit risk. DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 109

109 Requirements for various risk types Section 5: Counterparty credit risk (CRD, annex XII, part 2, point 5) Section 5.a (CRD, annex XII, part 2, point 5(a)) The Group uses the mark-to-market approach described in the CRD when calculating risk-weighted assets for counterparty credit risk. The Group also takes counterparty credit risk into account in its calculation of economic capital, which is included in the ICAAP under Pillar II (see Risk Management 2008, section 3). In economic capital, counterparty credit risk is simulated as the so-called effective Expected Positive Exposure (eepe), which is then multiplied by. The multiplier expresses the effect of using an expected exposure instead of the stochastic exposure in a full simulation for eepe. Counterparty credit risk is part of the general credit process, including the approval of lines (see Risk Management 2008, section 4.3). Section 5.b (CRD, annex XII, part 2, point 5(b)) See Risk Management 2008, section Section 5.c (CRD, annex XII, part 2, point 5(c)) Not relevant since the Group uses the mark-to-market method. Section 5.d (CRD, annex XII, part 2, point 5(d)) See Risk Management 2008, section 6.3, table 6.4. Section 5.e and 5.f (CRD, annex XII, part 2, point 5(e)-(f)) COUNTERPARTY CREDIT RISK EXPOSURE (EAD) (DKr m) Current net credit exposure (EaD) 255, ,028 Collateral (credit risk mitigation) 7,242 9,348 See Risk Management 2008, section 4.5.3, table 4.15 for gross value of derivatives with positive fair value and netting benefits. Section 5.g (CRD, annex XII, part 2, point 5(g)) The Group did not use credit derivative hedges for counterparty credit risk exposures in Section 5.h (CRD, annex XII, part 2, point 5(h)) See Risk Management 2008, section 4.5.3, table Section 5.i (CRD, annex XII, part 2, point 5(i)) Not relevant since the Group uses the mark-to-market method. Section 6: Credit and dilution risk (CRD, annex XII, part 2, point 6) In this appendix, the Group reports exposure values as Exposure at Default (EaD). Risk Management 2008 (section 4), on the other hand, is based on accounting data. The table below shows the difference between credit exposure based on accounting data and credit exposure based on EaD at the end of Because of this difference, the distribution of the figures in this appendix may differ from the distribution in Risk Management 2008 (for example for exposure broken down by industry and geographical location). 110 APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

110 FROM CREDIT EXPOSURE TO EXPOSURE AT DEFAULT (EAD) (DKr m) 2008 Credit exposure, lending activities 2,519,870 Shares and bonds, lending activities 36,272 Offers and revocable commitments 632,310 LR Realkredit A/S and Danmarks Skibskredit A/S 16,744 Other 4,570 Unweighted amount 3,209,766 Adjustment for CF 551,223 EaD 2,658,543 Breakdown by capital requirement approach: IRB approach 2,212,514 Standardised approach 446,029 Total (EaD) 2,658,543 Section 6.a (CRD, annex XII, part 2, point 6(a)-(b)) For accounting purposes, impaired debts are debts for which objective evidence of impairment exists, and the amount of the impairment charge is determined individually. They are exposures in rating categories 10 and 11 (2007: 9 and 10). For accounting purposes, past due amounts are debts in rating categories 1-9 (2007: 1-8) that are in arrears or have unauthorised excesses. Section 6.b-6.c (CRD, annex XII, part 2, point 6(c)) CREDIT EXPOSURE (EAD) (DKr m) At December 31 Average At December 31 IRB approach: Institutions 324, , ,155 Corporate customers 1,057,537 1,002, ,664 Exposures secured by real property 590, , ,766 Qualifying revolving retail exposures 40,355 39,031 35,665 Other retail exposures 140, , ,816 Securitisation 39,927 45,464 53,475 Other non-credit-obligation assets 20,174 20,750 30,034 IRB approach, total 2,212,514 2,249,722 2,378,575 Standardised approach: Central governments and central banks 121, , ,530 Regional governments and local authorities 1,714 2,016 2,344 Administrative bodies and non-commercial undertakings Multilateral development banks Institutions 10,887 16,807 9,848 Corporate customers 142, ,341 60,951 Retail customers 48,319 49,401 17,220 Exposures secured by real property 110, ,666 33,090 Past due items 4,426 3, Securitisation positions 1,447 2,256 - Other items 4,411 9,257 1,640 Standardised approach, total 446, , ,373 Total credit exposure (EaD) 2,658,543 2,721,433 2,659,948 Note: Average exposure for 2008 is a simple average based on quarterly observations for each exposure class. Sampo Bank is included from January 1, Total EaD for Sampo Bank was DKr236bn at the end of DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 111

111 Section 6.d (CRD, annex XII, part 2, point 6(d)) GEOGRAPHICAL BREAKDOWN OF CREDIT EXPOSURE (EAD) At December 31, 2008 (DKr m) Denmark Finland Sweden Ireland IRB approach: Institutions 72,499 4,443 29,476 35,406 Corporate customers 609,672 18, ,080 51,409 Exposures secured by real property 500, , Qualifying revolving retail exposures 36, ,308 6 Other retail exposures 104, ,898 9 Securitisation Other non-credit-obligation assets IRB approach, total 1,322,362 24, ,288 87,739 Standardised approach: Central governments and central banks 79,172 10,455 20,999 1,372 Regional governments and local authorities Administrative bodies and non-commercial undertakings Multilateral development banks Institutions 5,159 4, Corporate customers 34,355 63,700 2, Retail customers 2,496 20, ,032 Exposures secured by real property 3 69, ,883 Past due items - 1, Securitisation positions - 1, Other items Standardised approach, total 121, ,211 23,306 34,798 Total credit exposure (EaD) 1,443, , , , APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

