Too good to be true?

Inflation is soaring at record high levels, interest rates are rising rapidly, the war in Ukraine is putting pressure on energy prices and equity prices keep falling.

Yet, despite all this turbulence the large Nordic banks delivered excellent results in the quarter with an average return on equity (ROE) of 12.5% and a cost-to-income ratio (C/I) of 42% (both figures are calculated excluding Danske Bank due to reasons we will explain below). Even OP, a cooperative, delivered a ROE of 11% that is quite remarkable and far above its target of 8.5%.

Chart 1: Key financial figures for Q3/2022. Source: The sample banks’ Q3/2022 interim reports.
FX rates as of 30 September 2022. Source: https://www.ecb.europa.eu/stats/policy_and_exchange_rates/html/index.en.html

There is, however, a quite simple reason for the stellar performance of the banks and that is their significantly improved net interest income (NII), driven by the rising interest rates in all Nordic countries.

Those are boosting the banks’ profits, especially by increasing the net interest margin the banks earn on the deposits they hold. The banks have not increased their deposit interest rates (funding cost to the banks) nearly to the same extent they have increased their lending interest rates (income to the banks). We already saw the first major benefits of this in Q2/2022, and the trend continued in Q3/2022 with double-digit growth of NII both in the quarter and during the first nine months of the year.

With Danske, SEB, DNB and OP, we can observe geographical concentrations, but given their well-diversified business mixes, we do not consider their risk levels to be elevated in a particularly significant manner.

It’s a mixed bag

With the rising interest rates, traditional retail banking is becoming profitable again and as mentioned above, the banks’ NII is increasing significantly. This is expected to continue in 2023 with additional positive effects on the banks’ income.

However, this is only one part of the story, and the negative consequences of the macroeconomic headwinds already show in some signs of distress in the banks’ income statements.

The falling equity prices and rising interest rates have caused significant turmoil in the capital markets and asset management businesses with lower asset valuations and falling fee income, especially from savings and investment services. These were still partly offset during the quarter by strong fee income from payment and card services that are benefitting from the post-pandemic recovery of consumer spending. However, if the economic downturn continues and inflation remains elevated, this may come under pressure again as consumers need to adjust their spending to the higher cost environment by cutting back on some discretionary items, such as travel and leisure.

The biggest risk, though, lies in the banks’ lending portfolios. While we are seeing additional provisions being booked and existing Covid-19 allowances being repurposed (rather than released) to the current macroenvironment, this will be the #1 risk for the banks in 2023, as we will discuss in more detail below.

Finally, light at the end of the tunnel for Danske Bank

The biggest news of the quarter came from Danske, which announced an additional provision of 14.0 bn Danish kronor (DKK) (on top of the DKK 1.5 bn provision made in 2018) for the expected regulatory fines related to its Estonian money-laundering breaches⁵.  While the amount – which equals EUR 2.0 bn – puts a massive dent in Danske’s financial figures for the quarter and the whole year, the news was greeted very positively by investors as Danske’s share price rose by more than 10% after the announcement. This is due to the fact that it now seems that Danske will finally be able to leave the scandal behind and focus on its business performance in a completely different fashion than it has for the past four years.

We agree that this is great news for Danske and are really eager to see what kind of strategic direction the bank will take when it updates its strategy to build on the Better Bank plan it has been focusing on during the last couple of years. According to Danske, their new strategy can be expected during 2023.

During the quarter, Danske also reported three additional major one-off items, that is, a write-off of DKK 1.6 bn and an additional operating expense of DKK 600 m combined with a loan impairment charge of DKK 650 m. The write-off is related to the goodwill of its life insurance business⁶,  and the expense and loan impairment charge are for its debt collection breaches. So, Danske is really wiping the slate clean now, and we hope this proves to be the point where their ascent back to being a winning business begins.

How are the banks prepared for the uncertainty ahead?

As we have repeatedly mentioned, the current macroeconomic backdrop is – to say the least – challenging, and a lot of uncertainties abound regarding the future. We believe that all the large Nordic banks are well prepared for any headwinds with strong capital buffers, sizeable loan loss allowances and conservative credit policies, including, for example stress testing for higher interest rates as a standard part of their credit processes. However, the business mixes of the banks are quite different, and we believe that some of the banks are more vulnerable to future shocks than others.

Nordea is by far the most diversified of the banks with its operations fairly equally spread across four Nordic countries (Denmark, Finland, Norway and Sweden) and across four different business divisions, that is private customers, small and medium-sized businesses, large corporates and asset management⁷.  Because of this, we believe that Nordea is best positioned for any market disruptions among the banks we analysed.

SHB and Swedbank are very concentrated on the Swedish mortgage and real estate lending businesses with major exposures in these sectors⁸.  While we do not currently foresee a major risk for extensive loan losses in Sweden, we do acknowledge that the risk level is elevated for both banks and also acknowledge the fact that the Swedish property prices have declined significantly during the year⁹.  As Sweden’s central bank is expected to raise its policy rate even further¹⁰,  putting more pressure on property prices, it is worth keeping an eye on the health of the credit portfolios of both SHB and Swedbank in the coming quarters.

In Denmark, Nykredit is in a similar situation with a major exposure to the local mortgage market¹¹.  The housing prices have decreased in Denmark as well¹²  so, as with SHB and Swedbank, credit risk management emerges as the main focus point for Nykredit in the coming quarters.

Concluding remarks

Q3/2022 provided another reminder of the strength of the Nordic banking sector. The banks remain profitable and, for the most part, are supported by the rising interest rate environment. On the other hand, as the economic environment keeps deteriorating, the risks for the banks are increasing, especially for those with highly concentrated business models.

The current situation highlights the importance of credit risk management in banking, and the coming quarters and years may well reveal whether all the large Nordic banks have stayed disciplined in their credit decision-making or if there have been cases of opportunistic volume and income growth pursuit in the highly competitive business environment. We truly hope the former holds and that the resilience of the banks will not be seriously tested during the coming economic slowdown.

We will certainly keep following the situation and keep you posted on the developments.

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[1] Nordea Bank (Nordea), Danske Bank (Danske), Skandinaviska Enskilda Banken (SEB), Svenska Handelsbanken (SHB), Swedbank, DNB, Nykredit, OP Financial Group (OP)
[2] Excluding regulatory costs, e.g. the Swedish bank tax and resolution fees
[3] Common Equity Tier 1 capital
[4] The figures include SHB’s total operation, i.e. they also include Denmark and Finland
[5] https://danskebank.com/news-and-insights/news-archive/company-announcements/2022/ca27102022a
[6] More specifically, to the acquisition of SEB Pension Denmark in 2017–2018.
[7] Served by Nordea’s Personal Banking, Business Banking, Large Corporates & Institutions and Asset & Wealth Management divisions.
[8] On aggregate 88% of SHB's and 78% of Swedbank's loans to the public are in these sectors (mortgages, housing associations, property management) and 64% and 71% in Sweden, respectively.
[9] https://www.bloomberg.com/news/articles/2022-10-20/sweden-s-home-price-slump-reaches-double-digits-led-by-houses?leadSource=uverify%20wall
[10] https://www.reuters.com/markets/rates-bonds/swedish-cbank-surprises-with-full-percentage-point-rate-hike-2022-09-20/
[11] 80% of Nykredit’s total assets are mortgages.
[12] https://www.bloomberg.com/news/articles/2022-11-09/danish-housing-market-cools-in-steepest-downturn-since-2011?leadSource=uverify%20wall