112 UK Norway Baltics Rest of Europe North America Rest of the world No residence Total 47,291 9, ,497 20,685 6, ,049 43,648 92, ,819 38,381 4,420-1,057, , , , , , ,355 1,902 6, , ,154 35, , , ,174 20, , , ,553 62,629 13,870 20,174 2,212,514 1,669 3,216 2,084 1, ,121 1, , , ,887 25, ,223 1, ,142 3,885-16, ,319 13, ,909 1, , , ,411 4,411 48,302 4,041 33,794 4, , , , ,915 34, ,793 62,911 14,329 24,585 2,658,543 DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 113

113 GEOGRAPHICAL BREAKDOWN OF CREDIT EXPOSURE (EAD) At December 31, 2007 (DKr m) Denmark Finland Sweden Ireland IRB approach: Institutions 73,972 2,223 31,989 38,328 Corporate customers 458,061 18, ,027 40,776 Exposures secured by real property 436, , Qualifying revolving retail exposures 34, Other retail exposures 160, , Securitisation Other non-credit-obligation assets IRB approach, total 1,162,818 20, ,013 80,175 Standardised approach: Central governments and central banks 94, ,113 1,454 Regional governments and local authorities Administrative bodies and non-commercial undertakings Multilateral development banks Institutions 6, Corporate customers 29, Retail customers ,232 Exposures secured by real property ,685 Past due items Other items Standardised approach, total 130, ,154 31,862 Total credit exposure (EaD) 1,293,462 21, , ,037 Note: Sampo Bank is included from January 1, APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

114 UK Norway Baltics Rest of Europe North America Rest of the world No residence Total 224,601 7, ,565 46,897 8, ,155 64,543 96, ,581 87,421 6, , , , , , ,665 3,357 12, , , ,816 43, , , ,034 30, , , , ,818 17,669 30,034 2,378,575 12,157 15, ,218-1, ,530 1, , , ,848 30, ,951 6, ,220 13, , ,640 1,640 68,212 16, , ,663 1, , , , , ,948 19,332 31,674 2,659,948 DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 115

115 Section 6.e (CRD, annex XII, part 2, point 6(e)) INDUSTRY BREAKDOWN OF CREDIT EXPOSURE (EAD) At December 31, 2008 (DKr m) Central and local governments Subsidised housing companies Banks Diversified financials Other financials Energy and utilities Consumer discretionary and consumer staples IRB approach: Institutions ,471 13,205 19, Corporate customers 99 90, , ,039 33,289 72,484 Exposures secured by real property - 4, ,507 Qualifying revolving retail exposures Other retail exposures , ,915 Securitisation ,561 5, Other non-credit-obligation assets IRB approach, total 99 95, , , ,752 33,487 83,906 Standardised approach: Central governments and central banks 85,881-3, Regional governments and local authorities 1, Administrative bodies and non-commercial undertakings Multilateral development banks Institutions - - 3,925-6, Corporate customers ,744 17,565 4,514 10,996 Retail customers ,150 Exposures secured by real property Past due items Securitisation positions , Other items Standardised approach, total 87, ,966 4,929 26,052 4,720 13,016 Total credit exposure (EaD) 87,745 95, , , ,804 38,207 96, APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

116 Commercial property Construction, engineering and building products Transportation and shipping Other industrials IT Materials Health care Telecommunication services Personal customers No industry Total , ,787 78,775 59, ,575 13,431 38,834 28,349 5, ,057,537 3,661 1, , , , ,355-40,355 1,274 3,167 1,853 6, , , , , ,174 20, ,722 83,221 62, ,234 14,436 40,007 29,880 5, ,316 20,174 2,212, , , , ,887 24,344 11,242 2,826 52,194 1,163 8,475 2, , , ,125-48,319 1, , , , ,556-4, , ,411 4,411 27,222 13,254 3,526 88,209 1,348 8,616 2, ,264 4, , ,944 96,475 65, ,443 15,784 48,623 32,742 6, ,580 24,585 2,658,543 DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 117

117 INDUSTRY BREAKDOWN OF CREDIT EXPOSURE (EAD) At December 31, 2007 (DKr m) Central and local governments Subsidised housing companies Banks Diversified financials Other financials Energy and utilities Consumer discretionary and consumer staples IRB approach: Institutions , ,214 14, Corporate customers 7,267 93, ,473 59,065 23,264 61,660 Exposures secured by real property - 2, ,359 Qualifying revolving retail exposures Other retail exposures ,935 Securitisation ,327 9, Other non-credit-obligation assets IRB approach, total 7,267 97, , ,072 82,903 23,474 71,954 Standardised approach: Central governments and central banks 59,214-23, Regional governments and local authorities 2, Administrative bodies and non-commercial undertakings Multilateral development banks Institutions - - 3,464-6, Corporate customers ,559 16, ,457 Retail customers Exposures secured by real property Past due items Other items Standardised approach, total 61, ,857 1,814 22, ,589 Total credit exposure (EaD) 69,147 97, , , ,592 23,615 76,543 Note: Sampo Bank is included from January 1, APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

118 Commercial property Construction, engineering and building products Transportation and shipping Other industrials IT Materials Health care Telecommunication services Personal customers No industry Total , ,335 85,722 51, ,496 11,103 32,451 18,632 5, ,664 2, , , , ,665-35,665 1,818 2,994 1,688 7, , , , , ,034 30, ,717 89,595 53, ,874 11,916 33,478 20,161 5, ,563 30,034 2,378, , , , ,848 12,221 7, , , ,017-17, , ,439-33, ,640 1,640 13,010 7, , ,696 1, , ,727 97,169 54, ,616 12,099 34,326 20,852 5, ,259 31,674 2,659,948 DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 119

119 Section 6.f (CRD, annex XII, part 2, point 6(f)) MATURITY BREAKDOWN OF CREDIT EXPOSURE (EAD) 2008 At December 31 (DKr m) < 1 year 1 year < 2 years 2 years < 3 years 3 years < 4 years 4 years < 5 years 5 years IRB approach: Institutions 8, ,612 3,863 1, ,923 Corporate customers 1, ,176 43,851 28,445 21, ,636 Exposures secured by real property - 21,633 2,737 2,757 3, ,642 Qualifying revolving retail exposures - 3, ,051 Other retail exposures - 30,719 11,658 8,216 6,596 82,965 Securitisation - 2, ,298 Other non-credit-obligation assets IRB approach, total 10, ,450 62,628 41,589 32,854 1,313,515 Standardised approach: Central governments and central banks 2,486 76,110 1,254 1, ,467 Regional governments and local authorities ,660 Administrative bodies and noncommercial undertakings Multilateral development banks Institutions 486 5, ,780 Corporate customers ,525 3,387 3,514 3,380 87,804 Retail customers - 13,242 1, ,417 Exposures secured by real property - 54,123 2,315 2,549 3,131 48,791 Past due items - 1, ,418 Securitisation positions ,447 Other items Standardised approach, total 3, ,519 8,246 8,653 8, ,160 Total credit exposure (EaD) 13, ,969 70,874 50,242 41,390 1,531,675 Note: Sampo Bank is included from January 1, APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

120 2007 No maturity Total 1 year < 2 years 2 years < 3 years 3 years < 4 years 4 years < 5 years 5 years No maturity Total - 324, ,312 8,498 2, , ,155-1,057, ,203 59,864 23,800 30, , , ,318 23,293 2,628 2,589 3, , ,766-40,355 4,030 1, ,354-35, ,154 37,786 12,931 9,824 8, , ,816-39,927 2, ,023-53,475 20,174 20, ,034 30,034 20,174 2,212, ,847 85,124 38,992 43,775 1,308,803 30,034 2,378, , ,832 1,391 1, , ,530-1, ,216-2, ,887 9, , ,142 13,830 1,219 1,122 1,308 43,472-60,951-48,319 5,908 1, ,211-17, ,909 10, ,145 19,769-33,090-4, , ,411 4, ,640 1,640 4, , ,076 5,003 3,337 3, ,690 1, ,373 24,585 2,658,543 1,038,923 90,127 42,329 47,402 1,409,493 31,674 2,659,948 DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 121

121 Section 6.g (CRD, annex XII, part 2, point 6(g)) See Risk Management 2008, table Section 6.h (CRD, annex XII, part 2, point 6(h)) See Risk Management 2008, table Section 6.i (CRD, annex XII, part 2, point 6(i)) See Risk Management 2008, table Section 7: Disclosure requirements under the standardised approach (CRD, annex XII, part 2, point 7) Section 7.a-b (CRD, annex XII, part 2, point 7(a)-(b)) NOMINATED RATING AGENCIES BY EXPOSURE CLASS At December 31, 2008 S&P Moody s Regional governments and local authorities X X Administrative bodies and non-commercial undertakings X X Multilateral development banks Institutions X X Corporate customers X X Retail customers Exposures secured by real property Past due items Covered bonds Securitisation positions X X Other items Section 7.c (CRD, annex XII, part 2, point 7(c)) The Group follows the CRD rules on the use of ECAIs credit assessments for the determination of risk weights. These rules are also applied to securitisation exposures for which the Group uses the ratingsbased method under the IRB approach. If only one credit assessment is available from one of the Group s nominated ECAIs for a rated item, the credit assessment is used to determine the risk weight of that item. If two credit assessments available from the Group s nominated ECAIs correspond to different risk weights for a rated item, the higher risk weight is assigned. If more than two credit assessments are available from nominated ECAIs for a rated item, the two assessments generating the two lowest risk weights are referred to. If the two lowest risk weights differ, the higher of the two is assigned. If the two lowest risk weights are identical, this risk weight is assigned. Section 7.d (CRD, annex XII, part 2, point 7(d)) Not relevant since the Group complies with the standard association published by the Danish FSA. 122 APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

122 Section 7.e (CRD, annex XII, part 2, point 7(e)) CREDIT EXPOSURE (EAD) TO COUNTERPARTIES WHERE EXTERNAL RATINGS ARE APPLIED At December 31, 2008 (DKr m) Quality step Central governments and central banks Corporate customers Total (after risk mitigation) Collateral (risk mitigation) 1 18, , Total 18, ,523 - CREDIT EXPOSURE (EAD) TO COUNTERPARTIES WHERE EXTERNAL RATINGS ARE APPLIED At December 31, 2007 (DKr m) Quality step Central governments and central banks Corporate customers Total (after risk mitigation) Collateral (risk mitigation) 1 3, , Total 3, ,747 - Note: Sampo Bank is included from January 1, CREDIT EXPOSURE (EAD) TO COUNTERPARTIES WHERE COUNTRY-RISK CLASSIFICATIONS ARE APPLIED At December 31, 2008 (DKr m) Central governments and central banks Regional governments and local authorities Administrative bodies and non-commercial undertakings Risk classification Institutions Total (after risk mitigation) Collateral (risk mitigation) 0 98,909 1, , ,479 8, , , Total 101,162 1, , ,294 8,916 DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 123

123 CREDIT EXPOSURE (EAD) TO COUNTERPARTIES WHERE COUNTRY-RISK CLASSIFICATIONS ARE APPLIED At December 31, 2007 (DKr m) Central governments and central banks Regional governments and local authorities Administrative bodies and non-commercial undertakings Risk classification Institutions Total (after risk mitigation) Collateral (risk mitigation) 0 97,502 2, , , Total 98,585 2, , , Note: Sampo Bank is included from January 1, For exposure values deducted from own funds, see Risk Management 2008, section 3.6. Section 8: Disclosure requirements under the internal ratings-based method (CRD, annex XII, part 2, point 8) Section 8.a (CRD, annex XII, part 2, point 8(a)) The Group complies with the minimum requirements for using its own estimates of PDs for exposures under the advanced IRB approach, including specialised lending. The Group does not assign the risk weights for specialised lending referred to in section 82 of appendix 3 to the Danish executive order on capital adequacy (CRD, annex VII, part 1, point 6). Section 8.b (CRD, annex XII, part 2, point 8(b)) Not relevant since the Danish FSA has granted the Group a permanent exemption from the advanced IRB approach for equities. Section 9: Section 9 (CRD, annex XII, part 2, point 9) See section 4.b-e (CRD, annex XII, part 2, point 4(b)-(e)). Section 10: Market risk (CRD, annex XII, part 2, point 10) Section 10.a.1-3 (CRD, annex XII, part 2, point 10(a)(i)-(iii)) See Risk Management 2008, sections 5.4 and Section 10.b (CRD, annex XII, part 2, point 10(b)) For the calculation of general risk for interest rate risk, equity risk and exchange rate risk, the Group uses an internal model based on the Value at Risk method. The Danish FSA approved the Group s parametric VaR model in In 2007, the Group was permitted to apply a more sophisticated method based on historical simulations. Section 10.c (CRD, annex XII, part 2, point 10(c)) See Risk Management 2008, section APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

124 Section 11: Operational risk (CRD, annex XII, part 2, point 11) Section 11.a (CRD, annex XII, part 2, point 11(a)) See Risk Management 2008, sections 3.2 and 7.4. Section 11.b (CRD, annex XII, part 2, point 11(b)) Not relevant since the Group uses the standardised approach for operational risk. Section 12: Equity exposures outside the trading book (CRD, annex XII, part 2, point 12) Section 12.a (CRD, annex XII, part 2, point 11(a)) Equity exposures outside the trading book consist of long-term investments. Equities outside the trading book are valued at fair value, with value adjustment in the income statement. Associated undertakings, on the other hand, are recognised in accordance with the equity method. None of the associated undertakings is listed on a stock exchange. Section 12 b, c, d (CRD, annex XII, part 2, point 12(c)-(e)) EXPOSURES TO EQUITIES OUTSIDE THE TRADING BOOK At December 31, 2008 (DKr m) Balance sheet value Fair value Realised gains/ losses Unrealised gains/ losses Net position in listed equities Unlisted equities: Banking-related investments 1,128 1, Unutilised commitments, private equity Other unlisted equities 1,225 1, Total 3,193 3, Note: Listed equities are valued at the latest market price available. EXPOSURES TO EQUITIES OUTSIDE THE TRADING BOOK At December 31, 2007 (DKr m) Balance sheet value Fair value Realised gains/ losses Unrealised gains/ losses Net position in listed equities Unlisted equities: Banking-related investments 1,120 1, Unutilised commitments, private equity Other unlisted equities 1,629 1, Total 3,500 3, Note: Listed equities are valued at the latest market price available. DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 125

125 Section 13: Interest rate risk on positions outside the trading book (CRD, annex XII, part 2, point 13) Section 13.a (CRD, annex XII, part 2, point 13(a)) See Risk Management 2008, section 5.6. Section 13.b (CRD, annex XII, part 2, point 13(b)) GROUP-LEVEL INTEREST RATE RISK IN THE BANKING BOOK At December 31 (DKr m) DKK EUR GBP NOK SEK - 6 EEK 2 8 LTL 1 8 USD 12 4 CHF 1 3 JPY - 1 Total The interest rate risk management includes interest rate risk in the banking book (see Risk Management 2008, section 5.6). Section 14: Securitisation (CRD, annex XII, part 2, point 14) The following disclosure focuses on exposures included in the securitisation asset class. The description in section of Risk Management 2008 also includes these activities. In addition, the disclosure below focuses on securitisation activities qualifying for reduced weighting under the CRD rules (Basel II). Section 14.a-c (CRD, annex XII, part 2, point 14(a)-(c)) The Group acts as originator of the exposure included under section 14 (g)-(h). This relates to the synthetic transactions that Sampo Bank entered into in 2006 to hedge credit risk on loans to SMEs. The exposure qualifies for reduced weighting under the CRD rules. The Group does not act as sponsor except for a limited part of the activities originally entered into through Polonius (included under section 14 (i)-(j)). For other exposures included under section 14 (i)-(j), the Group acts mainly as liquidity provider or swap provider (in relation to ABCP and ABS programmes). In addition, the Group acts as investor for part of the activities originally entered into through Polonius. Section 14.d (CRD, annex XII, part 2, point 14(d)) The Group uses the following methods for its securitisation exposures: For the exposure included under section 14 (g), the Group uses the standardised approach; relates to the transaction that Sampo Bank entered into in APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

126 For the customer transactions in Polonius, the risk-weighted assets are calculated in accordance with Kirb. For all other exposures, the Group uses the ratings-based method under the IRB approach. Section 14.e (CRD, annex XII, part 2, point 14(e)) For accounting purposes, the Group treats exposure in the form of loan commitments to securitisation entities as lending activities. This means that, if it is likely that the loan commitment will be drawn, the obligation can be reliably measured, and the net present value of the expected payments discounted at the interest rates agreed upon is negative, a liability equal to this amount is recognised. For drawn loan commitments, the Group recognises an impairment charge if objective evidence of impairment appears after the commitment was made. For the securitisation activities in which the Group acts as originator (the exposures shown under 14(g)-(h)), the Group retains the first-loss tranche. The Group recognises an impairment charge on the hedged lending portfolio if there is objective evidence of impairment of the portfolio. If it is virtually certain that payments will be received under the CDS, the Group recognises an asset representing the net present value of the expected payments. Section 14.f (CRD, annex XII, part 2, point 14(f)) The Group uses the credit rating agencies (ECAIs) shown in the table below to rate its securitisation positions, which are broken down by securitisation category. ECAIS USED FOR SECURITISATION POSITIONS At December 31, 2008 Securitisation category Moody s Standard & Poor s Fitch Ratings Residential mortgages X X X Commercial mortgages X X Credit card receivables X X Leasing Loans to corporates or SMEs X X Consumer loans X X Trade receivables Securitisations / resecuritisations X X Other assets X X DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 127

127 Section 14.g (CRD, annex XII, part 2, point 14(g)) TOTAL OUTSTANDING AMOUNT OF SECURITISED EXPOSURE (EAD) BROKEN DOWN INTO TRADITIONAL AND SYNTHETIC TRANSACTIONS At December 31 (DKr m) Securitisation category Traditional Synthetic Traditional Synthetic Residential mortgages Commercial mortgages Credit card receivables Leasing Loans to corporates or SMEs - 3,618-5,755 Consumer loans Trade receivables Securitisations / resecuritisations Other assets Total - 3,618-5,755 Section 14.h (CRD, annex XII, part 2, point 14(h)) PAST DUE, IMPAIRED AND DEFAULTED AMOUNTS FOR SECURITISED EXPOSURES Past due Past due At December 31 (DKr m) > > 90 Securitisation category days days days Impaired days days days Impaired Residential mortgages Commercial mortgages Credit card receivables Leasing Loans to corporates or SMEs Consumer loans Trade receivables Securitisations / resecuritisations Other assets Total APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

128 Section 14.i (CRD, annex XII, part 2, point 14(i)) AGGREGATE AMOUNT OF RETAINED OR PURCHASED SECURITISATION POSITIONS (EAD) At December 31 (DKr m) Securitisation category Residential mortgages 14,782 17,519 Commercial mortgages 13,867 13,648 Credit card receivables 545 3,421 Leasing - - Loans to corporates or SMEs 2,911 8,865 Consumer loans Trade receivables - - Securitisations / resecuritisations 4,203 7,782 Other assets 4,092 2,786 Total 40,830 54,632 41% of the securitisation position under section 14(i)-(j) was super senior at the end of Section 14.j (CRD, annex XII, part 2, point 14(j)) AGGREGATE AMOUNT OF RETAINED OR PURCHASED SECURITISATION POSITIONS (EAD), BROKEN DOWN BY RISK-WEIGHT BAND At December 31 (DKr m) Risk-weight band % 32,071 51,658 >10 20% 2, >20 50% 1,223 1,759 >50 100% 1, > % >650 < 1,250% - - 1,250% / deduction 1,960 - Total 40,830 54,632 Section 14.k (CRD, annex XII, part 2, point 14(k)) Not relevant since the Group has not securitised any qualifying revolving exposures. Section 14.l (CRD, annex XII, part 2, point 14(l)) Not relevant since, in 2007 and 2008, the Group did not enter into any securitisation activities to hedge credit risk on exposures qualifying for reduced weighting under the CRD. DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 129

129 Qualifying requirements for the use of particular instruments or methodologies Section 15.a (CRD, annex XII, part 3, point 1(a)) See Risk Management 2008, section 3.2. Section 15.b.1 (CRD, annex XII, part 3, point 1(b)(i)) See Risk Management 2008, section 4.4. Section 15.b.2 (CRD, annex XII, part 3, point 1(b)(ii)) The Group uses internal estimates in its day-to-day credit management and for calculating economic capital. See also Risk Management 2008, sections 3.2.2, 3.3.2, 4.4 and Section 15.b.3 (CRD, annex XII, part 3, point 1(b)(iii)) The Group includes all collateral to which a value is assigned in accordance with its internal procedures. The internal procedures fulfil the minimum requirements under the CRD. Guarantees are included if they imply lower risk weights than the original exposure. In addition, collateral is volatility-adjusted (haircut-adjusted) in order to take price volatility and the expected costs of compulsory sales of collateral into account. Section 15.b.4 (CRD, annex XII, part 3, point 1(b)(iv)) See Risk Management 2008, section 4.4. Section 15.c.1 (CRD, annex XII, part 3, point 1(c)(i)) See Risk Management 2008, section Section 15.c.2 (CRD, annex XII, part 3, point 1(c)(ii)) See Risk Management 2008, section Section 15.c.3 (CRD, annex XII, part 3, point 1(c)(iii)) See Risk Management 2008, sections and Section 15.c.4 (CRD, annex XII, part 3, point 1(c)(iv)) See Risk Management 2008, section Section 15.c.5 (CRD, annex XII, part 3, point 1(c)(v)) Not relevant since the Danish FSA has granted the Group a permanent exemption from the advanced IRB approach for equities. Section 15.d (CRD, annex XII, part 3, point 1(d)) The Group does not use the foundation IRB approach for any asset class. The exposures shown below are included in the Group s advanced IRB portfolio. CREDIT EXPOSURE (EAD) (IRB PORTFOLIO) At December 31 (DKr m) Institutions 324, ,155 Corporate customers 1,057, ,664 Exposures secured by real property 590, ,766 Qualifying revolving retail exposures 40,355 35,665 Other retail exposures 140, ,816 Securitisation 39,927 53,475 Other non-credit-obligation assets 20,174 30,034 Total credit exposure (EaD) 2,212,514 2,378,575 Note: Sampo Bank is included from January 1, APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

130 Section 15.e.1 (CRD, annex XII, part 3, point 1(e)(i)) The following tables are broken down by rating category. In 2008, the Group adopted a new rating scale with 11 categories instead of 10. The tables show 10 rating categories for purposes of comparison. The tables exclude other non-credit-obligation assets as this asset class cannot be broken down by rating category. CREDIT EXPOSURE (EAD) At December 31, 2008 (DKr m) Institutions Corporate customers Exposures secured by real property Qualifying revolving retail exposures Other retail exposures Total 1 20, ,088 24,718 3,457 3,901 31, , ,309 77,785 85,625 8,287 10,539 1, , , , ,874 8,120 20, , , , ,721 5,329 22,903 3, , , , ,898 4,931 20, , , ,854 95,274 6,033 32,880 1, , ,309 83,122 55,771 3,758 25, , ,935 2, ,364-19, , , ,641 2, ,667-26,023 Total 324,049 1,057, ,320 40, ,154 39,927 2,192,342 Note: Other non-credit-obligation assets amounted to DKr20,174m at the end of CREDIT EXPOSURE (EAD) At December 31, 2007 (DKr m) Institutions Corporate customers Exposures secured by real property Qualifying revolving retail exposures Other retail exposures Securitisation Securitisation Total 1 20,065 4, ,203 48,825 76, ,519 71, ,003 7,210 22,009 2, , , , ,195 8,374 37, , , , ,405 4,757 32,390 1, , , , ,489 6,783 42, , , ,886 43,193 3,797 25, , ,078 55,878 3,189 30, , ,488 5, ,915-19, , , ,091 1, ,255-6,795 Total 541, , ,766 35, ,817 53,476 2,348,542 Note: Other non-credit-obligation assets amounted to DKr30,034m at the end of DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 131

131 Section 15.e.2 (CRD, annex XII, part 3, point 1(e)(ii)) EXPOSURE-WEIGHTED AVERAGE LGD Exposures secured by real property Qualifying revolving retail exposures At December 31, 2008 (%) Institutions Corporate customers Other retail exposures Total Total Note: The securitisation asset class is not included because the Group uses mainly the ratings-based approach (see section 14 in this appendix). No LGD for other non-credit-obligation assets is applied as the risk weight is set at 100% in accordance with the rules under the IRB approach. EXPOSURE-WEIGHTED AVERAGE LGD Exposures secured by real property Qualifying revolving retail exposures At December 31, 2007 (%) Institutions Corporate customers Other retail exposures Total Total Note: The securitisation asset class is not included because the Group uses mainly the ratings-based approach (see section 14 in this appendix). No LGD for other non-credit-obligation assets is applied as the risk weight is set at 100% in accordance with the rules under the IRB approach. 132 APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

132 Section 15.e.3 (CRD, annex XII, part 3, point 1(e)(iii)) EXPOSURE-WEIGHTED AVERAGE RISK WEIGHT At December 31, 2008 (%) Institutions Corporate customers Exposures secured by real property Qualifying revolving retail exposures Other retail exposures Securitisation Total , , Total Note: For the asset class other non-credit-obligation assets, the risk weights are set at 100% in accordance with the rules under the IRB approach. Risk weights for securitisation exposures are based mainly on external ratings. EXPOSURE-WEIGHTED AVERAGE RISK WEIGHT At December 31, 2007 (%) Institutions Corporate customers Exposures secured by real property Qualifying revolving retail exposures Other retail exposures Securitisation Total Total Note: For the asset class other non-credit-obligation assets, the risk weights are set at 100% in accordance with the rules under the IRB approach. Risk weights for securitisation exposures are based mainly on external ratings. DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 133

133 Section 15.e.4 (CRD, annex XII, part 3, point 1(e)(iv)) UNUTILISED COMMITMENTS At December 31, 2008 (DKr m) Institutions Corporate customers Exposures secured by real property Qualifying revolving retail exposures Other retail exposures Total 1 13,775 5, ,234 1,430 18,640 43, ,565 16,501 1,392 6,744 2,084-83, ,858 33,280 1,631 5,661 3, , ,726 44,239 1,364 2,520 3, , ,966 1,106 1,853 3,030-30, ,416 19,299 1,065 1,838 5,056-28, , ,747-11, , Total 118, ,983 7,293 22,887 20,964 19, ,096 UNUTILISED COMMITMENTS At December 31, 2007 (DKr m) Institutions Corporate customers Exposures secured by real property Qualifying revolving retail exposures Other retail exposures Securitisation Securitisation Total 1 6,267 3, ,097 43,085 55, ,966 21,249 1,243 6,318 6, , ,116 37,459 1,683 5,610 10, , ,272 59,947 1,373 2,148 7, , ,197 26,446 1,723 2,130 8,795-48, ,341 20, ,239-29, , ,516-12, , Total 113, ,676 6,963 18,547 46,422 45, , APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

134 EXPOSURE-WEIGHTED CONVERSION FACTORS At December 31, 2008 (DKr m) Institutions Corporate customers Exposures secured by real property Qualifying revolving retail exposures Other retail exposures Total Total EXPOSURE-WEIGHTED CONVERSION FACTORS At December 31, 2007 (DKr m) Institutions Corporate customers Exposures secured by real property Qualifying revolving retail exposures Other retail exposures Securitisation Securitisation Total Total Section 15.f (CRD, annex XII, part 3, point 1(f)) See section 15.e.1-4. (CRD, annex XII, part 3, point 1(e)(i)-(iv)). DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 135

135 Section 15.g (CRD, annex XII, part 3, point 1(g)) ACTUAL VALUE ADJUSTMENTS (IRB PORTFOLIO) At December 31 (DKr m) Institutions Corporate customers 6, Exposures secured by real property Qualifying revolving retail exposures Other retail exposures 1, Securitisation - 10 Other non-credit-obligation assets - 8 Total 8,696 2,043 statement. Section 15.h-i (CRD, annex XII, part 3, point 1(h)-(i)) For the purpose of calculating risk-weighted assets under the IRB approach, the Group uses parameter values based on extended historical periods (through-the-cycle PD and downturn LGD and CF parameters). The tables in this section are based on these parameters. The asset class other non-credit-obligation assets is not included in the tables in this section because the risk weight is set at 100% in accordance with the rules for the IRB approach. The securitisation asset class is not included either because the Group uses mainly the ratings-based method for these exposures and therefore does not use internal estimates. EXPECTED LOSS VS. ACTUAL VALUE ADJUSTMENTS (IRB PORTFOLIO) Exposures secured by real property Qualifying revolving retail exposures At December 31 (DKr m) Institutions Corporate customers Other retail exposures Total 2008 Expected loss 182 3, ,911 6,591 Actual value adjustments 550 6, ,490 8, Expected loss 131 3, ,547 5,389 Actual value adjustments ,025 as new individual impairment charges plus write-offs charged directly to the income statement. EL is defined as the EL at the beginning of the period (January 1) on the basis of PD (through-the-cycle), LGD (downturn) and CF (downturn). 136 APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

136 The probability of default (PD) represents the probability that a customer will default on a loan within the next 12 months. PROBABILITY OF DEFAULT (PD) Exposures secured by real property Qualifying revolving retail exposures At December 31 (%) Institutions Corporate customers Other retail exposures Total 2008 Outcome Estimate Outcome Estimate estimated at the beginning of the year. Loss given default (LGD) is the loss on an exposure calculated as the percentage of the expected facility utilisation that will be lost if a customer defaults. LOSS GIVEN DEFAULT (LGD), GROSS Exposures secured by real property Qualifying revolving retail exposures At December 31 (%) Institutions Corporate customers Other retail exposures Total 2008 Outcome Estimate Outcome Estimate settled and individual impairment charges on defaults not yet settled. DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 137

137 The conversion factor (CF) represents the percentage of amounts not yet drawn that is expected to be drawn within the next 12 months. CONVERSION FACTOR (CF) Exposures secured by real property Qualifying revolving retail exposures At December 31 (%) Institutions Corporate customers Other retail exposures Total 2008 Outcome Estimate Outcome Estimate Section 16: Credit risk mitigation (CRD, annex XII, part 3, point 2) Section 16.a (CRD, annex XII, part 3, point 2(a)) Amounts due to and from the Group are offset when the Group has a legally enforceable right to set off a recognised amount and intends either to settle on a net basis or to realise the asset and settle the liability simultaneously. Section 16.b (CRD, annex XII, part 3, point 2(b)) See Risk Management 2008, sections 4.2 and 4.6. Section 16.c (CRD, annex XII, part 3, point 2(c)) See Risk Management 2008, table 4.16 (section 4.6). 138 APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

138 Section 16.d (CRD, annex XII, part 3, point 2(d)) CREDIT EXPOSURE (EAD) COVERED BY GUARANTOR OR CREDIT DERIVATIVES, BY RATING CATEGORY OF COUNTERPARTY At December 31, 2008 (DKr m) Total IRB approach: Institutions , ,988 Corporate customers , ,600 Exposures secured by real property Qualifying revolving retail exposures Other retail exposures ,984 1,289 1,592 7, ,503 Securitisation Other non-creditobligation assets IRB approach, total ,841 4,388 2,265 3,918 8, ,091 Standardised approach: Central governments and central banks 29,293 7,163 1, , ,797 Regional governments and local authorities Administrative bodies and non-commercial undertakings Multilateral development banks Institutions ,255-2, ,089 Corporate customers Retail customers Exposures secured by real property Past due items Securitisation positions , ,447 Other items Standardised approach, total 29,293 7,266 1,166 1, , ,313 Total credit exposure (EaD) 29,313 7,880 3,007 5,643 2,376 11,139 8, ,404 Note: In 2008, the Group adopted a new rating scale with 11 categories instead of 10. The tables show 10 rating categories for purposes of comparison. DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 139

139 CREDIT EXPOSURE (EAD) COVERED BY GUARANTOR OR CREDIT DERIVATIVES, BY RATING CATEGORY OF COUNTERPARTY At December 31, 2007 (DKr m) Total IRB approach: Institutions 6 1,240 2,339 7, ,971 Corporate customers , , ,165 Exposures secured by real property ,102 Qualifying revolving retail exposures Other retail exposures ,607 Securitisation Other non-creditobligation assets IRB approach, total 6 1,501 3,036 10, ,382 1, ,860 Standardised approach: Central governments and central banks 4,702 5, ,149 Regional governments and local authorities Administrative bodies and non-commercial undertakings Multilateral development banks Institutions Corporate customers Retail customers Exposures secured by real property Past due items Securitisation positions Other items Standardised approach, total 4,702 5, ,302 Total credit exposure (EaD) 4,708 6,707 3,304 10, ,424 1, ,162 Note: Sampo Bank is included from January 1, APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

140 Section 16.e-g (CRD, annex XII, part 3, point 2(e)-2(g)) CREDIT EXPOSURE (EAD) BY CREDIT-RISK-MITIGATION TYPE (AFTER VOLATILITY ADJUSTMENT) Eligible financial collateral Other eligible collateral At December 31, 2008 (DKr m) Guarantees Credit derivatives Real property Total IRB approach: Institutions 4, , , ,735 Corporate customers 2,601-16, , , ,462 Exposures secured by real property Qualifying revolving retail exposures ,662 15, ,954 Other retail exposures 13,504-8,388 9,269 7,155 38,316 Securitisation Other non-credit-obligation assets IRB approach, total 21,093-24, , ,869 1,225,467 Standardised approach: Central governments and central banks 39, ,382 Regional governments and local authorities Administrative bodies and non-commercial undertakings Multilateral development banks Institutions 1,485 2, ,591 6,679 Corporate customers Retail customers Exposures secured by real property Past due items Securitisation positions - 1, ,447 Other items Standardised approach, total 41,388 4, ,180 49,494 Total credit risk (EaD) 62,481 4,925 24, , ,049 1,274,961 DANSKE BANK RISK MANAGEMENT 2008 APPENDIX A 141

141 CREDIT EXPOSURE (EAD) BY CREDIT-RISK-MITIGATION TYPE (AFTER VOLATILITY ADJUSTMENT) Eligible financial collateral Other eligible collateral At December 31, 2007 (DKr m) Guarantees Credit derivatives Real property Total IRB approach: Institutions 10, , ,406 Corporate customers 27, , , ,320 Exposures secured by real property 3, ,743 66, ,302 Qualifying revolving retail exposures Other retail exposures 1, ,375 37,768 42,751 Securitisation Other non-credit-obligation assets IRB approach, total 42, , ,602 1,297,794 Standardised approach: Central governments and central banks 10, ,208 Regional governments and local authorities Administrative bodies and non-commercial undertakings Multilateral development banks Institutions Corporate customers Retail customers Exposures secured by real property Past due items Securitisation positions Other items Standardised approach, total 10, ,361 Total credit risk (EaD) 53, , ,662 1,308,155 Note: Sampo Bank is included from January 1, Section 17 (CRD, annex XII, part 3, point 3) Not relevant since the Group uses the standardised approach for operational risk. 142 APPENDIX A DANSKE BANK RISK MANAGEMENT 2008

142 DANSKE BANK A/S HOLMENS KANAL 2-12 / DK KØBENHAVN K / TEL CVR-NR KØBENHAVN /